Ellington Credit Co (EARN) 2015 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 and full-year 2015 financial results conference call. Today's call is being recorded. (Operator Instructions)

It is now my pleasure to turn the floor over to Ania Pritchard of Investor Relations. You may begin.

Thanks, Jackie.

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 12th, 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, Ania. It's 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 -- [was] another challenging quarter for agency RMBS. Ellington Residential managed to generate positive net income of $0.11 per share. Excluding catch-up amortization, core earnings increased to $0.61 per share in the fourth quarter from $0.59 per share in the third quarter, comfortably covering our $0.45 dividend. Our dividend represents an 11.3% annualized yield based on our December 31st book value and an annualized yield of 16.5% based on our February 9th closing price.

As Mark will elaborate on, the biggest challenges that we've been navigating recently have been -- first, an incredibly volatile interest rate environment; second, interest rate swap spreads that have been pushing further and further into negative territory, which was once unthinkable but which may very well be the new norm, given regulatory constraints on bank balance sheets and other factors; and third, agency RMBS yield spreads continuing to widen in sympathy with other fixed income sectors, especially the credit-sensitive sectors of the market that have been hit so hard.

While 2015 was a challenging year, and the beginning of 2016 has been challenging as well, we believe that agency RMBS are currently trading at very attractive levels, and that we are well positioned to take advantage of what should be wider net interest margins going forward.

In addition, our portfolio is highly liquid, and our investment mandate is broad. With such a small portion of our portfolio in credit-sensitive securities, we believe we are extremely nimble and can reposition ourselves quickly to seize opportunities as they arise in the credit-sensitive sectors of our markets.

We haven't yet seen the entry points that we're looking for to start rethinking our asset allocation, but we're getting a lot closer. And we're seeing lots of cracks in the system that tell us the time may be coming soon.

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 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 fourth 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'll sometimes refer to Ellington Residential by its New York Stock Exchange ticker, E-A-R-N, or EARN for short.

Hopefully, you now have the presentation in front of you and open to page 4. And with that, I'm going to turn it over to Lisa.

Thank you, Larry, and good morning, everyone.

In the fourth quarter, we had net income of approximately $1 million or $0.11 per share. The components of our net income were as follows -- our core earnings totaled approximately $4.5 million or $0.49 per share. Net realized and unrealized losses from our mortgage-backed securities portfolio were $10.4 million or $1.14 per share. And we had net realized and unrealized gains from derivatives of $6.9 million or $0.76 per share, excluding the net periodic costs associated with our interest rate swaps.

Our core earnings includes the negative impact of catch-up premium amortization. In the fourth quarter, this adjustment reduced our core income by $1.1 million or $0.12 per share, as our portfolio was impacted by faster prepayment speeds. If we add back the catch-up premium amortization adjustment, our core earnings amounted to $5.6 million or $0.61 per share in the fourth quarter. On that same basis, our third quarter core earnings, excluding the catch-up premium amortization adjustment, was $0.59 per share.

The quarter-over-quarter increase in our core earnings adjusted to exclude the impact of catch-up premium amortization was a result of two main factors. First, the weighted average yield on our mortgage-backed securities increased slightly in the fourth quarter to 3.18% from 3.14% in the third quarter. As we actively traded our agency RMBS during the fourth quarter, we replaced securities that we sold with higher-yielding securities. And at the same time, our small non-agency RMBS portfolio benefitted from higher yields.

Second, our cost of funds declined quarter over quarter. In the fourth quarter, our weighted average cost of funds decreased 4 basis points, to 1.17%. This net decrease resulted from an 11-basis point decrease in periodic costs related to our interest rate swaps and interest expense related to U.S. Treasury security hedges, partially offset by a 7-basis point increase in our repo borrowing costs.

For the quarter, our weighted average cost of repo increased to 50 basis points, while the combined cost of interest rate swaps and U.S. Treasury security hedges declined to 67 basis points. Rising interest rates puts upward pressure on our repo borrowing costs, while a slight shift to short TBA hedges from swaps, as well as a decline in the weighted average remaining term of our swaps, resulted in lower swap costs.

As a result of the slight increase in our portfolio yield and our net lower cost of funds, our net interest margin, excluding the impact of catch-up premium amortization, increased quarter over quarter to 2.01% from 1.93%.

As I mentioned earlier, our cost of repo increased during the fourth quarter. We have found dealer appetite for repo lending to continue to be strong. There will likely be additional demand for agency repo in light of the FHFA's decision to ban insurance captives from membership in the FHLB system. It is possible that if other institutions transition their borrowings from the FHLBs to the broker-dealer community, this could put additional upward pressure on agency repo borrowing rates.

During the fourth quarter, we turned over approximately 40% of our agency RMBS portfolio, which generated net realized gains of approximately $1.2 million or $0.13 per share. However, the increase in interest rates and high level of market volatility led to unrealized losses on our MBS, which were partially offset by interest rate hedges.

During the fourth quarter, we purchased approximately 6,100 shares. And subsequent to year end, we have purchased approximately 18,000 more shares. In the aggregate since August 2015, we've repurchased about 47,500 shares, or one-half of 1% of our outstanding shares. And these purchases have been $0.02 accretive to our book value.

In terms of GAAP net income -- for the year and against the backdrop of a very challenging market landscape, we essentially broke even. We ended this year with book value per share of $15.86, and we've held our expenses in line and ended the year with an expense ratio of 3.2%.

Adjusted for unsettled purchases and sale, our leverage ratio was 8.1 to 1, similar to where it was at the end of the third quarter. Our year-end equity relative to September 30th, 2015, was slightly lower, and our portfolio size also slightly declined. And as a result, our leverage ratio was relatively unchanged.

With that, I turn the presentation over to Mark.

Thanks, Lisa.

Looking at the fourth quarter and what we've experienced so far this year -- interest rates have been a rollercoaster. Consider the five-year swap rate, a good proxy for durations in much of the mortgage market. In the fourth quarter, it increased 34 basis points. Already this year, as of Tuesday's closing prices, it has dropped an eye-popping 60 basis points; so we've had some incredible volatility.

Our performance for the quarter showed an economic gain, a modest book value drop of 2%, and core earnings that covered our dividend. We believe that this demonstrates that our portfolio management approach, which emphasizes limiting interest rate risk, diversifying hedges, focusing on identifying undervalued prepayment protection to capture outside net interest margin, and then augmenting that NIM by actively trading inefficiencies in the mortgage market is the best path to high sustainable dividends and limited book value volatility.

At the end of the fourth quarter, we noted how agency RMBS widened in sympathy with other spread products like high-yield. But its under-performance versus swaps was technical, and it wasn't driven by any fundamental change in mortgage cash flows.

Since the start of 2016, agency RMBS performance has decoupled from other spread products. As investors are increasingly concerned about defaults in the high-yield market and a vicious downgrade cycle in investment-grade corporates, agency RMBS seemed like the safest way to capture spread over treasuries, so the widening of agency RMBS so far this year has been quite modest.

If we look back over the year -- EARN's economic performance is breakeven. The dividend we paid equaled our drop in book value. This is not the performance we look for, but we believe it will put us at the top of our peer group.

What happened in 2015 is that agency RMBS cheapened dramatically versus swap hedges. Consider two data points -- from January 1st to December 31st, 2015, Fannie Mae's 3.5s dropped in price by 1.1 points, while the five-year swap rate and appropriate swap hedge went up in price by half a point. That large under-performance is what weighed on book value.

Dramatic under-performance sets us up for a much more compelling valuation entry point for 2016, because the under-performance can't be traced back to anything fundamental. There wasn't more prepayment volatility, or more policy risk or anything like that. It was just a material cheapening of mortgages relative to swaps.

The macro environment is also good. We've had a tremendous amount of volatility to start the year. But if the market is correct in its assumption that global headwinds will force the Fed into a much more muted hiking cycle, volatility could really drop, which is great for MBS.

Despite the rate rally, prepayment protection can still be bought at reasonable levels. The big movement in swap spreads last year was a short-term drag on book value. But long term, it leads to a better NIM.

What matters the most to core earnings is whether the floating leg we receive on our swap tracks our repo expense, and it has. At the end of the third quarter, there were some balance sheet pressures on broker-dealers and a widening in repo spreads. But levels have been lower since year end, and we expect repo rates will continue to drop in the face of less concern about an aggressive Fed hiking cycle.

It's always more art than science to infer what is behind market sentiment that drives asset prices. But we believe that the big drop in price to book levels of agency mortgage REITs last year was primarily driven by two concerns.

First, until December, there was tremendous uncertainty around the path of Fed hikes. The market got its hike in December, and it turned out to be one of the least volatile days of the quarter for rates. And it now seems that an aggressive hiking cycle is off the table. An environment where interest rates remain lower for a longer time should be great for mortgage REITs.

The second biggest concern was stability in the repo market -- can mortgage REITs access enough repo and at rates that give them a wide NIM?

This concern was appropriate. Look at slide 7, which shows the quantity of agency MBS repo over time. The decline is dramatic. Repo volumes are way down, from $650 billion pre-crisis to $300 billion during the depth of the crisis; and incredibly now only $250 billion and dropping. So agency MBS repo is down by over 60% relative to pre-crisis levels.

This is in the context of a $5 trillion market. So repo is now only used for about 5% of the agency market. Repo is not a big factor in pricing agency MBS, especially when most mortgage REITs are not growing, and, in many cases, are shrinking.

What has happened is that the capital treatments of the big banks, both US and European, make agency repo lending unattractive on a return-on-equity perspective. They have to hold too much capital against what is a relatively small spread.

So lots of smaller broker-dealers and non-US/non-European banks have stepped in. They have different capital requirements and repo lending to provide an attractive ROE for them. Granted, it's not an optimal situation, where market share has shifted from the biggest, best-capitalized players that are the most active in MBS trading to much smaller entities, but that seems to be the way things are headed.

Nevertheless, we think it's likely that over the course of the year, things will get better. As has been discussed on some of the other calls, their problem is not that there isn't cash available for agency repo. On the contrary, money market funds have lots of cash, and agency repo is a great product for them.

With the big US and European banks stepping back from agency repo, the market is still figuring out how to put the borrowers and lenders together. We think the problem will get better over time.

Since year end, things have gotten a little better and our three-month repo rate is now similar to three-month LIBOR. That is particularly significant, because three-month LIBOR is what we get paid on the floating leg of the swaps, where we are paying a fixed rate to hedge against interest rate increases.

This naturally leads to a discussion of swap spreads, which have been very volatile and were a source of a lot of the third quarter and some of the fourth quarter book value decline.

So the question is -- where are swap spreads going? Well, we don't know. But over the long run, what matters to us is that our repo costs still track what we get paid on the floating leg of our swaps. When that happens, we can focus on the net interest margin we can capture between the yields on fixed rate MBS and the fixed legs of swaps. That margin is very wide now.

Part of the decline in swap spreads is driven by large-scale liquidations of treasuries, and part of it is driven by the same limited dealer appetite for repo. We don't know what the new normal is, but lower swap spreads were a one-time hit to book value but a long-term benefit to NIM.

That under-performance between Fannie 3.5s and five-year swaps that I mentioned earlier directly translates into a wider NIM. Agency RMBS are now much wider than where they started 2015. So if mortgages just stay where they are, earnings could be strong.

And it is lower swap spreads that primarily drove this NIM increase. If swap spreads become even more negative and outperform MBS prices, then that would be an additional headwind to book value but it would also mean that the NIM would further increase. One caveat would be the possibility that rates drop low enough to ignite a significant refinancing wave.

With all the central bank quantitative easing and all the weakening in corporate bonds, what many bond investors now want is an asset that can provide a spread over treasuries but doesn't have credit risk. That is what the agency mortgage market offers.

When the market makes a big move in a short period of time, some investors need to act quickly in response to outflows or capital calls. And those moves in the short run can overwhelm relative value.

Over the long term, relative value matters, as investors with longtime horizons like bank, pension funds and insurance companies will probably be attracted to the mortgage market. One huge positive for MBS is that the Fed will probably feel pressured by the recent market volatility to reinvest its agency MBS principal pay-downs for a longer period of time.

That was a big source of uncertainty hanging over the market pre-hike. Now, that risk seems off the table. With all the central bank selling of dollar assets, it seems unlikely that the Fed will put more bonds into the market at this time.

Looking ahead -- the biggest risk now for agency RMBS is something that we have not had to worry about recently -- prepayment speeds. So far, they seem manageable. Pool [picks] have definitely increased, but not by an unwarranted amount. The market is getting close to an inflection point, where you could see faster prepayment speeds really weigh on the price of mortgage pools that don't have prepayment protection.

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

Thanks, Mark.

At Ellington, we've been battening down the hatches for the last couple of quarters in anticipation of possible stresses in the financial system, and stresses in the credit markets in particular.

On our website, www.earnreit.com, you'll see a link to a whitepaper that Ellington published in early November of last year. The whitepaper was entitled The Ninth Inning of the High Yield Bubble. I encourage you to read that whitepaper. And if you do, I think you'll appreciate that we anticipated much of the turmoil that's taken place and is continuing in many of the credit markets.

As I mentioned earlier, we are a small, nimble company. And our portfolio is very liquid, allowing us to quickly reposition ourselves as market conditions change. Active trading is one of the hallmarks of our portfolio management style. And during the fourth quarter, we turned over a full 40% of our agency RMBS portfolio. While the turmoil that we've seen so far in the credit markets hasn't yet created the entry points that we're looking for to seriously rethink our asset allocation, we're getting a lot closer.

Meanwhile, we also see tremendous investment opportunities in agency RMBS. Not only are yield spreads wide on specified pools, but now long-term interest rates are nearing that danger zone where prepayments become a real risk and where opportunities in prepayment-sensitive securities have historically become abundant. Believe me, concentrated holders of agency interest-only securities are definitely starting to sweat out there.

For the past few years, we have consciously avoided a large allocation to interest-only securities, since we didn't think the market was adequately pricing in the risk of declining rates. Now, with a possible shakeup in the IO market threatening, should prepayment fears turn into prepayment realities, our portfolio allocation to IOs may also change soon.

So in summary -- we preserved economic value for shareholders in 2015. We currently have a liquid portfolio that we're not shy about turning over. And we're looking at a potential trove of opportunities in sectors in which we currently have only small allocations. We believe that's just a great all-around position to be in.

Lisa mentioned the FHFA's decision to ban captive insurance companies from membership in the FHLB system, and the potential for some additional upward pressure on agency repo funding costs as a result. At EARN, we had in fact formed our own captive insurance subsidiary to retain the optionality of gaining access to FHLB borrowings. And late this past December, EARN's captive insurance company was actually approved for membership in the Federal Home Loan Bank of Cincinnati.

Then, just two weeks later, the FHFA ruling banning membership for captive insurance companies came out. Now, we had not actually taken out any borrowings from the FHLB. So we're now basically in the same position that we were before. And we're certainly not in the position of some other companies that are going to have to move large borrowings to different lenders in a relatively short period of time.

Nevertheless, we haven't abandoned all hope for gaining access to FHLB funding. And we're currently exploring various options to that end.

I'd like to end with a brief statement about our share repurchase program. As a small company, we're always mindful of the effect that [tricking] our capital base will have on our expense ratios and on our liquidity of our stock.

That being said, during the fourth quarter, we did repurchase some of our shares in light of the discount on our stock price relative to our book value. And as Lisa mentioned, we've increased the pace of our share repurchases so far in the first quarter of this year, as our stock price fell further in sympathy with the entire mREIT sector.

In the near term, we would expect to continue to repurchase shares, albeit on a measured pace, as long as our stock price to book value ratio remains low. That said, our main focus for 2016 will be to generate good earnings by continuing to hedge interest rate risk in a disciplined fashion across the yield curve, and by capitalizing on the opportunities we see now and the dislocations that look to be developing.

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

(Operator Instructions) Douglas Harter, Credit Suisse.

I was hoping you could talk about what type of -- how much more in spread widening or return availability it would be until you guys might look to get a little bit more aggressive in terms of taking up risk in the portfolio.

I don't want to give a number, because it's going to depend not just on kind of where the knife is, but whether we think it's still falling. And that's going to depend upon what we see going on in other markets. If the -- just to give an example -- if the high-yield market just implodes much, much, much further -- and that, I think, for us -- we're traders, we want to get the right entry point -- that would increase sort of our threshold, our standards, in terms of when we would jump in. So it's really going to depend not just on a specific further spread widening in non-agency RMBS, for example, but also where we see that going, which is going to depend on what else we're seeing in the market.

And look at a day like today -- there's obviously -- continue to be a lot going on outside the non-agency market that's going to affect where the non-agency market is heading.

And then, just how are you thinking about having the portfolio positioned, or what the opportunities might be if we were to see the high-yield market continue to be weak? And let's say the 10-year were to continue to fall substantially from here -- I guess, how would you view that opportunity, and the ways to sort of protect yourself going into that and take advantage of it?

Hey, Doug; it's Mark.

I think in that scenario -- and this is a scenario we certainly contemplate, along with several others -- is the most important thing for us is to make sure that the portfolio we have has substantial prepayment protection built into it by virtue of having pools where you've lent money to the least efficient borrowers, not the most efficient borrowers. So staying away from jumbo mortgages, staying away from the bigger balances that are very low LTV, very high FICO, where both the borrower has a big incentive to refinance and the mortgage originator -- because it's a big loan, and they make a big profit -- has a big incentive to refinance then.

So I think -- and it's also just an acknowledgement that we don't think we have any predictive powers about where rates can go, right? Like we don't come in thinking -- oh, 10-year note can't go below 1.50, or 10-year note can't go above 2.25. The forces driving this are so big and so macro that we feel like what we have to do is admit there's a degree of uncertainty in where the direction of rates go, but take a portfolio -- and given the rate environment we're in, and the likely prepayment response to that rate environment -- have our portfolios constructed where the cash flows on our securities don't evaporate from prepayments.

And just to add to that, in the IO market -- and we've been big in the IO market here at Ellington since our inception 21 years ago -- when you are in a [cusp] situation like we're in now, where prepayments are going to start to increase, and if rates drop more they could really increase quite a bit -- you're really supposed to get rewarded for buying IOs. You got to buy them. But they have to be, look, very attractive as we model out the cash flows in various scenarios. And we felt, when rates were much higher even, that you weren't adequately compensated for the risk in IOs.

So that market, if you look at historically, tends to move in quantum jumps. So it's probably going to take a shakeup. But a shakeup very well could happen. So we're going to wait until what we view as a genuine shakeup before we increase the allocation there. But if we see it, we'll take advantage of it.

Great. I appreciate that color.

(Operator Instructions) There are no further questions at this time.

No, no, no; we'll take that question.

Trevor Cranston, JMP Securities.

Trevor, you were a little late on putting your question in. We almost --

Yes, just got it in right at the end there.

I'm glad we got you.

Lucky timing. Thanks.

I was wondering if you guys could maybe elaborate a little bit on the prepay risk that's increased so far this year. And maybe talk a little bit first about kind of the rate level you think we need to get to to start seeing a significant response in terms of refi applications, and also maybe what you think the magnitude of the response could be like this time for a given rate incentive, versus what we've seen in the past at similar rate incentive levels. Thanks.

Sure.

Yes, I think if we stay where we are right now, you're definitely going to see a prepayment response. The Refi Index ticked up -- last reported value. And also, what's interesting about the last Refi Index was, if you look at the average loan size of what's getting refi-ed, that jumped up a lot. So it tells you that the most responsive borrowers are taking advantage of this opportunity.

And a lot of market share in the agency mortgage market has gone from -- in the agency origination market has gone from banks to nonbanks. Nonbanks tend to be a little bit more responsive, a little bit more aggressive. You're seeing more ads on TV. So we're closely watching the Refi Index.

But I would say that I don't know where the market is at this exact second, but before I walked into the room, you're at levels where you're going to see a heightened prepayment response.

Yes. That makes sense.

The other thing, looking at the portfolio details -- it looked like the allocation to Ginnies went up a little bit in the fourth quarter. Was that sort of a unique opportunity there? Or is there anything that you guys are finding more compelling about Ginnies versus conventionals right now?

I would say that --

By the way, just to clarify, this is the non-HECM Ginnie.

Right, that's right, the 30-year. Yes.

There has been a lot of volatility in the relationship between Ginnie securities versus Fannie and Freddie securities.

If you look at sort of the most liquid swap there, it's Ginnie 2, 3.5s versus Fannie 3.5s. And that swap over the course of last year got to the point where Ginnies were 6 ticks higher than Fannies. And it got to the point where Ginnies was -- well, Ginnie started the year a point higher, they went to six ticks higher, then they went back to a point higher.

So at times when the Ginnie securities get depressed versus Fannie's and Freddie's, we find them as more attractive alternatives. Because for banks, the Ginnie cash flow is lower risk weighting. So it's sort of -- it's rewarded.

So whenever we can buy Ginnies at yields very close to Fannies and Freddies, we like them. Ginnies also come with -- last year, they had a little bit more policy risk to them when there was a mortgage insurance premium cut, which kind of roiled the market for a while. So there's been a little bit more volatility and policy risk opportunities to trade around the Ginnies. And that was sort of driving that.

And when Ginnies were very expensive, the way they were at the start of the year, we didn't find them compelling. But when they cheapened up, we saw opportunities to get into the Ginnie cash flow, which we think over time is going to be -- will garner premium over Fannies, because the different risk weighting.

I mean, in general, if you look at our portfolio over time, there hasn't been much Ginnie exposure. And it's been more, as Mark alluded to, trading opportunity. So that probably reflects as just something that happened around quarter end, where we saw that the Ginnie-Fannie spread had tightened more than we thought was warranted. So that was more of a short-term trade.

But Ginnies in general on a long-term hold basis are not going to supply us as healthy a NIM as we're going to see in the other space. So we're going to use those Ginnies -- I'm not talking about the reverse mortgages -- more as trading securities than on very long-term hold securities.

Right. Okay. Thanks, guys.

Jim Young, West Family Investors.

I was wondering what drove the notable increase in reverse mortgages from the September to the December quarter. And I'm just kind of curious how you're thinking about the overall reverse mortgage space at the time. Thank you.

Yes. There was a pretty large seller in the market who was liquidating a substantial position, and it depressed prices. So we took advantage of that.

We like the reverse mortgages, because they have a healthy spread. But they don't have the same prepayment risk that's correlated to mortgage rates, same way the rest of the portfolio does. So whenever we can pick up reverse mortgages at a level that it's a big NIM, we like doing it. Because we think it's great risk reduction for us.

But yes -- but what really happened in the fourth quarter -- there was one very large seller that was liquidating a big chunk of a portfolio.

Okay, great. Thank you.

There are no further questions at this time.

Ladies and gentlemen, this concludes Ellington Residential Mortgage REIT's fourth quarter and full-year 2015 financial results conference call. Please disconnect your lines at this time and have a wonderful day.