Business Context and Reporting Period
This unaudited Form 10-Q covers Ellington Residential Mortgage REIT (the filing entity identified in the source), for the quarter and six months ended June 30, 2017. The request metadata identifies Ellington Credit Co, which does not match the registrant named in the filing. The company is an externally managed Maryland REIT focused primarily on Agency residential mortgage-backed securities (RMBS), with smaller non-Agency RMBS and related hedging positions.
The company uses repurchase agreements to finance Agency RMBS and derivatives, including interest-rate swaps, TBAs, Treasury securities, and futures, to manage interest-rate risk. It had 12,367,598 common shares outstanding at June 30, 2017 and no preferred shares outstanding.
Financial Performance and Position
| Metric | Three months ended June 30, 2017 | Three months ended June 30, 2016 | Six months ended June 30, 2017 | Six months ended June 30, 2016 |
|---|---|---|---|---|
| Interest income | $10.9 million | $7.5 million | $23.2 million | $17.2 million |
| Net interest income | $6.9 million | $5.3 million | $16.0 million | $12.9 million |
| Total expenses | $1.4 million | $1.3 million | $2.7 million | $2.6 million |
| Other income/(loss) | $(3.8) million | $(0.5) million | $(9.6) million | $(7.0) million |
| Net income | $1.6 million | $3.5 million | $3.7 million | $3.3 million |
| Basic and diluted EPS | $0.15 | $0.38 | $0.37 | $0.36 |
| Dividends declared per share | $0.40 | $0.40 | $0.80 | $0.85 |
- Adjusted Core Earnings were $5.1 million, or $0.47 per share, in the second quarter and $9.9 million, or $1.00 per share, for the first six months. Core Earnings were $4.8 million and $12.2 million, respectively.
- Interest income on securities was $10.7 million in the quarter, with an average portfolio yield of 2.94%; excluding the catch-up premium amortization adjustment, management reported a 3.01% weighted-average yield.
- Average repo borrowings were $1.34 billion in the quarter at a 1.09% average cost of funds. Including periodic swap and Treasury-short costs, management reported an alternative average cost of funds of 1.38%.
- Total assets were $2.0 billion and shareholders’ equity was $181.9 million at June 30, 2017, compared with $1.4 billion and $141.7 million at December 31, 2016.
- Mortgage-backed securities totaled $1.65 billion at fair value, including $1.63 billion of Agency RMBS and $20.6 million of non-Agency RMBS.
- Cash and cash equivalents were $41.7 million, up from $33.5 million at December 31, 2016. Operating activities provided $30.6 million of cash, investing activities used $490.7 million, and financing activities provided $468.3 million during the first six months.
- Book value per share was $14.71 at June 30, 2017, compared with $15.35 at March 31, 2017 and $15.52 at December 31, 2016.
Material Changes Versus Comparable Periods
- Second-quarter net income declined 54% year over year, primarily because derivative losses increased to $7.6 million from $8.5 million of losses in the prior-year quarter while securities gains fell to $3.8 million from $8.0 million.
- Six-month net income increased modestly to $3.7 million from $3.3 million, as higher net interest income more than offset larger total other losses.
- Net interest income increased 30% in the quarter and 24% for the six months, reflecting a larger Agency RMBS portfolio and higher reported portfolio yields.
- Repurchase-agreement borrowings rose to $1.63 billion from $1.20 billion at year-end 2016. Debt-to-equity increased to 9.0:1 from 8.5:1 at year-end, or 8.5:1 versus 8.3:1 after adjustment for unsettled purchases and sales.
- The company issued approximately 3.24 million common shares in the first half, generating approximately $45.1 million of net proceeds. It also established a $100 million at-the-market equity program and issued 6,738 shares under that program through June 30.
- Agency RMBS fair value increased from $1.20 billion at December 31, 2016 to $1.62 billion at June 30, 2017. Non-Agency RMBS fair value increased from $19.4 million to $20.6 million.
Guidance, Outlook, Risks, and Unusual Items
Management did not provide formal earnings guidance. It expects to continue targeting specified Agency pools with attractive yields, lower prepayment sensitivity, or potential trading opportunities, and may increase non-Agency RMBS exposure if more attractive entry points develop.
- Management highlighted Federal Reserve policy normalization and the possible reduction of Agency RMBS purchases as important market factors. It viewed Agency RMBS spreads as relatively wide but expected investor demand for specified pools to improve as Federal Reserve purchases decline.
- Prepayment rates increased modestly during the quarter. Management reported a 3-month constant prepayment rate of 8.2% for its fixed-rate specified pools, compared with 12.7% in the prior quarter.
- Lower long-term interest rates produced losses on interest-rate swaps, Treasury shorts, and TBA hedges. Management reported $8.1 million of net realized and unrealized losses on the hedging portfolio in the quarter.
- The portfolio remains highly leveraged and exposed to repo rollover, margin-call, counterparty, interest-rate, prepayment, valuation, and liquidity risks. A 100-basis-point parallel rate increase was estimated to reduce portfolio value by $12.5 million, or 6.9% of equity, while a 100-basis-point decrease was estimated to reduce value by $11.0 million, or 6.0% of equity, under the filing’s model assumptions.
- Approximately $1.7 billion of RMBS was pledged as repo collateral at quarter-end. The company had 13 repo counterparties; four counterparties each represented more than 5% of shareholders’ equity in reported amounts at risk.
- The company’s external management agreement provides for a management fee equal to 1.50% annually of defined shareholders’ equity and, in certain termination circumstances, a termination fee equal to 5% of defined shareholders’ equity.
- An Ellington affiliate received an SEC subpoena in January 2017 relating primarily to loan origination, analysis, purchases, securitizations, and servicing. The affiliate responded and indicated that it was cooperating; management stated that no material proceeding was currently contemplated but could not assure that further investigation or proceedings would not arise.
- The company reported no material legal proceedings, no material off-balance-sheet arrangements, and no recorded liabilities for indemnification contingencies. It stated that disclosure controls were effective as of June 30, 2017.
Important Facts for Investors to Verify
- Confirm the correct issuer: the filing is for Ellington Residential Mortgage REIT, not Ellington Credit Co.
- Reconcile GAAP net income and EPS with Core Earnings and Adjusted Core Earnings, particularly the substantial derivative losses and premium-amortization adjustments.
- Monitor repo leverage, borrowing costs, maturities, haircuts, collateral requirements, and counterparty concentrations.
- Assess sensitivity to Federal Reserve balance-sheet normalization, interest-rate movements, specified-pool pay-ups, and mortgage prepayment speeds.
- Review the valuation assumptions and Level 3 exposure for non-Agency RMBS and Agency interest-only securities.
- Track the SEC inquiry involving the Ellington affiliate and assess whether it develops into a material regulatory or legal matter.
- Evaluate dividend sustainability relative to Core Earnings, taxable income, liquidity, and the REIT requirement to distribute at least 90% of taxable income.