Ellington Credit Co Q2 FY2021 Earnings Call

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2021 Second Quarter Financial Results Conference Call. 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 second 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. 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.

Thanks, Jay, and good morning, everyone. We appreciate your time and interest in Ellington Residential. Please turn to Slide 4. Ellington Residential's core earnings increased a robust 19% sequentially to $0.37 per share, driven by an incrementally larger portfolio and a further reduction in our cost of funds. With our core earnings continuing to exceed our quarterly dividend run rate, on June 9th, our Board increased our quarterly dividend by 7% to its current level of $0.30 per share. I was very pleased with this increase, especially since we had kept our dividend level constant throughout the COVID-19 related volatility of 2020. Now please turn back to Slide 3. As you can see on this slide, after long-term interest rates increased sharply during the first quarter, interest rates reversed course and fell during the second quarter. The yield curve flattened, mortgage rates declined, and the MBS investor's hope for prepayment burnout fell far short. Meanwhile, sentiment began to shift towards the increased likelihood that in the coming months the Federal Reserve would commence tapering its asset purchases. In light of all these factors, Agency yield spreads widened across the board and most Agency RMBS significantly underperformed comparable interest rate swaps and U.S. treasury hedges on a total return basis. As a result, from a book value perspective, the second quarter was a challenging one for leveraged hedged Agency RMBS portfolios such as ours. During the second quarter, we again saw a meaningful divergence of performance across the various subsectors of Agency RMBS. In contrast to the first quarter, higher coupons fared the worst during the second quarter, while lower coupons held up relatively well. For example, prices on Fannie 4.5s declined by more than one point, which represented a substantial widening during the quarter. Our prices on Fannie 2.5s increased by a little less than one point, which represented only a modest widening given the 27 basis point decline in 10-year treasury yields during the quarter. For Ellington Residential, losses on our interest rate hedges, together with the Agency RMBS yield spread widening, combined to generate an overall GAAP net loss for the quarter.

Thank you, Larry, and good morning, everyone. Please turn to Slide 5, where you can see a summary of EARN's second quarter financial results. For the quarter ended June 30, we reported a net loss of $4.5 million or negative $0.36 per share and core earnings of $4.6 million or $0.37 per share. These results compare to net income of $127,000 or $0.01 per share and core earnings of $3.8 million or $0.31 per share for the first quarter. Core earnings exclude the catch-up premium amortization adjustment, which was $2.6 million in the second quarter compared to $70,000 in the prior quarter. The net loss for the second quarter was due to net losses on specified pools, interest-only securities, interest rate swaps, U.S. treasuries, and futures, which exceeded net interest income and net gains on TBA positions.

Thanks. As Chris stated, we had a total economic return for the quarter of negative 3%. It was a quarter of weak mortgage performance across the board, especially in higher coupons. The rally in interest rates, combined with continued fast prepayment speeds resulted in our Agency MBS holdings underperforming their hedging instruments. For the year, Delta hedging costs have increased with greater interest rate volatility and there has been a further headwind to earnings. The challenges of the second quarter did not present the core earnings issue for us. In fact, our core earnings increased and we raised our dividend, but rather, our portfolio felt the impact through mark-to-market losses. Further, we don't see any Q2 agency underperformance as a result of some new or negative information about Agency MBS, but more as a result of the market continuing to digest existing news. By this, I mean, prepayment speeds running in excess of market expectations and in excess of many model projections has been a market reality for a few quarters now, not just the second quarter, but digesting that news gave the market indigestion this quarter. That said, I do think that the drop in interest rates surprised many investors. At the end of March, market consensus was overwhelmingly for continued higher interest rates, driven by higher inflation reports. So, at the end of Q1, the market was shrugging off faster prepayment speeds and the steeper S-curve for mortgage valuations because expectations were that the continued increase in interest rates would make it uneconomical for many lower coupon mortgages to refinance. But the drop in rates this past quarter put faster MBS prepayments back in the spotlight. Meanwhile, another negative for the quarter was marginally reduced bank demand, possibly as a result of lower yields and higher prices on MBS. We have talked on previous calls about how consistent bank buying has been a strong source of support for Agency MBS. Not surprisingly, that support waned a little bit this quarter and was a negative technical for the sector. Fed messaging on tapering has been consistent and their words have been chosen very carefully to not ruffle the market's feathers. You know tapering is just a fancy word for buying less. The Fed is such a big buyer of MBS now that even if they start buying a little less, their activities are still very supportive of MBS prices. People forget that during the Taper Tantrum of 2013, after an initial few weeks of underperformance, MBS wound up significantly outperforming treasuries that year. That doesn't mean to say that the Fed can't surprise the market with a tapering schedule that is more aggressive than expectations, but we do expect them to be supportive of Agency MBS in some form or fashion throughout at least mid-2022.

Thanks, Mark. I'm pleased to have increased our core earnings and dividend during what has been a challenging year for Agency RMBS so far. We have not sat still or been complacent as the shifting environment and higher volatility of 2021 has given us another opportunity to pivot. We have sold non-agency assets at significant gains, and we have shifted to offense in our agency portfolio, adding some very attractively priced agency pools. The agency mortgage market is a deep and liquid market with ample opportunities, especially during times of volatility, providing Ellington Residential with a consistent opportunity to generate strong returns. Importantly, these opportunities are not just present on the long side of the market, but on the short side of the market as well. In fact, our willingness to take substantial short positions in TBA mortgages was and continues to be a major differentiator for EARN in the mortgage REIT space. We believe that we are well-positioned to capitalize on pricing dislocations that could occur as the Fed's footprint in the market eventually diminishes. As we look to the second half of the year, we expect to continue to be nimble and look to take advantage of relative value discrepancies across subsectors as they arise. And as always, we will rely on our dynamic hedging strategy to help protect book value. And with that, I'll now open the call to questions.

And we will take our first question from Doug Harter with Credit Suisse.

This is John on for Doug. The first thing I'd like to kind of get some color on is, what you guys are able to talk about your thoughts and expectations going forward for MBS spreads and how much of the bed paper is currently priced in?

Sure. This is Mark. I think what's priced in is the expectation that Fed tapering will be gradual and that you have a Fed that will respond to market dislocations. There's been a lot of comments from Fed governors, Harker in particular, was on the tape in June, saying that the Fed needs to avoid causing a taper tantrum. So I expect we're going to get clarity on that in Q4 of this year. They're buying a lot right now. I think market valuation can certainly accommodate them buying less. Our expectation is that you have a Fed that is going to act gradually and is very cognizant of what happened to MBS for a brief period of time in the spring of 2013, where the market didn't understand what they meant by tapering. At that point, there really was no precedent, and they didn't give out a schedule when they just talked about tapering. Now there is a precedent for how they tapered the previous round of QE. So, I think they'll go gradually. And the other thing is that the stock effect, how much of the mortgage market the Fed currently holds that it's bought from private investors is a significant stabilizing force for spreads.

That makes sense. So just kind of switching gears here. Can you guys talk about your thoughts on leverage in the current environment and what you see from a return or spread perspective or what you would need to see from those perspectives to sort of take it up in a meaningful way? I know on the last call, you talked about trying to stay between 7x and 9x, I think a max of 10x. So, kind of where you're looking at in terms of the near future, where you're looking at it to go in the next few quarters?

Yes. I would say that the current valuations of some of our holdings are certainly influenced by interest rates. With the ongoing uncertainty surrounding the tapering schedule, I believe this is not the right time to significantly increase our leverage at present levels. A better opportunity would arise when there is more clarity on tapering and wider mortgage spreads compared to their current state. The environment has certainly changed from six months ago; now the market is heavily influenced by what the Fed communicates, which will bring new information. Six months ago, the situation was different, with the Fed focusing on maintaining low rates without discussing tapering. Given the current context, I appreciate the leverage we possess as demonstrated in this quarter, allowing us to generate strong core earnings. We also have the flexibility to increase or reduce leverage depending on valuations and potential entry points.

And we will take our next question from Eric Hagen with BTIG.

I wanted to get your perspective on what you think the carrier will look like for specified pools over the next few months, just maybe more generally, what's reflected in the price of securities right now? I mean, on the one hand, there's likely this demand for prepayment protection for all the obvious reasons. But on the other, like you noted, there's this potential for spread widening related to Fed policy. So just hoping you can kind of frame what's embedded in the market right now?

So, hey, Eric, it's Mark. You did get this cheapening up of MBS in the quarter, right? And that's sort of reflected in the fact that, generally speaking, agency-focused REITs had negative economic returns. So you did get this cheapening up. I think right now, net interest margins look pretty good. And we're more focused on finding prepayment protection that's fairly priced and looking for pools that appear attractive versus TBA or look attractive versus other hedging instruments, interest rate swaps, or short treasuries. I'm more focused on that than making big predictions about how the taper is going to occur. We're able to find pools on those metrics we think can generate 8% to 10% levered ROEs.

And what's the long-term prepayment assumption underlying your core earnings number? And then just a separate kind of modeling question, if you will. Just wanted to check in on expenses and see if there's wiggle room there or if we should kind of expect more of the same?

Yes. So in regards to the long-term prepayment expectation that's embedded in core earnings assumptions, it's really each pool is different, right? Because you have a range of note rates from 15-year 1.5 coupons, which might have a note rate of 2% all the way up to Fannie 5s, which might have a note rate close to 6%. Even within that, you have a tremendous range of loan attributes, right? Balances of 40,000, 50,000 in some cases, balances of 400,000, 500,000 in other cases. So it's really pool-by-pool specific and it's versus the forward curve. We've spoken on this call a few times about technology and steepening S-curves and you’re seeing that play itself out. If you look at the core earnings we have now, I think those are reflective of our best thoughts right now on current prepayment expectations.

Yes, this is Larry. Eric, let me add that while burnout may not be as significant as some expected, prepayment rates have decreased somewhat. I don’t believe that prepayments will significantly impact our core earnings at this time. In fact, we’ve seen our core earnings improve in the last few quarters due to our portfolio performing well, stable or reduced funding costs, and our ability to extend terms. We have room with a dividend of $0.37 compared to $0.30, which allows for some compression in core earnings without affecting the dividend in the near term. As rates have dropped since the end of the quarter, we expect to reinvest at lower yields as we refresh our portfolio. Financing costs have limited potential for further decreases. Overall, we may see slight downward pressure on core earnings, but it shouldn’t affect the dividend shortly.

Okay. Yes, I mean it would be nice to see what your expectation is each quarter. But how about on the expense side? Is there any wiggle room?

Did you tie your book value through July? Sorry, I'm talking over. Go ahead.

Yes, of course. Our expense ratio, given our size, is about 3.5%, possibly a bit higher. We believe this is a reliable estimate for our current run rate. Typically, we don’t provide mid-quarter updates on our books. Mark, could you share some insights on how spreads have changed since the end of the quarter?

Yes, you've had cross currents, right? You've had very strong role levels. They probably strengthened a little bit. That's benefited some TBAs. You've had some TBAs struggle with keeping pace with hedging instruments. But you've also seen pool pay-ups reprice higher. I would say there's been a lot of cross currents, really how I would characterize it.

And we will take our final question from Mikhail Goberman with JMP Securities.

Most of my questions have already been answered. But I was just wondering if maybe you could expand a little bit further on the follow-on offering from June and the extra bit of liquidity that has been added to the float and kind of what your thoughts are for the company going forward with regard to that?

With regard to sort of share offerings? Not just share offerings, but just what the added liquidity does for the company going forward and your thoughts on Blackstone in general, not the exit, but them lowering their position by a great amount. Yes, I believe we have concluded that addressing this overhang was the best decision for the company, which we have accomplished. You can already see higher liquidity, which I expect will be a permanent change. Share repurchases will also contribute to a lasting increase in float. It’s worth noting that the increase in float was significant, at 38%. Our stock price has faced challenges since then. This situation was somewhat of a necessary action to eliminate the overhang. Although our stock has declined considerably since the offering, I remain optimistic that investors will recognize our trading position in relation to our book value, dividend yield, and the trend in our core earnings. I am hopeful that the stock will be able to recover sooner rather than later.

And this does conclude today's program. Thank you for your participation. You may disconnect at any time and have a wonderful day.