Larry Penn - CEO Mark Tecotzky - Co-CIO Lisa Mumford - CFO.

Analysts:.

Good morning, ladies and gentlemen. Thank you for standing by and welcome to the Ellington Residential Mortgage REIT Third Quarter 2014 Financial Results Conference Call. Today’s call is being recorded. At this time, all participants have been placed in listen-only mode and the floor will be open for your questions following the presentation.

(Operator instructions). And it is now my pleasure to turn the floor over to Lindsey Tragler, Vice President of Investor Relations. You may begin..

Thank you. Before we start, 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 21, 2014, 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 prediction 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.

I have on the call with me today Larry Penn, our Chief Executive Officer of Ellington Residential; Mark Tecotzky, our Co-Chief Investment Officer; and Lisa Mumford, our Chief Financial Officer. With that, I will now turn the call over to Larry..

Thanks, Lindsey. It’s our pleasure to speak with our shareholders this morning as we release our third quarter results. As always we appreciate you’re taking the time to participate on the call today. First, a few highlights. We earned $3.5 million or $0.39 per share on a fully mark-to-market basis in the second quarter.

We maintained our $0.55 dividend which equates to a 12% yield based on our September 30th book value and a yield of more than 12% based on Friday’s closing price. Through September 30th our year-to-date earnings per share totaled $1.90 more than covering our $1.65 in dividends paid.

In our agency portfolio, our holdings of higher coupon specified tools continue to perform well during the third quarter. And as usual, we actively traded our agency portfolio to further enhance its composition and generate trading profits.

Our non-agency portfolio contributed positively to our results, benefiting from support of home price depreciation and for closure trends. Looking forward as you’ll hear from Mark, we’ve already seen some interesting developments in the market in the fourth quarter including a steep drop in mortgage rates.

We’ll follow the same format as we have on previous calls. First, Lisa will run through our financial results. Then, Mark will discuss how the residential mortgage-backed securities market performed over the course of the quarter, how we positioned our RMBS portfolio and what our market outlook is.

Finally, I will follow with some additional remarks before opening the floor to questions. As described in our earnings press release, we have posted a third quarter earnings conference call presentation to our website, www.earnreit.com.

You can find it in three different places on the website; on the homepage, on the For Our Shareholders page or on the Presentations page. Lisa and Mark’s prepared remarks will track the presentation, so it would be helpful if you have this presentation in front of you and turn to Slide 4 to follow along.

As a reminder, during this call, we’ll sometimes refer to Ellington Residential via New York Stock Exchange ticker, E-A-R-N or EARN for short. Hopefully, you now have the presentation in front of you and opened to page 4. And with that, I’m going to turn it over to Lisa..

Thank you, Larry and good morning everyone. In the third quarter, we generated net income of $3.5 million or $0.39 per share.

Our net income for the quarter was composed of core earnings of $6.9 million or $0.76 per share, offset by net realized and unrealized losses on mortgage-backed securities of $3.4 million or $0.37 per share, and net realized and unrealized losses on our interest rate hedging derivatives excluding that portion related to the net periodic cost associated with our interest rate swaps of $42,000 or less than $0.01 per share.

While core earnings was up slightly from the second quarter of $6.8 million or $0.75 per share. Net income was lower than the second quarter of $11.1 million or $1.21 per share. The $0.01 increase in our core earnings per share in the third quarter was mainly due to the decline in swap funding cost.

Over the third quarter our average notional swap holdings declined slightly. In the third quarter, interest income related to cash of premium amortization was approximately $150,000 or $0.02 per share, whereas last quarter it was negligible.

The increase in interest income from cash of premium amortization was offset by a slight decline in the yield of the portfolio and as a result interest income was essentially flat quarter-over-quarter.

For the third quarter our net interest margin increased 5 basis points to 2.38% excluding the cash of premium amortization our net interest margin for the quarter was 2.34%.

The unleveraged yield on our agency portfolio was 3.24% over the third quarter, over the quarter the yields on our non-agency RMBS portfolio was 10.2% and additionally our earnings benefited from net realized and unrealized gains in this portfolio during the quarter.

We ended the third quarter with a portfolio of 1.368 billion, essentially unchanged from the second quarter. During the third quarter, we turned over approximately 25% of our agency portfolio as measured by sales and excluding principal pay-downs. Turnover in our non-agency portfolio was lower at only 11% for the quarter.

The amount of turnover can vary significantly from quarter-to-quarter depending on the trading opportunities that we see in the market. We slightly reduced our outstanding borrowings and as a result our debt to equity ratio dropped from 7.5 to 1 at the end of June, 7.3 to 1 at the end of September.

Year-to-date we have declared and paid dividends totaling $1.65 per share for the first three quarters of 2014. We estimate that our year-to-date taxable income is running somewhat ahead of our year-to-date dividends. With that, I turn the presentation over to Mark. .

Thanks, Lisa. With the third quarter, two key things to be identified at the beginning of the quarter help to drive our returns.

The first thing was that prepayment protection was very cheap and the second was we believed that the Federal Reserve’s gradually shrinking footprint in the agency RMBS market would create relatively value opportunities for us. Both factors contributed to strong performance.

Before discussing our portfolio’s evolution during the quarter I want to show you a few slides of interest that help explain our thinking. First, slide seven. This amazing chart that shows the change in mortgage prepayment responsiveness as measured by refinancing for the past 12 months versus the previous 12 months period.

The lower black line is the past year. You can see that mortgages have been surprisingly unresponsive to prepayment incentive by low interest rates during the past year. And to put this in a historical perspective if we’d put a line on here to show the responsiveness of mortgage prepayment say 10 years ago would be way-off this chart.

Mortgage prepayments used to be much, much more responsive to repay opportunities and lower rates than they are now. There are a variety of contributing factors; mortgage rates have been higher in the past 12 months than the previous 12 months.

There has been some burn out, a slew of multi-billion dollar settlements and the mountain of regulation have originated debt [ph] accretive loan put backs so unwilling to losing some credit, the cost of origination has skyrocketed in the phase of increasing compliance burdens.

The market seems to have a pretty short memory about how quickly mortgages and prepay during the Refi waiting. This lower black line the regime of unresponsive mortgages is seems to be driving in best just thinking now when they price mortgages.

But there have been two very interesting developments post quarter end; first Mel Watt, Director of the FHFA delivered a speech outlining upcoming initiatives to make mortgage credit more widely available and to reduce the risk that originated will be required to repurchase mortgages.

Second, we experienced a rapid drop in interest rates in the middle of October. Look at the graph on the left of slide eight. All with our sharp uptake in the Refi index and rates dropped. This was a degree of prepayment responsiveness that we had not recently seen.

And what is most interesting is that the spike in the mortgage Refi index is driven by the cohort of larger loans within the Fannie Freddie mortgage universe. There was a massive jump in the average balance of loans that borrowers are trying to be financed. It had been hovering around 220,000 in one week and one week it spiked to over 300,000.

We think there were a few point takeaways here. First I think was Chairman, Matt speech, the drop in mortgage prepayment response sluggishness is now behind that was in the past 12 months. While the compliance burdens and costs are very significant damper on prepayment, we think they will loosen.

Another takeaway from these graphs is that as prepayment responsiveness increases, the refinancing will be increasing tiered by loan bounce.

Part of this is a natural response by originators, who faced the higher fixed cost of compliance, folks and customers with higher loan bounces and part of that is natural response by borrowers who have greater incentive to refinance higher loan balances from the standpoint of time and effort for dollar of statements.

So we don’t we think prepayment response will increase uniformly. We think the largest premium loans will be basking more responses that are used to maintaining our strategy and paying the still low cost to buy significant prepayment protections for our portfolio.

As this increasingly financing speed might not occur rates may rise, mortgage may move out of the money and then the incentive to prepay result responsiveness becomes a heavy variable now when you can observe. If you don’t give borrowers a rate incentive to Refi you never really know how responsive they’re going to be.

We structurally hedge our portfolios with the assumption that the future path of rate is unknowable. We try to construct portfolios that will generate solid returns over the range of future into scenarios.

Think back to the start of this year there was a rare consensus among the interest rate forecasters that interest rate would rise instead quite the opposite occurred. Portfolios constructed for rising rates to start at this year would have performed very poorly. As you can see from slide 12 the portfolio grew slightly during the quarter.

Slide 12 shows that we continue to get most of prepayment protection from lower loan balance paper.

This is the time tested forward prepayment protection that is largely impervious to any changes in FHFA policy and as we saw in the earlier slides that those prepayment responsive mortgages this past year has kept this prepayment protection inexpensive despite the decline in mortgage rates and despite the shrinking of that footprint.

But it isn’t quite as inexpensive as it was the start of the quarter, [indiscernible] did appreciate modestly in the quarter which helped our performance. The prepayments to be done in our portfolio continue to be very low.

There are only 5.35 CPR for the quarter that’s only a 1.35 CPR increase in the second quarter despite the typical summer increase in prepayment scheme. Additionally, opportunities to actively manage still abound and we turned over 25% of the portfolio during the third quarter as we constantly try to monetize inefficacies and pricing discrepancies.

Looking forward we think the rates market will present us with continued volatility, exaggerate challenges to U.S. growth are difficult to quantify and since quarter end has been a mild schizophrenic nature to U.S. interest rates with two competing stories. One is stronger U.S.

growth in job creation and a competing narrative of weaker growth abroad that could ultimately impact the U.S. growth. As always we try to construct the amount of portfolios to perform over a range of potential economic scenarios as oppose to having a single minded view of what the future will hold.

The future path of interest rates is impacted by multiple factors many of which are impossible to forecast, so managing for a range of outcomes is in our opinion the best way to simultaneously drive shareholder returns and preserve book value.

The feds footprint is shrunk but it is still large by reinvesting pay-down from TBA it will be buying many of the worst quality new production mortgage pull which makes the rest of the market more valuable for other investor. The stock effect to their holdings also create strong technical demand.

This should support mortgage valuations and we believe our portfolio should benefit. With that, I’ll turn the call over to Larry. .

Thanks Mark. I’m extremely pleased with our strong consistent performance in the year and a half since our IPO. For the past six quarters including the quarter when we went public, we’ve delivered on economic return on book value of 8.5% while the average economic return for agency peers over the same period is actually negative.

Active trading and dynamic hedging which enabled us to avoid the sizable book value decline suffered by many of our peers in 2013 continue to drive our stability and our performance.

Even this past quarter when interest rates were relatively stable we were still able to outperform the peer group on an economic return basis with economic return on book value at a solid 2%.

Looking forward with the FED no longer a net buyer of agency RMBS or treasuries, we see the potential for increased volatility and we believe an interest grade or prepayment shock will bring numerous dislocations. With our active trading style we believe that some volatility in dislocations will generate lots of opportunities for us.

If interest rates rise our TBA shorts and long dated swap hedges should protect us. If interest rates fall our prepayment protective tool should protect us.

Either way we would hope to be able to take advantage of dislocations just like we did in the middle of last year to pick up assets when other market participants are forced to sell at distress level. On October 15th after quarter end we saw a remarkable move in interest rates.

The 10 year treasury yield plunged from about 2.20% to about 1.90% in less than three hours. If that drop in interest rates have lasted, we surely would have seen some very significant dislocation in many of our markets and perhaps most upon the IO markets.

While the drop in interest rates didn’t last, in fact about six hours later amazingly that 30 basis point movement had almost entirely been retraced and the IO market basically shrunk the whole thing off.

And as you can see on slide 11, our IO position at quarter end was roughly unchanged from the prior quarter end and around $14 million of market value. Our current IO holdings are low because pricing levels are still relatively rich in our opinion. We are always keeping a close eye in the IO market and the rest of MBS derivatives market as well.

We look forward to increasing our IO position when the time is right, but for now we believe that patience is the best course of action. As Mark demonstrated earlier, the rumors of the demise of prepayment risk maybe greatly exaggerated.

The FHFA is poised to refinancing more attractive for both borrowers and lenders and meanwhile interest rates are now position at dangerously low levels that are actually not too far above where they were back in the first quarter of 2013 when refinancing were still booming.

This concludes our prepared remarks and we’re now pleased to take your questions.

Operator?.

The floor is now open for questions. (Operator Instructions) We have no questions at this time. Ladies and gentlemen, this concludes Ellington Residential Mortgage REIT third quarter 2014 financial results conference call. Please disconnect your lines at this time and have a wonderful day..