Ellington Credit Co Q1 FY2021 Earnings Call

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2021 First Quarter Financial Results Conference Call. Today's call is being recorded. 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 First Quarter 2021 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 16, 2021, 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.

Thanks, Jay, and good morning, everyone. We appreciate your time and interest in Ellington Residential. During the first few months of 2021, we saw a decidedly different market environment than in the latter part of 2020. The yield on the 10-year U.S. Treasury, which had been historically low and range-bound during the months following the outbreak of COVID-19, broke above 1% at the beginning of January and continued to rise throughout the first quarter of 2021, increasing 83 basis points in total, as you can see on Slide 3. At the same time, short-term interest rates remain anchored near 0%, thanks to the continued accommodative policies of the Federal Reserve, and what had been a relatively flat yield curve suddenly steepened with a 2-year 10-year spread increasing to its widest level since 2015. Meanwhile, interest rate volatility increased, and mortgage rates rose off of their all-time lows, particularly during the latter half of the quarter. The spike in long-term interest rates and surge in implied volatility was not a constructive scenario for Agency RMBS, and most Agency RMBS prices declined during the quarter, though performance across subsectors diverged meaningfully. Higher coupon RMBS fared reasonably well, boosted by lower expected prepayments ushered in by the higher mortgage rates. However, extension risk really took its toll on lower coupon RMBS. For example, the effective duration of Fannie Mae IIs roughly doubled over the course of the quarter from around 3 years to around 6 years. And as a result, Fannie Mae II prices plummeted by over 4 points. As usual, we had a highly diversified portfolio. So we were not overly exposed to lower coupons, but our largest long TBA position was, in fact, in Fannie Mae IIs. And not surprisingly, that position was the greatest drag on our results.

Thank you, Larry, and good morning, everyone. Please turn to Slide 5, where you can see a summary of EARN's first quarter financial results. For the quarter ended March 31, we reported net income of $127,000 or $0.01 per share and core earnings of $3.8 million or $0.31 per share. These results compared to net income of $7.4 million or $0.60 per share and core earnings of $4.2 million or $0.34 per share for the fourth quarter. Core earnings exclude the Catch-up Premium Amortization Adjustment, which was positive $70,000 in the first quarter compared to negative $559,000 in the prior quarter. During the quarter, long-term interest rates increased, actual and implied volatility rose, and the yield curve steepened. As a result, Agency RMBS durations extended and yield spreads widened, leading to most Agency RMBS prices declining sharply, particularly those lower coupon RMBS. During the first quarter, we continued to concentrate our long TBAs in lower coupons, and price declines in that subsector generated significant losses, as you can see on Slide 5. In addition, the increase in long-term interest rates reduced the demand for prepayment protection, which caused our prepayment-protected specified pools to underperform. Meanwhile, the rise in long-term interest rates drove net gains on our interest rate hedges and Agency interest-only securities, which, along with net interest income, more than offset the net losses on our long Agency RMBS holdings.

Thanks, Chris. The first quarter was characterized by a sharp move up in interest rates, a much steeper yield curve, and with it, higher levels of realized and implied volatility. What's interesting is that the smooth hiring rates and yield curve steepening were of similar magnitude to the taper tantrum, but Agency MBS performed much better this time around. That was undoubtedly because the Fed continued to steadfastly support the Agency MBS market, and in fact, there was not even a whiff of wavering of Fed support. Big bear market steepening moves, which is what we had in Q1, are notoriously challenging for mortgage investors. MBS extended duration on the part of the yield curve that’s selling off faster than where previous duration hedges were. Delta hedging costs eat into net interest margins, and higher rates typically bring out sellers of mortgages. Coupling those dynamics with relentlessly fast prepayments, you had a challenging fundamental backdrop this quarter. Because of the lag between changes in interest rates and changes in prepayment speeds, MBS have yet to reap the benefits of a slowdown from the rise in mortgage rates. The offset is that technicals for MBS remain incredibly strong. Fed buying has been big and consistent, and bank buying has been big and consistent, and roll levels in many coupons have been strong. The stock effect of Fed purchases becomes more powerful over time, especially when banks are also buying. While MBS look expensive on a fundamental basis, on a relative basis to other spread products such as corporates and high yield, MBS look okay. For the quarter, we did marginally better than breakeven, which was not the result we were looking for. However, the higher rates and steeper yield curve are creating some better opportunities for us. One positive aspect is that spec pool pay-ups came down with the interest rate sell-off. You can see this on Slide 4 where our pay-ups dropped by 80 basis points. Some previously high pay-up sectors that we had avoided now look more attractive, creating a nice optionality for us should interest rates drop further. Also, for production coupons, duration extension has already largely happened. Given that the forward curve already implies sharply higher future interest rates, there isn't much more duration extension left even if rates increase further from here. Interestingly, the interest rate rise in the quarter almost brought yields back to pre-COVID levels on the 10-year note. At the start of 2020, before COVID, the 10-year note yield was 1.9%. It dropped down to 50 basis points last summer and ended this quarter at 1.75%. EARN's book value is actually higher now than what it was pre-COVID, and that's a really good outcome in a year of unprecedented volatility.

Thanks, Mark. I'm pleased that Ellington Residential was able to protect book value and maintain strong core earnings in what was a challenging quarter for Agency residential mortgage-backed securities. The quarter was, in many ways, reminiscent of previous periods of rapidly rising long-term interest rates, such as the taper tantrum of mid-2013 as well as the weeks following the U.S. presidential election of 2016. I'd like to remind everyone that EARN outperformed virtually all of its peers during the 2013 taper tantrum, and even more to our credit, we actually had a positive economic return in the fourth quarter of 2016. In this past quarter, despite the 10-year Treasury yield almost doubling from 0.91% at year-end to 1.74% at March 31, we again still managed to generate a positive economic return. As Mark mentioned, we still like the technicals for Agency RMBS. Institutional investors remain flush with cash, and the Federal Reserve is still buying. Add to that, a big appetite from commercial banks for Agency RMBS today, along with incredibly inexpensive and available financing for leveraged investors; you have lots of stabilizing forces in the market today. We expect this technical support to continue. With these factors in mind, we like the opportunity to add some attractively priced specified pools during the first quarter, mainly around the volatility in February and March, but we also hedged a good portion of those purchases with short positions in TBAs to protect against the downside. We are staying liquid, as Mark mentioned. Previous market shocks have taught us the importance of staying disciplined on risk management, including staying appropriately hedged. Looking forward, we are seeing signs that the prepayment wave could be abating as mortgage rates are on the rise and fewer agency mortgages are refinanceable. As we discussed on our last earnings call, in this environment, it's critical to weigh both the prepayment risks and the extension risks that are present in the market, constructing a portfolio that strikes a balance between these countervailing risks. Just as we saw during the first quarter, we anticipate a substantial ongoing divergence of performance between different subsectors of the Agency RMBS market. We believe that such a rapidly shifting marketplace suits our strengths, where asset selection and risk management will continue to drive performance. Across market cycles, and we've seen a lot of them over senior management's 35-plus years in the mortgage market, we will continue to deploy a dynamic and adaptive interest rate hedging strategy to protect book value, while dialing up and down our Agency RMBS exposure in response to market opportunities. With that, we'll now open the call to questions. Operator, please go ahead.

Your first question is from the line of Eric Hagen with BTIG.

I have a couple here. You noted speeds for higher coupons look somewhat unclear at this point, can you elaborate on what you think is driving the direction sensitivity of specified pools from this point forward? Are you guys looking for anything in this week's prepayment report that might offer clues into potential burnout? And then can you address the premium exposure in the portfolio? I think the fair value mark is somewhere around half of stockholder's equity at this point. Can you talk about the approach in managing that premium if the bias is toward higher benchmark rates going forward?

Sure, Eric. This is Mark. So I can address the first part about this week's prepayment report. So I think this is going to be the first prepayment report in several where the expectation is a slowdown in prepayments driven by higher mortgage rates. The open question is how much capacity has the mortgage industry added over the course of 2020 to contend with the huge refinance wave and how much of the technological improvements that have been put in place, not only from the GSEs, with appraisal waivers and their Day 1 certainty initiatives, but also just technology from some of the nonbanks that could quicken standalone depot – how much is that going to change the response function? So you have a prepayment report where certain coupons that had been in the money, say, Fannie 2.5s, are now not going to be in the money, but some other coupons, say, Fannie 3.5s, that had been significantly in the money, are still in the money, but not as significantly. I think the question is, as sort of the easy refinance pickings have ended, has the mortgage industry and mortgage brokers shifted their focus to some of these higher coupons, which are a little bit harder to refinance, sometimes they're more seasoned. Borrowers have been in their home for longer. Typically, they don't need an appraisal. But has there been renewed focus on those types of borrowers such that you're not going to see a slowdown in prepayment speeds? That's really, I think, a big open question for the market and one thing that we're going to be parsing the report in great detail when we get it because, to me, that's a big open question. How is technology, not only from the GSEs, but from the originators, changing borrower responses to mortgage rates?

Maybe you guys can follow up on how you're approaching the premium in the portfolio, just running a portfolio of specified pools relative to TBA, if the bias is towards higher rates?

Eric, it's Larry. Are you referring to what we sometimes refer to - are you just looking at the - purely on the asset side of the balance sheet as opposed to also taking into account the TBAs? What numbers are you looking at in terms of - you said something about how our premium was half of our equity?

Right. Yes, just the asset side, Larry, exactly.

Okay. Yes. So like I think - and we give more details in the Q, but it's all derivable from - I think that if you take into account our short side as well, it looks like our net Agency premium as a percentage of the fair value of the whole sort of pool holdings was 4.4%, which is pretty much - it's actually maybe even slightly on the low side, I would say, what it's been looking back several years. But yes, so I think that's very manageable, even if, say, rates were to drop a lot, and we would have another significant prepayment spike. So I think it's very manageable.

Your next question is from the line of Doug Harter with Credit Suisse.

You talked about the 80 basis point decline in the pay-up on spec pools in the quarter, can you just talk about how they performed relative to your hedges?

Sure. Doug, it's Mark. It's a good question. So right, when we have specified pools, we don't treat them as having the same duration as TBA. We treat them as depending on what type of pool it is; it's typically longer duration. We also treat them as having yield curve exposure a little bit differently than TBAs as well. By and large, specified pools for the quarter for some of the lower coupons sort of underperformed slightly, and the same thing with the higher coupon specified pools. So I'd say underperformed, at least the way we see them, our hedge ratios versus TBA. Part of it was the theme that rolls just continued to be strong, and they really gathered strength towards the end of the quarter.

Got it. And just on the specialness of rolls, kind of what is your outlook for that kind in the coming months and if when that might normalize?

So you have just pretty good visibility in that. In the markets, you can trade rolls that settlement dates go out to July already. So you can lock in 2 months of rolls if you want to. This combination of Fed buying and bank buying has been a strong technical. I would say that the March and April were particularly strong technicals for the mortgage market. We sort of alluded to it a little bit in the call, but what happens is the way the Fed decides how much they’re going to buy each month is they look at how much paydowns they actually got and then they add $40 billion to it. In the second half of this quarter, interest rates went up. If you looked at the amount of mortgages originators were selling each day, that dropped considerably; it went from about $8 billion a day to about $6 billion a day as rates went up. However, the Fed buying is set based on their actual prepayments received, and that's a lag versus when mortgages are sold; they're sold in the borrower basically applies. In March and April, Fed buying was outsized relative to new production. There's a chance you could see that reverse a little bit because the 10-year note ended the quarter at 1.75%, it's 1.56% now or something. So you've had about a 20 basis point rally, but now you're going to get a slower speed report. So now the Fed buying is actually going to drop while the production of mortgages might increase a little bit. I think that the next month or so, we think mortgages will be strong. Beyond that, the technicals are probably not quite as good as what they've been for the last month or two. The other thing I would say is that when you're in the market solely focused on the rolls, it means you have a portfolio that's very concentrated in a particular coupon. We tend to like having greater diversity across a range of coupons.

Next question is from the line of Mikhail Goberman with JMP Securities.

Most of my questions have been attended to. Just had a follow-up on the leverage. You guys mentioned that you perhaps have some appetite for further leverage going forward, I was wondering how high could it go? If there's a range that you absolutely won't go past and just your overall thoughts on leverage going forward?

Mik, it's Larry, how are you? So we've – in the past, we have varied it; obviously, it was a lot lower in last spring. It's never – we've never gotten it higher than, say, 10:1. We would probably only get to that level in the mid- to high 9s if we had a significant TBA short position against the long side. But I think in sort of normal times, we think of it sort of between the 7 and 9 handle in terms of the range, just on absolute leverage, let's just say, ignoring the shorts. So that’s the good range to keep in mind just over market cycles. The other thing that can also make that leverage ratio be a little lower is when we have a lot more non-Agency, right because we're not going to leverage those as much. And when we bought a lot of non-Agency in spring of last year, our leverage didn't go up really that much because as a percentage of equity, those purchases were not that great, but we didn’t even need to finance them with repo because we had plenty of repo capacity. On the Agency side, where financing is much cheaper. So that was a situation where we could gain a lot of core earnings and core income tailwinds by buying all those non-Agencies. That's exactly what happened without even increasing our leverage. But just looking at the Agency side, I think the sort of 7 handle to 9 handle range is a good one to keep in mind.

Great. Larry, that's a very detailed answer. And if I may, one more question on specified pools. You mentioned that you were adding significantly last quarter, given the fall in the pay-ups, and you saw a lot of good attractiveness in the specified pools. Wondering what kind of pools you're looking at, which are more attractive than the others as you see things right now?

Sure. It's a great question. I'd say we added. It wasn't significant, but certain stories that typically command a very high pay-up that had dropped a lot. Certain stories that used to trade 0.5 to 2 points that all of a sudden, you could buy up 0.5 points or 5 of a point. So that's a big difference. Some of those stories, what we see from time to time are pools that when you run them on a model, the model doesn't know that most of the specified pools are deliverable through TBA; you can just sell them into a TBA, right? So there are certain types of specified pools that when you get a steep yield curve, models can be very punishing because they might assign them a duration that's two or three years longer than TBA. However, in reality, if the pay-up is not that high, they're deliverable into TBA. Some of those stories that may look attractive because they can really – the pay-up can greatly increase if you rally. If you sell off, they don't come off that much. So there's been some of that. The other thing has been there's been a significant change in the WAC of certain coupons, right? Many of the higher coupons now assume that pools created have a lot lower note rate; the difference between the WAC and the coupon is a lot less than what it was a year ago. Some of those pools are attractive to us. Additionally, the GSEs are making some changes into how much investor loans originators can deliver to them. We think this is marginally making it harder for some of the originators to offer very aggressive refinancing terms on investor loans. That's another story we've liked as well.

Our final question is from the line of Jason Stewart with JonesTrading.

Larry, I wanted to pull back up a little bit and ask your view on inflation, how you think the Fed reacts to your expectations for that throughout the summer, including a taper and then how you position the overall balance sheet for that?

Thanks, Jason. We try not to let our views of such fundamental macroeconomic factors like inflation color too much how we position the portfolio. There’s a huge amount of stimulus. On the one hand, there’s a lot of asset inflation, whether it be real estate, bond prices, and stock prices. However, you've got the countercurrents of continued globalization and issues with the pricing power of labor, among others. As I said, we’re not going to take our own opinions too seriously in terms of predicting what will happen. The Fed will certainly react if inflation gets out of control; for now, it looks like they're not too concerned about that. We always do scenario analysis in terms of what could happen to our portfolio if this happens with inflation or if it doesn’t. If you look at our interest rate sensitivity tables, you'll see we hedge along the whole yield curve. We try to be very disciplined in thinking about where our edge is. Our edge as portfolio managers, we believe, is not in prognosticating inflation, interest rates, or what the Fed will do from a macroeconomic perspective, but more in terms of what happens to our portfolio under various scenarios.

Ladies and gentlemen, that concludes today's Q&A session. We thank you for your participation. We ask that you now disconnect your lines.