Ellington Residential Mortgage REIT (EARN) — 2016 Second-Quarter Form 10-Q Summary
Reporting period: Quarter and six months ended June 30, 2016. The filing identifies the registrant as Ellington Residential Mortgage REIT, although the request metadata refers to Ellington Credit Co. The company is an externally managed Maryland REIT investing primarily in Agency residential mortgage-backed securities, with a smaller non-Agency portfolio, financed largely through repurchase agreements.
Key Financial Metrics
| Metric | Three months ended June 30, 2016 | Six months ended June 30, 2016 |
|---|---|---|
| Interest income | $7.5 million | $17.2 million |
| Interest expense | $2.3 million | $4.3 million |
| Net interest income | $5.3 million | $12.9 million |
| Total expenses | $1.3 million | $2.6 million |
| Other income/(loss) | $(0.5) million | $(7.0) million |
| Net income | $3.5 million | $3.3 million |
| Basic and diluted EPS | $0.38 | $0.36 |
| Dividends declared per share | $0.40 | $0.85 |
- Total assets were $1.474 billion and shareholders’ equity was $140.3 million at June 30, 2016.
- Mortgage-backed securities at fair value totaled $1.229 billion, including $1.206 billion of Agency RMBS and $22.8 million of non-Agency RMBS.
- Cash and cash equivalents were $36.2 million, down from $40.2 million at December 31, 2015.
- Repurchase-agreement borrowings were $1.206 billion with 12 counterparties. The weighted-average borrowing rate was 0.69%, versus 0.54% at December 31, 2015.
- Total debt-to-equity was 8.6:1 at quarter-end, compared with 8.4:1 at year-end; adjusted for unsettled trades, the ratio was 8.1:1 at both dates.
- Book value per share was $15.38, compared with $15.86 at December 31, 2015 and $15.39 at March 31, 2016.
- Operating cash flow for the first six months was $21.9 million. Investing activities used $0.7 million and financing activities used $25.1 million, producing a $4.0 million decrease in cash.
- Core earnings were $2.9 million, or $0.32 per share, in the second quarter and $7.8 million, or $0.86 per share, for the six months. These are non-GAAP measures and should not replace GAAP net income.
Material Changes Versus Comparable Periods
- Second-quarter net income increased to $3.5 million from $0.2 million in the prior-year quarter, primarily because 2016 securities gains largely offset derivative losses, whereas 2015 securities losses exceeded derivative gains.
- Six-month net income declined to $3.3 million from $3.9 million. Net interest income fell to $12.9 million from $17.3 million as average holdings and yields declined and repo funding costs increased.
- Second-quarter interest income declined to $7.5 million from $9.8 million, while interest expense increased to $2.3 million from $1.5 million.
- Second-quarter net realized and unrealized gains on securities were $8.0 million, compared with a $16.3 million loss in the prior-year quarter. Derivative losses were $8.5 million, compared with a $9.4 million gain in the prior-year quarter.
- For the six months, securities generated $19.6 million of net realized and unrealized gains, but derivatives generated $26.6 million of losses.
- The Agency RMBS portfolio declined modestly from $1.211 billion at December 31, 2015 to $1.206 billion at June 30, 2016, while the non-Agency portfolio declined from $31.4 million to $22.8 million.
- The company repurchased 17,920 common shares for $0.2 million during the first six months. Shares outstanding declined to 9,117,183 from 9,135,103 at year-end.
- Quarterly dividend declarations decreased to $0.40 per share from $0.55 in the prior-year quarter; six-month dividends decreased to $0.85 from $1.10.
Management Commentary, Outlook, and Risks
- Management reported that the Brexit vote increased market volatility but that Agency RMBS spreads were relatively stable and credit-sensitive spreads ended the quarter generally tighter than at the start.
- Mortgage rates declined, prepayment rates increased, and the three-month constant prepayment rate for fixed-rate specified pools rose to 10.1% from 7.1% in the prior quarter. Management expects continued interest-rate and prepayment volatility.
- Management continued to favor specified Agency pools with characteristics intended to reduce prepayment sensitivity and generate trading opportunities. It increased net short TBA positions and reduced interest-rate swaps during the quarter.
- Management expects current cash, investment cash flows, securities-sale proceeds, and repo financing to satisfy anticipated liquidity needs, but liquidity depends materially on continued access to repo financing and compliance with margin requirements.
- Primary risks include rising interest rates, repo refinancing and margin-call risk, leverage, mortgage prepayments, valuation uncertainty, non-Agency credit losses, market volatility, changing GSE and government policy, and the company’s ability to maintain REIT and Investment Company Act status.
- Level 3 assets totaled $12.8 million at June 30, 2016. The company transferred $3.1 million of non-Agency RMBS from Level 2 to Level 3 because of reduced price transparency, highlighting valuation sensitivity.
- There were no material legal proceedings or material changes to previously disclosed risk factors. Management stated that disclosure controls were effective as of June 30, 2016.
- The filing includes an ITRA disclosure concerning a Blackstone affiliate’s former Syrian bank account and guarantees. The company states it had no involvement or control over those activities.
Important Facts Investors Should Verify
- Confirm the issuer identity, since the filing names Ellington Residential Mortgage REIT while the request metadata names Ellington Credit Co.
- Assess whether recurring net interest income and core earnings support the dividend level, particularly after the reduction in portfolio yield and higher repo costs.
- Review leverage, collateral haircuts, counterparty concentrations, repo maturities, and potential margin calls; collateral pledged for repo borrowings was approximately $1.3 billion.
- Evaluate the effect of faster prepayments and lower mortgage rates on premium amortization, specified-pool values, interest-only securities, and future earnings.
- Review derivative positioning and losses, including $382.9 million of fixed-payer swap notional and a net derivative fair-value liability of $11.5 million at quarter-end.
- Test the sensitivity of book value and portfolio valuation to interest-rate changes; management’s modeled total portfolio value change was negative under both 50- and 100-basis-point parallel rate increases and decreases.
- Monitor non-Agency RMBS credit performance and the assumptions used for Level 3 valuations, including projected prepayments, losses, recoveries, and discount rates.