Business Context and Reporting Period
The filing is Ellington Residential Mortgage REIT’s Form 10-K for the fiscal year ended December 31, 2015. The request identifies Ellington Credit Co., but the filing’s registrant is Ellington Residential Mortgage REIT, NYSE ticker EARN.
The company is an externally managed Maryland REIT focused primarily on Agency residential mortgage-backed securities (RMBS), with smaller investments in non-Agency RMBS and other mortgage-related assets. It relies on Ellington Residential Mortgage Management LLC and Ellington Management Group for management, personnel, investment sourcing, valuation, risk management and operations. The company had no employees of its own.
Key Financial Metrics
| Metric | 2015 | 2014 |
|---|---|---|
| Interest income | $40.8 million | $46.8 million |
| Interest expense | $6.2 million | $4.5 million |
| Net interest income | $34.5 million | $42.3 million |
| Total expenses | $5.1 million | $5.8 million |
| Net realized and unrealized gains/(losses) | $(29.3) million | $(20.4) million |
| Net income/(loss) | $30 thousand | $16.2 million |
| Core Earnings | $22.0 million | $27.8 million |
| Core Earnings per share | $2.41 | $3.04 |
| Dividends declared per share | $2.00 | $2.20 |
| Total assets | $1.56 billion | $1.52 billion |
| Mortgage-backed securities at fair value | $1.24 billion | $1.39 billion |
| Shareholders’ equity | $144.9 million | $163.4 million |
| Book value per share | $15.86 | $17.86 |
| Repurchase agreement borrowings | $1.22 billion | $1.32 billion |
| Debt-to-equity ratio | 8.4:1 | 8.1:1 |
| Cash and cash equivalents | $40.2 million | $45.2 million |
Interest income on RMBS was $40.7 million, with a reported weighted-average yield of 3.08% on average holdings of $1.32 billion. The average repo cost of funds increased to 0.42% from 0.35%. Including interest-rate swaps and Treasury short positions, management reported an annualized average cost of funds of 1.10%, compared with 1.05% in 2014.
Cash flow from operating activities was $24.8 million and cash flow from investing activities was $90.1 million. Financing activities used $119.9 million, including $19.2 million of dividends paid, $0.4 million of share repurchases and net repo repayments. Cash declined by $5.1 million during the year.
Portfolio, Leverage and Liquidity
- Agency RMBS fair value was $1.21 billion at year-end, compared with $1.36 billion in 2014. Non-Agency RMBS fair value was $31.4 million, compared with $32.5 million.
- Agency RMBS represented the vast majority of the investment portfolio, including specified pools, fixed-rate securities, adjustable-rate mortgages, reverse mortgages and interest-only securities.
- The company had $1.22 billion of repo borrowings with 13 counterparties. The weighted-average repo rate was 0.54%, with weighted-average remaining maturity of 37 days.
- Collateral pledged under outstanding repos had an aggregate fair value of approximately $1.3 billion. The company had posted $20.7 million of net cash collateral and $2.0 million of additional securities in connection with margin calls.
- Management stated that current cash, investment cash flows, repo financing and available credit were expected to be sufficient for anticipated liquidity needs, but repo financing is short term and subject to renewal, margin calls and changing market conditions.
Material Changes Versus the Prior Comparable Period
- Net income declined from $16.2 million to $30 thousand, primarily because 2015 included $29.3 million of net losses on securities and derivatives, compared with $20.4 million of net losses in 2014.
- Net interest income decreased 18% to $34.5 million as interest income declined and financing costs increased.
- Core Earnings decreased from $27.8 million to $22.0 million, while Core Earnings per share declined from $3.04 to $2.41.
- Shareholders’ equity declined by $18.5 million, principally reflecting $18.3 million of dividends and $0.4 million of share repurchases, partially offset by $30 thousand of net income and $0.1 million of share-based compensation.
- Book value per share decreased from $17.86 to $15.86.
- Repo borrowings declined by approximately $100.4 million, but the debt-to-equity ratio increased from 8.1:1 to 8.4:1 because equity declined more rapidly than debt.
- The company increased its use of short U.S. Treasury positions, with fair value of $78.4 million at year-end versus $14.0 million in 2014, and increased fixed-payer swap notional exposure from $424.8 million to $553.8 million.
- Portfolio turnover was approximately 112%, and the company reported $9.0 million of net realized gains on Agency RMBS excluding hedges.
Outlook, Management Commentary, Risks and Unusual Items
Management described 2015 as a period of significant interest-rate volatility and widening fixed-income spreads. The Federal Reserve raised the federal funds target range by 25 basis points in December 2015 while continuing to reinvest principal payments from Treasury and Agency RMBS holdings. Management expected continued uncertainty regarding the pace of future rate increases and reinvestment policy.
Management stated that subdued prepayment rates and wider Agency RMBS spreads created what it considered attractive relative value and net interest-margin opportunities. The company intended to continue targeting specified Agency pools with favorable prepayment characteristics and to use swaps, TBAs, Treasury securities and other derivatives to manage interest-rate and prepayment risk.
- Leverage and refinancing risk: Short-term repo financing creates maturity mismatch, rollover risk, counterparty risk and exposure to margin calls. Failure to meet margin requirements could force asset sales at unfavorable prices.
- Interest-rate risk: Rising rates can increase borrowing costs, reduce asset values and pressure net interest income. Hedges may be imperfect, costly or adversely affected by changes in swap spreads and market volatility.
- Prepayment risk: Faster or slower mortgage prepayments can alter yields, accelerate premium amortization and adversely affect interest-only securities and other investments.
- Credit risk: Non-Agency RMBS, including subordinated, lower-rated or unrated positions, are exposed to borrower defaults, loss severity, servicing performance and declines in home prices.
- REIT and Investment Company Act compliance: Failure to maintain REIT qualification or the company’s exclusion from Investment Company Act registration could require restructuring, asset sales or payment of corporate-level taxes.
- Management and conflicts: The company is externally managed, pays a 1.50% annual management fee based on defined shareholders’ equity and may owe a termination fee equal to 5% of defined shareholders’ equity in certain circumstances. Ellington manages other accounts with overlapping strategies, including Ellington Financial LLC.
- Valuation risk: Certain RMBS are valued using third-party quotations or models with significant unobservable inputs. Reported fair values and earnings may differ materially from realizable market values.
- Dividend risk: The quarterly dividend was reduced from $0.55 per share in the first two quarters to $0.45 in each of the final two quarters. The Board approved a $0.45 per-share dividend for the first quarter of 2016, payable April 25, 2016.
- Unusual disclosure: No material legal proceedings or significant contingencies were reported. The filing states that the company had no direct transactions with Iran, but reproduced related disclosure concerning a Blackstone affiliate’s activities.
Most Important Facts for an Investor to Verify
- Confirm that the filing applies to Ellington Residential Mortgage REIT rather than Ellington Credit Co.
- Reconcile GAAP net income of $30 thousand with Core Earnings of $22.0 million and understand the treatment of realized and unrealized securities and derivative losses.
- Review the sustainability of the $2.00 annualized 2015 dividend level against Core Earnings, taxable income and cash available for distribution.
- Assess the effect of 8.4:1 leverage, short repo maturities, collateral haircuts, margin calls and counterparty concentration on liquidity.
- Evaluate the impact of higher short-term rates, wider spreads and changes in swap spreads on net interest income, book value and hedge performance.
- Review valuation assumptions for Level 3 assets, including projected prepayments, losses, recoveries and discount rates.
- Monitor REIT qualification, Investment Company Act exclusion and evolving regulation of Fannie Mae, Freddie Mac, Ginnie Mae, derivatives and mortgage finance.
- Examine external-management fees, termination provisions, related-party expense reimbursements and allocation of investment opportunities among Ellington-managed accounts.