Ellington Residential Mortgage REIT (NYSE:EARN) Q2 2023 Earnings Call Transcript

Ellington Residential Mortgage REIT (NYSE:EARN) Q2 2023 Earnings Call Transcript August 13, 2023

Operator: Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2023 Second Quarter Financial Results Conference Call. Today’s call is being recorded. [Operator Instructions] It is now my pleasure to turn the floor over to Alaael-Deen Shilleh, Associate General Counsel. Sir, you may begin.

Alaael-Deen Shilleh: Thank you. 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 and 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. We strongly encourage you to review this information — review information that we have filed with the SEC, including the earnings release, the Form 10-K and the Form 10-Q for more information regarding these forward-looking statements and any risks related risks and uncertainties.

Unless otherwise noted, 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 Tecotzky, our Co-Chief Investment Officer; and Chris Smernoff, our Chief Financial Officer. As described in our earnings press release, our first — our second quarter earnings conference call presentation is available on our website earnreit.com. Our comments this morning will track to the presentation. Please note that any references to figures in this presentation are qualified in their entirety by the notes in the back of the presentation.

With that, please turn to Slide 4 of the presentation, I will now turn the call over to Larry.

Larry Penn: Thanks, Alaael-Deen, and good morning, everyone. We appreciate your time and interest in Ellington Residential. Following the first quarter turmoil in the regional banking system, the second quarter began with investors bracing for the impact of FDIC directed sales of MBS. The Federal Reserve was no longer buying MBS and demand even from healthy banks seemed unlikely. As a result, early April saw Agency MBS yield spreads widening even further. However, when the FDIC directed sales finally got started later in April, the wider yield spreads attracted strong investor interest for money managers and the sales ended up being well absorbed by the market. With support levels established, the month of May saw even stronger demand for MBS, even while interest rate volatility remained elevated.

While this rally was temporarily interrupted by the debt ceiling dispute, once that was resolved, volatility declined and MBS yield spreads tightened further all the way into quarter end. Accordingly, we experienced moderate portfolio losses in April, but these were reversed in May and June. On balance, Ellington Residential generated net income of $0.09 per share and adjusted distributable earnings of $0.17 per share for the second quarter. Over the course of the quarter, we maintained a relatively stable overall portfolio composition in size. We continue to hold mostly discount specified pools, and we continue to believe in the value of our portfolio going forward. In recent quarters, we have highlighted how our research and asset selection efforts have focused on finding pools with the lowest payoffs that will get the fastest prepayments.

Indeed, as you can see on Slide 4, prepayment rates on our portfolio increased nicely quarter-over-quarter from 4.3 CPR to 7.4 CPR. If you now flip to Slide 8, you can see that we continue to be underweighted, low coupon MBS in the second quarter. Keep in mind that over half of the universe of conventional MBS pools have pass-through rates of 2.5% or less. This low coupon cohort comprised a big portion of the holdings of the failed regional banks. And so not surprisingly, this cohort severely underperformed in the first quarter due to the anticipation of FDIC asset sales. Since we’ve been underweighted in this cohort, our results benefited in the first quarter from that position. As I mentioned, the FDIC asset sales ended up being well absorbed by the market, which caused this cohort to outperform in the second quarter.

So EARN did not benefit from that outperformance in the second quarter. Nevertheless, we continue to strongly favor the middle of the coupon stack. Avoiding high coupons shields us from some of the technical pressures of new production, especially with the Fed no longer a buyer. This also reduces our negative convexity and this reduces our delta hedging costs in what have recently been very volatile periods. And with rates this low, we don’t think the extra call protection compensates you enough for the lower yield spreads in the low coupons. By contrast, we continue to see both meaningfully higher yield spreads and better technicals in the middle of the coupon stack, namely MBS with pass-through rates between 3% and 5%. Elsewhere, our non-Agency and IO portfolios again contributed nicely to our quarterly results, driven by net gains and strong net interest income.

Although the total size of our overall non-Agency portfolio was roughly unchanged quarter-over-quarter, we did rotate some capital into credit risk transfer assets at some very wide spreads before the spread tightening in that sector in June and July. The loans back in the 2019 and 2020 CRT issues that we bought recently had both significant home price appreciation and fast prepayment speeds until mid-last year, both of which have helped to substantially derisk these bonds. Additionally, these borrowers have locked in 30 years of very low fixed rate payments and now rate change are driving their debt-to-income ratios even lower. Combined this with the bond tendering programs this year by Fannie and Freddie, and you have a combination of great fundamentals and great technicals driving strong total returns.

This is a good example of how the breadth of Ellington’s platform, combined with the flexibility of EARN’s mandate helps drive EARN’s total return. Moving to the liability side of the balance sheet, both our debt-to-equity and net mortgage assets to equity ratios were roughly unchanged quarter-over-quarter. I will note, however, that the second metric, which reflects our net mortgage exposure, did fluctuate a lot intraquarter. With markets choppy and spreads wider in May, we covered the majority of our net TBA short position. And then with the market rally in June, we put most of that net short TBA position back on. Similar to last quarter, we ended the second quarter still well below the high end of where we’re comfortable adding leverage or net mortgage exposure.

Finally, we continue to turn over our lower-yielding MBS with the aim to improve our net interest margin and adjusted distributable earnings. I’ll now pass it over to Chris to review our financial results for the second quarter in more detail. Chris?

Chris Smernoff: Thank you, Larry, and good morning, everyone. Please turn back to Slide 5 for a summary of Ellington Residential’s second quarter financial results. For the quarter ended June 30, we reported net income of $0.09 per share and adjusted distributable earnings of $0.17 per share. These results compare to net income of $0.17 per share and ADE of $0.21 per share in the first quarter. ADE excludes the catch-up premium amortization adjustment, which was negative $376,000 in the second quarter as compared to a negative $299,000 in the prior quarter. As Larry mentioned, positive results in May and June exceeded net losses in April and Ellington Residential finished with positive net income overall for the second quarter as net gains on our interest rate hedges exceeded net losses on our Agency RMBS and negative net interest income, which was the result of sharply higher financing costs.

Our asset yields also increased during the quarter, but by a lesser amount than our borrowing rates. As a result, our net interest margin decreased to 0.93% from 1.16%. Additionally, we continue to benefit from positive carry on our interest rate swap hedges where we receive an overall higher floating rate and pay a lower fixed rate. Our lower NIM, combined with slightly lower average holdings on our Agency RMBS portfolio, drove the sequential decrease in ADE. Meanwhile, pay-ups on our specified pools decreased to 0.98% at June 30 from 1.09% at March 31 for two reasons. First, average sales on our existing specified pools decreased quarter-over-quarter with higher interest rates; and second, the pools that we sold during the quarter had higher payoffs than the health population.

Please turn now to our balance sheet on Slide 6. Book value per share was $8.12 at June 30 as compared to $8.31 at March 31. Including the $0.24 per share in dividends in the quarter, our economic return was 60 basis points. We ended the quarter with cash and cash equivalents of $43.7 million which was up from $36.7 million at March 31. Next, please turn to Slide 7 for a summary of our portfolio holdings. Our Agency RMBS holdings were essentially unchanged at $889 million at June 30th as net purchases were roughly offset by principal paydowns and net losses. Similarly, our aggregate holdings of non-Agency RMBS and interest-only securities decreased only slightly over the same period. Our Agency RMBS portfolio turnover was 19% for the quarter.

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Our leverage ratios were roughly unchanged quarter-over-quarter. Our debt-to-equity ratio adjusted for unsettled purchases and sales was 7.6x as of June 30 as compared to 7.5x as of March 31, while our net mortgage assets to equity ratio was 7x as compared to 6.9x as of March 31. Finally, on Slide 9, you can see the details of our interest rate hedging portfolio. During the quarter, we continued to hedge interest rate risk through the use of interest rate swaps and short positions in TBAs, U.S. Treasury securities and futures. We again ended the quarter with a net short TBA position. I will now turn the presentation over to Mark.

Mark Tecotzky: Thank you, Chris. After a strong first quarter, EARN had a modest positive return for the second quarter and yet another period of significant volatility. And that volatility was across the board, not just in yields. Yields were on a rollercoaster ride during the quarter, with the high and low points for the two-year note, a jaw dropping 112 basis points apart. In addition, the slope of the yield curve oscillated drastically during the quarter with the spread between two-year and 10-year treasury trading in a 68 basis point range. Market expectation is strong between fear that the wave of bank failures would force the Fed to be more accommodative and fears that inflation would be resistant to higher interest rates.

Ultimately, by the end of June, inflation fears had worn out. The curve reinverted to levels seen just prior to the collapse of Silicon Valley Bank and interest rates rose, most dramatically for five-year notes and shorter maturities. How MBS performed in the quarter depends a lot on what coupons you’re talking about. Now with 90% of the FDIC MBS pool selling behind us, the MBS sector has weathered the supply wave and fared better than many had feared, and the supply was absorbed in a much shorter timeframe than originally anticipated. When demand materialized for $1 billion block of season discount MBS, the FDIC accelerated their pace of sales. The process is now largely over, well ahead of early expectations. Money managers showed up in size for the opportunity to get invested in coupons and loan attributes that have been difficult to source.

As a result, low coupon MBS performed quite well for the quarter after that early April spoon. For intermediate coupons between 3% and 5%, performance was not nearly as strong, relatively little of this intermediate coupon cohort was included in the FDIC sales. Concerns of a deeper yield curve inversion combined with less investor focus caused performance of the intermediate coupons to trail that of 2.5% and below. On balance, EARN had a modest net gain for the quarter, constrained primarily by limited exposure to low coupons as well as delta hedging costs related to the elevated volatility. We did not make any major changes to our positioning and think we are well positioned for the current market opportunities and risks. We believe that the current environment is very favorable for Agency MBS.

Market expectations are that the Fed hiking cycle is largely behind us. We’ve gotten encouraging inflation data for a few months in a row now. Fears of an ongoing deluge of Agency MBS supply from waves of bank failures did not materialize, and we’ve now just passed the peak seasonal supply months of mortgage origination. Money managers have been big buyers of MBS this year and are no longer underweight MBS, but we think that some bank buying may materialize before year-end, given new capital requirements, which would be a further tailwind to the sector. For EARN, as you can see on Slide 15, we did raise our weighted average coupon slightly in the quarter by about 15 basis points incrementally to nearly 4%, which is still well below new production.

That positioning should shield us from the current coupon production with giant average loan sizes and lots of negative convexity, but still provide us with a hefty yield and potential for strong price appreciation if the forward curve is right and we have a recession. Repo rates have stopped marching higher so as we turn over our portfolio and increase our asset yields that should support our NIM in ADE. In addition, our lower dollar price holdings continued to deliver consistent paydowns well above TBA expectations. Ellington has had ongoing data studies to analyze out-of-the-money prepayments as a function of loan attributes. There is currently a 22-point price range for liquid mortgage coupons spanning 2 through 6 NAVs and also a myriad of different issue years and loan attributes as well.

So there is a really rich opportunity set now to take advantage of that research. Mortgages remain at widespreads, the market has just absorbed almost all of the FDIC supply and peak summer origination volumes are now passed. So far, in the third quarter, realized volatility has remained high although the full trading range has been noticeably tighter than what we saw in the second quarter. At the same time, Agency MBS have substantially underperformed investment-grade corporates and high-yield bonds so we think they had ample room to catch up. And in the widely discussed scenario where we get a mild recession, we think Agency MBS will offer very good relative value versus corporates. Now back to Larry.

Larry Penn: Thanks, Mark. In what continues to be a highly volatile market, I am pleased with Ellington Residential’s ability to preserve value — preserve book value over the first half of the year and generate $0.26 in earnings per share. Looking ahead, our outlook for Agency MBS is positive as both nominal yield spreads and option-adjusted spreads are still wide. Realized volatility has declined and higher interest rates are helping to bring inflation down. The Fed may be nearing the end of its tightening cycle and FDIC sales have been well digested by the market with around 90% of pool positions and 60% of CMO positions already reported as having been liquidated. Longer term, the return of bank demand for MBS should help stabilize spreads as well.

As we look forward to the second half of the year, we have maintained excess liquidity and additional borrowing capacity to capitalize on attractive investment opportunities as they arise and to manage volatility if it spikes again. We will continue to be opportunistic about adding leverage, allocating capital between agency and credit and rotating the portfolio to drive NIM and ADE. As always, we will also rely on our dynamic hedging strategy and active management to protect book value. With that, we’ll now open the call to questions. Operator, please go ahead.

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Q&A Session

Operator: [Operator Instructions] And our first question comes from Doug Harter with Credit Suisse.

Doug Harter: Thanks. Hoping you could talk a little bit more about the potential to add more mortgage leverage, and what would kind of be the catalyst that would cause you to increase that leverage.

Larry Penn: Hey, Doug, thanks for the question. So, to me, I think the catalyst will be some kind of reduction in interest rate volatility, and you’ve seen it a little bit, right? So, yesterday was volatile, last Friday was volatile. We’re not making as big a range. I mentioned this in my prepared remarks, like the difference in the highs and the lows in this quarter is a lot less than what it was in the second quarter, the second quarter was pretty extraordinary. But you’re still seeing a lot of elevated volatility. So I think reduction of volatility is important because the delta hedging costs when things really move around can be significant. So that’s one thing. I think the other thing is to see other pools of capital come in and start supporting the mortgage market.

So what you saw in the second quarter is money managers that had a lot of them have been sort of underweight mortgages relative to Bloomberg Agg or Barclays Agg allocation mix, bought a lot from the FDIC, and they covered their underweights, right? But you haven’t seen bank participation yet, I mentioned again in the prepared remarks, we think that’s something that you could materialize in Q4. But I think that’s important that you need to see other large pools of capital. I mean a lot of people recognize mortgage spreads are wide, but what you need to see is actually demand. And so you saw the money manager demand in Q2 that absorbed sort of simplicity, but like that absorbed to a large extent the selling from the FDIC portfolios, but you need to see other pools of capital who want to get invested in mortgages because you may see money managers sort of not nearly as aggressive in mortgage additions going forward, given that they’re not nearly — that do not underweight the sector as the way they had been.

Doug Harter: Got it. And how do you think about the demand by coupon depending on kind of where that — those other pools of capital come from? How do you think about which coupons are most likely to be interested in?

Mark Tecotzky: So it’s an interesting question, right, because I think historically, bank buying was typically around current coupon. I think now, though, with contemplated changes in capital charges, more scrutiny on interest rate risk. You might see them have a preference towards shorter duration mortgages than they historically have. But you haven’t — it’s just really too early to say. But in my mind, just other investors, whether it be insurance companies or banks, coming and taking advantage of not only the very widespread of mortgage versus treasuries, but the widespreads on mortgages versus corporates, that I think I want to see a little bit of that for — we would increase the exposure. We kept the exposure relatively constant through the quarter.

We still have room to grow it. It’s a little bit — if you look at sort of the mortgage exposure we’ve had over a long period of time, over five years, it’s a little bit higher than what we’ve normally run. But mortgages are wide, but there’s a lot of interest rate volatility. And you need to see, I think, other large pools of capital, be it foreign investors, insurance companies, banks or money managers continue to deploy. And you’ve seen — you’ve definitely seen a slowdown of on the part of money managers, right? They covered a lot of their underweights in Q2. And they’ve been less sort of just all-in bonds than they were.

Operator: Our next question comes from Mikhail Goberman with JMP Securities.