Ellington Credit Co (EARN) 2015 Q1 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT first-quarter 2015 financial results conference call. Today's call is being recorded. At this time, all participants have been placed in a 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 Lindsay Tragler, VP 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 12, 2015, 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 on the call today Larry Penn, our Chief Executive Officer; 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 is our pleasure to speak with our shareholders this morning as we release our first-quarter results. As always, we appreciate you taking the time to participate on the call today.

First, an overview. It was a good quarter for EARN, particularly given the high levels of interest-rate volatility that impacted the market and we earned $3.7 million or $0.40 per share on a fully mark-to-market basis. Our core earnings of $0.66 per share comfortably covered our $0.55 dividend, which equates to a 12% yield based on our March 31 book value and a yield of more than 13% based on our May 4 closing price.

In our agency portfolio, we benefited from the strong performance of our holdings of specified pools, which we still believe offer substantial prepayment protection. The surge in refinancing activity in the first half of the quarter served as a reminder that prepayment risk is still significant and enhanced the value of our specified pools relative to our short TBA hedging portfolio.

The first quarter's volatility also created trading opportunities for us as we turned over 25% of our agency portfolio to further enhance its composition and capitalize on inefficiencies. Meanwhile, our non-agency portfolio again contributed positively to our results as the non-agency market continued to benefit from a lack of new issuance, as well as supportive fundamentals such as improving delinquency and foreclosure trends.

Looking forward, as you will hear from Mark, we expect specified pools to continue to outperform in the near to medium term and we remain positioned accordingly. 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've 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 posted a first-quarter earnings conference call presentation to our website, www.EARNREIT.com. You can find it at three different places on the website -- on the homepage, on the For Our Shareholders page or on the Presentations stage. 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 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 opened to page 4 and with that, I'm going to turn it over to Lisa.

Thank you, Larry. Good morning, everyone. In the first quarter, we generated net income of $3.7 million or $0.40 per share. The components of our net income were as follows. Our core earnings totaled approximately $6 million or $0.66 per share, net realized and unrealized gains from our mortgage-backed securities portfolio were $11.9 million or $1.30 per share and we had net realized and unrealized losses from derivatives of $14.3 million or $1.56 per share, excluding the net periodic costs associated with our interest rate swaps. This is a significant improvement over the fourth quarter when sharp losses in our interest rate hedging portfolio had driven a net loss of $1.2 million or $0.13 per share.

Our fourth-quarter net income had been comprised of core earnings of $7 million or $0.76 per share, net realized and unrealized gains on mortgage-backed securities of $14.1 million or $1.54 per share and net realized and unrealized losses on our interest rate hedging derivatives of $22.2 million or $2.43 per share.

Our first-quarter core earnings declined by approximately $1 million or $0.10 per share. This drop resulted from a decrease in our net interest income of $1.6 million or $0.18 per share, which was partially offset by a decline in our swap cost of $360,000 or $0.04 per share and a decrease in our operating expenses of $331,000, also $0.04 per share. Our first-quarter net interest margin decreased to 2.21%, down 28 basis points from 2.49% in the fourth quarter. This decline was driven by a 29 basis point drop in our average asset yield, which was only slightly offset by a 1 basis point decline in our quarterly cost of funds.

With respect to our average asset yields, in the first quarter, our overall yield was 3.14%, including a reduction resulting from a premium amortization catch-up adjustment of $440,000 or approximately 13 basis points. Conversely, last quarter, our catch-up amortization adjustment was a positive $186,000 or 6 basis points. The remaining 16 basis point decrease in our first-quarter average yield was principally related to a decline in yields of purchased and held agency RMBS assets.

As I mentioned, our cost of funds decreased slightly in the first quarter to 0.93% as compared to 0.94% in the fourth quarter. Essentially our cost of repo increased by 2 basis points, but the cost of our interest rate swaps declined by 3 basis points. Our swaps were impacted by a decline in interest rates, as well as the fact that the weighted average remaining term dropped by about 1.2 years to 7.3 years. I also mentioned that our first-quarter expenses were about $0.04 per share lower than they had been in the prior quarter. The decline resulted from lower professional fees.

While our core earnings decreased by $0.10 during the first quarter, our estimated taxable income for the quarter was in the low $0.60 per share and as you know, our first-quarter dividend was $0.55 per share, so our core earnings comfortably covers both our taxable income and the dividend. The size of our portfolio was relatively unchanged at $1.39 billion, although we did actively trade our agency RMBS portfolio, generating net realized gains of $6.7 million.

Agency portfolio turnover, which represents sales, excluding paydowns, was 25% for the quarter. Our outstanding borrowings decreased slightly to $1.2 billion at the end of the first quarter from $1.3 billion at the end of the fourth quarter and as a result, our leverage ratio declined to 7.5 to 1 from 8.1 to 1. However, if we adjust each period for unsettled security purchases and sales, our leverage portfolio actually increased ever so slightly to 8.0 to 1 at the end of March from 7.9 to 1 at the end of December.

With that, I turn the presentation over to Mark.

Thank you, Lisa. With the significant interest rate volatility that we saw during the first quarter, the period had the potential to be very challenging for agency REIT managers. Volatility was as high as it has been for quite some time and the chart of the 10 years course over the quarter looks a bit like a roller coaster ride. For many it was. Even though the change between the quarter's beginning and ending yields wasn't enormous, the distance traveled was large. The 10-year yield peaked at 224 and fell to a low of 164. That is a total swing of 60 basis points during the first quarter. That is a challenge for mortgage REIT managers who typically earn spread income by owning higher-yielding MBS negative convexity and hedging them with lower yielding swaps with positive convexity.

To produce returns in this environment, which was not a particularly hospitable one for agency MBS investors, we don't just aim to capture mortgage spread or market data; we seek to manage EARN to generate significant alpha first and foremost through smart portfolio construction and second, through opportunistic trading to capture inefficiencies and improve portfolio composition.

It is challenging to manage agency MBS portfolios through periods when interest rates move dramatically because the portfolio construction that captures a big net interest margin while the markets are improving also can expose you to greater book value to clients in times of turbulence. We've tried to design our portfolio to simultaneously capture a healthy NIM without taking undue interest rate risk. A big part of this is accomplished on the hedging side of the portfolio by our significant use of TBA shorts where we essentially buy back a significant chunk of the negative convexity of our agency pools.

This portfolio construction helped us in two ways during the first quarter. First, in January, we benefited from a rallying market from the duration of our TBA shorts declined faster than the duration of our long pool portfolio. Second, in early February, when the 10-year note made a U-turn and surged after bottoming at 164 at the end of January, the duration of our portfolio shorts increased faster than the duration of our loan portfolio reducing the need for costly delta hedging.

Our ability to select not only attractive assets, but also effective hedges for those assets has always been an important driver of our returns. We benefited greatly from our asset hedge pairing during the first quarter. For example, if you look at slide 7 labeled since the beginning of the year, payups have increased, but interest rates have retraced, this slide shows the relative performance from the start of the year through the end of April of a typical specified pool in our portfolio, namely Fannie Mae 30-year medium loan balance 4s or Fannie Mae MLB4s. MLB pools are pools where all the underlying loans had an original balance of $110,000 or less, so they tend to be less reactive to refinancing opportunities than pools with larger loans since both borrowers and lenders are less motivated in absolute dollar terms to refinance smaller loans.

On the graph, the blue line shows the payups and ticks for Fannie Mae MLB4s over Fannie Mae TBA4s. The scale for that dark blue line is shown on the Y axis on the right. The maroon line shows the yield on the 10-year note with an inverted scale, lower yields shown on the Y axis on the left. I am sorry -- lower yields on the top, higher yields on the bottom. The scale for that maroon line is shown on the Y axis on the left, so yields are currently well above the lows they reached earlier this year, but in fact you can see they are very close to where they started the year.

But you can see payups are much higher than where they started the year. Now why is that? It is because not only did prepayments spike in the middle of the quarter, but even as interest rates have risen since then, prepayments have remained significantly higher than they were towards the end of last year. So understandably the perceived value of prepayment protection has increased relative to late last year and you can see that clearly on the graph and the way that payups have performed this year.

Now what is interesting is that it isn't as though the absolute price of medium loan balance Fannie 4s has increased much, but their price is up relative to TBAs. Look at slide 8, this shows the same time series in blue, mainly the payups for Fannie MLB4s relative to TBAs, but the maroon line is now just the price of TBA Fannie 4s. What is interesting is that you had a big move up in the payup, but the TBA4s actually fell in price over this time period.

What that means is that to capture this movement to generate returns from this repricing, you couldn't just own medium loan balance 4s and hedge 4s, hedge them by paying fixed [done] swaps. Instead, you had to own medium loan balance 4s and hedge them with TBAs. The actual prices of these pools didn't move significantly compared to interest rates since the start of the year. So to capture this return, it wasn't just simply a matter of owning the right asset; it was also a matter of owning the right asset and putting the correct hedge in place.

TBA hedges on Fannie 4 drove the profitability and were the key to capturing the increase in the value of prepay protection. Because the Fed is no longer a net buyer of mortgages, they are just reinvesting principal payments from their existing portfolio, we think we will see more opportunity for relative value trading of this kind.

Our first-quarter results were driven by strong performance in many sectors of our specified pool portfolio as the value of prepayment protection increased in response to the overall rise in prepayment speeds. The drop in mortgage rates, combined with government policy actions intended to encourage refinancings, created a tipping point for mortgage refinance ability in January and the refinancing index increased sharply, which also weighed on TBA performance.

This was in marked contrast to the fourth quarter when the interest rates dropped substantially, but refinancing activity didn't change. The increase in prepayments in early 2015, coupled with the lack of Fed purchasing of some higher coupons like 30-year 4s in particular, caused TBAs of these coupons to underperform their rate hedges. Specified pools outperformed as the higher realized prepayments and lower roll levels in many coupons led investors to seek the better carry and better convexity of many sectors of the specified pool market.

A prepayment trend that we addressed in our fourth-quarter earnings call continued in this first quarter. Depending on which company originated their services alone, certain mortgage loans are showing very significantly more refinance ability than market averages. There has been a lot written about how tight mortgage credit is and how hard it is to qualify for a mortgage and that is largely true, but there have also been some very successful initiatives on the part of some mortgage originators, especially some of the non-bank originators to bring down the cost of the entire refinancing process from reaching out to borrowers eligible for refinancings all the way to closing the new loan.

Technological innovation is a major driver here. While the mortgage industry is burdened by a tremendous amount of regulation and for many, it is still document-intensive with forms faxed from borrower to lender, there are more and more lenders that are trying to improve technology, improve their workflow and we are seeing evidence of this when we dissect prepayment reports. This trend has been in place for at least a year now and it seems to be gathering steam. For us, it means we have to be even more careful about what we buy and we have to constantly pour over data to spot trends early on.

In addition to variation by servicer or originator, increases in prepayments were not uniformly distributed among coupon or issue year vintages. Many of the newer vintages showed a very sharp increase in prepayment speeds while some seasoned vintages were less reactive. As a result, the relative price movements of specified pools were not uniform. Some forms of prepayment protection appreciated and priced materially in the quarter while prices of certain other forms were largely unchanged. We were well-positioned for these moves at the start of the quarter and we were able to monetize many of these changes.

Market volatility also presented us with trading opportunities and we turned over about 25% of our portfolio. Agency MBS didn't perform particularly well in the first quarter, but volatility and dislocation gave rise to opportunities for us to capitalize on trading inefficiencies and capture output to enhance our returns. There were movements in payups and interquarter mispricings to take advantage of.

Nevertheless, on slide 11, you can see that based on quarter-end snapshots, our loan portfolio composition didn't change that much quarter-over-quarter. Going forward, we expect volatility. The market is schizophrenic and for good reasons. The US economy is improving and so the Federal Reserve has put the market on notice that they could raise rates as early as June, but meanwhile quantitative easing in Europe and Japan is keeping yields incredibly low on high-quality foreign sovereign bonds. In fact, much lower than US treasury yields.

In the face of this uncertainty, our strategy is to try to construct portfolios that don't have a lot of directional interest rate risk and that can generate alpha by taking advantage of the reliable interest spreads afforded by high-quality prepayment protected pools that are carefully selected and then augmenting our spread income through active opportunistic trading. We think that the volatility we are seeing and the potential for dislocation that comes along with it will bring many opportunities for us to acquire attractive assets and generate trading gains in the coming quarters.

With that, I will turn the call over to Larry.

Thanks, Mark. I'm sure that you can appreciate that Mark just scratched the surface in terms of the richness of the opportunity set in agency pools. The agency pool market is one of those ideal market combinations of high liquidity, agency pulls trade with a bid offer spread of just a few 30 seconds, but at the same time, they have high complexity. Just look at all of the different types of specified pools, each one with its unique and highly complex prepayment characteristics, not only involving interest rates, but servicer-specific and originator-specific behavior, geography, loan to value ratios, FICO credit scores and others, including of course loan balances, which was the characteristic that Mark happened to be discussing.

This makes it an exciting market for us. The liquidity of this market allows us to very actively manage the portfolio. The depth and breadth of this market allows us to be disciplined about what kind of pools we choose to be invested in at any given time and the complexity, the wide availability of data and the rich history of this market allows us to really drill down and try to tease out the value of all these different pool characteristics, including applying Ellington's extensive expertise in prepayment and interest rate modeling and analysis.

We delivered a total economic return of 2.2% for the first quarter, which equates to 9.3% on an annualized basis and this week marks the two-year anniversary of our IPO and over that period, which includes the steep rise in interest rates known as the taper tantrum, we have generated a 10% total economic return with low volatility. Compare that combination to the performance of our peer group over the same period. Our disciplined risk management has enabled us to generate strong returns since our inception despite heightened volatility and heightened interest rate, prepayment and policy risks.

Our objective is to manage our portfolio for total return over cycles and we don't try to make bets on the future path of interest rates, which we believe are virtually impossible to accurately predict. In the first quarter, as usual, there was a significant cost to maintaining our interest rate hedges. However, by seeking to control our risk, we believe we can maximize returns and minimize book value volatility over time. We have certainly been rewarded for that philosophy so far in the second quarter with 10-year swap rates having risen over 25 basis points already.

We remain keenly aware of potential policy risk and so we weren't heavily impacted by the FHA's 50 basis point reduction in mortgage insurance premiums in early January. Ginnie Mae is comprised only a small portion of our portfolio coming into 2015 and so the acceleration of Ginnie Mae prepayments that followed the announcement causing those bonds to significantly underperform didn't weigh at all on our results. We actually view this as a buying opportunity for us, albeit a relatively small one.

In the IO market, we did see some widening of high LTV, lower credit quality paper in the first quarter driven by the drop in interest rates and the FHA's mortgage insurance premium reduction. The mortgage market initially expected the FHFA to follow suit with its own refinancing-friendly policy changes, but the April FHFA announcement that Fannie Mae and Freddie Mac guarantee fees would not be lowered largely eliminated these concerns. The FHFA's announcement and the recent increases in interest rates have led to a relatively quick recovery in IOs.

Looking forward to the remainder of the year, we continue to believe that interest rate volatility and prepayment volatility will present challenges, but also numerous dislocations and thereby lots of opportunity for us. When dislocations do arise, we believe that our nimble size will enable us to reposition the portfolio quickly to take advantage of the opportunities whether in the IO sector or otherwise.

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

(Operator Instructions). Stephen DeLaney, JMP Securities.

Maybe I would like to start with Lisa's comments about the premium adjustment. You reported core EPS of $0.66, but shouldn't we view that as $0.70 if we add back the $0.04 one-time premium catch-up?

Yes, yes. You could view it that way and also, last quarter, we had a positive adjustment and that would add back $0.02.

Okay, so you had $0.76 reported, what was the per-share positive benefit last quarter, Lisa?

$0.02.

$0.02, okay? So that would normalize -- if we went to apples and apples, that would be $0.74, so $0.70 versus $0.74. Okay, thank you very much. Looking at the compression in yield, that looks like that was really the story, especially since you had a good quarter from a trading standpoint. So 28 basis points decline in the NIM to 221 and I believe you said the 13 bps was associated with that catch-up premium. Is that correct?

That is correct.

So I guess, Mark or Larry, should we attribute the remaining decline of 15 basis points or so -- is that just related pretty much to the CPR picking up to 6.3 versus 4.6 in the fourth quarter?

Well, it is not just that. This is Larry, Steve. That is part of it, but we turn over the portfolio a lot, so especially on the asset side, so you are going to see, as yields decline, let's just say from one quarter to the next, you are just going to naturally see a decline in yields just because we are replacing higher-yielding assets that were purchased in the higher rate environment with lower yielding assets that were purchased more recently.

As we turn over especially the asset side of the portfolio, and Mark mentioned how -- when you saw the volatility in payups and just the overall volatility, that is going to lead to that kind of turnover. You are going to see a natural decline when rates decline and then conversely this quarter I would expect the reverse to happen.

So coupon rolldown -- rolldown or rollup just based on what you are getting into and out of in the marketplace on your trading?

Yes.

Okay, okay. Got it. And obviously, we've got a pretty big backup in rates. I guess we're over 220 now in the 10-year. So as you look at the second quarter, can you comment on what your expectations for CPR would be in the second quarter versus the 6.3 average in 1Q?

Steve, it is Mark. Tonight we -- I believe tonight is the night we get the monthly prepayment report, so I think in aggregate expectations are that the prepayments should drop somewhere in the order of 8% to 10%.

Quarter to quarter?

Yes, quarter to quarter.

Quarter-over-quarter.

That is for the market as a whole. When you have prepayment protected pools, maybe you might see the same thing on a percentage basis, but on an absolute basis the actual prepayment changes aren't that large. So for most of what we own, I don't think it is going to be a big issue. We had not -- we have been trying not to expose ourselves to things that we thought had a lot of potential prepayment volatility to them like a lot of the jumbo pools and things like that.

Okay, great. Just one final thing. Obviously, we have heard about the impact of rate volatility on just about every earnings call and book values have certainly been challenged for some and you did not have a significant drop of less than 1%, but nevertheless you have a hallmark of stability there. I guess as you look at two quarter, the second quarter and the market, would you say generally that since March 31 that conditions in the market have generally been more supportive of book value stability than they were in the first quarter? And I don't if you can comment on the trend in your book value post March 31, but anything you can say would be appreciated.

Yes, I think that mortgages have traded well so far in the second quarter, but the interest rate volatility has really been with us in earnest really since the third or fourth week of April. You have had several days in a row where yields have climbed. So then when that happens, there's pretty significant changes in the duration of your portfolio. So it is something we look at every day, something we manage through. So I would say it is really crosscurrents. Mortgages have done very well relative to swaps and this move-in rate is going to reduce some of the refi-generated supply so it sort of takes all the supply pressures off the market, but these move-in rates also requires some delta hedging and that can manifest itself like buying high and selling low if it reverses course. I just think right now rates are very unpredictable, so it is important to try to stay on top of these moves and make sure you have them contained as best you can.

I appreciate your candor. I mean what I'm hearing you say is maintaining a stable book value is a very challenging job in this type of market and it just sounds like that is something that you guys focus on every day.

Part of it, I would say, if you don't have a big portfolio of either swaptions or short TBA positions, then it is going to be very, very difficult when you have got a quick upswing like this to not have a significant deterioration in book value, so if you have got a big portfolio of fixed rate pools. I think we have tended to focus on the TBA short side of that because that accomplishes other things for us as well and it also allows us to express our view of TBAs. So for us, you can see the percentages over time, we generally have had a pretty healthy share of our interest rate hedges in the form of TBAs. That really comes in incredibly handy when you have got a big rate move.

Guys, I appreciate the color and congrats on another solid quarter and covering the dividend very well.

There are no further questions at this time. Ladies and gentlemen, this concludes Ellington Residential Mortgage REIT's first-quarter 2015 financial results conference call. Please disconnect your lines at this time and have a wonderful day.