Ellington Residential Mortgage REIT (EARN) — Form 10-Q Summary
Filing-period note: The supplied filing is for Ellington Residential Mortgage REIT, not Ellington Credit Co. It covers the quarter and nine-month period ended September 30, 2016. The company is an externally managed Maryland REIT focused primarily on Agency residential mortgage-backed securities (RMBS), with a smaller non-Agency RMBS portfolio. It had 9,127,039 common shares outstanding at October 28, 2016.
Business Context and Portfolio
- At September 30, 2016, mortgage-backed securities were carried at fair value of $1.233 billion, comprising Agency RMBS of approximately $1.215 billion and non-Agency RMBS of $17.9 million.
- The company primarily invests in specified Agency pools designed to provide prepayment protection and uses repurchase agreements and derivatives to finance and hedge the portfolio.
- The company had $1.159 billion of repurchase borrowings with 13 counterparties and a debt-to-equity ratio of 8.1:1.
- Blackstone Tactical Opportunities Funds owned approximately 29% of outstanding common shares at September 30, 2016.
Key Financial Metrics
| Metric | Three Months Ended September 30, 2016 | Three Months Ended September 30, 2015 | Nine Months Ended September 30, 2016 | Nine Months Ended September 30, 2015 |
|---|---|---|---|---|
| Interest income | $7.1 million | $11.3 million | $24.3 million | $31.4 million |
| Net interest income | $4.8 million | $9.7 million | $17.7 million | $27.0 million |
| Total expenses | $1.3 million | $1.3 million | $3.9 million | $4.0 million |
| Net realized and unrealized gains/(losses) | $3.1 million | $(13.2) million | $(3.9) million | $(24.0) million |
| Net income/(loss) | $6.6 million | $(4.8) million | $9.9 million | $(0.9) million |
| Basic and diluted EPS | $0.73 | $(0.53) | $1.09 | $(0.10) |
| Dividends declared per share | $0.40 | $0.45 | $1.25 | $1.55 |
- Shareholders’ equity was $143.3 million at September 30, 2016, compared with $144.9 million at December 31, 2015.
- Book value per share was $15.70, compared with $15.86 at December 31, 2015 and $15.38 at June 30, 2016.
- Cash and cash equivalents were $43.0 million, compared with $40.2 million at December 31, 2015.
- Average repo borrowing cost was 0.71% for the third quarter and 0.68% for the first nine months, versus 0.43% and 0.39%, respectively, in the comparable 2015 periods.
- Core earnings were $2.9 million, or $0.32 per share, for the third quarter and $10.7 million, or $1.18 per share, for the first nine months. These are non-GAAP measures and exclude specified realized and unrealized gains and losses.
Cash Flow, Liquidity, Debt and Capital
- For the first nine months, operating activities provided $26.5 million and investing activities provided $52.2 million of cash.
- Financing activities used $75.8 million, including net repayments of repurchase agreements and $11.9 million of dividends paid.
- Cash increased by $2.9 million from December 31, 2015 to September 30, 2016.
- Repurchase agreements generally mature within 180 days. The weighted-average remaining maturity was 44 days, and the weighted-average interest rate was 0.72% at quarter-end.
- The company believes available cash, investment cash flows, repo financing and credit availability will satisfy anticipated liquidity requirements. Liquidity remains exposed to margin calls, refinancing needs and collateral values.
Material Changes Versus Prior Comparable Period
- Third-quarter net income improved to $6.6 million from a $4.8 million loss, primarily because securities gains and substantially smaller derivative losses more than offset lower net interest income.
- Nine-month net income improved to $9.9 million from a $0.9 million loss, although net interest income declined by $9.3 million because of lower average holdings, lower Agency RMBS yields and higher financing costs.
- Interest income declined 23% for the quarter and 23% for the nine-month period, while repo-related and other interest expense increased.
- Agency RMBS fair value was approximately $1.215 billion at September 30, 2016, broadly similar to year-end. Non-Agency RMBS declined to $17.9 million from $31.4 million.
- Derivative liabilities increased to $9.9 million from $4.7 million at year-end, and the net fair value of derivatives worsened to a liability of $8.2 million from $2.5 million.
- Quarterly specified-pool prepayment rates increased to 12.7% from 10.1% in the second quarter and 6.5% in the fourth quarter of 2015.
- Dividends declined to $0.40 per share in the third quarter from $0.45 in the comparable 2015 quarter; nine-month dividends declined to $1.25 from $1.55 per share.
Outlook, Management Commentary and Risks
- Management reported strong demand for Agency RMBS and favorable performance in non-Agency RMBS during the quarter, supported by housing-market fundamentals and investor demand for yield.
- Management expects continued elevated prepayment risk and interest-rate volatility. It intends to emphasize specified pools and use TBAs, interest-rate swaps, Treasury shorts and other derivatives for hedging.
- The Federal Reserve maintained a federal funds target range of 0.25% to 0.50% during the quarter. Management noted substantial risk that interest rates could rise as monetary policy normalizes.
- Key risks include high leverage, short-term repo funding, margin calls, refinancing and counterparty risk, interest-rate movements, mortgage prepayments, valuation uncertainty, non-Agency credit losses and changes affecting Fannie Mae and Freddie Mac.
- At September 30, 2016, a 100-basis-point parallel rate increase was modeled to reduce portfolio fair value by approximately $8.5 million; a 100-basis-point decrease was modeled to reduce fair value by approximately $7.2 million. Management cautioned that actual results could differ materially.
- The company is externally managed. The management fee equals 1.50% annually of defined shareholders’ equity, and the management agreement may require a termination fee equal to 5% of defined shareholders’ equity in specified circumstances.
- The company reported no material legal proceedings, no material changes to previously disclosed risk factors, no material contingencies, and effective disclosure controls as of September 30, 2016.
Important Facts for Investors to Verify
- Confirm the issuer identity: the filing is for Ellington Residential Mortgage REIT, not Ellington Credit Co.
- Reconcile GAAP net income with non-GAAP Core Earnings and assess how much earnings and dividends depend on realized gains, unrealized marks and premium-amortization adjustments.
- Monitor repo financing availability, collateral haircuts, margin-call exposure and the concentration of counterparty risk.
- Evaluate whether higher prepayment speeds reduce asset yields, accelerate premium amortization or impair interest-only securities.
- Review the sensitivity of book value and earnings to interest-rate changes, derivative positioning and valuation assumptions for Level 3 assets.
- Assess the sustainability of dividends relative to Core Earnings, cash flow and REIT distribution requirements.