Ellington Credit Co (EARN) 2020 Q4 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2020 Fourth Quarter Financial Results Conference Call. Today's call is being recorded. (Operator Instructions)

It is now my pleasure to turn the floor over to Jason Frank, Deputy General Counsel and Secretary. Sir, you may begin.

Thank you, and welcome to Ellington Residential's Fourth Quarter 2020 Earnings Conference Call.

Before we begin, 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, 2020, and Part 2, Item 1A of our quarterly report on Form 10-Q filed on May 11, 2020, 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.

Joining me on the call today are Larry Penn, Chief Executive Officer of Ellington Residential; Mark Tecotzky, our Co-Chief Investment Officer; and Chris Smernoff, our Chief Financial Officer.

As described in our earnings press release, our fourth quarter earnings conference call presentation is available on our website at earnreit.com. Our comments this morning will track the presentation.

Please note that any references to figures in this presentation are qualified in their entirety by the end notes at the back of the presentation.

With that, please turn to Slide 3 of the presentation. I will now turn the call over to Larry.

Thanks, Jay, and good morning, everyone. We appreciate your time and interest in Ellington Residential. During the fourth quarter, Federal Reserve purchasing activity remained elevated, dollar rolls continue to be strong and yield spreads on Agency RMBS tightened very significantly.

In addition, as you can see on Slide 3, long-term interest rates started to increase with a 10-year treasury rising 23 basis points during the quarter. While the U.S. treasury yield curve steepened with the 2-year 10-year spread increasing to 79 basis points. It's been over 3 years since we've been in a yield curve environment that's this steep. Despite these movements, actual and implied interest rate volatility remained low and Agency RMBS outperformed dramatically.

As you can see here on this slide, even with the sizable increase in long-term interest rates, the price of Fannie Mae 2.5s increased by more than 0.5 point, which equates to a spread tightening of nearly 30 basis points. So far, in 2021, we have seen long-term interest rates continue to rise and the yield curve continue to steepen. As the market is anticipating a significant stimulus package from Congress and a modest increase in inflation expectations.

Turning to Slide 4. You can see that Ellington Residential had another excellent quarter. We generated net income of $0.60 per share and an economic return of 4.5% for the fourth quarter, which brought our full year 2020 net income to $1.63 per share and our full year 2020 economic return to 13.1%.

Core earnings for the fourth quarter was $0.34 per share, again comfortably in excess of our $0.28 quarterly dividend. A dividend, which I'm proud to say, we maintained throughout all of 2020 without interruption or cut.

You can also see on this slide that our net margin again exceeded 200 basis points this past quarter despite lower asset yields. Notably, we were again able to deliver strong results this past quarter, even while maintaining leverage that's well below our historical averages.

Our debt-to-equity ratio as of December 31 was just 6.1:1 down from 6.5:1 at the end of the prior quarter and well below our historical debt-to-equity ratio, which has typically been in the 8s or 9s to 1.

During the fourth quarter, we continue to maintain a long position in current coupon TBAs. And as a result, we again benefited from attractive dollar rolls, driven by Federal Reserve purchasing activity. Our non-Agency RMBS portfolio also had another excellent quarter as yield spreads in that sector continued to revert toward pre-COVID levels.

At the same time, the rise in long-term interest rates generated significant net gains on our interest rate hedges. Meanwhile, along with our net long positions in current coupon TBAs, we also held net short positions in high coupon TBAs. This long short portfolio positioning was similar to our positioning in the third quarter, and this positioning again paid off as lower coupon TBAs significantly outperformed higher coupon TBAs.

One wonderful thing about the Agency mortgage market is that it's not only a deep and liquid market on the long side, but it's also easy and efficient to take short positions via TBA contracts. This simple fact increases the investment opportunity set for us dramatically, but it also allows us to manage our risk and returns much better, adding or reducing our TBA short positions and thereby dialing down or up, our overall net mortgage exposure has been an effective tool for us, whether to protect our book value when yield spreads look tight to us or to take a more aggressive posture when yield spreads look attractive. The strategic use of significant short TBA positions has been a major differentiator for EARN in the agency mortgage REIT space.

Finally, despite the increase in interest rates this past quarter, we had another solid quarter of performance from our specified pools, which comprise the vast majority of our assets. This capped off an incredibly strong year for the specified pool sector.

Over the past few years, we have regularly highlighted some larger themes in the mortgage market, as the underlying rationale for our continued focus on prepayment-protected specified pools. Many of these themes kicked into hyperdrive as a result of the COVID-19 pandemic.

One example is the dramatic effect that technological advances and automation have had on lowering the hurdle on refinancing. Combined with all-time low mortgage rates, these technological advancements led to a surge in prepayment rates in 2020, which resulted in significant increases in pay-ups across many specified pool sectors.

The performance of low loan balance Fannie Mae 3s is a great example. Over the course of 2020, as investors flock to prepayment protection, pay-ups for this specified pool sector tripled from around 2 points to around 6 points or a markable increase of around 4 points.

The outperformance of specified pools is even more remarkable given that on certain days during the liquidity crunch of March and April, pay-ups on most specified pool sectors had utterly collapsed.

Later on this call, Mark will elaborate further on the impact of technology on the Agency MBS market.

And I'll now pass it over to Chris to review our financial results for the fourth quarter in more detail. Chris?

Thank you, Larry, and good morning, everyone. Please turn to Slide 7, where you can see a summary of EARN's financial results. For the quarter ended December 31, we reported net income of $7.4 million or $0.60 per share and core earnings of $4.2 million or $0.34 per share. These results compared to net income of $8.1 million or $0.66 per share and core earnings of $4.8 million or $0.39 per share for the third quarter.

Core earnings excludes the catch-up premium amortization adjustment, which was negative $559,000 in the fourth quarter compared to positive $405,000 in the prior quarter.

As you can see on Slide 7, our fourth quarter results were driven by strong net interest income on our Agency RMBS investments, net realized and unrealized gains on our long TBA holdings, and net realized and unrealized gains on our interest rate hedges and other activities.

A portion of this income was offset by net realized and unrealized losses on our Agency RMBS investments, driven largely by elevated prepayment activity.

You can also see on Slide 7 that our net interest margin narrowed modestly by 9 basis points to 2.12%, driven by lower asset yields. As we mentioned last quarter, we expect our asset yields to come down as the portfolio naturally pays down and as we turn over our higher-yielding non-Agency portfolio and Agency RMBS assets and reinvest at lower market yields.

You can also see here that we continue to benefit from very low borrowing costs. Average pay-ups on our specified pools decreased to 2.4% as of December 31 as compared to 2.55% as of September 30, but this was primarily because our new purchases during the fourth quarter consisted mainly of lower pay-up pools.

Next, please turn to our balance sheet on Slide 8. During the fourth quarter, we continued to maintain higher liquidity and lower leverage as compared to periods prior to the onset of the COVID-19 pandemic.

At December 31, we had cash and cash equivalents of $58.2 million, down modestly from $61.2 million at the end of the prior quarter, but well above the $35.4 million cash holdings at year-end 2019.

Our debt-to-equity ratio adjusted for unsettled purchases and sales, declined quarter-over-quarter to 6.1:1 at December 31 from 6.5:1 at September 30 and 8.1:1 at December 31, 2019. The quarter-over-quarter reduction was driven by larger shareholders' equity and smaller overall RMBS portfolio.

You can also see here that our book value per share was $13.48 at December 31, 2020, compared to $13.17 at September 30 and $12.91 at the start of the year, reflecting increases of 2.4% and 4.4%, respectively, for the quarter and year as our earnings exceeded dividends by a healthy margin.

Our economic return for the fourth quarter was 4.5%, including the impact of the fourth quarter dividend of $0.28 per share. For the full year 2020, our economic return was 13.1%, inclusive of $1.12 per share of dividends declared during the year.

Next, please turn to Slide 9, which shows a summary of our portfolio holdings. In the fourth quarter, we continued to monetize gains in our non-Agency RMBS portfolio, most of which we had opportunistically purchased in the aftermath of the March and April market distress. As a result of those sales, our non-Agency portfolio declined by an additional 28% quarter-over-quarter. The size of our Agency RMBS portfolio declined by 2% over the same period.

Next, please turn to Slide 10 for details on our interest rate hedging portfolio. During the quarter, our interest rate hedging portfolio consisted primarily of interest rate swaps, short positions in TBAs and U.S. treasury securities and futures, consistent with the prior period.

On Slide 11, you can see that our net long exposure to RMBS was 5.6:1 at December 31, unchanged from prior quarter.

I will now turn the presentation over to Mark.

Thank you, Chris. I'll first update how EARN performed for both the quarter and the full year, and I'll close with our forward outlook and we are positioning the company to drive future returns.

2020 was quite a year. I've been active in the mortgage market for a long time, and I don't think I've ever seen a rollercoaster ride like 2020. The lows were lower and the highs were higher, you had to expect the unexpected.

Starting at the screens in March and talking to our most important counterparties then, I literally saw and heard things I had trouble believing. But we have always managed EARN with 2 primary and simultaneous objectives, and these objectives helped us persevere through the turmoil. First, we protect book value against downside moves. And second, be opportunistic and capture upside when it presents itself. That philosophy is what drove our 2020 performance.

Market shocks are almost always caused by something that is not on people's radar, and COVID-19 was no exception. The balance sheet shocked that the pandemic caused in the second half of March was sudden and enormous and demonstrated how thoughtfully we managed our liquidity as we were able to meet all margin calls, avoid forced asset sales and build up a liquidity cushion during this period. And the subsequent opportunity that followed, the massive Fed intervention, was also sudden and equally enormous, we were able to capitalize on it.

For the year, EARN did great. Stock delivered a best-in-class total return of over 30%, and our total return on book value was an impressive over 13% for the year. We got there with a disciplined team approach. As the pandemic caused panic and balance sheet shortages in March, we had ample liquidity and we were appropriately levered, and our repo maturities were well-staggered with the diversified set of lenders who were able to weather the storm with modest controlled asset sales that did minimal book value damage.

Throughout our history, we have generally favored lower leverage than much of the peer group. The reason for that is the couple of extra turns of leverage that companies reach for when NIMs are tight and earnings are hard to generate mean the difference between being a forced seller or an opportunistic buyer during times of distress.

Instead of extra leverage, we try to make up additional returns with more active trading and a deeper dive into prepayment. We don't just try to leverage the beta of the mortgage market. We also try to leverage the alpha, which is the incremental return available to investors with the deepest understanding of prepayments and market's inefficiencies.

In the spring, we pivoted and used the flexibility of our investment mandate by non-Agency MBS at very distressed prices. This flexibility and willing to take credit risk when yields are attractive, something that Larry has mentioned a few times on our recent calls. It shows one of the benefits that EARN enjoys in terms of being part of a much larger investment management complex that manages over $11 billion as deep and broad expertise in mortgage credit where EARN's primary focus has been Agency MBS, we have the benefit of world-class PMs with deep expertise in mortgage credit and that EARN can opportunistically take advantage of that.

Now let's look at the fourth quarter. EARN had a very solid 4.5% economic return. The portfolio shrank slightly as paydowns exceeded new investments, but we actually traded almost 100 million current phase of pools and CMOs. We continue to monetize substantial gains in our non-Agency MBS portfolio.

As Larry mentioned, we continue to operate with leverage that's below our historical average as asset yield spreads over financing and hedging instruments not currently look compelling for many sectors of the Agency MBS market.

Our portfolio had solid performance during the quarter, and our coupon positioning in TBA MBS continue to help performance. The TBA coupons that we were long had large positive roles and those that we were short had negative roles. Those with the relative price performance across the coupon stack ended us allowing us to make money on both the long side and the short side of our TBA trade.

Security selection kept portfolio prepayments to be manageable for EARN in 2020, but make no mistake about it, we are in a big, long-lasting prepayment wave, and it's not clear whether it's starting to abate. Work from home and technology are playing havoc with the historical pattern of seasonal trends. And while the most recent prepayment data that came out 2 weeks ago seems to show some signs of slowdown, still too early to tell if that's the case.

Going forward, we see a balanced outlook for Agency MBS with both substantial tailwinds and headwinds, which guide us to a lower levered positioning. We think there will be more volatility in 2021 than there was during the second half of last year when price action was muted. The big outperformance of Agency MBS versus hedging instruments that happened in the second half of 2020 and in the early days of 2021 was driven by 2 big tailwinds, Fed support and bank buying. A lot has been made of Fed buying, it's very significant. But banks with a lot of cash and limited investment options have also been huge buyers of Agency MBS. While there has been a recovery since March 2020 in virtually all fixed income spread product, Agency MBS is unique because the Fed is buying them in large predictable size, and they have no credit risk.

The result has been stable and tightening spreads relative to treasuries, strong dollar rolls and very low borrowing costs. Relative to other parts of fixed income, Agency MBS looked pretty good because everything has experienced a massive spread recovery. Consistent Fed buying in strong current production coupon rolls and very low financing costs. We've been able to borrow 1 year repo at 20 basis points. So that means to buy and finance $100 million of Agency MBS for a year where repo cost is a mere $200,000, which is an enormous tailwind for the Agency MBS investors.

What about the headwinds? Well, the fintech revolution has come to the Agency mortgage market, an industry that previously seems stubbornly resistant, the technology, which could have streamlined a process that involves dozens of paper documents and human touch points is now changing and changing fast. Electronic notaries, appraisal waivers, uploaded documents, automated poles of bank statements, et cetera. These are all changing the refinance experience as a new tech-savvy generation embraces homeownership.

The old guards of money center bank changing or being left behind. But this technology costs money, historically, mortgage companies as opposed to big banks are typically run with very limited capital. But not anymore. The IPO activity for more companies has been fast and furious, Rocket, Home Depot, Home Point, WM, now all have big market caps. And to race to use tech to create the best consumer or mortgage broker experience. These nonbank originators are rapidly grabbing market share and are dramatically streamlining the closing process. For example, one nonbank originator boasts loan closing times of less than half the industry average. So to drive our returns going forward, a big focus for us will be understanding how the technological improvements in mortgage underwriting, changing prepayment behavior in ways that many prepayment models miss. This has been a research focus of ours and informs how we position our portfolio in this high prepayment environment.

Going forward, we expect not only increased volatility in interest rates but also increased volatility in the relationship in mortgages and hedging instruments, such as interest rate swaps. At the right time, we will look to opportunistically increase our mortgage exposure in either pool or TBA form.

In the meantime, we see lots of opportunities to add excess returns to the portfolio through both active trading and thoughtful positioning.

Now back to Larry.

Thanks, Mark. EARN's strong fourth quarter concluded what has been a remarkable year of outperformance for us.

Please turn back to Slide 5. During an unpredictable and unprecedented 2020, EARN generated an economic return of 13.1%, a total return on its stock of 36% and net income and core earnings that significantly exceeded dividends, dividends that we kept constant throughout the crisis and throughout the year.

How did we do this? Through the extreme volatility of March and early April, our disciplined risk and liquidity management protected book value allowed us to avoid forced asset sales and preserve liquidity, enabling EARN to withstand the extreme market-wide volatility and liquidity crunch. We emerged from the crisis with a strong liquidity position, and that allowed us to take advantage of some extraordinary investment opportunities, while asset prices were still depressed.

All the while, we were able to navigate a mortgage refinancing wave that Saw agency prepayment rates surge to their highest levels since 2012.

EARN's outstanding 2020 also followed a strong 2019 for EARN when we generated an economic return of 14.6%. You can see the cumulative economic return for these 2 years on Slide 6. Over this 2-year period, EARN generated a cumulative economic return of nearly 30%, which I believe puts us at the top of the publicly traded Agency mortgage REITs.

Clearly, the operating and investment environments of 2019 and 2020 could not have been much more different. Nevertheless, EARN was able to prosper in both periods. And by doing so, I believe that we have, without question, demonstrated our ability to achieve our objective which is to deliver strong and steady returns to our shareholders in a diversity of market environments across market cycles.

Now turning to the opportunities that lie ahead in 2021. Short-term interest rates are likely to remain near 0 for another year, and it seems unlikely that the Fed will start tapering asset purchases this year. There's no question these dynamics have been beneficial for Agency RMBS investors. And our high net interest margin is certainly a nice tailwind for 2021. But as we saw last year, market dynamics can change quickly. Fiscal stimulus can be a boom to asset prices, but the fear of large fiscal deficits can wreak havoc on MBS prices.

Meanwhile, as Mark discussed, technology continues to evolve at a blistering pace. And we're expecting even more private nonbank mortgage originators to go public in 2021 bringing even more capital attention and technology to the sector.

In this environment, Agency MBS portfolio managers need to find the right balance between, on the one hand, constructing a portfolio that is not -- that can hold up in today's high prepayment environment. And on the other hand, constructing a portfolio that is not overly exposed to extension risk and spread widening risk should interest rates continue to rise.

Finding this balance allows a disciplined portfolio manager to play offense during times of stress, something that differentiated EARN from the peer group in 2020. Whatever path the residential mortgage market takes from here, changes in the prepayment landscape should favor our core strengths of prepayment modeling, asset selection and dynamic interest rate hedging. And with our relatively low leverage and disciplined hedging, EARN should be well positioned to capitalize both on the opportunities that we see right now and on those that are bound to emerge when things inevitably change.

It bears repeating that our success at EARN does not necessarily depend on the absolute level of interest rates, on the shape of the yield curve or where net interest margins happen to be. And that's because of our portfolio management strategy. We trade actively, we shift our capital to where we think the best opportunities are, and we hedge along the entire yield curve. Often using significant TBA short positions.

Finally, please now turn to Slide 15 for our 2021 objectives. As we look ahead, our investment principles remain unchanged. Capitalizing on investment opportunities presented by market volatility and uncertainty, diligently hedging and managing liquidity to protect book value, dialing up and down our MBS exposure opportunistically and rotating our portfolio based on where we see the best value at each moment in time. We look forward to meeting the opportunities and challenges to come in the year ahead.

Before we open the floor to questions, I would like to thank the entire Ellington team for their hard work in 2020. And for all of those listening on the call today, we wish you the best for 2021.

And with that, we'll now open the call to questions. Operator, please go ahead.

(Operator Instructions) And your first question will come from Doug Harter with Crédit Suisse.

Hoping you could talk a little bit more about the type of environment that might allow you to kind of dial up the risk and kind of after kind of living through last March. If you could talk about kind of where the upper end of the range might be if the environment presented itself?

Doug, it's Mark. So when we wrote the script, it was a few days ago, and I think yesterday is a good example of some of the market volatility that we were starting to expect as you see a lot more focus and a lot more being written about inflation. So yesterday, for example, was a day of a pretty substantial mortgage underperformance. So I think that we use opportunities like that to increase our mortgage exposure, either in pool form or in TBA form. But people need to realize that you have a giant buyer out there in the Fed, that's not driven by economics. So there's going to be times where they're going to cause a pricing structure in the market that doesn't leave a lot of room for attractive NIM. But what they do, do is they also create pricing distortion. So there's going to be lots of belt to value opportunities as well.

Great. And then just on how you might think about the range of where kind of your net MBS exposure or net leverage could get to if the environment presented itself?

Yes, I would say, if you look historically where we've been at, sort of the upper end of that range, I think would sort of still serve sort of is an upper balance for us. And I think where we -- where we ended the year, was probably close to a lower bound. Mortgages had a very, very strong Q4. If you look at the prices where things ended Q4 relative to where they are now, big sectors of the market substantially lower, down over 1 point.

And if I could just add to that, one of the -- couple of things we talked about earlier on the call, Doug, one was the fact that you've got obviously, prepayment is very, very high. But you also have rates very low and the possibility of extension risk, especially as more and more of the mortgage universe has -- is refinancing lowering coupon, right? If that all of a sudden interest rates reverse, you're going to have some low coupon mortgages extending tremendously. So we're at this real balancing act right now. Where it's just very -- it's a very dangerous environment.

But on the other hand, it's also an environment where, for example, we talked about how we made money on our longs and our shorts and TBAs, right? I mean this is -- made money in our shorts, even though mortgages had just a tremendous quarter, right?

So it just shows you that in this type of environment, yes, if things move a lot it's dangerous, but as an active trader and as a company that's not afraid to put these alpha generating trades on, I think that's just a much higher quality way for us to generate earnings as opposed to dialing our just mortgage exposure at all times or dialing our leverage up to that maximum, whatever you want to call it, probably 7:1 on net mortgage exposure, I don't know if we've ever been much higher than that at 9:1 on leverage. I mean, that's not the way that we think is the best way to make money for shareholders in an environment like this.

The next question is from Eric Hagen with BTIG.

Can you talk about what the bull case is for specified pools to hold their ground or even strengthen a bit further from here relative to TBA if the backdrop is for higher rates and a steeper curve? And then on the TBA position, can you shed some more light around how you're maybe feeling about being lower in the coupon stack on the long side and where you guys might be more active going forward here?

Sure. Eric, it's Mark. In terms of specified pools, if you are in the right ones, a lot of them still have substantial carry versus either TBA shorts or versus interest rate for treasury hedges. So even if you don't have pay up expansion from here, a lot of them still have very good positive carry.

In terms of positioning along the coupon stack, you still do have -- I mean, yesterday was a big sell off, but it's still, by and large, a premium market. So I would say that what rate moves like yesterday mean is that some of your hedges need to migrate from shorter parts of the curve to longer parts of the curve as prepayment models are now pricing more prepayment slowdowns. So certain coupons. Even -- the move just the start of this year, you've had about 30 -- about a 40 basis point move in 10-year swap rates, that's enough to change where sort of your cash flow risk is concentrated. Look at the mortgage market, outside of Fannie 1.5s, everything else is still a premium, 102 on up to say 110. So the moves this year have lowered some prices, but repayments are still going to affect things. And I would say that the flexibility you have interest rate hedges across the curve, it doesn't make us gun-shy about lower dollar priced TBAs, if that's the best value. I think that we have enough tools to manage the interest rate risk and potential extension risk.

The next question is from Mikhail Goberman with JMP Securities.

Congrats on another fine quarter. Most of my questions have been answered, but I was wondering if you could maybe talk about the non-Agency book, of course, the last 2 quarters have done very well in monetizing the portfolio there in terms of earnings. Do you see any potential for that kind of mini wave to come forward again? Or are you going to opportunistically look for the next excellent entry point on that?

Yes. Thanks for the question. It's Mark. I think now investor sentiment in regards to housing is very strong, and that applies to expectations of credit losses and legacy non-Agency, which is what EARN owns as well as non-QM as well as prime jumbo as well as single-family rental. So right now, the set of assumptions that's embedded in the pricing of all those sectors is, I think it's sort of appropriately optimistic. So for where we are now, you'll probably see that portfolio continue to come down in size. If prices drop and yields go up, let's say, there's another shock to the system in some form that the markets are not anticipating. And you see a pullback in prices and are upticking yields, and those look like a good alternative and a good diversification to the Agency strategy. We can certainly add it. I don't know where that would come from, but that's sort of nature of the shocks. But I'd say right now, where we look at the pricing there, we're probably going to see that portfolio continue to shrink.

There are no further questions at this time. Ladies and gentlemen, thank you for participating in today's conference. You may all disconnect.