Q2 2020 Ellington Residential Mortgage REIT Earnings Call

Ladies and gentlemen, this is the operator today's call will begin momentarily until that time, you will be I'm used to cold. Thank you for your patience.

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Good morning, ladies and gentlemen, thank you for standing by welcome to the Ellington residential mortgage Riet 2022nd quarter Financial results Conference call. Today's call is being recorded at this time all participants have been placed on in listen only mode and the floor will be open for your questions. Following the presentation.

If you want to ask the question at that time. Please press star one I go telephone keypad anytime. If your question has been answered you may removed himself from queue. My question. The pound key lastly, if you should require operators assistance. Please press star zero. It is now my pleasure to try to account for over two terabyte manager of FCC.

Reporting and she may begin.

Thank you.

Welcome to Ellington residential second quarter 2020 earnings conference call.

Before we begin I'd 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 one age or annual report on form 10-K filed on March 12, 2020, and part too I don't want eight of our quarterly report on form 10-Q filed on May 11, 2020 forward looking statements are subject to a variety of risks and uncertainties that could cause the company's actual results to differ.

Let me beliefs expectations estimates and projections.

Currently you should not rely on these forward looking statements as predictions of future events.

Statements made during this conference call are made us at 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, our Larry Penn Chief Executive Officer at Ellington residential.

Mark Tecotzky, our co Chief investment Officer.

Chris Smirnoff, our Chief Financial Officer.

As described in our earnings press release, our second 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 his presentation are qualified in their entirety by the end to notes at the back presentation.

With that I will now turn the call over to Larry.

Thanks, Tara and good morning, everyone. We appreciate your time in interest and Ellington residential.

This was a great second quarter for Ellington residential capping an amazing first half for the year performance for the company. It was obviously an extremely challenging environment for mortgage rates.

The second quarter of 2020 began with a continuation of the kobin related market turmoil that it rock the markets in March.

Mid April however, these market stresses set subsided considerably.

Massive purchasing by the Federal reserve continued to inject liquidity into the system calming market and putting a ceiling on agency mortgage spreads.

In fact, the fed now owns about 30% of the entire agency MBS market.

At the same time, many credit sensitive fixed income assets rebounded sharply over the course of the second quarter. Following the violent sell off in credit in March.

The movie Index, which measures interest rate volatility reverted to pre crisis levels in mid April.

After reaching its highest point since the to tout 2008 financial crisis in March.

The 10 year Treasury traded in an extremely tight 33 basis point range in the second quarter as compared to a 134 basis point range for the first quarter.

As you can see on slide three the tenure treasury yield was virtually unchanged quarter over quarter and remain near an all time low at June Thirtyth.

With mortgage rates also near all time lows prepayment speed spike during the quarter with overall market CPR, reaching at more than seven year high in June.

During March payoffs had declined considerably and also compressed considerably in the face of market wide liquidity stresses.

Cash which came in March in early April and the market really stopped distinguishing between pools based on deep value.

As discussed on our last earnings call. You responded to de stress is by selling our low pay off specified pools to bolster our liquidity, while maintaining our positions and our higher payout pools, where the value was much greater.

We were rewarded for the strategy as our enhanced liquidity enabled us to get through the market daps without any forced asset sales and then when the market recovered.

Payoffs expanded again and our value pools bounce back.

As you can see on slide four payoffs rallied strongly as liquidity stress the subsided and as investors again turned their attention to prepayment protection amidst accelerating CP ours.

As a result are specified pools had a tremendous second quarter.

Furthermore, our enhanced liquidity coming out of March in early April even allowed us to turned to playing offense not just an agency MBS, but also in credit.

When we saw an attractive entry point non agency MBS, we grew those holding substantially at heavily discounted prices.

This decision also paid off handsomely as non agency prices recovered sharply as the quarter progressed.

Finally, our results benefited from the strong performance of reverse mortgage pools, which rebounded from the distress in March and which we believe will attract even greater investor demand in this low interest rate environment.

And to reiterate we were only in a position to take advantage of these investment opportunities because of our adherence to our risk and liquidity management principles, which enabled us to avoid forced asset sales and enhance our liquidity during the stress as of March in early April.

I'll now pass it over to Chris to review, our financial results for the quarter in more detail Chris.

Thank you Larry and good morning, everyone.

Please turn to slide six for a summary of earn financial results.

For the quarter ended June Thirtyth, we reported net income of $21.3 million or a dollar and 73 cents per share core earnings was $3.2 million or 26 cents per share.

These results compared to a net loss of $16.7 million, where dollar 35 per share a core earnings of $3.4 million or 27 cents per share for the first quarter.

Core earnings excludes the catch up premium amortization adjustment.

<unk> negative $3.8 million into second quarter compared to negative zero point $7 million in the prior quarter.

As you can also see on slide six net income for the quarter was primarily driven by net realized and unrealized gains on our agency specified pools and non agency RMBS.

You can also see here that our net interest margin improved significantly during the quarter, increasing 66 basis points to 1.86% driven by significantly lower borrowing costs.

Despite the increase in NIM or core earnings per share decreased slightly as a result of significantly lower average holdings quarter over quarter.

Average pay ups center supper specified pools increased to 2.69% as of June thirtyth as compared to 1.67% as of March 31st as actual and projected prepayments rose significantly with declining mortgage rates.

Turning next to our balance sheet on slide seven.

We continue to maintain ample liquidity during the second quarter.

At June Thirtyth, we had cash of $50.9 million along with other unencumbered assets of approximately $45.1 million most of those unencumbered assets, where non agency RMBS.

We did not finance it any of the non agency RMBS that we purchased during the quarter.

As of June Thirtyth substantially all of our borrowings continues to be secured by specified pools.

Our debt to equity ratio declined modestly quarter over quarter to 6.8 to one as of June Thirtyth from 7.2 to one as of March 31st adjusting for unsettled purchases and sales.

Our book value per share was 12080 cents at June thirtyth compared to $11.34 per share at March 31st an increase of 12.9%.

Our economic return for the quarter was 15.3%, including the impact of the second quarter dividend of 28 cents per share.

Next please turn to slide eight which shows a summary of our portfolio holdings.

In the second quarter, we Opportunistically increased the size of both our agency RMBS and non agency RMBS holdings as markets stabilize.

Notably we grew our non agency RMBS portfolio by fortune, 58% quarter over quarter and as Larry mentioned.

These holdings appreciated over the quarter and contributed to our excellent performance.

We also increased our agency RMBS holdings by 6.8% quarter over quarter.

Next please turn to slide nine for details on our interest rate hedging portfolio.

During the quarter, our interest rate hedging portfolio continued to consist primarily of interest rate swaps short positions in TV a.

U.S. Treasury Securities.

Futures.

During the quarter, we reduced the size of our net short TBA position as measured by tenure equivalence to just 1.3% of our hedging portfolio down from 16.8% by increasing the amount of long TB held for investment.

Turning to slide 10, you can see that our net long exposure to RMBS increased modestly to 5.9 to one from 5.6 to one.

Ill now turn the presentation over to Mark.

Thanks, Chris.

I'm pleased with turns performance for both the quarter and year to date through the second quarter.

Returning over 15% for the quarter and now three enough present for the year.

Able to mitigate the march draw down their prudent leverage and disciplined hedging well still being able to capture the tremendous upside in Q2, when the fed support repaired investor balance sheets and drove asset prices higher.

There were a number of notable things in this quarter.

The first thing to note for Q2 was the interest rate volatility was extremely low. So that tells you that you extended the fed intervention was more than equal to the task at hand, as one example of low volatility the magnitude of the trading range and agency MBS entire corridor was comparable to what it was uncertain.

Single trading days in March.

But with the consistent and substantial fed purchases. This column in Q2 was obviously tailwind for agency MBS.

Of course, whenever you make 15% in the quarter you can't expect your assets to be as cheap as they weren't the started the quarter. So we can't get complacent.

In General we think there was still a very good opportunity you need and CMBS agency RMBS right now, but we see big differences between SEC subsectors that that market.

We view this is a market, where some coupons and specified pools stories are very attractive, but many other parts of the market frankly, our our unappealing right now.

Another thing to note for Q2 was at the Federal Reserve purchasing was the overwhelming driver of the market for a levered mortgage investor like earn what is great. About this market is that you have one giant participant the fed which telegraph everything it does the fed is also not focused on profits who's actually content binder.

What was quality generic pools that nose bleed levels.

So how do you profit from that basically you can get out in front of the fed.

Relatively easy to predict what they're going to buy and then what size and they move forward with their plans of the steady pace, regardless of price movements, northern large investor behave that way.

You have the fed indiscriminately buying the front month TB a pools combined with the biggest forward month production.

Ever.

What do you do.

Of course, you sell pools to the fed into front month and by the backman pools much cheaper in other words you sell the rules.

Q2, we capitalize on this dynamic by doing something we hadn't done in a long time, we bought current coupon TPH early on mostly just the benefit from what we anticipated to be very attractive roll levels as we approach settlement.

Normally we're looking at loan attributes and we're trying to find the most undervalued form of prepayment protection. When the fed is involved in the coupon. We often think its best just to go along for the right.

Besides the Telegraphing the best thing about these fed purchases is if you're buying the fastest leased attractive pools.

So in the process, they're improving the quality of TB, a pools left for the rest of the market.

So why is the fed doing this primarily because they want to lower the mortgage rate to consumers consumers take up mortgages for two reasons to buy a home or to refinancing existing mortgage.

And the vast majority of consumers end up with some varied of just three mortgage rates 30 year, Fannie Mae rate 30 year, Ginnie Mae rate, where the 15 year Fannie Mae rate.

That is what the fired fed cares about so that's what they buy it's actually a very effective way of transmitting fed policy to millions of American homeowners. The fed doesn't care about loan balances seasoned pools, and higher coupons and everything else, that's complexity and richness to the mortgage market.

So you have an army of mortgage origination, it's right now producing Fannie Mae twos into an AFE and is there locking in their new borrowers, they're selling TB AIDS for for September and October, but Meanwhile, you have the fed buying all these twos until we got through August settlement, when the fed buys and size of the given coupon is such a powerful dynamic.

It creates special roles generating demand in August or the current supplies in September.

Simultaneously, all the fastest pools and Fannie to NAV, which despite their low coupon are still a 105 handle dollar price MBS get delivered to the fed so they get removed from the tradable float, which the which improves the TV that remains no other investor would do that they would either by TB enrollment or by slick specified.

Pools.

Putting wheel numbers on it through a billions of dollars of two NAF the paint axis of 30, CPR, which quick to yield to maturity at that speed of only 45 basis points, that's a tiny spread over treasuries and normally we would never buy anything like that.

If we factor in that we can roll these pools for six picks per month.

That's a 225 basis point, that's 225 basis points annualized which is massive in a world of zero rate.

To put all this together and investors can ride the fed's coat tails to vary at attractive returns by being long P.B.A. Andy's coupons.

Another positive for the market. Although this is more of a double edged sword is it the fed is keeping short rates almost zero.

We are now doing three month repo around 26 basis points.

These amazing is that the annual repo cost is less than one month of carry on some of the pools, we buy that's an incredible dynamic and one that I've never seen before.

Borrowing money is almost free in the agency MBS market.

The other great thing is that with the curve so flat our current hedging costs are so much lower.

Well, we hedge our interest rate risk by paying fixed on swaps and receiving library, the flick fixed leg and the floating leg of the swap are now virtually identical. So we can pay fixed rate of 26, beeps and a five year swap right. Now we are receiving like three month LIBOR at 25 basis points. So the net cost at least for the first three month, it's only one.

Basis point.

Put her altogether and the repo costs combined with the swap hedging cost for many MBS no right. Now is only 25 basis points, obviously things can change. What this means is that even while MBS yields are low there NIM can still be very high.

NIM is essentially the yield on our assets might start repo cost our hedging costs. So now the NIM of our pools, and only 25 basis points less than their yield.

Volatility low the delta hedging that we do to protect book value isn't costing us much either.

But this abundant low cost me buys a downside.

Some specified pools expanded tremendously in June that is what happens on prepayments bike surprising to the high side well repo used to hold specified pools is abundant in cheap.

Back at slide for the tried and true forms of call protection completely re priced higher this quarter to levels, where we now find many of them unattractive. So that means for a higher coupon holdings, we have to really work hard to find call protection and attractive level to take advantage of the low hedging in repo costs.

And this gets us to a fascinating, but challenging development in the market. The technological workarounds that came about from cobot I likely here to stay and should lead to faster and steeper prepayment curve than before given the same loves the prepayment incentive for example node. We can now operate online and more appraisals are being accepted without the.

Appraises physically entering the home.

These are technological changes that we expect to stay with us at the onset of Coke at the code at the onset of the cobot outbreak lots of mortgage researchers were predicting that social distancing would create a wet blanket for prepayments, but quite the opposite it's been the case necessity truly is the mother of invention and mortgage originators and.

Conjunction with the G seasoned regulators came up with some creative work around.

For borrowers de solutions that simultaneously lowered cost and reduce closing times, but for originators. It's all summit much bigger gain on sale margins.

The same time because of cobot related locked down too many people aren't commuting you're going out they have extra time on their hands and are better able to focus on Wi Fi opportunities.

Meanwhile, the huge gain on sale margins in the agency mortgage origination business, our leading to lots of hiring which should increase origination capacity industrywide, putting putting even more upward pressure on prepayment speeds.

We expect pending quicken IPO to garner focus and it was more capital to flow into the origination business.

That's good news for consumers, but the challenge for investors from a prepayment standpoint.

But ellington has over 25 years of modeling you trading.

Pre.

But ellington has over 25 years of modeling and trading prepayment behavior and leave you have a distinct advantage and extracting value in this environment.

So, let's look at how earns portfolio evolved during the quarter.

We grew it by almost 10% quarter over quarter that was essentially keeping pace with our increased capital from the profits. We generated Meanwhile, we shrunk garden TB a short position. We did this by adding 30 year and 15 year twos into an F. The same coupons that the fed with buying while increasing our short TBA positions and the higher.

Coupons.

Turning to slide 17.

We're really able to keep a lid on prepayments or prepayment only increase quarter over quarter from 15 to 18 CPR in the world of one or three to 112 dollar prices that is critical.

Fortunately, we also added non agency MBS and the quarter, which you can see back on slide eight the recovery in agency MBS was driven by fed intervention didn't happen first so even as agency MBS start to recover in April the non agency market still remain very distressed with lots of for selling.

We have mentioned it a few times, including in our last earnings call that during times of distress and Opportunistically had credit exposure. We did that in Q2 and has worked out very well as both fundamentally as the fundamentals and technical have improved in the non agency market and price of now recovered substantially we're.

<unk> for the second half of the year, we see some incredible opportunities and are very focused on continuing to drive returns for the rest of the year now back to Larry.

Thanks Mark.

I'm really pleased with our performance for the first six months of 2020.

During the extreme volatility of the first quarter, our risk and liquidity management protecting book value allowed us to avoid for sales and freed up capital putting us in but in a position to play offense in the second quarter all asset prices were still depressed.

We took advantage of some very attractive investment opportunities in both agency and not in non agency MBS and as a result, we were able to participate in the market recovery more than earning back the first quarter last.

Remarkably we generated a positive year to date economic return of 3.5% through June Thirtyth.

And our strong performance has enabled us to maintain our dividend throughout.

Despite historically low interest rates and high volatility.

Just as remarkably I believe that earn was the only publicly traded mortgage riet have a positive total return on its common stock for the first half of the year.

Year to date through August Threerd. The total return on their own stock was a positive 7.4% again unmatched by its mortgage REIT peers.

As Mark mentioned, we're still seeing lots of good tailwinds, such as record low repo borrowing costs, which helped increase our net interest margin by 66 basis points last quarter towards widest level in a few years and which should help drive core earnings going forward.

But there are also significant headwinds as well as crosscurrents.

We are in an ultra low interest rate environment with record high levels of prepayments. This will doubtless drive further divergence of performance between different sub sectors of the agency MBS market.

We believe that this market environment actually plays to our strengths.

All selection hedging choices in risk management should continue to drive long term performance.

The divergence over the first half of the year gene earns performance and the performance of our peer group is stark and the portfolio management choices to be made in this kind of environment are not simple.

Remember one of the ways that we distinguish ourselves is through our heavy use of TV ace not just on the long side, but also on the short side, which increases our opportunity set tremendously.

And these uncertain times, including us the life in severity of the economic downturn not to mention and upcoming general presidential election in November.

We will continue to rely on our discipline interest rate hedging an active portfolio management to protect book value and benefit from potential upside.

Our smaller size should also continued to be an advantage as it enables us to receive enables us to react quickly to repositioned the portfolio as market conditions change in some cases extremely rapidly.

I truly believe that that's for the foreseeable future. It will continue to be a wide dispersion in the performances of agency mortgage rates.

Our shareholders couldn't be in better hands with Mark Tecotzky and our entire investment team, who did such a terrific job navigating the first half of the year with positive results.

Before we open the floor to questions I'd like to thank the entire Ellington team for their hard work over the past few months, despite difficult circumstances and for all of those listening on the call today, we hope that you and your family's say healthy and safe.

With that well now open the call to your questions. Operator. Please go ahead.

At this time, if you like to ask a question. Please press star one I got telephone keypad.

Again to ask a question press star one.

Your first question comes from line of Doug Harter Credit Suisse.

Thanks, I'm, hoping you could just talk about kind of how how are your risk profile might look a little different given that you're kinda buying or some of the current production to be is versus kind of pools, and you know kind of how you're thinking about.

Managing <unk> different risk profile.

Hey, Doug it's Mark So I think the one thing. It does is it improved liquidity, a little bit wall specified pools or liquid they're not as liquid to TB and as you get into specified pools with higher pay up.

Liquidity comes down little bit so I think.

One thing with the <unk>, if you pick up a bit little bit better liquidity.

Now the flipside is you have a little bit works convexity right. So you're the TB ace are typically the cheapest to deliver.

So they tend to be most reactive to prepayments and so one of the reasons why this TV strategy has been working out well.

It's because we've been in an environment, where there was not a lot of interest rate volatility right to the fed has really dampened a lot of the interest rate volatility and Larry mentioned it so.

It adds a little negative convexity you'd go up a little bit liquidity, but you're adding negative convexity. The time when delta hedging costs has been extremely low.

And that.

The benefit of these very high roll levels.

Yeah, you put it all together I think it's been a plus.

You know for the higher coupons, there's still a lot of things to do it just.

You know, we're just bringing to bear all our prepayment expertise.

And you know all the data analysis, we do.

Try to find you know the most call protected pools.

Where the pay ups are not well, we don't find the pay ups onerous.

Got it and just on that almost pay ups you know I guess, how have you seen them trend. So far I guess for for July and pursued as of August.

You know there well supported.

You know you Havent seen as big a move as you saw in second quarter.

The completely reprice, you know a lot of the way we understood.

Hey up.

At the end of Q1.

Was the very depressed pay up levels were a manifestation of the fact that balance sheet was in very short supply.

And the way, we understand a lot of the.

Returned to stability of the market is that the fed was very very aggressive in providing balance sheet. So it's interesting I talked in the script, how now they're focused on buying the coupons that.

Pack the mortgage rate for homeowners that want to buy in homeowners don't want to refi, but that's a little bit different tax than what they took in March in March they were buying a range of coupons because these stupidly recognize that.

There were some big holders of the agency mortgages that were had very stressed balance sheets and in order to give them balance sheet relief. The fed had to buy sort of the coupon distribution of what some of these platforms held because what they did but once the balance sheets were repaired and you really saw that manifests.

By the big drop in repo rates, how repo rates came down and collapse basically the three month LIBOR once that happened then the fed shifted their purchases.

The market calls production coupon, so the coupons, where you're going to have the biggest impact.

On the mortgage rates that are offered to consumers.

Great. Thank you.

Sure.

Your next question comes from line of kill Doberman with JMP Securities.

Hi, good afternoon, good morning.

I was wondering if you guys could give me a update on books I performance, thus far in the third quarter. Please.

Hey, it's Larry how are you.

Good Larry Howard.

Good Yeah, we're we're not gonna.

Given an update on that but you know it's Mark just mentioned payoffs were well supported in July.

And job the you know the market was.

Continued sort of it very low vol environment rates didn't move much and so those are both supportive of book value was you can imagine.

Alright fair enough. Thank you Larry I'm I'm, Mark forgive me if I'm wrong in your prepared comments did you mention that you're looking at some CMBS opportunistically or am I wrong.

No I'm, if I misspoke I apologize what I mentioned is that in the second quarter. We opportunistically added some legacy RMBS. So those are non agency mortgages that were.

Originated generally 2007 in earlier and earn had very small allocation to that sector pre cove. It and you know when the fed sort of killed a lot of agency mortgage focus balance sheets.

In March and April even at that point, there was still a lot of stress on.

Balance sheets that owned non agency RMBS or non agency CMBS and so we saw an opportunity in the second quarter.

To add to our holdings in non agency RMBS.

All right. Thank you if I can get one more in just a quick question about expenses.

Noticed a bit of a spike in the professional fees wondering if that's kind of a onetime thing or.

Any color on that.

Sure Hi, it's Chris I can take that question. So given that both our current S. Three shelf registration and ATM program.

We're set to ours set to expire in October of this year, we decided to expense the majority of our deferred offering costs in the second quarter and this is what created that spike in professional fees.

Absent the spike we expect our expense ratio.

To hover around the mid mid 3%.

Great. Thanks, a lot gentlemen, congrats on that book value getting pretty much all the way back to the 12 91 at the end of the year that's.

It's almost there about 10 more sense.

Take care. Thank you.

At this time there no further questions.

This concludes todays call you may now disconnect your lines.

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