Ellington Credit Co (EARN) 2015 Q2 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by and welcome to the Ellington Residential Mortgage REIT second-quarter 2015 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 Lindsay Tragler, VP of Investor Relations.

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 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 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 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, Lindsay. It's our pleasure to speak with our shareholders this morning as we release our second-quarter results. As always, we appreciate you taking the time to participate on the call today. First an overview. It was a challenging quarter for agency mortgage REITs given the significant increase in interest rates and widening of agency RMBS spreads that impacted the market. We earned a little under $200,000 or $0.02 per share on a fully mark-to-market basis. Our core earnings of $0.57 per share covered our 55% dividend, although without much room to spare. Our dividend now equates to a 12.8% yield based on our June 30 book value and a yield of over 16% based on our August 4 closing price.

While our earnings declined from the prior quarter, we are very pleased with EARN's performance in this environment. We were actually able to generate positive earnings during the second quarter on a fully mark-to-market basis. As you know, most other agency mortgage REITs have reported significant losses for the quarter on a fully mark-to-market basis. Aggressively hedging against the risk of rising interest rates has always been one of our fundamental objectives and this significantly helped our second-quarter results.

Another way that we differentiate ourselves is by our heavy use of TBA short positions as part of our hedging strategy and this was a key factor in our results this quarter. First, these short TBA positions naturally lengthen in duration during the selloff. So that enabled us to limit the amount of interest rate swap hedges that we had to add at the higher rate levels. And second, our short TBA positions protected us to a considerable extent from the overall spread widening in agency RMBS that occurred during the quarter.

EARN's outperformance relative to its peers is a reflection of our focus on managing the portfolio for stability and a value preservation in difficult markets, even if that sometimes means forgoing some upside in bull markets. We turned over 20% of our agency portfolio during the second quarter and active and opportunistic trading is one of the things that we think benefits us in all our environments good or bad. Meanwhile, our nonagency portfolio again contributed positively to our results as the nonagency market continued to benefit from a lack of new issuance, as well as supportive fundamentals such as improving delinquency and foreclosure trends.

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 second-quarter earnings conference call presentation to our website, www.EARNREIT.com. 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 open to page 4 and with that, I'm going to turn it over to Lisa.

Thank you, Larry and good morning, everyone. In the second quarter despite difficult market conditions, we generated positive net income from $0.2 million or $0.02 per share. The components of our net income were as follows. Our core earnings totaled approximately $5.2 million or $0.57 per share. Net realized and unrealized losses from our mortgage-backed securities portfolio were $16.3 million or $1.78 per share and we had net realized and unrealized gains from derivatives of $11.3 million or $1.23 per share, excluding the net periodic costs associated with our interest rate swap.

In comparison, in the first quarter, we had net income of $3.7 million or $0.40 per share. Our first-quarter net income was comprised of core earnings of $6 million or $0.66 per share, net realized and unrealized gains on mortgage-backed securities of $11.9 million or $1.30 per share and net realized and unrealized losses on our interest rate hedging derivatives of $14.3 million or $1.56 per share.

At the beginning of the quarter, our book value per common share was $17.71 and after taking into account our second-quarter dividend of $0.55 per share and net income of $0.02 per share, we ended the quarter with a book value per share of $17.18. While our book value declined approximately 3%, our total economic return for the quarter was slightly positive at 0.1%.

Our second-quarter core earnings declined by approximately $0.09 per share to $0.57 per share. The decline was caused by two main factors. First, our interest income declined by about $0.05 per share quarter-over-quarter as our portfolio yields declined. In accounting for our agency pools, we anticipate prepayments in the determination of yield as opposed to assuming a zero CPR. Each quarter, we record a catch-up amortization adjustment based on actual cash flows to date and our forward projections of prepayment and this either positively or negatively impacts our interest income. Note that we had a negative premium catch-up amortization adjustment of $0.05 per share in both the first and second quarter.

Including the negative catch-up premium amortization adjustment, our portfolio book yield declined to 2.92% in the second quarter from 3.14% in the first. Excluding the negative catch-up premium amortization adjustment in each quarter, our average yields declined to 3.05% from 3.28%. So each period was impacted by roughly the same amount.

The second factor negatively impacting our core earnings was an increase in our cost of funds. Our total cost of funds increased by $0.06 per share. The increase in swap expense accounted for $0.04 of the $0.06 as, on a notional basis, we had more of our interest rate hedges in the form of interest rate swaps versus short TBAs in the second quarter as compared to the first quarter. The remaining $0.02 came from our repos and short US treasuries. By the end of the second quarter, we extended the maturities of our repos by 22 days and over the course of the second quarter, our weighted holdings of short treasuries increased slightly. As a result, our net interest margin, excluding the negative catch-up premium amortization, was 1.96% for the second quarter compared to 2.34% for the first quarter.

Our annualized expense ratio declined from 3.5% in the first quarter to 3.1% in the second quarter. The decline was generally attributable to lower professional fees in the second quarter, as well as the frontloaded nature of certain expenses, which impacted the first quarter. Our second-quarter core earnings benefited by $0.02 per share given this decline. Overall, our expectation is that our annual expense ratio will be approximately 3.3% assuming that we maintain our current capital base.

Our outstanding borrowings increased by $53 million to $1.26 billion at the end of the second quarter and as a result, our leverage ratio increased to 8 to 1 from 7 to 1. However, if we adjust each period for net unsettled security purchases and sales, our leverage ratio actually was flat at just under 8 to 1 for each period. We had net unsettled agency sales of $20.2 million at the end of June, which would have lowered our borrowings and net unsettled purchases of $81 million at the end of March that would have increased our borrowings. With that, I turn the presentation over to Mark.

The second quarter was certainly a challenging one for agency RMBS markets. We saw lots of interest rate volatility, lots of yield curve volatility and lots of changes in prepayment expectations and full pay-ups. It's in this type of environment that you can see differentiated manager performance and we are very pleased with EARN's second-quarter results. When the market's stable, it's difficult to see how risk is really being managed, but this is clearly revealed during the period of market volatility.

We fundamentally embrace the idea that portfolio composition should be dynamic over market cycles. What was best last quarter might not be optimal this quarter and we continue to believe that an actively managed portfolio is the best way to simultaneously protect book value and capture excess return in dynamic markets. In seeking to deliver shareholders the highest risk-adjusted returns over the longer term, we believe that managers need to constantly adjust their portfolio in response to changing markets.

Though portfolios should be structured to perform in a range of rate environments as market moves are often unpredictable. This quarter reminds us again that the path of interest rates and the shape of the yield curve can be dominated by exogenous and unforeseeable events half a world away as recent events in Greece and volatility in the Shanghai composite drove fixed income pricing dynamics for much of the quarter. Acknowledging the uncertainty inherent in the market and focusing on relative value opportunities to enhance core earnings are an important part of what we do.

What's interesting is if you look at the starting point and ending point for agency RMBS prices for the quarter, they didn't perform so badly, but the challenge was navigating all the ups and downs within the quarter. Our TBA shorts really helped in that regard. We implicitly buy back some of the volatility that a mortgage portfolio is generally short. The interest rate volatility in the quarter created some trading opportunities. We were able to capitalize on some of that volatility. The average pay-up over TBA, which we sold to specified pools earlier in the quarter, was higher than where we were able to buy them later in the quarter.

Pay-ups dropped substantially due to the quarter as interest rates rose and both actual and expected level of prepayments declined. As we have said many times before, we need to buy a prepayment protection when others don't want it. We view the sharp drop in pay-ups during the second quarter as a buying opportunity and took advantage by adding to our positions in highly prepaid protected pools.

While the refinancing index dropped during the quarter, first-quarter refis that were still in the pipeline drove some faster speeds in the second quarter. The benefit of owning pools with prepayment protection was evident as our portfolio only saw an incremental 1% increase in CPR from mid-6s to mid-7s. This was a smaller increase than what would have been expected from seasonality. So it was a combination of thoughtful pool selection, a mix of hedges across the yield curve and active trading that allowed us to generate a positive economic return in a quarter that was decidedly inhospitable to agency mortgages.

The declining sides of the size of the Federal Reserve's footprint in the agency RMBS market is another trend that continued to impact the market during the second quarter and helped us to offset weak mortgage price performance. The Fed is now only reinvesting prepayments, not increasing the size of its portfolio. As prepayments drop, Fed buying activity drops almost proportionately. This helped to depress the price level of many TBA [rules] for the quarter. Because we were selectively short in certain TBA coupons, this drop in low levels effectively reduced our borrowing costs. Since the Fed has stopped increasing the size of its agency mortgage portfolio, we have seen more relative value opportunities in this market and we expect that trend to continue as the Fed eventually tapers its reinvestments. The first half of 2015 saw strong agency mortgage net issuance, which has replenished the float in many coupons.

So we believe that the outlook going forward appears more hospitable. The sharp rally in rates that we have seen close to quarter-end has reduced the cost of hedging mortgages and the lower level of pool pay-ups relative to the beginning of the second quarter makes hedging cheaper. We are moving past the fastest seasonal prepayment months and the refi index remains at very low absolute levels. Lower prepayment risk, wider mortgage spreads and a steeper yield curve all create an environment in which the net interest margin for agency RMBS is wider. We can never know what kind of interest rate volatility may lie ahead, but at least by historical standards the sharp rate moves of the second quarter were outsized driven in part by uncertainty about the future of Greece and the violent pricings in the Chinese stock market.

In the current environment, we see more attractively priced agency RMBS with an opportunity to put on interest rate swaps at attractive rates. Prepayment risk seems well-contained and we took advantage of lower prepayment protection pricing in the second quarter and early in the third quarter to enhance the call protection of our portfolio. With that, I will turn the call over to Larry.

Thanks, Mark. EARN was able to deliver a small positive total economic return during the second quarter despite an extremely challenging environment. While we made money, our book value did decline after we paid our dividend; though that decline was modest relative to many of our peers. The cost of maintaining our interest rate hedges sometimes eats into our earnings, but during the second quarter we were rewarded for our disciplined risk management as we avoided losses. By seeking to control our risk and focusing on downside protection, we believe we can maximize returns and minimize book value volatility over the full market cycle. We think our results and relative stability this quarter demonstrate the virtues of our approach.

In addition to interest rate and spread moves, potential policy changes still pose a risk, though announcements since our first-quarter call haven't resulted in meaningful market moves. While the FHFA did announce that the HARP refinancing program would be extended for one year through the end of 2016, the market showed little reaction. Since the universe of HARP-eligible borrowers wasn't expanded. But rather the timeframe was just extended for the subset of eligible borrowers who for various reasons haven't taken advantage of the program.

The majority of our agency assets continue to be in specified pools with prepayment protection characteristics as opposed to in long TBA positions, reverse mortgage pools or in agency CMOs or agency I/Os. In agency I/Os, activity has been slow and evaluations have been tight, so we are still waiting for better entry points. In the reverse mortgage market where we increased our holdings by $12 million during the second quarter, the FHA began requiring financial assessment of potential borrowers for the first time. This could eliminate a fraction of prospective borrowers, though we think it would be small. So we may potentially see issuance decline a little in the reverse market.

Looking forward, we believe we are well-positioned to capitalize on better opportunities now available in the market as we are currently able to buy specified pools at more attractive levels than we've seen in a while. Our manager also enhanced our capabilities during the quarter by adding a highly experienced trader to Mark Tecotzky's agency pool portfolio management team. We are excited about our prospects given our expanded resources and the current buying opportunities we are seeing.

I want to touch a little on our core earnings and dividend. While our core earnings again covered our dividend this quarter, it didn't cover it by much. With our book value per share now at $17.18, our $0.55 dividend now equates to a 12.8% yield on book, which is quite a high book yield target given the low interest rates on fixed income investments generally with very limited credit risk in our portfolio and our continued focus on book value stability. Given that our dividend already very comfortably covers our REIT taxable income, we will be keeping a close eye on all these metrics as we set our dividend level recommendations going forward.

Finally, I'd like to mention our stock price and our share repurchase program. Obviously, stock prices in the agency mortgage REIT sector are extremely depressed and EARN's stock price has fallen in sympathy with the entire sector. We think concerns about market volatility after a potential Fed rate hike are the main culprit and this may persist until the market sees how each company actually fairs with each rate hike.

In the meantime, we think that as a sector agency REIT stocks seem attractively priced, especially as an alternative to mortgage-focused mutual funds that own substantially similar assets, but trade at book value as opposed to a very large discount to book value and that have a 3% give or take dividend yield as opposed to the high single digit low double digit dividend yields you see in the agency REIT sector.

As you know, we have had a $10 million share repurchase program in place since right after our IPO. As you might imagine, we've been in a blackout period recently pending release of our second-quarter earnings. But if not for that, we reached levels yesterday where we would have purchased shares. We are a small company, so we always have to be mindful of the effect that shrinking our capital base will have on our expense ratios and on the liquidity of our stock.

That said, while we are continuing to see excellent investment opportunities, we believe that, at the right price, the repurchase of some of our shares can be an effective and appropriate use of our capital. This concludes our prepared remarks. We are now pleased to take your questions.

(Operator Instructions). Steve DeLaney, JMP Securities.

Congratulations on that CPR performance. I think it's probably the smallest increase in speed we've seen so far this earnings season. I guess I'd like to start, Larry, with your final comment. You talked about the dividend policy with respect to core, but given that you do have the stock buyback authorization, you also certainly -- do you consider the attractiveness of buying back your shares below 80% of book value as being maybe more beneficial to shareholders over the long term versus just an incremental 1% or so on the dividend?

So, yes, we are going to be keeping a close eye on our core earnings and there were some things that were I think particular to the last quarter that may reverse themselves. We may see a bounce in core earnings; we'll see what happens. But we are going to be keeping a close eye on that. I think of the two a little bit differently. I certainly understand how you've got capital leaving the Company either way, whether it be in the form of dividends or whether be in the form of share repurchases and I think that's definitely a valid way of looking at things, but I don't think we are linking them at this point.

We think that we are looking at the repurchase really more as a quasi-permanent investment if you will in our own shares, something that is immediately accretive both to value and also to EPS. So we will definitely weigh the benefits of that against the detriments of the reduced capital base, which would be the higher expense ratio, of course and the liquidity of our shares.

In terms of the dividend, I think we are going to think of that more in terms of how comfortably does it cover our taxable earnings, which is quite comfortably -- how comfortably does it relate to our core earnings and how comfortably does the core earnings exceed our dividend. That's where we are going to be taking it really one month at a time, seeing what happens and making our recommendations accordingly. But you are right that we do have some room in terms of -- versus our taxable earnings and if we are repurchasing shares, then that would also create additional constraints on our capital. So all these things we would definitely take into account.

Okay, thanks. That's definitely helpful to clarify your posture there. And I guess shifting over more to the market and the outlook going into 2016, a lot of chatter -- obviously, everyone's focused on the Fed and when they are going to hike, etc. But I'm just curious, I don't really hear a lot of chatter or don't read a lot of fixed income research commentary about reinvestment of principle. So in the scenario whereby the Fed does hike in September, or by the end of the year and moves up next year, how are you guys thinking about the Fed's next decision, which will be reinvestment on their $1.7 trillion of MBS. So when do you think that reinvestment might end? What would the impact be and as portfolio managers, what do you do given your active management style ahead of that possible event to prepare for it?

It's interesting that while the Fed has said a lot and chosen their words with a tremendous amount of care when they talk about timing of potential rate hikes, in regards to tapering their reinvestment program, they haven't said a lot. So a lot of the better regarded mortgage researchers think that it's unlikely they would start to taper their reinvestment purchases until at least six months after the first rate hike.

I think there was a comment one of the Fed governors said about didn't want to taper until they felt like short rates had reached a more normal policy level. Now that they are just reinvesting, when we get into this winter and you're at the trough in seasonal pre-payment, they might only be buying maybe $12 billion to $15 billion -- the reinvestments might only be on the order of $12 billion to $15 billion a month, which isn't really all that significant.

So I think it will certainly keep mortgage spreads on the wider end when they actually start to taper, but I think it's far enough in the future now that I think at least for this quarter the relative relationships of mortgages versus swaps and treasuries is going to be more dominated by investors other than the Fed -- foreign buyers, money managers, REITs.

For us, we have -- as Larry mentioned, we have kept a significant TBA short; was helpful this quarter. It's something we've had in place for a while in part in deference to the fact that the Fed has been buying and it's kept spreads tighter than what they would be without Fed support. So we will certainly -- at a time -- if the Fed stops buying and mortgages underperform other assets and there's a much larger NIM to be captured, we could change that current portfolio structure and have a portfolio that took more mortgage basis risk if we felt we were really getting paid to do that.

So I think in some sense, we are set up in anticipation for there being hiccups when they announce how they are going to slow down their pace of reinvestments, but I still think it's at least two quarters out on the horizon.

Got it, that's helpful. The balance there, it seems like the two levers you pull is you probably would -- on your hedge allegations, going into that event or at least the market discounting that event, you probably want to have a bigger TBA short position before the widening and then that widening gives you the opportunity to move back just to more of a traditional swap position. Is that what I'm understanding how the playbook might look?

Yes, I look at our net mortgage exposure now and I feel like if mortgages were wider, it would make a lot of sense for us to increase that net mortgage exposure. We haven't done it because the valuations haven't been sufficiently compelling and you saw obviously this quarter it's very helpful having the TBA short. So I feel like we've positioned in a way that we have a lot of headroom to increase on mortgage exposure when the time is right.

If I could just add to that, I think making very flexible use of the TBA short as one of our components of our hedging strategy I think is something that is really important for us and it goes part and parcel with our active trading posture. And we try to generate a decent portion of our earnings each quarter by actively trading whether it be the mortgage basis, which we are sort of talking about now, actively trading the specified pool pay-up market, shifting between different sectors. So that's something that I think without that active trading -- I think if we were just to always have a very large core TBA short, it would be tough to achieve the type of returns that we want to achieve. But it really goes part and parcel I think the two together and that's why I think we are not afraid to put on a large TBA short especially compared to some of the others in the peer group.

Got it. And one final quick thing if I may. The credit book, from the get-go, you said you may from time to time do some nonagency type investments and it's pretty small now at $30 million. You're only 2.5% of your asset allocation. Can you just comment about how you view that going forward? Are you seeing anything that looks attractive that you might add to the EARN balance sheet, especially given all the strategic investments that Ellington management is making in various originators and different float product. Just curious how you are looking at the small credit silo within EARN. Thanks. That was my last question.

Yes, we are a small company. We are keeping it simple right now. Even though that book is only as you said maybe 2% or 3% of assets, it's obviously a bigger portion of our capital and has performed well. It's certainly a -- never want to stop reminding people that we have a broad charter and that if we at some point come to a fork in the road where having much more of our capital in nonagency type strategies makes sense, we will absolutely do that. For now, as a small company, we are trying to keep it simple. We see good opportunities in the agency market, but we always have that in the back of our minds that we could shift and obviously our agency pools are very liquid. We could shift strategies at any time.

The nonagency market has been slowly tightening over time and as you probably know from some of the other portfolios that we manage, we have been actually selling down recently some of those positions. But if anything were to change where either the prospects and agencies were to worsen -- so for example, let's say for some reason leverage wasn't available in the agency market, obviously, we are nowhere near that, but let's say that were to happen or flipside let's say something really amazing were to open itself up in terms of an opportunity in the agency market, absolutely we have that flexibility. But I would say in the near term certainly we have no plans to increase that nonagency portion of our portfolio to say be the majority of our capital allocation.

Got it. Thanks. Appreciate the comments, guys and good job in a challenging quarter.

Douglas Harter, Credit Suisse.

Can you talk about how you would view the attractiveness of your specified pool portfolio if we go into a period of rising rates, particularly on the long end and how you think those will perform?

We've had a bias towards pools with lower pay-ups that generally speaking have much smaller loan balances than the agency mortgage market as a whole. And part of the reason why we have that bias is that if you get into a rate environment where most of the current mortgagees in the agency market are sitting with mortgages that are 100 or 200 basis points below the prevailing mortgage rate then you're in an environment where a lot of the current mortgage market is now trading at a discount to par as opposed to premium and then what's attractive from a pool standpoint is faster turnover speeds.

So what's interesting, when you analyze the data for smaller loan balance pools relative to the market as a whole, not only do they have much slower, much better behaved prepayment when the borrowers have a rate incentive to pre-pay, but they also tend to have maybe 20%, 30% faster pre-payment speeds when they are out of the money. So when the mortgages are at a discount and the borrowers don't have an incentive to pre-pay, there tends to be more mobility in smaller priced homes and the geographic footprint of some of these pools tend to be in areas with a little bit faster turnover.

So part of our attractiveness of the pools with the lower loan balances, when their pay-ups aren't that high, and we saw this in 2013, is that they still trade at a premium to TBA when they are at a discount because people pick up on the factor that they yield more because they are paying faster at a discount, but they also have a shorter duration to them so the liability cost that's the appropriate hedge is a little bit less than the production mortgage.

As we've been in this for a while, we have had the advantage of allowing -- we turn things over a lot, but we also have pools we've owned for a long time. So a lot of those pools now have seasoned to the point where we think they have attributes that are going to be very much sought after by the market if you get into a rising rate environment.

Great, thank you.

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