Ellington Credit Co Q4 FY2020 Earnings Call

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. At this time, all participants have been placed on a listen-only mode and the floor will be opened for your presentation. 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.

Thanks, Jay, and good morning, everyone. We appreciate your time and interest in Ellington Residential. During the fourth quarter, the Federal Reserve purchasing activity remained elevated, dollar rolls continued to be strong, and yield spreads on Agency RMBS tightened significantly. In addition, as you can see on Slide 3, long-term interest rates began to rise with a 10-year treasury increasing 23 basis points during the quarter, while the US Treasury yield curve steepened with the two-year tenure spread increasing to 79 basis points. It's been over three years since we've seen a yield curve environment this deep. 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 has increased by more than 0.5 points, which equates to a spread tightening of nearly 30 basis points. So far in 2021, we have experienced continued rises in long-term interest rates and a continuing steepening of the yield curve as the market anticipates a significant stimulus package from Congress and a modest increase in inflation expectations.

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 exclude 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.

Thank you, Chris. Our first update on how EARN performed for both the quarter and the full year is now closed, along with our forward outlook. 2020 was quite a year. I have been active in the mortgage markets for a long time, and I don't think I've ever seen a roller coaster ride like 2020. The lows were lower and the highs were higher; you had to expect the unexpected. During the turbulence in March and through communications with our most important counterparties, I literally heard things I had difficulty believing. However, we have always managed EARN with two primary and simultaneous objectives. These objectives helped us persevere through the turmoil. First, we aimed to protect book value against downside moves, and second, to opportunistically capture upside when it presents itself. This philosophy 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 shock that the pandemic caused in the second half of March was sudden and enormous, demonstrating how thoughtfully we manage our liquidity. We were able to meet all margin calls, avoid forced asset sales, and build up a liquidity cushion during this period. The subsequent opportunity that followed massive Fed intervention was also sudden and equally significant, and we were able to capitalize on it. For the year, EARN achieved 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 achieved this through a disciplined team approach. As the pandemic caused panic and balance sheet shortages in March, we had ample liquidity, were appropriately levered, and had our repo maturities well staggered with a diversified set of lenders. We were able to weather the storm with modest controlled asset sales that had minimal impact on book value. Throughout our history, we have generally favored lower leverage compared to much of the peer group. The reason for this is that a couple of extra turns of leverage that companies reach for when NIMs are tight and earnings are hard to generate can make all the difference between being a forced seller or an opportunistic buyer during times of distress. Instead of relying on extra leverage, we have aimed to achieve additional returns through active trading and a deeper dive into prepayment.

Thank you, Mark. EARN's strong fourth quarter concluded what has been a remarkable year of outperformance for us. Please turn back to Slide Five. 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, which allowed us to avoid forced asset sales and preserve liquidity. This enabled EARN to withstand the extreme market-wide volatility and liquidity crunch. We emerged from the crisis with a strong liquidity position, allowing us to take advantage of 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, during which we generated an economic return of 14.6%. You can see the cumulative economic return for these two years on Slide six. Over this two-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 environment 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 we have 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 zero for another year, and it seems unlikely that the Fed will start tapering asset purchases this year. There is no question these dynamics have been beneficial for Agency RMBS investors, and our high net interest margin is certainly a nice tailwind for 2021. However, as we saw last year, market dynamics can change quickly. Fiscal stimulus can be a boon to asset prices, but the fear of large fiscal deficits can adversely affect MBS prices. Meanwhile, as Mark discussed, technology continues to evolve rapidly, and we expect even more private non-bank mortgage originators to go public in 2021, bringing additional capital, attention, and technology to the sector. In this environment, Agency MBS portfolio managers need to find the right balance between constructing a portfolio that can hold up in today's high prepayment environment and avoiding excessive exposure to extension risk and spread widening risk should interest rates continue to rise. Finding this balance allows disciplined portfolio managers to take advantage during times of stress, a strategy that differentiated EARN from its peer group in 2020. Regardless of the 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. With our relatively low leverage and disciplined hedging, EARN should be well-positioned to capitalize on both current opportunities and those that are bound to emerge when circumstances change. It bears repeating that our success at EARN does not necessarily depend on the absolute level of interest rates or the shape of the yield curve, or where net interest margins happen to be because of our portfolio management strategy. We trade actively, shift our capital to where we think the best opportunities are, and 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, adjusting 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 that lie ahead in the coming year. Before we open the floor to questions, I would like to thank the entire Ellington team for their hard work in 2020, and wish all those listening on the call today the best for 2021. With that, we'll now open the call to questions. Operator, please go ahead.

And your first question will come from Doug Harter with Credit Suisse. Please go ahead.

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

Hey, 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 on what has been written about inflation. So, for example, yesterday was a day of substantial mortgage underperformance. I think we will use opportunities like that to increase our mortgage exposure, either in pool form or in TBA form. People recognize that a large buyer, the Fed, is out there who is not driven by economics. There will be times when they influence the pricing structure of the market, which does not leave much room for attractive NIM. However, they also create pricing distortions, leading to many good opportunities.

Great. Thanks, Mark. Can you also discuss how you might think about the range of your net MBS exposure and net leverage if the environment presented itself?

Yes, I would say, historically speaking, the upper end of the range has served as an appropriate upper bound for us. I believe our ending position for the year was likely close to a lower bound. Mortgages had a very strong Q4, and if you look at the prices where things ended in Q4 compared to their current state, significant sectors of the market have repriced substantially lower, down over a point.

If I could just add to that, Doug, a couple of points we discussed earlier on the call. One is the fact that prepayments are currently very high. But we also have rates at very low levels and are facing the possibility of extension risk, especially as more of the mortgage universe is refinancing lower coupon rates. If interest rates were to suddenly reverse, low coupon mortgages would greatly expand in duration. So, we are balancing a challenging environment that is very risky; however, we have made money on both our long and short TBA positions. This indicates that as active traders, we feel confident in our approach to generating earnings, as opposed to simply increasing mortgage exposure or maximizing leverage to whatever extent possible, probably around 7 to 1 on net mortgage exposure. I am not sure we have ever reached much higher than 9 to 1 on leverage; I do not believe this is the best way to generate returns for shareholders under such conditions.

That makes sense. Thank you.

The next question is from Eric Hagen with BTIG. Please go ahead.

Hey, good morning. I hope you're well. Can you talk about what the bulk case is for specified pools to hold their ground or even strengthen a bit further from here relative to TBA, if the backdrop indicates higher rates and a steeper curve? In addition, for the TBA position, can you provide some insight into how you may feel about being lower in the coupon stack on the long side and where you might be more active moving forward?

Sure. Hi Eric, it's Mark. Regarding specified pools, if you are in the right options, many of them still have substantial carry versus either TBA shorts or interest rate hedges. Even if no pay-up expansion occurs from this point, many still have quite a positive carry. Concerning positioning along the coupon stack, despite the significant sell-off, the vast majority of the market remains a premium market. In other words, the moves we witnessed this year have lowered some prices, and while pre-payments will still impact valuations, our flexibility with interest rate hedges does not discourage us from lower dollar-priced TBAs if they represent optimal value. We are equipped with sufficient tools to manage interest rate risk as well as potential extension risk.

Thanks for the response.

The next question is from Mikhail Goberman with JMP Securities. Please go ahead.

Hi, good morning gentlemen, congratulations on another fine quarter. Most of my questions have been answered, but I was wondering if you could discuss the non-Agency book? The last two quarters have gone very well for us in monetizing that portfolio in terms of earnings. Do you see any potential for that kind of mini-wave to come forward again, or will you be opportunistically seeking the next excellent entry point?

Yes, thanks for the questions, it’s Mark. Currently, investor sentiment regarding housing is very strong. This applies to expectations of credit losses in legacy non-Agency, as well as non-QM, jumbo loans, and single-family rentals. Right now, the assumptions embedded in the pricing of all these sectors seem appropriately optimistic. From this position, you might see that portfolio continue to decrease in size if prices decline and yields rise. If another shock to the system occurs and the mortgage market does not anticipate it, leading to a drop in prices and an increase in yields, those non-Agency assets may prove a good diversification strategy to the Agency strategy. We can certainly add them if suitable conditions arise. However, as it stands, where we are with pricing, it seems that portfolio will likely continue to shrink.

Okay, great. Thank you very much. That's it from me. Thanks.

Thank you.

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