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spk00: We appreciate your patience and ask that you please continue to stand by. We are still checking in participants for today's program, and your program will begin in approximately one minute. Thank you. © transcript Emily Beynon Please stand by, your program is about to begin. 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, and the floor will be open for questions following the presentation. If you would like to ask a question at any time, please press the star and one 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. Sir, you may begin.
spk03: Thank you, and welcome to Ellington Residential's 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. Forward-looking statements are not historical in nature. As described under item 1A 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 Ducati, our Co-Chief Investment Officer, and Chris Smirnoff, our Chief Financial Officer. As described in our earnings press release, our second quarter earnings conference call presentation is available on our website, EarnReach.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.
spk01: Thanks, Jay, and good morning, everyone. We appreciate your time and interest in Ellington Residential. Please turn to slide four. Ellington Residential's core earnings increased a robust 19% sequentially to 37 cents 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 30 cents 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 three. 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 rates declined, and MBS investors' hope for prepayment burnout fell far short. Meanwhile, sentiment began to shift 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 RMBS significantly underperformed comparable interest rate swaps and U.S. Treasury hedges on a total return basis. As a result, from a book value perspective, the second quarter was a challenging one for leveraged, hedged agency RMBS portfolios such as ours. During the second quarter, we again saw a meaningful divergence of performance across the various subsectors of agency RMBS. In contrast to the first quarter, it was higher coupons that fared the worst during the second quarter, while lower coupons held up relatively well. For example, prices on Fannie 4.5 declined by more than a point, which represented a substantial widening during the quarter, or prices on Fannie 2.5 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 RMVS yield spread widening, combined to generate an overall gap net loss for the quarter. That said, we were actually relatively well positioned for the divergence of performance across agency RMBS subsectors. In recent quarters, we have been shifting more and more of our specified pool portfolio out of higher coupons and into lower coupons. And we had accelerated this trend in the first quarter of this year, having added more lower coupon pools after yield spreads on lower coupons widened dramatically. And at TBAs, we've recently been concentrating our long TBA holdings in lower coupons, which the Fed has been buying, while maintaining short TBA positions and 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 in U.S. Treasuries. Meanwhile, on the liability side of our balance sheet, our repo lenders have been offering aggressive financing terms for longer-dated repos. and we continue to take advantage of that in the second quarter. In fact, since year end, we have 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%. You can see our latest repo details on slide 18. Finally, in our first common share issuance in over four years, we completed a follow-on offering in June. The offering was split between primary shares and secondary shares, with Earn's co-founding shareholder, Blackstone, selling 2,675,000 secondary shares, and with the company selling 575,000 primary shares. Back on April 26, Blackstone, which had owned around 27% of our outstanding shares, 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 shares sooner rather than later. The offering increased the public float for earned stock by a full 38%, which should provide a lasting boost in liquidity for all earned shareholders. I will now pass it over to Chris to review our financial results for the second quarter in more detail. Chris?
spk05: Thank you, Larry, and good morning, everyone. Please turn to slide five, 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, or negative $0.36 per share, and core earnings of $4.6 million, or $0.37 per share. These results compared to net income of $127,000, or a penny per share, and core earnings of $3.8 million, or $0.31 per share for the first quarter. Core earnings exclude the catch-up premium amortization adjustment, which was $2.6 million in the second quarter compared to $70,000 in the prior quarter. The net loss for the second quarter was due to net losses on specified pools, interest-only securities, interest rate swaps, U.S. Treasuries, and futures, which exceeded net interest income and net gains on TBA positions. During the quarter, the yield curve flattened with long-term interest rates decreasing and short-term interest rates increasing modestly. Yield spreads on most agency RMBS widened amidst concerns that 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 RMBS impacted most significantly. During the quarter, we continue 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 five that our net interest margin increased quarter-over-quarter to 2.04 percent from 1.96 percent, driven by slightly higher average asset yields and incrementally lower cost of funds. Average pay-ups on our specified pools decreased to 1.55% from 1.61%, primarily because new purchases during the quarter were mainly of lower pay-up pools. Please turn next to our balance sheet on slide six. Book value per share was $12.53 at June 30th compared to $13.22 at March 31st, which includes the effect of the $0.30 per share second quarter dividend. Given the drop in 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 30th as compared to 7 to 1 as of March 31st. 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 seven, which shows a summary of our portfolio holdings. In the second quarter, agency RMBS holdings increased by approximately 1% to $1.19 billion as of June 30th, and our non-agency RMBS holdings decreased by 10% to $9.3 million. Please turn now to slide eight for details on our interest rate hedging portfolio. Our interest rate hedging portfolio continued to consist of interest rate swaps short positions in TBAs, U.S. Treasury securities, and futures. During both quarters, we were long some TBAs and short others. And even though we were net short TBAs on a notional basis, we were actually net long TBAs as measured by 10-year equivalents. So you don't see that slice in the pie chart. On slide 9, you can see that our net long exposure to RMBS was 6.7 to 1 as of June 30th. up from 6.2 to 1 as of March 31st, primarily due to a smaller net short TVA position quarter-over-quarter. Finally, as Larry mentioned, we completed a public follow-on offering of 3,250,000 common shares, of which 2,675,000 shares were sold by Blackstone and 575,000 shares by Earn. The offering generated net proceeds to us of $7.1 million, after underwriters discounts and commissions and offering costs. I will now turn the presentation over to Mark. Thanks.
spk07: 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. For the year, delta hedging costs have increased with greater interest rate volatility, and there has been a further headwind to earnings. The challenges of the second quarter did not present a core earnings issue for us. In fact, our core earnings increased, and we raised our dividend. But rather, our portfolio felt the impact through mark-to-market losses. Further, we don't see any Q2 agency underperformance as 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 a 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, market consensus was overwhelmingly for continued higher interest rates driven by higher inflation reports. So at the end of Q1, the market was shrugging off what faster prepayment speeds and a steeper S-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 have talked on previous calls about how consistent bank buying has been a strong source of support for agency MBS. Not surprisingly, that support waned a little bit this quarter and was negative technical for the sector. Fed messaging on tapering has been consistent, and their words have been chosen very carefully so as not to ruffle the market's feathers. You know, tapering 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, their activities are still very supportive of MBS prices. People forget that during the taper tantrum of 2013, after an 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 a 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 is 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 2020. Agency MBS will now be treated similarly to treasuries by the Fed. Prior to QE, and that's going back to 2008, agency MBS were not treated like treasuries by the Fed, meaning they were not part of the Fed's balance sheet and were not part of lending facilities. Now they are. This 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 have gone overlooked was the leadership change at FHFA. Mark Calabria was replaced by the Biden administration with Sondra Thompson. The message is loud and clear. This administration has no intention of privatizing the GSEs. How these leadership changes manifest themselves as policy changes is 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 GSEs. While it's disappointing to have a quarter of negative economic return, it's easy to see why we and other agency-focused mortgage REITs 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 a portion of the MBS spread widening. When you have a negative economic return because assets underperform hedging instruments, that generally means going forward returns look more attractive because assets have repriced with now higher yields relative to hedges. 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, so 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 ROEs to reinvest those proceeds and paydowns. We are clearly in a different environment today than at the start of the year. The Fed is not on autopilot, and we should get details on QE tapering before year end. 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 an evolving prepayment landscape has created some better relative value trading opportunities. Now, back to Larry.
spk01: Thanks, Mark. I'm pleased to have increased our core earnings and dividend during what has been a challenging year for agency RMBS so far. We have not sat still or 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 in 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 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 Fed's 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, will rely on our dynamic hedging strategy to help protect book value. And with that, we'll now open the call to questions. Operator?
spk00: And once again, if you would like to ask a question, please press the star and 1 on your touch-tone phone. You may remove yourself from the queue at any time by pressing the bound key. And we will take our first question from Doug Carter with Credit Suisse. Your line is now open.
spk06: Hi, this is John on for Doug. The first thing I'd like to kind of get some color on is, would you guys be able to talk about your thoughts and expectations going forward for MBS spreads and how much of the Fed taper is currently priced in?
spk07: Sure. This is Mark. You know, I think what's priced in is the expectation that Fed tapering will be gradual and that you have a Fed that will – respond to market dislocations. There's been a lot of comments from Fed governors. Harker, in particular, was on the tape in June saying that the Fed needs to avoid causing a taper tantrum. So, you know, I think I expect we're going to get clarity on that, you know, Q4 this year. You know, they're buying a lot right now. I think market valuation can certainly accommodate them buying less. And so our expectation that you have a Fed that is going to go gradually and a Fed that is very cognizant of what happened to MBS for a brief period of time in the spring of 2013, where the market didn't understand what they meant by tapering. 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. I think they'll go gradually. And the other thing is that the stock effect, so the effect of how much of the mortgage market the Fed currently holds that it's bought from private investors is a significant stabilizing force for spreads.
spk06: 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 or what you would need to see from those perspectives to sort of take it up in a meaningful way? I know on the last call you talked about trying to stay between seven and nine times, I think a max of 10. So kind of where you're looking at in terms of the near future, where you're looking at to go in the next few quarters.
spk07: Yeah, I would say given current valuations, for some of our holdings is certainly dependent on role levels. Given current valuations and given the fact that there is still uncertainty around the tapering schedule, I don't think this is a time where at current levels we would significantly increase leverage. I think the time for that would be if and when you had more clarity on tapering and And you saw wider mortgage spreads relative to where they are. So I think, you know, we're in a definitely a different environment than what we were six months ago, where now we have a market that it's going to hang on what the Fed says, because They're going to give us some new information, and that wasn't the case six months ago. Six months ago, it was just they were going to keep rates low, and they weren't, as they said, even talking about tapering. This is different now. So in front of that, I like the leverage we have now, as you saw from this quarter. We can drive significant core earnings. And we have the ability to, you know, add leverage if we want to or reduce leverage if we think valuations get to the point where there will be better entry points.
spk06: Great. Makes sense. Thank you so much for your time. Sure. Thank you for the questions.
spk00: And we will take our next question from Eric Hayden with BTIG. Your line is now open.
spk04: Hey, thanks. Good morning. Hope you guys are well. Wanted to get your perspective on what you think the carry 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? I mean, on the one hand, there's likely this demand for prepayment protection for all the obvious reasons. But on the other, like you noted, there's this potential for spread widening related to Fed policy. So just hoping you can kind of frame what's embedded in the market right now.
spk07: Hey, Eric. It's Mark. You know, you did get this cheapening up of MBS in the quarter, right? And that's sort of, you know, reflected in the fact that, you know, generally speaking, agency-focused rates had negative economic returns. So you did get this cheapening up. I think right now net interest margins look pretty good. And, you know, 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 instruments, interest rate shops, interest rate swaps, or short treasuries. I'm more focused on that than making big predictions about how the taper is going to occur, and if we're able to find, you know, we brought leverage up a little bit this quarter, we're able to find pools on those metrics we think can generate, you know, 8% to 10% levered ROEs.
spk04: Okay, got it. And what's the long-term prepayment assumption underlying your core earnings number? And then just a separate kind of modeling question, if you will. 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.
spk07: 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, you know, 15-year one-and-a-half coupons might have a note rate of 2%, all the way up to, you know, Fannie Fives might have a note rate close to 6%. And then even within that, you have tremendous range in loan attributes, right? Balances of $40,000, $50,000 in some cases, balances of $400,000, $500,000 in other cases. So it's really pool-by-pool specific, and it's versus the forward curve. You know, we've spoken on this call recently, a few times about technology and steepening S-curves, and you're seeing that play itself out. So, you know, I think if you look at the core earnings we have now, I think those are sort of reflective of, you know, our best thoughts right now on current prepayment expectations.
spk01: Yeah, just let me – Larry, Eric, let me just add. So maybe burnout hasn't been as pronounced as many people thought, but – certainly, and rates have dropped somewhat. Wouldn't expect that prepayments at this point are probably going to be too much of a problem for our core earnings. In fact, you've seen our core earnings widen in the last couple quarters as a result of our portfolio is still yielding nicely, our cost of funds have, you know, come down or, you know, or stayed the same and be able to, you know, lengthen the, you know, lengthen the term of it. So I think that probably, so first of all, we have room, you know, at 37 cents versus the 30 cent dividend. We do have room for, you know, definitely a good amount of core earnings compression versus where our dividend is. And, you You know, if anything, I just think that with now, you know, as relatively recent occurrence, now rates have dropped even since quarter end. Right. So and, you know, we'd like to turn over the portfolio. So as we turn over the portfolio, it's only natural that we'll be reinvesting with, you know, at some lower yields. Financing costs really don't have a lot of room to come down from here. Let's hope rates don't go negative. And. So I think, you know, when you put that all together, I think, you know, probably, if anything, have a little bit of downward pressure on core earnings, but, you know, not so much that we see any, you know, certainly near-term impact on the dividend.
spk04: Okay. Yeah, I mean, it would be nice to see what your expectation is, you know, each quarter. But how about on the expense side? Is there any wiggle room? Sure, Eric. Did you also give your book value through July? Sorry, I'm talking over. Go ahead.
spk05: Yeah, sure. No problem, Eric. Yeah, so our expense ratio, you know, given our size, is, you know, around 3.5%, maybe slightly north of that. And we expect, you know, again, given our size, that that's, you know, a good proxy for our run rate now.
spk04: Okay. Yeah, we're not – Did you go and give an update?
spk01: Okay. Well, we're not going to give – we don't, you know, give updates on books. I certainly, you know, mid-quarter usually. But, Mark, you want to just comment on kind of where, you know, what's happened to spreads, you know, et cetera, sort of since quarter end?
spk07: Yeah, you've had cross-currents, right? You've had very strong role levels that probably strengthened a little bit that's benefited some TBAs. You've had some TBAs struggle with keeping pace with hedging instruments, but you've also seen pool pay-ups reprice higher. So, you know, I would say there's been a lot of cross-currents is really how I would characterize it. Okay. Thank you. Thanks.
spk00: And we'll take our final question from Mikkel Gooberman with JP. JMP Securities, your line is now open.
spk02: 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 extra bit of liquidity that it's added to the float and kind of what your thoughts are for the company going forward with regard to that. Thank you.
spk01: With regard to sort of share offerings?
spk02: Not just share offerings, but just what the added liquidity does for the company going forward and your thoughts on the exit of Blackstone in general. Not the exit, but they're lowering the position by a great amount.
spk01: Oh, yeah. Yeah. I mean, I think, as I said, I think we concluded that this was really the best thing for the company to address that overhang, which I think we've done. And, you know, I think it's been pretty soon since the offering, but you're seeing, I think, higher liquidity already. And that's something that I think, you know, the float, that's going to be a permanent, I think, you know, short of share repurchase, things like that should be a permanent increase in the float. And it's obviously, look, it was a big percentage, right? 38% increase in float is a large increase. And our stock prices 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 overhanging. 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 dividend yield, the trend in our core earnings, all that stuff. And I'm certainly hopeful that that the stock will sooner rather than later be able to recover. And, yeah, I don't think there's really more I can say than that.
spk02: All right. Well, thank you for that.
spk00: And this does conclude today's program. Thank you for your participation. You may disconnect at any time. And have a wonderful day.
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