Q3 2020 Ellington Residential Mortgage REIT Earnings Call
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Ladies and gentlemen, today's call will begin momentarily until that time, you will be on music hold thank you for your patience.
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First call today's call is being recorded at this time all participants have been placed on the listen only mode and the floor will be open for your presentation for your questions. Following the presentation, if you'd like to ask a question at that time. Please press star one on your telephone keypad.
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Lastly, if you should require operator assistance. Please press star zero. It is now my pleasure to turn the floor over to Jason Frank Deputy General Counsel and Secretary. Please go ahead Sir.
Thank you and welcome to Ellington residential third 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.
Looking statements are not historical in nature.
Described under item one a up our annual report on form 10-K filed on March 12, 2020 impart to item one a 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 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.
There was 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 Smirnoff, Our Chief Financial Officer.
As described in our earnings press release, our third quarter earnings Conference call presentation is available on our website earned be dot 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.
Thanks, Jay and good morning, everyone. We appreciate your time and interest in Ellington residential.
During the third quarter. The Federal reserve continued its accommodative monetary policy, maintaining its target rate for the federal funds rate near zero and continuing to buy heavy volumes of treasuries and agency RMBS turning.
Turning to slide three you can see that the feds actions had their exact desired effect on the agency RMBS market agency RMBS yield spreads have been stable treasury yields have stayed low interest rate volatility has remained muted in.
In fact, the move index, which measures the implied volatility of interest rates in an all time low at the end of September.
As you can see on this slide treasury yields and swap rates were uncannily unchanged quarter over quarter and Moreover, they barely moved at all since March 31st.
You can also see that for the interest rates that most affect private borrowers such as mortgage rates and LIBOR rates well there was a slightly lag reaction. These rates have caught up to the decline in treasury rates, having declined significantly over the past six months.
Meanwhile, agency yield spreads have remained stable after bouncing back from their more spikes. Despite the continued rise in prepayment speeds with Fannie Mae 30 year she'd be ours and again nearly eight year high in September.
Turning now to slide four.
Clinton residential had another quarter of strong performance generating net income of 66 cents per share and growing core earnings to 39 cents per share in the third quarter, which exceeded our 28 cents dividend by a wide margin.
Our 28 cents dividend is a dividend that we have maintained in full by the way without interruption or cut throughout all of 2020.
Similar to prior quarters, our long agency RMBS portfolio continue to be concentrated in prepayment protected specified pools and these assets performed extremely well relative to their hedges, which provided a big boost to our results.
Additionally, non agency RMBS sector continued to recover during the quarter and so we were able to monetize significant gains on many non agency RMBS assets <unk>, we had opportunistically acquired in the second quarter when prices had been extremely depressed.
And keep in mind was only because we were able to navigate the March April distressed so well that we were able to play offense and take advantage of that distress in non agency RMBS.
In fact during the second quarter, we were buying non agency RMBS at distressed prices when many other mortgage Reits are forced to sell them.
In the third quarter, we maintained our long position in current coupon Tvs and by doing so we benefited from the strong dollar rolls that were driven by fed purchasing activity.
At certain times in our history Weve been short current coupon TV A's and at other times like recently, we've been long current coupon Tvs current.
Current coupon Tvs are incredibly liquid and sometimes we view them as a great hedging instrument and other times, we view them as a great investment.
This particular sector well with relative ease we can go either long or short we were actually quite complex instruments is yet another reason why the agency RMBS market is such a rich opportunity set for us.
Notably this past quarter, we were able to deliver strong results, while maintaining our leverage well below historical averages. We felt that this was prudent positioning given the significant macroeconomic uncertainty and given that there was a presidential election looming.
Our debt to equity ratio as of September Thirtyth was only 6.5 to one as compared to historical data at equity ratios, which have typically been the age or nines to one.
Finally, I'm pleased to report that our net interest margin widened by 35 basis points to 2.21% quarter over quarter, which is the highest our NIM has been in more than five years turning.
Turning to slide five in the lower part of the table you can see that the main driver of our NIM expansion was a significant drop in our cost of funds.
Another driver arm of our NIM, which are larger non agency RMBS portfolio with its higher asset yields.
Now I expect our NIM to come down a bit from here for a couple of reasons first asset yields are down on agency RMBS generally and we will feel that impact as we naturally rotate our portfolio and reinvest pay downs and second now that we've downsized our non agency portfolio upper fours a portion of that outsize NIM support is going away.
All that said, there's no question that earn and the entire mortgage sector has benefited from the significant external tailwinds provided by record low borrowing rates and low levels of interest rate volatility. However.
However, as we have repeatedly demonstrated over past market cycles, including of course, the big ups and downs of 2020, our success at our does not necessarily dependent on the absolute level of interest rates or volatility on the shape of the yield curve or on where nims happened to be and that's because of our portfolio management strategy. We trade actively we shift our capital.
Where we think the best opportunities are we hedge along the entire yield curve.
Often using significant Tvs short positions.
I'll now pass it over to Chris to review, our financial results for the third quarter in more detail Chris.
Thank you Larry and good morning, everyone. Okay.
I'll continue on slide five where you can see a summary of our financial results.
For the quarter ended September Thirtyth, we reported net income of $8.1 million or 66 cents per share.
Core earnings of $4.8 million or 39 cents per share.
These results compared to net income of $21.3 million or $1.73 per share and core earnings of $3.2 million or 26 cents per share for the second quarter.
Core earnings excludes the catch up premium amortization adjustment, which was positive 405000 in the third quarter compared to negative 3.8 million in the prior quarter.
As you can see on slide five our third quarter results were driven by strong net interest income.
<unk> performance on our specified pools relative to our hedges.
Net realized and unrealized gains on our interest rate hedges and other activities.
What's includes positive you know from our long PB held for investment.
During the quarter, we increased our holdings of long PVA, which we concentrated in current coupon production.
These investments performed well driven by federal reserve purchasing activity.
You can also see that our net interest margin widen even further this quarter, increasing 35 basis points to 2.21% driven by significantly lower borrowing costs, which in turn drove the increase in core earnings.
Average pay up and our specified pools increased to 2.55% as of September thirtyth as compared to 2.5% as of June thirtyth as actual and projected prepayment.
Prepayment rates continue to rise in the low mortgage rate environment.
Please turn next to our balance sheet on slide six.
During the third quarter, we continued to maintain higher liquidity and lower leverage as compared to prior to periods prior to the onset of the Coca 19 pandemic.
At September Thirtyth, we had cash and cash equivalents of $61.2 million, along with other unencumbered assets of approximately $28.1 million.
Our debt to equity ratio declined modestly quarter over quarter to 6.5 to one at September Thirtyth from 6.8 to one at June Thirtyth adjusted for unsettled purchases and sales.
These amounts compared to cash and cash equivalents of $35.4 million that debt to equity ratio of 8.1 to one as of December 30, Onest 2019.
Our book value per share was $13.17 at September thirtyth compared to $12, an 80 cents at June Thirtyth.
And $12.91 at the start of the year, reflecting increases of 2.9% and 2.2% respectively over the three and nine month periods as our earnings continued to exceed dividends by a healthy margin.
Our economic return for the quarter was 5.1%, including the impact of the third quarter dividend of 20 cents per share.
Next please turn to slide seven which shows a summary of our portfolio holder.
In the third quarter, we monetize gains in our non agency RMBS portfolio and as a result, the portfolio declined by 41% quarter over quarter.
Size of our agency RMBS portfolio declined slightly over the same period.
Next please turn to slide eight for details on our interest rate hedging portfolio.
During the quarter, our interest rate hedging portfolio consisted primarily of interest rate swaps and short positions in P.A.
U.S. Treasury Securities and futures.
We enormous whether you look at it on a gross or on that basis, she need significant fires to absorb it all gross supply which is simply the volume of new agency mortgages originated it's expect it to be an unprecedented three trillion plus this year.
To put this number in context.
The gross supply in 2019 was approximately one and a half trillion net supply, which subtract pay down from the gross supply number is expected to be over 400 billion. This year. This net supply number is the amount of new capital that has to get invested in the agency M. B S market for the supply to clear the market.
And that net supply number is also enormous on a historical basis and in addition to the net supply from origination the M. B S. Mark. It will also have to be able to absorb the volume of secondary market sales such as Freddie Mac cause been mandated test shrink their portfolio.
The fed there's a lot of heavy lifting to absorb all the supply, but they can't do all of it remember that they came into this round of QE with a giant portfolio, it's paying off very fast recently between 30 and 35 C. P R and.
And the fed has to reinvest those pay down just to maintain a constant portfolio.
As it turns out even with this large volume of purchases the feds net buying in recent months, there's only been roughly equivalent to the net supply.
So we'll have an orderly market, you'll still need to have a steady source of buyers to absorb the supply from the secondary market. The good news is that given all the concerns about credit risk posts covid. The M. B S market has plenty of other buyers relative to treasuries the extra yield on M. B S without credit risk is currently attracting.
A wide range of investors.
And given that M. B S financing as widely available as widely available in huge size and it's almost free we think that M. B S make the most sense an elaborate form which is exactly what a mortgage reap does.
Another tailwind now is it the drag on that interest margin to insulate a portfolio from interest rate risk as close to zero in some cases is less than zero you actually can get paid to be short with just a relatively modest dragging on them.
We can run a fully duration hedge portfolio, which by itself health, which by itself helps to stabilize booked value.
Even with their strong Q3 performance.
Several T b, a coupons that we've been long still look attractively priced to us with or without attractive rules. When you add this the value of special rolls. The leopard returns are fantastic roles are benefiting from the perfect storm, a front month fed buying and backman mortgage banker selling.
But we also see headwinds too that argue for against being fully leopard, specifically prepayments are blazing and mortgage companies are aggressively staffing up.
We don't see any compelling reasons for a slowdown of the refi wave outside the normal seasonal effects. We believe that some of the covid related work around that the G. S. He's put in place in the spring such as exterior appraisals and the use of you know that we are here to stay and that these innovations only make speeds faster.
Of course, we were always working to mitigate many of these restore portfolio construction I'm happy that we were able to keep our C. P. R down in the portfolio to a very manageable 21.4%.
Another risk we think about the sustainability of road levels Rolls are great. While they last but you can't count on them in perpetuity. The only large T V. A coupon that underperformed treasuries this month.
Was 30 year Three's T B, a [noise] after the fed stop buying them the role collapsed once they're all collapsed the price collapsed.
Reviewing how we were positioned for the quarter and what work we were long P. B as with big positive roles, which was great. But we also benefited from being short T. B as with negative rolls. So we want both ways. It sounds simple, but it worked well this quarter being short negative roles is the way you get some of your hedging costs down below zero.
In addition, as I mentioned or realize prepayment speeds rowboat contained.
The size of our agency portfolio was roughly constant quarter over quarter, we liked mortgage valuation is coming into the quarter, but mortgages have done well, they're not as cheap as they once were.
Was still really like some of the short immaturity M. B S. Like 15 year mortgages. They fed buys them. The rules are good and they don't have anywhere near the same extension risk is 30 years, which makes the hedging simpler.
Also during the third border is already mentioned, we sold many of our non agencies, which we that we opportunistically bought last quarter price isn't that sector have gone up a lot since the market meltdown, you'll get back down to less interesting levels and the credit risk may be price wider depending on the future path of stimulus and economic recovery three.
<unk> to monetize a good chunk of that portfolio.
Heading into the last two months of the year, a big focus of ours will be avoiding prepayment mistakes, but without pink so much for prepayment protection their assets will be out of favor and a big market sell off well not only well not only Wanna state thoughtful about what the fed is doing right now, but will also want to anticipate what the fed is going to do in the future.
The worst performing coupons for the quarter by a wide margin was T. B, a fanny three's as I mentioned earlier, that's because Fannie threes went from being a coupon that the fed is buying to a coupon that the fed was buying the role collapsed and the price collapsed.
And given that we're in the middle of a refi wave the current market environment presents lots of great opportunities to put out prepayment knowledge to the test some very optimistic about the return potential now back to Larry.
Thanks Mark.
Ellington residential excellent results from the third quarter continue to what has been a stellar year for the company.
Thanks to a redskin liquidity management, we were able to weather the volatility then hammered the market in the spring emerging a strong liquidity position and with our book value intact.
That put us in a position to take advantage of some tremendous investment opportunities and participate in the market recovery.
Arlington residential has now generated an annualized economic return of 11.5% through the first nine months of 2020.
As Chris mentioned and as you can see on slide six or book value coming into the year was $12 91.
And it was $13.17 at the end of the third quarter.
So we've grown book value of this year by over 2% after paying our full 28% dividend each and every quarter.
Hats off again to Mark to catch gate and our entire investment team for this tremendous performance in a year when many if not most other mortgage reached really struggled.
But this is no time to take a victory lap we are decidedly in a refinancing waves. Please.
Please turn to slide 12.
With the interest rates near the historical lows. The vast majority of outstanding mortgages are currently refinance ago and given the lower for longer interest rate and messaging from the federal reserve. This refinancing wave could persist for quite some time.
As Mark mentioned, we will likely see the first three trillion dollars a year ever for mortgage originations in 2020.
But not surprisingly for refinancing wave agency Rmb's performance is diverging across the coupon stack and across the various specified pool profiles. While this dynamic presents many challenges for the MBS market, we believe that a place right to our core strengths a prepayment modeling asset selection and dynamic interest rate hedging.
As we move into the final weeks of the year. We expect this prepayment focus environments create numerous attractive investment opportunities for us and our current high levels of liquidity and relatively low leverage and enable us to capitalize on these opportunities as they arise.
Are smaller size should also continue to be an advantage, allowing us to react quickly as market conditions change just as we did earlier this year during the stretches distresses of March and April.
Before we open open the floor to questions I would like to thank the entire Ellington team for their continued hard work in 2022 challenging circumstances and for all of those listening on the call today, We hope that you and your families are stenhouse healthy and stay in shape.
With that will now open the call to questions. Operator. Please go ahead.
As a reminder, if you would like to ask a question. Please press star one on your telephone keypad.
Again that is star one.
Your first question comes from the line of the hotter credit please.
Thanks.
Can you talk about what your well I'll still relatively small overall, what your outlook would be for for the remainder of of the non agency portfolio.
You know I I'm kind of how you would think about you know the portfolio mix going forward.
Sure Doug This is mark Thank you for the question.
You know even before Covid, we had a small portion of our capital in non agencies. So.
During Covid, we grew that because we saw really material price drops at a time when.
Our research and our data, we're showing that home prices were gonna be well supported for a number of reasons.
And so I like having a small amount of the capital in non agencies. It's a market we know well we have a great sweet a P M.
We have you know a great research tools. There you know given current valuations in the non agency market and the way earn has always branded itself, where the primary driver of risk and returned comes from Levering Agency M. B S.
These valuation levels I think we'll probably see the portfolio of non agencies stay at about the size where they are.
Should are expected return on capital in the agency market go up a lot because valuations change or go down a lot because valuations chains.
And then we might then you could see an impact on the nine agency portfolio as a result of that but given right now where prices stand I think the balance.
Nine eight and to stay roughly consistent relative to our capital.
Great and then can can you talk about what the outlook for for the net interest spread.
Would be yeah kind of as you get as you get loan repayments come in and and kind of how you know how those can be reinvested today versus kind of the the the spread that you have had in the third quarter.
Sure Larry you talked to yeah.
Yeah I think.
Yeah.
Mentioned, we had a 39 cents core, but we see that trending downward.
We've been consistently maintaining our dividend 28 cents.
We've.
Viewed our dividend at times, our core has been lower than that but there were other opportunities that we were able to take advantage of and to take advantage of to supplement to get back to the 28 chance know sort of in the other direction where quarters exceeding that we still view 28 cents as a good longterm right.
And.
So I think that we see a trending down no probably two something in that neighborhood.
And but we like the number we'd like to 28% number.
And we think that will either quarterly to trend just slightly higher than that are slightly lower than that to try and slightly lower than.
That probably will be because there are other opportunities going on in the sector.
We again, where we can continue to supplement and earn a dividend. So I think I think sort of heading towards our dividend rate is a good kind of a good marker to thinking about.
Great. Thank you guys.
As a reminder to ask any question. Please press star one on your telephone keypad.
Your next question is from the lying on the couch Doberman JMP security.
Thanks, Good morning.
Could you guys, perhaps give an update on when you're where you are seeing prepaid trends, thus far in the fourth quarter.
Sure Yeah, we get.
Another prepare report.
And the next day or so so the one we had last month.
Pretty much in line with expectations it wasn't a big.
Change from where prepayments have been I guess there are two things. We are watching closely one is looking for burnout right the extent to which pools that are paid very fast in the last six months or sort of cohorts that are paid very fast in the last six months are starting to exhaust themselves because.
Sort of the borrowers that or.
Most incentive and most focused on refinancing have prepaid and the remaining borrowers are less focused on it. So we're looking for evidence of that we haven't seen it yet and I you mentioned in the prepared remarks.
You know we were aware and we think a lot about hiring trends mortgage originators have had so they are adding capacity so.
We're not looking for we're not expecting or looking for a lot of burn out.
The other thing is that.
You know it matters a lot on the path of rates and so one thing that's happened.
And the last week or so or two weeks is that now the federal reserve is buying 30 year mortgages with one and a half coupon right. So that is something different and when the fed starts doing that it adds liquidity to that coupon. So now you're gonna start seeing for the best bar, where it's sort of a two and a half person.
<unk> note right that's offered so.
Some of the coupons that looked like coupons earlier in the year say Fannie tune as you're starting to see some.
Pretty fast prepayments speeds there so the report coming up this week, our expectations things slowed down slightly.
But we don't expect any kind of near term relief in this prepayment wave right now but.
That said there are.
Lots of relative value opportunities and the market pricing right now for higher coupons.
Is incorporating expectations. It very press prepayment speeds do you have a coupon that's priced 40 or 50 C. P R and the role.
Find something that Prepays at 30, CPR, that's a big that's a big advantage versus a T.
T be hedging with T b as price that much faster rule.
Oh I gotcha, Thank you for that Mark.
And also kind of maybe a bit of a macro fed related question and you may have touched a little bit on this earlier mark but Ah.
Assuming this scenario plays out that we're gonna have political gridlock and for awhile and the chances of the stimulus our masks the meals nor gonna be it and then a short to near term at least a little bit lower.
Uhm.
What are your thoughts on what the fed is concerned is gonna feel more pressure to do more.
And if that is the case, how will that affect the mortgage market going in the next year.
Sure I mean, I can give you.
My personal opinion and really sure that since the start of Covid. We have directed some of our research resources.
N two virus tracking and quantifying the impact of things like the cares act on consumers ability to pay their debt and so so we have more of a research effort.
Focused on those issues, because they're so front and center now since the virus.
But you know given that you know the election is still uncertain we haven't.
We haven't really formalized use them with the different administrations mean for.
Taylor former things like that.
So if you have buyten presidency, but the Republicans.
Maintain call the Senate Yeah, I do think that argues for less stimulus than what you would have gotten if the Democrats. It flip the Senate. So we think about that and we certainly take it in to account when we think about credit exposure.
On the agency side, that's less of a factor for us it probably you know it it might unfortunately mean that some of the more the borrowers that are gonna be coming off forbearance.
Might have a harder time getting off their forbearance plans.
You know for US we look at a lot of conditional outcomes, who will kind of like game plan, you know four or five different possible scenarios and have views of that and sort of have you know ideas on portfolio construction should those things play out with generally not.
We generally don't.
Take big positions or set up the portfolio in expectation that we can predict some of these macro events. So that you approach we've taken with Covid I guess, the only thing we.
With covid, but with the election I guess, our view was that.
There was the potential for volatility we didn't know if it was necessarily gonna happen, but there was certainly that potential so I think too insulate and protect the portfolio. It made sense for us to keep our debt to equity ratios relatively low given valuations right before the election set something we did.
Let me have more clarity was certainly we'll certainly revisit that but.
We're not going to take big directional exposures based on our expectation of what will happen but.
This issue of stimulus that you asked about is a great question and it's something that we've spent a lot of resources on teasing out.
What sort of a hypothetical what how would borrower pastings being impacted be impacted if if stimulus was if stimulus is greater stimulus is less and we certainly didn't notice and some of the remaining support something on agency side.
The impact when the 600 dollar a week you know unemployment benefits on top of the state minimum changed so it's measurable we see it.
And there's been a lot of great alternative data sources that we've tapped into their allow us to track that.
Great. Thank you very much gentleman and hope everybody continues to be safe and healthy.
You too thank you.
Thanks.
That concludes today's Q&A portion of today's call.
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