Ellington Credit Co (EARN) 2016 Q1 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington residential mortgage REIT 2016 financial results conference call. Today's call is being recorded. (Operator Instructions). It is now my pleasure to turn the floor off to Maria Cozine of Investor Relations. You may begin.

Thanks. 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 on our Annual Report on Form 10-K filed on March 10, 2016 forward-looking statements are suggested 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 on the call with me today Larry Penn, Chief Executive Officer of Ellington Residential, Mark Tecotzky, our co-Chief Investment Officer, and Lisa Mumford, our Chief Financial Officer. As described in our earnings press release, our first quarter earnings conference call presentation is available on our website earnreit.com. Management's prepared remarks will track the presentation. Please turn to slide four to follow along. As a reminder we'll sometimes refer to Ellington Residential by its New York Stock Exchange E-A-R-N, or EARN, for short. With that I will now turn the call over to Larry.

Thanks, Maria. It's our pleasure it speak with our shareholders this morning as we release our first quarter results. As always we appreciate your taking the time to participate on the call today.

First, an overview. At a fully mark-to-market basis, Ellington residential had a small loss of $0.03 per share in the first quarter. In some sense the first quarter was very similar to recent quarters. Extreme interest rate volatility made hedging extremely challenging, [MBS] yield spreads continue to widen and loan return interest rate swap spreads tightened, in this case moving further into negative territory. While recent quarters have been challenging, we have preserved capital through them and as Mark will describe later, we have reached a point where we believe that the risk reward for agency RMBS is as good as we've seen in a while. As an expression of that view and as you can see on slide 18 of the presentation, we have pared down our TBA short positions with the result that they now represent as lower portion of our hedging portfolio as they have since our IPF.

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 portfolio, and what our market outlook is. Finally, I will follow with some additional remarks before opening the floor to questions. Go ahead, Lisa.

Thank you, Larry. Good morning, everyone. In the first quarter, we had a net loss of $239,000 or $0.03 per share. The components of net income were as follows -- our core earnings totalled approximately $4.9 million or $0.53 per share net realized and unrealized gains from our securities portfolio were $11.6 million or $1.28 per share, and we had net realized and unrealized losses from derivatives of $16.7 million or $1.83 per share excluding the net periodic costs associated with our interest rate swap.

Our core earnings includes the impact of catch-up premium amortization which in the first quarter increased our core income by about $260,000 or $0.03 per share. Catch-up premium amortization is calculated based on interest rate levels and prepayment projections at the beginning of each quarter. In this case, interest rates had recently risen at the beginning of the first quarter and future prepayments were projected to slow down as a result, thus leading to a positive effect on interest income from the amortization adjustment. If we subtract the catch-up premium amortization adjustment, which tends to be volatile from quarter-to-quarter, our core earnings amounted to $4.6 million or $0.50 per share in the first quarter. On that same basis, our fourth quarter core earnings was $0.61 per share.

The quarter over quarter decrease in our core earnings adjusted to exclude the impact of catch-up premium amortization was principally the result of the decline in our interest income. If we exclude the impact of the catch-up premium amortization adjustment from our interest income, in the first quarter our interest income was $9.3 million as compared to $10.4 million in the fourth quarter.

The decrease in our interest income was related to two main factors. First it declined because of the decrease in the size of our portfolio. On the basis of amortized cost, our total MBS portfolio was $1.16 billion as of March 31, 2016 as compared to $1.239 billion as of the end of the year. This decline of approximately $79 million accounts for about one half of the drop in interest income. Second, the weighted average book yields on our portfolio excluding the catch-up premium amortization adjustment declined about 14 basis points to 3.04% and this accounts for the remainder of the decline in interest income.

Also impacting our core earnings was a slight increase in our cost of funds. As noted in our earnings release, our cost of repo increased during the quarter but this was partially offset by a decrease in the periodic cost associated with our interest rate hedges. Our interest rate swaps make up a large component of our cost of funds and during the first quarter they slightly decreased both in terms of notional size, consistent with the decline in the size of our asset portfolio, and in remaining average maturity consistent with the drop in the effective duration of our agency pooled portfolio. The net impact of the increase in our cost of funds was small as approximately $100,000, or $0.01 per share. Our net interest margin excluding the impact of catch-up premium amortization adjustment was 1.83% for the first quarter as compared to 2.01% for the fourth quarter.

Quarter over quarter our total expenses increased slightly. Including base management fees our total expense increased to $1.4 million in the first quarter from $1.2 million in the fourth quarter or $0.02 per share. Overall, while there may be some slight variation in certain line items, we expect our total operating expenses in 2016 to be similar to what they were in 2015.

As I mentioned, our cost of repo increased during the first quarter. While the cost of repo has increased and there's additional market demand for repo given the FHLB's decision to ban insurance (inaudible) from membership in the FHLB system, we have found dealer appetite for repo lending to continue to be strong -- since quarter end, we've seen a slight easing in repo borrowing rates.

During the first quarter, we turned over approximately 48% of our agency RMBS portfolio which generated net realized gains of approximately $4 million or $0.44 per share. In addition, this portfolio and our non-agency RMBS portfolio each appreciated in value resulting in unrealized gains of $10.1 million or $1.11 per share. However the decline in interest rates and high level of market volatility led to unrealized losses on our interest rate hedges which is offset the unrealized on our NBS securities. We ended the quarter with book value per share of $15.39, which when compared to the $15.86 per share at the end of the fourth quarter up 2016 essentially reflects the payment of our first quarter dividend in the amount of $0.45 per share. Adjusted for unsettled purchases and sales, our leverage ratio was 7.7-to-1, slightly lower than it was at the end of the fourth quarter at 8.1 to 1. Our equity relative to December 31st 2015 was slightly lower and our portfolio size also slightly declined as I mentioned earlier.

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

Thanks, Lisa. This is a quarter of extreme market volatility where we basically broke even. As has been our policy since inception, we try to inflate investors from interest rate risk and unlike some others in the mortgage REIT space we try to operate with a large duration gap, positive or negative. Maintaining an interest rate posture with interest rate volatility is high can be a drag on returning but it helps to stabilize book value in violent sell-offs (inaudible). Instead we focus on driving returns with thoughtful prepayment choices, active trading, and careful pool selection.

In the space of about interest rate movements we saw in the first quarter, projected prepayments based on agency MBS changed within the quarter with their duration shortening in early part of the quarter as rates dropped. As durations changed, we have to rebalance our hedges in order to control our interest rate risk. That rebalancing is a drag on returns and that impacted our performance in the quarter. Rate volatility declined in the second half of the quarter and remained relatively low so far in the second quarter. This return to a more normal interest rate environment has helped performance so far after quarter end.

The way that we've positioned the portfolio going into the first quarter protected it from large prepayment increases and our actual CPR has only increased less than one CPR in the quarter, less than the market as a whole. While the refi index more than doubled from peak to trough in the first quarter, our prepayments (inaudible) were much better behaved. Those lower realized prepayment (inaudible) helped to preserve the yield on our mortgage holdings in the declining interest rate environment, leading directly to higher NIMs and higher core earnings as our hedging cost dropped.

During times when the market is moving quickly from a higher rate to a lower rate environment, like we saw in the first quarter, the dynamic hedging adjustment is a headwind. However once you reach the lower rate environment, and see some stability you reap a benefit in lower hedging costs both from lower swap rates overall and from being able to shift more of your hedges to a shorter part of the yield curve.

Another benefit of having a slow paying portfolio and a fast repayment environment is the cost of our TBA hedges have dropped materially. Slide seven shows the monthly courses of a TBA short in FN4s taking by averaging 60-day moving average of the roll of FN4s. Yes, it's actually an annual cost. The recent drops in the roll market for the most actively traded coupons mainly come from increasing repayments on TBA-type pools together with much larger tradeable floats in these coupons with the Fed having not been a net buyer for well over a year now.

Now it was nice enough to have a slow paying portfolio with overall market prepayment speeds were slow as they were before the recent rally since slower speeds mean higher yields, but it's even better to have a slower paying portfolio when overall prepayment speeds are fast as they are now. In this environment, rolls are lower so our TBA hedging costs are lower. Look at the table on slide eight showing what happened in the April prepayment report. There was a big divergent in speed between pools with and without prepayment selection. Generic FN 3.5s have been paying about 10 CPR for March from December through February. In March they increased to over 24 CPR. On the other hand, while loan balance Fannie Mae 3.5s, had been paying 6PR from December through February and they only increased to 7CPR. You can see that the CPR difference between loan balance and generic pools has increased dramatically. The prepaid insurance we bought is benefiting us now.

[MBS] underperformance was a headwind for us in quarter but this underperformance was modest compared to other sectors and should be expected in times of extreme market volatility. In fact, given the substantial underperformance of the S&P high yield indices and CMBX, the agency [MBS] actually held up very well. Look at the graph on slide NINE. This shows the performance of the S&P CMBX, CMBX (inaudible), and high yield bond index with everything all normalized to 100% at the start of the quarter. Asset classes with very different risks were nonetheless highly correlated through the middle of February with all three indices hitting a trough on February 11. RMBS underperformance was modest given these movement in the other markets. Going forward, we are constructive on mortgage spreads. Agency RMBS are liquid, they don't have credit risk and yield a lot more than G3 sovereign bonds.

One emerging trend for the quarter was an increase in foreign buying of agency RMBS. We show this on slide ten. Faced with negative yields on Japanese ten-year notes, it's not surprising that Japanese investors have an interest in higher yield and liquid agency RMBS. While our own central bank executed its rate hike in December, both the ECB and the BOJ went the other way, providing more stimulus in the quarter.

We attribute the recent increase from foreign sponsorship of agency RMBS is a response to the wider gap between agency RMBS and foreign sovereign bonds. There remains substantial yield pickup in agency RMBS relative to Japanese ten-year bonds even after hedging out the currency risk. While hard to quantify, we believe the broad based agency RMBS help moderate underperformance in the first quarter and we believe this new sponsorship along with continued sponsorship from banks, insurance companies and money managers will be a stabilizing factor for agency RMBS yield spreads for a while to come. Less spread volatility should stabilize book value movements and potentially allows to capture a greater portion of our NIMs in our earnings.

We actively turned over the portfolio during the first quarter and we expect continued trading activity. Declining dealer appetite to hold inventory creates more opportunity to capture efficiencies and turn them into trading gains. The great liquidity of the agency RMBS market with narrow bid/offer spread allows us to drop most of the trading gains to the bottom line as opposed to having it leak away in bid/offer spread. Active trading allows it to rotate our portfolio into the most attractively priced forms of repayment protection. We think that active trading is increasingly important as prepayment protection is now in the money, not out of the money as we discussed on an earlier slide. Despite our active trading, the composition of our portfolio did not change significantly during the quarter. As you can see on slide 14, we show our current portfolio slightly keeping our leverage roughly constant given our book value decline.

We held on to a lot of our prepayment protections. The price of payoffs has increased and we're always trying to get the best prepaid protection at the lowest payout.

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

Thanks, Mark. In the early part of the first quarter, our stock price declined somewhat relative to our $15.86 yearend book value and in light of this wider gap, we repurchased a modest amount of shares at an average price of $10.94. While going forward, we expect to continue to opportunistically execute share repurchases, we also continue to be mindful as a small company of the effect that shrinking our capital base would have on our expense ratios and on the liquidity of our stock. Our focus remains on enhancing shareholder value and generating attractive returns over the long term.

We've been talking recently about reallocating more of our capital from our agency strategy to our non-agency strategy and also to the agency IM market. Given how wild yield spreads are on agency pass-throughs now, we remain in no hurry to do this. As non-agency RMBS spreads widened during the first half of the quarter, we almost but not quite reached the entry point we were looking for. In the agency IM market, mortgage rates are now again nearing an inflection point where a big prepayment wave could be coming. And as a result, we believe that many IOs are currently extremely overvalued from a risk/reward standpoint and could experience a big shake-up should interest rates fall further. We are committed to being disciplined by a possible portfolio realignment and we view the current simplicity and liquidity of our portfolio as a huge benefit to the company in this market environment.

The first quarter vividly exposed both a fundamental vulnerability the technical vulnerabilities in the credit markets. Easy monetary policy has resulted in a lot of yield chasing and we believe that many credit-sensitive sectors of the fixed income market, especially after their stunning recovery in the second half of the first quarter are underestimating the risks presented by global economies that are truly weak and structural changes in energy and commodity markets that may be here to stay. The first quarter showed just how exaggerated market moves can be and just how wild the rush to the exits can be when sentiment changes in the credit markets. We believe that Ellington Residential shareholders are best served by our continuing to be patient and disciplined in our choice of entry points.

While being a small company has its drawbacks, our nimbleness is definitely a big asset in this regard. Meanwhile, we believe that the agency RMBS market is providing excellent opportunities. Although prepayment risk is currently heightened, we believe that this is actually a plus for yours as our strong analytical team and proprietary technology adds more value in an environment where repayment risk is not only greater, but varies so divergently by loan characteristics, servicer behavior and many other factors.

Operator?

(Operator Instructions). Your first comes from Steve DeLaney of JMP Securities.

Good morning, everyone. Larry, my first question was going to be what the shift were formerly agency REITs moving into credit and hybrid but your closing remarks pretty much covered that and I guess maybe the right of way to look at it is the opportunity in agency is there for those that really can get the prepay risk right and have the ability to dynamically hedge, because we saw several double-digit book value losses in agency strategies in the first quarter.

And that was in a down rate environment, right?

Yes.

That's happened sometimes more in an up rate environment. So as we said before, we like the value in the agency market right now but given how fragile at time, the non-agency market seems to be and although the IO market hasn't been fragile, we think that it probably should be more fragile than it is and it could really come under some pressure if rates go down and other let's say 25 basis points. So we want to be disciplined and as I said, we really value the liquidity of our portfolio. We can turn on a dime, I think, if we want to. I think having a liquid portfolio has a lot of ancillary benefits even above and beyond that. So yes, so I think we covered that.

Yes. And obviously swap spreads were a big part of it especially with people with a very long durations on their swaps. Do you see a reasonable scenario where we would see a reversal in this swap tightening? It seems that it all other things equal, that would obviously have a very direct benefit on your NAV it we were to get some widening there.

Hi, Steve, it's Mark.

Hi, Mark.

Hi. So I think a few considerations. One really important consideration for us is that the floating rate negative swap, how closely that tracks our repo expenses and one really good piece of now in the last few months was that the floating rate of the swap where we're paying six and receiving three month LIBOR -- when we finance for a three-month period of time, our repo costs have been very, very close to the three-month LIBOR we're receiving under swaps.

Great.

So that's one important consideration. Swap spreads, in the long end, they have become less negative in the last few weeks. I think a few technicals. One is that it's impacted by the size of the Treasury auction calendar. There's been some stuff written that you will see decreasing amount of Treasury issuance that can be a catalyst for having swap spreads become less negative. The other thing is short squeezes can occur in Treasury bonds and you saw some of those in the first quarter. That can be another factor that can make swap spreads less negative.

Okay. That's helpful. And you mentioned -- Lisa mentioned in her remarks that you had actually seen some improvement in agency repo rates since quarter end. It you give me an idea of what you're seeing currently in 30, 60-day repo or the range of quotes?

We're going out longer like the 90-day repo and I think it's been somewhere between 68 and 70 basis points

Now back into the single digits.

Okay.

I think the biggest positive trend we saw in repo the last two months was a re-emergence of some large US banks wanting to grow their agency repo book. So sort of the one trend that had been in place for the last couple of years is sort of a changing of the guard as to who is providing repo and you saw a lot of smaller broker dealers entering the repo market.

Yes.

And a reversal of that trend occurred a little bit in the last couple months that we saw large US banks that had not had a substantial interest in agency repo wanting to re-enter the market and aggressively looking to increase their repo exposure with us. And that is a good thing because rates matter but also the size, the sort of staying power of our counterparties is also very important. We like to have repo counterparties that we can sort of count on through market cycles and having a big bank which -- big US bank that are access to most unlimited funding is zero, having them with a repo counterparty versus a smaller broker dealer, we view that as positive.

That's very good color, Mark and I had actually not heard that. I had not heard that we were having any tightness in repo but obviously the banks are -- that's the kind of muscle and clout that you need to have a really safe, deep market. Are you getting any sense of what the bank's motivation is because everything we've heard with the capital standards and liquidity rules and everything would be that that would be negative to repo. So I'm surprised that the banks are stepping up.

I don't know. This is only speculation but I think they've had some time now where they've been trying to right-size their balance sheets so maybe some of them are pretty far along in that process. And now they just look at it as an asset, right? Getting paid 70 bases points with a big haircut on something liquid, they probably view that as favorable versus what they are gating on some of the shortest high quality floaters they can buy.

Sure, sure. Okay. Well guys, appreciate the comments.

I just wanted to add one more thing.

Yes, Larry.

it's not -- look we have to make choices when we hedge and I wouldn't say that it's our core business to prognosticate swap spreads, but nevertheless we have to make choices, right? And I think that if you look at a negative ten-year swap spread and we do have swaps that are tend to be longer duration because they're assets --

yes

-- are long duration and we try to match our assets and liabilities. So we try to be disciplined about that. If you look at, say, swaps in the ten-year area, I mean negative swap spreads are a recent phenomenon. There was a blip a few years ago but getting to these types of negative levels is a very recent phenomenon and it's one that I think there are some structural changes that are permanent. So for example now that interest rate swaps are essentially cleared, I think that that's helped heighten swap spreads because not all, but a lot of credit risk that was previously --

Counterparty risk.

Is somewhat off the table, right? So that's certainly helpful and that's here to stay. On the other hand there's a lot of technical factors involving balance sheets and people preferring to do things off-balance sheet versus on balance sheet that has had people basically accept these much lower rates, receiving rates on long-term contracts that you get on Treasurys. And I personally I'm not convinced that that's something that will necessarily be here for the long term. And if you look at how swap spreads got out to what, maybe negative 17 or something like that in a ten-year area?

That's about right

And I think that they seem to hit pretty good support there. So from a -- so from a risk/reward standpoint, we are at least at this point in no hurry to change that position because we think that of course there's risk of swap spreads re-tightening but we think there's a limit there. There are arbitrages that you can do if you've got the balance sheet to buy Treasurys and lever them up and basically earn that difference between Treasurys and swaps over the term of the contract. So that's going to be a regulating factor as well. So I like the position we're in and I think that obviously it's been painful for the last call it six months if not nine month in terms of where swap spreads have gone, but we're here and we like the position that leaves us in.

That's great. And Larry, when you take that slight widening in swap spreads maybe four or five basis points, other conditions in the market, is it reasonable for us to assume that your book value has probably improved somewhat from the [$15.39] level at March 31 given the general movement in the market?

Yes. We don't typically like to give guidance on book value, post quarter end but I think that you did hear Mark say that there have been a lot of things whether it be spread tightening, spread tightening in the agency markets since quarter end.

Yes.

I would put swap spreads in the same category that if you were to extrapolate, right, with our portfolio should imply a decent performance since quarter end.

That's great. Guys, I appreciate the comments. Thank you.

Thanks, Steve.

Your next question comes from Douglas Harter of Credit Suisse.

Thanks. Can you talk about how pay-up prices have performed relative to the change in CPRs and how that might compare to prior periods where rates have fallen?

Sure. This is Mark. So that's a good question. In the first quarter, our view was you saw this very violent drop in interest rates. Through the middle of February and pay-ups appreciated materially but that appreciation was sort of in line or an expectation. It was in line with what you would have assumed given that drop in rates. So we think pay-ups performed sort of as expected. They didn't do better. They really didn't do worse.

Since then now gear a back to near [180], I think it got to [160] mid quarter. And pay-ups really have sort of stayed where they were sort of when rates were a little bit lower. So I would say from mid-February to now, pay-ups have outperformed. and one aspect of the market that we mentioned in in the call and have a slide about it is that the rolls have generally are at lower levels. So they're a less expensive short. So for certain arbitrageurs it's more compelling now to have specified pools and hedging those with TBAs because your monthly costs of the roll is, sort of your borrowing cost has gone down. So that dynamic has been supportive of prepayment, has been supportive of pay-ups as well.

And then the other aspect that again we try to document in the slide was the prepayment report of March activity which was released the first week in April. There were some surprises there. So I wouldn't have anticipated a big increase in prepayments and you got a big increase in prepayments. We documented what happened to a couple of the large cohorts. 2014 (inaudible) and early 2014 4s, early the 2014 3.5s for the unprepaid protective pools to jump from 11 to 24, that was a bigger move than what the market thought and that sent some investors scrambling for cover in the form of prepayment protection. So that repayment report was also supportive of the pay-off levels.

And I just -- and let me just add one thing, Mark which is that when you have big moves like we had in the first quarter, and especially, well, actually it could happen either when we're going up or going down but there were these downward moves in the credit market, right? And one of the things that happens is sometimes the liquid products move more than the less liquid products. And all our agency products are fairly liquid, but sometimes you'll see bigger moves -- for example you'll see bigger moves in indices than you see in individual corporate bonds, for example. That was one phenomenon that we definitely saw in the first quarter and I think similarly here, some of the moves that that you'll see, the specified pool payouts for example, sometimes in a market environment like that where people are really focusing on the most liquid products, sometimes you'll see that pay-ups and in case in a down rate environment don't move as much as we might otherwise had hoped.

But I think that one thing that we've seen over time is that if you're patient things will catch up. And so we like the position and we especially like it given that we could be on the cusp of a prepayment wave especially if things move down further and again initially sometimes the moves are not as big as you would want them to be or as your models say you should be but if you're patient, usually things do go back to where more theoretical value or closer to where you think they should be. So we're expecting that to catch up even more than we thought it would be.

Got it. Makes sense. Thank you.

There are no further questions at this time. Ladies and gentlemen, this concludes Ellington Residential Mortgage REIT's first quarter 2016 financial results conference call. Please disconnect your lines that the time and have a wonderful day.