Ellington Credit Co (EARN) 2014 Q4 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by and welcome to the Ellington Residential Mortgage REIT fourth-quarter 2014 financial results conference call. Today's call is being recorded. At this time all participants have been placed in listen-only mode and the floor will be open for your questions following the presentation. (Operator Instructions). It is now my pleasure to turn the floor over to Jason Frank, Secretary. You may begin.

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 provisions 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 a 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 with me today on the call Larry Penn, 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, Jason. It is our pleasure to speak with our shareholders this morning as we release our fourth-quarter results. As always we appreciate your taking the time to participate on the call today.

First, an overview. Our interest rate hedges cost us in the fourth quarter and we lost $1.2 million or $0.13 per share on a fully mark to market basis. However, we maintained our core earnings at $0.76 per share again, comfortably covering our $0.55 dividend which equates to a 12% dividend yield based on our December 31 book value and a dividend yield of more than 13% based on our February 13 closing price.

As you know, we try to avoid directional bets on interest rates and we hedge our interest rate exposure primarily using a combination of fixed payer interest rate swaps and TBAs. Not only did interest rates drop quite a bit in the fourth quarter but realized volatility in the current coupon agency passthrough market spiked almost 50% in the quarter as compared to the third quarter.

While it helped a lot in this volatile environment to have a hedging portfolio that included a mixture of TBAs and fixed payer swaps as opposed to fixed payer swaps alone, our fixed payer swap hedges did weigh heavily on our performance during the quarter.

In our agency portfolio, we maintained our focus on 30 year specified pools which we believe offers substantial repayment protection and as usual we actively traded our agency portfolio to further enhance its composition and capitalize on inefficiencies. While specified pools performed reasonably well in the fourth quarter, we had expected them to perform better relative to our TBA hedges.

Meanwhile, our non-Agency portfolio contributed positively to our results benefiting from supportive fundamentals such as improving delinquency and foreclosure trends. Looking forward as you will hear from Mark, we have already seen some interesting developments in the new year including a meaningful increase in mortgage refinancings which is significantly enhancing the value of our specified pools relative to TBAs.

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 a 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 our fourth-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 will sometime refer to Ellington Residential by its New York Stock Exchange ticker, EARN 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. Though our core earnings was stable quarter over quarter, in the fourth quarter our hedges generated losses as interest rates declined. In the fourth quarter we had a net loss of $1.2 million or $0.13 per share. The breakdown was as follows: our core earnings was approximately $7 million or $0.76 per share, we had net realized and unrealized gains from our mortgage-backed securities portfolio of $14.1 million or $1.54 per share, and we had net realized and unrealized losses from our derivatives of $22.2 million or $2.43 per share excluding that portion which is related to the net periodic costs associated with our interest rate swaps.

Our derivatives are principally our interest rate hedges and are primarily comprised of interest rate swaps and short TBAs. For comparison in the third quarter, we had net income of $3.5 million or $0.39 per share. Our net income for the third quarter was composed of core earnings of $6.9 million or $0.76 per share, 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 of $42,000 or less than $0.01 per share.

Our net interest margin increased 11 basis points in the fourth quarter to 2.49%. This was driven by a 3 basis point increase in our average portfolio yield and an 8 basis point decline in our cost of funds for the quarter. Our portfolio yield benefited from increased cash flows on our non-Agency RMBS and to a lesser extent a catch up premium amortization adjustment related to our Agency RMBS. Our interest rate swap hedging costs were positively impacted by the decline in interest rates as well as the fact that the weighted average remaining term of our interest rate swaps declined by about six months to 8.6 years.

Additionally, we shifted our interest rate hedges a little bit during the fourth quarter and increased the weight of our TBA short position.

On our income statement, gains and losses from these TBA hedges are included in that realized losses on financial derivatives and change in net realized gains and losses on financial derivatives and they do not impact core earnings. During the quarter, we also generated positive income from our long TBA positions. This income is also not included in our core earnings and it amounted to approximately $1.7 million or $0.19 per share.

We ended the fourth quarter with a portfolio of assets totaling $1.393 billion, up slightly from the third quarter. To enhance our portfolio and generate training gains, we turnover approximately 20% of our agency portfolio during the fourth quarter as measured by sales and excluding principal paydown.

Our outstanding borrowings grew to $1.323 billion in the fourth quarter, up from $1.233 billion at the end of the third quarter resulting in an increase in our leverage ratio to 8.1 to 1 up from 7.3 to 1. However, if we adjust each period for unsettled security purchases and sales, our leverage ratios were 7.9 to 1 and 7.5 to 1 as of December 31 and September 30 respectively.

We have declared and paid dividends totaling $2.20 per share for the 2014 year. Based on our estimates, our taxable income for 2014 ran somewhat ahead of our dividends.

With that I will turn the presentation over to Mark.

Thanks, Lisa. During the fourth quarter, the biggest story in the bond market was the big drop in yield in the long end of the treasury curve. While TBA mortgages performed well, specified pool pricing didn't reflect the increase in prepayment risk associated with the decline in long-term interest rates. This left specified pools which offer investors prepayment protection to underperform their swap hedges. Despite a 35 basis point decline in 30-year mortgage rates, payout values fairly moved in the fourth quarter.

Within our Agency portfolio, our average pay up increased only 11 basis points in the quarter. Our weighted average coupon actually increased slightly and we increased the percentage of loan balance paper in the portfolio. The underperformance of prepayment protection values hurt our performance during the quarter but as often the case in the bond market, underperformance in one quarter can be reversed by outperformance in the following quarter. Since the end of the year, the refinancing index has increased materially revealing the risk to premium MBS that don't offer protection as prepayments increase.

As the refinancing index is increased payups have increased materially in 2015 reversing their fourth-quarter underperformance.

You can see this on slide 7 which shows the price spread between Fannie 4s, which are the most responsive and Fannie 4s are the least responsive to refinancing incentive. The graph shows how the market is following the trade-off between a small amount of extra yield provided by jumbo loan pools versus significant prepayment protection provided by low loan balance pools.

The blue line is the deferential in 30 seconds of a point or ticks between the two types of Fannie Mae 4% coupon bonds. The underlying borrowers had a 40 basis point incentive to refinance at the start of the fourth quarter and with rates dropping, that expanded to a 90 basis point incentive to refinance by early February 2015.

The jumbo pools are not TBA eligible so they trade at lower prices than TBAs. They are also the most responsive pools to a drop in interest rates. The underlying loan have an average balance of $520,000 in pristine borrower credit so borrowers with loans in this category realize the greatest dollar savings when they refinance at a lower rate and reduce their monthly payments and because they have the best credit, they are able to navigate the refinancing process most efficiently.

Additionally mortgage originators burdened by high fixed costs for each new loan

are more likely to target higher loan balance borrowers for refinancings in order to maximize profitability.

The low loan balance pools have an average balance of only $65,000, one-eighth the size of the jumbo pools. When prepayment risk is low, investors buy jumbos to get a little extra yield because they trade at a lower price than TBAs. In the most recent prepayment report, 2014 vintage jumbo pools paid at the 47 CPR and low loan balance pools paid at 4 CPR.

As you can see on slide 7 despite the drop in mortgage rates and the associated increase in incentive to refi during the fourth quarter, the jumbo low loan balance price spread really didn't move much in the fourth quarter. Since quarter end as refi indexes increased, the spread differential has increased a lot.

Going forward we expect a lot of volatility in payups and based on current interest rate levels, prepayment risk is definitely a concern.

Technology is also making prepayment risk more of a factor. Take a look at slide 8 entitled some efficient originators prepay faster. We have all heard a lot about how tight mortgage credit is and how difficult and time-consuming it is to get a mortgage now. In general that is true and Fannie Mae and Freddie Mac no longer offer streamlined origination programs comparable to what they had precrisis. But if you look on a more granular level, some of the non-bank originators have been able to lower origination costs and increase efficiencies to the point where borrowers with loans in their pools are significantly more responsive to refinance incentives compared to the market as a whole.

With these more efficient originators with low cost structures -- I'm sorry -- and these more efficient originators with low cost structures have been taking market share from less efficient originators. Quicken is the most dramatic example. Prepayment speeds on Quicken new production Fannie Mae 3.5 coupons ramped up into the 40s and 50 CPR, 10 times more than other originators. Quicken has been successful in increasing market share and over time they and other similar originators will make many borrowers more efficient in taking advantage of refi opportunities. So we expect to see a kind of slow increase in prepayment responsiveness occur over time as a greater percentage of new borrowers are touched by more efficient originators.

Remember, TBA mortgages are a cheapest to deliver pool. If Quicken pools are materially faster than the cohort and if the Fed (inaudible) they can quickly become the type of pool that gets delivered into TBA trades therefore determining the TBA price.

If you go through a refi wave, this whole process gets accelerated as more borrowers are out looking for new mortgages.

Another significant event in our last earnings call was the reduction in the FHA insurance premium. I will discuss this more in a minute but that development definitely puts policy risk back on the table as a factor that can affect prepayments.

The cumulative impact of these effects has led to faster prepayment speeds and more risk for the generic pools underlying TBAs and combined with the absence of Fed buying in higher coupon this has resulted in sharply lower roll levels for many higher coupon TBAs. You can see this on slide nine.

This shows you the yield an investor gets by annualizing the most recent monthly roll on Fannie Mae 4.5 coupons. The Fed has not settled any trades in this coupon since March 2014. Back then when the roll was high, the annualized yield was about 3.5%. Now with outfit sponsorship with faster prepayment speeds and with some non-bank originators putting some more responsive pools into the market, the roll has declined materially. The annualized yield is down to about 1.5%. This is another effect that really only started to see at the very end of last quarter and has been persistent into 2015. With such a notable drop in roll levels, specified pools are much more attractive.

We expect high rolls only in coupons where the Fed is buying a lot of the production. That is now Fannie Mae 3%s and 3.5%s. These are the longer duration mortgages so roll strategies are going to force investors into longer duration MBS. We like long TBA roll positions from time to time and we use them but only as a small part of our investment portfolio. It won't allow for a range of coupon and a range of asset durations.

As I just mentioned, the other significant development in the mortgage market since quarter end was the 50 basis point reduction in the FHA insurance premium. Our holdings were not directly impacted by this as we don't have any material holdings in Ginnie Maes. The bigger implication is that this ruling will make an inflection point in credit costs and credit availability. Since the credit crisis, mortgage credit has been tight and the cost of credit has gone up.

For years we have seen steady GC increases from Freddie and Fannie and steady insurance premium increases from FHA. The announcement in January marks a change. This is the government trying to support the housing market by further reducing mortgage costs. It is another prepayment risk investors who don't own pools with prepayment protection.

We think it is likely that Fannie and Freddie will respond with some reduction in the cost of Agency guarantee fees especially with the improved pricing information they now have from their risk transfer deals.

Moving on to how we manage our portfolio during the fourth quarter, we traded actively turning over about 20% of the Agency portfolio. As low loan balance payup prices lagged, increases in prepayment risk, we increased our holdings even though they already made up the vast majority of our agency pool holdings at the end of the third quarter. By the end of the fourth quarter MHA and loan balance protected pools made up almost 90% of our Agency pool holdings.

We continue to allocate a small portion of our capital to non-Agency mortgages where we primarily own deeply discounted jumbo and Alt A. That portfolio gives us some diversification benefits and enhances yield. Given that we own our non-Agency portfolio at an average dollar price of 64, our non-Agency portfolio can benefit from any loosening of the Agency credit box as more non-Agency borrowers are able to refinance into Agency loans.

Looking forward, we expect continued rate volatility. The market might have to contend with the Fed rate hike later this year; they might have to contend with the Greek exit from the euro. Prepayment volatility has also increased in 2015 driven not only by the drop in yields but also by increasing policy risk and the lower cost structures and better technology platforms of some mortgage originators. Against this backdrop we like the high quality prepayment protection in our portfolio which protects our net interest margin and we welcome the trading opportunities that we see in times of increased volatility.

With that I will turn the call over to Larry.

Thanks, Mark. While we experienced a moderate loss in the fourth quarter, I am pleased with our performance for the full year including our solid and consistent core earnings and our economic return on book value of almost 10%. Given that we have accomplished this while simultaneously focus on controlling interest rate risk, prepayment risk and government policy risk, we think these results are quite good.

And looking back over the nearly two-year period since our IPO, you can see that we have outperformed the Agency REIT peer group as a whole since our inception.

We believe that our active trading and dynamic hedging are the keys to our long-term outperformance. As the pace of mortgage refinancing has accelerated in early 2015, our specified pools have appreciated in value and so far have nicely outperformed our hedges.

Looking forward to the rest of 2015, while interest rate volatility and prepayment volatility each present distinct challenges, we believe that some real shocks in either category will bring numerous dislocations and thereby lots of opportunities for us. We are keeping an especially close eye on the Agency IO market where pricing levels are still relatively rich in our opinion but which could come under tremendous pressure if interest rates return to the levels we saw just late last month.

We are also always keenly mindful of potential policy risk. In fact, we have consciously avoided taking positions that we feel would leave us vulnerable to foreseeable policy risks such as expansions to HARP refinancing programs and loosening Agency underwriting standards.

Meanwhile we are able to be nimble given our size which should make it easier for us to reposition the portfolio quickly to take advantage of any opportunities that may suddenly arise including in niche sectors such as reverse mortgages or esoteric IOs.

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

(Operator Instructions). Steve DeLaney, JMP Securities.

So, Larry, when I look back at 2014 for EARN, I have to -- the first thing that strikes me is I think the cushion that you put up between your core EPS of just over $3 and your dividends paid at $2.20 is probably the widest in the mortgage REIT space. And I wanted to tie that into Lisa's comments that at year end or I believe you said, Lisa, correct me if I am wrong, that for 2014, that your actual taxable EPS did exceed the dividends paid. Did I care you correctly there?

So our taxable income runs kind of in between our core earnings and our dividend. So what I would say is when you look at our dividends, I would say it has been sized really more to our taxable income than to our core earnings. And the other thing I would say is that our dividend is also sized -- obviously we have to meet all the REIT tests so we need to distribute sufficient income but we want to leave ourselves a little room because we see over time we have sized our dividend to where we see a longer-term run rate in our taxable income. So that is what I think you should take out of this is that. And exactly where is it in between the core earnings and the dividend? I'm not in a position to say that now but it has been consistently in the middle, maybe even slightly closer to our dividend than it is to our core earnings.

Got it. That is helpful. Larry, certainly I think investors appreciate stability of the dividend as much as they do the level of the dividend.

Lisa, could you help me understand as far as the difference between core and taxable, I don't want to take us into the weeds with a lot of tax stuff but are there one or two items that cause taxable to be less than core on a rolling basis?

It is mostly fees related to the amortization on our bond portfolio under tax versus GAAP. That is the primary difference.

Is that premium amortization or is that discount accretion?

I'm sorry, premium amortization.

So the way that it works is that the agencies actually publish the tax factors for their pools. And what we found is -- and I can explain why I think this is the case -- what we found is that they tend to use prepayment assumptions, long-term prepayment assumptions that are a little faster than what the accountants would have. So they are actually if you will the implied yield that they are reporting to the IRS is a little lower than the yield that the accountants have us amortize our premium at. And eventually it all evens out but -- and when you sell pools, you are going to make up the difference as a realized tax gain or loss but that is not what drives the dividend. What drives the dividend is the more ordinary REIT income and excluding the realized part of it.

That is very helpful. I didn't understand that you were facing a meaningful difference there between tax and GAAP on the MBS amortization.

Let me just switch to one other thing and this is kind of big picture but hedging is obviously something that you guys spend a lot of time thinking about. We have been seeing more of the mortgage REITs, the Agency and hybrid guys shift from traditional fixed pay swaps into Eurodollar futures. And looking at your portfolio, you are clearly in the camp of saying okay, we are going to use swaps and we are going to use short TBAs as our primary hedging tools. I am just curious why you see the benefits of traditional swaps versus the EDFs?

Steve, it is Mark. So we like the Eurodollar futures when we are hedging risk say two years and shorter. So as opposed to two years swaps, there we probably have Eurodollar futures, they are a little bit less liquid but the portfolio right now, it doesn't have a lot of hybrids and it doesn't have a lot of 15 year. So most of our interest rate exposure is on parts of the curve where the Eurodollar futures really don't match up with the duration. So I would say two years [NIM], we like Eurodollar futures but most of the exposure right now is a little bit further on the curve than that.

Got it. So it is really not a question of margin and everything else, it is really a matter of having an effective hedge versus what you own?

Yes. So if we had -- if arms cheapened up, if we owned a lot more arms then I'm sure we would have a lot more Eurodollars.

Got it. That is very helpful. Okay. Thank you for the comments.

Richard Eckert, MLV & Co.

I want to thank you for the color on that last question. Also wanted to ask about the leverage. It kicked up in the last quarter. Can I expect to see that come back down into the mid-7s where it has run for most of the last year?

So what I mentioned in my remarks, Rick, was that if you look at the fourth quarter compared to the third quarter adjusting for unsettled sales and purchases, the leverage ratio was 7.9 and 7.5 respectively. That has been sort of the range that it has been in over the last couple of years actually.

So we still owned some pools that we have sold but the sale was awaiting settlement. Usually when you sell pools you sell them at the same type of -- I used to call them PSA dates, I don't know what they are called now -- the same dates that the TBAs settle. And so you have a lot of forward sales that are pending settlement at any given month end. We don't have any more risk on the portfolio and of course we have a receivable for the securities that we have sold forward and we are going to use those proceeds to pay off a borrowing but we still have that borrowing at month end.

So it sort of artificially increases our leverage and depending upon the sales activity of a particular month versus the month before, it could make our leverage move around a little bit. So I would say that we would encourage people to break out from the leverage because it will create a more even picture -- the borrowings that are related to security sold forward.

Okay, thank you very much.

Jim Young, West Family Investments.

I was just wondering as you look at 2015 and the risks that are apparent in the marketplace, how do you assess the different risks that you feel are potentially impacting the portfolio? Which of these risks including some of the tail risks are you hedging for and which of the risks out there in the marketplace are you willing to assume for the portfolio? Thank you.

Jim, it is Mark. I think what we have seen so far in 2015 is US interest rates being much more impacted by events outside the US than we saw earlier in the year. That is a risk we are not willing to take. We will do that by trying to hedge our interest rate exposure on an aggregate basis but also different points on the curve. You might see us from time to time add volatility hedges.

The other risk I think we have is that it seems like there has been a little bit of a drifting apart between market yield levels -- (inaudible) this past week between market levels and the docs the Feds put out. So potentially in June, potentially later in the year, there will be some reconciliation there.

So I think you can have a lot of interest rate volatility this year and it is not clear what direction things will go. A lot of people are talking about US 10-year is so cheap versus (inaudible) [bonds], but then on the other hand, you look at US interest rates and you potentially have a fed that might raise rates in June, which argue that rates should be higher. So I think that is a risk we are not willing to take.

The risks that we want to take that we think we will get paid to take, you have also seen big changes in prepayment expectations and how the market values that and we see from time to time the market undervaluing it, sometimes the market overvaluing it. That we want to actively reposition the portfolio if those opportunities exist.

The other thing I think you can see, you can also see there is some uncertainty around when the Fed might stop reinvesting its principal paydowns. So just what they have said to date is that they plan on reinvesting their principal payment down at least through the first interest rate increase. But it is not clear how long there after that that will increase. How long after that they will keep reinvesting. So that can introduce a lot of basis risk to the mortgage market and that is something that you can hedge a little bit by increasing your amount of TBA hedges. But that is a risk that we will want to take some of and we think that that is a risk that volatility on a mortgage basis will present us with opportunities this year.

Let me add one more thing. If you look at the percentage of IOs that we have right now in the portfolio, on our capital base maybe it is only 6% of our capital is in IOs. And in terms of the types of risk that we would be willing to take if the opportunity arises, we could increase that to 30% of our capital. That would be a huge increase and look, IOs our risky, they are a lot riskier than buying pools.

But based upon our experience in the market going back really now 30 years and 20 years at Ellington, that is exactly the kind of risk that we think where we do have a competitive edge in assessing that risk. And we again should the opportunity be compelling enough we could take that position up very significantly and there I think the risk profile of the Company would be higher but at the same time I think the reward profile of the Company would be higher as well.

Okay, thank you.

(Operator Instructions). There are no further questions at this time. Ladies and gentlemen, this does conclude Ellington Residential Mortgage REIT's fourth-quarter 2014 financial results conference call. Please disconnect your line at this time and have a wonderful day.