Business Context and Reporting Period
This filing is the Form 10-K of Ellington Residential Mortgage REIT (NYSE: EARN), externally managed by Ellington Residential Mortgage Management LLC, for the fiscal year ended December 31, 2018. The filing text identifies the registrant as Ellington Residential Mortgage REIT, although the request metadata refers to Ellington Credit Co.
The company is a Maryland REIT investing primarily in Agency residential mortgage-backed securities, with smaller allocations to non-Agency RMBS, Agency interest-only securities, and other mortgage-related assets. It uses repurchase agreements and derivatives to finance and hedge its portfolio. Blackstone Funds owned approximately 25% of outstanding common shares at year-end.
Key Financial Metrics
| Metric | 2018 | 2017 |
|---|---|---|
| Interest income | $54.6 million | $49.2 million |
| Interest expense | $32.5 million | $19.0 million |
| Net interest income | $22.0 million | $30.1 million |
| Total expenses | $5.5 million | $5.7 million |
| Net income (loss) | $(11.3) million | $10.8 million |
| Basic and diluted EPS | $(0.88) | $0.93 |
| Core earnings | $17.1 million, or $1.34 per share | $22.1 million, or $1.91 per share |
| Adjusted core earnings | $17.2 million, or $1.34 per share | $20.9 million, or $1.80 per share |
| Net interest margin | 1.20% | 1.63% |
| Book value per share | $12.30 | $14.45 |
| Shareholders’ equity | $153.8 million | $192.7 million |
| Cash and cash equivalents | $18.6 million | $56.1 million |
At December 31, 2018, mortgage-backed securities totaled $1.540 billion at fair value, including $1.513 billion of Agency RMBS, $16.4 million of Agency IOs, and $11.2 million of non-Agency RMBS. The total RMBS portfolio declined 8.7% from $1.686 billion at December 31, 2017.
Outstanding repurchase agreements were $1.482 billion with 12 counterparties, compared with $1.597 billion with 15 counterparties in 2017. The year-end debt-to-equity ratio was 9.6:1, or 9.2:1 adjusted for unsettled transactions. The weighted-average repo interest rate was 2.56% at year-end, compared with 1.47% in 2017.
Operating activities provided $28.8 million of cash and investing activities provided $62.8 million. Financing activities used $129.2 million, including $115.6 million of net repo repayments, $19.1 million of dividends, and $9.4 million of share repurchases. Cash decreased by $37.5 million during the year.
The company declared dividends of $1.45 per share for 2018: $0.37 per share in each of the first three quarters and $0.34 per share in the fourth quarter. A $0.34 per share dividend for the first quarter of 2019 was approved on March 4, 2019.
Material Changes Versus the Prior Comparable Period
- Net income reversed to an $11.3 million loss from $10.8 million of income, primarily because of larger securities losses and higher interest expense.
- Net interest income declined $8.1 million, as interest expense increased 70.7% to $32.5 million while interest income increased 10.9%.
- The portfolio experienced $35.8 million of net realized and unrealized securities losses, including $40.2 million of losses on Agency RMBS. These were partly offset by $7.9 million of net derivative gains.
- Core earnings declined to $17.1 million from $22.1 million, and core earnings per share declined to $1.34 from $1.91.
- Book value per share fell 14.9% to $12.30 despite $1.45 per share of dividends, producing a 2018 economic return of negative 4.8%.
- Leverage increased while the equity base contracted. Debt-to-equity rose to 9.6:1 from 8.3:1, and shareholders’ equity fell $38.9 million.
- Short TBA hedges declined to $294.0 million from $713.4 million, while short U.S. Treasury positions declined to $0.4 million from $82.5 million. Interest-rate swap notional increased to $732.8 million from $617.3 million.
- The share count declined through repurchases. The company repurchased 852,380 shares for $9.4 million at an average price of $11.01.
- Specified-pool prepayments were 6.6% in the fourth quarter of 2018, down from 8.4% in the third quarter and 7.5% in the fourth quarter of 2017.
Outlook, Management Commentary, Risks and Unusual Items
Management described 2018 as a period of rising short-term rates, a flatter yield curve, wider credit spreads, and significant fourth-quarter market volatility. One-month LIBOR increased 94 basis points during the year to 2.50%, while three-month LIBOR increased 111 basis points to 2.81%. Management expects to continue emphasizing specified Agency pools and may increase non-Agency RMBS exposure if more attractive entry points develop.
Management stated that current cash, investment cash flows, financing availability, and the existing portfolio are expected to be sufficient for anticipated liquidity needs. However, repo agreements are generally short term, typically 30 to 180 days, and must be renewed or replaced. The company is subject to margin calls and collateral requirements.
- Interest-rate and spread risk: A modeled immediate 100-basis-point increase in rates was estimated to reduce portfolio value by $17.2 million, or 11.18% of equity. The analysis is model-based and actual results may differ materially.
- Leverage and liquidity: High leverage magnifies gains and losses. Declines in collateral values could trigger margin calls, forced asset sales, higher financing costs, or loss of financing.
- Prepayment risk: Faster-than-expected prepayments can reduce yields, accelerate premium amortization, and impair IO securities. Slower prepayments can extend asset duration and reduce discount accretion.
- Funding concentration: Three repo counterparties each represented more than 10% of shareholders’ equity in reported amount-at-risk exposure at year-end.
- Valuation risk: Approximately $7.5 million of mortgage-backed securities were classified as Level 3 assets and valued using significant unobservable inputs, including projected prepayments, losses, recoveries, yields, and option-adjusted spreads.
- REIT and Investment Company Act status: Failure to maintain REIT qualification or the exclusion from Investment Company Act registration could result in additional taxes, operational restrictions, asset sales, or restructuring.
- Management and related-party risks: The external manager receives a fee of 1.50% annually based on defined shareholders’ equity, and the management agreement generally requires a termination fee equal to 5% of defined shareholders’ equity if terminated or not renewed by the company without cause.
- Regulatory matter: An Ellington affiliate received an SEC subpoena in January 2017 concerning a loan originator and related loan purchases, securitizations, analyses, and servicing. Management stated that no material proceeding was then known to be contemplated, but could not assure that further investigation or proceedings would not occur.
- Legal proceedings and contingencies: The company reported no material legal proceedings and no accrued liabilities for indemnification arrangements as of December 31, 2018.
Important Facts for Investors to Verify
- Confirm the registrant and ticker because the filing identifies Ellington Residential Mortgage REIT, while the request metadata identifies Ellington Credit Co.
- Reconcile the reported annual net loss, core earnings, dividends, and book-value decline, particularly the effect of Agency RMBS losses and derivative gains and losses.
- Review repo maturities, haircuts, collateral balances, margin-call provisions, counterparty exposure, and the ability to refinance approximately $1.5 billion of short-term borrowings.
- Assess whether the 1.20% net interest margin can be sustained as funding costs, LIBOR-related benchmarks, and the yield curve change.
- Evaluate the sensitivity of book value and earnings to interest rates, prepayments, Agency RMBS spreads, and hedge effectiveness.
- Examine Level 3 valuation assumptions and the potential effect of changes in projected prepayments, collateral losses, recoveries, and discount rates.
- Monitor the company’s REIT qualification, Investment Company Act exclusion, external-management agreement renewal, and related-party conflicts.
- Verify the status and potential consequences of the SEC inquiry involving an Ellington affiliate and any subsequent regulatory developments.