Q3 2021 Ellington Residential Mortgage REIT Earnings Call
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Good morning, ladies and gentlemen, thank you for standing by welcome to the Ellington residential mortgage our I T 2021 third quarter financial results Conference call.
Today's call is being recorded.
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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 third 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.
Forward looking statements are not historical in nature.
As described under item <unk> 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 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 <unk>, Our co Chief investment Officer, and Chris Martin off our chief.
Natural officer.
As described in our earnings press release, our third quarter earnings Conference call presentation is available on our website <unk> Dot com.
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 Alex residential.
To begin please turn to slide four.
In the third quarter Ellington residential generated core earnings of 31 per share, which continued to cover our dividend and we had a modestly positive economic return during the quarter in which performance of agency MBS was mixed.
Turning back to slide three in the first shaded Green column, you can see that the interest rates ended the third quarter not far from where they started but that comparison masks while were significant intra quarter movements.
July interest rates continued to decline as they have done during the second quarter as investor concerns increased around the delta variant economic growth outlook and potential fed tapering.
Between June 30, and August 3rd the yield on the 10 year U S. Treasury declined by 30 basis points to one 7% and interest rate volatility picked up.
In response agency MBS yield spreads widened during July, particularly for lower coupon MBS.
Moving into the latter half of the quarter interest rates began to rise while volatility declined in agency yield spreads tightened as the market got more clarity on the federal Reserve's tapering plan.
Following our September meeting the fed signaled that it could be good asset tapering late this year with new purchases decreasing incrementally through mid year 2022.
Even though this timeline was a bit more accelerated than some market participants had previously anticipated.
This was mitigated by the lack of signaling of any change to the fed's policy of reinvesting all paydowns on its existing portfolio.
Overall, the market welcomed the update on most agency MBS yield spreads tightened in response.
Clearly the federal reserve is trying hard to avoid another market taper tantrum such as was seen in 2013.
The late quarter agency MBS spread tightening was not uniform across all coupons and it was most pronounced for higher coupon MBS, which also benefited from reduced payment prepayment expectations driven by incrementally higher mortgage rates.
Meanwhile, lower coupon MBS lagged around concerns with the anticipated withdrawal of federal reserve purchases will disproportionately impact the current coupon agency MBS that the fed exclusively buys.
All in all higher coupon significantly outperformed lower coupons over the course of the third quarter and a sharp reversal of second quarter performance.
This is illustrated in multiple ways on slide three.
Fannie Mae three five and four and a half prices increased nicely in contrast to the modest price declines of Fannie Mae to in house and you can see that Oas's and Z spreads Fannie Mae three 5% and foreign has tightened far more than those of Fannie may two and a half.
For Ellington residential net interest income on our portfolio more than offset net realized and unrealized losses, which came mostly from our lower coupon holdings.
On the hedging side net gains on interest rate swaps and U S. Treasury hedges, roughly offset net losses on our TBA short positions, which were concentrated in higher coupons.
Meanwhile, our debt to equity ratio declined slightly to six seven times from 7.0 times at the end of the prior quarter.
Finally in October we announced our shifts from a quarterly dividend to a monthly dividend.
We believe that this shift will further enhance our appeal to income oriented investors and increase the breadth of our investor base.
I'll now pass it over to Chris to review, our financial results for the third quarter in more detail. Thank you Larry and good morning, everyone.
Please turn to slide five where you can see a summary of earn.
Third quarter financial results for.
For the quarter ended September 30, we reported net income of $860000 or <unk> <unk> per share and core earnings of $4 million $4 31 per share.
These results compared to a net loss of $4 5 million or <unk> 36 per share and core earnings of $4 6 million or <unk> 37 per share in the second quarter.
Core earnings excludes the catch up premium amortization adjustment, which was a negative $1 2 million in the third quarter compared to positive $2 6 million in the prior quarter.
During the third quarter as Larry mentioned net interest income more than offset net realized and unrealized losses, which were concentrated in our lower coupon holdings.
Also during the quarter, we had positive results from our interest only securities and non agency MBS portfolio and negative results from our reverse mortgage portfolio driven by widening yield spreads in that sector.
And in the interest rate hedging portfolio net gains on interest rate swaps U S Treasury hedges, roughly offset net losses on our TBA short positions.
You can also see towards the bottom of that slide that our net interest margin decreased quarter over quarter to one 8% from two zero to 4% largely driven by lower average.
Asset yields.
In addition average pay ups on our specified pool decreased to 144% from 155%, primarily because new purchases during the quarter consisted mainly of lower pay up pools.
Please turn next to our balance sheet on slide six.
Book value per share was $12 28 at September 30, compared to $12 53 at June 30.
Including the third the 33rd quarter dividend, our economic return for the quarter was positive 40 basis points.
Our debt to equity ratio decreased to six seven times as of September 30, as compared to.
Seven seven times as of June 30.
We continue to maintain higher liquidity and lower leverage as compared to periods prior to 2020 and the onset of the COVID-19 pandemic next.
Next please turn to slide seven which shows a summary of our portfolio holdings.
In the third quarter, our agency MBS holdings increased slightly to $1 2 billion as of September 30, and our non agency MBS holdings decreased slightly to $9 1 million.
Turnover in the agency portfolio was 23% for the quarter.
Please turn now to slide eight for details on our interest rate hedging portfolio.
During the quarter, we continued to hedge interest rate risk through the use of interest rate swaps short and short positions in TBA is U S Treasury Securities and futures.
Similar to recent the recent quarters, we ended the third quarter with a net short overall TBA position on a notional basis.
But a small net long overall TBA position as measured by 10 year equivalents.
On slide nine you can see that our net long exposure to <unk> was six four times.
At September 30 down from six seven times at June 30, primarily due to larger due to a larger net short notional TBA position quarter over quarter I will now turn the presentation over to Mark.
Thanks, Chris.
For the third quarter. If you only considered is starting and ending point of interest rates. It doesn't look like much happened, but it was actually a fairly volatile quarter for interest rates and the yield curve.
The market oscillated between fears of a spreading delta variant slowing down the economy and concerns that inflation would prove both larger and more persistent than defense assessments at higher inflation will likely be transitory.
So even though the 10 year only changed by two basis points quarter over quarter and hit a high and a low of 154 and $1 170, intra quarter, which has a much wider 37 basis point range.
During the third quarter, we also got significantly more clarity from the fed and as planned for tapering of course, the fed meetings today.
And so we'll be getting an additional updates soon.
The tapering plan that the fed articulated following mid September meeting is very similar in structure to the previous taper in 2013, although this taper is going to happen at a faster pace than the previous one and unlike 2013, it's coming at a time when the mortgage market has been growing rapidly.
I think there are a few ways to think about the upcoming paper on the one hand. The fed is expected to continue to be net buying agency MBS through the summer of 2022 with net buying means is that they are buying agency MBS. In addition to reinvesting paydowns their portfolio of agency MBS will continued growth for the next several more.
Even as tapering ramps up.
Right now it looks like taper is scheduled to end sometime in Q3 2022.
So between now and the end of the paper.
Net by approximately 180 billion more MBS.
The word net is important because the fed will probably by two to three times that amount just reinvesting paydowns, but that reinvestment size is a function of prepayment speeds.
Our portfolio is going to grow by another 180 billion and that's obviously a lot of projected growth on an absolute basis on the other hand, however that projected growth is not so big on a relative basis. For example, the fed's MBS portfolio has grown by approximately 400 billion. So far just this year and Meanwhile, the agency.
<unk> market is still growing at its fastest pace ever.
Home prices are up cash out refi activity is strong and the agency conforming loan limits are back to increase significantly.
In 2021 alone the residential mortgage market is expected to grow by about $860 billion for 2022 estimates are for about $635 billion in net growth. So that still leaves plenty of incoming mortgage supply that will need to find a home in private hands.
The MBS sector had mixed performance in the third quarter prepayments for higher coupons slowed from the elevated levels that we saw during the first half of the year dispute.
This prepayment news was encouraging for higher coupon seasoned vintages and a gradual slowing the speed and as a result price performance of higher coupon MBS was better than production coupons high coupon outperformance has reversed so far into Q4, however, as a flattening of the yield curve has pressured high coupon MBS prices with the shorter.
In the month of October the spread between the two year and the 10 year swap rate narrowed by 26 basis points.
We continue to be cautious on our outlook for higher coupon MBS as we remain concerned about the rise in prominent of large public nonbank mortgage lenders, which bringing increased efficiencies to the mortgage market, which should continue to keep prepayments speeds elevated relative to historical patterns.
Rolls in production coupon TBA as were strong during the third quarter. So these positions effectively generated much more positive carry production coupon roles in both 15 and 30 year remained quite strong today and the fed will continue to buy a lot of production coupon MBS.
Should they stick with their taper schedule.
In addition, as you can see on slide 10, the agency MBS sector continues to look attractive on a relative basis versus other sectors of fixed income QE has been a rising tide has lifted the valuation of almost all fixed income sectors MBS included but despite agency MBS being the direct recipient recipient of fed.
<unk> and <unk>.
<unk> measures they don't look expensive relative to investment grade corporates and MBS investors can get the direct benefit of very high TBA roll levels. The fed buying has created there was no analogous fed benefit in the corporate market.
Ellington residential we are we were actively trading in the third quarter because on a net basis. We only grew the portfolio slightly quarter over quarter, we had a drop in portfolio CPR consistent with the overall decline in MBS prepayment speeds.
We also switched to a monthly dividend in October, which we believe is generally preferred by investors or core earnings continue to cover our dividend, we have ample room to grow our leverage in net mortgage exposure, which could be even more supportive of core earnings going forward.
While we did mentioned on our previous earnings call that we did not expect clarity on paper because the big MBS spread widening we do expect to see pockets of spread volatility and given current current MBS valuations, we prefer to set up our portfolio with lower leverage and higher liquidity, which enables us to be opportunistic should that spread volatility occurred.
Looking forward to the final months of the year fed support is still large and ongoing we continue to expect production coupon TBA roll levels to be strong, but then to diminished gradually over time.
That incremental 25 to 50 basis points of ROE benefit when added to the current yield on production coupon makes them relatively attractive compared to other asset classes, but we see two headwinds.
The first headwind comes from the technology, driven non bank mortgage lenders the brick and mortar operations of traditional banks are being supplanted by call centers email and text message marketing and increasingly online underwriting and loan processing all of which can be much more efficient and effective this.
This is creating heightened prepayment sensitivity as a function of refi incentive as long as the fed is actively buying it is still gobbling up the worst pools via the TBA market.
And so TBA pricing does not need to fully reflect clearing levels for private investors see value that can still be the case, even after tapering is over if as expected. The fed continues to reinvest paydowns, but this dynamic is going to be greatly impacted by the level of mortgage rates.
The most recent Freddie Mac survey mortgage rate was $3 15, we believe that an increase in mortgage rates just to three and a half may materially slowdown refi generated supply on the other hand, if mortgage rates dropped back below 290 refi supply will continue and it may produce an increase in net mortgage supply at a time of Dominion fed support.
Yes.
The second headwind is the shape of the yield curve.
<unk> typically have stronger performance in the steeper yield curve environment.
Ladder curve typically leads to diminished agency MBS demand from CMO issuance and exacerbate negative convexity, so far in the fourth quarter. There has been a big curve flattening, which is weighted most heavily on higher coupons.
So we have kept our net mortgage exposure relatively low and have lots of room to add mortgage exposure should we see spread widening in the last two months of the year.
That would not be uncommon at all market liquidity has gotten worse as many predict.
Participants have diminished risk appetites coming into year end.
Slightly diminished fed support when properly managed can be a great thing for earn this year, we've been in a market dominated by one giant investor the fed whose objective is not motivated by investment returns.
The feds footprint shrinks, however, and return seeking investors gradually become the marginal buyers of agency MBS, we believe potential investment returns will increase.
We don't necessarily expect a large widening event, but we do expect some investment opportunities to emerge at attractive entry points. So far we're off to a good start in Q4 now back to Larry.
Thanks Mark.
As we move into the final weeks of 2021, I think Ellington residential is well positioned to capitalize on pricing with dislocations that fed tapering or even just spear of fed tapering could generate.
We finished the quarter with a debt to equity ratio of six seven times, which is significantly lower than pre COVID-19 periods, such as 2018 in 2019, when our debt to equity ratio averaged around nine times.
With this lower leverage we've also maintained higher liquidity.
So moving forward, we have plenty of room to add assets and be opportunistic should spreads widened and pockets of volatility return.
Our smaller size also enables us to move nimbly in and out of positions and redirect capital Opportunistically as we did in the spring of 2020, when we rotated aggressively into non agency RBS in response to the Covid related market selloff.
Time and time again, we have demonstrated our ability to protect book value through diligent hedging and liquidity management. We've also demonstrated our ability to capitalize quickly on investment opportunities such as by dialing up or down our mortgage exposure based on changing market conditions.
The day finally seems to be coming when the agency MBS market will have to reckon with the impact of fed tapering and we expect our portfolio of specified pools.
TBS and short Tva's to outperform.
The fed's constant buying of current coupon TBA has put steady pressure on pay ups for many specified pool sectors.
Since TBA short positions represent a significant component of our hedging portfolio. We believe that a rise in pay ups will flow right through to our bottom line.
We have positioned this way not because we're making a bet on interest rates or fed policy.
Because we believe that this strategy will outperform in a wide range of possible near and medium term outcomes.
Finally, the prepayment landscape continues to evolve as we see more signs of prepayment burnout and I believe that this is a competitive advantage for Ellington residential as we draw on Ellington's 26, plus years of experience modeling prepayments and trading these markets.
As the fed withdraw support even while mortgage rates remain very low by historical standards. We think that there will be compelling opportunities in the agency MBS sector for those who can successfully navigate the crosscurrents of prepayment risk and extension risk.
And we believe that we are best in class when it comes to agency MBS assets of our asset selection and portfolio construction.
We view Ellington residential as an all weather REIT able to thrive in a diversity of market environments.
And with that we'll now open the call to questions. Operator. Please go ahead.
At this time, if you would like to ask a question press Star one on your Touchtone phone again that is star one on your telephone keypad will take a question from Doug Harter of credit Suisse.
Thank you this is John <unk> on for Doug Harter.
Just going back to your comments on leverage I understand that.
You brought it down a little bit last quarter and from some of your agency peers, we've seen the appetite to take it up a bit this quarter and I wanted to see what viewers was or what you sort of need to see in the market in order for you to bring leverage up this quarter.
Okay.
Yes so.
Look we get big let's say from the fed.
The market has performed reasonably well.
In front of that.
We sort of that was consistent with our expectations, but I guess a quarter ago. If we had said what's more likely underperformance your outperformance right in front of the fed who as I said, we think performance will be steady but out of those two scenarios, probably underperformance is more likely so.
I think youre coming into year end balance sheets are generally.
Reduced you see a pullback in liquidity, you're going to get news today, So I think youre going to get pockets of volatility Youre also going to get.
A big increase in projected mortgage supply when Fannie Freddie loan limits are updated for the really extraordinary HPA. We saw so I think a modest pullback we would increase our leverage.
Got it thank you.
And I guess my second question would be.
Just some color around TBA performance versus spec pools, this quarter than what we've seen as being more attractive so far in the quarter, where youre thinking about spending incremental dollars.
<unk> and <unk>.
So great question, a lot depends on the coupon.
I'd say this quarter, so far you've probably seen a little bit of.
Spec pool weakness relative to TBA.
We've.
When I think about what we've done in the last couple of weeks, it's been adding on both sides. It's been adding some pools in production coupon some pools and higher coupons, but also actively trading TBA. So.
I think our view is at least for the next.
Three months or so sort of the trends in place you saw in the second the third quarter are likely to persist specifically.
Hi.
Hi values for production coupon rolls, which were a real tailwind to performance.
Weakness in higher coupon rolls.
And.
Continued.
<unk>.
Heightened mortgage responsiveness to prepay incentives, we referenced in the call, but I think what's kind of been interesting is that.
Many of the Nonbanks have been growing market share and they are really growing market share at the expense of traditional bricks and mortar banks and so that change in prepayment responsiveness. We think it's something that's going to be with here with us for a while if you have a big selloff in rates and a big chunk of the market doesn't have refinance opportunities than that.
Incent Insensitivities is going to be more latency you won't necessarily see it in prepayment report, but I think that to us is sort of a permanent theres a permanent shift in mortgage responsiveness.
Accrued over the last two years that we think is unlikely to reverse.
Got it thank you so much.
Just a quick last question do we have a book value update.
For today.
We typically don't.
To give a specific estimates.
<unk> quarter, but I can just tell you the quarter is off to a good start for us.
Got it thank you so much sure.
And we will take our next question from Crispin Love with Piper Sandler.
Good morning, and thanks for taking my questions.
First on the on the yield side. So can you speak to what drove the lower yields in the quarter and then just some of your expectations over the near to intermediate term.
Over the next in the fourth quarter and next couple of quarters would you expect that kind of yields to kind of move closer to what we saw in the second quarter or kind of stick around where it kind of a lower that we saw in the third.
Yes, I think.
Hey, Chris It's Larry.
I think.
We saw a drop in yields.
But a lot of that is.
<unk> do.
Due to a couple of different factors so first of all.
Im just portfolio turnover right I think Mark mentioned, our portfolio turnover was was a little higher this quarter.
And we're not afraid we have some maybe higher yielding assets and if we think that they've run their course, where we're not afraid certainly to replace them with assets that we think we have more upside.
Even if they have a slightly.
Lower NIM I mean, our NIM, if you look at our NIM, yes, it dropped.
<unk> over quarter, but it's still really quite high historically.
So.
And we're still comfortably covering our dividend even.
With this low leverage so.
If you think about what Mark said, we are going into year end, we think theres going to be pockets of opportunity and volatility that we're going to be able to increase our leverage back to more.
Whatever historically been more normal levels for us.
You can see that we've got a lot of room.
Two.
To increase core even.
With nims contracting on a.
On a dollar for dollar basis, let's just say so.
So, yes, so I wouldn't I wouldn't be too concerned about.
Just having the overall asset yield drop a bit.
Okay. Thanks.
Yes.
Helpful.
Just one more from me so looking at the interest rate sensitivity slide slide 19 in the deck and it looks like there were some changes in the quarter.
I'm, especially focused on the 50 bps increase in rates side.
<unk> done last quarter's deck. So can you walk through some of the changes in.
What caused the changes relative to last quarter, but is there any anything important to really point out there whether it's changes that.
That you saw in your portfolio or the assumptions that go into the interest rate sensitivity.
Yes, I think if you youre right. It is.
Is a little different than it was in the prior quarter, but I wouldn't read too much into it frankly.
Where it was.
If you look at the overall duration you remember this is all on a leveraged basis.
Still still quite low.
So I wouldn't read like that we had some sort of market call in mind or anything like that.
And I would imagine that if you look at it today or next week or whatever it might have reverted back to the levels where.
Where it was even before in terms of.
Closer to zero duration, so I wouldn't read much into it.
Okay. Thanks for taking my question, Glenn Yes of course.
Yes.
And once again that is star one on your telephone keypad will move next to.
I'll move next.
We'll move next to Macau Guberman of JMP Securities. Your line is open.
Hi, good morning, gentlemen, thanks for taking the questions.
So the agency MBS portfolio has been pretty pretty steady over the last few quarters I'm wondering.
What sort of spread widening would you need to see to to begin to meaningfully add to the to the MBS portfolio.
Assuming we start to see that in the near future.
Hey, it's mark. Thank you for the question. So I would say that it depends it certainly depends on where interest rates are right that you've had this.
In the past year and change.
Really changed the.
Composition of the agency mortgage market and you have created lots and lots of Fannie twos lots and lots of Fannie two and a half.
A lot of borrowers have taken advantage of refinance opportunities. So.
If you bring mortgage rates up to say a three 5%.
Mortgage right now.
Thank you are going to really slow down.
Supply right.
Really going to cutoff supply so in that scenario.
I think sort of spreads where they are maybe five basis points wider wed want to increase our leverage.
If you were to get though a rally and I think we mentioned $2 90 as sort of an important.
Mortgage rate level for <unk>.
Get a rally to there and then youre going to have more borrowers take advantage of refinance opportunities at a time when Fred.
Fed support is diminished then we'd look for a bigger widening.
I think what youre going to see is a shift.
What's interesting is that.
Most of the big non banks are now public company rocket.
Loan depot.
UWS and they've been growing market share and not really at the expense of each other but growing market share at the expense of traditional.
Brick and mortar bank mortgage origination platforms, and so I think what Youll see is if you have an increase in mortgage rates youre going to see a reduction in supply.
But a lot of the focus on refinance is going to be focused on these higher coupons, where there still are borrowers that can really benefit from taking advantage of today's lower mortgage rates. So.
So where we think it makes sense to increase the net mortgage exposure is going to be really.
Two factors what are the spread levels and also what interest rate regime are we in now which is going to inform how much supply we're going to get relative to serve this diminished fed net fine we're going to see.
Yes.
Right so.
The other day.
Even within the quarter, we'll move around our mortgage exposure rates. So what you get on these earnings call earnings presentations or sort of snapshot at the end of the quarter, but sometimes things can be fairly dynamic dynamic within the quarter.
Alright.
Yes.
Ed if I could if I could just point you to slide 20.
Which shows.
This shows you, where we have are well positioned and TBS.
So you can see there.
That we're still as Mark, saying, we're still defensive on higher coupons and for exactly the reasons that.
That Mark said, even in the current environment, obviously, you've got these non banks that are getting more and more efficient in terms of refining higher coupons, but then if rates go up.
Which certainly is a possibility those higher coupons are going to be even more focused on by those companies.
In terms of where they are.
They are concentrating their.
They are marketing and all the other things so.
So thats.
So I think thats something too.
To keep in mind in terms of.
Where where we're focusing.
Alright, I appreciate that and just one more.
As a small part of the portfolio, but what's the sort of strategy on reverse mortgages going forward.
Well reverse mortgages widened actually have widened quite a bit recently so we.
We think that now there are less liquid than other agency MBS.
That we that we trade more actively but they actually provide.
Much more.
Much more yield much more NIM.
Much less negative convexity.
So I think at current levels, we really liked them. So if anything I think we could see an increase there, but it's never going to be.
The.
A huge portion of what we do.
Great and if I could one more.
When you mentioned that there is quite a lot of activity within the quarter.
No.
As analysts don't usually get a lot of insight into.
What goes on in the three months in between quarters, but was there a shift.
And your hedging strategy, perhaps during those days when rates fell.
To the lows.
Well I guess early August.
So I guess my.
Sorry, no I was going to say no that's a good point and.
I talked about the interest rate volatility in the script, but I.
I didn't really connect the dot so what we do is we look at our interest rate exposure every day right.
And mortgages are negatively convex relative to treasury. So when you get a.
Klein and interest rates to mitigate interest rate risk, we have to buy back some of our hedges or add duration to the portfolio and then if interest rates make a U turn and go back to where they started you have to unwind that and the sort of there is a toll in that round trip and that that expect.
The coal is built into mortgage spreads right. So mortgages have this yield advantage versus treasuries because there was this expectation that.
There is some delta hedging costs associated with it now in some quarters. The delta hedging costs are sort of more than whats implied by market levels of volatility in some quarters. They are less so yes that was certainly.
There was a cost that this quarter.
Our strategy, though didn't deviate at all from how it has always been that when you get a material move in interest rates that has had a significant change in portfolio duration you need to take you would take portfolio steps to mitigate that and to bring things sort of back into the guardrails. So.
That was certainly a component this quarter.
But the way we approached it is the way we've always approached it.
Yes.
Great I appreciate the answers thank you.
And this does conclude our question and answer session as well as our conference for today you May now disconnect your lines and everyone have a great day.
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