Business Context and Reporting Period
Ellington Residential Mortgage REIT (NYSE: EARN), although the request identifies Ellington Credit Co, filed this unaudited Form 10-Q for the quarter ended March 31, 2019. The company is an externally managed Maryland REIT that acquires and manages primarily Agency residential mortgage-backed securities (RMBS), with a smaller non-Agency RMBS portfolio. It uses repurchase agreements and derivatives to finance assets and manage interest-rate risk.
The company had 12,467,103 common shares outstanding as of May 3, 2019 and no preferred shares outstanding. It intends to maintain REIT status and generally distribute taxable income to shareholders.
Key Financial Metrics
| Metric | Q1 2019 | Comparable period or date |
|---|---|---|
| Interest income | $12.6 million | $13.4 million in Q1 2018 |
| Interest expense | $9.6 million | $7.2 million in Q1 2018 |
| Net interest income | $3.1 million | $6.2 million in Q1 2018 |
| Total expenses | $1.4 million | $1.5 million in Q1 2018 |
| Net realized and unrealized securities gains | $20.3 million | $(25.1) million in Q1 2018 |
| Net realized and unrealized derivative gains/(losses) | $(13.1) million | $16.5 million in Q1 2018 |
| Net income/(loss) | $8.9 million | $(4.0) million in Q1 2018 |
| Basic and diluted EPS | $0.72 | $(0.30) in Q1 2018 |
| Core earnings | $2.4 million, or $0.19 per share | $4.3 million, or $0.32 per share |
| Adjusted core earnings | $3.3 million, or $0.27 per share | $4.4 million, or $0.34 per share |
| Economic return | 5.9% | Not provided for Q1 2018 in the filing text |
| Book value per share | $12.69 | $12.30 at December 31, 2018 |
| Total shareholders’ equity | $158.2 million | $153.8 million at December 31, 2018 |
| Cash and cash equivalents | $44.3 million | $18.6 million at December 31, 2018 |
| Mortgage-backed securities at fair value | $1.492 billion | $1.540 billion at December 31, 2018 |
| Repurchase agreement borrowings | $1.427 billion | $1.482 billion at December 31, 2018 |
Excluding catch-up premium amortization adjustments, the portfolio yield was 3.61%, adjusted net interest margin was 1.08%, and total average cost of funds, including interest-rate swaps and short U.S. Treasury securities, was 2.53%. Reported net interest margin was 0.83%.
Cash Flow, Liquidity, Debt and Capital
- Operating activities provided $4.8 million of cash; investing activities provided $84.4 million.
- Financing activities used $63.5 million, including $54.4 million of net repurchase-agreement repayments, $4.3 million of dividends paid, and $0.4 million of share repurchases.
- Cash increased by $25.7 million during the quarter, to $44.3 million.
- Total debt-to-equity was 9.0:1 at March 31, 2019, or 8.9:1 adjusted for unsettled purchases and sales, versus 9.6:1 and 9.2:1, respectively, at December 31, 2018.
- Repurchase agreements had a weighted-average interest rate of 2.70% and 45 remaining days to maturity. The company used 13 repo counterparties and had $87.3 million of aggregate amounts at risk under those agreements.
- The company posted $8.2 million of net cash collateral to repo counterparties and held $1.0 million of securities collateral at quarter-end.
- The company declared a first-quarter dividend of $0.34 per share, compared with $0.37 per share in Q1 2018.
Material Changes Versus Prior Comparable Period
- Net income improved by $12.9 million year over year, primarily because securities markets reversed the prior-year losses: securities generated $20.3 million of gains in Q1 2019 versus $25.1 million of losses in Q1 2018.
- Derivative performance reversed to a $13.1 million loss from a $16.5 million gain, as declining interest rates caused losses on short TBAs, interest-rate swaps and futures.
- Net interest income fell $3.1 million. Interest income declined because of lower average Agency RMBS holdings and a larger negative catch-up premium amortization adjustment, while interest expense increased because of higher repo funding costs.
- Average repo borrowings declined to $1.42 billion from $1.59 billion, but average repo cost increased to 2.70% from 1.63% in Q1 2018.
- The RMBS portfolio decreased 3.1% from year-end 2018. Agency RMBS remained dominant; non-Agency RMBS fair value was approximately $11.2 million at both March 31, 2019 and December 31, 2018.
- Long TBA notional exposure increased to $216.2 million from $95.1 million, while short TBA notional exposure increased to $374.5 million from $294.0 million.
- Share repurchases declined to 40,110 shares costing $0.4 million, compared with 512,367 shares costing $5.7 million in Q1 2018.
Guidance, Outlook, Risks and Unusual Items
Management expects current capital resources, cash flows, repo financing and available credit to satisfy anticipated liquidity needs, but no formal earnings or dividend guidance was provided. Management intends to continue emphasizing specified Agency pools and using swaps, TBAs, U.S. Treasury securities and futures to hedge interest-rate exposure.
- Management reported declining interest rates, a flattening yield curve and sharply lower mortgage rates during the quarter. Lower mortgage rates were expected to increase prepayments and refinancing activity.
- Higher expected prepayments increased specified-pool pay-ups and contributed to a $1.1 million charge related to adverse cash-flow changes on Agency interest-only securities.
- Prepayment risk is material, particularly for interest-only securities and specified pools. The three-month constant prepayment rate for fixed-rate specified pools was 6.0% versus 6.6% in the prior quarter and 7.0% in Q1 2018.
- The company is highly leveraged and relies on short-term repo financing against longer-lived RMBS. Margin calls, collateral requirements, refinancing risk and counterparty exposure could materially affect liquidity.
- A hypothetical immediate 100-basis-point rate increase was estimated to reduce portfolio value by $17.2 million, or 10.86% of equity; a 100-basis-point decrease was estimated to reduce value by $17.4 million, or 11.02%, under the filing’s assumptions.
- Non-Agency RMBS expose the company to borrower defaults, property-value declines, loss severity and servicing risks, although the portfolio was relatively small.
- Fair values for certain Level 3 securities depend on non-binding third-party valuations and models using assumptions for yields, prepayments, losses and recoveries.
- The external management agreement provides for a 1.50% annual management fee based on defined shareholders’ equity, expense reimbursements and, in certain circumstances, a termination fee equal to 5% of defined shareholders’ equity.
- No material legal proceedings or significant contingencies were reported. An SEC subpoena involving an Ellington affiliate remains a disclosed regulatory risk; management stated that it was not aware of any contemplated material proceeding against the company or Ellington.
- Management concluded that disclosure controls and procedures were effective as of March 31, 2019, with no material changes in internal control over financial reporting.
Investor Verification Checklist
- Confirm the issuer identity: the supplied filing is for Ellington Residential Mortgage REIT, ticker EARN, not an entity identified in the request as Ellington Credit Co.
- Reconcile GAAP net income of $8.9 million with core earnings of $2.4 million and adjusted core earnings of $3.3 million, particularly the impact of fair-value gains and hedging losses.
- Review repo maturities, collateral haircuts, margin-call requirements and counterparty concentrations supporting the 9.0:1 leverage ratio.
- Assess whether rising prepayments could reduce income or impair the value of Agency interest-only securities and specified pools.
- Evaluate the sensitivity of book value and liquidity to interest-rate changes, yield-curve movements and derivative collateral requirements.
- Review the external management agreement, expense reimbursements, termination-fee provisions and related-party governance.
- Monitor the disclosed SEC inquiry involving an Ellington affiliate and any effect on the manager, financing relationships or regulatory standing.