Business Context and Reporting Period
Ellington Residential Mortgage REIT (NYSE: EARN) filed its Form 10-K for the fiscal year ended December 31, 2020, including fourth-quarter results. The company is an externally managed mortgage REIT investing primarily in Agency residential mortgage-backed securities (RMBS), with smaller investments in non-Agency RMBS and related assets. It is managed by Ellington Residential Mortgage Management LLC and has elected REIT tax treatment.
The filing identifies the registrant as Ellington Residential Mortgage REIT; the supplied metadata refers to Ellington Credit Co. The company had 12,343,542 common shares outstanding at March 5, 2021, and the Blackstone Funds owned approximately 26.8% of outstanding common shares at December 31, 2020.
Key Financial Metrics
| Metric | 2020 | 2019 |
|---|---|---|
| Interest income | $27.3 million | $43.8 million |
| Interest expense | $10.0 million | $35.3 million |
| Net interest income | $17.4 million | $8.6 million |
| Net income | $20.1 million | $22.3 million |
| Net income per share | $1.63 | $1.79 |
| Core earnings | $15.6 million; $1.26 per share | $11.3 million; $0.91 per share |
| Operating cash flow | $24.4 million | $17.5 million |
| Shareholders’ equity | $166.4 million | $160.8 million |
| Book value per share | $13.48 | $12.91 |
| Dividends declared per share | $1.12 | $1.18 |
Excluding the catch-up premium amortization adjustment, the weighted-average portfolio yield was 2.82%, compared with 3.29% in 2019. Total average cost of funds, including swaps and short Treasury positions, declined to 1.01% from 2.41%, producing a net interest margin of 1.81% versus 0.88%.
Economic return for 2020 was 13.1%, calculated using the increase in book value per share plus dividends. The company reported $27.0 million of net realized and unrealized gains on Agency RMBS, partially offset by $21.8 million of losses on interest-rate hedges.
Balance Sheet, Portfolio, Debt and Liquidity
- Total assets were $1.195 billion at December 31, 2020, versus $1.489 billion at December 31, 2019.
- Mortgage-backed securities at fair value totaled $1.081 billion, including $1.051 billion of Agency RMBS, $17.6 million of non-Agency RMBS and $13.0 million of Agency interest-only securities.
- Outstanding repurchase-agreement borrowings were $1.015 billion with 15 counterparties, compared with $1.296 billion at year-end 2019.
- The debt-to-equity ratio declined to 6.1:1 from 8.1:1. The weighted-average repo rate declined to 0.25% at year-end from 2.00%.
- Cash and cash equivalents increased to $58.2 million from $35.4 million. Other unencumbered assets were approximately $47.4 million.
- The weighted-average contractual repo haircut was 5.3%, compared with 4.9% at year-end 2019. Net cash collateral posted to repo counterparties was $34.7 million.
- The company had no other borrowings outstanding and no material off-balance-sheet arrangements.
Material Changes Versus the Prior Comparable Period
- Net income declined 9.6%, primarily because total other income decreased to $8.6 million from $19.0 million, despite substantially higher net interest income.
- Interest income fell because average Agency RMBS holdings and asset yields declined, while interest expense fell sharply because of lower short-term rates and reduced borrowings.
- Agency RMBS holdings decreased approximately 24%, from $1.393 billion to $1.064 billion. Non-Agency RMBS holdings increased approximately 99%, from $8.9 million to $17.6 million.
- Core earnings increased approximately 38% to $15.6 million, reflecting the improvement in net interest income and lower funding costs.
- Agency RMBS turnover increased to 64% from 52%, with net realized Agency RMBS gains of $11.8 million compared with $2.8 million in 2019.
- The company repurchased 136,142 common shares for approximately $1.0 million during 2020. Quarterly dividends were $0.28 per share throughout 2020, versus $0.34 in the first quarter and $0.28 thereafter in 2019.
- During March and April 2020, the company experienced elevated margin calls and higher repo haircuts as COVID-19 disrupted markets. Management reduced portfolio size and leverage in response and stated that all margin calls were satisfied.
Fourth-Quarter Results and Cash Flow
| Three months ended December 31, 2020 | Amount |
|---|---|
| Net interest income | $5.5 million |
| Total expenses | $1.4 million |
| Total other income | $3.3 million |
| Net income | $7.4 million |
| Net income per share | $0.60 |
| Dividend declared per share | $0.28 |
For full-year 2020, investing activities provided $304.1 million of cash and financing activities used $305.6 million. After dividends and share repurchases, cash increased by $22.8 million.
Guidance, Outlook, Risks and Unusual Items
Management did not provide quantitative earnings or leverage guidance. It expects portfolio allocation and leverage to remain flexible and dependent on market opportunities, financing availability, interest rates and prepayment conditions. Management intends to continue emphasizing Agency specified pools while opportunistically adjusting non-Agency RMBS exposure.
- COVID-19 caused extreme market volatility, liquidity dislocations, elevated margin calls and higher financing haircuts. The company remains operational in a largely remote-work environment.
- Rapidly falling mortgage rates increased prepayments; the Fannie Mae 30-year mortgage prepayment rate reached 37.2 CPR in October 2020 and ended the year at 35.6 CPR. Faster prepayments can reduce yields and impair interest-only securities.
- The portfolio remains exposed to interest-rate mismatches, repo refinancing risk, margin calls, leverage, counterparty risk and derivative losses. A modeled 100-basis-point rate increase was estimated to reduce portfolio value by $5.2 million, or 3.13% of equity, while a 100-basis-point decrease was estimated to reduce value by $7.7 million, or 4.63%, under the stated assumptions.
- Future changes to Fannie Mae, Freddie Mac and Ginnie Mae, including their guarantees and government support, could materially affect Agency RMBS values, financing and REIT or Investment Company Act compliance.
- The company relies on externally managed personnel and pays its Manager a management fee equal to 1.50% annually of defined shareholders’ equity. Termination or non-renewal generally requires a fee equal to 5% of defined shareholders’ equity.
- The management agreement expires in September 2021 and automatically renews for one-year periods unless properly terminated or not renewed.
- The company made a Section 475(f) mark-to-market tax election effective January 1, 2021. This may create taxable income without corresponding cash and carries uncertainty regarding REIT tax treatment.
- Fair value measurements include $21.5 million of Level 3 mortgage-backed securities, requiring assumptions regarding yields, prepayments, losses and recoveries. The independent auditor identified valuation of these investments as a critical audit matter.
- No material legal proceedings or significant contingencies were reported. Management concluded that disclosure controls and internal control over financial reporting were effective at year-end.
Important Facts for Investors to Verify
- Reconcile reported GAAP net income with core earnings and determine how much performance depended on mark-to-market gains, realized gains and hedge losses.
- Assess whether the lower 6.1:1 leverage ratio and $58.2 million cash balance provide sufficient protection against renewed repo margin calls or higher haircuts.
- Review the composition, duration, premium exposure and prepayment behavior of the Agency specified-pool portfolio.
- Evaluate the effect of continued high prepayments and low mortgage rates on Agency interest-only securities, asset yields and dividend capacity.
- Review funding maturity concentration, counterparty exposures, collateral requirements and the ability to roll approximately $1.0 billion of short-term repos.
- Monitor the transition from LIBOR to alternative reference rates, including the effect on repos, swaps and hedge effectiveness.
- Review the Section 475(f) election, potential phantom income and continuing compliance with REIT income, asset and distribution tests.
- Evaluate external management fees, expense reimbursements, related-party conflicts and the potential 5% management-agreement termination fee.