Ellington Residential Mortgage REIT — FY2016 Form 10-K Summary
Reporting period: Fiscal year ended December 31, 2016; filed March 13, 2017. The source filing identifies the registrant as Ellington Residential Mortgage REIT, ticker EARN, rather than “Ellington Credit Co.” The filing includes unaudited fourth-quarter 2016 results.
Business Context
The company is an externally managed Maryland REIT investing primarily in Agency residential mortgage-backed securities, with a smaller allocation to non-Agency RMBS and related mortgage assets. It uses repurchase agreements to finance Agency RMBS and derivatives, including interest-rate swaps, TBAs, futures and Treasury short positions, to manage interest-rate and prepayment risk. Ellington Management Group and its affiliates provide personnel and operating resources; the Blackstone Funds owned approximately 29% of common shares at year-end.
Financial Performance and Position
| Metric | FY2016 | FY2015 |
|---|---|---|
| Interest income | $33.5 million | $40.8 million |
| Interest expense | $(9.3) million | $(6.2) million |
| Net interest income | $24.2 million | $34.5 million |
| Total expenses | $5.0 million | $5.1 million |
| Net realized and unrealized gains/(losses) | $(7.3) million | $(29.3) million |
| Net income | $11.9 million | $0.03 million |
| Net income per share | $1.31 | Near zero |
| Core earnings | $15.6 million | $22.0 million |
| Core earnings per share | $1.71 | $2.41 |
| Dividends declared per share | $1.65 | $2.00 |
Fourth quarter: Net income was $2.0 million, or $0.22 per share, compared with $1.0 million, or $0.11 per share, in fourth-quarter 2015. Fourth-quarter net interest income was $6.5 million and total other loss was $3.4 million. The quarterly dividend was $0.40 per share.
| Balance-sheet metric | December 31, 2016 | December 31, 2015 |
|---|---|---|
| Total assets | $1.429 billion | $1.557 billion |
| Mortgage-backed securities at fair value | $1.227 billion | $1.242 billion |
| Repurchase agreements | $1.198 billion | $1.223 billion |
| Shareholders’ equity | $141.7 million | $144.9 million |
| Book value per share | $15.52 | $15.86 |
| Cash and cash equivalents | $33.5 million | $40.2 million |
| Debt-to-equity ratio | 8.5:1 | 8.4:1 |
Agency RMBS represented the vast majority of the portfolio, with fair value of approximately $1.208 billion excluding Agency interest-only securities. Non-Agency RMBS declined to $19.4 million from $31.4 million. The average repo borrowing cost increased to 0.71% from 0.42%, while year-end repo borrowings carried a weighted-average rate of 0.88% and had 45 days of weighted-average remaining maturity.
Operating activities provided $19.9 million of cash and investing activities provided $13.9 million. Financing activities used $40.5 million, including $15.5 million of dividends and $0.2 million of share repurchases. Cash declined by $6.7 million during the year.
Material Changes Versus the Prior Comparable Period
- Net income improved substantially from approximately breakeven in 2015, primarily because securities and derivative losses were materially lower.
- Net interest income declined 30% because average portfolio holdings and asset yields decreased while repo funding costs increased.
- Core earnings declined to $15.6 million from $22.0 million, and core earnings per share declined to $1.71 from $2.41.
- Derivative losses improved to $5.6 million from $20.0 million, while securities losses improved to $1.7 million from $9.3 million.
- Shareholders’ equity declined 2.2% and book value per share fell from $15.86 to $15.52, primarily reflecting dividends exceeding net income and share repurchases.
- The Agency portfolio was relatively stable in size, while the non-Agency portfolio declined approximately 38% year over year.
- The company increased its use of short TBAs relative to interest-rate swaps within its hedge portfolio and ended 2016 with net derivative assets of $4.0 million, compared with net derivative liabilities of $2.5 million in 2015.
Outlook, Risks and Unusual Items
Management reported sharply higher interest rates and volatility in the fourth quarter, including an 85-basis-point increase in the 10-year Treasury yield to 2.44% during the quarter. The Federal Reserve raised the federal funds target range by 25 basis points in December 2016. Management expects continued risk from rising rates and mortgage prepayment volatility and intends to continue using swaps, TBAs, Treasury securities and other hedges.
- Interest-rate increases can reduce RMBS fair values, increase repo costs and create margin calls.
- Short-term repo financing creates refinancing and maturity-mismatch risk; all outstanding borrowings were scheduled to mature within one year.
- Prepayment changes can reduce yields, accelerate premium amortization and impair interest-only securities.
- Non-Agency RMBS carry substantially higher credit and loss-severity risk and are not guaranteed by a government agency or GSE.
- Maintenance of REIT qualification and the exclusion from Investment Company Act registration limits portfolio composition, hedging and operating flexibility.
- The company is externally managed, pays its manager a fee equal to 1.50% per year of defined shareholders’ equity, and reimbursed approximately $1.8 million of expenses in 2016. Termination or non-renewal may require a fee equal to 5% of defined shareholders’ equity.
- The company reported no material legal proceedings against it or Ellington affiliates, but disclosed a January 2017 SEC subpoena received by an Ellington affiliate concerning a loan originator and related loans, analyses, purchases, securitizations and servicing. Management stated that it was not aware of any material proceeding contemplated at that time.
- Management and the CEO concluded that disclosure controls and internal control over financial reporting were effective as of December 31, 2016. The independent auditor issued an unqualified opinion.
- On March 6, 2017, the board approved a $0.40 per-share dividend for the first quarter of 2017.
Most Important Facts to Verify
- Confirm the intended company identity: the filing is for Ellington Residential Mortgage REIT, not an entity named Ellington Credit Co.
- Review the sustainability of the $0.40 quarterly dividend against core earnings, funding costs and taxable income.
- Assess exposure to repo rollovers, margin calls, counterparty concentration and the 8.5:1 debt-to-equity ratio.
- Reconcile GAAP net income with core earnings and distinguish recurring net interest income from fair-value gains and losses.
- Evaluate sensitivity to further interest-rate increases, prepayment changes and hedge performance.
- Review valuation assumptions and Level 3 assets, including non-Agency RMBS and Agency interest-only securities.
- Monitor the SEC inquiry involving an Ellington affiliate and any effect on the manager, servicing relationships or reputation.
- Verify continued compliance with REIT qualification and Investment Company Act exclusion requirements.