Ellington Residential Mortgage REIT — Form 10-Q Summary
Reporting period: Quarter and six months ended June 30, 2013. The company commenced operations on September 25, 2012 and completed its initial public offering and concurrent private placement in May 2013; therefore, prior-period comparisons are limited.
Business Context
The company is an externally managed mortgage REIT investing primarily in Agency residential mortgage-backed securities (RMBS), with a smaller allocation to non-Agency RMBS and related instruments. It finances Agency RMBS largely through repurchase agreements and uses interest-rate swaps and TBA contracts to hedge financing and interest-rate exposure.
Financial Highlights
| Metric | Three Months Ended June 30, 2013 | Six Months Ended June 30, 2013 |
|---|---|---|
| Interest income | $4.3 million | $4.6 million |
| Net interest income | $3.8 million | $4.1 million |
| Total expenses | $1.4 million | $1.6 million |
| Net realized and unrealized loss on real estate securities | $48.8 million | $47.7 million |
| Net realized and unrealized gain on derivatives | $36.7 million | $36.7 million |
| Net loss | $9.7 million | $8.6 million |
| Basic loss per share | $1.55 | $2.17 |
| Core earnings | $1.3 million | $1.4 million |
| Core earnings per share | $0.21 | $0.35 |
- Assets: $1.497 billion at June 30, 2013, compared with $32.2 million at December 31, 2012.
- Investment portfolio: $1.351 billion of real estate securities at fair value, consisting of $1.313 billion of Agency RMBS and $38.8 million of non-Agency RMBS.
- Cash: $52.3 million at quarter-end, versus $18.2 million at year-end 2012.
- Debt: $1.216 billion of repurchase-agreement borrowings, with a weighted-average interest rate of 0.37% and 33 days to maturity.
- Leverage: Total debt-to-equity ratio of 7.17-to-1. Management indicated an expected Agency RMBS leverage range of 6-to-1 to 10-to-1.
- Equity: $169.6 million at June 30, 2013, versus $31.0 million at December 31, 2012.
- Book value: $18.57 per share at June 30, 2013, compared with $19.65 at March 31, 2013 and $18.96 at December 31, 2012.
- Dividend: A second-quarter dividend of $0.14 per share, or approximately $1.3 million, was declared and paid on July 26, 2013.
- Cash flow: Operating activities used $14.0 million and investing activities used $1.317 billion; financing activities provided $1.365 billion. Cash increased by $34.2 million during the six-month period.
Material Changes Versus Prior Comparable Period
- The company substantially expanded its balance sheet following the May 2013 offering, issuing 7.5 million common shares for $150.0 million of gross proceeds, or approximately $148.5 million net of offering costs.
- Real estate securities increased from $13.6 million at December 31, 2012 to $1.351 billion at June 30, 2013, primarily through purchases of Agency RMBS.
- Repurchase-agreement borrowings increased from zero to $1.216 billion.
- Derivative positions increased from zero to $28.3 million of net fair value, including interest-rate swaps and TBA contracts.
- The second quarter experienced significant market-driven valuation losses as interest rates rose and expectations increased that the Federal Reserve would reduce asset purchases. Hedging gains offset a substantial portion, but not all, of the RMBS losses.
- Book value per share declined during the quarter, while the company generated positive Core Earnings despite reporting a GAAP net loss.
Outlook, Risks, and Unusual Items
- Management viewed the higher-rate environment as creating opportunities to acquire Agency specified pools at more attractive prices and expected to continue actively managing and hedging the portfolio.
- Interest-rate volatility, Federal Reserve policy, changes in mortgage rates, prepayment speeds, and extension risk remain significant drivers of portfolio performance.
- Rising mortgage rates reduced refinancing activity and prepayment expectations, but created potential extension risk and could adversely affect housing affordability and non-Agency RMBS performance.
- Non-Agency RMBS carry greater credit risk, including borrower default, loss severity, property-value declines, servicing deficiencies, and economic weakness.
- Repo financing is short term relative to the expected lives of the RMBS assets, creating refinancing, margin-call, counterparty, and liquidity risks. The company had five repo counterparties at quarter-end.
- Fair values for non-Agency RMBS and Agency interest-only securities included Level 3 measurements using third-party valuations and model assumptions; actual realizable values could differ materially.
- The company elected corporate tax treatment for the May 1–December 31, 2013 short taxable period and intended to elect REIT status for that period. Continued REIT qualification and exemption from Investment Company Act registration depend on meeting applicable requirements.
- The external management agreement provides for a 1.50% annual management fee based on defined shareholders’ equity, expense reimbursement, and a potential termination fee equal to 5% of defined shareholders’ equity.
- On August 13, 2013, the board approved an open-ended $10 million share repurchase program.
- Management reported no material legal proceedings or significant contingencies as of June 30, 2013, and stated that disclosure controls were effective.
Investor Verification Checklist
- Verify the effect of the May offering and private placement on per-share book value, leverage, and future earnings capacity.
- Reconcile GAAP net loss with Core Earnings and assess whether valuation losses or gains are recurring under prevailing market conditions.
- Review repo maturities, haircuts, collateral requirements, margin-call exposure, and counterparty concentration.
- Assess the sensitivity of portfolio value and earnings to interest-rate shifts, prepayment speeds, and Federal Reserve policy.
- Examine the assumptions and valuation uncertainty associated with Level 3 RMBS and interest-only securities.
- Confirm the company’s subsequent REIT election and ongoing compliance with REIT and Investment Company Act requirements.
- Evaluate the sustainability of the $0.14 per-share dividend relative to Core Earnings, liquidity, and leverage.