Ellington Credit Co (EARN) 2015 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 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 Anya Prichard of Investor Relations. 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 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 over the call to Larry.

Thanks, Anya. 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, an overview. It was another challenging quarter for agency mortgage REITs, as global volatility and falling interest rates led to significant yield spread widening across most sectors of the fixed income markets, with agency RMBS spared little of the damage. At EARN, we tend not to run a significant net long duration position the way many other mortgage REITs do. Furthermore, earlier on in the third quarter, as the mortgage base has cheapened, we have reduced our TBA hedges somewhat in favor of interest rate swaps.

Then, later on in the quarter, with more interest rate swaps and fewer TBA short positions, the combination of sharply falling and volatile interest rates, and a widening mortgage basis, hit us harder than it otherwise would have. We lost $4.8 million or $0.53 per share on a fully mark-to-market basis. Core earnings, even after backing out catch-up amortization adjustments, was a healthy $0.59 per share, comfortably covering our $0.45 dividend.

And we believe that the outlook for our core earnings is even stronger following the substantial widening in agency RMBS yield spreads that hit our book value during the third quarter. Our $0.45 dividend represents an 11.1% annualized yield based on our September 30 book value, and an annualized yield of more than 14% based on our November 2 closing price.

Our portfolio of agency specified pools performed well relative to their genetic pool counterparts, as they prepaid slowly, and as pay-ups increased more or less as expected. And given how low interest rates are, we think that they currently offer tremendous value. Meanwhile, as Mark will discuss later, we are seeing a real lack of balance sheet capacity in the entire agency RMBS space, and that's creating lots of trading opportunities for us.

So, while this was a tough quarter for us, especially on the hedging side, we expect to benefit from wider net interest margins. And we believe that we are well-positioned to take advantage of all the dislocations.

We'll 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. 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, EARN, 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, and good morning, everyone. In the third quarter, we had a net loss of $4.8 million or $0.53 per share. The components of our net income were as follows. Our core earnings totaled approximately $6.3 million or $0.69 per share. Net realized and unrealized gains from our mortgage-backed securities portfolio were $5.5 million or $0.60 per share. And we had net realized and unrealized losses from derivatives of $16.6 million or $1.81 per share, excluding the net periodic costs associated with our interest rate swaps.

In comparison, in the second quarter, we had net income of $0.2 million or $0.02 per share. Our second-quarter net income was comprised of core earnings of $5.2 million or $0.57 per share; net realized and unrealized losses on mortgage-backed securities of $16.3 million or $1.78 per share; and net realized and unrealized gains on our interest rate hedging derivatives of $11.3 million or $1.23 per share.

Our core earnings increased quarter-over-quarter approximately $1.1 million or $0.12 per share to $0.69 per share. The increase was the result of two main factors. First, our interest income increased approximately $1.5 million or $0.16 or share; and second, our cost of funds increased approximately $350,000 or $0.04 per share, and partially offset the increase in interest income.

Our third-quarter interest income included a catch-up premium amortization adjustment of approximately $900,000 or $0.10 per share. For the third quarter, slower prepayment speeds in our agency RMBS reduced our amortization of bond premiums.

In the second quarter, we had a negative premium catch-up adjustment of approximately $440,000 or $0.05 per share, as prepayment speeds increased in our portfolio. If we exclude these catch-up premium amortization adjustments in each quarter, we can see that our third-quarter interest income increased slightly by about $130,000 or $0.01 per share, as our agency RMBS portfolio benefited from slightly higher yields.

As I mentioned, our cost of funds increased quarter-over-quarter by approximately $350,000 or $0.04 per share. Approximately one-third of this increase was related to an increase in our cost of repo, while the remaining two-thirds was related to our swap expense. During the third quarter, our weighted average repo borrowing rate increased 4 basis points to 0.43%. In addition, our interest rate hedges were more heavily weighted towards interest rate swaps than short TBA's in the third quarter, relative to the second quarter, which resulted in a higher quarter-over-quarter expense.

Following the September decision by the Federal Reserve to not raise the target federal funds rate, we've seen somewhat of a decline in the repo -- in repo borrowing costs. However, we are mindful of the fact that borrowing costs usually increase over year-end as banks manage their own year-end balance sheets. Towards the end of the third quarter, we intentionally shortened the term of our repo borrowings to give us greater flexibility to manage through the year-end cycle.

Excluding catch-up premium amortization adjustments in both the second and third quarters, our net interest margin declined slightly. On this basis, our net interest margin was 1.93% in the third quarter as compared to 1.96% in the second quarter, and our core earnings was $0.59 in the third quarter compared to $0.62 in the second quarter.

During the third quarter, we turned over approximately 27% of our agency RMBS portfolio, which generated net realized gains of approximately $600,000 or $0.07 per share. However, the sharp decline in interest rates and very high level of market volatility led to losses on our interest rate hedges, which exceeded net realized and unrealized gains on our agency pools. Our annualized expense ratio was 3.3% in the third quarter and was in line with our expectations.

With that, I will now turn the presentation over to Mark.

Thanks, Lisa. There was substantial interest rate volatility during the third quarter, as weakening fundamentals in many emerging economies, especially China, raised concerns that weakness abroad would hurt the US economy. Interest rates trended lower during the third quarter, and this accelerated when the Federal Reserve decided not to raise the target Fed funds rate in September, as this decision reinforced the view that problems overseas were posing significant risk to the US economy.

This view was further supported by the very weak September employment report released in early October. In addition to a nearly 50 basis point decline in the 10-year swap rate over the third quarter, there were numerous telltale signs in the market that balance sheet was in very short supply as we approached quarter-end. Interest rate swap spread showed unusually high levels of volatility during the quarter, and the 10-year swap spreads actually became negative for the first time since late 2010.

One dealer strategist called it a perfect storm, with heavy fixed income issuance alongside central bank selling of US treasuries, all stressing dealer balance sheets right before the quarter-end. In September alone, the 10-year swap rate tightened by about 8 basis points, an unusually large one-month move. Against this backdrop, agency RMBS substantially underperformed swap hedges during the third quarter.

In a rally, the most common culprit for agency RMBS underperformance is an increase in prepayment speeds, either actual or anticipated. In the third quarter, though, market prepayment speeds were actually slower than they had been in the second quarter. The culprit in this case for the underperformance was a general risk off move and a scarcity of balance sheet.

Quarter-end has taken on increased significance for the systemically important financial institutions known as SIFI's, as their quarter-end balance sheet snapshots significantly impact their capital reserves. Because our large investment bank counterparties have been operating with increased balance sheet constraints and tighter value at-risk limits, quarter-end pressures to shrink balance sheet had a palpable impact on liquidity this past quarter-end, and this is the dynamic that we expect to see going forward.

Despite the underperformance of the sector, the benefit for us here is that we are reinvesting in what we believe are attractive valuations. LIBOR options as to spreads for agency pass-throughs are near levels unseen since the 2013 Taper Tantrum. While agency RMBS are largely immune to credit risk, agency RMBS still compete with other credit-sensitive assets for investor dollars. Yield spread-widening in many credit-sensitive sectors, such as corporates, high yields, and CMBS, all pressured agency RMBS spreads wider, and the third quarter turned out to be the biggest OAS widening since the 2013 Taper Tantrum.

Take a look at slide 7. In the graph on the right, you can see how correlated agency RMBS were to high yield corporate bonds during the dramatic spread-widening that happened the last two weeks of the quarter -- highly correlated despite very different fundamentals. Since then, a portion of this move has reversed. With much of the spread -- with much of the widening happening right before quarter-end, the snapshot of quarter-end pricing that drives our financial statements was not representative of valuations throughout most of the third quarter or valuations since quarter-end.

The graph on the left side shows a similar pattern. You can see that there was a very high correlation between agency MBS and investment-grade corporate bonds. So this mortgage-widening versus swaps had nothing to do with changes in cash flow expectations. Anticipated and realized prepayment speeds were well-behaved throughout the quarter. Our actual CPR's dropped from 7.4 to 7.1 in the quarter.

This pattern of quarter-end balance sheet stress didn't happen in a vacuum. It's the result of regulatory and capital changes that have evolved incrementally over time, but it seemed to reach a tipping point in the past quarter. Unlike this past quarter-end, year-end book values will be compared to values at the very end of the third quarter, which was already a time of great balance sheet stress.

Agency RMBS ended the third quarter significantly underperforming both US treasuries and interest rate swaps, but have participated with the market's recent tightening. In fact, the combination of street-wide balance sheet constraints, wider yield spreads in most fixed income markets, and the Fed's waning footprint in the agency pass-through market, have been very positive for our agency portfolio pair trades, where we hedge our specified pools with TPAs.

These trades are creating the best combination of carrying convexium we've seen in the past two years. Additionally, changes in the origination landscape have allowed us to expand these strategies, providing us with a wider set of creating opportunities.

To put in perspective how much more attractive agency RMBS prices are now than earlier in the year, look at slide 8. In late March/early April, 10-year swap rates were around 2%, right where they ended the third quarter. Back then, Fannie 3.5's were three-quarters-of-a-point higher in price than they are now.

The cheapening relative to the front-end of the curve is even more dramatic, as shown on slide 9. This agency RMBS underperformance hit our book value hard, but it represents a long-term benefit to our net interest margin. The market is handsomely rewarding companies with balance sheets. The base level of core earnings that we can generate just for having balance sheet has gone way up, even before fine-tuning with CUSIP selection and enhancing returns through active trading.

Turning to our agency RMBS portfolio, we shrunk it by about $50 million during the quarter, roughly in line with the decline in book value, in order to keep our leverage roughly constant. The prepayment speeds in our portfolio declined slightly during the quarter, and every sector of the portfolio was well-behaved from a prepayment perspective, as you can see on slide 13.

We believe that agency RMBS valuations at the end of the third quarter were attractive and still are. Prepayment speeds should remain contained, barring a move in 10-year rates substantially below 2%, while yield spreads to interest rate swaps are historically wide. We actively traded through the volatility, always looking to upgrade our portfolio and replace the call protection we own with less-expensive versions.

One slow-moving development that we've been monitoring is a very gradual loosening of mortgage credit. This is coming from two directions. The FHFA and FHA have both been softening their stance on putbacks, and mortgage originators have been improving their pricing on higher LTV loans and lower FICO borrowers.

The 50 basis point reduction in mortgage insurance premium announced by the FHA earlier this year has caused a lot of new purchase loan activity to shift away from Fannie Mae and Freddie Mac and over to the FHA. There was a possibility that Fannie and Freddie could respond with a drop of their own in pricing, and there is also discussion that the FHA could cut MIPS further. We are closely monitoring these developments.

With that, I'll turn the call over to Larry.

Thanks, Mark. By any measure, this was a really tough quarter for hedged agency mortgage portfolios. Many of our agency M REIT peers choose to run with a positive duration gap. And yes, that worked out for them this past quarter.

Even Freddie Mac just reported their first loss in four years. And even their boatloads of guarantee fee income couldn't overcome the losses on their hedged mortgage portfolio. We deliberately stayed the course so far in the fourth quarter, and the markets are, in fact, recovering somewhat.

To conclude, I want to touch a little on our dividend and our repurchase program. Our new $0.45 dividend is an 11.1% annualized yield relative to our September 30 book value of $16.20. And as I mentioned, we are comfortable that our core earnings will continue to cover that dividend.

And as to our repurchase program, the program was live only for about a month -- basically, from right after our last earnings call until mid-September, when we hit our blackout period. And while it was live, we laddered down our purchases, entering an order at a certain price limit, and once we filled that order, entering a new order at a lower price limit, et cetera. We ended up repurchasing about 0.25% of our outstanding common shares before our trading window closed.

Dividend adjusted, our common shares are now trading a bit higher than they were when we were last repurchasing shares. So I wouldn't expect to see much repurchasing activity from us, unless our common shares trade lower from here. As I mentioned on last quarter's call, we are a small company and we always have to be mindful of the affected shrink in our capital base will have on our expense ratios and on the liquidity of our stock.

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

(Operator Instructions) Douglas Harter, Credit Suisse.

This is actually Sam Choe filling in for Doug Harter. I was wondering how you guys were thinking about leverage going forward? Do you see that trending up as you take -- consider opportunities in the agency MBS space?

Hi, this is Mark. Thanks for the question. I would say that while valuations are attractive now, given the fact that you haven't seen the Fed act, so you haven't seen how the market is going to react to a Fed action, I would not expect to see leverage increase right now. I feel like the potential December hike coming right in front of year-end can cause some volatility.

And, as you saw for this past quarter, with the leverage we have now, we are able to generate sufficient core earnings to cover the dividend. So I think the time to consider changes in leverage or a possible increase in leverage would come after we've seen how the market reacts to a Fed rate increase.

I see. So it's safe to assume that you guys will continue the defensive positioning?

Yes, I wouldn't really characterize our positioning right now as defensive. I think it's sort of appropriate, given the opportunities in the market and given the potential volatility that is possible for the market to have to trade through.

Yes, and if I could add one thing to that. One way that you can see that our position isn't quite as defensive is that we are not long as many TPAs -- I'm sorry, we are not short as many TPAs in terms of our hedging portfolio, as we were before. That's because we were constructive on a basis. So, I think one good measure of how defensive we are is how -- what portion of our hedges is comprised of short TPAs as opposed to interest rate swaps and similar instruments.

Sure. Okay. Thank you so much.

You're welcome.

Trevor Cranston, JMP Securities.

I think you guys touched a little bit on the kind of phenomenon of swap spreads going negative in the third quarter. Looking at them quarter-to-date, it looks like that's kind of continuing, and like the 10-year swap spread has gotten increasingly negative. Can you just comment on how you guys are thinking about that, and how it impacts -- how you think about the portfolio, in particular the hedge positions over the near-term? Thanks.

Sure. Yes, that's a great question. And that's definitely the biggest issue we've been wrestling with. I think that if you have the view that these -- this pricing structure is going to continue and swaps are going to get more negative, then you have some options, right?

You can increase TBA shorts and you can increase our treasury shorts. We've always had small amount of treasury shorts. And those are liquid; they are easy to repo. You can certainly increase those. You can do it in treasury futures. You know, the attractiveness of the interest rate swaps, is that's the one that, over the long run, it's probably going to be most closely tied to our repo borrowing, and these things can reverse.

So, moving a big portion of the hedge from swaps into treasuries, then you are taking some risk that your funding costs over time can be decoupled from your interest rate hedge. But I think this movement in swap spreads is definitely emblematic of a trading environment now where a lot of the big trading counterparties -- and this is one thing I mentioned in the prepared script -- have -- are operating under value at risk constraints and balance sheet constraints that make it difficult for them to balance sheet the amount of risk that different customers want to move around the market.

And ultimately -- this is Larry. Ultimately, these are judgment calls, whether it's how long we are going to be the mortgage basis, whether it's where we going to hedge with interest rate swaps, futures, treasuries -- these are judgment calls. And I think that there's a lot of technical factors that are involved. It's really hard to predict where this is going to go. Some people view this as a bubble, but it's always hard to see bubbles while they are happening. So, it's just really hard to know where this is going to go.

Right. Okay. I appreciate the color. Thank you.

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