Ellington Credit Co (EARN) 2014 Q3 法說會逐字稿

Good morning, ladies and gentlemen, thank you for standing by. Welcome to the Ellington Residential Mortgage REIT third-quarter 2014 financial results conference call. Today's call is being recorded. (Operator Instructions). It is now my pleasure to turn the floor over to Lindsay Tragler, Vice President of Investor Relations. You may begin.

Thank you. Before we start I would like to remind everyone that certain statements made during this conference call may constitute forward-looking statements within the meaning of the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical in nature.

As described under Item 1A of our annual report on Form 10-K filed on March 21, 2014, forward-looking statements are subject to variety of risks and uncertainties that could cause the Company's actual results to differ from its beliefs, expectations, estimates and projections. Consequently, you should not rely on these forward-looking statements as predictions of future events.

Statements made during this conference call are made as of the date of this call and the Company undertakes no obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

I have on the call with me today Larry Penn, our Chief Executive Officer of Ellington Residential; Mark Tecotzky, our Co-Chief Investment Officer; and Lisa Mumford, our Chief Financial Officer. With that I will now turn the call over to Larry.

Thanks, Lindsay. It's our pleasure to speak with our shareholders this morning as we release our third-quarter results. As always, we appreciate your taking the time to participate on the call today. First a few highlights.

We earned $3.5 million or $0.39 per share on a fully mark-to-market basis in the second quarter. We maintained our $0.55 dividend which equates to a 12% yield based on a September 30 book value and a yield of more than 12% based on Friday's closing price.

Through September 30, our year-to-date earnings per share totaled $1.90, more than covering our $1.65 in dividends paid. In our agency portfolio our holdings of higher coupon specified pools continued to perform well during the third quarter and, as usual, we actively traded our agency portfolio to further enhance its composition and generate trading profits.

Our non-agency portfolio contributed positively to our results, benefiting from supportive home price appreciation and foreclosure trends. Looking forward, as you will hear from Mark, we've already seen some interesting developments in the market in the fourth quarter, including a steep drop in mortgage rates.

We will follow the same format as we have on previous calls. First, Lisa will run through our financial results. Then Mark will discuss how the residential mortgage backed securities market performed over the course of the quarter, how we positioned our RMBS portfolio and what our market outlook is. Finally, I will follow with some additional remarks before opening the floor to questions.

As described in our earnings press release we have posted a third-quarter earnings conference call presentation to our website, www.earnreit.com. You can find it in three different places on the website: on the homepage, on the For Our Shareholders page, or on the presentations page. Lisa and Mark's prepared remarks will track the presentation, so it would be helpful if you have this presentation in front of you and turn to slide 4 to follow along.

As a reminder during this call we'll sometimes refer to Ellington Residential by its New York Stock Exchange ticker, E-A-R-N, or EARN for short. Hopefully you now have the presentation in front of you and open to page 4 and with that I'm going to turn it over to Lisa.

Thank you, Larry, good morning, everyone. In the third quarter we generated net income of $3.5 million or $0.39 per share. Our net income for the quarter was composed of core earnings of $6.9 million or $0.76 per share offset by net realized and unrealized losses on mortgage-backed securities of $3.4 million or $0.37 per share. And net realized and unrealized losses on our interest-rate hedging derivatives, excluding that portion related to the net periodic cost associated with our interest-rate swap of $42,000 or less than $0.01 per share.

While core earnings was up slightly from the second quarter, $6.8 million or $0.75 per share, net income was lower than the second quarter's $11.1 million or $1.21 per share. The $0.01 increase in our core earnings per share in the third quarter was mainly due to a decline in our swap funding cost. Over the third quarter our average notional swap holdings declined slightly.

In the third quarter interest income related to catch-up premium amortization was approximately $150,000 or $0.02 per share whereas last quarter it was negligible. The increase in interest income from catch-up premium amortization was offset by a slight decline in the yield of the portfolio and, as a result, interest income was essentially flat quarter over quarter.

In the third quarter our net interest margin increased 5 basis points to 2.38%. Excluding the catch-up premium amortization our net interest margin for the quarter was 2.34%. The unleveraged yield on our agency portfolio was 3.24% over the third quarter. Over the quarter the yield on our non-agency RMBS portfolio was 10.2% and, additionally, our earnings benefited from net realized and unrealized gains in this portfolio during the quarter.

We ended the third quarter with a portfolio of $1.368 billion, essentially unchanged from the second quarter. During the third quarter we turned over approximately 25% of our agency portfolio as measured by sales and excluding principal pay downs. Turnover in our non-agency portfolio was lower at only 11% for the quarter. The amount of turnover can vary significantly from quarter to quarter depending on the trading opportunities that we see in the market.

We slightly reduced our outstanding borrowings and as a result our debt to equity ratio dropped from 7.5 to 1 at the end of June to 7.3 to 1 at the end of September. Year to date we have declared and paid dividends totaling $1.65 per share for the first three quarters of 2014. We estimate that our year-to-date taxable income is running somewhat ahead of our year-to-date dividend. With that I turn the presentation over to Mark.

Thanks, Lisa. We had a solid quarter. Two key themes that we identified at the beginning of the quarter helped drive our returns. The first theme was that prepayment protection was very cheap and the second was that we believed that the Federal Reserve's gradually shrinking footprint in the Agency RMBS market would create relative value opportunities for us. Both factors contributed to strong performance.

Before we discuss our portfolio's evolution during the quarter, I want to show you a few slides of interest that help explain our thinking. First slide 7. This is an amazing chart that shows the change in mortgage prepayment responsiveness as measured by refinancings for the past 12 months versus the previous 12-month period. The lower black line is the past year.

You can see that mortgages have been surprisingly unresponsive to prepayment incentives, like low interest rates, during the past year. And to put this in a historical perspective, if we were to put a line on here to show the responsiveness of mortgage prepayments say 10 years ago it would be way off this chart.

Mortgage prepayments used to be much, much more responsive to refi opportunities and lower rates than they are now. There are a variety of contributing factors: mortgage rates have been higher in the past 12 months that the previous 12 months; there's been some burn out; a slew of multibillion-dollar settlements and a mountain of regulation have originated deathly afraid of loan put backs as they are unwilling to loosen credit; the cost of origination has skyrocketed in the face of increasing compliance burdens.

This market -- the market seems to have a pretty short memory about how quickly mortgages can prepay during a refi [weighting]. This lower black line, the regime of unresponsive mortgages, is what seems to be driving investors' thinking now when they price mortgages. But there have been two very interesting developments post quarter end.

First, Mel Watt, Director of the FHFA, delivered a speech outlining upcoming initiatives to make mortgage credit more widely available and to reduce the risk that originators will be required to repurchase mortgages. Second, we experienced a rapid drop in interest rates in the middle of October.

Look at the graph on the left of slide 8; all of a sudden you saw a sharp uptick in the refi index when rates dropped. This was the degree of prepayment responsiveness that we had not recently seen. And what is most interesting is that the spike in the mortgage refi index was driven by the cohort of larger loans within the Fannie/Freddie mortgage universe.

There was a massive jump in the average balance of loans that borrowers are trying to refinance. It had been hovering around $220,000 in one week and in one week it spiked to over $300,000. We think there are a few important takeaways here.

First, I think with Chairman Watts' speech the trough in mortgage prepayment response sluggishness is now behind us; it was in the past 12 months. While the compliance burdens and costs are still a very significant damper on prepayments we think they will loosen.

Another takeaway from these graphs is that as repayment responsiveness increases the refinancings will be increasingly tiered by loan balance. Part of this is a natural response by originators who are faced with higher -- faced with higher fixed cost of compliance focus on customers with higher loan balances. And part of that is natural response by borrowers who have greater incentive to refinance higher loan balances from the standpoint of time and effort per dollar of savings.

So we don't think prepayment response will increase uniformly. We think the largest cleaner loans will be vastly more responsive. That argues for maintaining our strategy of paying the still low cost to buy significant prepayment protection for our portfolio.

Now this increase in refinancing speeds might not occur -- rates may rise, mortgages may move out of the money and then as the incentives to prepay dissolve responsiveness becomes a hidden variable, not one you can observe. If you don't give borrowers a rate incentive to refi you never really know how responsive they are going to be.

But we structure and hedge our portfolios with the assumption that the future path of rates is unknowable. We try to construct portfolios that will generate solid returns over a range of future interest rate scenarios.

Think back to the start of this year, there was a rare consensus among interest rate forecasters that interest rates would rise. Instead quite the opposite occurred. Portfolios constructed for rising rates at the start of this year would have performed very poorly.

As you can see from slide 12, the portfolios grew slightly during the quarter. Slide 12 shows that we continue to get most of our prepayment protection from lower loan balance paper.

This is a time tested form of prepayment protection that is largely impervious to any changes in FHFA policies. And as we saw in the earlier slides, the sluggish prepayment responsive mortgages this past year has kept this prepayment protection inexpensive despite the decline in mortgage rates and despite the shrinking Fed footprint.

But it isn't quite as inexpensive as it was at the start of the quarter. Pay ups did appreciate modestly in the quarter which helped our performance. The prepayment speeds on our portfolio continued to be very low, at only 5.35 CPR for the quarter that is only a 1.35 CPR increase from the second quarter despite the typical summer increase in prepayment fees.

Additionally, opportunities to actively manage still abound and we turned over 25% of the portfolio during the third quarter as we constantly try to monetize inefficiencies and pricing discrepancies.

Looking forward we think the rates market will present us with continued volatility. Exogenous challenges to US growth are difficult to quantify and since quarter end there has been a mildly schizophrenic nature to US interest rates with two competing stories: one, a stronger US growth in job creation; and a competing narrative of weaker growth abroad that could ultimately impact US growth.

As always we try to construct and manage portfolios to perform over a range of potential economic scenarios as opposed to having a single minded view of what the future will hold. The future path of interest rates is impacted by multiple factors, many of which are impossible to forecast. So managing for a range of outcomes is in our opinion the best way to simultaneously drive shareholder returns and preserve book value.

The Fed's footprint has shrunk but it is still large. By reinvesting pay downs in TBAs you will be buying many of the worst quality new production mortgage pools which makes the rest of the market more valuable for other investors. The stock effect to their holdings also creates strong technical demand. This should support mortgage valuations and we believe our portfolio should benefit. With that I'll turn the call over to Larry.

Thanks, Mark. I'm extremely pleased with our strong consistent performance in the year and a half since our IPO. For the past six quarters, including the quarter when we went public, we have delivered an economic return on book value of 8.5% while the average economic return for our agency REIT peers over the same period is actually negative.

Active trading and dynamic hedging, which enabled us to avoid the sizable book value decline suffered by many of our peers in 2013, continue to drive our stability and outperformance. Even this past quarter when interest rates were relatively stable we were still able to outperform the peer group on an economic return basis with economic return on book value at a solid 2%.

Looking forward, with the Fed no longer a net buyer of Agency RMBS or treasuries, we see the potential for increased volatility and we believe that an interest rate or prepayment shock will bring numerous dislocations. With our active trading style we believe that some volatility in dislocations will generate lots of opportunities for us.

If interest rates rise our TBA shorts and long dated swap hedges should protect us. If interest rates fall our prepayment protected pools should protect us. Either way we would hope to be able to take advantage of dislocations, just like we did in the middle of last year, to pick up assets when other market participants are forced to sell at distressed levels.

On October 15, after quarter end, we saw a remarkable move in interest rates. The 10-year treasury yield plunged from about 2.20% to about 1.90% in less than three hours. If that drop in interest rates had lasted we surely would have seen some very significant dislocation in many of our markets and perhaps most of all in the IO markets.

Well, the drop in interest rates didn't last. In fact, about six hours later, amazingly, that 30 basis point movement had almost entirely been retraced and the IO market basically shrugged the whole thing off.

And as you can see on slide 11, our IO position at quarter end was roughly unchanged from the prior quarter end at around $14 million in market value. Our current IO holdings are low because pricing levels are still relatively rich in our opinion. We are always keeping a close eye on the IO market and the rest of the MBS derivatives market as well.

We look forward to increasing our IO position when the time is right, but for now we believe that patience is the best course of action. As Mark demonstrated earlier, the rumors of the demise of prepayment risk may be greatly exaggerated.

The FHFA is poised to make refinancing more attractive for both borrowers and lenders and meanwhile interest rates are now positioned at dangerously low levels. They are actually not too far above where they were back in the first quarter of 2013 when refinancings were still booming.

This concludes our prepared remarks and we are now pleased to take your questions. Operator?

(Operator Instructions). And we have no questions at this time. Ladies and gentlemen, this concludes Ellington Residential Mortgage REIT's third-quarter 2014 financial results conference call. Please disconnect your lines at this time and have a wonderful day.