Business Context and Reporting Period
Ellington Residential Mortgage REIT (NYSE: EARN), an externally managed Maryland REIT, filed its unaudited Form 10-Q for the quarter ended March 31, 2023. The company invests primarily in Agency residential mortgage-backed securities (RMBS), with a smaller allocation to non-Agency RMBS, and uses repurchase agreements and derivatives to finance and hedge its portfolio.
Key Financial Metrics
| Metric | Q1 2023 | Comparable / Prior Period |
|---|---|---|
| Interest income | $9.3 million | $6.5 million in Q1 2022 |
| Interest expense | $9.7 million | $1.1 million in Q1 2022 |
| Net interest income | $(0.4) million | $5.4 million in Q1 2022 |
| Net income | $2.3 million | $(17.5) million in Q1 2022 |
| Basic and diluted EPS | $0.17 | $(1.33) in Q1 2022 |
| Adjusted distributable earnings | $2.8 million, or $0.21 per share | $3.9 million, or $0.30 per share |
| Net interest margin | 1.16% | 1.76% in Q1 2022 |
| Cash and cash equivalents | $36.7 million | $34.8 million at December 31, 2022 |
| Shareholders’ equity | $115.0 million | $112.4 million at December 31, 2022 |
| Book value per share | $8.31 | $8.40 at December 31, 2022 |
| RMBS at fair value | $925.5 million | $893.3 million at December 31, 2022 |
| Repurchase agreement borrowings | $875.7 million at 4.95% weighted average rate | $842.5 million at 3.70% at December 31, 2022 |
Operating activities used $2.4 million of cash and investing activities used $45.1 million. Financing activities provided $49.3 million, including net repo borrowings and $3.5 million of net ATM offering proceeds. Cash increased by $1.8 million during the quarter.
Material Changes Versus Prior Comparable Period
- Net income improved to $2.3 million from a $17.5 million loss, primarily because securities generated $12.8 million of net realized and unrealized gains versus a $64.7 million loss in Q1 2022.
- Derivative results reversed to an $8.8 million net loss from a $43.1 million net gain in Q1 2022, reflecting lower interest rates during the quarter.
- Interest income increased, but higher repo financing costs drove net interest income to a loss. Average repo cost rose to 4.46% from 0.29% in Q1 2022.
- Adjusted distributable earnings declined to $0.21 per share from $0.30 per share.
- RMBS fair value increased $32.2 million from year-end, with Agency RMBS holdings increasing to $890.9 million from $863.3 million. The company indicated that it expects to continue increasing its non-Agency RMBS allocation when market opportunities arise.
- Common shares outstanding increased to 13.83 million from 13.38 million, primarily through issuance of 455,671 shares under the ATM program.
Outlook, Commentary, Risks and Unusual Items
Management reported a challenging market characterized by elevated interest-rate volatility, an inverted yield curve, banking-sector stress, quantitative tightening and wider Agency MBS spreads. The company reported a 1.8% economic return for Q1 2023, including dividends, despite book value per share declining to $8.31.
The portfolio was predominantly Agency RMBS, including $866.5 million of fixed-rate specified pools, $7.8 million of Agency ARMs, $16.7 million of Agency reverse mortgage pools, $9.7 million of Agency IOs, $14.7 million of non-Agency RMBS and $10.2 million of non-Agency IOs. Fixed-rate specified-pool prepayments declined to a 4.3% three-month CPR from 17.0% in Q1 2022.
The company targets a leveraged strategy and had approximately 7.6:1 total debt-to-equity at quarter-end, or 7.5:1 after adjustment for unsettled purchases and sales. Its net mortgage assets-to-equity ratio was 6.9:1, compared with 6.6:1 at year-end. Repurchase agreements were secured by approximately $0.9 billion of collateral and were spread across 16 counterparties.
Management stated that current liquidity and financing resources are expected to satisfy anticipated short- and long-term needs, but noted that margin calls, higher haircuts, inability to roll short-term repos, collateral declines and adverse market conditions could materially impair liquidity. The filing provides no formal earnings or dividend guidance. The board declared monthly dividends of $0.08 per share for April and May 2023, payable in May and June, respectively.
Primary risks include interest-rate and spread volatility, prepayment and extension risk, leverage and repo refinancing risk, margin calls, counterparty exposure, credit losses on non-Agency RMBS, valuation uncertainty for Level 3 assets, changes in Fannie Mae and Freddie Mac policy, REIT qualification requirements and potential regulatory or legal proceedings. Management reported no material legal proceedings, no material changes to previously disclosed risk factors and effective disclosure controls.
Investor Verification Priorities
- Verify the sustainability of the $0.08 monthly dividend against adjusted distributable earnings, which were $0.21 per share for the quarter.
- Monitor repo borrowing costs, refinancing availability, haircuts, margin requirements and the company’s 7.6:1 reported leverage.
- Reconcile book value changes with RMBS valuations, derivative marks and the company’s interest-rate sensitivity analysis.
- Assess the effect of falling or rising rates on Agency RMBS, hedges, prepayments and net interest margin.
- Review the quality, valuation assumptions and credit performance of the non-Agency RMBS and Level 3 portfolio.
- Confirm the effect of ATM share issuance on per-share book value, earnings and dividend coverage.
- Note that adjusted distributable earnings is a non-GAAP measure and is not equivalent to REIT taxable income or cash available for distribution.