Ellington Credit Co (EARN) 2017 Q1 法說會逐字稿

Good morning, ladies and gentlemen, thank you for standing by, and welcome to the Ellington Residential Mortgage REIT First Quarter 2017 Financial Results and Conference Call. Today's call is being recorded. (Operator Instructions).

It is now my pleasure to hand the program over to Maria Cozine, Vice President of Investor Relations. You may begin.

Thanks, Kristen, and good morning. 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 13, 2017, 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 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 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.

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

Thanks, Maria. It's our pleasure to 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.

Once again, Ellington Residential had a very solid quarter. Adjusted core earnings remain strong at $0.53 per share, up $0.06 from the prior quarter. We paid and maintained our $0.40 dividend, book value per share decreased only slightly. And our adjusted net interest margin for the first quarter improved to a very healthy 1.76%, up from 1.69% in the fourth quarter.

The first quarter market environment was, in many ways, completely different from that of the fourth quarter. If you recall, volatility surged tremendously in the fourth quarter of last year. We had just come off a third quarter that saw near-record low mortgage rates and the highest market-wide level of prepayments since 2013. And then in the fourth quarter, long-term interest rates had one of their largest spikes in over 20 years. The agency mortgage market experienced an extreme whipsaw from an environment at the beginning of the quarter where investors were worried about a refinancing wave and watching their yields and duration [strength] to an environment at the end of the quarter where refinancings were coming to a screeching halt and their portfolio durations had all of a sudden become longer than they had planned for. The 30-year mortgage rate increased 90 basis points over the course of the fourth quarter, leaving a majority of 30-year agency mortgages out of the money for refinancing.

Contrast all that with this first quarter, when interest rate volatility did a complete about-face from the fourth quarter. The 10-year treasury traded within a mere 31 basis point range during this past quarter. And its average over the quarter was a 2.44% yield, exactly to the basis point where it began the quarter. Whereas the yield curve had steepened by 42 basis points in the fourth quarter, it flattened by 11 basis points in the first quarter. Agency RMBS widened in the first quarter. As a Federal Reserve showed itself to be as committed as ever, both to continued interest rate hikes and to the ultimate winding down of its mortgage portfolio.

Many other agency mortgage REITs were absolutely crushed in that fourth quarter, especially in their book value per share. But EARN posted a solid fourth quarter with $0.47 of adjusted core earnings per share and only a slight decline in book value per share. And then in this first quarter, despite the very, very different market environment, EARN again had a solid quarter. The $0.53 of adjusted core earnings per share and again, only a slight decline in book value per share.

How were we able to have such consistent results in such 2 very different quarters when other agency mortgage REITs rose and fell in sync with the markets and with each other. We believe that the answer lies in all of Ellington Residential's competitive advantages and differentiating factors that we've been highlighting since our inception. Later, in my closing remarks, I'll once more run through those competitive advantages and differentiating factors. And then I'll briefly discuss our positive outlook for the rest of the year.

We'll follow the same format on the call today as we have in the past. First, Lisa will run through our financial results. Then, Mark we 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'll follow with closing remarks, and then we'll open the floor to questions. Over to you, Lisa

Thanks, Larry, and good morning, everyone. In the first quarter, we had net income of $2 million or $0.22 per share, the main components of our net income were core earnings of $7.4 million or $0.81 per share, net realized and unrealized losses from our securities portfolio of $5.3 million or $0.58 per share and essentially flat net realized and unrealized gains and losses from our derivative. By this measure, net realized and unrealized gains from our derivatives excludes the net periodic cost associated with our interest rate swaps since they are included as a component of core earnings. Our core earnings includes the impacts of catch-up premium amortization, which in the first quarter, increased our core earnings by $2.6 million or $0.28 per share. After backing out the catch-up premium amortization from interest income in both the first quarter of 2017 and the fourth quarter of 2016, we arrived at our adjusted core earnings of $0.53 per share and $0.47 per share, respectively. The main factors driving the net increase in our quarter-over-quarter adjusted core earnings were higher interest income -- the increase in our quarter-over-quarter adjusted core earnings, were high interest income, partially offset by higher cost of funds and expenses. The increase in this interest income in the first quarter was due to an increase in the average book yields on our assets, given the decrease in our prepayment expectations, coupled with a 3% increase in our average portfolio holdings. This increase was partially offset by an increase in our weighted average cost of funds, coupled with a 2.1% increase in our average outstanding borrowings. Quarter-over-quarter, our weighted average repo-borrowing rate rose 13 basis points as LIBOR increased during the period, and our total cost of funds increased 17 basis points.

Based on the components of adjusted core earnings, the weighted average yield on our average -- on our aggregate portfolio increased 24 basis points to 2.99% in the first quarter, and our net interest margin increased 7 basis points to 1.76%.

Finally, we had higher quarter-over-quarter expenses of approximately $140,000 or $0.02 per share. Our quarter-over-quarter expense ratio increased from 3.1% to 3.6%, but this was basically just a result of the timing of certain professional fees incurred, so our first quarter expense ratio was atypically high and our fourth quarter expense ratio was atypically low. Based on our current capital base, we are forecasting our full year expense ratio at between 3.4% and 3.5%.

During the first quarter, we had a modest net realized and unrealized losses on our Agency RMBS portfolio because of slightly wider spreads. We actively traded our portfolio to capitalize on sector rotation opportunities and our turnover for the quarter was 21%.

Net realized and unrealized losses on our Agency RMBS was partially offset by positive income from our interest rate swaps, which benefited from higher short-term rates, our short TBAs which we also use as a component of our interest rates hedging strategy, generated modest losses as lower prepayment activity led to the outperformance of TBAs relative to specified pools.

Finally, we had losses on our U.S. Treasury securities and futures hedges, which were impacted by lower, longer-term interest rates. Treasuries and futures represent a smaller component of our interest rate hedging portfolio relative to TBAs and swaps. All in all, when we look at our interest rate hedges, excluding the periodic costs associated with our interest rate swaps, which is included in core earnings, their net impact was negligible during the quarter.

We ended the quarter with book value per share of $15.35, and when the first quarter dividend of $0.40 per share is taken into account, our economic return for the quarter was 1.5%. Quarter-over-quarter, our leverage ratio adjusted for unsettled purchases and sales, dropped slightly to 8.2:1 as compared to 8.3:1 as of December 31, 2016.

I'd now like to turn the presentation over to Mark.

Thank you, Lisa. In sharp contrast to the fourth quarter, the first quarter had limited interest rate move. In mid-March, the bond market tested the high-end of the range in interest rate with 10-year swaps at 2.6%, but quickly rallied back. Since then, markets have settled into a level about 50 basis points higher than on election day, or about 30 basis points lower than the March highs. This range-bound market helped first quarter performance and is continuing to present a favorable backdrop. It isn't just reduced volatility that makes this a good earnings environment for mortgage REITs. It's also the absolute level of rates, which right now are very mortgage investor friendly.

What caused problems for some managers in the fourth quarter was merely mortgages behaving like they typically behave when rates break out of a range. When rates make new lows, you have to worry about prepayment risk, when rates makes new highs, you have to worry about extension risk. Those kinds of gyrations can hurt book value if you have a lot of leverage, if you aren't diligent about your hedging, if you don't have the right mix of hedges. We managed this gauntlet of volatility very well in the fourth quarter and we were able to emerge into this more hospitable environment without a scratch in contrast to the body blows that others took. Reaching now about 40 basis points away from having the market really focus on extension risk and we're about 40 basis points away from worrying about prepayment risk. Net interest margin is wide and rates have to move a decent amount before the situation changes. With delta hedging costs currently low, a lot of spread income drops to the bottom line.

We show another positive on Slide 7. Most of the mortgage market is out of the money and significantly, most of the post-2014 production that chose refi responsiveness is out of the money. So barring a substantial rally, the market shouldn't have to contend with a lot of refi-generated supply. A strong fundamental for mortgages is that the spreads are wide from an absolute standpoint and they are very wide relative to other fixed income sectors. Of course, spreads are wide because of the fear of the Fed's ultimate balance sheet reduction. What is important to bear in mind is that perhaps a lot of this potential spread widening is already priced in.

After years of QE from the Fed, ECB and the BOJ, many sectors of fixed income spread assets are now priced at the tightest levels we have seen in years. Look at Slide 8. This was put together by Morgan Stanley and does a nice job of illustrating the point. Agency mortgages are the only substantial fixed income asset class that is much closer to its 2-year wide in the spreads than its tights. One stated goal of QE was to force bond investors to sell their Treasury and Agency MBS, and to buy higher yielding things instead, and it worked. Investors bought high yield and investors grade corporate bonds, they bought CMBS and so on. So now, your Agency MBS look like good relative value and can generated a healthy NIM. But what's the catch? The catch is potential Fed balance sheet reduction. Fed officials went out of their way in the first quarter to dial-up the messaging about this. They have given us some guidance on when it might start, either fourth quarter of this year or the first quarter of next year, and the implied that it will happen with treasuries and MBS simultaneously, but they haven't said much else. Obviously, their goal is for orderly markets. Understandably, in anticipation of this balance sheet reduction, Agency MBS have widened and we now at some of the widest OES levels in the past 2 years.

While we expect some MBS spread volatility when tapering starts, some underperformance is already priced into this sector. And the further widening in MBS spread could actually be a very good thing for us. It may result in book value decline when it occurs, although our use a TBA shorts [its hedge] that should quickly mitigate that risk, but it should also result in higher going-forward NIM with better core earnings and therefore, maybe a higher dividend as well. As a manager, you want to be positioned in the way that allows you to take advantage of spread widening, but aren't so offside such that you have to deleverage because of book value declines in the middle of it.

EARN has taken a conservative approach. Compared to our agency weak peers, we have chosen the road of less duration with, generally, and the more TBA hedges at least for now. And thanks to this approach, we have a lot less levered MBS risk than our peers. As a result, in times of volatility, we should have better book value stability. That's our approach and it has served us well in the past. We are now seeing better opportunities to deploy capital than we had in the fourth quarter.

I'll elaborate on a few more positives that we see. First, the cost of prepayment protection is cheap. Look at Slide 9. As prepayments have slowed down, the prepayment differential between specified pools and generic pools is compressed. So the cost of adding prepayment protection has come down. As we have seen compressions and prepayment fees such as we're see now, can often be temporary.

Second, another positive is that mortgages have a lot more debenture-like, or a lot more debenture-like in their cash flows than they used to be. Look at Slide 10. This slide compares re-financeability of MBS pre- and post-crisis. Mortgages used to be a lot more callable. The cumulative weight of regulation and high compliance costs have allowed MBS to hold onto a lot of their duration in recent rallies. This also has reduced the cost of prepayment protection so we can currently protect ourselves very cheaply from some of the risks that regulation-based prepayment frictions diminish over time. So mortgages are currently behaving more like corporate bonds substitutes at a time when corporates look expensive and mortgages look attractively priced.

A third positive is that turnover speeds are faster. A stronger housing market and a slightly stronger economy have increased prepayment speeds on out-of-the-money pools. That is important because it reduces extension risk in the selloff.

Finally, a fourth positive is the financing market. We have financed it below LIBOR for several months in a row thanks to money market reform. So all these factors together make us more constructive on mortgage spreads than we were 6 months ago and consequently, we have reduced our TBA hedges somewhat post quarter end.

For the first quarter, while we didn't make any large changes to portfolio composition, we did see numerous relative value opportunities and we turned over more than 20% of the portfolio. We increased our 30-year conventional allocation and we decreased our position in 15 years in Ginnie Mae's. We dialed up our TBA hedges slightly during the quarter, but then we dialed it back down a bunch in April. As specified loan balance payoff generally underperformed, we added slightly to those positions. Prepayments dropped by almost 20% in the quarter. Alpha opportunities continue to be plentiful in the specified pool sector. There have been a number of newer, lesser-known refinancing programs designed for new and for under-serviced borrowers. Some of these are taking place at the municipal level, others specific to an individual originator. We have good success in trading these around and used them as a source of bonds for our core position.

We have been more conservatively positioned since the fall of 2016. In the fourth quarter of 2016, it really helped and it really enabled us to generate solidly positive economic returns. The first quarter was a good quarter for us as well, even though the environment was totally different.

Our view of the opportunity and mortgages changes a lot when we get near rate boundaries, because MBS can love a range-bound market. When rates drop to the low-end of the range, prepayments can change and then uncertainty can cause problems. When rates get to the high end of the range, then extension risk rears its ugly head in portfolios and that may cause some investors to sell their holdings. With rates back in the middle of the post-election range, we see better value on MBS now. There is still the potential for substantial volatility from Fed speak, and Fed balance sheet reduction fears.

Just because things might work out in the long run, isn't enough. You still have to get through the short-term dynamics of the holder -- of a full 1/3 of the entire MBS universe potentially exiting the market.

So there is always a complex trade-off between risk and reward in the markets. Only in hindsight is portfolio positioning so obvious. In reality, the market can evolve along many paths. As the manager, you have to acknowledge some unpredictability and make a choice. We think the prudent choice in the current market is to take incrementally more mortgage risk. The pros outweigh the cons and the NIM is strong and the cash flows are easily hedgeable. That's all good news. This environment is supportive of core earnings and supportive of dividends.

We took down our risk during the post-election fireworks, and that really ended up helping preserve book value. But you can't bring the same playbook to every game. Now it seems that it will be tougher for the government to enact policy changes than what the markets had originally anticipated and yet, valuations remain on the wider side. So it seems that now, a little more mortgage risk makes sense.

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

Thanks, Mark. For many agency mortgage REITs, the fourth quarter and the first quarter was a roller coaster. At they rode the fourth quarter down and then rode the first quarter up. Many still haven't recovered their fourth quarter losses. But Ellington Residential is different. We trade actively, our portfolio turnover is high and we're flexible. This lets us not only take advantage of short-term trading opportunities, but it also enables us both to adapt quickly to fast-changing market environments, like what we saw in the fourth quarter, and our style also enables us to adapt to longer term trends in the markets. All the while, we are laser-focused on risk management and book value preservation. Our hedging style is disciplined and dynamic. We hedge across the entire yield curve. We rebalance our hedges when we should. And we are unique in the peer group in the extent to which we have used TBAs as hedging positions, which has significantly reduced many portfolio risks. We're not afraid to dial our mortgage basis exposure up and down, especially when markets looks shaky like they did late last year. Of course, asset selection is key as well. And here, we take advantage of Ellington's 20-plus year history in these markets, modeling and managing prepayment risk and identifying the right entry and exit points. We do all this because we're not in the business of Fed policy prognostication or interest rate prophesy, staying out of that business helps us sleep better at night. Thanks to our hedging strategy, we're more insulated from interest rate spikes and we're more insulated from widening yield spreads; a flatter yield curve doesn't bother us. We're also more insulated from prepayment shocks and that's a function, not only of our use of TBAs to hedge, but it's also a function of our asset selection. For our -- where we are always looking for the best value in prepayment protection.

We think a lot about government and GSE policy risk. And again, it's a primary focus of both our asset selection and our hedging strategy to avoid getting overexposed to policy risks.

So looking forward to the rest of the year. We think we're more than ready for whatever rate hikes seem to be coming and for whenever the Fed decides to start tapering its reinvestment program. We remain nimble and ready to make adjustments. We believe we can adapt to extreme volatility as evidenced by our peer group outperformance in the fourth quarter and capture upside in good markets as well, as evidenced by solid results in the first quarter. The way I like to put it, I believe that EARN is truly an all-weather mortgage REIT.

Since our IPO in 2013, we've consistently been saying that our objective is to deliver attractive dividend yields over market cycles while mitigating risk, especially interest rate risk, and all in the form of an agency-focused mortgage REIT.

I continue to believe that we have delivered. EARN outperformed all of the other agency mortgage REITs last year, with the highest economic return in the whole sector. We are extremely pleased that our shareholders have benefited from our stocks' nearly 20% total return since the start of the year. As Mark described, we certainly see no shortage of excellent opportunities in the current environment, and we have the utmost confidence in our investment strategy and in EARN's ability to succeed in a wide variety of market scenarios without taking undue risk.

And with that, our prepared remarks are concluded. I will now turn the call to the operator for questions. Operator, go ahead.

(Operator Instructions) Our first question comes from Doug Harter with Crédit Suisse.

You talked about removing some of the TBA hedges in April. Did you replace those with interest rate hedges? Just kind of want to better understand the risks that you're comfortable taking today.

Sure. Doug, it's Mark. So yes, when we bought back TBA hedges, we replaced them with interest rate hedges. Either interest rate swaps, treasuries or treasury futures. So in terms of risks we're comfortable taking and risks we're not comfortable taking. So risks we're not comfortable taking is to expose the portfolio to a lot of interest rate risk. We feel like interest rate risk is prone to sharp movements from exogenous factors that are very difficult to predict, central bank activity, geopolitical events. So we don't generally expose the portfolio to interest rate risk. We will expose the portfolio to different amounts of levered agency mortgage exposure relative to swaps and treasuries, right? And by doing that, we're also implicitly exposing the portfolio to different levels of volatility risk, right? So in the fourth quarter, the TBA hedges really helped a lot because as interest rates were selling off and the assets we hold were extending in durations, the market was anticipating slower prepayment speeds. The TBA portion of our hedges were also extending in duration as a result of market anticipation of slower prepayment speeds. So that helps a lot. Now that we're in this range-bound environment, pretty far away, as I mentioned in the prepared remarks, from concerns about prepayment risk or extension risk, we decided to reduce some TBA hedges. It's a little expensive -- it's a less expensive mix of hedges we have on the books now. I think for all the reasons we articulated, this current environment, that positioning makes sense and it should manifest itself in a little bit higher earnings.

I guess, just looking forward, obviously, you don't exactly know how it plays out. But if we assume that you see some additional widening once the Fed announces the reinvestment plans. Is that something where you could further reduce the TBA hedges? Would that kind of be the thought process?

Yes. I mean, there are plenty of companies in this space. Most companies operate with no TBA hedges and they just have more volatility exposure and more levered MBS exposure. So if we got to the point where mortgages were significantly more attractive relative to swaps and treasuries than they are now, we could adopt that positioning and just choose to more frequently delta hedge the interest rate risk in the portfolio. I think for us, a lot will depend on the specifics you get of how the Fed is going to taper. So there's certainly tapering scenarios they could articulate that we think mortgages would need to widen from here that compensate investors for increased supply. And there are certain tapering scenarios they can articulate, but we think the current levels of spreads are sort of excessive compensation, and then we might add more mortgage basis.

Yes, if you look over time, Mark, tell me if you agree with this. I would say that for Ellington Residential, we've probably never gotten above a 50% TBA hedge, and we probably never gotten below 20%.

That's right.

And I think that -- we also haven't had the type of basis widening that we saw in 2009, right? Where, if that happened, then I think we could move outside the lower end of that range. But I think that's a pretty good, granted it's a wide range, but I think that's a pretty good indication of kind of where we usually max out and where we min out. And Mark, I don't know if you want to give a -- we were at 45% roughly at quarter end, we were at 40% at the end of the year. If you want to give a little more color in terms of roughly, maybe where we've been since April, dialing down a bit, dialing up the exposure or down the TBA hedge.

Right. So we've dialed down the TBA hedge incrementally another 5% or 10%. The one thing I would add is that, if you compare an agency mortgage strategy to a credit strategy. In an agency mortgage strategy, if mortgages underperform swaps and treasuries, then it's a short-term book value hit. But you're getting a long-term better net interest margin that you sort of earn out that book value hit over time. In a credit strategy, if you're wrong on credit and there is an increase in credit losses, greater than expectations, that's a loss that doesn't come back to you. So it's just a fundamental difference that when mortgages widen, it's a little -- it's a short-term headwind, but there's a long-term benefit to that, to NIM and potentially, dividend.

And let me add one more thing which is that -- I think that -- when you think about almost, you can look at this as sort of an overlay of several different risks that we're taking. But I think that to what extent are we exposed to the mortgage basis is obviously, a risk that we dial up and down. And I think there, we have convictions that can raise from extremely high convictions to much lower convictions. And -- but except in exceptional circumstances, I think, generally speaking, our convictions on a mortgage basis are not going to be as high as our convictions on the relative value of many specified pool sectors versus TBAs. And our ability to sort of capture that alpha. And I think that -- so you've got basically, the -- sort of our -- what we look at as very high conviction on specified pools versus TBAs very often. And I think that we are more comfortable taking lots and lots of that risk and in terms of the mortgage basis, I think we are comfortable, obviously, taking that risk and dialing up and down. But we generally think of that as, except in exceptional circumstances, a lower conviction positioning. So trade, so that's where we think that we can generate the best returns for investors, risk-adjusted returns for investors, over cycles.

(Operator Instructions) And at this time, we have no further question. Ladies and gentlemen, we do thank you for participating in today's conference call. You may now disconnect your line.