Ellington Credit Co quarterly report, Q3 FY2019

Business Context and Reporting Period

This unaudited Form 10-Q covers the three and nine months ended September 30, 2019, filed November 6, 2019. The filing entity is Ellington Residential Mortgage REIT, ticker EARN, although the request identifies Ellington Credit Co. The company is an externally managed REIT investing primarily in Agency residential mortgage-backed securities, with smaller non-Agency RMBS, derivatives, and related assets.

The company had 12.45 million common shares outstanding at September 30, 2019 and no preferred shares outstanding. It is taxed as a REIT and intends to distribute at least 100% of taxable income within applicable deadlines.

Key Financial Metrics

Metric	Q3 2019	Q3 2018	9M 2019	9M 2018
Interest income	$10.5 million	$13.2 million	$35.2 million	$40.7 million
Interest expense	$8.8 million	$8.5 million	$28.0 million	$23.4 million
Net interest income	$1.7 million	$4.7 million	$7.2 million	$17.2 million
Net income	$3.7 million	$0.9 million	$12.6 million	$(1.2) million
GAAP EPS	$0.30	$0.07	$1.01	$(0.09)
Core earnings	$0.9 million	$3.7 million	$5.1 million	$13.1 million
Adjusted core earnings	$2.4 million	$4.1 million	$8.5 million	$13.2 million

Reported net interest margin was 0.38% in Q3 2019 versus 1.02% in Q3 2018, and 0.53% for the first nine months versus 1.12% in the prior-year period. Excluding catch-up premium amortization adjustments, adjusted net interest margin was 0.81% in Q3 and 0.83% for the first nine months.

Total assets were $1.67 billion at September 30, 2019, broadly unchanged from year-end 2018.
Mortgage-backed securities were $1.395 billion at fair value, down from $1.540 billion at December 31, 2018.
Agency RMBS represented approximately $1.385 billion of the portfolio, while non-Agency RMBS were $9.2 million.
Repurchase-agreement borrowings were $1.338 billion, versus $1.482 billion at year-end; weighted-average rate was 2.31% and remaining maturity was 44 days.
Cash and cash equivalents were $50.2 million, compared with $18.6 million at December 31, 2018.
Shareholders’ equity was $154.6 million, versus $153.8 million at year-end. Book value per share was $12.42, compared with $12.30 at December 31, 2018.
Debt-to-equity was 8.7:1, or 8.6:1 adjusted for unsettled transactions, compared with 9.6:1 and 9.2:1, respectively, at year-end.
Dividends declared were $0.28 per share in Q3 and $0.90 per share for the first nine months, compared with $0.37 and $1.11 in the comparable 2018 periods.

Cash Flow, Liquidity, and Capital

For the first nine months, operating activities provided $13.1 million and investing activities provided $193.5 million.
Financing activities used $175.0 million, including $12.0 million of dividends paid, $0.7 million of share repurchases, and net repayments of repurchase agreements.
Cash increased by $31.6 million from year-end 2018.
Management stated that current cash, portfolio cash flows, repo financing, and anticipated credit availability were expected to be sufficient for short- and long-term liquidity needs.
RMBS collateral pledged under repo agreements had a fair value of approximately $1.4 billion. The company posted $22.5 million of net cash collateral for repo margin calls at quarter-end.

Material Changes Versus Prior Comparable Period

Q3 net income increased to $3.7 million from $0.9 million, while nine-month net income changed from a $1.2 million loss to $12.6 million of income.
The improvement was driven primarily by securities gains: $10.6 million in Q3 and $46.8 million for the nine months, compared with securities losses in the 2018 periods.
Derivative performance reversed sharply. Derivatives produced a $7.2 million loss in Q3 and a $37.5 million loss for the nine months, compared with gains of $8.7 million and $32.3 million, respectively, in 2018.
Lower interest rates supported RMBS valuations but caused losses on interest-rate hedges. The company reported $7.8 million of net realized and unrealized hedge losses in Q3 and $37.5 million of derivative losses for the nine months.
Interest income declined because of lower average Agency RMBS holdings and larger negative catch-up premium amortization adjustments. The Q3 adjustment was $(1.6) million versus $(0.4) million in 2018; the nine-month adjustment was $(3.4) million versus $(0.1) million.
Prepayments increased materially. The company’s specified-pool constant prepayment rate was 14.5% in Q3, compared with 9.6% in Q2 and 8.4% in Q3 2018.
The portfolio and leverage were reduced during the quarter. RMBS fair value declined 4.4% from June 30, 2019, adjusted debt-to-equity declined to 8.6:1 from 8.9:1, and net mortgage assets-to-equity declined to 7.7:1 from 9.0:1.

Guidance, Outlook, Risks, and Unusual Items

No quantitative earnings or dividend guidance was provided. Management expects to continue targeting specified Agency pools with favorable prepayment characteristics and may increase non-Agency RMBS investments if more attractive entry points develop.

Management highlighted falling interest rates, rising mortgage prepayments, an inverted yield curve, repo-market volatility, changing Federal Reserve policy, and shifting government policy as important market developments.
The Federal Reserve reduced the federal funds target range twice during the quarter, while one-month LIBOR declined to 2.02% at quarter-end. Repo rates temporarily spiked in September, requiring Federal Reserve liquidity operations.
Prepayment risk is significant, particularly for Agency interest-only securities. The company recognized a $4.0 million year-to-date charge to Agency IO cost basis because of adverse cash-flow changes from increased prepayments.
Leverage and short-term repo financing create refinancing, margin-call, collateral, and liquidity risks. Repo agreements generally mature within 180 days, while the underlying RMBS have longer expected lives.
Interest-rate sensitivity analysis estimated that a parallel 100-basis-point rate increase would reduce portfolio market value by approximately $2.8 million, or 1.81% of equity, while a 100-basis-point decrease would reduce it by approximately $3.4 million, or 2.22%, under stated assumptions.
Non-Agency RMBS expose the company to borrower defaults, loss severity, property-value declines, servicing risk, and broader credit-market conditions.
The manager is entitled to a 1.50% annual management fee based on shareholders’ equity, expense reimbursements, and, in certain termination circumstances, a fee equal to 5% of defined shareholders’ equity.
No material legal proceedings were reported. An Ellington affiliate had previously received an SEC subpoena concerning loan origination, analysis, securitization, and servicing matters; management stated that no material proceeding was currently contemplated but could not assure that future action would not occur.
Management concluded that disclosure controls were effective as of September 30, 2019, with no material changes to internal control over financial reporting.

Most Important Facts for Investors to Verify

Confirm the filing entity and ticker: the supplied filing is for Ellington Residential Mortgage REIT, EARN, not an entity named Ellington Credit Co.
Reconcile reported GAAP net income with core and adjusted core earnings, especially the substantial securities and derivative fair-value effects.
Review the sustainability of dividends relative to recurring core earnings, adjusted core earnings, and taxable income.
Monitor repo counterparties, maturities, haircuts, margin requirements, collateral levels, and the company’s high debt-to-equity ratio.
Assess sensitivity to rising prepayments, particularly the impact on specified pools, premium amortization, and Agency IO securities.
Review derivative positioning and hedge losses, including the approximately $647.3 million fixed-payer swap notional, net short TBA exposure, and Treasury shorts.
Evaluate valuation uncertainty in Level 3 assets and the assumptions underlying prepayment, spread, and fair-value models.
Track the SEC inquiry involving an Ellington affiliate and any potential effects on the manager, affiliated entities, or the company.