Ellington Credit Co (EARN) 2020 Q3 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2020 Third 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. Please go ahead, sir.

Thank you, and welcome to Ellington Residential's Third 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 third quarter earnings conference call presentation is available on our website, 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, 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 third quarter, the Federal Reserve continued its accommodative monetary policy, maintaining its target rate for the federal funds rate near 0 and continuing to buy heavy volumes of treasuries and Agency RMBS.

Turning to Slide 3. You can see that the Fed's actions had their exact desired effect on the Agency RMBS market. Agency RMBS yield spreads have been stable, Treasury yields have stayed low, and the interest rate volatility has remained muted. In fact, the MOVE Index, which measures the implied volatility of interest rates, hit an all-time low at the end of September.

As you can see on this slide, Treasury yields and swap rates were uncandidly unchanged quarter-over-quarter. And moreover, they barely moved at all since March 31. And you can also see that for the interest rates that most affect private borrowers, such as mortgage rates and LIBOR rates, while there was a slightly lag reaction, these rates have caught up to the decline in Treasury rates, having declined significantly over the past 6 months. Meanwhile, Agency yield spreads have remained stable after bouncing back from their March spikes despite the continued rise in prepayment speeds with Fannie Mae 30-year CPRs hitting a nearly 8 year high in September.

Turning now to Slide 4. Ellington Residential had another quarter of strong performance, generating net income of $0.66 per share and growing core earnings to $0.39 per share in the third quarter, which exceeded our $0.28 dividend by a wide margin. Our $0.28 dividend is a dividend that we have maintained in full, by the way, without interruption or cut throughout all of 2020.

Similar to prior quarters, our long Agency RMBS portfolio continue to be concentrated in prepayment-protected specified pools, and these assets performed extremely well relative to their hedges, which provided a big boost to our results. Additionally, the non-Agency RMBS sector continued to recover during the quarter, and so we were able to monetize significant gains on many non-Agency RMBS assets that we had opportunistically acquired in the second quarter when prices have been extremely depressed.

And keep in mind, it was only because we were able to navigate the March-April distress so well that we were able to play offense and take advantage of that distress in non-Agency RMBS. In fact, during the second quarter, we were buying non-Agency RMBS at distressed prices when many other mortgage REITs were forced to sell them.

In the third quarter, we maintained our long position in current coupon TBAs. And by doing so, we benefited from the strong dollar rolls that were driven by Fed purchasing activity. At certain times in our history, we've been short current coupon TBAs. And in other times, like recently, we've been long current coupon TBAs. Current coupon TBAs are incredibly liquid, and sometimes we view them as a great hedging instrument. And other times, we view them as a great investment. This particular sector, where, with relative ease, we can go either long or short, but are actually quite complex instruments is yet another reason why the Agency RMBS market is such a rich opportunity set for us.

Notably this past quarter, we were able to deliver strong results while maintaining our leverage well below our historical averages. We felt that this was prudent positioning given the significant macroeconomic uncertainty and given that there was a presidential election looming. Our debt-to-equity ratio as of September 30 was only 6.5:1 as compared to our historical debt-to-equity ratios, which have typically been in the 8s or 9s to 1.

Finally, I'm pleased to report that our net interest margin widened by 35 basis points to 2.21% quarter-over-quarter, which is the highest our NIM has been in more than 5 years. Turning to Slide 5, in the lower part of the table, you can see that the main driver of our NIM expansion was a significant drop in our cost of funds. Another driver of our NIM was our larger non-Agency RMBS portfolio with its higher asset yields.

Now I expect our NIM to come down a bit from here for a couple of reasons. First, asset yields are down on an Agency RMBS generally, and we will feel that impact as we naturally rotate our portfolio and reinvest paydowns. And second, now that we've downsized our non-Agency portfolio, a portion of that outsized NIM support is going away. All that said, there's no question that EARN and the entire mortgage sector has benefited from the significant external tailwinds provided by record low borrowing rates and low, low levels of interest rate volatility.

However, as we have repeatedly demonstrated over past market cycles, including, of course, the big ups and downs of 2020, our success in EARN does not necessarily depend on the absolute level of interest rates or volatility, on the shape of the yield curve or on where NIMs 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; we hedge along the entire yield curve, often using significant TBA short positions.

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

Thank you, Larry, and good morning, everyone. I'll continue on Slide 5, where you can see a summary of EARN's financial results. For the quarter ended September 30, we reported net income of $8.1 million or $0.66 per share and core earnings of $4.8 million or $0.39 per share. These results compare to net income of $21.3 million or $1.73 per share and core earnings of $3.2 million or $0.26 per share for the second quarter. Core earnings excludes the catch-up premium amortization adjustment, which was positive $405,000 in the third quarter compared to negative $3.8 million in the prior quarter.

As you can see on Slide 5, our third quarter results were driven by strong net interest income, strong performance on our specified pools relative to our hedges and net realized and unrealized gains on our interest rate hedges and other activities, which includes positive P&L from our long TBAs held for investment. During the quarter, we increased our holdings of long TBAs, which we concentrated in current coupon production. These investments performed well, driven by Federal Reserve purchasing activity.

You can also see that our net interest margin widened even further this quarter, increasing 35 basis points to 2.21%, driven by significantly lower borrowing costs, which in turn drove the increase in core earnings. Average pay-ups on our specified pools increased to 2.55% as of September 30 as compared to 2.5% as of June 30 as actual and projected prepayment rates continue to rise in the low mortgage rate environment.

Please turn next to our balance sheet on Slide 6. During the third quarter, we continue to maintain higher liquidity and lower leverage as compared to prior -- to periods prior to the onset of the COVID-19 pandemic. At September 30, we had cash and cash equivalents of $61.2 million, along with other unencumbered assets of approximately $28.1 million.

Our debt-to-equity ratio declined modestly quarter-over-quarter to 6.5:1 at September 30 from 6.8:1 at June 30, adjusted for unsettled purchases and sales. These amounts compared to cash and cash equivalents of $35.4 million and a debt-to-equity ratio of 8.1:1 as of December 31, 2019.

Our book value per share was $13.17 at September 30 compared to $12.80 at June 30 and $12.91 at the start of the year, reflecting increases of 2.9% and 2%, respectively, over the 3- and 9-month periods as our earnings continue to exceed dividends by a healthy margin. Our economic return for the quarter was 5.1%, including the impact of the third quarter dividend of $0.28 per share.

Next, please turn to Slide 7, which shows a summary of our portfolio holdings. In the third quarter, we monetized gains in our non-Agency RMBS portfolio, and as a result, the portfolio declined by 41% quarter-over-quarter. The size of our Agency RMBS portfolio declined slightly over the same period.

Next, please turn to Slide 8 for details on our interest rate hedging portfolio. During the quarter, our interest rate hedging portfolio consisted primarily of interest rate swaps and short positions in TBAs, U.S. Treasury securities and futures.

Next, on Slide 9, you can see that our net long exposure to RMBS decreased to 5.6:1 from 5.9:1, primarily as a result of a slight decline in our overall RMBS portfolio and increase in shareholders' equity.

I will now turn the presentation over to Mark.

Thanks, Chris. EARN had a very good quarter with total return of 5.1%, bringing our economic return over 8% for the year. I view this as a very good outcome, given the extreme volatility we had earlier in the year. Our core earnings has easily covered our dividend this year. And as of last night's closing price of $11.13, our stock has had a total return over 13.5% this year.

We've also kept our debt-to-equity ratio low, below 7. So we have lots of room to add additional mortgage exposure. Armed with ample cash and low leverage on our balance sheet, we should be well positioned to play offense if there is any year-end volatility.

While the themes that we outlined for the second quarter largely played out again in the third quarter, the macroeconomic backdrop for a levered Agency MBS strategy still remains strong today. Most significant is the consistent, large and predictable Agency MBS purchases for the next few quarters that the Fed is telegraphing. The Fed is buying a lot, it's buying every day, and it's telling the market it will continue to buy a lot.

In addition to the Fed, other pools of capital, such as banks are, also big buyers of Agency MBS. This is significant because while the Fed is buying a lot, supply is absolutely enormous, whether you look at it on a gross or a net basis as you need significant buyers to absorb it all.

Gross supply, which is simply the volume of new Agency mortgages originated, is expected to be an unprecedented $3 trillion plus this year. To put this number in context, the gross supply in 2019 was approximately $1.5 trillion. Net supply, which subtracts paydowns from the gross supply number is expected to be over $400 billion this year. This net supply number is the amount of new capital that has to get invested in the Agency MBS market for the supply to clear the market, and that net supply number is also enormous on a historical basis. And in addition to the net supply from origination, the MBS market will also have to be able to absorb the volume of secondary market sales, such as Freddie Mac, who has been mandated to shrink their portfolio.

The Fed does a lot of heavy lifting to absorb all the supply, but they can't do all of it. Remember that they came into this round of QE with a giant portfolio that's paying off very fast, recently between 30 and 35 CPR, and the Fed has to reinvest those pay downs just to maintain a constant portfolio. As it turns out, even with this large volume of purchases, the Fed's net buying in recent months has only been roughly equivalent to the net supply. So to have an orderly market, you'll still need to have a steady source of buyers to absorb the supply from the secondary market. The good news is that given all the concerns about credit risk post COVID, the MBS market has plenty of other buyers. Relative to Treasury, the extra yield on MBS without credit risk is currently attracting a wide range of investors. And given that MBS financing is widely available in huge size and it's almost free, we think that MBS make the most sense in the levered form, which is exactly what a mortgage REIT does.

Another tailwind now is that the drag on net interest margin to insulate a portfolio from interest rate risk is close to 0, and in some cases, is less than 0. You actually can get paid to be short, which is a relatively modest drag on our NIM. We can run a fully duration hedge portfolio, which by itself helps to stabilize book value.

Even with their strong Q3 performance, several TBA coupons that we've been long still look attractively priced to us with or without attractive rolls. When you add this to the value of special rolls, the levered returns are fantastic. Rolls are benefiting from the perfect storm of front month fed buying and back month mortgage banker selling.

But we also see headwinds, too, that argue for -- against being fully levered. Specifically, prepayments are blazing, and mortgage companies are aggressively staffing up. We don't see any compelling reasons for a slowdown of the refi wave outside the normal seasonal effects. We believe that some of the COVID-related workarounds that the GSEs put in place in the spring, such as exterior appraisals and the use of e-notaries, are here to stay and that these innovations only make speeds faster. Of course, we are always working to mitigate many of these risks to our portfolio construction. I'm happy that we were able to keep our CPR down in the portfolio to a very manageable 21.4%.

Another risk we think about is sustainability of roll levels. Rolls are great while they last, but you can't count on them in perpetuity. The only large TBA coupon that underperformed Treasury this month was 30-year 3s TBA. After the Fed stops buying them, the roll collapses. And once the roll collapsed, the price collapsed.

Reviewing how we were positioned for the quarter and what worked. We were long TBAs with big positive rolls, which was great, but we also benefited from being short TBAs with negative rolls. So we won both ways. It sounds simple, but it worked well this quarter. Being short negative rolls is the way you get some of your hedging costs down below 0.

In addition, as I mentioned, our realized prepayment speeds were well contained. The size of our Agency portfolio was roughly constant quarter-over-quarter. We like mortgage valuations coming into the quarter, but mortgages have done well, so they are not as cheap as they once were. We still really like some of the shorter maturity MBS, like 15-year mortgages. The Fed buys them, the rolls are good, and they don't have anywhere near the same extension risk as 30 years, which makes the hedging simpler.

Also, during the third quarter, as Larry mentioned, we sold many of our non-agencies which we -- that we opportunistically bought last quarter. Prices in that sector have gone up a lot since the market melted down, yields are back down to less interesting levels, and the credit risk may be priced wider depending on the future path of stimulus and economic recovery. So we opted to monetize a good chunk of that portfolio.

Heading into the last 2 months of the year, a big focus of ours will be avoiding prepayment mistakes, but without paying so much for prepayment protection that our assets will be out of favor and a big market sell off. We'll not only want to stay thoughtful about what the Fed is doing right now, but we'll also want to anticipate what the Fed is going to do in the future. The worst-performing coupon for the quarter by a wide margin was TBA Fannie 3s. As I mentioned earlier, that's because Fannie 3s went from being the coupon that the Fed is buying to a coupon that the Fed was buying. The roll collapsed, and the price collapsed. And given that we're in the middle of a refi wave, the current market environment presents lots of great opportunities to put our prepayment knowledge to the test. So I'm very optimistic about the return potential.

Now back to Larry.

Thanks, Mark. Ellington Residential's excellent results in the third quarter continued what has been a stellar year for the company. Thanks to our risk and liquidity management, we were able to weather the volatility that hammered the market in the spring, emerging in a strong liquidity position and with our book value intact. That put us in a position to take advantage of some tremendous investment opportunities and participate in the market recovery.

Ellington Residential has now generated an annualized economic return of 11.5% through the first 9 months of 2020. As Chris mentioned and as you can see on Slide 6, our book value coming into the year was $12.91, and it was $13.17 at the end of the third quarter. So we've grown book value this year by over 2% after paying our full $0.28 dividend each and every quarter. Hats off again to Mark Tecotzky and our entire investment team for this tremendous performance in a year when many, if not most, other mortgage REITs have really struggled.

But this is no time to take a victory lap. We are decidedly in a refinancing wave. Please turn to Slide 12. With interest rates near their historical lows, the vast majority of outstanding mortgages are currently refinanceable. And given the lower for longer interest rate messaging from the Federal Reserve, this refinancing wave could persist for quite some time. As Mark mentioned, we will likely see the first $3 trillion year ever for mortgage originations in 2020.

But not surprisingly for a refinancing wave, Agency RMBS performance is diverging across the coupon stack and across the various specified pool profiles. While this dynamic presents many challenges for the MBS market, we believe that it plays right to our core strengths of prepayment modeling, asset selection and dynamic interest rate hedging. As we move into the final weeks of the year, we expect this prepayment-focused environment to create numerous attractive investment opportunities for us, and our current high levels of liquidity and relatively low leverage can enable us to capitalize on these opportunities as they arise.

Our smaller size should also continue to be an advantage, allowing us to react quickly as market conditions change, just as we did earlier this year during the stretches -- distresses of March and April.

Before we open the floor to questions, I would like to thank the entire Ellington team for their continued hard work in 2020 through challenging circumstances. And for all of those listening on the call today, we hope that you and your families are staying healthy and safe.

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

(Operator Instructions) Your first question comes from the line of Doug Harter with Crédit Suisse.

Can you talk about what you're -- while still relatively small overall, what your outlook would be for the remainder of the non-Agency portfolio and kind of how you would think about the portfolio mix going forward?

Sure, Doug. This is Mark. Thank you for the question. Even before COVID, we had a small portion of our capital in non-agencies. So during COVID, we grew that because we saw really material price drops at a time when our research and our data was showing that home prices were going to be well supported for a number of reasons. And so I like having a small amount of the capital in non-agencies, it's a market we know well. We have a great suite of PMs. We have great research tools there.

Given current valuations in the non-Agency market and the way EARN has always branded itself, where the primary driver of risk and returns comes from levering Agency MBS, at these valuation levels, I think we'll probably see the portfolio of non-Agency stayed about the size where they are. Should our expected return on capital in the Agency market go up a lot because valuations change or go down a lot because valuations change, then we might -- then you could see an impact on the non-Agency portfolio as a result of that. But given right now where prices stand, I think the balance of non-Agency will stay roughly consistent relative to our capital.

Great. And then can you talk about what the outlook for the net interest spread would be kind of as you get loan repayments come in and kind of how those can be reinvested today versus kind of the spread that you have had in the third quarter?

Sure. Larry, you talked about...

Yes, yes. I think as mentioned, we had a $0.39 core, but we see that trending downward. We've been consistently maintaining our dividend at $0.28. We've viewed our dividend at times, our core has been lower than that, but there were other opportunities that we were able to take advantage of and to take advantage of to supplement to get back to the $0.28 now sort of in the other direction where core is exceeding that.

We still view $0.28 as a good long-term rate, and so I think that we see it trending down probably to something in that neighborhood. And -- but we like the number, we like the $0.28 number. And we think that we'll either -- core will either trend just slightly higher than that or slightly lower than that. If it trends slightly lower, then that probably will be because there are other opportunities going on in the sector that -- again, where we can continue to supplement and earn the dividend.

So I think sort of heading towards our dividend rate is a good kind of a good marker to think about.

(Operator Instructions) Your next question is from the line of Mikhail Goberman with JMP Securities.

Could you guys perhaps give an update on when your -- where you're seeing prepaid trends thus far in the fourth quarter?

Sure. Yes, we get another prepaid report in the next day or so. So the one we had last month, pretty much in line with expectations. It wasn't a big change from where prepayments have been.

I guess there are 2 things we're watching closely. One is looking for burn out, right, the extent to which pools that have paid very fast in the last 6 months, the sort of cohorts that are paid very fast in the last 6 months are starting to exhaust themselves because sort of the borrowers that are most incented and most focused on refinancing have prepaid, and the remaining borrowers are less focused on it. So we're looking for evidence of that. We haven't seen it yet.

And I -- you mentioned in the prepared remarks, we are aware and we think a lot about the hiring trends mortgage originators have had. So they are adding capacity. So we're not looking for -- we're not expecting or looking for a lot of burnout. The other thing is that it matters a lot on the path of rates. And so one thing that's happened in the last week or so or 2 weeks is that now the Federal Reserve is buying 30-year mortgages with 1.5% coupon, right? So that is something different. And when the Fed starts doing that, it adds liquidity to that coupon. So now you're going to start seeing for the best borrowers sort of a 2.5% note rate that's offered. So some of the coupons that looked like low coupons earlier in the year, say, Fannie 2.5s, you're starting to see some pretty fast prepayment speeds there.

So the report coming up this week, our expectation is things slow down slightly, but we don't expect any kind of near-term relief in this prepayment wave right now. But that said, there are lots of relative value opportunities. And the market pricing right now for higher coupons is incorporating expectations of very fast prepayment speeds. So you have the coupon that's priced to 40 or 50 CPR in the roll and you find something that prepays a 30 CPR, that's a big advantage versus a -- hedging with TBAs priced at a much faster roll.

Got you, Mark. And also kind of maybe a bit of a macro Fed-related question, and you may have touched a little bit on this earlier, Mark. But assuming this scenario plays out that we're going to have political gridlock and -- for a while and the chances of a stimulus -- mass stimulus door going to be in the short to near term, at least a little bit lower, what are your thoughts on what the Fed -- if the Fed is going to feel more pressure to do more? And if that is the case, how will that affect the mortgage market going into next year?

Sure. I mean I can give you my personal opinion. And really, I would say that since the start of COVID, we have directed some of our research resources into virus tracking and quantifying the impact of things like the CARES Act on consumers' ability to pay their debt. And so we have more of a research effort focused on those issues because they're so front and center now since the virus.

But given that the election is still uncertain, we haven't really formalized views on what the different administrations mean for reform or things like that. So if you have the Biden presidency, but the Republicans maintain control of the Senate, yes, I do think that argues for less stimulus than what you would have gotten if the Democrats had flipped the Senate. So we think about that, and we certainly take it into account when we think about credit exposure.

On the Agency side, that's less of a factor for us. It probably -- it might unfortunately mean that some of the -- more of the borrowers that are going to be coming off forbearance might have a harder time getting off their forbearance plans. For us, we look at a lot of conditional outcomes. So we'll kind of like game plan 4 or 5 different possible scenarios and have views of that and sort of have ideas on portfolio construction should those things play out.

We're generally not -- we generally don't take big positions or set up the portfolio in expectation that we can predict some of these macro events. So that's the approach we've taken with COVID. I guess the only thing we've -- not with COVID, but with the election. I guess our view was that there was a potential for volatility. We didn't know if it was necessarily going to happen, but there was certainly that potential.

So I think to inflate and protect the portfolio, it made sense for us to keep our debt-to-equity ratios relatively low given valuations right before the election. That's something we did. And when we have more clarity, we'll certainly revisit that. But we're not going to take big directional exposures based on our expectation of what will happen.

But this issue of stimulus that you asked on about is a great question, and it's something that we've spent a lot of resources on teasing out what sort of the hypotheticals, what -- how would borrower being be impacted if stimulus is greater, if stimulus was less. And we certainly did notice in some of the remittance reports on the non-Agency side, the impact when the $600 a week unemployment benefits on top of the state minimum changed.

So it's measurable. We see it, and there's been a lot of great alternative data sources that we've tapped into that allow us to track that.

Thank you. This does conclude today's Q&A portion of today's call. Thank you for joining and ask that you please disconnect your lines.