Q3 2019 Earnings Call
Hi, Mark each week 2019 third quarter financial results Conference call today's call is me recording.
Time, all participants had been placed on in listen only mode and the floor will be open for questions. Following the presentation.
If he would like to ask a question at that time. Please press star one on your telephone keypad at any time. If your question has been answered you may removed himself from the Q about placing the pound.
Lastly, if he shouldn't require operator assistance. Please press star one it is now my pleasure to turn the floor off to Jason Frank Deputy General Counsel and Secretary, Sir you may begin.
Thank you before we start 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.
Right right and one day over annual report on Form 10-K filed on March 2019 forward looking statements are subject to a variety of risks and uncertainties that could cause the companys actual results could differ from the beliefs expectations estimates or 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 in 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, our Larry Penn Chief Executive Officer of Ellington residential Mark the Coskey, our co Chief investment officer, and Kretzmer It off our chief financial.
Officer.
Described in our earnings press release, our third quarter earnings Conference call presentation is available on our website <unk> Dot com.
Our comments this morning, we'll track the presentation. Please note that any references to figures in this presentation are qualified in their entirety by the I know it's at the back of the presentation with that I will now turn the call over to Larry.
Thanks, Jay and good morning, everyone.
As always we appreciate your time and interest in Ellington residential.
On our call today I'll begin with an overview of the third quarter.
Chris will then summarize our financial results next Mark will review the performance of the residential mortgage backed securities market during the quarter.
Portfolio positioning and our market outlook and finally I'll provide some brief closing remarks, and then we'll open the floor to questions.
The third quarter began with a quiet July interest rates range bound U.S. equity indices reached record highs and on July 31st the Federal Reserve cut short term interest rates by 25 basis points and announced an end to which treasury portfolio run off two months early.
Sentiment flipped and on August however, and significant market volatility return as messaging from the fed shifted hawkish concerns over global growth intensified and U.S. trade negotiations with China grew tests.
During the month various volatility indices searched some equity <unk> domestic equities fell interest rates plummeted and big parts of the yield curve inverted.
The Federal reserve responded to the increased volatility like pledging more monetary stimulus if need be.
Several central banks around the Globe also responded by cutting interest rates.
Moving into September volatility subsided domestic equities were covered and U.S. treasury yields rose.
European Central Bank cut short term rates its first cut since 2016 and launched a quantitative easing program.
Later in September the Federal Reserve cut short term rate again that the decision was not unanimous clouding the outlook for future reductions.
I'm extremely pleased with our performance during the third quarter, our disciplined hedging strategy and portfolio of high quality specified pools helped out Ellington residential deliver strong earnings despite large fluctuations and long term interest rates, increasing prepayment rates and an inverted yield curve.
As you can see on slide four of the presentation. We reported net income of 30 cents per share, which exceeded our dividend of 28 cents per share and our book value per share. It sits at September Thirtyth increased to 12 42 from 12 for to get June Thirtyth.
Opportunistic share repurchases helped boost book value and altogether economic return from the for the quarter was a solid 2.4% or 10% annualized.
Well it just while our adjusted core earnings declined quarter over quarter, we believe that the prospects to expand our net interest margin and grow core earnings are improving as we benefit from lower repo borrowing rates and wider yield spreads on new investments following the with the spread widening that we saw in August .
With LIBOR rates declining.
You know borrowing cost come down as a reset our short term repos, we expect that our funding cost will continue to come down and there should be a tailwind to earnings going forward.
Now I'll turn the call over to our CFO , Chris Smirnoff to discuss our financial results in greater detail.
Thank you Larry and good morning, everyone.
Please turn to slide seven for a summary of earns financial results.
For the quarter ended September Thirtyth 2019, we reported net income of $3.7 million were 30 cents per share compared to a net loss of $107000 were one penny per share for the second quarter.
Adjusted core earnings was $2.4 million or 19 cents per share compared to $2.7 million or 22 cents per share for the prior quarter.
Adjusted core earnings was lower this quarter, primarily as a result of lower asset yields.
Our adjusted core earnings exclude the catch up premium amortization adjustment, which was negative $1.6 million in the third quarter compared to negative $904000 in the prior quarter.
For each period declining mortgage rates cause actual and projected prepayments to increase and the catch a premium amortization adjustment was negative.
Despite elevated interest rate volatility rising prepayment risk and portions of the yield curve inverting we've been if we benefited from strong performance in our agency RMBS portfolio during the quarter.
Fabs that are specified pools increase for the fourth consecutive quarter and along with declining interest rates generated net realized and unrealized gains on our portfolio.
Similar to previous quarters, the decline in mortgage rates and associated increased an actual and projected prepayments drove the expansion of path.
Turnover in our agency RMBS portfolio was 15% for the quarter and we generated net realized gains of $2.7 million.
Our non agency RMBS portfolio also performed well during the quarter driven by strong net interest income and unrealized gains.
Even though lower medium and long term interest rates caused losses on our hedges this past quarter the gains on our assets exceeded hedging losses, and we and these net gains were a nice supplement to core earnings in the quarter.
Our adjusted NIM, which excludes the impact of catch a premium amortization increased slightly to 81 basis points. During the current quarter, that's compared to 70 basis points in the prior quarter.
Our cost of funds decreased by 16 basis points to 2.4%, while the adjusted weighted average yield on our portfolio decreased by 13 basis points to 3.21 person.
During the quarter, we repurchased 33706 shares at an average price of $9, an 87 cents per share, which was about a 20% discount to our June thirtyth book value and which provided a modest boost to our book value per share.
At the ended the third quarter, our book value per share was 12042 cents of two cents from the prior quarter.
Our economic return for the quarter was 2.4%.
Next please turn to slide eight which shows a summary of our portfolio holdings.
Our MBS portfolio decreased to $1.39 billion as of September thirtyth as compared to $1.46 billion as of June Thirtyth.
Our debt to equity ratio at the ended the third quarter adjusted for unsettled purchases and sales was 8.6 to one decreased from 8.9 to one as of June Thirtyth.
Next please turn to slide nine for details on our interest rate hedging portfolio.
During the third quarter, our interest rate hedging portfolio consisted primarily of interest rate swaps and to a lesser extent short positions and TB and us Treasury Securities and futures.
We increased the size of our net TV short positions during the third quarter to 11.3% that's compared to 7% at the end of last quarter, although the size of our net PBH short position remains considerably considerably lower than it has been historically, because we remain constructive on the agency mortgage basis.
Turning now to slide 10.
Primarily because of the larger net TB, a short position our net exposure to RMB.
This is the aggregate market value of our RMBS holdings, including our net short TBA position decreased to $1.19 billion as of September Thirtyth from $1.39 billion as of June Thirtyth.
This translates to a net mortgage assets the equity ratio of 7.7 to one as of September thirtyth compared to nine to one as of June Thirtyth.
Well now turn the presentation over to Mark.
Thanks, Chris earn had a strong quarter in a market that presented a lot of potential headwinds pre payments for the fastest they've been in years repo funding costs were high relative to LIBOR interest rates were volatile with the 10, you know yields moving into 68 basis point range.
Or parts of the quarter segment to the yield curve inverted well that sounds like a tough backdrop, we did well because our prepayment protected pools came into the quarter with attractive valuations and their prepayments continued to be well behaved Gordon any other quarter in the past few years. This was the quarter, where pool selection hedging choices and mismatch.
And it made a big difference in total return.
Even after our strong third quarter, we see the current market is actually much more favorable for elaborate MBS strategy.
After a few episodic funding stresses in Q3, the fed has been very aggressive in adding both repo capacity and excess reserves into the system.
Turn has never relied much overnight funding. So we were at most minimally impacted by the so for rate spikes already in Q4, we have seen our repo funding improved.
And we expect more improvement going forward as we enter late fall and winter seasonal effect should dampen prepayments and also a decent reduced mortgage supply which are both strong positives for mortgage performance. Additionally, after three fed rate cut yield curve is starting to steepen again.
Look at Slide 11, which shows the difference between the 30 year mortgage survey rate and three month LIBOR.
That spread narrowed in the third quarter, many investors who own mortgages just for their current carry became salaries and that in turn drove yield spreads wider.
We took advantage of that opportunity by keeping our mortgage basis exposure relatively high now in the fourth quarter. We're finally seeing mortgage yields getting significantly above repo costs again in fact as you can see on the right side of the graph, where now already almost 50 basis points deeper than we were in early September which should attract carry.
Conscious investors back to the market and provides with a great total return opportunity.
As a result, a very fast prepayment.
Very fast prepayments to be done generic TB like pools are prepayment protected specified pools significantly outperformed TB, a mortgages and even performed very well versus swaps during the quarter.
The fast speeds and resulting negative roles for many TB a coupons created a rush by investors in the specified pools.
Slide 12, the left hand, the left hand chart shows that less than 20% of pools are currently trading with little or no pay ups to TB A's the other 80%.
Have a pay up in most cases, a very significant payout.
Compare this to the 2016 refinancing wave.
Even when that its peak you still had about 40% of the pools trading your TV prices.
The right hand chart shows that much of the pool market is trading well over one point over TB eight.
Active specified pool market has created a lot of relative value opportunities for us because we have always focused on prepayment analysis and pool selection. This is definitely a pool pickers market with lots of interesting prepayments stories to tease out from the data and lots of opportunities now prepared some specified pools to expanding contract in a wide band which plays right.
Turning to our strengths.
Over the years talked about a lot of aspects of the agency MBS market. They don't think we have ever discussed negative roles, which we've been seeing recently. This phenomenon is a consequence of the fast prepayments on premium priced TB aid combined with the relatively narrow difference between implied PVA yields and funding costs negative.
Rolls rise when the cost of the monthly paydown exceeds the positive carry a bit coupon over your repo cost for example, one a $104 price Tpa is expected to pay at 40 CPR.
You get back about 4% of your principal each month at a four point loss, which is a 16 basis points cost per month.
60 basis point Paydown cost can easily exceed your monthly carry on the pool.
So with negative roles will you lose carry being long TBA you actually make positive carried being short PVA. These negative rolls created some of the best positive carry mortgage trade we've seen in years.
We're able to find some high coupon prepayment protected specified pools at low pay ups that we're paying close to zero CPR.
These positive carry pools combined with the positive carry TB a short hedge had as much as seven tick positive carry per month, that's in NIM of over 250 basis points. Now these pools don't necessarily have long lasting prepayment protection, but they have short term prepayment protection. So do the ended the year. These trade can be very profitable.
You now have a mortgage market, where you literally see a 45 CPR differential between the slow paying it fast paying pools for the same coupon by comparison in 2018, you could barely see it 20 CPR differential across the entire agency mortgage universe.
With so many fast paying pools and so many TB april's currently priced very fast prepayment assumptions. This is a great market for those willing to make it deep dive into prepayments. The trick now is to get prepayment protection without paying too much board. Many loan bounce stories of run up in price, we've been selling some pools that what we consider nosebleed levels.
Yeah.
By the way at the same time that we were getting paid via positive Kerry hedge our interest rate risk by being short TBA mortgages, we had a similar dynamic in the interest rate swap market this past quarter.
Most of the quarter hedging interest rate risk by paying fixed on medium term swap was also positive carry trade because the three month LIBOR you received on the floating leg of the swap exceeded the coupon you paid out on the fixed like the more you were hedged the better your carry was.
In terms of portfolio evolution, this past quarter, we shrunk the portfolio a little bit and further reduced our net mortgage exposure by increasing our net PVA short to take further advantage of weak roles.
As you know, we actively trade up portfolio and we told from pools, where we thought the market was overvaluing them.
We still find agency mortgage is very attractively priced overall, but we also think yearend balance sheet constraints may result in some attractive entry points in Q4.
We still like being fully interest rate hedged that only should that reduce risk, but it should also generate some incremental positive period for the portfolio, though not as much as in Q3.
There were a few there are some new tailwinds for the agency mortgage market for example, with faster prepayments. The fed is now stepping into by in order to meet their policy limit of 20 billion a month in their portfolio reduction of agency MBS that buying gets been supportive of mortgage spreads and that has contributed to strong October for earn.
Another tailwind came into effect on November onest, when LTV caps on fresh cash out we fight went into effect for both the FHLB and VA.
While we don't see GNC reforms in near term event, we do think it is more likely than not that the epic table increment that the FHLB will incrementally reduced the footprint to Fannie and Freddie which could reduce agency MBS supply in cost further out performance finally banks have already reduced their agency securitization rates with the result being that more.
<unk> eight and fields will loans are now being securitizing, the private label market now back to Larry.
Thanks Mark.
I'm pleased with earns performance so far this year and I'm, especially pleased with the stability of our book value this past quarter despite market volatility.
As always we were disciplined in our approach to hedging interest rate risk and we not only closely watched or overall portfolio duration, but we also closely watched our exposure to the potential steepening or flattening of the yield curve.
This discipline again paid off in the third quarter with solid results year to date through September Thirtyth generated an economic return of 8.3% or 11.2% annualized.
As we move into the final quarter over the year I like our position I'm excited about the investment opportunities we're seeing.
Wider yield spreads and lower funding costs are improving the prospects for margin expansion and core earnings growth and mortgage valuation seem very attractive to US right now both relative to recent history and relative to other high grade sectors, such as investment grade corporate bonds.
It between now and year end interest rates were to fall back to early September levels, and the prepayment wave were to intensify in response.
I would expect to see further divergence of performance between different sub sectors of the agency RMBS market, including iOS and we would expect to capitalize on the opportunities created by that divergence.
Very light an Io product right now we'd love to add on significant weakness, if we see distress selling in that market.
On the other head of interest rates were to rise substantially from here will be very glad that we maintain such a low overall portfolio duration as shown on slide 20 for example.
Especially dangerous to take duration risk in an ultra low interest rate environment and I believe earn stands apart and its ability to generate solid returns, while keeping such a tight leash on portfolio duration.
It's never been our policy at aren't just a pattern net interest margin net interest margin I, reaching for the highest yielding pools those types of fools tend to be the most negatively convex.
Portfolio, followed those types of pools like boost our earnings temporarily our book value. We just got slaughter in a big interest rate move.
Instead, we've concentrated up portfolio and high quality specified pools, which carry lower yields but are much more resistant to duration draft when interest rates rise or fall, which they inevitably do.
And with the yield curve, where currently as let's face it it can be a challenging environment from a headline NIM and core earnings perspective.
However in return the market is giving us an absolute abundance of total return opportunities and so that's where we're rightfully concentrating many of our efforts.
Agency mortgage basis is currently wide and it's bouncing around the roles on TV ads are often negative and pay ups on specified pools are all over the place as Mark said earlier. This is a pool pickers market. We are seeing lots of opportunities for active trading and price appreciation to drive earnings as they did in the third quarter.
Finally, we always want to be able to play off that's not defects, we see significant yearend selling pressure in any of our markets. The time being that means that we don't want to leverage too much you want to keep our portfolio highly liquid.
When it continued to be disciplined about interest rate hedging.
We believe that are smaller size of the big advantage and this type of active trading environment as an enabler enables us to be nimble and react quickly to reposition our portfolio in response to market distress.
With that we'll now open the call to your questions. Operator. Please go ahead.
As a reminder, if you would like to ask the question. Please press star one of your telephone keypad.
Your first question is from the line of does today with credit Suisse.
Hey, guys. This is actually Josh on for Doug I'm, just looking at the core earnings this quarter and then thinking about where the dividend is how are you feeling about current dividend and also if you could just walk us through some of the puts and takes around how you see core getting closer to that level and from your comments is it fair to say.
The third quarters, feeling like maybe a marketing.
Mark a trough in core earnings of the portfolio. Thanks.
I think.
I think in terms of.
Where the dividend as yes, sorry, our core earnings are not covering have not been covering the dividend recently, but our earnings have so I know my my our view is that Theres, no need to panic and and.
But the dividend as long as were earning it whether it be through core or.
Where as I just mentioned this market is providing us opportunities through total return and gain and gain opportunities. So I think that.
The market sort of.
Given the market taken away right and so as we've had some.
Inversion of the yield curve and now obviously, we're seeing that reversed some what we see some seems more steepening.
We've seen.
Repo rates repo funding costs that were a decent spread above livewatch and now they are we're seeing them below livewatch. So we see a lot of tailwinds, we see a lot of ways that the trend is reversing itself in terms of NIM compression and that leads to core earnings compression so as long as we.
Feel like they're good opportunities out there and in that were we're actually achieving those by having our total GAAP earnings exceed our dividend we are comfortable where it is right now.
Great that makes sense and then just one do you have any update on how book value is trending quarter to date or through the end of October . Thank you.
Sure Yeah, that's not something that we give typically with much precision apps and I think we've done at once or twice in some unusual market conditions.
But I think as Mark mentioned that October was looking like a good month and I'll just leave it at that.
Fair enough. Thanks, Larry.
Thank you Josh.
Your next question is from the line of Michael will remain with JMP Securities.
Good morning Gentleman quick question on where you're perhaps seeing CPR is trending so far in the fourth quarter.
Sure so.
The prepayment report, we got on fit business, Dave October that was market wide an increase relative to September .
And we're going to get another prepayment report fifth business day November and expectations are that will be further increase in prepayments you know some of that comes some that's a function of.
Where mortgage rates were six weeks ago sort of typical lag and also the difference in day count month to month right. So.
The prepayment speeds are impacted by how many business days you have in the month, but it looks like the prepayment report we get the fit business day of November is going to be the peak for this cycle because December January February our slowest slower seasonal month, and you've also seen now a increasing in mortgage rate.
And that corroborated by a drop in the Rifai index now for our portfolio. Specifically you know if we rotate out of some very call protected pools that have had tremendous price appreciation.
In two some pools that are.
Shorter term prepayment protection, but tremendous Kerry you know you could see all the prepayments on our portfolio tick up right. So you have some of these rolls out here now.
Where they're priced for 40 or 50 CPR. So if you can find a pull that paying 20, CPR that's materially higher than where our portfolio normally pays but that can have significant carry versus the role. So if we migrate the portfolio composition of.
To little bit less prepayment protection, but lower pay ups you could see our prepayment speeds increased relative to what they've been but they could still be you know.
Lower than you know if we do a good job they can be lower than sort of market expectations. If those pools, but I think the prepayment report youre going to see.
Fifth business day in November that should represent the peak and then you're going to see a decline from there.
Great. Thank you that makes sense and.
Quick question on.
I think in your slide deck, you showed as of about a month ago. The the repo funding disadvantage at about 30 basis points.
Can you comment on where you're seeing repo funding currently and if what your expectations are for maybe for that spread too.
To become more positive become more positive less negative yes. So.
We typically.
We typically role about a third of our holdings each month and we do it for three months. So we typically stagger, what we're doing so that.
Well you see on that slide is really a combination of.
There were three month LIBOR is now, but you are kind of comparing it to where we did repo over the last three months. So I'd say if you just compared three month LIBOR three month repo in Q3, we were typically doing repos were typically costing us about I.
I think five to eight basis points more than three month LIBOR and now we're starting to see and that's really what Didnt. There was a significant difference in October we are starting to see a material difference November now we're starting to see.
Repo rates below three month LIBOR. So when you lever that that's a pretty big advantage. So I would expect relative to LIBOR.
For two thirds of Q4, our repo Oh, a relative funding versus LIBOR to improve by maybe 10 basis points.
But October is kind of locked in and it was sort of similar to what Q3 was.
Uh-huh, so about a 10 basis point improvement in November I'm, hoping you have what we just had some very preliminary levels now, but you know the cumulative impact of everything that fit fed did with.
You know the repo facilities in buying the treasury bills are starting to have an impact.
Great. Thank you very much on them and looking forward to a senior next week. Thank you likewise.
Thank you, ladies and gentlemen, there no further questions Hello turn call back over to you.
Okay. Now is just that thanks for participating again and.
We'll see you next quarter.
Thank you, ladies and gentlemen for participating in today's conference call you may now disconnect.
Oh.
Oh.
[noise].