Q4 2020 Ellington Residential Mortgage REIT Earnings Call
Good morning, ladies and gentlemen, thank you for standing by welcome to the Ellington residential mortgage REIT 2024th quarter Financial results Conference call. Today's call is being recorded at this time all participants have been placed on a listen only mode and the floor will be opened for your questions. Following the presentation.
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It is now my pleasure to turn the floor over to Jason Frank Deputy Deputy General Counsel and Secretary, Sir you may begin.
Thank you and welcome to as Luna 10 residential fourth 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.
Described under item one a up our annual report on form 10-K filed on March 12, 2020, and part two item one day 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 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 to Koskey, Our co Chief investment Officer, and Chris Smirnoff Archie.
Officer.
As described in our earnings press release, our fourth quarter earnings Conference call presentation is available on our website at earn beat Dot Com. Our comments. This morning will track. The presentation. Please note that any references to figures from this presentation are qualified in their entirety by the endnotes at the back of the presentation with that please turn to slide three of the presentation I will now turn the call over to Larry.
Yeah.
Thanks, Jay and good morning, everyone. We appreciate your time and interest in Ellington residential.
During the fourth quarter Federal reserve purchasing activity remained elevated.
<unk> continued to be strong and yield spreads on agency MBS tightened very significantly.
In addition, as you can see on slide three long term interest rates started to increase with the 10 year Treasury rising 23 basis points during the quarter, while the U S treasury yield curve steepened with the two year tenure spread increasing to 79 basis points.
It's been over three years since we've been in a yield curve environment, that's the steep.
Despite these movements actual and implied interest rate volatility remains low and agency RBS outperformed dramatically.
You can see here on this slide even with the sizable increase in long term interest rates. The price of Fannie may two and has increased by more than half a point, which equates to a spread tightening of nearly 30 basis points.
So far in 2021, we have seen long term interest rates continue to rise and the yield curve continue to steepen as the market is anticipating a significant stimulus package from Congress and a modest increase in inflation expectations.
Turning to slide four you can see the Ellington residential had another excellent quarter. We generated net income of <unk> 60 per share and an economic return of four 5% for the fourth quarter, which brought our full year 2020, net income to $1 63 per share and our full year 2020 economic return to <unk>.
14, 1%.
Core earnings for the fourth quarter was <unk> 34 per share again comfortably in excess of our 28 cent quarterly dividend, a dividend, which I am proud to say, we maintain throughout all of 2020 without interruption or cut.
You can also see on this slide that our net interest margin again exceeded 200 basis points this past quarter, despite lower asset yields.
Notably we were again able to deliver strong results this past quarter, even while maintaining leverage that's well below our historical averages our debt to equity ratio as of December 31 was just six one to one down from $6 five to one at the end of the prior quarter and well below our historical debt to equity ratio, which has typically been.
And in the eights or nines to one.
During the fourth quarter, we continue to maintain a long position in current coupon Tva's and as a result, we again benefited from attractive dollar rose driven by federal reserve purchasing activity.
Our non agency MBS portfolio also had another excellent quarter as yield spreads in that sector continued to revert toward pre COVID-19 levels at the same time the rise in long term interest rates generated significant net gains on our interest rate hedges.
Meanwhile, along with our net long positions in current coupon TBA is we also had net we also held net short positions in high coupon Tva's. This long short portfolio positioning, which similar to our positioning in the third quarter and this positioning again paid off as lower coupon TBA has significantly outperformed higher coupon Tvs.
Yes.
One wonderful thing about the agency mortgage market is that it's not only a deep and liquid market on the long side, but it's also easy and efficient to take short positions the TBA contracts.
This simple fact increases the investment opportunity set for us dramatically.
But it also allows us to manage our risks and returns much better, adding or reducing our TBA short positions and thereby dialing down or up our overall net mortgage exposure has been an effective tool for us whether to protect our book value when yield spreads what tied to us or to take a more aggressive posture when yield spreads look attractive.
The strategic use of significant short TBA positions has been a major differentiator for earn in the agency mortgage REIT space.
Finally, despite the increase in interest rates. This past quarter, we had another solid quarter of performance from our specified pools, which comprised the vast majority of our assets.
This capped off an incredibly strong year for the specified pool sector.
Over the past few years, we have regularly highlighted some larger themes in the mortgage market as the underlying rationale for our continued focus on prepayment protected specified pools.
Many of these themes kicked into hyperdrive as a result of the COVID-19 pandemic.
One example is the dramatic effect that technological advantage.
Advances in automation have had on lowering the hurdle on refinancing.
And bind with all time low mortgage rates. These technological advancements led to a surge in prepayment rates in 2020, which resulted in significant increases in pay ups across many specified pool sectors.
The performance of low loan balance Fannie Mae Threes is a great example.
Over the course of 2020 as investors flocked to prepayment protection.
Ups for this specified pool sector tripled from around two points to around six points remarkable increase of around four points.
The outperformance of specified pools is even more remarkable given that on certain days during the liquidity Crunch at March and April pay ups on most specified pool sectors had utterly collapsed les.
Later on this call Mark will elaborate further on the impact of technology on the agency MBS market.
And I'll now pass it over to Chris to review, our financial results for the fourth quarter in more detail Chris.
Thank you Larry and good morning, everyone.
Please turn to slide seven where you can see a summary of <unk> financial results.
For the quarter ended December 31, we reported net income of $7 $4 million or <unk> 60 per share and core earnings of $4 2 million or <unk> 34 per share.
These results compared to net income of $8 1 million or <unk> 66 per share and core earnings of $4 8 million or <unk> 39 per share for the third quarter.
Core earnings excludes the catch up premium amortization adjustment, which was negative 559000 in the fourth quarter compared to positive 405000 in the prior quarter.
As you can see on slide seven our fourth quarter results were driven by strong net interest income on our agency MBS investments.
Net realized and unrealized gains on our long TBA holdings.
Our net realized and unrealized gains on our interest rate hedges and other activities.
A portion of this income was offset by net realized and unrealized losses on our agency MBS investments.
<unk> largely by elevated prepayment activity.
You can also see on slide seven that our net interest margin narrowed modestly by nine basis points to 212% driven by lower asset yields.
As we mentioned last quarter, we expect our asset yields to come down as the portfolio naturally pays down and as we turned over our higher yielding non agency.
Portfolio and agency MBS assets and reinvest at lower market yields.
You can also see here that we continue to benefit from very low borrowing costs.
Average pay ups on our specified pools decrease of two 4% as of December 31, as compared to $2 five 5% as of September 30th, but this was primarily because of our new purchases. During the fourth quarter consisted mainly of lower pay up pools.
Next please turn to our balance sheet on slide eight.
During the fourth quarter, we continued to mean higher liquidity and lower leverage as compared to periods prior to the onset of the COVID-19 pandemic.
At December 31, we had cash and cash equivalents of $58 $2 million down modestly from $61 2 million at the end of the prior quarter, but well above the $35 $4 million of cash holdings at year end 2019.
Our debt to equity ratio adjusted for unsettled purchases and sales declined quarter over quarter to $6. One to one at December 31 from six five to one at September 30, and $8 one to one at December 31 2019.
The quarter over quarter reduction was driven by larger shareholders equity and smaller overall, our MBS portfolio.
You can also see here that our book value per share was $13 48 at December 31, 2020, compared to $13.17 at September 30th and $12 91 at the start of the year.
Reflecting increases of two 4% and four 4% respectively for the quarter and year as our earnings exceeded dividends by a healthy margin.
Our economic return for the fourth quarter was four 5%, including the impact of the fourth quarter dividend of <unk> 28 per share.
For the full for the full year 2020, our economic return was 13, 1%.
Of a $1 12 per share of dividends declared during the year.
Next please turn to slide nine which shows the summary of our portfolio holdings.
In the fourth quarter, we continued to monetize gains in our non agency MBS portfolio, most of which we had upper opportunistically purchased in the aftermath of the March and April market distress.
As a result of those sales our non agency portfolio declined by an additional 20% quarter over quarter.
Size of our agency MBS portfolio declined by 2% over the same period.
Next please turn to slide 10 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 TBA U S Treasury securities and futures consistent with the prior period.
On slide 11, you can see that our net long exposure to <unk> was $5 six to one at December 31.
The change from prior quarter.
I'll now turn the presentation over to Mark.
Okay.
Thank you Chris.
Our first update how earned performed for both.
And the full year.
Our forward outlook, how we are positioning the company to drive future returns.
2020 was quite a year.
And active in the mortgage markets for a long time, and I don't think I've ever seen a roller coaster ride like 2020.
The loans were lower and the highs where higher you had to expect the unexpected.
Staring at the screens in March and talking to our most important Counterparties then.
I literally saw and heard things I have trouble believing.
But we have always managed earn with two primary and simultaneous objectives. These objectives helped us persevere through the turmoil.
First.
Protect book value.
Against downside moves.
The opportunistic and capture upside when it presents itself.
That philosophy is what drove our 2020 performance market shocks are almost always caused by something that is not on People's radar. When COVID-19 was no exception with balance sheet shot the chocolate dependent it caused in the second half of March was sudden and enormous and demonstrated how thoughtfully we manage our liquidity as we were able to meet all mark.
<unk> calls avoid forced asset sales sales and buildup of liquidity cushion during this period.
And the subsequent opportunity that followed massive fed intervention was also sudden equally enormous we were able to capitalize on it.
For the year earned did great stock delivered a best in class total return of over 30%.
Our total return on book value was an impressive over 13% for the year.
We got there with a disciplined hemochrome it.
As the pandemic caused panic in balance sheet shortages in March.
Liquidity, we were appropriately levered in our repo maturities were well staggered with the diversified sales lenders, who are able to weather the storm with modest controlled asset sales as did minimal book value damage.
Throughout our history generally favored lower leveraged and much of the peer group. The reason for that is a couple of extra turns of leverage the company's reach for when nims are tight and earnings are hard to generate.
I mean, the difference being the <unk>.
<unk> seller REIT opportunistic buyer during times of distress.
Instead of extra leverage we tried to make additional returns with more active trading and a deeper dive into prepayments.
Don't just try to leverage the fate of the mortgage market. We also tried to leverage the alpha gist.
Mental return available to investors with the deepest understanding of prepayments and marketing efficiencies.
And this free pivoted and use the flexibility of our investment mandate by non agency MBS at very distressed prices.
<unk> I'm willing to take credit risks when yields are attractive.
<unk> mentioned, a few times in our recent calls.
It shows what are the benefits that earn enjoys in terms of being part of a much larger investment management complex manages over $11 billion.
Deep and broad expertise in mortgage credit.
<unk> primary focus has been agency MBS give the benefit of world class Pms with deep expertise in mortgage credit.
And to earn can opportunistically take advantage of that.
Now, let's look at the fourth quarter had a very solid four 5% economic return the portfolio shrank slightly as paydowns exceeded new investments, but we actually traded almost 100 million current face of schools and CMO.
Continued to monetize substantial gains in our non agency MBS portfolio as Larry mentioned, we continue to operate with leverage sits below our historical average.
Yield spreads over financing and hedging instruments not currently look compelling from many sectors of the agency MBS market.
Our portfolio had solid performance during the quarter and our coupon positioning with TBA MBS.
To help performance tier.
EBITDA coupons that we were long and large positive roles and those that we were short has negative rolls.
Those with the relative price performance.
Across the coupon stack and it does allowing us to make money on both the long side in the short side of our TBA trip.
Security selection portfolio prepayments to be manageable for earn in 2020, but make no mistake about it we're in a big long lasting prepayment wave, it's not clear whether it's starting to abate.
Work from home and technology are playing havoc with the historical pattern of seasonal trends.
And while the most recent prepayment data that came out two weeks ago seems to show some signs of a slowdown still too early to tell if that's the case going forward, we see a balanced outlook for agency MBS with both substantial tailwind headwinds, which guide us to a lower levered positioning.
We think there will be more volatility in 2021 and there was during the second half of last year when price action was muted.
Performance of agency MBS versus hedging instruments that happened in the second half of 2020 and in the early days of 2021 was driven by two big tail winds that support and bank buying a lot has been made of fed buying into very significant banks with a lot of cash and limited investment options. I've also been huge buyers of agency MBS.
While there has been a recovery since March 2020, and virtually all fixed income spread product.
<unk> unique because the fed is buying them in large predictable size, India no credit risk.
<unk> has been stable and tightening spreads relative to treasuries strong dollar rolls and very low borrowing costs.
Let's move to other parts of fixed income agency MBS look pretty good as everything has experienced a massive spread recovery.
Consistent fed mines, and strong current production coupon rolls and very low financing costs.
Unable to borrow one year repo at 20 basis points.
So that means to buy and finance $100 million of agency MBS for a year or repo costs is a mere $200000, which is an enormous tailwind for the agency MBS investors.
What about the headwinds with the Fintech.
Evolution has come to the agency mortgage market and industry that had previously seen stubbornly resistant.
The technology to streamline the process involves dozens of paper documents and human touch points changing and changing fast.
Chronic notaries appraisal waivers uploading documents automated polls of bank statements et cetera. These are all changing the refinance experience as a new tech savvy generation.
Races homeownership.
Youll guards at the money Center bank, changing or being left behind.
Technology cost money historically mortgage companies as opposed to big banks typically run with very limited capital.
Not anymore.
Activity from these companies.
Has been fast and furious rocket from Depo <unk>.
Wm now all have big market caps in two ways.
To create the best consumer mortgage broker experience.
These non bank originators are rapidly grabbing market share dramatically streamline the closing process. For example, one non bank originator gross loan closing times of less than half the industry average.
So the drive our returns going forward, our focus for us will be understanding how the technological improvements in mortgage underwriting changing prepayment behavior in ways that many prepayment models Miss.
This has been a research focus of ours informs how we positioned our portfolio and this high prepayment environment going forward, we expect not only increased volatility in interest rates also increased volatility in the relationship in mortgages and hedging instruments, such as interest rate swaps.
At the right time, we will look to Opportunistically increase our mortgage exposure exposure, neither pool and TBA form in the meantime, we see lots of opportunities to add excess returns of the portfolio from both active creating and thoughtful positioning now back to Larry.
Thanks Mark.
Earn strong fourth quarter concluded what has been a remarkable year of outperformance for us.
Please turn back to slide five.
During an unpredictable and unprecedented 2020 earned generated an economic return of 13, 1%.
Total return on its stock of 36% and net income and core earnings that significantly exceeded dividends dividends that we kept constant throughout the crisis and throughout the year.
How did we do this.
Through the extreme volatility of March and early April our disciplined risk and liquidity management protected book value allowed us to avoid forced asset sales and preserve liquidity, enabling earn to withstand the extreme market wide volatility and liquidity crunch.
We emerge from the crisis with a strong liquidity position and that allowed us to take advantage of some extraordinary investment opportunities while asset prices were still depressed.
All the while we were able to navigate a mortgage refinancing wave. That's so agency prepayment rates surge to their highest levels since 2012.
Earns outstanding 2020 also followed a strong 2019 for earn when we generated an economic return of 14, 6%.
You can see the cumulative economic return for these two years on slide six.
Over this two year period earned generated a cumulative economic return.
Of nearly 30%, which I believe puts us at the top of the publicly traded agency mortgage Reits.
Clearly the operating and investment environments of 2019, and 2020 could not have been much more different.
Nevertheless, earn was able to prosper in both periods and by doing so I believe that we have without question demonstrated our ability to achieve our objective, which is to deliver strong and steady returns to our shareholders and a diversity of market environments across market cycles.
Now turning to the opportunities that lie ahead in 2021.
Short term interest rates are likely to remain near zero for another year and it seems unlikely that the fed will start tapering asset purchases this year.
There's no question that these dynamics have been beneficial for agency MBS investors.
And our high net interest margin is certainly a nice tailwind for 2021.
We saw last year market dynamics can change quickly.
Fiscal stimulus can be a boon to asset prices, but the furore of large fiscal deficits can wreak havoc on MBS prices.
Meanwhile, as Mark discussed technology continues to evolve at a blistering pace and we're expecting even more private non bank mortgage originators to go public in 2021, bringing even more capital attention and technology to the sector.
In this environment agency MBS portfolio managers need to find the right balance between on the one hand constructing a portfolio that is not that can hold up in today's high prepayment environment.
And on the other hand, constructing a portfolio that is not overly exposed to extension risk and spread widening risk should interest rates continue to rise.
Finding this balance allows it disciplined portfolio manager to play offense during times of stress something that differentiate it earned from the peer group in 2020.
Whatever path the residential mortgage market takes from here changes and the changes in the prepayment landscape should favor our core strength of prepayment modeling asset selection and dynamic interest rate hedging.
And with a relatively low leverage and disciplined hedging earned should be well positioned to capitalize both on the opportunities that we see right now and on those that are bound to emerge when things inevitably change it.
It bears repeating that our success at arent does not necessarily dependent on the absolute level of interest rates on the shape of the yield curve or where net interest margins happened to be and thats because of our portfolio management strategy. We trade actively we shift our capital to where we think the best opportunities are and we hedge along the entire yield curve often using significant TB.
Short positions.
Finally.
Please now turn to slide 15 for our 2021 objectives.
As we look ahead, our investment principles remain unchanged capitalizing on investment opportunities presented by market volatility and uncertainty diligently hedging and managing liquidity to protect book value dialing up and down our MBS exposure opportunistically and rotating our portfolio based on where we see the best value at each moment in time.
We look forward to meeting the opportunities and challenges to come in the year ahead.
Before we open the floor to questions I would like to thank the entire Ellington team for their hard work in 2020 and for all of those listening on the call today, we wish you the best for 2021.
And with that we'll now open the call to questions. Operator. Please go ahead.
And just wondering if he would like to ask a question. Please press star one again Thats star one for any questions over the phone line, we'll pause for just a moment.
And your first question will come from Doug Harter with Credit Suisse. Please go ahead.
Oh.
And good morning.
Hoping you could talk a little bit more about.
Yeah.
Type of environment.
Mike.
Allow you to kind of dial up the risk and kind of after you know kind of living through last March and if you could talk about you know kind of where where the upper end of the range might be if the environment presented itself.
Hey, Doug it's Mark.
So.
We will the script it was a few days ago and I think yesterday.
A good example of some of the market volatility.
We were starting to expect.
Do you see.
A lot more focus and a lot moving.
Nevada inflation.
So.
Yesterday for example was a day of a pretty substantial mortgage underperformance. So I think that will use opportunities like that.
Two.
Increase our mortgage exposure.
In pool form or in TBA form people.
Realize that.
You have a giant buyer out there and the fed is not driven by economics, so theres going to be times.
Where they're going to cause a pricing structure of the market that doesn't leave a lot of.
With two room for attractive NIM, but what they do do is they also create price distortion. So it's going to be lots of.
Relative value opportunities as well.
Great. Thanks, Marc and then just on how you might think about the range of Oh.
Where we're kind of your net net MBS exposure net leverage could get to if the environment presented itself.
Yes, I would say.
If you look historically, where we've been that.
Sure.
Early end of that range I think we still serve sort of as an upper bound for us.
And I think where we came into.
Where we ended the year.
Was probably close to a lower bound mortgages had a very very strong Q4. If you look at the prices where things ended Q4 relative to where they are now big sectors of the market is weak price substantially lowered down over a point.
And if I could just add to that.
What are the couple of things we talked about earlier on the call. Doug One was the fact that you've got obviously prepayment is very very high.
But you also have rates very low and the possibility of extension risks, especially as more and more.
The mortgage universe.
<unk> has its refinancing lower and lower coupon REIT, if that all of a sudden interest rates reversed so you're going to have some low coupon mortgage is extending tremendously so.
We know where at this real balancing act right now.
Where it's just very day, it's a very dangerous environment, but on the other hand.
It's also an environment where for example, we talked about how we made money on our logs out our shorts and TBA is right. I mean, this has made money in our shorts, even though mortgages had just a tremendous quarter right.
So it just shows you that in this type of environment.
Yes, if things move a lot its dangerous, but as an active trader and as a company that's not afraid to put these alpha generating trades on.
I think that's just a much higher quality way for us to generate earnings as opposed to dialing or.
Dialing just mortgage exposure at all times are dialing our leverage up to.
To that maximum.
You want to call it that probably seven to one.
Net mortgage exposure I don't know if you've ever been much higher than that of 90 to one on leverage I mean, that's not the way that we think is the best way to make money for shareholders in an environment like this.
Yeah.
That makes sense. Thank you.
The next question is from Eric Hagen with BTG. Please go ahead.
Hey, Good morning, guys hope, you're well can you talk about what the bull cases for specified pools to hold their ground or even strengthen a bit further from here relative to TBA. If the backdrop is for higher rates and a steeper curve.
And then on the TBA position can you shed some more light around how you're maybe feeling about being lower than the coupon stack on the long side on where you guys might be more active.
Going forward here. Thanks.
Sure Hi, Eric its mark.
In terms of specified pools.
Yes, you are right ones a lot of them still have substantial carriers versus either.
TBA shorts.
Vs interest.
Interest rates are treasury hedges, so even if you don't have.
Pay up expansion from here.
A lot of them still have very good positive carry.
In terms of positioning along the coupon stack.
Still do have I mean, yes, there was a big sell off but.
It's still by and large a premium market so.
I would say that.
REIT moves.
Moves like yesterday need is that.
Some of your hedges migrate from.
Shorter parts of the curve to longer parts of the curve.
Net models will now pricing more prepayments slow downs, so certain coupons EBIT even move since the start of this year you've had about.
Yes.
About a 40 basis point moving tenure swap rates, that's enough to change where.
It sort of your cash flow risk is concentrated.
The mortgage market outside of Fannie one and a half.
Anything else is still a premium.
102 on up to say 110 so.
The moves this year of lowered some prices, but the payments are still done in fact things and I would say that there's a.
The flexibility you have net interest rate hedges across the curve.
Does it make us gun shy about lower dollar price tba's, if thats the best value I think that you have enough tools to manage the interest rate risk and potential extension risk.
Yeah.
Thanks for the response.
The next question is from Mechelle Guberman with JMP Securities. Please go ahead.
Hi, good morning, gentlemen, congrats from another fine quarter.
Yes.
Most of my questions have been answered, but I was wondering if you could maybe talk about the non agency book of course, the last two quarters have done very well in monetizing the portfolio there in terms of earnings day.
Do you see any potential for that kind of mini wave to come forward again or are you going to opportunistically look for the next.
Excellent entry point on that.
Yeah, Thanks to the questions Mark.
I think now.
Investor sentiment in regards to housing.
Very strong in that.
It applies to.
Expectations of credit losses and.
Legacy non agency, which has worked on.
Loans as.
As well as non QM.
As well as <unk>.
Jumbo as well as you know single family rental so.
Right now the set of assumptions that's embedded in the price of all those sectors.
As you know.
I think it's sort of appropriately optimistic.
So from where we are now.
Youll, probably see that portfolio continued to come down in size.
Yes.
Prices dropped and yields go up let's say there is another.
Shock to the system in some form that the mortgage not anticipating.
And you see a pullback in prices and an uptick in yields and those look like a good alternative and good diversification to the agency strategy.
We can certainly add it I don't know I don't know where that would come from.
The nature of the shocks.
Right now, where we look at the pricing there probably going to see that portfolio continue to shrink.
Okay, great. Thank you very much.
That's it from me thanks.
Thank you.
There are no further questions at this time, ladies and gentlemen, thank you for participating in today's conference you may all disconnect.
Okay.
Sure.
Yes.
Thanks.
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Okay.
Okay.
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