Business Context and Reporting Period
This Form 10-K covers the fiscal year ended December 31, 2013, with unaudited fourth-quarter results for the three months ended December 31, 2013. The filing identifies the registrant as Ellington Residential Mortgage REIT (NYSE: EARN), not “Ellington Credit Co.” The company is an externally managed Maryland REIT investing primarily in Agency residential mortgage-backed securities (RMBS), with smaller non-Agency RMBS and related mortgage assets. It began operations on September 25, 2012 and completed its initial public offering and concurrent private placement in May 2013, raising $150.0 million gross.
Financial Highlights
| Metric | 2013 / December 31, 2013 | Comparable period or prior year |
|---|---|---|
| Net interest income | $24.8 million | $0.2 million for September 25–December 31, 2012 |
| Net loss | $1.9 million, or $0.29 per share | $0.5 million loss, or $0.33 per share |
| Core Earnings, non-GAAP | $13.7 million, or $2.09 per share | Not measured for 2012 |
| Interest income | $27.9 million | $0.2 million |
| Interest expense | $3.1 million | None reported |
| Operating expenses | $4.3 million; expense ratio 3.7% | $0.9 million |
| Real estate securities, fair value | $1.326 billion | $13.6 million |
| Shareholders’ equity | $167.2 million | $31.0 million |
| Book value per share | $18.29 | $18.96 |
| Cash and cash equivalents | $50.1 million | $18.2 million |
| Repurchase agreements | $1.310 billion | None |
| Debt-to-equity ratio | 7.84 to 1 | Not applicable |
Agency RMBS represented $1.295 billion, or approximately 97.7% of real estate securities at fair value. Non-Agency RMBS had a fair value of $30.7 million. The portfolio’s weighted-average yield was 3.38%, with a weighted-average coupon of 3.72% and weighted-average life of 8.56 years.
Net realized and unrealized losses on real estate securities were $63.6 million, principally reflecting declining Agency RMBS prices as interest rates rose. Net realized and unrealized gains on financial derivatives were $41.2 million, providing a partial hedge. Net interest income was $24.8 million, but the investment losses and expenses resulted in a GAAP net loss.
Fourth-Quarter Results
| Metric | Q4 2013 | Q3 2013 |
|---|---|---|
| Net interest income | $10.8 million | $10.0 million |
| Total expenses | $1.4 million | $1.4 million |
| Other loss | $9.5 million | $1.8 million |
| Net income/(loss) | $(0.1) million, or $(0.01) per share | $6.8 million, or $0.74 per share |
Cash Flow, Liquidity, Debt and Dividends
Operating activities provided $25.5 million of cash in 2013. Investing activities used $1.447 billion, primarily reflecting purchases of real estate securities. Financing activities provided $1.453 billion, including $150.0 million of share issuance proceeds and net repurchase-agreement borrowings. Cash increased by $32.0 million to $50.1 million.
Repurchase agreements were the company’s only outstanding borrowings at year-end, with nine counterparties, a weighted-average interest rate of 0.38%, weighted-average remaining maturity of 49 days, and a weighted-average haircut of 4.6%. Agency RMBS with a fair value of approximately $1.4 billion collateralized the borrowings. The short-term financing structure exposes the company to refinancing, margin-call and forced-liquidation risks.
The company declared cash dividends of $0.14 per share for the second quarter and $0.50 per share for each of the third and fourth quarters, totaling $1.14 per share for 2013. The fourth-quarter dividend was payable in January 2014. On March 12, 2014, the board approved a first-quarter 2014 dividend of $0.55 per share, payable April 28, 2014.
Material Changes Versus the Prior Comparable Period
- The company transitioned from a small, primarily non-Agency RMBS portfolio to a highly leveraged Agency RMBS strategy beginning in April 2013.
- Real estate securities increased from $13.6 million to $1.326 billion, while repurchase-agreement debt increased from zero to $1.310 billion.
- Shareholders’ equity increased from $31.0 million to $167.2 million following the May 2013 public offering and private placement.
- Net interest income increased substantially as the portfolio and leverage expanded, but rising rates caused significant RMBS mark-to-market and realized losses.
- Interest-rate hedges generated $41.2 million of net realized and unrealized gains in 2013; the company held no derivatives at December 31, 2012.
- Book value per share declined to $18.29 from $18.96, while the year-end share price was $15.20 based on the reported market-performance data, below book value.
Guidance, Outlook, Commentary and Risks
Management expects continued market volatility to create opportunities in specified Agency pools, particularly higher-coupon pools with prepayment protection. It remains positive on non-Agency RMBS because of improving home prices, declining delinquencies and reduced foreclosure inventory, while acknowledging that double-digit home-price appreciation may not recur.
Management highlighted Federal Reserve tapering, rising interest rates, changing Fannie Mae and Freddie Mac policies, bank-capital rules and the availability and cost of repo financing as key market factors. The company expects to continue dynamically adjusting its portfolio and hedges, including interest-rate swaps and TBAs.
- High leverage magnifies both returns and losses; repo maturities are substantially shorter than the expected lives of the RMBS assets.
- Margin calls or loss of repo capacity could force asset sales at unfavorable prices and impair liquidity.
- Rising interest rates can reduce RMBS fair values, increase financing costs and extend mortgage durations.
- Prepayment speeds affect premium amortization, asset yields and the value of interest-only securities.
- Non-Agency RMBS are exposed to borrower defaults, loss severity, foreclosure delays and servicing performance.
- The company relies heavily on its external manager and Ellington personnel, and the management fee is based on shareholders’ equity rather than portfolio performance.
- Failure to qualify as a REIT or maintain the Investment Company Act exclusion could result in additional taxes, forced asset sales or operating restrictions.
- Fair values for Level 3 assets depend on models, broker quotes and assumptions regarding prepayments, losses and recoveries.
Most Important Facts for Investors to Verify
- Confirm that the filing and financial statements relate to Ellington Residential Mortgage REIT, ticker EARN, rather than the company name in the request metadata.
- Review the sustainability of $13.7 million of 2013 Core Earnings relative to the $10.4 million of dividends declared and the company’s GAAP net loss.
- Assess the sensitivity of book value and earnings to interest rates, prepayments, hedge effectiveness and Agency RMBS spread movements.
- Review repo counterparty concentration, collateral requirements, maturity dates, haircuts and potential margin calls.
- Evaluate whether the 7.84-to-1 debt-to-equity ratio is appropriate for the portfolio and current financing conditions.
- Verify continued REIT qualification, Investment Company Act exclusion and the tax treatment of dividends.
- Review external-management fees, expense reimbursements, conflicts with other Ellington-managed accounts and the 5% termination fee.