Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2021 Third Quarter Financial Results Conference Call. Today's call is being recorded. 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 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 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. To begin, please turn to Slide 4.

In the third quarter, Ellington Residential generated core earnings of $0.31 per share, which continued to cover our dividend, and we had a modestly positive economic return during the quarter in which performance of Agency RMBS was mixed. Turning back to Slide 3.

In the first shaded green column, you can see that interest rates ended the third quarter, not far from where they started, but that comparison masks where were significant intra-quarter movements.

In July, interest rates continued to decline as they had done during the second quarter as investor concerns increased around the Delta variant, economic growth outlook, and potential Fed tapering. Between June 30 and August 3, the yield on the 10-year U.S. Treasury declined by 30 basis points to 1.17% and interest rate volatility picked up.

In response, Agency MBS yield spreads widened during July, particularly for lower coupon MBS. Moving into the latter half of the quarter, interest rates began to rise, while volatility declined and Agency yield spreads tightened as the market got more clarity on the Federal Reserve's tapering plan.

Following its September meeting, the Fed signaled that it could begin asset tapering late this year with new purchases decreasing incrementally through midyear 2022. Even though this time line was a bit more accelerated than some market participants had previously anticipated.

This was mitigated by the lack of signaling of any change to the Fed's policy of reinvesting all paydowns on its existing portfolio. Overall, the market welcomed the update, and most Agency MBS yield spreads tightened in response. Clearly, the Federal Reserve is trying hard to avoid another market paper tantrum such as was seen in 2013.

The late quarter Agency MBS spread tightening was not uniform across all coupons and was most pronounced for higher coupon MBS, which also benefited from reduced payment -- prepayment expectations, driven by incrementally higher mortgage rates.

Meanwhile, lower coupon MBS lagged around concerns of the anticipated withdrawal of Federal Reserve purchases would disproportionately impact the current coupon Agency MBS that the Fed exclusively buys.

All in all, higher coupons significantly outperformed lower coupons over the course of the third quarter and a sharp reversal of second quarter performance. This is illustrated in multiple ways on Slide 3. Fannie Mae 3.5 and 4.5 prices increased nicely in contrast to the modest price declines of Fannie Mae 2.5s.

And you can see that OASs and Z-spreads of Fannie Mae 3.5s and 4.5s have tightened far more than those of Fannie Mae 2.5s. For Ellington Residential, net interest income on our portfolio more than offset net realized and unrealized losses, which came mostly from our lower coupon holdings. On the hedging side, net gains on interest rate swaps and U.S.

treasury hedges roughly offset net losses on our TBA short positions, which were concentrated in higher coupons. Meanwhile, our debt-to-equity ratio declined slightly to 6.7x from 7.0x at the end of the prior quarter. Finally, in October, we announced our shift from a quarterly dividend to a monthly dividend.

We believe that this shift will further enhance our appeal to income-oriented investors and increase the breadth of our investor base. 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 5, where you can see a summary of EARN's third quarter financial results. For the quarter ended September 30, we reported net income of $860,000 or $0.07 per share and core earnings of $4 million or $0.31 per share.

These results compare to a net loss of $4.5 million or $0.36 per share and core earnings of $4.6 million or $0.37 per share in the second quarter. Core earnings excludes the catch-up premium amortization adjustment, which was a negative $1.2 million in the third quarter compared to positive $2.6 million in the prior quarter.

During the third quarter, as Larry mentioned, net interest income more than offset net realized and unrealized losses, which were concentrated in our lower coupon holdings.

Also during the quarter, we had positive results from our interest-only securities and non-Agency RMBS portfolio and negative results from our reverse mortgage portfolio driven by widening yield spreads in that sector. And in the interest rate hedging portfolio, net gains on interest rate swaps U.S.

treasury hedges roughly offset net losses on our TBA short positions. You can also see towards the bottom of that slide that our net interest margin decreased quarter-over-quarter to 1.88% from 2.04%, largely driven by lower average asset yields.

In addition, average pay-ups on our specified pools decreased to 1.44% and from 1.55%, primarily because new purchases during the quarter consisted mainly of lower pay-up pools. Please turn next to our balance sheet on Slide 6. The book value per share was $12.28 at September 30 compared to $12.53 at June 30.

Including the third -- the $0.30 third quarter dividend, our economic return for the quarter was positive 40 basis points. Our debt-to-equity ratio decreased to 6.7x as of September 30 as compared to 7x as of June 30.

We continue to maintain higher liquidity and lower leverage as compared to periods prior to 2020 and the onset of the COVID-19 pandemic. Next, please turn to Slide 7, which shows a summary of our portfolio holdings.

In the third quarter, our Agency RMBS holdings increased slightly to $1.2 billion as of September 30, and our non-Agency RMBS holdings decreased slightly to $9.1 million. Turnover in the agency portfolio was 23% for the quarter. Please turn now to Slide 8 for details on our interest rate hedging portfolio.

During the quarter, we continued to hedge interest rate risk for the use of interest rate swaps and short positions in TBAs, U.S. Treasury securities and futures. Similar to recent quarters, we ended the third quarter with a net short overall TBA position on a notional basis but a small net long overall TBA position as measured by 10-year equivalents.

On Slide 9, you can see that our net long exposure to RMBS was 6.4x at September 30, down from 6.7x at June 30, primarily due to a larger net short notional TBA position quarter-over-quarter. I will now turn the presentation over to Mark..

Thanks, Chris. For the third quarter, if you only consider the starting and ending points of interest rates, it doesn't look like much happened. But it was actually a fairly volatile quarter for interest rates and the yield curve.

The market oscillated between fears of a spreading Delta variant, slowing down the economy and concerns that inflation would prove both larger and more persistent than the Fed's assessment that higher inflation will likely be transitory.

So even though the 10-year only changed by 2 basis points quarter-over-quarter, it hit a high and a low of 1.54 and 1.17 intra-quarter, which is a much wider 37 basis point range. During the third quarter, we also got significantly more clarity from the Fed on its plan for tapering.

Of course, the Fed meeting is today and we'll be getting an additional update soon. And the tapering plan that the Fed articulated follow its September meeting is very similar in structure to the previous taper in 2013, although this taper is going to happen at a faster pace than the previous one.

And unlike 2013, it's coming at a time when the mortgage market has been growing rapidly. I think there are a few ways to think about the upcoming taper. On the one hand, the Fed is expected to continue to be net buying Agency MBS through the summer of 2022. What net buying means is that they are buying Agency MBS in addition to reinvesting paydowns.

The portfolio of Agency MBS will continue growth for the next several months, even as tapering ramps up. Right now, it looks like taper is scheduled to end sometime in Q3 2022. So between now and the end of taper, the Fed should still net by approximately $180 billion more MBS.

The word net is important because the Fed will probably buy 2 to 3x that amount just reinvesting paydowns, but that reinvestment size is a function of prepayment speed. So portfolio is going to grow by another $180 billion, and that's obviously a lot of projected growth on an absolute basis.

On the other hand, however, that projected growth is not so big on a relative basis. For example, the Fed's MBS portfolio has grown by approximately $400 billion so far just this year. And meanwhile, the Agency MBS market is still growing at its fastest pace ever.

Home prices are up, cash out refi activity is strong and the agency conforming loan limits are about to increase significantly. In 2021 alone, the residential mortgage market is expected to grow by about $860 billion. For 2022, estimates are for about $635 billion in net growth.

So that still leaves plenty of incoming mortgage supply that will need to find a home in private hands. The MBS sector had mixed performance in the third quarter, prepayments for higher coupons flows from the elevated levels that we saw during the first half of the year.

This prepayment news was encouraging for higher coupon seasoned vintages and a gradual slowing of speed. And as a result, price performance of higher coupon MBS was better than production coupons.

High coupon outperformance has reversed so far into Q4, however, as the flattening of the yield curve has pressured high coupon MBS prices with the shorter duration. In the month of October, the spread between the 2-year and the 10-year swap rate there by 26 basis points.

We continue to be cautious on our outlook for higher coupon MBS as we remain concerned about the rise in prominence of large public nonbank mortgage lenders, which bring increased efficiencies to the mortgage market, which should continue to keep prepayment speeds elevated relative to historical patterns.

Roles in production coupon TBAs were strong during the third quarter. So these positions effectively generated much more positive carry. Production coupon rolls in both 15 and 30 year remain quite strong today, and the Fed will continue to buy a lot of production coupon MBS should they stick with their taper schedule.

In addition, as you can see on Slide 10, the Agency MBS sector continues to look attractive on a relative basis versus other sectors of fixed income. QE has been a rise and tied that has lifted the valuation of almost all fixed income sectors MBS included.

But despite Agency MBS being the direct recipient of Fed buying, in most measures, they don't look expensive relative to investment-grade corporates. And MBS investors can get the direct benefit of very high TBA roll levels the Fed buying has created. There is no analogous fed benefit in the corporate market.

Ellington Residential, we are -- we were actively trading in the third quarter, but on a net basis, we only grew the portfolio slightly quarter-over-quarter. We had a drop in portfolio CPR consistent with the overall decline in MBS prepayment speeds.

We also switched to a monthly dividend in October, which we believe is generally preferred by investors. Our core earnings continue to cover our dividend. We have ample room to grow our leverage and net mortgage exposure, which could be even more supportive of core earnings going forward.

What we did mention on our previous earnings call that we did not expect clarity on taper to cause a big MBS spread widening, we do expect to see pockets of spread volatility.

And given current MBS valuations we prefer to set up our portfolio with lower leverage and higher liquidity, which enables us to be opportunistic should that spread volatility occurs. Looking forward to the final months of the year, Fed support is still large and ongoing.

We continue to expect production coupon TBA roll levels to be strong, but then to diminish gradually over time. That incremental 25 to 50 basis points of roll benefit when added to the current yield on production coupon makes them relatively attractive compared to other asset classes. But we see 2 headwinds.

The first headwind comes from the technology-driven nonbank mortgage lenders. The brick-and-mortar operations of traditional banks are being supplemented by call centers, e-mail and text message marketing and increasingly online underwriting and loan processing, all of which can be much more efficient and effective.

This is creating heightened prepayment sensitivity as a function of refi incentive. As long as the Fed is actively buying, it is still gobbling up the worst pools via the TBA market. And so TBA pricing does not need to fully reflect clearing levels where private investors see value.

That can still be the case even after tapering is over, if as expected, the Fed continues to reinvest paydowns. But this dynamic is going to be greatly impacted by the level of mortgage rates. The most recent Freddie Mac survey mortgage rate was 3.15%.

We believe that an increase in mortgage rates just to 3.50% may materially slow down refi-generated supply. On the other hand, if mortgage rates dropped back below 2.90%, refi supply will continue, and it may produce an increase in net mortgage supply at a time of diminished Fed support. The second headwind is the shape of the yield curve.

Agency MBS typically have stronger performance in the steeper yield curve environment. A flatter curve typically leads to diminished Agency MBS demand from CMO issuance and exacerbate negative convexity. So far in the fourth quarter, there has been a big curve flattening, which has weighed most heavily on higher coupons.

So we have kept our net mortgage exposure relatively low and have lots of room to add mortgage exposure should we see spread widely in the last 2 months of the year. That would not be uncommon at all, market liquidity has gotten worse as many participants have diminished risk appetite coming into year-end.

Slightly diminished fed support when properly managed can be a great thing for EARN. This year, we have been in a market dominated by 1 giant investor, the Fed, whose objective is not motivated by investment returns.

As the Fed's footprint shrinks, however, and return-seeking investors to gradually become the marginal buyers of Agency MBS, we believe potential investment returns will increase. We don't necessarily expect a large widening event but we do expect some investment opportunities to emerge at attractive entry points.

So far, we're off to a good start in Q4. Now back to Larry..

Thanks, Mark. As we move into the final weeks of 2021, I think Ellington Residential is well positioned to capitalize on pricing dislocations that Fed tapering or even just fear of Fed tapering could generate.

We finished the quarter with a debt-to-equity ratio of 6.7x, which is significantly lower than pre-COVID periods such as 2018 and 2019 when our debt-to-equity ratio averaged around 9x. With this lower leverage, we've also maintained higher liquidity.

So moving forward, we have plenty of room to add assets and be opportunistic should spreads widen and pockets of volatility return.

Our smaller size also enables us to move nimbly in and out of positions and redirect capital opportunistically as we did in the spring of 2020 when we rotated aggressively into non-Agency RMBS and in response to the COVID-related market sell-off.

Time and time again, we have demonstrated our ability to protect book value through diligent hedging and liquidity management, but we've also demonstrated our ability to capitalize quickly on investment opportunities, such as by dialing up or down our mortgage exposure based on changing market conditions.

The day finally seems to be coming when the Agency RMBS market will have to reckon with the impact of Fed tapering. And we expect our portfolio of specified pools, long TBAs and short TBAs to outperform. The Fed's constant buying of current coupon TBAs has put steady pressure on pay-ups for many specified pools sectors.

Since TBA short positions represent a significant component of our hedging portfolio, we believe that a rise in payoffs will flow right through to our bottom line.

We are positioned this way not because we're making a bet on interest rates or Fed policy but because we believe that this strategy will outperform in a wide range of possible near and medium-term outcomes. Finally, the prepayment landscape continues to evolve as we see more signs of prepayment burn out.

And I believe that this is a competitive advantage for Ellington Residential as we draw in Ellington's 26-plus years of experience modeling prepayments and trading these markets.

As the Fed withdraws support, even while mortgage rates remain very low by historical standards, we think that there will be compelling opportunities in the Agency MBS sector for those who can successfully navigate the crosscurrents of prepayment risk and extension risk.

And we believe that we are best in class when it comes to Agency MBS asset selection and portfolio construction. We view Ellington Residential as an all-weather REIT, able to thrive in a diversity of market environments. And with that, we'll now open the call to questions. Operator, please go ahead..

We'll take a question from Doug Harter of Crédit Suisse..

This is John Kilichowski on for Doug Harter. Just going back to your comments on leverage. I understand that you brought it down a little bit last quarter. And from some of your agency peers we've seen the appetite to take it up a bit this quarter.

And I wanted to see what your was or what you sort of need to see in the market in order for you to bring leverage up this quarter..

Yes. So look, we get big news today from the Fed. The market has performed reasonably well in front of that. We sort of -- that was still consistent with our expectations. But I guess, a quarter ago, if we had said, what's more likely underperformance or outperformance right in front of the Fed.

We would've said, we think performance will be steady, but out of those 2 scenarios, probably underperformance is more likely. So I think you're coming into year-end. Balance sheets are generally reduced. You see a pullback in liquidity, going to get news today. So I think you're going to get pockets of volatility.

You're also going to get a big increase in projected mortgage supply when Fannie, Freddie loan limits are updated for the really extraordinary HPA we saw. So I think a modest pullback would increase our leverage..

Got it. And I guess my second question would be just some color around TBA performance versus spec pools this quarter, and what we've seen as being more attractive so far in the quarter where you're thinking about spending incremental dollars..

So it's a great question. A lot depends on the coupon. I would say this quarter so far, you've probably seen a little bit of spec pool weakness relative to TBA. We've -- when I think about what we've done in the last couple of weeks, it's been adding on both sides.

It's been adding some pools in production coupons, some pools and higher coupons but also actively trading TBA.

So I think our view is at least for the next 3 months or so, sort of the trends in place, you saw in the second -- the third quarter are likely to persist, specifically high value for production coupon roles, which were a real tailwind to performance, weakness in higher coupon rolls and continued sort of heightened mortgage responsiveness to prepay incentives.

And we referenced it in the call, but I think what's kind of been interesting is that many of the nonbanks have been growing market share, and they're really growing market share at the expense of traditional bricks-and-mortar banks.

And so that change in prepayment responsiveness, we think it's something that's going to be with here -- with us for a while. If you have a big sell-off in rates, and a big chunk of the market doesn't have refinance opportunities, then that difference in sensitivity is going to be more latent. You won't necessarily see it in prepayment reports.

But I think that, to us, is sort of a permanent -- there's a permanent shift in mortgage responsiveness that occurred over the last 2 years that we think is unlikely to reverse..

Got it. And I would -- just a quick last question.

Do we have a book value update forward today?.

We typically don’t give specific estimates intra-quarter. But I can just tell you, the quarter is off to a good start for us..

And we'll take our next question from Crispin Love of Piper Sandler..

First on the yield side. So can you speak to what drove the lower yields in the quarter? And then just some of your expectations over the near to intermediate term.

I guess, over the next -- in the fourth quarter and the next couple of quarters, would you expect that kind of yields to kind of move closer to what we saw in the second quarter or kind of stick around where kind of the lower that we saw in the third..

Yes, I think the -- Chris, it's Larry. I think we saw a drop in yields. But a lot of that is, I think, due to a couple of different factors. So first of all, just portfolio turnover, right? I think Mark mentioned our portfolio turnonover was a little higher this quarter. And we're not afraid. We have some maybe higher yielding assets.

And if we think that they've run their course. We're not afraid certainly to replace them with so we think we have more upside even if they have a slightly lower NIM. I mean, our NIM -- if you look at our NIM, yes, it dropped quarter-over-quarter, but it's still really quite high historically.

So -- and we're still comfortably covering our dividend even with this low leverage.

So if you think about what Mark said, we're going into year-end, we think there's going to be pockets of opportunity and volatility that we're going to be able to increase our leverage back to more whatever historically been more normal levels for us, you can see that we've got a lot of room to increase core even with NIMs contracting on a dollar-for-dollar basis, let's just say.

So yes, so I wouldn't be too concerned about just having the overall asset yield drop a bit..

Okay. That's helpful. Just one more for me. So looking at the interest rate sensitivity slide, Slide 19 in the deck, it looks like there were some changes in the quarter? And I'm especially focused on the 50 bps increase in rates side compared to last quarter's deck.

So can you walk through some of the changes and what caused the changes relative to last quarter, if there's anything important to really point out there, whether it's changes that you saw in your portfolio or the assumptions that go into the interest rate sensitivity?.

Yes. I think if you – you’re right, it is a little different than it was in the prior quarter, but I wouldn’t read too much into it, frankly. Where it was – if you look at the overall duration – remember, this is on a leveraged basis, still quite low. So I wouldn’t read like that we had some sort of market call in mind or anything like that.

And I would imagine that if you look at it today or next week or whatever, it might have reverted back to the levels where it was even before in terms of closer to 0 duration. So I wouldn’t read much into it..

We'll move next to Mikhail Goberman of JMP Securities..

So the agency MBS portfolio has been pretty steady over the last few quarters.

I'm wondering what sort of spread widening would you need to see to begin to meaningfully add to the MBS portfolio, assuming we start to see that in the near future?.

It's Mark. Thank you for the question. So I would say that it depends -- it certainly depends on where interest rates are, right? That you've had this -- in the past year and change. You have really changed the composition of the agency mortgage market, and you have created lots and lots of Fannie 2s, lots and lots of Fannie 2.5s.

So you've a lot of borrowers have taken advantage of refinance opportunities. So if you bring mortgage rates up to, say, a 3.5% mortgage rate now, we think you're going to really slow down supply, right? You're really going to cut off supply.

So in that scenario, I think sort of spreads where they are or maybe 5 basis points wider, we'd want to increase our leverage. If you were to get though a rally, and I think we mentioned 2.90% is sort of an important mortgage rate level.

If you get a rally to there and then you're going to have more borrowers take advantage of refinance opportunities at a time when Fed support is diminished, then we'd look for a bigger widening. So I think what you're going to see is the shift.

Like what's interesting is this, most of the big nonbanks are now public companies, Rocket, Loan Depot, UWN, and they've been growing market share, not really at the expense of each other. But growing market share at the expense of traditional brick-and-mortar bank mortgage origination platforms.

And so I think what you'll see is if you have an increase in mortgage rates. You're going to see a reduction in supply, but a lot of the focus on refinance is going to be focused on these higher coupons where there still are borrowers that can really benefit from taking advantage of today's lower mortgage rates.

So where we think it makes sense to increase the net mortgage exposure is going to be really 2 factors, right? What are the spread levels and also what interest rate regime are we in now, which is going to inform how much supply we're going to get relative to sort of this diminished Fed net buying we're going to see..

Right. So -- sorry, go ahead..

The other thing even within a quarter, we'll move around our mortgage exposure, right? So what you get on these earnings calls and our earnings presentations are sort of snapshots at the end of the quarter, but sometimes things can be fairly dynamic within a quarter..

And if I could, if I could just point you to Slide 20, which shows you where we have our -- where we're positioned in TBAs. So you can see there that we're still, as Mark is saying, we're still defensive on higher coupons.

And for exactly the reasons that Mark said, even in the current environment, obviously, you've got these nonbanks that are getting more and more efficient in terms of refi-ing higher coupons.

But then if rates go up, which certainly is a possibility, those higher coupons are going to be even more focused on by those companies in terms of where they're concentrating their marketing and all the other things. So that's -- so I think that's something to keep in mind in terms of where we're focusing..

Great. I appreciate that. And just one more.

It is a small part of the portfolio, but what's the sort of strategy on reverse mortgages going forward?.

Well, reverse mortgage has widened, actually have widened quite a bit recently. So we think that now they're less liquid than other Agency MBS that we trade more actively, but they actually provide much more much more yield, much more NIM. They have much less negative convexity. So I think at current levels, we really like them.

So if anything, I think we could see an increase there, but it's never going to be a huge portion of what we do..

Great. And if I could, one more. Within -- you mentioned that there's quite a lot of activity within the quarter. We, as analysts, don't usually get a lot of insight into what goes on in the 3 months and between quarters. But was there a shift in your hedging strategy perhaps during those days when rates fell to the lows level, I guess, early August.

So I guess my -- yes, sorry..

No, I was going to say, no, that’s a good point. And I talked about the interest rate volatility in the script, but I didn’t really connect the dots. So what we do is we look at our interest rate exposure every day, right, and mortgages are negatively convex relative to treasury.

So when you get a decline in interest rates to mitigate interest rate risk, we have to buy back some of our hedges or add to duration to the portfolio. And then if interest rates make a turn and go back to where they started, you have to unwind that. And the sort of there’s a toll in that round trip.

And that expected toll is built into mortgage spreads, right? So mortgages have this yield advantage versus treasuries because there’s this expectation that there’s some delta hedging costs associated with it. Now in some quarters, the delta hedging costs are sort of more than what’s implied by market levels of volatility.

In some quarters, they’re less. So yes, that was certainly a – there was a cost that this quarter.

It – our strategy, though, didn’t deviate at all from how it’s always been that when you get a material move in interest rates, that has had a significant change in portfolio duration, you need to take – you take portfolio steps to mitigate that and to bring things sort of back into the guardrails. So that was certainly a component this quarter.

But the way we approached it is the way we’ve always approached it..

And this does conclude our question-and-answer session as well as our conference for today. You may now disconnect your lines, and everyone, have a great day..