Q2 2021 Ellington Residential Mortgage REIT Earnings Call

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Yeah.

Good morning, ladies and gentlemen, thank you for standing by welcome to the Ellington residential mortgage REIT 2021 second quarter financial results Conference call. Today's call is being recorded at this time all participants have been placed on a listen only mode.

There will be opened for questions following the presentation.

I'd like to ask a question at any time, Please press the star and 1 on your telephone keypad at.

At any time if your question has been answered you may remove yourself from the queue by pressing the pound key 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, Sir you may begin.

Thank you and welcome to Ellington residential second quarter 2021 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.

We're looking statements are not historical in nature.

Scribe funds or item 1 a of our annual report on form 10-K filed on March 16, 2021 forward looking statements are subject to a variety of risks and uncertainties that could cause the companys 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.

Once 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.

With me on the call today are Larry Penn Chief Executive Officer of Ellington residential Mark to copy our co Chief investment Officer, and Chris Martin off 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 will track. The presentation. Please note that any references to figures in this presentation are qualified in their entirety by the endnotes 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.

Please turn to slide 4.

Ellington residential is core earnings increased a robust 19% sequentially to 37 per share.

Driven by an incrementally larger portfolio and a further reduction in our cost of funds.

With our core earnings continuing to exceed our quarterly dividend run rate.

On June 9th our board increased our quarterly dividend by 7% to its current level of <unk> 30 per share.

I was very pleased with this increase especially since we had kept our dividend level constant throughout the COVID-19 related volatility of 2020.

Now please turn back to slide 3.

As you can see on this slide after long term interest rates increased sharply during the first quarter.

Interest rates reversed course and fell during the second quarter.

The yield curve flattened mortgage.

As rates declined and.

And the MBS investors hope for prepayments burnout fell far short.

Meanwhile, sentiment began to ship towards the increased likelihood that in the coming months, the federal reserve would commence tapering of its asset purchases.

In light of all these factors agency yield spreads widened across the board.

And most agency RMB significantly underperformed comparable interest rate swaps and U S. Treasury Treasury hedges on a total return basis.

As a result from a book value perspective, the second quarter was a challenging 1 for leveraged hedged agency MBS portfolios such as ours.

During the second quarter, we again saw a meaningful divergence of performance across the various subsectors of agency MBS and.

In contrast to the first quarter it was higher coupons that fared the worst during the second quarter of lower coupons held up relatively well for.

For example prices on Fannie 4 in a house declined by more than a point.

This represented a substantial widening during the quarter.

Prices on Fannie 2 and has increased by a little less than a point, which represented only a modest widening.

Given the 27 basis point decline in 10 year treasury yields during the quarter.

For Ellington residential losses on our interest rate hedges together with agency MBS yield spread widening combined to generate an overall GAAP net loss for the quarter.

That said, we were actually relatively well positioned for the divergence of performance across agency RBS Subsectors and.

In recent quarters, we have been shifting more and more of our specified pool portfolio added higher coupons and into lower coupons and we get accelerated this trend in the first quarter of this year, having added more lower coupon pools after yield spreads on lower coupons widen dramatically.

And at Seabee as we've recently been concentrating our long TBA holdings in lower coupons, which the fed has been buying while maintaining short TBA positions in higher coupons as an important component of our interest rate hedging portfolio.

Our hedging portfolio benefited from this positioning as net gains on our higher coupon TBA short positions were able to offset a portion of the losses on our interest rate swaps and U S treasuries.

Meanwhile, on the liability side of our balance sheet, our repo lenders have been offering aggressive financing terms for longer dated repo and we continued to take advantage of that in the second quarter.

In fact since year end, we've extended the average term of our repo from 48 days to 134 days, even while lowering our average borrowing rate from 0.25% to 0.17 per cent.

You can see our latest repo details on slide 18.

Finally in our first common share issuance in over 4 years, we completed a follow on offering in June the.

The offering was split between primary shares and secondary shares with Ernst co founding shareholder Blackstone selling $2 million 675000, and secondary shares with a company selling 575000 primary shares.

Back on April 26th Blackstone, which had owned around 27% of our outstanding shares had measures had registered all of their unregistered shares for sale.

When we were preparing for this June share offering we concluded that it was in the best interest of the company and its shareholders to address the obvious overhang from Blackstone share sooner rather than later.

The offering increased the public float for earn stock by a full 38%.

Which should provide a lasting boosting liquidity for all our shareholders.

I will now pass it over to Chris to review, our financial results for the second quarter in more detail Chris. Thank.

Thank you Larry and good morning, everyone.

Please turn to slide 5 where you can see a summary of earned second quarter financial results.

For the quarter ended June 30th we reported a net loss of $4.5 million were negative <unk> 36 per share and core earnings of $4.6 million or 37 per share.

These results compared to net income of $127000 or a penny per share and core earnings of $3.8 million or 31 per share for the first quarter.

Core earnings excludes the catch up premium amortization adjustment, which was $2.6 million in the second quarter compared to $70000 in the prior quarter.

The net loss for the second quarter was due to net losses on specified pools.

It's only securities interest rate swaps U S treasuries and futures.

Which exceeded net interest income and net gains on TBA positions.

Joining us during the quarter the yield curve flattened with long term interest rates decreasing in short term interest rates increasing modestly.

Yield spreads on most agency our MBS widened midst concerns at the federal reserve will commence tapering its asset purchases in the coming months.

Prepayment risk increased as well driven by lower mortgage rates with yield spreads on higher coupon MBS impacted most significantly.

During the quarter, we continued to concentrate our long TBA investments in lower coupons, and our short TBA investments in higher coupons as Larry mentioned and this positioning contributed.

Positively to our quarterly results.

You can also see on slide 5 debt, our net interest margin increased quarter over quarter to 2.0% to 4% from 196% driven by slightly higher average asset yields and incrementally lower cost of funds.

Average pay ups on our specified pools decreased to $1.5 5% from $1.6 1%, primarily because new purchases during the quarter were mainly of lower pay up pools.

Please turn next to our balance sheet on slide 6.

Value per share was $12.53 at June 30, compared to $13.22 at June at March 31, which includes the effect of the 30 <unk> per share second quarter dividend.

The drop in book that book value per share our economic return for the second quarter was negative 3%.

Our debt to equity ratio adjusted for unsettled purchases and sales increased moderately to 7.2 to 1 as of June 30, as compared to 7 to 1 as of March 31, we.

We continue to maintain higher liquidity and lower leverage as compared to periods prior to the onset of COVID-19 pandemic.

Next please turn to slide 7 which shows a summary of our portfolio holdings.

In the second quarter Agency MBS holdings increased by approximately 1% to $1..1 9 billion as of June 30, and our non agency MBS holdings decreased by 10% to $9.3 million.

Please please turn now to slide 8 for details on our interest rate hedging portfolio our.

Our interest rate hedging portfolio continued to consist of interest rate swaps short positions in TBA.

Treasury Securities and futures.

During both quarters, we were long some TBA short others and even though we were net short TBA as on a notional basis, we were actually net long Tvs.

As measured by 10 year equivalents.

Don't see that slide from the Pie chart.

On slide 9 you can see that our net long exposure to RMB US was 6.7 to 1.

As of June 30 up from 6.2 to 1 as of March 31.

Primarily due to a smaller net short TBA position quarter over quarter.

Finally, as Larry mentioned, we completed a public follow on offering of $3 million 250000, common shares of which $2 million 675.

<unk> thousand shares were sold by Blackstone and 575000 shares by earn the offering generated net proceeds to us of $7.1 million after underwriting underwriters discounts and commissions and operating costs I'll now turn the presentation over to Mark.

Thanks.

As Chris stated, we had a total economic return for the quarter of negative 3%.

It was a quarter of weak mortgage performance across the board, especially in higher coupons. The rally in interest rates combined with continued fast prepayment speeds resulted in our agency MBS holdings underperforming their hedging instruments per the year Delta hedging costs have increased with greater interest rate volatility and there has been a further headwind.

Earnings.

The challenges of the second quarter did not present, the core earnings issue for US in fact, our core earnings increased and we raised our dividend, but rather a portfolio felt the impact through mark to market losses.

Further we don't see any Q2 agency underperformance is a result of some new or negative information about agency MBS, but more as a result of the market continuing to digest existing news by this I mean prepayment speeds running in excess of market expectations and in excess of many model projections has been.

Market reality for a few quarters now not just the second quarter, but digesting that news gave the market indigestion. This quarter that said I do think that the drop in interest rates surprised many investors at the end of March Martin consensus was overwhelmingly per continue to higher interest rates driven by higher inflation reports.

So at the end of Q1, the market was shrugging off with faster prepayment speeds and the steeper curve meant for mortgage valuations because expectations were the continued increase in interest rates would make it uneconomical for many lower coupon mortgages to refinance.

But the drop in rates this past quarter put faster MBS prepayments back in the spotlight.

Meanwhile, another negative for the quarter was marginally reduced bank demand, possibly a result of lower yields and higher prices on MBS we.

We've talked on previous calls about how consistent bank buying has been a strong source of support for agency MBS not surprisingly that has waned a little bit this quarter and was negative technical for the sector.

Fed messaging on tapering has been consistent in their words have been chosen very carefully so as not to ruffle the market's feathers.

<unk> is just a fancy word for buying less the fed is such a big buyer of MBS now that even if they start buying a little less the activities are still very supportive of MBS prices.

People forget that during the taper tantrum of 2013. After the initial few weeks of underperformance MBS wound up significantly outperforming treasuries that year.

That doesn't mean to say that the fed can't surprise the market with the tapering schedule that is more aggressive than expectations, but we do expect them to be supportive of agency MBS in some form or fashion throughout at least mid 2022.

Agency MBS did get a significant positive announcement last week, namely that agency MBS will now be included in the standing repo facility provided by the fed.

In our view this as a meaningful development that should reduce MBS volatility if or when some unforeseen market event causes a balance sheet shortage for agency MBS like what was experienced in March of 2028.

Agency MBS will now be treated similarly, the treasuries by the fed prior to QE and Thats going back to 2008.

Agency MBS are not treated like treasuries by the fed being they were not part of the fed's balance sheet and we're not part of lending facilities now they are.

<unk> news might not be as relevant for the current market, where repo funding for agency MBS is plentiful, but it is a significant shift in how the fed treats this asset class and it should dampen episodic price volatility that comes from significant funding balance sheet stresses.

Another piece of good news for the agency MBS that might've gone overlooked was the leadership change at FHFA Mark Calabria was replaced by the Biden Administration Ms. Sandra Thompson. The message is loud and clear. This administration has no intention of privatizing the gse's.

How does these leadership changes manifest themselves as policy changes, it's still somewhat unclear. We expect some policies will be supportive of agency MBS prices and others won't be but government support for housing got a strong boost and this leadership change removed further uncertainty about the fate of the GSE.

While its disappointing debit quarter of negative economic return, it's easy to see why we another agency focused mortgage REIT had a decline in book value quite simply the price of our long MBS assets did not increase in value as much as the hedging instruments that we held short this underperformance was much more pronounced in higher coupons than lower.

Coupons, so our portfolio positioning of being somewhat disproportionately long low coupons and short higher coupons helped mitigate to mitigate a portion of the MBS spread widening.

When you have a negative economic return because assets underperforming hedging instruments that generally means going forward returns are more attractive because assets have repriced with now higher yields relative to hedges that.

And that was generally the case at the end of Q2 relative to Q1 with the only slippage being some delta hedging costs and moving forward current valuations look more attractive than they did a few months ago.

You can see on slide 9 that during this past quarter, we increased our net mortgage exposure by half a turn in response to the opportunity.

During the second quarter, we actively turned over the portfolio, but we didn't make broad compositional changes.

This is a time of evolving prepayment trends. If we were active in pruning positions that no longer look attractive relative to hedging instruments or TBA. We were also active in finding pools with attractive Roe to reinvest those proceeds debt pay downs we.

We are clearly in a different environment today than at the start of the year. The fed is not on auto pilot and we should get details on QE tapering before year end in.

In addition, the level of interest rates is much more data dependent than last year, and we can expect volatility as new inflation data either confirms or challenges the notion that recent higher inflation prints are transitory.

MBS valuations look reasonably attractive dollar rolls have given us a strong tailwind and then evolving prepayment landscape has created some better relative value trading opportunities now back to Larry.

Thanks Mark.

I am pleased to have increased our core earnings and dividend during what has been a challenging year for agency MBS so far.

We have not sat still are been complacent as the shifting environment and higher volatility of 2021 has given us another opportunity to pivot.

We have sold non agency assets at significant gains and we have shifted to offense and our agency portfolio, adding some very attractively priced agency pools.

The agency mortgage market is a deep and liquid market with ample opportunities, especially during times of volatility providing ellington residential with a consistent opportunity to generate strong returns and.

And importantly, these opportunities are not just present on the long side of the market, but on the short side of the market as well.

In fact, our willingness to take substantial short positions in TBA mortgages was and continues to be a major differentiator for earn in the mortgage REIT space.

We believe that we are well positioned to capitalize on pricing dislocations that could occur as the feds footprint in the market eventually diminishes as we look to the second half of the year, we expect to continue to be nimble and look to take advantage of relative value discrepancies across subsectors as they arise.

And as always we will rely on our dynamic hedging strategy to help protect book value.

And with that I'll now open the call to questions.

Later.

And once again, if you would like to ask a question. Please press the star and 1 on your Touchtone phone you may remove yourself from the queue at any time by pricing about key.

And we will take our first question from Doug Harter with Credit Suisse. Your line is now open.

Hi, This is John on for Doug.

The first thing I'd like to kind of get some color on is what are you guys are going to talk about.

And expectations going forward for MBS spreads and how much of the paper is currently price then.

Okay.

Sure This is mark.

I think what's priced in is <unk>.

Expectations debt fed tapering will tapering will be gradual and that you have a fed debt will.

Respond to market dislocations, there's been a lot of comments from fed governors heartburn in particular was on the tape in June saying that the fed needs to avoid causing a taper tantrum. So.

I think I expect we're going to get clarity on that Q4 this year.

Sure.

They are buying a lot right now.

Market valuation can certainly accommodate them buying less.

And so our expectation that youll have a fed debt is going to grow gradually and the fed debt is very cognizant of what happened to MBS for a brief period of time.

In the spring 2013, where the market didn't understand.

What day net by taping so at that point, there really was no precedent and they didn't give out a schedule when they just talked about tapering now there is a precedent for how they tapered.

The previous round of QE, So I think there'll be they'll go gradually and the other thing as debt.

Stock effect, so the effect of how much of the mortgage market. The fed currently holds that it's bought from private investors is significant stabilizing force for spreads.

Okay, great. Thank you.

That makes sense, so just kind of switching gears here.

Can you guys talk about your thoughts on leverage in the current environment and what you see from a return or spread perspective, what you would need to see from those perspectives.

Sort of take it up in a meaningful way I know on the last call you talked about trying to stay between 7 to 9 times I think our backs with Penn So kind of where youre looking at in terms of the near future where youre looking at to go in the next few quarters.

Yeah, I would say given current given current valuations.

For some of our holdings is certainly dependent on ROE levels, given current valuations and given the fact that there is still interest certainty around the tapering schedule.

I think this is a time where at current levels, we would significantly increase leverage.

I think.

For the time.

For that would be if and when you had more clarity on tapering.

And you saw wider mortgage spreads relative to where they are so I think we're in a definitely a different environment than what we were 6 months ago well now we have a market that is going to hang on what the fed says because theyre going to give us some new information that wasn't the case 6 months ago 6 months ago. It was just there.

We're going to keep rate flow and they werent as they said even talking about they werent, even talking about talking about tapering. This is different now so in front of that I like the <unk>.

The leverage we have now as you saw from this quarter, we can drive significant core earnings.

And we have.

The ability to.

Add leverage if we want to or reduce leverage if we think valuations get to the point, where we'll be better entry points.

Great makes sense. Thank you so much for your time sure. Thank you for the questions.

And we will take our next question from Eric Hagen with <unk> your.

Your line is now open.

Hey, Thanks. Good morning Hope you guys are well wanted to get your perspective on what you think the carrier will look like for specified pools over the next few months just.

Maybe more generally what's reflected in the price of securities right now and then on the 1 hand, there is likelihood this demand for prepayment protection.

For all the obvious reasons, but on the other like you noted.

There is this potential per spread widening related to fed policy.

So just hoping you can kind of frame what's embedded in the market right now.

So.

Eric its Marc.

You did get this cheapening up.

Of MBS in the quarter right and Thats.

Reflected in the fact that.

Generally speaking.

Agency focused REIT had negative economic return. So you did get this cheapening up.

I think right now net interest margins look pretty good.

And.

We're more focused on finding prepayment protection that's fairly priced.

And looking for pools that look attractive versus TBA or look attractive versus other hedging interest instrument sale interest rate chops interest rate swaps or.

A short treasuries are more focused on that.

And then.

Making big predictions about how the taper is going to occur.

And we were able to find we brought leverage up a little bit this quarter, we were able to find pools on those metrics, we think can generate.

8% to 10% Levered Roe.

Okay got it.

And what's the long term prepayment assumptions underlying our core earnings number.

And then just as a separate kind of modeling question I just wanted to check in on expenses and see if there's wiggle room, there or if we should kind of expect more of the same. Thanks, yeah. So in regards to the long term prepayment expectation that's.

Embedded in core earnings assumptions, it's really each pool is different right. Because you know you have a range of note rates from.

Yeah.

15 year wanted to hash coupons, which might have a note rate of 2%.

All the way up to you know Fannie <unk> might have a note rate close to 6%.

And then even within that you have.

Tremendous range in loan attributes right.

Ounces of 40.50000 in some cases balances of 400.500000 other cases so.

It's really.

We'll buy pool specific and its versus the forward curve.

We've spoken on this call.

A few times about technology and Steepening S curves.

And youre seeing that play itself out so.

I think if you look at the core earnings we have now I think those are sort of reflective of our.

Best thoughts right now on current prepayment expectations, Yes, just let me just Larry Eric Let me just add.

No.

Maybe burn out hasnt been.

As pronounces as many people thought but.

Certainly in rates have dropped somewhat.

Wouldn't expect that prepayments at this point.

Probably.

Going to be too much of a problem for our core earnings in fact.

You've seen our corridor core earnings widened.

The last.

A couple of quarters.

As.

As a result of our portfolio is still yielding nicely our.

Cost of funds have come down.

Stayed the same EBITDA.

Lengthened.

Lengthen the term of it so I think that probably so first of all we have room at <unk> 37 versus a 30 cent dividend, we do have room for free.

Definitely a good amount of core earnings compression.

This is where our dividend is.

And.

If anything I, just think that with now is relatively recent occurrence now rates have dropped.

Even since quarter end right. So.

And we'd like to turn over the portfolio. So as we turn over the portfolio. It's only natural that we will be reinvesting.

With.

At some lower yields.

Financing costs really don't have a lot of room to come down from here.

Rates don't go negative.

<unk>.

So I think when you put that altogether I think probably if anything have a little bit.

Of downward pressure.

Core earnings but.

Not so much that we see any.

I'm certainly near term.

Impact on the dividend.

Okay.

As you can see what your expectation is.

You know each quarter, but how about on the expense side is there any wiggle room.

Eric 1 of the same.

Did you also give me a book value. Please.

Sorry, I'm talking to you.

Yes, sure no problem Erica, yes, so our expense ratio.

Given our size is around 3.5%, maybe slightly north of that.

And we expect again, given our size that.

That's.

A good proxy for our run rate now.

Okay, Yeah, and we're not you guys have an update okay.

Well, we're not going to give we don't give updates on.

Both of that shortly.

Mid quarter usually.

But mark you want to just comment on kind of where what's happened to spreads.

Et cetera sort of since since quarter end <unk> had cross current REIT you've had.

Very strong ROE levels that probably strengthened a little bit that's benefited some TBA.

You've had some TBA is.

Struggle with keeping pace with hedging instruments, but you've also seen pool pay ups reprice higher so.

I would say theres been a lot of cross currents really how I would characterize it.

Okay. Thank you thanks.

And we will take our final question from Macau Guberman with JMP.

JMP Securities. Your line is now open.

Hi, Good morning, gentlemen, most of my questions have already been answered, but I was just wondering if maybe you could.

Expound a little bit further on the follow on offering from June.

And the the extra bit of liquidity that it's added to the float and kind of what your thoughts are for <unk>.

For the company going forward with regard to to that thank you.

With regard to sort.

Sort of share offerings.

Yes.

Not just share offerings, but just what the added liquidity does does for the company going forward.

And your thoughts on the Blackstone in general about the exit, but they're lowering the position by greater volume.

Oh, Yeah, Yeah, I mean, I think as I've said I think we concluded that this was really the best thing for the company too.

Address that overhang.

Which I think we've done.

And.

You're I think got assets.

Been pretty soon since the offering but you are seeing.

Thanks, a higher liquidity already.

And that's something that I think the flow, that's really going to be a permanent I think.

Sort of share repurchases things like that should be a permanent increase in our Florida is obviously like it was a big percentage right, 38% increase in flow.

Is a large increase and our.

Our stock price is obviously struggled since then so this was a little bit of a rip the band aid moment off I guess, you could say rather than have that overhang overhanging.

<unk>.

We.

And our stock has dropped quite a bit since the offering but I'm certainly optimistic that people will see where we're trading relative to our book value.

Relative to our our dividend yield.

The trend in our core earnings all of that stuff.

And I'm, certainly hopeful that the stock will sooner rather than later be able to recover.

And yeah.

I don't think Theres really more I can say than that.

Alright, well thank you for that.

Okay.

And this does conclude today's program. Thank you for your participation you may disconnect at any time.

Have a wonderful day.

Okay.

Yes.

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Okay.

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Uh huh.

Yeah.

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