Ellington Credit Co Q2 FY2023 Earnings Call

Good morning, ladies and gentlemen, and thank you for being here. Welcome to the Ellington Residential Mortgage REIT 2023 Second Quarter Financial Results Conference Call. Today's call is being recorded. It is now my pleasure to turn the floor over to Alaael-Deen Shilleh, Associate General Counsel. Sir, you may begin.

Thank you. Before we begin, I want to remind everyone that some statements made during this conference call may be considered forward-looking statements under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not historical and involve various risks and uncertainties that could lead to actual results differing from our beliefs, expectations, estimates, and projections. Therefore, you should not view these forward-looking statements as predictions of future events. We encourage you to review the information we have filed with the SEC, including the earnings release, the Form 10-K, and the Form 10-Q, for more details about these forward-looking statements and the associated risks and uncertainties. Unless noted otherwise, statements made during this call are as of today’s date, and the company has no obligation to update or revise any forward-looking statements based on new information or future events. Joining me on the call today are Larry Penn, Chief Executive Officer of Ellington Residential; Mark Tecotzky, Co-Chief Investment Officer; and Chris Smernoff, Chief Financial Officer. As mentioned in our earnings press release, our second-quarter earnings conference call presentation is available on our website earnreit.com. Our comments will align with the presentation. Please note that any references to figures in this presentation are fully qualified by the notes at the end of the presentation. With that, please turn to Slide 4 of the presentation, and I will now turn the call over to Larry.

Thanks, Alaael-Deen, and good morning, everyone. We appreciate your time and interest in Ellington Residential. Following the first-quarter turmoil in the regional banking system, the second quarter began with investors bracing for the impact of FDIC-directed sales of MBS. The Federal Reserve was no longer buying MBS, and demand even from healthy banks seemed unlikely. As a result, early April saw Agency MBS yield spreads widening even further. However, when the FDIC-directed sales finally got started later in April, the wider yield spreads attracted strong investor interest from money managers, and the sales ended up being well absorbed by the market. With support levels established, the month of May saw even stronger demand for MBS, even while interest rate volatility remained elevated. While this rally was temporarily interrupted by the debt ceiling dispute, once that was resolved, volatility declined, and MBS yield spreads tightened further all the way into quarter-end. Accordingly, we experienced moderate portfolio losses in April, but these were reversed in May and June. On balance, Ellington Residential generated net income of $0.09 per share and adjusted distributable earnings of $0.17 per share for the second quarter. Over the course of the quarter, we maintained a relatively stable overall portfolio composition in size. We continue to hold mostly discount specified pools, and we continue to believe in the value of our portfolio going forward. In recent quarters, we have highlighted how our research and asset selection efforts have focused on finding pools with the lowest payoffs that will get the fastest prepayments. Indeed, as you can see on Slide 4, prepayment rates on our portfolio increased nicely quarter-over-quarter from 4.3 CPR to 7.4 CPR. If you now flip to Slide 8, you can see that we continue to be underweighted in low coupon MBS in the second quarter. Keep in mind that over half of the universe of conventional MBS pools have pass-through rates of 2.5% or less. This low coupon cohort comprised a big portion of the holdings of the failed regional banks. And so, not surprisingly, this cohort severely underperformed in the first quarter due to the anticipation of FDIC asset sales. Since we've been underweighted in this cohort, our results benefited in the first quarter from that position. As I mentioned, the FDIC asset sales ended up being well absorbed by the market, which caused this cohort to outperform in the second quarter. So EARN did not benefit from that outperformance in the second quarter. Nevertheless, we continue to strongly favor the middle of the coupon stack. Avoiding high coupons shields us from some of the technical pressures of new production, especially with the Fed no longer a buyer. This also reduces our negative convexity and lowers our delta hedging costs in what have recently been very volatile periods. With rates this low, we don't think the extra call protection compensates enough for the lower yield spreads in the low coupons. By contrast, we continue to see meaningfully higher yield spreads and better technicals in the middle of the coupon stack, namely MBS with pass-through rates between 3% and 5%. Elsewhere, our non-Agency and IO portfolios again contributed nicely to our quarterly results, driven by net gains and strong net interest income. Although the total size of our overall non-Agency portfolio was roughly unchanged quarter-over-quarter, we did rotate some capital into credit risk transfer assets at some very wide spreads before the spread tightening in that sector in June and July. The loans back in the 2019 and 2020 CRT issues that we bought recently had significant home price appreciation and fast prepayment speeds until mid-last year, both of which have helped to substantially derisk these bonds. Additionally, these borrowers have locked in 30 years of very low fixed-rate payments, and now rate changes are driving their debt-to-income ratios even lower. Combined with the bond tendering programs this year by Fannie and Freddie, and you have a combination of great fundamentals and technicals driving strong total returns. This is a good example of how the breadth of Ellington's platform, combined with the flexibility of EARN's mandate helps drive EARN's total return. Moving to the liability side of the balance sheet, both our debt-to-equity and net mortgage assets to equity ratios were roughly unchanged quarter-over-quarter. I will note, however, that the second metric, which reflects our net mortgage exposure, did fluctuate a lot intraquarter. With markets choppy and spreads wider in May, we covered the majority of our net TBA short position. And then with the market rally in June, we put most of that net short TBA position back on. Similar to last quarter, we ended the second quarter still well below the high end of where we're comfortable adding leverage or net mortgage exposure. Finally, we continue to turn over our lower-yielding MBS with the aim to improve our net interest margin and adjusted distributable earnings. I'll now pass it over to Chris to review our financial results for the second quarter in more detail.

Thank you, Larry, and good morning, everyone. Please turn back to Slide 5 for a summary of Ellington Residential's second quarter financial results. For the quarter ended June 30, we reported net income of $0.09 per share and adjusted distributable earnings of $0.17 per share. These results compare to net income of $0.17 per share and ADE of $0.21 per share in the first quarter. ADE excludes the catch-up premium amortization adjustment, which was negative $376,000 in the second quarter as compared to a negative $299,000 in the prior quarter. As Larry mentioned, positive results in May and June exceeded net losses in April, and Ellington Residential finished with positive net income overall for the second quarter as net gains on our interest rate hedges exceeded net losses on our Agency RMBS and negative net interest income, which was the result of sharply higher financing costs. Our asset yields also increased during the quarter, but by a lesser amount than our borrowing rates. As a result, our net interest margin decreased to 0.93% from 1.16%. Additionally, we continue to benefit from positive carry on our interest rate swap hedges where we receive an overall higher floating rate and pay a lower fixed rate. Our lower NIM, combined with slightly lower average holdings on our Agency RMBS portfolio, drove the sequential decrease in ADE. Meanwhile, pay-ups on our specified pools decreased to 0.98% at June 30 from 1.09% at March 31 for two reasons. First, average sales on our existing specified pools decreased quarter-over-quarter with higher interest rates; and second, the pools that we sold during the quarter had higher payoffs than the overall health population. Please turn now to our balance sheet on Slide 6. Book value per share was $8.12 at June 30 as compared to $8.31 at March 31. Including the $0.24 per share in dividends in the quarter, our economic return was 60 basis points. We ended the quarter with cash and cash equivalents of $43.7 million, which was up from $36.7 million at March 31. Next, please turn to Slide 7 for a summary of our portfolio holdings. Our Agency RMBS holdings were essentially unchanged at $889 million at June 30 as net purchases were roughly offset by principal paydowns and net losses. Similarly, our aggregate holdings of non-Agency RMBS and interest-only securities decreased only slightly over the same period. Our Agency RMBS portfolio turnover was 19% for the quarter. Our leverage ratios were roughly unchanged quarter-over-quarter. Our debt-to-equity ratio adjusted for unsettled purchases and sales was 7.6x as of June 30 as compared to 7.5x as of March 31, while our net mortgage assets to equity ratio was 7x as compared to 6.9x as of March 31. Finally, on Slide 9, you can see the details of our interest rate hedging portfolio. During the quarter, we continued to hedge interest rate risk through the use of interest rate swaps and short positions in TBAs, U.S. Treasury securities, and futures. We again ended the quarter with a net short TBA position. I will now turn the presentation over to Mark.

Thank you, Chris. After a strong first quarter, EARN had a modest positive return for the second quarter and yet another period of significant volatility. That volatility was across the board, not just in yields. Yields were on a rollercoaster ride during the quarter, with the high and low points for the two-year note a jaw-dropping 112 basis points apart. In addition, the slope of the yield curve oscillated drastically during the quarter with the spread between two-year and 10-year treasury trading in a 68 basis point range. Market expectations were strong between fears that the wave of bank failures would force the Fed to be more accommodative and fears that inflation would be resistant to higher interest rates. Ultimately, by the end of June, inflation fears had worn out. The curve reinverted to levels seen just prior to the collapse of Silicon Valley Bank, and interest rates rose, most dramatically for five-year notes and shorter maturities. How MBS performed in the quarter depends a lot on which coupons you're talking about. Now with 90% of the FDIC MBS pool selling behind us, the MBS sector has weathered the supply wave and fared better than many had feared, and the supply was absorbed in a much shorter timeframe than originally anticipated. When demand materialized for a $1 billion block of seasoned discount MBS, the FDIC accelerated their pace of sales. The process is now largely over, well ahead of early expectations. Money managers showed up in size for the opportunity to invest in coupons and loan attributes that have been difficult to source. As a result, low coupon MBS performed quite well for the quarter after that early April slump. For intermediate coupons between 3% and 5%, performance was not nearly as strong; relatively little of this intermediate coupon cohort was included in the FDIC sales. Concerns of a deeper yield curve inversion combined with less investor focus caused the performance of the intermediate coupons to trail that of 2.5% and below. On balance, EARN had a modest net gain for the quarter, constrained primarily by limited exposure to low coupons as well as delta hedging costs related to the elevated volatility. We did not make any major changes to our positioning and think we are well positioned for the current market opportunities and risks. We believe that the current environment is very favorable for Agency MBS. Market expectations are that the Fed hiking cycle is largely behind us. We have received encouraging inflation data for a few months now. Fears of an ongoing deluge of Agency MBS supply from waves of bank failures did not materialize, and we've now just passed the peak seasonal supply months of mortgage origination. Money managers have been big buyers of MBS this year and are no longer underweight MBS, but we think that some bank buying may materialize before year-end, given new capital requirements, which would be a further tailwind to the sector. For EARN, as you can see on Slide 15, we did raise our weighted average coupon slightly in the quarter by about 15 basis points incrementally to nearly 4%, which is still well below new production. That positioning should shield us from the current coupon production with giant average loan sizes and a lot of negative convexity, but still provide us with a hefty yield and potential for strong price appreciation if the forward curve is right and we have a recession. Repo rates have stopped marching higher, so as we turn over our portfolio and increase our asset yields, that should support our NIM in ADE. In addition, our lower dollar price holdings continued to deliver consistent paydowns well above TBA expectations. Ellington has conducted ongoing data studies to analyze out-of-the-money prepayments as a function of loan attributes. There is currently a 22-point price range for liquid mortgage coupons spanning 2 through 6 NAVs and many different issue years and loan attributes as well. So there is a rich opportunity set now to take advantage of that research. Mortgages remain at wide spreads, the market has absorbed almost all of the FDIC supply, and peak summer origination volumes are now past. So far, in the third quarter, realized volatility has remained high, although the full trading range has been noticeably tighter than what we saw in the second quarter. At the same time, Agency MBS have substantially underperformed investment-grade corporates and high-yield bonds, so we think they have ample room to catch up. In the widely discussed scenario where we get a mild recession, we believe Agency MBS will offer very good relative value versus corporates. Now back to Larry.

Thanks, Mark. In what continues to be a highly volatile market, I am pleased with Ellington Residential's ability to preserve book value over the first half of the year and generate $0.26 in earnings per share. Looking ahead, our outlook for Agency MBS is positive as both nominal yield spreads and option-adjusted spreads are still wide. Realized volatility has declined, and higher interest rates are helping to bring inflation down. The Fed may be nearing the end of its tightening cycle, and FDIC sales have been well digested by the market, with around 90% of pool positions and 60% of CMO positions already reported as having been liquidated. Longer term, the return of bank demand for MBS should help stabilize spreads as well. As we look forward to the second half of the year, we have maintained excess liquidity and additional borrowing capacity to capitalize on attractive investment opportunities as they arise and to manage volatility if it spikes again. We will continue to be opportunistic about adding leverage, allocating capital between agency and credit and rotating the portfolio to drive NIM and ADE. As always, we will also rely on our dynamic hedging strategy and active management to protect book value. With that, we'll now open the call to questions. Operator, please go ahead.

Our first question comes from Doug Harter with Credit Suisse.

Thanks. Hoping you could talk a little bit more about the potential to add more mortgage leverage, and what would kind of be the catalyst that would cause you to increase that leverage.

Hey, Doug, thanks for the question. So, to me, I think the catalyst will be some kind of reduction in interest rate volatility, and you've seen it a little bit, right? So, yesterday was volatile, last Friday was volatile. We're not making as big a range. I mentioned this in my prepared remarks, like the difference in the highs and the lows in this quarter is a lot less than what it was in the second quarter. The second quarter was pretty extraordinary. But you're still seeing a lot of elevated volatility. So I think reduction of volatility is important because the delta hedging costs when things really move around can be significant. So that's one thing. I think the other thing is to see other pools of capital come in and start supporting the mortgage market. So what you saw in the second quarter is money managers that a lot of them have been sort of underweight mortgages relative to Bloomberg Agg or Barclays Agg allocation mix, bought a lot from the FDIC, and they covered their underweights, right? But you haven't seen bank participation yet, I mentioned again in the prepared remarks, we think that's something that could materialize in Q4. But I think it's important that you need to see other large pools of capital. I mean, a lot of people recognize mortgage spreads are wide, but what you need to see is actually demand. And so you saw the money manager demand in Q2 that absorbed sort of simplicity, but that absorbed to a large extent the selling from the FDIC portfolios, but you need to see other pools of capital that want to be invested in mortgages because you may see money managers sort of not nearly as aggressive in mortgage additions going forward, given that they're not nearly as underweight the sector as they had been.

Got it. And how do you think about the demand by coupon depending on where those other pools of capital come from? How do you think about which coupons are most likely to be interested in?

It's an interesting question because historically, banks typically bought at current coupon levels. However, with potential changes in capital charges and increased scrutiny on interest rate risk, banks may now prefer shorter duration mortgages than they have in the past. It's still too early to determine definitively. I believe that other investors, such as insurance companies or banks, might take advantage of the wide spread between mortgages and treasuries, as well as the spread between mortgages and corporates. I think I want to see a bit more of that before we increase our exposure. We maintained a relatively constant exposure throughout the quarter and still have room to grow it. Over the long term, our mortgage exposure has been slightly higher than what we've usually maintained. Although mortgages are attractive due to the wide spreads, the interest rate volatility is a concern. It's crucial to see large pools of capital, including foreign investors, insurance companies, banks, or money managers, continuing to invest. You've noticed a slowdown from money managers, as they have covered a lot of their underweights in the second quarter and have been less aggressive in adding bonds than previously.

Our next question comes from Mikhail Goberman with JMP Securities.

Just kind of a capital management question. How are you guys thinking about the trade-off of issuing a little more stock at the margin going forward as you see investment opportunities versus the use of share buybacks with the stock, I guess, sort of in the upper 80s of book value currently?

I believe we're following a consistent approach as in the past. If we reach around 80%, hopefully we won't, but if we do, that's historically been the point at which we've repurchased shares. I think that's a reasonable expectation unless something unexpected occurs. Regarding issuance, we're aiming to maintain a stable capital base. There are considerations regarding G&A expenses if we drop below approximately $100 million. Therefore, I expect to see some moderate issuance to keep our capital base about the same. I hope this information is helpful.

Yes. And what kind of opportunities are you seeing at the margin in the non-Agency portfolio? I know it's very small, but you always mention you could always add a little bit at the margin. So just wondering what you're seeing there.

Mark?

Yes. So we've liked CRT. We mentioned that in prepared remarks. That's a sector that we weren't buying in 2019, in 2020, we didn't really like it. What's happened to that market is you've had a huge amount of home price appreciation. So you have extremely low LTVs. Some of these deals are LTVs in the 50 now. And the other thing you've had is the deals that were in existence during 2020 and 2021 and the beginning of '22 went through periods of time of fast prepayments. So that deleverages the structure. This builds up on a current basis, the amount of credit enhancement below these tranches. That's important to us because we see sometimes the biggest risk in some of these sectors isn't a home price decline and high defaults like what you saw in '08, but it can be more weather-related events or sort of idiosyncratic things like that. So building up that cushion, credit enhancement, for us, raises the credit enhancement levels above the noise that can come from some of the weather-related stress. So we'd like CRT. That sector has performed well in the second quarter, so spreads have come in. We've also historically liked some legacy agency. That sector over time isn't as liquid as it used to be as it's paid down. So our return threshold of that relative to CRT has changed a little bit as CRT remains very liquid. Those have been the two primary things, but you could also see us add some mortgage 2.0. Volumes in that sector are lower than what they've been, but you do get opportunities from time to time with very wide spreads, and that would be mostly investment-grade securities.

And our next question comes from Crispin Love with Piper Sandler.

Mark, your comments a little bit earlier in the Q&A may seem like on spreads made it seem like they will stay stable kind of wide as they are right now, just given the need for more demand. So I'm just curious how you're thinking about the near term. And for EARN, if you would have a preference for tighter spreads or a preference for stability in spreads and just what those scenarios can mean for EARN?

That's a great question. So right now, spreads are so wide, and you make a lot of money on your shorts like all the SOFR swaps, you're paying a rate that is significantly lower than the rate you receive. So as opposed to 2020, 2021, wherever hedge you had cost you money, you're paying a lot more than what you're receiving. This is the exact opposite. So spreads are wide enough now that if you just see stability, you can put together a very strong quarter. In terms of widening or tightening, what would I rather see? I think when you get tightening, what you get is short-term book value gains that come at a little bit of the expense of longer-term ADE. But I guess, probably my preference is a little bit towards tighter spreads because I think that would come with the market where it would probably imply to me that you've seen some reduced volatility. You have the market expectation that the Fed is going to not do very much for the next few meetings, probably came to fruition. You've seen enough demand for mortgages to offset just new origination supply or sort of demand exceeding that to drive them tighter. So I think I'd like to see that because you went through 2022, which was a really challenging year. This year, it's sort of been ups and downs, but there's been a lot of volatility. The sector as a whole benefits from stability, and I think that would be a nice thing to deliver to investors to not only ADE, but also some book value gains.

I would just add. So yes, I think less interest rate volatility would certainly be better given how we're positioned. But I think spread fluctuation is a positive for us, because we do have dry powder in terms of our net mortgage exposure and our leverage. As we said in the prepared remarks, we took advantage of that in the second quarter, covering a lot of our TBA shorts when spreads were wider and then we're putting them back on. So I think a fluctuating spread market is actually a good market for us, particularly since we do dial up and down our exposure sometimes.

That's all helpful color. And then in the prepared remarks, I wanted to make sure I caught this right, but you made some comments that made it seem like banks could come back and be buyers of Agency MBS, I think, a little earlier than some expected. So can you just flush that out a little bit? And is this demand that you might expect later in the year or early 2024? Just curious what you think there. And if I heard you right.

Certainly. Before 2022, the mortgage market was significantly supported by two primary sources of capital: the Federal Reserve and banks. There was substantial pandemic-related stimulus and significant growth in bank deposits, which led banks to purchase a large number of mortgages while their deposit costs were very low. Consequently, banks expanded their mortgage portfolios significantly. However, in 2022, they faced substantial losses in these portfolios, with some banks experiencing severe issues, not just Silicon Valley Bank but others as well, albeit to a lesser degree, with particular vulnerabilities in certain mortgage sectors that dropped significantly in value. As a result, banks found themselves in a tough position, struggling with the disparity between their deposit costs and the yield on their mortgage holdings. Many reduced their securities investments and focused more on loans to minimize volatility in their portfolios. In light of the challenges faced by banks like Silicon Valley Bank, new regulations are being discussed, including different capital charges for mid-sized banks and changes in how loan loss reserves are calculated. This could potentially make investing in securities more appealing for banks again. This year, however, the primary focus has been on ensuring deposit stability; without it, banks are hesitant to make new investments. As concerns over the stability of deposits begin to ease, particularly at a higher cost, banks are likely to reevaluate the investment landscape and find agency mortgage-backed securities appealing compared to treasuries and certain segments of the commercial mortgage market. Therefore, we may see banks positioned to take advantage of these opportunities.

Great. That makes sense. And then just one last quick one for me. Could you give any update or book value third quarter to date?

No, we don't.

Thank you for participating in the Ellington Residential Mortgage REIT second-quarter 2023 earnings conference call. You may disconnect your line at this time, and have a wonderful day.