Ellington Residential Mortgage REIT

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Edmonton Residential Mortgage REIT 2020 Third 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 open for your questions following the presentation. If you would like to ask a question at that time, please press star 1 on your telephone keypad. 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. Please go ahead, sir.

Thank you, and welcome to Ellington Residential's third quarter 2020 earnings conference call. Before we begin, I would like to remind everyone that certain statements made during this conference call may constitute forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical in nature. As described under Item 1A of our annual report on Form 10-K, filed on March 12, 2020, and Part 2, Item 1A 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 Takotsky, our Co-Chief Investment Officer, and Chris Smirnoff, our Chief Financial Officer. As described in our earnings press release, our third quarter earnings conference call presentation is available on our website, earnread.com. Our comments this morning will track the presentation. Please note that any references to figures in this presentation are qualified in their entirety by the end notes at the back of the presentation. With that, I will now turn the call over to Larry.

Thanks, Jay, and good morning, everyone. We appreciate your time and interest in Ellington Residential. During the third quarter, the Federal Reserve continued its accommodative monetary policy, maintaining its target rate for the federal funds rate near zero, and continuing to buy heavy volumes of treasuries and agency RMBS. Turning to slide three, you can see that the Fed's actions had their exact desired effect on the agency RMBS market. Agency RMBS yield spreads have been stable, treasury yields have stayed low, and interest rate volatility has remained muted. In fact, the move index, which measures the implied volatility of interest rates, hit an all-time low at the end of September. As you can see on this slide, Treasury yield and swap rates were uncannily unchanged quarter over quarter. And moreover, they've barely moved at all since March 31st. And you can also see that for the interest rates that most affect private borrowers, such as mortgage rates and LIBOR rates, while there was a slightly lag reaction, these rates have caught up to the decline in Treasury rates, having declined significantly over the past six months. Meanwhile, agency yield spreads have remained stable after bouncing back from their March spikes, despite the continued rise in prepayment speeds, with Fannie Mae 30-year CPRs hitting a nearly eight-year high in September. Turning now to slide four, Ellington Residential had another quarter of strong performance, generating net income of $0.66 per share and growing core earnings to $0.39 per share in the third quarter, which exceeded our $0.28 dividend by a wide margin. Our 28-cent dividend is a dividend that we have maintained in full, by the way, without interruption or cut throughout all of 2020. Similar to prior quarters, our long agency RMBS portfolio continued to be concentrated in prepayment-protected specified pools, and these assets performed extremely well relative to their hedges, which provided a big boost to our results. Additionally, the non-agency RMBS sector continued to recover during the quarter, And so we were able to monetize significant gains on many non-agency RMBS assets that we had opportunistically acquired in the second quarter when prices had been extremely depressed. And keep in mind, it was only because we were able to navigate the March-April distress so well that we were able to play offense and take advantage of that distress in non-agency RMBS. In fact, during the second quarter, we were buying non-agency RMBS at distressed prices when many other mortgage REITs were forced to sell them. In the third quarter, we maintained our long position in current coupon TBAs, and by doing so, we benefited from the strong dollar rolls that were driven by Fed purchasing activity. At certain times in our history, we've been short current coupon TBAs, and at other times, like recently, we've been long current coupon TBAs. Current coupon TBAs are incredibly liquid, and sometimes we view them as a great hedging instrument, and other times we view them as a great investment. This particular sector, where with relative ease, we can go either long or short but are actually quite complex instruments, is yet another reason why the agency RMBS market is such a rich opportunity set for us. Notably, this past quarter, we were able to deliver strong results while maintaining our leverage well below our historical averages. We felt that this was prudent positioning, given the significant macroeconomic uncertainty and given that there was a presidential election looming. Our debt-to-equity ratio as of September 30th was only 6.5 to 1, as compared to our historical debt-to-equity ratios, which have typically been in the eights or nines to one. Finally, I'm pleased to report that our net interest margin widened by 35 basis points to 2.21 percent quarter over quarter, which is the highest our NIM has been in more than five years. Turning to slide five, in the lower part of the table, you can see that the main driver of our NIM expansion was a significant drop in our cost of funds. Another driver of our NIM was our larger non-agency RMBS portfolio with its higher asset yields. Now, I expect our NIM to come down a bit from here for a couple of reasons. First, asset yields are down on agency RMBS generally, and we will feel that impact as we naturally rotate our portfolio and reinvest paydowns. And second, now that we've downsized our non-agency portfolio, a portion of that outsized NIM support is going away. All that said, There's no question that Earn and the entire mortgage sector has benefited from the significant external tailwinds provided by record low borrowing rates and low, low levels of interest rate volatility. However, as we have repeatedly demonstrated over past market cycles, including, of course, the big ups and downs of 2020, our success at Earn does not necessarily depend on the absolute level of interest rates or volatility, on the shape of the yield curve, or on where NIMS happened to be. And that's because of our portfolio management strategy. We trade actively, we shift our capital where we think the best opportunities are, we hedge along the entire yield curve, often using significant TVA short positions. I'll now pass it over to Chris to review our financial results for the third quarter in more detail. Chris?

Thank you, Larry, and good morning, everyone. I'll continue on slide five where you can see a summary of Earns financial results. For the quarter ended September 30th, we reported net income of $8.1 million or $0.66 per share, and core earnings of $4.8 million, or $0.39 per share. These results compare to net income of $21.3 million, or $1.73 per share, and core earnings of $3.2 million, or $0.26 per share for the second quarter. Core earnings exclude the catch-up premium amortization adjustment, which was positive $405,000 in the third quarter compared to negative $3.8 million in the prior quarter. As you can see on slide five, our third quarter results were driven by strong net interest income, strong performance on our specified pools relative to our hedges, and net realized and unrealized gains on our interest rate hedges and other activities, which includes positive P&L from our long TBAs held for investment. During the quarter, we increased our holdings of long TBAs, which we concentrated in current coupon production. These investments performed well, driven by Federal Reserve purchasing activity. You can also see that our net interest margin widened even further this quarter, increasing 35 basis points to 2.21%, driven by significantly lower borrowing costs, which in turn drove the increase in core earnings. Average pay-ups on our specified pools increased to 2.55% as of September 30th, as compared to 2.5% as of June 30th. as actual and projected prepayment rates continue to rise in the low mortgage rate environment. Please turn next to our balance sheet on slide six. During the third quarter, we continue to maintain higher liquidity and lower leverage as compared to prior to periods prior to the onset of the COVID-19 pandemic. On September 30th, we had cash and cash equivalents of $61.2 million, along with other unencumbered assets of approximately $28.1 million. Our debt-to-equity ratio declined modestly quarter-over-quarter to 6.5 to 1 at September 30th from 6.8 to 1 at June 30th, adjusted for unsettled purchases and sales. These amounts compare to cash-in-cash equivalents of $35.4 million and a debt-to-equity ratio of 8.1 to 1 as of December 31st, 2019. Our book value per share was $13.17 at September 30th compared to $12.80 at June 30th and $12.91 at the start of the year, reflecting increases of 2.9% and 2% respectively over the three and nine month periods as our earnings continue to exceed dividends by a healthy margin. Our economic return for the quarter was 5.1%, including the impact of the third quarter dividend of 28 cents per share. Next, please turn to slide seven. which shows a summary of our portfolio holdings. In the third quarter, we monetized gains in our non-agency RMBS portfolio, and as a result, the portfolio declined by 41% quarter over quarter. The size of our agency RMBS portfolio declined slightly over the same period. Next, please turn to slide eight for details on our interest rate hedging portfolio. During the quarter, our interest rate hedging portfolio consisted primarily of interest rate swaps and short positions in PBAs US Treasury securities and futures. Next on slide nine, you can see that our net long exposure to RMBS decreased to 5.6 to one from 5.9 to one, primarily as a result of a slight decline in our overall RMBS portfolio and increase in shareholders' equity. I will now turn the presentation over to Mark.

Thanks, Chris. Earn had a very good quarter. with total return of 5.1%, bringing our economic return over 8% for the year. I view this as a very good outcome given the extreme volatility we had earlier in the year. Our core earnings has easily covered our dividend this year, and as of last night's closing price of $11.13, our stock has had a total return over 13.5% this year. We've also kept our debt-to-equity ratio low, below 7, so we have lots of room to add additional mortgage exposure. Armed with ample cash and low leverage on our balance sheet, we should be well-positioned to play offense if there is any year-end volatility. While the themes that we outlined for the second quarter largely played out again in the third quarter, the macroeconomic backdrop for a levered agency MBS strategy still remains strong today. Most significant is the consistent, large, and predictable agency MBS purchases for the next few quarters that the Fed is telegraphing. The Fed is buying a lot, it's buying every day, and it's telling the market it will continue to buy a lot. In addition to the Fed, other pools of capital, such as banks, are also big buyers of agency MBS. This is significant because while the Fed is buying a lot, supply is absolutely enormous, whether you look at it on a gross or a net basis. so you need significant buyers to absorb it all. Gross supply, which is simply the volume of new agency mortgages originated, is expected to be an unprecedented $3 trillion plus this year. To put this number in context, the gross supply in 2019 was approximately $1.5 trillion. Net supply, which subtracts paydowns from the gross supply number, is expected to be over $400 billion this year. This net supply number is the amount of new capital that has to get invested in the agency MBS market for the supply to clear the market. And that net supply number is also enormous on a historical basis. And in addition to the net supply from origination, the MBS market will also have to be able to absorb the volume of secondary market sales, such as Freddie Mac, who has been mandated to shrink their portfolio. The Fed does a lot of heavy lifting to absorb all this supply, but they can't do all of it. Remember that they came into this round of QE with a giant portfolio that's paying off very fast, recently between 30 and 35 CPR. And the Fed has to reinvest those paydowns just to maintain a constant portfolio. As it turns out, even with this large volume of purchases, the Fed's net buying in recent months has only been roughly equivalent to the net supply. So it would have an orderly market you'll still need to have a steady source of buyers to absorb the supply from the secondary market. The good news is that given all the concerns about credit risk post-COVID, the MBS market has plenty of other buyers. Relative to treasuries, the extra yield on MBS without credit risk is currently attracting a wide range of investors. And given that MBS financing is widely available in huge size and it's almost free, We think that MBS make the most sense in a levered form, which is exactly what a mortgage REIT does. Another tailwind now is that the drag on net interest margin to insulate a portfolio from interest rate risk is close to zero, and in some cases is less than zero. You actually can get paid to be short with just a relatively modest drag on our NIM. We can run a fully duration hedge portfolio, which by itself helps to stabilize book value. Even with their strong Q3 performance, several TBA coupons that we've been long still look attractively priced to us, with or without attractive rolls. When you add the value of special rolls, the levered returns are fantastic. Rolls are benefiting from the perfect storm of front-month Fed buying and back-month mortgage bankers selling. But we also see headwinds, too, that argue against being fully levered. Specifically, prepayments are blazing and mortgage companies are aggressively staffing up We don't see any compelling reasons for a slowdown of the Reef I-Wave outside the normal seasonal effects. We believe that some of the COVID-related workarounds that the GSEs put in place in the spring, such as exterior appraisals and the use of e-notaries, are here to stay and that these innovations only make speeds faster. Of course, we were always working to mitigate many of these risks through our portfolio construction. I'm happy that we were able to keep our CPR down in the portfolio to a very manageable 21.4%. Another risk we think about is sustainability of role levels. Roles are great while they last, but you can't count on them in perpetuity. The only large TBA coupon that underperformed Treasuries this month was 30 Year 3's TBA. After the Fed stopped buying them, the role collapsed, and once the role collapsed, the price collapsed. Reviewing how we were positioned for the quarter, and what worked. We were long TBAs with big positive rolls, which was great, but we also benefited from being short TBAs with negative rolls. So we won both ways. It sounds simple, but it worked well this quarter. Being short negative rolls is the way you get some of your hedging costs down below zero. In addition, as I mentioned, our realized prepayment speeds were well contained. The size of our agency portfolio was roughly constant quarter over quarter. We like mortgage valuations coming into the quarter, but mortgages have done well. They are not as cheap as they once were. We still really like some of the shorter maturity MBS, like 15-year mortgages. The Fed buys them, the rolls are good, and they don't have anywhere near the same extension risk as 30 years, which makes the hedging simpler. Also during the third quarter, as Larry mentioned, we sold many of our non-agencies that we opportunistically bought last quarter. Prices in that sector have gone up a lot since the market meltdown, yields are back down to less interesting levels, and the credit risk may be priced wider depending on the future path of stimulus and economic recovery. So we opted to monetize a good chunk of that portfolio. Heading into the last two months of the year, a big focus of ours will be avoiding prepayment mistakes, but without paying so much for prepayment protection that our assets will be out of favor in a big market sell-off. Well, not only will not only want to stay thoughtful about what the Fed is doing right now, but will also want to anticipate what the Fed is going to do in the future. The worst performing coupon for the quarter by a wide margin was TBA Fannie 3s. As I mentioned earlier, that's because Fannie 3s went from being a coupon that the Fed is buying to a coupon that the Fed was buying. The role collapsed and the price collapsed. And given that we're in the middle of a refi wave, the current market environment presents lots of great opportunities to put our prepayment knowledge to the test. So I'm very optimistic about the return potential. Now, back to Larry.

Thanks, Mark. Ellington Residential's excellent results in the third quarter continued what has been a stellar year for the company. Thanks to our risk and liquidity management, we were able to weather the volatility that hammered the market in the spring, emerging in a strong liquidity position and with our book value intact. That put us in a position to take advantage of some tremendous investment opportunities and participate in the market recovery. Ellington Residential has now generated an annualized economic return of 11.5% through the first nine months of 2020. As Chris mentioned, and as you can see on slide six, our book value coming into the year was $12.91, and it was $13.17 at the end of the third quarter. So we've grown book value this year by over 2% after paying our full 28-cent dividend each and every quarter. Hats off again to Mark Takotsky and our entire investment team for this tremendous performance in a year when many, if not most, other mortgage REITs have really struggled. But this is no time to take a victory lap. We are decidedly in a refinancing wave. Please turn to slide 12. With interest rates near their historical lows, the vast majority of outstanding mortgages are currently refinanceable. And given the lower for longer interest rate messaging from the Federal Reserve, this refinancing wave could persist for quite some time. As Mark mentioned, we will likely see the first $3 trillion a year ever for mortgage originations in 2020. But not surprisingly for a refinancing wave, agency RMBS performance is diverging across the coupon stack and across the various specified pool profiles. While this dynamic presents many challenges for the MBS market, we believe that it plays right to our core strengths of prepayment modeling, asset selection, and dynamic interest rate hedging. As we move into the final weeks of the year, we expect this prepayment-focused environment to create numerous attractive investment opportunities for us, and our current high levels of liquidity and relatively low leverage should enable us to capitalize on these opportunities as they arise. Our smaller size should also continue to be an advantage, allowing us to react quickly as market conditions change, just as we did earlier this year during the stresses of March and April. Before we open the floor to questions, I would like to thank the entire Ellington team for their continued hard work in 2020 through challenging circumstances. And for all of those listening on the call today, we hope that you and your families are staying healthy and safe. With that, we'll now open the call to questions. Operator, please go ahead.

As a reminder, if you would like to ask a question, please press star 1 on your telephone keypad. Again, that is star 1. Your first question comes from the line of Doug Hodder with Credit Suisse.

Thanks. Can you talk about what your, while still relatively small overall, what your outlook would be for the remainder of the non-agency portfolio and kind of how you would think about the portfolio mix going forward.

Sure, Doug. This is Mark. Thank you for the question. You know, even before COVID, we had a small portion of our capital in non-agencies. So during COVID, we grew that because we saw really material price drops at a time when... our research and our data was showing that home prices were going to be well supported for a number of reasons. And so I like having a small amount of the capital in non-agencies. It's a market we know well. We have a great suite of PMs. We have great research tools there. Given current valuations in the non-agency market, and the way earn has always branded itself, where the primary driver of risk and returns comes from levering agency MBS. At these valuation levels, I think we'll probably see the portfolio of non-agencies stay at about the size where they are. Should our expected return on capital in the agency market go up a lot because valuations change, or go down a lot because valuations change, then you could see an impact on the non-agency portfolio as a result of that. But given right now where prices stand, I think the balance of non-agencies will stay roughly consistent relative to our capital.

Great. And then can you talk about what the outlook for the net interest spread is? would be kind of as you get loan repayments come in and kind of how those can be reinvested today versus kind of the spread that you have had in the third quarter?

Sure, Larry, you talked about it.

Yeah, I think, as you know, as mentioned, we had a 39 cent core, but we see that trending downward. You know, we've been consistently maintaining our dividend at 28 cents. We've, you know, viewed our dividend at times our core has been lower than that, but there were other opportunities that we were able to take advantage of and did take advantage of to supplement to get back to the 28 cents now, sort of in the other direction where core is exceeding that. We still view 28 cents as a good long-term rate and You know, so I think that we see it trending down, you know, probably to something in that neighborhood. But, you know, we like the number. We like the 28-cent number. And we think that we'll either, you know, core will either trend to slightly higher than that or slightly lower than that. If it trends slightly lower, then that probably will be because there are other opportunities going on in the sector that we, again, where we can continue to supplement and earn the dividend So I think sort of heading towards our dividend rate is a good marker to think about. Great. Thank you, guys.

As a reminder, to ask a question, please press star 1 on your telephone keypad. Your next question is from the line of Mikael Goberman with JMP Securities.

Thanks. Good morning. Could you guys perhaps give an update on where you're seeing prepaid trends thus far in the fourth quarter?

Sure. Yeah, we get another prepaid report in the next day or so. So the one we had last month, pretty much in line with expectations. It wasn't a big change from where prepayments have been. I guess there are two things we're watching closely. One is looking for burnout, right? The extent to which pools that have paid very fast in the last six months or sort of cohorts that have paid very fast in the last six months are starting to exhaust themselves because sort of the borrowers that are most incented and most focused on refinancing have prepaid and the remaining borrowers are less focused on it. So we're looking for evidence of that. We haven't seen it yet, and you'll mention in the prepared remarks, we are aware and we think a lot about the hiring trends mortgage originators have had, so they are adding capacity. So we're not expecting or looking for a lot of burnout. The other thing is that it matters a lot on the path of rates, and so one thing that's happened in the last week or so, or two weeks, is that now the Federal Reserve is buying 30-year mortgages with a 1.5 coupon, right? So that is something different. And when the Fed starts doing that, it adds liquidity to that coupon. So now you're going to start seeing, for the best borrowers, sort of a 2.5% note rate that's offered. So some of the coupons that looked like low coupons earlier in the year, say Fannie 2.5, you're starting to see some pretty fast prepayment speeds there. So the report coming up this week, our expectations, things slow down slightly, but we don't expect any kind of near-term relief in this prepayment wave right now. But that said, there are lots of relative value opportunities, and the market pricing right now for higher coupons is... incorporating expectations at very fast prepayment speeds. So if you have a coupon that's priced at 40 or 50 CPR on the roll, if you find something that prepays at 30 CPR, that's a big advantage versus hedging with TBAs priced at that much faster roll.

I got you. Thank you for that, Mark. And also kind of a maybe a bit of a macro fed related question. And you may have touched a little bit on this earlier, Mark, but assuming this scenario plays out that, um, we're going to have political gridlock and, um, for a while and, uh, the chances of a stimulus, a massive stimulus bill are going to be, um, in the short to near term, at least a little bit lower. Um, what are your thoughts on what the fed, if the fed is going to feel more pressure to do more and, um, If that is the case, how will that affect the mortgage market going into next year?

Sure. I mean, I can give you my personal opinion. And really, I would say that since the start of COVID, we have directed some of our research resources into virus tracking and quantifying the impact of things like the CARES Act on consumers' ability to pay their debt. And so we have more of a research effort focused on those issues because they're so front and center now since the virus. But given that the election is still uncertain, we haven't really formalized views on what the different administrations mean for FHA reform or things like that. if you have a Biden presidency but the Republicans maintain control of the Senate, yeah, I do think that argues for less stimulus than what you would have gotten if the Democrats had flipped the Senate. So we think about that, and we certainly take it into account when we think about credit exposure. On the agency side, that's less stimulus. of a factor for us. It probably, you know, it might unfortunately mean that some of the, you know, more of the borrowers that are going to be coming off forbearance might have a harder time getting off their forbearance plans. You know, for us, we look at a lot of conditional outcomes to kind of like game plan, you know, four or five different possible scenarios and have views of that and sort of have, you know, ideas on portfolio construction. should those things play out. We generally don't take big positions or set up the portfolio in expectation that we can predict some of these macro events. So that's the approach we've taken with COVID. I guess the only thing we've, not with COVID, but with the election, I guess our view was that there was the potential for volatility. We didn't know if it was necessarily gonna happen. But there was certainly that potential. So I think to inflate and protect the portfolio, it made sense for us to keep our debt to equity ratios relatively low, given valuations right before the elections. That's something we did. Let me have more clarity. We'll certainly revisit that. But we're not going to take big directional exposures based on our expectation of what will happen. This issue of stimulus that you asked about is a great question, and it's something that we've spent a lot of resources on, teasing out what sort of the hypotheticals, how would borrower pay strings be impacted if stimulus was greater, if stimulus was less? And we certainly did notice in some of the remittance reports on the non-agency side The impact when the $600 a week, you know, unemployment benefits on top of the state minimum changed. So it's measurable. We see it. And there's been a lot of great alternative data sources that we've tapped into that allow us to track that.

Great. Thank you very much, gentlemen, and hope everybody continues to be safe and healthy.

You too. Thank you.

Thanks.

This does conclude today's Q&A portion of today's call. We thank you for joining and ask that you please disconnect your lines.