EARN - NYSE

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2022 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. [Operator Instructions] 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's third quarter 2022 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, 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 Tecotzky, our Co-Chief Investment Officer; and Chris Smernoff, our Chief Financial Officer. As described in our earnings press release, our third quarter earnings conference call presentation is available on our website, earnreit.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. After a challenging first half of the year, the third quarter started off on a constructive note with interest rate declining and interest rate volatility subsiding in July. As has been the typical pattern this year, yield spreads follow the direction of interest rates with both declining in July, and virtually all fixed income products benefited. Agency RMBS, investment-grade corporates and high-yield corporates reversed most or all of their losses from the prior month and posted significant outperformance during July versus treasuries and interest rate swaps. Ellington Residential itself generated a positive economic return of nearly 6% in July. The good news proved short lived, however. Continued elevated inflation led the Fed not only to raise the Fed funds target range by 75 basis points in both July and September, but also to accelerate its balance sheet runoff. Central Banks around the globe also continued tightening their monetary policies. Over the course of August and September, interest rates rose sharply, large segments of the yield curve inverted further and volatility surged. The MOVE Index, which measures the yield volatility implied by short-term options on long-term treasury notes and bonds, reached its highest level since the COVID-related market volatility of March 2020. Market sentiment steadily weakened, and we saw widespread selling across asset classes, including forced selling by some asset managers to meet margin calls and redemptions, particularly toward the end of the quarter. Liquidity deteriorated and yield spreads widen in virtually every fixed income sector, including Agency RMBS, with many sectors hitting their widest levels of the year. Technical headwinds in the Agency RMBS market included not only the Fed's acceleration of the reduction of its MBS portfolio but also extremely weak bank demand. Turning to slide three. On the top half of the page, you can see just how large these yield curve moves were during the quarter. Then on the bottom half of the page, you can see the impact of these huge moves had on Agency RMBS yield spreads and prices. Both nominal yield spreads and option-adjusted yield spreads widened significantly across the coupon stack, and the combination of wider spreads and higher rates led to sharp price declines. You can see on this slide that Fannie 5.5s, which was still the current coupon at September 30, dropped by more than 4 points quarter-over-quarter. As you can also see on this slide, that represented an absolutely massive 57 basis points of OAS widening on that coupon, according to JPMorgan's models. And meanwhile, for the longer duration Fannie 3.5s, which was and is fairly -- a fairly representative coupon within the 30-year portion of Ellington Residential's agency portfolio, that coupon dropping more than 6 points in price, representing substantial OAS widening. Since the primary mortgage market takes its lead from the secondary mortgage market, the mortgage rates that homeowners see served in sympathy with Agency RMBS yields. The Freddie Mac 30-year survey rate ended the quarter at 6.7%, which was its highest level in the past 15-years and even touched 7.08% two weeks ago. That was its highest level in over 20-years. As expected, following these recent mortgage rate increases, prepayments continue to grind to a halt, housing is much less affordable, home sale volumes are declining, and we're seeing the first clear evidence of declining home prices nationally. In summary, the market environment in August and September could hardly have been more difficult for Agency RMBS. Ellington Residential experienced a significant net loss for the quarter, as net losses on our specified pools exceeded net gains on our interest rate hedges and net interest income from the portfolio and as we incurred significant delta hedging costs as a result of all the volatility. Our net loss was significant on a mark-to-market basis, but our disciplined and dynamic hedging strategy, which included aggressive duration rebalancing throughout the quarter and positive contribution from our meaningful short TBA position, helped prevent even greater book value declines. Next, on slide four. You'll see that we're reporting $0.23 per share of adjusted distributable earnings for the quarter. As we mentioned on last quarter's call, our ADE faces near-term headwinds as the sharp rise in short-term rates is repricing our repo liabilities higher, and they're repricing higher very quickly at that. And while our asset yields are also increasing, that only gets captured in our NIM as we rotate our portfolio. We're being patient about turning over our deep discount pools, given what we perceive as excellent relative value in that sector. As a result, our NIM is compressing in the short-term, but we think it's important to prioritize maximizing total economic return, while we're just trying to maximize short-term ADE. It bears repeating that this all underscores the limitations of focusing too much on ADE, which is a backward-looking measure, particularly in market environments with large swings in interest rates and spreads, such as we're seeing today. The disciplined approach that we're taking with the portfolio turnover, combined with our sequentially lower book value, also meant that our leverage ticked up this quarter. As always, we remain focused on liquidity and risk management, and we continue to follow the same guidelines that have helped us manage past financial shocks effectively. Of note, we continue to hold a strong liquidity position at quarter end, with cash and unencumbered assets representing 27% of our total equity at September 30. Finally, I'd like to point out that a significant portion of Ellington Residential's losses for the third quarter and indeed for the year resulted from yield spread widening, and I believe that the prospects of recouping many of these losses are strong. 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. Please turn to slide five, where you can see a summary of EARN's third quarter financial results. For the quarter ended September 30, we reported a net loss of $1.04 per share and adjusted distributable earnings of $0.23 per share. These results compare to a net loss of $0.82 per share and ADE of $0.20 per share in the second quarter. ADE excludes the catch-up premium amortization adjustment, which was positive $1.4 million in the third quarter, as compared to a positive $1.6 million in the prior quarter. During the third quarter, as Larry noted, Agency RMBS significantly underperformed U.S. Treasury Securities and interest rate swaps, and that drove our net loss for the quarter. Our net interest margin decreased quarter-over-quarter to 1.28% from 1.66% as higher interest rates drove a significant increase in our cost of funds, which exceeded the increase in our asset yields. Our lower NIM combined with lower average holdings quarter-over-quarter caused the decline in ADE. Meanwhile, average pay-ups on our specified pools decreased modestly to 1.02% as of September 30 from 1.09% as of June 30. Please turn now to our balance sheet on slide six. Book value was $7.78 per share at September 30, as compared to $9.07 per share at June 30. Including the $0.24 of dividends in the quarter, our economic return was negative 11.6%. We ended the quarter with cash and cash equivalents of $25.4 million. Next, please turn to slide seven, which shows a summary of our portfolio holdings. In the third quarter, our Agency RMBS, interest-only securities and non-Agency RMBS holdings, all decreased modestly. Agency RMBS portfolio turnover in the third quarter was 19%. Additionally, our debt-to-equity ratio adjusted for unsettled purchases and sales increased to 9.1 times as of September 30 as compared to 7.9 times as of June 30. The increase was primarily due to lower shareholders' equity quarter-over-quarter as the portfolio size was relatively constant. Similarly, our net mortgage assets-to-equity ratio increased to 7.5 times from 6.8 times over the same period. I'll note here too that repo financing has remained stable and available, despite the market volatility. On slide eight, 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. Finally, we were optimistic with our capital management strategy during the quarter as we issued approximately 148,300 shares to our ATM at a price -- an average price of $8.43 per share and repurchased approximately 9,500 shares at an average price of $6.53 per share. I will now turn the presentation over to Mark.

Thank you, Chris. Q3 was a unique quarter, whose defining characteristic was an enormous level of sustained volatility in almost every important fixed income metric. Beginning with interest rates, the five-year treasury traded in a range of 2.64% to 4.19% during the quarter. That is a 155 basis point swing within just one quarter. The change in the shape of the yield curve was also dramatic. The two year to 30-year treasury yield spread had a range of 87 basis points just for the quarter, which is a bigger range than you'd expect to see for an entire year. Meanwhile, the market CDX IG Index, which reflects the market's perception of credit risk for investment-grade corporates, had a range of 37 basis points for the quarter, whereas for all of 2021, it only had a range of 13 basis points. So this benchmark index moved about 3 times as much just this past one quarter as it did all of last year. And most important for EARN, mortgage prices and mortgage yields were not spared at all from this volatility. During the quarter, Fannie 4s traded in an nine point price range and Fannie 5s traded in an incredible 59 basis point yield spread range. This is not a normal market by any means. The Fed has now implemented 4 75 basis point hikes in succession. They've now hiked more in the last four meetings than they had hiked cumulatively in the preceding 10-years. EARN had an economic loss of 11.6% for the quarter and the rest of our peer group fared even worse. An Agency mortgage REIT is simply not designed to deliver good returns in the face of that magnitude of interest rate increases and mortgage spread widening. I do believe that much of our loss is reversible if spreads normalize. October was another month of a lot of volatility. But through today, it looks like our book value is around breakeven for the fourth quarter so far. Given the October volatility, I think that's a good outcome, but a negative economic return of more than 11% for the third quarter certainly is not. On the other hand, the spread widening has ushered in an opportunity set for agency REITs that the best we have seen in years. By virtually any metric, mortgage spreads are extremely wide now. Today, we have a 20-plus point price range in the coupon set trade. And while some of the coupons with worse convexity characteristics are wider than the others, they are all wide. And unlike what we used to get -- unlike what we got used to trading in the -- for the past decade, most Agency MBS don't currently have a lot of negative convexity. So they don't require a lot of delta hedging. At today's prices, discount coupons are providing high-quality NIMs. You can put appropriate hedges in place and not give away much of your NIM by having to rejigger those hedges when the market moves. And MBS are also wide based on a close to worst-case assumptions on prepayment speeds. From a research perspective, given that most everything recently has been trading at a discount rather than a premium, our prepayment models and our research team have been doing the opposite of what they were doing last year. Think about how the pricing distribution has changed. Last summer, TBA Fannie 2s were $102 price. TBA Fannie 4s were $107 and the cost of loan balance protection on 4s was multiple points in pay up. Last year, it was all about finding the slowest prepayments for the pay up. Now it's the exact opposite. For anything below $95 price, which is most of the MBS universe, excluding current coupon production, we are looking for the lowest pay up to get the fastest prepayments. In fact, another source of additional volume in the mortgage market today is that most models are currently underpredicting prepayment speeds versus what we are actually observing. Don't get me wrong. We think prepayments are going to be very slow. I'm just saying that there's upside from some of the worst case assumptions. And furthermore, if you know where to look, you can find pools that have even more upside, because they will pay much faster than model projections. On the technical side, supply is significantly lower in the Agency market now. Cash out refis are way down as very few borrowers want to refile low-rate mortgage and go into one that is at over 6% just to take out a little bit of money. And on top of that, Fannie Mae and Freddie are raising their fees on cash outs. Existing home sales are way down to that also lowers net supply because given the significant HPA we've seen over the past few years, most existing home sales have involved the buyer taking out a bigger mortgage than the one the seller is paying off. Of course, with housing affordability down so much recently, this dynamic is also changing. Another huge difference between the Agency MBS market this year and previous years is how much less banks are buying today. A lot has been written about the huge losses in available-for-sale bank portfolios and weak deposit growth. And the consequences for the Agency MBS market have been dramatic. Banks have been big buyers of MBS in past years, but have basically been absent this year. So going forward, it would frankly be hard for them to buy any less than they currently are. As rates stabilize and they begin to replenish their capital, some banks may return to the market. And if we enter into a recession, when banks start worrying about loan losses, that is typically a time of increased bank buying. Incremental bank buying could be a big tailwind for the sector. Further, at the September Fed meeting, we got the clearest statement yet from Powell on the subject of potential Fed asset sales. The Fed's thinking can always change, but Powell basically said they plan to keep their current runoff in place, and they are not currently discussing MBS sales. This clarification by Powell is yet another supportive technical for the market. There was a lot of selling in Q3 that caused Agency MBS to underperform as much as they did. But so far in November, supply seems to be more balanced relative to demand, and we are seeing more healthy two way flows. Now what about EARN's ADE going forward? We continue the process of rotating our portfolio into today's higher coupons. We are doing this methodically. And as we do it, our NIM and adjusted distributable earnings should get a boost because our book asset yields usually reflect our original purchase yields as opposed to current market yields. With reinvestment yields so much higher, portfolio rotation should be a tailwind for our ADE and enable our book asset yields to keep up with the rapidly increasing yields on our liabilities. What did we do with the portfolio in Q3? Given the extreme volatility, we were more concerned with preserving book value than maintaining or increasing ADE. It's not as though we're taking a victory lap with down 11%-plus economic return. But relative to other Agency peers, it's a better outcome. Raising ADE can come later and maybe starts now. But in a volatile market, we believe that preserving book value is more important. We did go up in coupon a bit during the quarter. And given our drop in equity, we also shrunk the portfolio a little bit, but spreads are really wide now. They can always get wider, but we think it's the right move to have relatively high mortgage exposure now. What is your outlook going forward? While things have improved over the past couple of weeks, it's still too early to let our guard down. I think we will need to see a slowdown in the magnitude of Fed hikes and some progress on inflation to get some reasonable stability back in the market. That said there are signs that demand for spread product is finally coming back into the market, which should be very supportive of our book value. Now back to Larry.

Thanks, Mark. 2022 has proven to be a challenging year so far. And while the market conditions have obviously hit our book value significantly, we have also recharged the opportunity set. The so-called mortgage basis, the spread between yields on Agency RMBS and treasuries or swaps looks extremely wide on a historical basis today. And with net mortgage supply likely be much lower going forward, as well as so much bad news already priced into the market, we think that Agency RMBS offer excellent investment value today. In addition, recession could actually be a boost for the sector because Agency RMBS have no credit risk. And because in a recession, the Fed might pause or even reverse the steps it has taken to tighten its monetary policy, which would be a support of technical. That said, we're near the upper end of the range where we've typically set our leverage. And referring back to slide nine, we're also near the upper end of the range, where we've typically set our net mortgage assets to equity ratio. The upshot is that it wouldn't expect us to be significantly adding to our net RMBS exposure from here. Finally, Ellington Residential has a broad mandate, and we think that there are currently many opportunities in the non-Agency mortgage markets that offer even more compelling value than agencies. Therefore, we are planning to significantly increase our capital allocation to the non-Agency market, perhaps to 25% or more. The last time we did that was right after the COVID market shocks in early 2020. And we ended up benefiting handsomely from that reallocation, which helped drive EARN's outperformance in 2020. As we've pointed out before, EARN smaller size should enable us to be nimble as market conditions evolve. And with that, we'll now open the call up to questions. Operator, please go ahead.

Thank you. [Operator Instructions] We'll take our first question from Crispin Love of Piper Sandler. Please go ahead.

Good morning, everyone. First, Larry, on the comments that you just made on increasing non-Agency exposure, maybe up to 25% or so, can you talk about -- just give a little bit more detail on that? And what kind of time frame you could do that? Is that something that would happen relatively quickly? Or thinking more over the next couple of quarters just because you're -- I think you're in the very low single-digits right now? So I was just a little bit surprised by that.

Yes. No, I think it can happen relatively quickly. I mean we're a small company. We're nimble. We're talking about mortgage-backed securities that are fairly easy to access. So yes, I would say, maybe even by year-end. Year-end is often a good time to be buying, as you know.

Right, right. Absolutely. No, that makes sense, and then just looking at the relative yield spreads that you have on slide 10, no surprise, but pretty eye-popping there just with everything near or a lot of the agency market near 24-months wide. Do you have any outlook on widening versus tightening, kind of, over near to intermediate term, because you could have some pretty big tailwinds to book value if we do see some tightening there?

Right. And I'm going to let Mark answer that question. But I would say that it's interesting. So everybody's got a different prepayment model, right? And we've talked about how research and prepayments are so important. So slide, I think it was three, we show some OASs based upon JPMorgan's models. And on this slide, I believe this is Morgan Stanley's OAS models. So you can see that Morgan Stanley's model, I mean, on Fannie 3s, and I think on the other slide, it was 2.5s and 3.5s, but you get the idea, as obviously a much slower prepayment model than many of the others. So it really is very model dependent on the mortgage market. But we do think that OASs are very wide. We think that perhaps Morgan Stanley model is a little bit too much on the pessimistic side. So I just wanted to point that out before Mark addresses the question about where, I guess, you're asking really where you see spreads heading ultimately?

Yes, yes.

Yes, Crispin, so you can see that given our historical track record, our mortgage basis exposure is relatively high now, which that is an indication that we do think it's more likely that spreads tighten from where they are then widen. And it also is even if they stay where they are, they're very wide. You generate a very wide net interest margin. In the prepared comments, I did mention some of the things that I thought could be supportive of the mortgage basis. Supply is way down, I think some of the deleveraging selling that weighed on the market in Q3, some of that feels as though it's behind us. And I mentioned that banks that are normally huge buyers throughout the course of the year have been noticeably absent from the securities market this year. So I think I said it's sort of hard for them to buy less. You've seen some overseas buying as well. So I think it's -- this number today has moved the market a lot, but it does feel to me that given the backdrop of greatly reduced supply that any, kind of, incremental buying from new pools of capital, be it banks or money managers of the redemption stock, can really move the basis a lot, because you're not dealing with a lot of supply coming into this market, given how high mortgage rates are. And obviously, geopolitical forces or other economic numbers can be gorgeous shocks that can change that. But I would say we sort of think it's more likely than not that spreads will recover from where they were at the end of the quarter. And so that was sort of the thought process behind our positioning.

Sorry, just to add one thing to that. Often what you see, right, when you've got good news like we saw today, look, why no one swallow does not a but we could -- this could be the sign that we're moving in the right direction. Often, you see the liquid markets like the agency markets move first in terms of spread tightening, let's just say. And that could really, from a timing perspective, work out very well, right? We'll recapture some of those losses from the spread winding earlier on our agency portfolio and the portion and then we'll rotate out some of that. Granted, there still may be more upside left in that. But if the non-Agency and the less liquid markets lag in terms of spread tightening, it could work out really well to our advantage.

Great, thanks. Larry, Mark for those comments. Just a final clarification question from me. So Mark, you made some comments about book value so far in the quarter. I think you said breakeven. So is book value at around $7.78 or so. Is that as of the end of October? Or is it even more recent than that?

Yes. We're -- this is Larry. We're -- yes, we're talking really through today, I guess, as you know, And yes -- and I don't want to sort of get into putting an estimate as of November 10, that's not our style. But yes, I think we meant book value, just to be clear, taking into account any interim dividends. And so we think book value is around breakeven.

Perfect. Thanks for taking my questions.

Thanks, Crispin.

Thank you.

Thank you. Our next question comes from Doug Harter of Credit Suisse.

Thanks. Can you just talk about how you are continuing to think about leverage in light of volatility today being kind of volatility to the good? But kind of moves continuing to kind of be very large and kind of how you think about positioning into that type of market?

Yes. It's Larry, hey Doug. So I think -- so let's talk about the two types of leverage. One of them actual technical leverage in terms of our financial leverage, our repo borrowings, et cetera, there quarter end at above 9:1, I mean, that's really -- I don't know if we've ever gotten about 10:1 at a quarter end, I don't think so. We've been here before though. So this is really the upper end of the leverage range. And so I wouldn't expect us, as I said, don't expect to see that go up much. In fact, if we do start this rotation, from some agencies to some non-Agencies, then you'll see that come down, right, because we obviously will leverage the non-Agencies a lot less. I mean, then from a mortgage exposure, Mark, you want to address that, we ended the quarter at 7.5:1 also sort of near the upper end of our range and spreads have tightened a little. What do you think, Mark?

Yes. So I guess what I would say is that today is, kind of, an interesting day, something Larry and I were discussing really right before the call that while you're having this enormous move in interest rates like a 30 basis point move and a big move in credit spreads, we talked about that IG Index that thing about six tighter today, it was something we talked about in the prepared comments. So while you're getting a 30 basis point move in interest rates, which is -- I mean you see moves that big maybe once a year or once every other year normally. So implied volatility is actually down today. So while this is an enormous move for today, at least what implied volatility is telling you that having seen a little bit of inflation seem to respond to the progressive hiking cycle of the Fed is, sort of, implied all saying that, that's going to usher in maybe less volatility going forward that you don't -- if you start to see economic numbers that are reflective of what the Fed has done, and I think the big comment in Powell's last statement that the market picked up on was this notion of long and variable lag. So there's a lag between when the Fed hikes rates and when it flows through the economy, and there's sort of like different sectors occur at different times. So the most responsive one to interest rates is generally housing, and you've seen housing really make 180-degree move, right? It had been up 20%-plus in 2021, then up 10% in the first six months of this year. And now you've seen in the last few months, some of the biggest one month declines you've seen in a very long time, right? So housing, where interest rates impact people's ability to qualify how what -- where they're at in terms of their debt-to-income ratios, so housing has really slowed down dramatically. Existing home sales back 20-year lows, new home sales slowing down, builders talking about order cancellation. So housing has been the first thing to respond, which isn't surprising because it's the most interest rate sensitive. Starting to see some movements in used car prices, so while there was a lot of volatility today. I do think it's -- it has potential to get us into a range of interest rates that we've seen that may have some market participants more comfortable that, okay, now is the time to commit capital to some of these markets. So looking what Larry said, the mortgage exposure is towards the upper end of where we normally run it. The -- if you just look at repo borrowings that's towards the upper end. But a lot of what we own -- a lot of the pools we own are relatively low pay-ups. So while they have financing against them, there's not a lot of risk to them. They're not three point, four point pay-ups that you saw a lot of other companies deal with during COVID. So there is a lot of pools that are positive carry versus rolls. So just even a low pay-up pool versus being along that versus short at TBA can generate economic return to the company with very, very limited downside. So there's some of that in the portfolio. I do expect, especially if we -- if the timing is right and the valuations make sense for us to obtain the credit, I think you'll see some of that agency mortgage exposure come down. And then if that comes down, you'll also see the repo borrowings come down. And we've also -- and that's -- those numbers are already almost six weeks in arrears.

Got it. Thank you.

Sure. You’re welcome.

Thank you. We'll take our next question from Eric Hagen of BTIG.

Hey, everyone. You have Ethan Saghi on for Eric today. Thanks for taking my questions. First one, just how do you see dollar roll financing evolving? And what conditions will it be most sensitive to?

So this is Mark. Thanks for the question, Ethan. Dollar rolls right now -- so people think about the dollar roll market a few different ways. So one way, a lot of people think about it. And one way we think about it is we kind of know what the repo rates are. So one month repo rates right now are about 3.9%, right? So you can look where dollar roll is and you can say, okay, what is the implied prepayment speed on that dollar roll for me to be indifferent between doing the dollar roll or having a pool on repo? And when dollar rolls are cheap, they're not special, there's not a lot of demand for them, you see the CPRs, now we're talking about discounts at very, very low numbers, right? So there are a bunch of rolls now with the implied CPRs are 1% to 3%. And you can find pools that pay above that. So that's sort of a little bit what I was alluding to when I was answering Doug's question. So dollar rolls for all the discount coupons are trading relatively poorly. So it's the opposite of what you saw in 2021 when the Fed was buying so many Fannie 6s and so many Fannie 2s, so many Fannie 2.5s, so many to 4.5s, so many to 2s that -- those rolls were consistently special. Those rolls were higher each month than what you would have earned from having a pool and taking it on balance sheet. And this year, it's kind of been the opposite. The rolls have not been special in the discounts. And I don't think that's surprising given that you don't have the Fed involved buying these things. And you don't have other players like banks involved in buying these lower coupons. Now when you get to some of the production coupons, like Fannie 6s that there has been some roll volatility. So I would say financing has been orderly this year. But obviously, the magnitude of the swings we've had has made people cautious about having excessively large balance sheets. And that's one of the reasons why you're not seeing a lot of the primary dealers, the investment banks, taking delivery on big portions of rolls to sort of earn a spread over where the financing, even though it looks economic, it's tied up a lot of balance sheet and the cost of that balance sheet relative to what they're going to make, that calculus is just -- you've seen a little bit of it, but you haven't seen a lot of it. So rolls, I'd say, for the lower coupons have been pretty uninteresting. And if you look at our positioning, we have pools there and we're short TBAs for that reason. Up in the higher coupons, there has been some roll volatility, and we expect that to continue, because if you have a whole bunch of banks pile into this market, and you haven't seen this yet, and I don't think you're going to see it like immediately. But if you saw a whole bunch of banks come in and want to buy Fannie 6s, there's just not a lot of float in that coupon that is sort of considered TBA and you could see some roll volatility, and you've seen some of that earlier and you have seen it in the last three or four months.

Got it, that all makes sense. And then just another question, kind of, piggybacking off the last question on leverage. Just how much net mortgage leverage do you feel comfortable with? And kind of if you can just talk about the relationship between the net mortgage leverage and debt to equity, that would be helpful.

Yes. So we're comfortable with where we're at now. I don't think we'd bring that up unless spreads were to take another leg wider. And so basically, if you take our mortgage exposure, right, you can think about the company is having, okay, if we just own a bunch of pools and we're paying fixed on a bunch of sulfur swaps, that's our mortgage exposure. And then on top of that, if we own some pools that are hedged with TBA, that won't change our mortgage exposure, because the mortgage exposure from the pool we own is netted against the mortgage exposure, we're short in shorting TBAs. So having pools versus TBA doesn't increase our net mortgage exposure, but it does increase our repo borrowings. So you can look at what we report from net mortgage exposure and what we report for the total repo borrowings, you can kind of partition the portfolio as some large portion of the pools hedge with SOFR swaps and then another portion of the pools hedged with being short TBA.

Yes. So if you refer to slide nine, right, you can see that as -- well, our leverage ticked up, but it's not on this slide from the second -- end of the second quarter to the end of the third quarter, but our net mortgage assets-to-equity ratio also ticked up. And that mid-7s, as Mark says, that's towards the high-end of the range for us. So I wouldn't expect that to tick up much from there.

Got it. All right. Thanks for answering my questions.

Thank you. Our next question comes from Mikhail Goberman of JMP Securities.

Good morning, gentlemen. Hope everybody is doing well?

Thanks, you too.

Most of my questions -- thanks -- most of mmy question have already been touched upon. But I was just kind of wondering, in the sort of hypothetical scenario given the CPI print today and the market reaction, if we continue to get more favorable CPI prints in the months ahead and the Fed say decides to do 50 in December and then cuts to -- comes down to 25 early next year and then stops, at some point maybe in the later spring, I guess the biggest wildcard is do we get a recession around the same time. But I guess my question is --

My question to you is, do you know something that we don't.

Like I said, a hypothetical scenario, I'm just kind of talking. What would the ideal sort of portfolio construction be in an environment where the Fed has stopped hiking? Forget about the potential recession. Just the Fed is that is no longer a hiking, they've achieved their neutral rate or so, they think. And you guys have gone with your portfolio rotation from now to that point, what would an ideal portfolio look like? What would that process kind of look like?

So I guess I would say we don't -- we have a great research effort here, but it's not about predicting what the Fed is going to do. So we really try to position these portfolios agnostic to the direction of interest rates and respectful exogenous things or surprise numbers that can move the market a lot. So just with that said, I think that if you get more good news on inflation, and it looks like the Fed is near the end of their hiking cycle, I think what you'll see is we have comments with a lot of our clients at Ellington, not having to do with the public companies, our perception is that there is a lot of capital that is getting interested in fixed income and getting into credit and has been waiting, because the market has been too volatile and they want to see how far the Fed goes and they want to see -- because this year, it's basically been a year of the market inflation numbers being running generally higher than predictions. And the Fed responding and the Fed dots going higher and higher, so there's been a lot of people that have been patient and their patience have been rewarded. So I do think there is a lot of cash that is available for the Agency MBS market and the credit market. So I think if you get some stability on if you get some better 2s on inflation and people's perception of the Fed is that the larger hikes are behind us, then I do think that money will get deployed. I don't think it will wait any longer. So then in that case, I think it's good for spread product, right? It's good for Agency MBS. It's good for the non-Agency MBS. We spoke in the prepared comments is one thing that we think can make sense for EARN is to rotate some of the capital into non-Agency securities is something that we did in 2020 made a lot of sense. And part of that thinking is that different sectors recover on different time frames, right? And so you're already seeing since our book value is roughly flat since the end of the quarter -- the end of September, that does say something about what mortgage spreads have done. If you look at some of the credit -- the non-Agency of the securitized products. So credit risk transfer, legacy non-agency bonds, non-QM bonds, that even though you've seen a pretty good recovery in these liquid credit indices, we talked about the IG Index, there's liquid high-yield index, those indices did well in October and cash credit bonds generally didn't. So cash credit bonds were -- the prices were weighed down by a lot of selling. It's mutual funds. It's all different corners. It's -- some of it was -- a lot has been written and a lot has been said about the U.K. pension funds that had doing a liability-driven these LDI strategies when they were getting margin called on their swaps had to sell. So you had a very big disconnect between structured product cash bonds away from the Agency MBS and IG and high-yield indices in October, right? You saw it in the CLO market, so on the CRT market. So that's kind of what caught our eye that you have a pretty big basis between cash and synthetic indices. And so I think everything does well in the scenario where you talk about the Fed kind of pauses. Now in the scenario where you talk about mild recession, I do think that will be supportive of Agency MBS, because it's a spread product that doesn't have credit risk to it. And so if people really start worrying about higher unemployment numbers, and you've already seen some pretty weak performance in some consumer loan deals and some sub-prime auto deals. But if you really get people worried about credit, I do think it -- it's a favorable thing for Agency MBS. And the other thing is if banks get worried about recession and they get worried about their obligations under CECL to reserve more capital, that can make securities more attractive than loans. You certainly saw that in post-COVID, right? When a lot of banks were very concerned about recession and very concerned about loans, but wanted to put money to work, and they were overwhelming going into securities. So it's a lot of hypotheticals there, but those are sort of some of the things we've been thinking about.

Thank you. Yes --

Thanks, Mark. Yes, just I can't resist I'm going to take the bait on that question, too. So I think if you look at where a lot of the credit markets are priced right now and frankly, even some of the noncredit markets like the agencies when you look at how wide spreads are and implied volatility and all that, I think the market is still pricing in a decent chance of rates going a lot higher from here, right? You could have wage price spiraling inflation, all sorts of things that are not off the table yet. Today, obviously, is very helpful. So in your scenario where, let's say that's off the table, and we're not going to get to a 6% 10-year or something like that. So that takes a lot of very specific risks off the table, right? So I think one thing that the market is very concerned about is what's going to happen to real estate prices, not just residential, but also commercial if rates were to go much higher. And if you're a debt holder or a lender like we are, you don't really worry about that so much about that first 5% or 10% drop in real estate prices. But you worry a lot about a drop if you got a 80 LTV or 75 LTV is sort of being a typical lending level. You worry a lot about a drop, that's 15%, 20%, 25%, right, because it's never going to be uniform anyway. So I think if you take that kind of risk off the table of really spiraling inflation, then I think you will see strong moves in the credit markets. You'll see real estate prices, kind of, stabilize. We think there's a big difference, right, between if -- I think in your scenario, if you got mortgage rates settling in more in that 5%, 5.5% area, let's just say, as opposed to 6.5%, maybe where they are now or possibly even lower now, it just makes a big difference. So I think that it just take -- would take a lot of risks off the table and tightened spreads quite a bit in all sectors because it would take -- even in the Agencies, it would take a lot of extension risk off the table on current coupons.

Thank you very much, gentlemen. That’s great detail. Thank you.