Earnings Call Transcript - EARN Q1 2020

Operator, Operator

Good morning, everyone. Thank you for joining us, and welcome to the Ellington Residential Mortgage REIT 2020 First Quarter Financial Results Conference Call. This call is being recorded. I would now like to hand it over to Jason Frank, Deputy General Counsel and Secretary. Please go ahead.

Jason Frank, Deputy General Counsel and Secretary

Thank you, and welcome to Ellington Residential's First 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, 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 first 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.

Laurence Penn, CEO

Thanks, Jay, and good morning, everyone. We appreciate your time and interest in Ellington Residential. The month of March will be remembered as one of the most challenging environments ever for leveraged mortgage portfolios. The COVID-19 pandemic and the associated measures to contain the pandemic led to extreme volatility and severe dislocations in virtually all financial markets. Economic activity plunged as countries around the world implemented social distancing restrictions. Unemployment claims surged, consumer spending plummeted and GDP growth rates turned negative. In March, equities sold off across the globe, yield spreads on most fixed-income assets widened sharply, and a flight to safety drove record-low yields on long-term U.S. treasuries. Portions of the yield curve inverted and interest rate volatility surged. On Slide 3, you can see the extraordinary quarter-over-quarter declines in treasury yields. Repo financing stress alongside a drop in asset prices severely reduced liquidity and prompted forced selling across virtually all credit-sensitive fixed-income asset classes, and the residential mortgage market was not spared. The selling pressure was severe, even in perceived safe havens like Agency RMBS. By mid-March, between the heightened interest rate volatility and the ongoing flight to the safe haven of U.S. treasuries, yield spreads on Agency RMBS had skyrocketed to levels not seen since the 2008/2009 financial crisis. In response, the Federal Reserve slashed short-term interest rates nearly to 0, injected liquidity into the repo markets, launched several credit facilities similar to what it had implemented during the financial crisis, and stepped in with unprecedented levels of quantitative easing, all of which provided meaningful support, especially to the more liquid sectors of the market. The U.S. Congress passed three rounds of stimulus packages during March, culminating in the $2 trillion CARES Act on March 27, the largest emergency spending bill in history. These actions were mirrored by central banks and governments around the globe, and the rollout of stimulus programs continued into April. As the Federal Reserve deployed its full crisis playbook, we saw it was in effect almost a full market cycle compressed into just a few weeks. U.S. equities bounced back sharply from the March 23 lows as what had been a 34% drop in the S&P 500 in less than five weeks was immediately followed by an 18% rise in just three days. The Federal Reserve's injections of capital eased liquidity stresses and yield spreads in the sectors targeted by the Federal Reserve's asset purchase programs tightened sharply, particularly in Agency RMBS, which recovered strongly during the last two weeks of the month. Take 30-year Fannie Mae 4s, for example. By some measures, LIBOR option-adjusted spreads on Fannie Mae 4s after reaching their widest level since the financial crisis tightened an astounding 140 basis points between March 19 and March 31. In fact, given the persistent high levels of interest rate volatility, which factored greatly into the calculation of option-adjusted spreads, Fannie Mae 4 LIBOR option-adjusted spreads were, by some measures, actually tighter at quarter-end than they were on December 31. In the credit space, yield spreads in some sectors, such as investment-grade corporate bonds also tightened significantly following the Fed's actions, while other sectors, including non-investment-grade CMBS, noticeably lagged. Many measures of market volatility subsided from their highs but still remain greatly elevated at quarter-end. For Ellington Residential, the precipitous decline in interest rates and high levels of interest rate volatility generated net losses on our hedges. And while our Agency RMBS assets did appreciate in price during the quarter, they significantly underperformed our hedges. As a result, we experienced a significant net loss for the quarter, as you can see on Slide 4. As we discussed on our last earnings call, we entered the year with an extremely liquid portfolio and strong balance sheet, which positioned us well to weather the volatility, especially compared to many other market participants who became forced sellers at distressed prices later in March. As March progressed, with the asset markets and financing markets looking more and more fragile, we proactively reduced the size of our agency portfolio in an orderly and measured way, which bolstered our liquidity and lowered our leverage. We entirely avoided any forced asset sales, which would have exacerbated losses. The vast majority of the agency assets that we sold in March were sold either earlier in the month before yield spreads hit their wides or later in the month after yield spreads had already recovered strongly, especially after the Fed removed any explicit limits on its asset purchase programs. As we reported in early April, we met all margin calls during the quarter. A significant portion of the loss that we experienced during the quarter was related to the market's pricing in lower pay-ups and high-quality specified pools. This pay-up compression was largely attributable to market-wide liquidity problems, exacerbated by quarter-end balance sheet pressures as well as to the implementation of the Federal Reserve's amplified asset purchase program during the quarter, which was generally limited to TBAs as opposed to specified pools with pay-ups. Given that the Fed's purchase program dominated the Agency RMBS market, fundamental valuation factors were overwhelmed by technical valuation factors. So even as mortgage rates hit all-time lows, the market decidedly preferred liquidity of TBAs and the lower capital required to hold them as opposed to paying up for the value of prepayment protection in the form of specified pools. Going into April, we thought this pay-ups on specified pools were artificially low and represented excellent value and upside to earnings, and indeed, specified pools outperformed in April. While losses are always disappointing, I believe that given that leveraged mortgage portfolios, we're in the crosshairs of the distress in the financial markets this past quarter, that it is a testament to our portfolio management, risk management and liquidity management capabilities that we were able to limit those losses and preserve book value to the extent that we did. I will now pass it over to Chris to review our financial results for the quarter. Chris?

Christopher Smernoff, CFO

Thank you, Larry, and good morning, everyone. Please turn to Slide 5 for a summary of EARN's financial results. For the quarter ended March 31, 2020, we reported a net loss of $16.7 million or $1.35 per share. Core earnings were $3.4 million or $0.27 per share. These results compared to net income of $9.7 million or $0.78 per share and core earnings of $2.8 million or $0.23 per share for the fourth quarter of 2019. Core earnings exclude the catch-up premium amortization adjustment, which was negative $0.7 million in the first quarter compared to negative $2.5 million in the prior quarter. As you can see on Slide 5, the loss in the quarter was primarily driven by net losses on our interest rate hedges as interest rates declined and were highly volatile during the quarter. A portion of these losses were offset by gains on our specified pools and also by net interest income on our portfolio, which increased significantly quarter-over-quarter with lower borrowing costs and a smaller negative catch-up premium amortization adjustment. TBAs outperformed specified pools during the quarter, as Larry mentioned, which depressed pay-ups on our specified pool portfolio. Despite the drop in mortgage rates during the quarter, average pay-ups on our specified pools decreased to 1.67% as of March 31 compared to 2.05% as at December 31. Also on Slide 5, you can see that our net interest margin improved significantly during the quarter, increasing 20 basis points to 1.2%, driven by lower borrowing costs. The wider NIM led directly to improved core earnings of $0.27 per share compared to $0.23 per share last quarter. Our small non-agency portfolio had a net mark-to-market loss for the quarter driven by substantial yield spread widening in that sector. Next, please turn to view our balance sheet on Slide 6. You can see that we increased cash and cash equivalents significantly quarter-over-quarter to $59.7 million from $35.4 million. In addition to cash, we had other unencumbered assets of approximately $12 million as of March 31. At the end of the quarter, our book value per share was $11.34 compared to $12.91 per share from the prior quarter. Our economic return for the quarter was negative 10%. Next, please turn to Slide 7, which shows a summary of our portfolio holdings. Our total mortgage-backed securities portfolio decreased to $1.05 billion as of March 31 compared to $1.4 billion as of December 31. As Larry mentioned, in light of the heightened levels of market volatility and systemic liquidity risk, we proactively reduced the size of our agency portfolio by 25%, thereby bolstering our liquidity and lowering our leverage. At the end of the first quarter, our debt-to-equity ratio adjusted for unsettled purchases and sales was 7.2:1, a decrease from 8.1:1 as of December 31. Substantially all of our borrowings continued to be secured by specified pools. We satisfied all margin calls under our financing arrangements during the quarter. 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, short positions in TBAs, U.S. treasury securities and futures. TBA short positions represented 16.8% of our interest rate hedging portfolio at the end of the current quarter, up from 13.6% at the end of the prior quarter. While TBAs outperformed specified pools during the quarter, they severely underperformed interest rate swaps and U.S. treasury securities. So our results benefited from the portion of our interest rate hedging portfolio that comprised TBA short positions rather than interest rate swaps. Next, turning to Slide 9. You can see the significant decrease in our net long exposure to RMBS as our net mortgage assets to equity ratio declined to 5.6:1 from 7.6:1. Additionally, as of January 1, 2020, we applied the new credit loss standard known as CECL. Because we have always fair-valued our portfolio through the income statement, CECL had no impact on our earnings or quarter-end book value. Finally, during the quarter, we repurchased 136,142 shares at an average price of $7.24 per share.

Mark Tecotzky, Co-Chief Investment Officer

Thanks, Chris. I've been involved in the mortgage market for over 30 years, and I have never experienced the level of market illiquidity and dysfunction that characterized the second half of March and early April. However, while each period of market disruption resulting in volatility is unique, they all share common characteristics. For EARN, recognizing early what was happening, anticipating what might follow, and understanding potential policy responses allowed our team to effectively reduce the extent of the decline in book value. To grasp what occurred with Agency MBS during March, we first need to consider the market conditions in the first two months of the year, prior to COVID-19. During January and February, we experienced a 75 basis point rally in the 10-year note, which sparked substantial prepayment concerns in the market. Mortgage originations surged, spreads on TBAs widened, and pay-ups on specified pools reached extremely high levels, with many exceeding four points. Then, the uncertainty brought on by COVID took hold of the market, creating real uncertainty that shocked the marketplace and was not reflected in historical data or traditional models. Without reliable predictive models, the market rapidly adjusted, influenced by fear and emotion, and was further impacted by the crucial technical factor of an excess of market participants with insufficient liquidity and over-leveraged balance sheets. As seen in past crises, the stock market plummeted, investors frantically redeemed shares from mutual funds, including those focused on fixed income, and repo lenders grew anxious about the security of their loans. The availability of balance sheets was severely limited. Consequently, any bond holdings needing balance sheet leverage became vulnerable as cash became the priority. Repo lenders’ best-case scenario is for borrowers to repay their repo loans on time and at full value, allowing them to gain a modest profit. Their worst concern is that the value of their collateral could fall below the amount of their repo loan. Thus, when repo lenders observe price drops, their first action is to execute a margin call. Over-leveraged borrowers typically have to sell immediately, often without regard for fundamental values. This forced selling happened during a peak of COVID-related panic as the quarter-end approached. Banks usually lower their risk going into quarter-end, limiting their available balance sheet, which caused prices, including pay-ups for specified pools, to tumble. Hence, it became nearly irrelevant that loan balance specified pools had longer durations than TBAs while rates declined. Repo lenders aggressively margin called their borrowers, as they faced both the risks associated with their repo loans and their own internal balance sheet constraints. This resulted in a cycle of selling, where the collapse of pay-ups for specified pools incited further margin calls on leveraged agency pool portfolios. The response from the Federal Reserve was both thoughtful and decisive. The Fed swiftly escalated QE, which we had anticipated, and they also adapted it to the current market. The Fed not only utilized QE to lower mortgage rates but also aimed to provide balance sheet relief for the private sector. Day after day, the Fed purchased tens of billions of dollars of MBS for next-day settlement across a variety of coupons, giving the market the balance sheet relief it desperately needed. By April, with balance sheets stabilized and a new quarter beginning, the market could refocus on relative values instead of being driven by the rampant fear and hasty actions of over-leveraged investors. As for EARN, the reality that agency mortgage QE is now an established tool for the Fed’s crisis management makes Agency MBS distinct from other structured products. There is an inherent limit to how much an agency portfolio’s value will decline if it is managed well enough to avoid forced selling to meet margin calls. When spreads are tight, the additional returns from leverage are often not worth the potential risks to balance sheets during crises. Additionally, we generally structure most of our repo agreements with a three-month term and staggered maturities, avoiding the temptation to cut costs with excessive reliance on overnight or one-month repo. Earlier this year, we decided that pay-ups were becoming fully valued, so we typically avoided adding high pay-up pools. This positioning allowed us to reduce our leverage proactively and affordably after the crisis struck when pay-ups collapsed. We had ample lower pay-up pools to sell, minimizing our costs compared to TBA sales. Our research efforts focused on identifying lower pay-up pools that could offer meaningful call protection at a low expense. The volatility period confirmed that many losses from spread widening could be reversed, provided we weren’t forced sellers, as we do not take credit risks. In contrast, various credit-sensitive areas of the fixed income market, like certain high-yield corporate bonds, will undoubtedly incur substantial credit losses from the economic impact of COVID, and those losses won't be reversible. Looking ahead, we now recognize substantial opportunities in the current market and are well-positioned to leverage them. We expect prepayment speeds to be surprisingly low for borrowers who qualified for mortgages under the credit standards that had been loosening until March’s crisis. MBS spreads remain appealing, and we believe we can continue benefiting from the Fed's support while managing prepayment risks with modest pay-ups. Moreover, given the difficulties in the credit risk transfer market, GSEs are likely worried about their capacity to manage credit risk moving forward. They may need to retain more credit risk on their balance sheets, which could lead to further tightening of the credit box, keeping prepayment speeds relatively low despite current mortgage rates. We are also interested in increasing our TBA holdings in this market. Recently, the Fed has scaled back its daily purchases from approximately $35 to $40 billion a day down to about $6 billion. However, if MBS were to widen significantly from current levels, we believe the Fed could promptly ramp up its purchases again. A further positive development is the improved availability of funding. Three-month repo rates have significantly decreased and are likely to settle below 40 basis points, creating a favorable net interest margin between asset yields and financing costs. The Fed has been focused on ensuring that the repo financing rates for treasuries and Agency MBS remain in line with the Fed funds rate, indicating a sustained low-rate environment for MBS repo. Our analytical models have proved effective in making conditional predictions. While we cannot predict specifics about workforce re-entry or unemployment levels, we are confident in forecasting outcomes like prepayment speeds based on mortgage rates, the implications of a shrinking credit box, and reactions to Fed purchases. Addressing these questions has always been and will continue to be our central priority in guiding portfolio decisions. However, in light of the events in March, we are also keeping a close eye on the broader landscape and remain keenly aware of the exceptional circumstances in the current environment. To summarize, we see immense opportunity moving forward. Agency MBS spreads are still favorable, bolstered by Fed support. Financing conditions are abundant and inexpensive, and we see the potential for prepayment protection at relatively low costs if we know where to look.

Laurence Penn, CEO

Thanks, Mark. I am pleased that we emerged from the volatility of March with our book value largely intact. Our risk and liquidity management practices did what they are always designed to do: They protected book value and they protected our shareholders. This past quarter, that meant protecting our shareholders, not only by avoiding any forced asset sales, but it also meant protecting our shareholders by avoiding any expensive or highly dilutive capital raises. And through it all, we were still able to end the quarter with a lot of cash on hand that should enable us to play offense going forward. The current investment opportunities look exceptional, given the continued dislocations in most sectors of the residential mortgage market. Even with pay-ups recovering strongly in April, specified pools are still attractively priced, and financing costs have come down considerably. Net interest margins in many RMBS sectors are the widest that we've seen in years, and I believe that we are in an excellent position to take advantage of these opportunities. Along those lines, we are currently considering increasing our capital allocation to our non-Agency RMBS portfolio. All that said, while the global government and central bank responses have provided a boost to liquidity and meaningfully improved market performance in the short term, the path forward for the economy generally and the credit markets, in particular, remains unclear. In light of this uncertainty, our disciplined approach to liquidity management, interest rate hedging, and asset selection will continue to be critical. We will continue to strive to balance defense, that is building in a margin of safety to absorb additional potential market shocks with offense, that is the ability to capture some incredible relative value opportunities. These principles will continue to guide us moving forward. Before we open the floor to questions, I would like to take this opportunity to thank the numerous members of the entire Ellington team for their hard work over the past weeks despite difficult circumstances. And for all of those listening on the call today and to all of those in our communities and around the globe impacted, we hope that you and your families stay healthy and safe. With that, we will now open the call to your questions. Operator, please go ahead.

Operator, Operator

Your first question comes from Doug Harter with Crédit Suisse.

Joshua Bolton, Analyst

This is actually Josh on for Doug. We saw lower leverage in the quarter, not surprising. Curious how you're thinking about target net mortgage leverage, just given the uncertainty in the market. And then, I guess, a follow-up to that would be, how does that translate into the ROEs you're seeing on incremental capital deployment? You mentioned possibly increasing allocation to non-agencies. So maybe just the difference in ROEs you're seeing in the different buckets that you look at.

Laurence Penn, CEO

Mark?

Mark Tecotzky, Co-Chief Investment Officer

Sure. So on the agency side, I think we can get ROEs of 10% to 12%. Spreads are not as wide as they were earlier in the month, but there's also a lot less volatility, right, and the volatility comes with an increased hedging expense. So I mentioned in the prepared remarks, we've spent a lot of time understanding where we can get call protection without exposing the portfolio to very high pay-ups. And I think that's the sector we'll continue to invest in and where we think we'll see the best relative value. In terms of the ROEs on the nonagency market, right? The nonagency market came under a lot of pressure in March. There were tremendous selling, not only from mortgage REITs but also from mutual funds. And so we've seen a substantial drop in those prices above and beyond what could be justified by higher loss expectations, longer timelines, etc. So there, I think, we'd apply certainly lower amounts of leverage because there's still tremendous uncertainty, and so you can't rule out the possibility of asset prices declining. But with modest amounts of leverage there, I think we can get sort of ROEs of 10% to 14%.

Operator, Operator

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

Mikhail Goberman, Analyst

Congrats on a very good quarter in difficult circumstances. It's kind of strange saying that given a 12% book value drop, but considering what other firms have posted, that's fantastic.

Laurence Penn, CEO

Appreciate that. Thank you.

Mikhail Goberman, Analyst

Yes, absolutely. Could you possibly give a book value update thus far through April and what we have in May?

Laurence Penn, CEO

We're not prepared to do that. We have those numbers internally, and we provided a lot of information in our early April release. We will keep considering if it is appropriate to issue intra-quarter releases, but generally, that has not been our practice.

Mikhail Goberman, Analyst

Okay. Fair enough. And you mentioned that spec pools are still pretty attractive. You also mentioned, I think, that you like TBAs at this point as well. Could you maybe talk about your appetite for one versus the other as we move forward?

Mark Tecotzky, Co-Chief Investment Officer

Sure. This is Mark. Regarding TBA, we see a notable change due to Fed support compared to three or six months ago. In our earnings calls discussing 2019 performance, we talked about advancements in technology within the mortgage sector and how that contributed to negative convexity. The significant rise in WACC and coupon rates we experienced in 2019 indicated an overall decline in TBA convexity. The cash flow from TBA can be hedged at a low cost using interest rate swaps or treasuries, but in 2019, there was considerable negative convexity introduced in the TBA market without any Fed purchases to balance the lowest prices. At that time, the Fed was actively reducing its portfolio, allowing it to decline by $20 billion each month. Now, two key changes have occurred. First, there is increased Fed support, as the Fed is now purchasing specific coupons. The implied financing costs derived from the roll market for the coupons the Fed is aggressively buying, such as Fannie 2.5s, Fannie 3s, and certain Ginnie coupons, have made roll levels very appealing. The rolls are no longer priced at the lowest quality TBA levels seen in 2019; they're responding to the Fed buying up poorer pools in substantial amounts, creating attractive roll levels for us. Secondly, the Fed has significantly reduced its purchasing activity, as we noted in our prepared remarks. Had we not seen this reduction, we would have anticipated that the Fed would eventually lower its purchases as the market stabilized, which could have led to wider mortgage spreads. However, that has already transpired. The Fed decreased its buying from as much as $40 billion daily to around $6 billion. This tapering means we can expect the pace of their mortgage purchases to be more balanced and likely sustained for some time. These two factors lead us to favor certain TBA coupons more compared to discount specified pools than we did in 2019. Both changes are significant, and we recognize that this situation can evolve. It’s crucial to emphasize that to achieve optimal risk-adjusted returns, one must be adaptable and responsive to new information. An investment strategy that seems solid one day may need reassessment with new data the next. That’s our current perspective, and we continuously evaluate our investment thesis based on emerging information.

Mikhail Goberman, Analyst

Thank you, Mark, for that answer. It's very detailed. One more, if I may. I'm looking at Slide 11 of your deck, which shows a negative spread of 3-month LIBOR versus repo of about, I guess, 20, 25 basis points at April 1. I believe in your prepared comments, you were saying that 3-month LIBOR should be settling at around 40 basis points. So what are you currently seeing for repo? And could you see that spread sort of turn positive not like it did back in 2018, of course, but basically, what are you seeing for that spread going forward?

Mark Tecotzky, Co-Chief Investment Officer

In the prepared remarks, we mentioned that we expect the 3-month repo to settle below 40 basis points. Recently, the 3-month LIBOR has experienced significant volatility. It was quite high a few weeks ago compared to the OIS, but now it is beginning to decrease. I believe that 3-month LIBOR and 3-month repo will align more closely, meaning we won't see the large advantages we had when 3-month LIBOR was much higher. The floating leg of your swap is adequately covering the repo expenses, so we anticipate that these two metrics will be roughly equivalent, which is an improvement over a lot of 2019. Additionally, the yields we can achieve when selecting assets in the agency mortgage market, when weighed against financing costs and the expenses from pay-fixed swaps, result in a healthy net interest margin. If we manage this carefully to avoid excessive volatility, our net interest margins are currently very robust.

Laurence Penn, CEO

Yes. And if I could just add that our interest rate swaps right now, Mark, correct me if I'm wrong, but they're either exclusively or almost exclusively LIBOR-based swaps.

Mark Tecotzky, Co-Chief Investment Officer

Yes. No, exclusively, I think.

Laurence Penn, CEO

Exactly. There are other types of swaps that some market participants in our sector have been using, known as OIS swaps. We have examined this closely. It was beneficial for us to be exclusively in LIBOR swaps during the stress of March when LIBOR rates surged. As a result, we received higher rates on the floating leg of our swaps, which helped us during that period of stress related to the repo market and asset prices. This served as a small advantage during March. It demonstrates that in stressful times, having LIBOR swaps can be advantageous when the markets are stable. While it's difficult to predict the future, if markets stabilize, our financing costs may align more with these OIS-based swaps, which involve less credit risk compared to LIBOR swaps. Therefore, it’s a matter of determining what will be more beneficial during times of crisis versus what will better correlate with our funding costs in more stable periods.

Operator, Operator

And we have no further questions. This will conclude today's meeting. You may now disconnect.