Ellington Residential Mortgage REIT (NYSE: EARN) — Form 10-Q Summary
Reporting period: Three and six months ended June 30, 2019; filed August 8, 2019. The supplied filing identifies the registrant as Ellington Residential Mortgage REIT, not Ellington Credit Co.
Business context
EARN is an externally managed Maryland REIT that invests primarily in Agency residential mortgage-backed securities (RMBS), with a smaller allocation to non-Agency RMBS and related mortgage assets. It finances Agency RMBS primarily through short-term repurchase agreements and uses interest-rate swaps, TBAs, U.S. Treasury securities and futures to manage interest-rate exposure.
Key financial metrics
| Metric | Q2 2019 | Q2 2018 | Six months 2019 | Six months 2018 |
|---|---|---|---|---|
| Interest income | $12.1 million | $14.1 million | $24.8 million | $27.5 million |
| Interest expense | $9.7 million | $7.7 million | $19.2 million | $14.9 million |
| Net interest income | $2.5 million | $6.4 million | $5.5 million | $12.6 million |
| Total expenses | $1.3 million | $1.4 million | $2.7 million | $2.9 million |
| Net realized and unrealized securities gains | $15.9 million | $(10.3) million | $36.2 million | $(35.5) million |
| Net realized and unrealized derivative gains | $(17.2) million | $7.1 million | $(30.3) million | $23.7 million |
| Net income (loss) | $(0.1) million | $1.8 million | $8.8 million | $(2.2) million |
| Basic and diluted EPS | $(0.01) | $0.14 | $0.71 | $(0.17) |
| Core earnings per share | $0.15 | $0.40 | $0.34 | $0.72 |
| Adjusted core earnings per share | $0.22 | $0.36 | $0.49 | $0.70 |
For Q2 2019, the portfolio yield was 3.11%, total average cost of funds including swaps and short Treasuries was 2.56%, and net interest margin was 0.55%. Excluding the catch-up premium amortization adjustment, adjusted net interest margin was 0.78%.
Balance sheet, liquidity and capital
- Total assets were $1.70 billion at June 30, 2019, including $1.46 billion of mortgage-backed securities, compared with $1.68 billion and $1.54 billion, respectively, at December 31, 2018.
- Shareholders’ equity was $154.6 million, versus $153.8 million at year-end 2018. Book value per share was $12.40, compared with $12.30 at year-end and $12.69 at March 31, 2019.
- Cash and cash equivalents increased to $41.5 million from $18.6 million at December 31, 2018.
- Repurchase-agreement borrowings were $1.44 billion, with a weighted-average rate of 2.61%, 45 weighted-average remaining days to maturity and 13 counterparties. Adjusted debt-to-equity was 8.9:1.
- Six-month operating cash flow was $9.1 million and investing cash flow was $69.3 million. Financing activities used $55.5 million, including $8.5 million of dividends and $0.4 million of share repurchases. Net cash increased by $22.9 million.
- Second-quarter dividends declared were $0.28 per share; first-half dividends totaled $0.62 per share.
Material changes versus comparable periods
- Q2 net income declined to a small loss from $1.8 million of profit, primarily because net interest income fell by $3.9 million and derivative losses increased, despite a $26.3 million improvement in securities results.
- First-half net income improved to $8.8 million from a $2.2 million loss, driven by a $71.7 million year-over-year improvement in securities gains, partly offset by a $53.9 million deterioration in derivative results and lower net interest income.
- Interest income declined as average Agency RMBS holdings decreased and a negative catch-up premium amortization adjustment reduced income by $0.9 million in Q2 and $1.8 million year to date. Interest expense increased because repo funding costs rose materially from 2018.
- The RMBS portfolio decreased to $1.46 billion from $1.54 billion at year-end. Agency RMBS represented approximately $1.45 billion of fair value; non-Agency RMBS represented $9.3 million.
- Derivative liabilities exceeded derivative assets by $14.1 million at June 30, 2019, compared with a net liability of $4.7 million at year-end, reflecting losses as interest rates declined.
- Short U.S. Treasury positions increased substantially to $34.5 million of fair value from $0.4 million at year-end, while interest-rate swap notional increased to $732.9 million from $639.6 million.
Outlook, management commentary and risks
- Management expects to continue emphasizing specified-pool Agency RMBS and actively managing prepayment and interest-rate risk. It may increase non-Agency RMBS exposure if more attractive entry points develop.
- Management stated that available cash, portfolio cash flows, current leverage and anticipated credit availability should be sufficient for expected liquidity needs.
- Falling mortgage rates increased prepayments and specified-pool pay-ups. Average specified-pool pay-ups rose to 1.56% from 0.99% at March 31, 2019, increasing exposure to prepayment risk.
- The principal risks are high leverage, short-term repo refinancing and margin-call risk, interest-rate volatility, prepayment risk, valuation uncertainty, non-Agency credit risk, counterparty risk and potential changes affecting Fannie Mae, Freddie Mac or the broader mortgage market.
- The filing states that no material legal proceedings were pending, but regulatory inquiries involving an Ellington affiliate remain possible. Management reported no significant contingencies and no material changes to previously disclosed risk factors.
- The company’s REIT status requires compliance with applicable qualification and distribution requirements. The management agreement provides for a 1.50% annual fee based on shareholders’ equity and, in specified termination circumstances, a termination fee equal to 5% of defined shareholders’ equity.
Investor verification items
- Verify the registrant identity: the filing is for Ellington Residential Mortgage REIT (EARN), while the request metadata names Ellington Credit Co.
- Reconcile GAAP net income with core and adjusted core earnings, particularly the treatment of derivative gains and losses and the catch-up premium amortization adjustment.
- Assess sustainability of the $0.28 quarterly dividend against adjusted core earnings of $0.22 per share and the company’s REIT distribution requirements.
- Monitor repo maturities, haircuts, margin requirements, counterparty concentrations and the 8.9:1 adjusted debt-to-equity ratio.
- Evaluate sensitivity to interest-rate movements and faster prepayments, including the $3.2 million first-half Agency IO cost-basis charge caused by adverse cash-flow changes.
- Review valuation assumptions for Level 3 assets and the potential impact of regulatory developments involving Ellington affiliates.