Ellington Credit Q4 2022 Earnings Call Transcript

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Provided by Quartr
March 7, 2023

Key Takeaways

  • Ellington generated an 11.1% non-annualized economic return in Q4 and reported net income of $0.88 per share, easily covering its dividend for the quarter.
  • Agency RMBS yields tightened sharply in Q4 despite modestly higher long-term rates, driving MBS prices up and boosting the net interest margin to 1.37%.
  • A disciplined hedging program—continuously rebalanced delta hedges across the yield curve—helped prevent deeper book value declines and now provides positive carry from interest rate swaps.
  • Leverage was reduced (net mortgage assets to equity down from 7.5× to 6.6×) while liquidity increased, positioning the REIT to capitalize on market opportunities.
  • Management remains cautious amid forward-curve uncertainty, planning selective capital rotation into credit risk transfer and legacy non-agency sectors and preparing for a range of rate scenarios.
AI Generated. May Contain Errors.
Earnings Conference Call
Ellington Credit Q4 2022
00:00 / 00:00

There are 8 speakers on the call.

Operator

Morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2022 4th Quarter Financial Results Conference Call. Today's call is being recorded. At this time, all participants have been placed on a listen only mode.

Operator

The floor will be open for your questions following the presentation. REIT. You may remove yourself from the queue by pressing star 2. Lastly, if you should require operator assistance, please press star 0. It is now my pleasure to turn the floor over to Aladdin Shalei with Associate General Counsel.

Operator

Sir, you may begin.

Speaker 1

Thank you. Before we begin, I would like to remind everyone that certain statements made during this conference call may constitute forward looking statements within the meaning of the Safe Harbor division of the Private Securities Litigation Reform Act of 1995. Forward looking statements are not historical in nature and are subject to a variety of risks and uncertainties that could cause the company's actual results to differ from its beliefs, expectations, estimates and projections. Consequently, you including the earnings release and the Form 10 ks for more information regarding these forward looking statements and any related risks and uncertainties. Unless otherwise noted, statements made during this conference call are made as of the date of this call and the company undertakes no obligation to update or revise any forward looking statements whether as a result of new information, future events or otherwise.

Speaker 1

Joining me on the call today are Larry Penn, Chief Executive Officer of Ellington Residential Mark Tecotzky, our Co Chief Investment Officer and Chris Smernoff, our Chief Financial Officer. As described in our earnings press release, our 4th quarter earnings conference call presentation is available on our website, earnreit.com. Our comments this morning will track the presentation. Please note that any references to figures in this presentation are qualified in their entirety by the notes at the back of the presentation. And with that, I will turn the call over to Larry.

Speaker 1

Thanks, Ella Dean,

Speaker 2

and good morning, everyone. We appreciate your time and interest in Ellington Residential. During the 4th quarter, Inflation continued to moderate and the Federal Reserve ratcheted back the pace of its interest rate hikes. The market welcomed these developments And Agency RMBS rebounded sharply following 3 consecutive quarters of dismal performance. Volatility declined incrementally and investor demand for RMBS increased.

Speaker 2

Together, this drove nominal and option adjusted yield spreads tighter, especially in November, So the year ended on a more positive note. Turning to the investor presentation. In the bottom sections of Slide 3, You can see the significant yield spread tightening that occurred across agency MBS coupons in the 4th quarter, which caused MBS prices to rise Even though long term interest rates were actually moderately higher. Meanwhile, short term interest rates spiked for yet another quarter. You can see on this slide just how much short term interest rates moved, not just during the Q4, but also over the course of 2022 in absolute terms as well as relative to long term rates.

Speaker 2

This trend has continued into 2023 and The yield curve is now the most inverted it's been since the early 1980s with the 2 year 10 year yield spread now more than 90 basis points negative. The inverted yield curve has pressured net interest margins industry wide and coupled with the extreme interest rate volatility that we've experienced since the beginning of 2022, It's really put the effectiveness of interest rate hedging programs under a microscope. For EARN, we've hedged along the entire yield curve And we balanced our hedges frequently, both of which can be more expensive at times, but also more effective across a wider variety of market environments. As interest rates surged last year, we were continuously rebalancing our hedges. The delta hedging costs associated with this rebalancing were high, But they were essential in preventing deeper book value declines.

Speaker 2

With the yield curve currently converted, we're at least getting the benefit of positive carry on our interest swap hedges, where we are receiving the higher SOFA rate while paying lower fixed rates. In the Q4, these swaps served of offsetting some of the impact of the higher long term interest rates, while also boosting our net interest margin and adjusted distributable earnings. Let's turn next to Slide 4 for an overview of EARN's strong results for the Q4. MBS had weakened significantly in September of last year And we responded by buying MBS aggressively into that weakness. As a result, we entered the 4th quarter with a net mortgage exposure of 7.5:one, which stood toward the upper end of our historical range.

Speaker 2

That positioned us incredibly well for the spread tightening that occurred during the Q4. And so we were able to recoup a good chunk of unrealized losses from the prior quarter. For the Q4, we generated a non annualized economic return of 11.1 percent and net income of $0.88 per share, which easily covered our dividends for the quarter. We were able to be positioned this way because we have been patient about portfolio turnover and we have been opportunistic about adding new investments. Throughout 2022, reinvestment yields were surging, but yield spreads were widening as well, especially on the lower coupon pools where we saw the best relative value.

Speaker 2

Larger portfolio sales of our discount pools might have boosted ADE in the near term, but as potential longer term cost to book value per share. Instead, we were selective in turning over Those portions of our portfolio that we viewed as offering superior relative value, particularly those lower coupon pools. And we continue to prioritize total return over short term ADE growth. Meanwhile, our strong liquidity position enabled us to add pools opportunistically in September when spreads gapped out. Over the course of the Q4, we continued to be opportunistic.

Speaker 2

In this case, by opportunistically selling when we felt that the mid quarter rally had run its course. As a result, by year end, our net mortgage exposure had declined by a full turn to 6.6:one, which brought it closer to our historical norms. I'll now pass it over to Chris to review our financial results for the Q4 in more detail. Chris?

Speaker 3

Thank you, Larry, and good morning, everyone. Please turn to Slide 5, where you can see a summary of EARN's 4th quarter financial results. For the quarter ended December 31, we reported net income of $0.88 per share and adjusted distributable earnings of $0.25 per share. These results compare to a net loss of $1.04 per share and ADE of $0.23 per share in the 3rd quarter. ADE excludes the catch up premium amortization adjustment, which was positive $658,000 in the 4th quarter as compared to a positive $1,400,000 in the prior quarter.

Speaker 3

During the Q4, tighter agency RMBS yield spreads and increased pay ups drove significant net realized and unrealized gains on our specified pools, which combined with net interest income exceeded net realized and unrealized losses on our interest rate hedges. Our net interest margin increased slightly quarter over quarter to 1.37% from 1.28% as higher asset yields exceeded the increase in our cost of funds and that included the positive carry that Larry mentioned on our interest rate swap positions. Our higher NIM drove the sequential increase in ADE even as our average holdings declined quarter over quarter. Meanwhile, pay ups on our specified pools increased to 1.26% as of December 31 from 1.02% as at September 30. As prepayment rates continue to decline market wide, Specified pool investors are increasingly focused on extension protection rather than prepayment protection.

Speaker 3

This has been a tailwind for the pay ups on our specified pools because the market is recognizing the significant extension protection they offer relative to their TBA counterparts. In addition, the pools that we did sell during the quarter had lower pay ups relative to our overall portfolio. The combination of these factors which led to the sequential increase in payouts. Please turn now to our balance sheet on Slide 6. Book value was $8.40 per share at December 31 as compared to $7.78 per share at September 30.

Speaker 3

Including the $0.24 of dividends in the quarter, our economic return was 11.1%. We ended the quarter with cash and cash equivalents of 34 point $8,000,000 up from $25,400,000 at September 30. Next, please turn to Slide 7, which shows a summary of our portfolio holdings. In the Q4, our agency RMBS holdings decreased by 5% to $863,300,000 The decrease was driven by net sales and principal payments of $57,900,000 which exceeded net realized and unrealized gains of 11,800,000 Agency RMBS portfolio turnover in the 4th quarter was 18%. Over the same period, our non agency RMBS portfolio increased by $4,800,000 to $12,600,000 while our holdings of interest only securities were roughly unchanged.

Speaker 3

Additionally, our debt to equity ratio adjusted for unsettled purchases and sales decreased to 7.6 times as of December 31, compared to 9.1 times at September 30. The decrease was primarily due to a decline in borrowings on our smaller agency RMBS portfolio and higher shareholders' equity quarter over quarter. Similarly, our net mortgage assets to equity ratio decreased to 6.6x from 7.5x over the same period. On Slide 8, you can see details of our interest rate hedging portfolio. During the quarter, we continued to hedge interest rate risk through the use of interest rate swaps and short positions in TBAs, U.

Speaker 3

S. Treasury Securities and Futures. The size of our net short TBA position based on 10 year equivalents increased quarter over quarter. I will now turn our presentation over to Mark.

Speaker 4

Thanks, Chris. After a challenging 9 months for Agency MBS, it's nice to be able to report a strong quarter and to make back some of the prior quarter's losses. Unlike most parts of securitized products, where investors take on credit risk and the possibility of principal loss in exchange for excess yield, The Agency MBS market is unique in its ability to offer high yields without credit risk. Most agency mortgage REIT hedge a good deal of their interest rate risk. So the primary driver of quarter by quarter economic returns for a hedged agency mortgage REIT is the relative total return of Agency MBS compared to hedging instruments, which are usually treasuries and interest rate swaps.

Speaker 4

The total return of Agency MBS starts with the carry on MBS assets compared to the carry on hedging instruments. But as interest rates and yield spreads move around, you also have to factor in delta hedging costs and the relative price performance of MBS assets, both pools and TBA compared to hedges. In quarters where yield spreads are very volatile as we've seen for the past 4 quarters, Economic return tends to be driven primarily by the relative MBS price performance, whether outperformance or underperformance. For the 1st 3 quarters of 2022, the relative price performance of Agency MBS was negative. Agency MBS dropped in price a whole lot more than a basket of similar duration treasuries in the face of heavy investor liquidations and soaring rates and volatility.

Speaker 4

But in Q4 that reversed dramatically. So what happened in Q4? Well, you finally saw some evidence that inflation is responding to the Federal Reserve's hiking cycle and higher interest rate environment. These green shoots put a potential end of this hiking cycle in sight and that changed the direction of fixed income capital flows from outflows to inflows. And when considered against the backdrop of greatly diminished new MBS production, those inflows led to significant MBS outperformance.

Speaker 4

You can see that in the price changes on Slide 3. Across the board, Agency MBS prices significantly outperformed their hedges. Financial markets generally normalize whatever current pricing levels are. What I mean by that is that the bond market participants and researchers, Especially in spread sectors like MBS, typically start with the assumption that current yield levels and spread relationships are fair. I think it's worth reminding everyone of the magnitude of the repricing in 2022 and what was considered fair versus where we are versus today.

Speaker 4

We started 2022 with Fannie 2's at dollar price of $99.8 and we ended the year with them at 81.6 down over 18 points. So at the start of the year Fannie 2's and there are more than $1,500,000,000,000 of them with a bellwether coupon and they yielded about 2%. Now we're buying Fannie 5.5 percent at a discount and the nominal spread on the par coupon mortgage is significantly wider than the 20 year historical average. That's almost a 400 basis point move in a little more than a year, undoing a 15 year bull market and bringing MBS yields back to their 2,007 levels. Now mortgage rates are higher than before the Fed began its mortgage on buying program and the Fed is just sitting on a large portion of the market, which has reduced what's available to private investors.

Speaker 4

So where are we now? The market is currently pricing in a terminal funds rate of almost 5.5% And that means more hikes from here, but the biggest moves are clearly behind us from the market's perspective. And what's this inverted yield curve saying about the future? It says lower rates are coming. The 2 year note now yields almost 5% and the 2 year note 2 years in the future is expected to be over 100 basis points lower.

Speaker 4

You put all this together and you can see why fixed income flows turned positive in Q4. There are some signs that inflation while high is starting to slow. Some Fed watchers expect the hiking cycle to pause as soon as next quarter and the risk of recession has set market expectations of significantly lower rates sometime next year. Whether all that actually happens, nobody knows, But that set of expectations puts fixed income in a pretty good place to attract capital. Capital flowing into fixed income as opposed to out of it Very significant for MBS.

Speaker 4

Fixed income investors have not seen yields this high since 2007 and they are voting with their wallet. You can see funds flowing into ETFs and mutual funds, but there are 2 headwinds. 1st, banks, which are normally huge Agency MBS investors have been quiet. They're struggling with diminished capital from held for sale losses and from weak deposit growth. Given competition from money market funds, commercial banks saw year over year deposits shrink for the first time in 70 years.

Speaker 4

And second, of course, is the absence of FedBine. We get a lot of questions about what an inverted yield curve means for ADE and return expectations going forward. A sharp rise in the Fed funds rate is Typically only a short term headwind. Spreads have widened on longer term repo and in response we've shortened the average tenor of our repo as you can see on Slide 17. As a result, our repo expense now goes up almost in lockstep with the Fed funds rate, But it takes at least a quarter or longer for our AD to normalize for a few reasons.

Speaker 4

The floating leg we receive on our swaps will also reset higher, But those only reset every 3 months. And the extent that our fixed payer swap portfolio is smaller than our asset portfolio, We need to raise asset yields through turnover to make up the difference. But once the hike stop and our portfolio turnover continues, our asset yields should catch up and fully reflect the wider spreads currently in the market. Those wider yield spreads relative to financing costs and hedging instruments Hedging Costs Should Drive ADE Moving Forward. But what will it mean for Agency MBS If the forward curve is correct and we get a mild recession in lower interest rates, that's probably the best case for Agency MBS.

Speaker 4

Nomura has put out some great research explaining this dynamic. A 75 basis point drop in the mortgage rate does very little for getting coupons in the money, So it's not material for refi supply, but in a recession banks typically favor securities over loans. So in a mild recession, we would expect an incremental increase in bank demand. Also within fixed income, Agency MBS tend to outperform corporates in a recession 2. Finally, slightly lower rates are also probably supportive of further fixed income flows.

Speaker 4

Right now housing is relatively unaffordable looking at monthly mortgage expense at current rate levels relative to median income. So you are seeing existing home sales really drop like a stone. The other powerful force that is slowing existing home sales is what mortgage researchers refer to as the lock in effect. The lock in effect is when a homeowner has a mortgage rate that is several 100 basis points below the current rate. They are locked in low payments significantly deter them from moving.

Speaker 4

Lots of moves are local. A growing family wants an extra bedroom or empty nesters want to downsize. These moves are discretionary and a 300 basis point jump in a new mortgage versus an existing one will dramatically change their monthly mortgage payment. This dynamic also helps keep new MBS supply in check. So all in all, a mild recession probably up ushers in a decent pickup in agency MBS demand with only a very modest uptick in new supply.

Speaker 4

So what did we do for the quarter and how are we currently positioned and what is our future outlook? You can see on Slide 14 that we shrunk our Agency MBS portfolio during the Q4. Given their strong performance in the quarter, It made sense to reduce MBS holdings on a relative as the relative value was not as compelling, but it was our disciplined hedging process and cash management that allowed us to hold our portfolio intact through some very volatile times in 2022 and that allowed us to capture returns in Q4 to offset some prior losses. You can see on this slide that we reduced our holdings of 15 year mortgages. Given the inverted yield curve, That sector is seeing almost no new origination, so it's shrinking from pay downs.

Speaker 4

The net negative supply has driven prices to much tighter spreads relative to treasuries and 30 year MBS. That may well continue, but we are just finding better relative value in the 30 year market right now. January was another month of strong performance. February reversed some of those gains, but we are still solidly up for the year. MBS spreads are currently attractive and the consensus path of a few more hikes followed by some better inflation news and weaker economic numbers Should be a very good backdrop for MBS performance.

Speaker 4

But experience has taught us that the forward curve is often wrong, so we remain disciplined about hedges and are prepared for a range of scenarios. We see lots of relative value opportunities in the market that we look to exploit to drive incremental returns. Now back to Larry.

Speaker 2

Thanks, Mark. 2022 was by many measures the worst year for MBS in at least 40 years and perhaps ever. In Ellington Residential's long standing sector of focus, the Agency MBS sector, It was truly nowhere to hide as the Bloomberg MBS Index had its worst yearly performance on record on an absolute basis and its 2nd worst year ever relative to treasuries. Throughout 2022, we had to navigate periods of extreme volatility and market dysfunction with interest rates rising rapidly and yield spreads widening along the way. Despite these challenges, our risk and liquidity management enabled us to avoid realizing even larger losses.

Speaker 2

As a result, we were able to buy into extreme weakness late in the Q3 and then sell into strength in the Q4. By doing so, we entered 2023 with reduced leverage and strong liquidity, which is now allowing us to play offense once again. On last quarter's earnings call, we discussed that we are planning to selectively rotate a portion of our capital from Agency MBS to other residential mortgage sectors. And that's still very much on our radar screen. As we pointed out before, earned smaller size should enable us to be nimble as market conditions evolve.

Speaker 2

And as usual, absent a big yield spread widening event where we want to pounce, we plan to be patient and opportunistic picking our spots. So far this year, January started the year off on a positive note with Agency RMBS enjoying an excellent month as agency yield spreads tighten further. The tightest turned a bit since then with interest rates and volatility up both in February and so far in March, especially with Powell's comments this morning. Year to date through the end of February, we estimate that EARN's book value per share was up close to 4 Center. With that, we'll now open the call to questions.

Speaker 2

Operator, please go ahead.

Operator

Thank you, sir. You may remove yourself from the queue by pressing star 2. Our first question comes from Eric Hagen with BTIG.

Speaker 5

Hey, thanks. Good morning, guys. I've got a couple here. I mean, how are you thinking about volatility in the market, especially connected to a recession and the impact that it has on the flexibility from banks to support repo financing. Like are there good ways you think to hedge against the kind of credit risk at banks because of the transition to SOFR from LIBOR over the last couple of years.

Speaker 5

And then as a smaller cap mortgage rate, are you concerned about the access that you have It's a repo and banks as the Fed continues to raise. And then, how do you think mortgages would respond to Any further backup in rates at the long end of the curve as well as the short end? I mean, we all know that most of the sensitivity is concentrated at the long end, but How sensitive do we think the basis is if fed funds are meaningfully higher than with the forward curve currently projects. Thank you guys.

Speaker 2

Hey Mark, why don't I take the repo portion of that and then you'll address How the mortgages should react to what's going on the yield curve?

Speaker 4

Sure.

Speaker 2

Yes. We're not really concerned about repo. Repo and especially in agency pools has just been incredibly resilient, including most notably through the financial global financial crisis. We have a lot of a very large diverse set of repo counter parties. We explicitly limit our exposure to smaller counterparties And we most of our repo is through the very large banks that are, again, since the global financial crisis extremely well capitalized, It's something that we watch.

Speaker 2

I mean, there's been a couple of banks that have been in the news and you've seen They are the credit spreads on their own debt, it will be a little bit volatile. But again, we limit our exposure there at Ellington Residential to those counterparties and it's just not something We're worried about whether it be from a counterparty credit risk of our repo counterparties or from a repo availability perspective. I mean, we've just Seeing absolutely no blips in terms of that availability. Mark, do you want to handle The second part.

Speaker 4

Sure. So I think the first question, Eric, was about volatility. Volatility has been pretty high this year, but realized volatility is certainly down from last year. And like to me, I think about sort of 2 types of volatility. One is, what's the volatility in treasury yields, right?

Speaker 4

So How many basis points a day are they realizing versus what's kind of built into market expectations? And you've been sort of Realizing about what's built on about market expectations are priced in, which it sort of means that If you think about things in OAS terms that your delta hedging costs are about what The OAS you thought you were buying is predicated upon. So that has been definitely manageable. It's been more manageable than last year. Now The other part of volatility that I think a lot about is what's the volatility of mortgage spreads relative to treasuries?

Speaker 4

And that's where you've really seen things come down that the amount by which mortgages outperform or under On sort of a given day this year versus last year, it's a lot less. So you've had kind of mortgages, they've had this modest outperformance this year, But the oscillation has been between sort of their best performing days and their worst performing days are a lot closer than what they were last year. And I attribute that to the flows in mortgages are a lot more balanced. So sort of like Anyone who needed to shed a lot of duration in response to the Fed hikes last year or outflows they had, let's say, to mutual fund or it's a pension fund raising cash. I think you've seen those big outflows occur.

Speaker 4

And if you look at ETF data and mutual fund data, you've seen kind of modest inflows into fixed income and some inflows into mortgages specifically, especially through some of the ETFs. So the flows have been more balanced. Now the second question you had about how the mortgages perform if rates go higher than what's currently built in the forward curve. So I mentioned that sort of like mild recession was probably the best case for mortgages. And so I would say that The case where I think right now sort of terminal fed funds rate is expected to be right around 5.5%.

Speaker 4

I think cases where it's materially higher than that and scenarios where You have say 10 year yields go materially through the highs of last year. I think last year we got to 4.35% or 4.40%. We sit a little bit below 4% now. So I think scenarios where yields go up through last year's highs on the long end And fed funds rate is a lot higher than what's currently built into expectations. I think those are harder scenarios for mortgages because I think In scenarios like that, you're more likely to see fixed income outflows.

Speaker 4

So it's sort of a little bit of the opposite of What made sort of what made, I think, kind of mild recession scenario, which is what's currently built into the forward curve So that mild recession scenario, those technicals are sort of the best for mortgages. And I think materially higher rates, Market seems like inflations aren't coming down as much. That I think is more challenging scenario.

Speaker 5

Yes. Appreciate the color from you guys as always. Thank you.

Speaker 4

Thanks, Eric.

Operator

Thank you. Our next question comes from Crispin Love with Piper Sandler.

Speaker 6

Thanks. Appreciate you guys taking my questions. Just First on looking at potential buyers of Agency MBS over the near term. Mark, you talked about this a bit, but with banks stepping back from the sector in 2022. Do you still view that there's an opportunity there for banks to be a meaningful buyer and agency in 2023 if If bank loan growth pulls back or could that be delayed, into kind of 2024?

Speaker 6

And then just any other potential tailwinds for agency you think are worth calling out?

Speaker 4

Sure. So I think what really Turned the dial on Agency MBS performance in Q4 as opposed to quarters 1, 2 and 3. It was really money manager buying in response to inflows, right? Like investors Like long term pools of capital, pension funds, insurance companies are seeing yields they haven't seen since 2007, right? So that Has been enough to get people when they see some modicum of stability in rates to commit capital to fixed income.

Speaker 4

So I think that was It was really money managers are the type of buyers that really have driven performance in Q4 and so far this year. Banks so far has still been on the sidelines. You've seen them basically Sell some of the Fannie Freddie's. The buying they're doing is mostly in Ginnie's because it's a different capital weighting. And they've also been preferring loans over securities for lower mark to market impact on their balance sheet.

Speaker 4

So I you did see some bank buying banks typically buy after they've seen a little bit of a rally. So they generally like they're not the kind of catch a falling knife type of buyer. They're sort of like they'd rather buy the bounce type buyer. So you did see a little bit of bank buying in Earlier this year when we had rallied some, but I think that's dissipated a lot. So I don't think you're going to see Material bank buying unless rates sort of stabilize, start going back down.

Speaker 4

And if concerns about credit performance are significant credit performance in loan portfolios is significant enough to cause them to favor securities over loans for credit reasons. And you typically see that happen in a recession. Right now, the economic numbers have been strong. The other thing, which can also drive some of the bank behaviors, now everyone's under this, CECL regime, right? So if you do have Weaker credit performance in the consumer or credit performance in mortgage loans, then that can drive a revision to The capital you need to hold against loan portfolios for CECL and if that starts happening that's certainly something that would cause them to favor Securities Over Loans.

Speaker 6

Thanks, Mark. And then just one other for me. It's More of a numbers question from the quarter, but looking at core other income after making all the adjustments for ADE was pretty sizable in the quarter versus the previous quarter, kind of after backing out the adjustments, I still got to core other income about 2,700,000 I'm just curious if you can comment on the key driver and the change there and kind of what's in there that drove the significant increase versus the previous quarter.

Operator

Sorry, can you repeat the question?

Speaker 3

This is Chris.

Speaker 6

Yes. So looking at core other income After making all the adjustments for ADE, was about $2,700,000 which was a kind of significant increase over the previous quarter After making the adjustments for different kind of realized and unrealized gains, I'm just curious if you can comment on kind of the key driver and what drove the higher core other income in the quarter. And we can definitely take this offline if you don't have it handy.

Speaker 3

Yes, yes, Chris. It's the swap payments, the swap benefit that we were talking about before.

Speaker 7

All

Speaker 6

right, perfect. Thank you very

Speaker 4

much. Thanks, Chris.

Speaker 5

All right. Thank you.

Operator

Thank you. Our next question comes from Mikhail Goberman with JMP Securities.

Speaker 7

Hey, good morning gentlemen. Congrats on a solid quarter and appreciate the book value update. Just a quick question from me on What kind of opportunities are you guys seeing in the non agency space? I guess you're mentioning here number 2 on your list of the annual objectives is to continue to rotate A portion of capital into that space, so I'm just curious about that. Thanks.

Speaker 4

Yes. So the 2 sectors in non agencies that look to us most attractive right now are some of the more seasoned credit risk transfer bonds And the other one is sort of the legacy non agency market. So that's sort of the pre crisis bonds 2007 and earlier, people have been in their homes 15, 16 years. It's kind of a fragmented market. It's a lot of smaller pieces.

Speaker 4

There's a lot of securities where you're backed by maybe 15, 20 loans, so cash flows are lumpy, but our analytics are very strong in that area. And because you really need to take a granular approach to looking at the individual loans, It's deterrent to people that sort of just want to buy beta. So we see that sector as attractive now. It's now it's You have to counterpunch a little bit there. You have to wait for sellers because it's not like the non QM market or another new issue market where There's new issue deals and you can just put new order on new issue and get invested that way.

Speaker 4

This you need to respond primarily to Bittelis, but those are the 2 sectors that we see the best relative value. And we're not looking to That portfolio is not designed to or it's not sort of contemplated Taking a lot of credit risk. So what we're going to put to work there are securities that we think you can shock home prices like a great financial crisis shock And you're going to get your capital back. So it's not going to be way down the capital stack and things that are subject where Small changes in loss expectations really changed your expected returns, things higher than the capital structure. It's not It's very similar to what we did in 2020 out of COVID, right?

Speaker 4

2020 out of COVID, we raised cash Once the Fed started buying and Agency MBS tightened and Agency MBS, their tightening cycle preceded the tightening cycle in credit sensitive assets. So after the agency MBS really started to form well Post March of 2020, we rotated into some non agencies and it worked out really well.

Speaker 7

Great. Thanks for that, Mark. And just kind of curious, obviously, it's not an issue at the moment, but Kind of looking forward, at what point could prepay speeds start to spike? What kind of environment would we have to get to As rates keep on rising, like I said, obviously not an issue at the moment, but what could happen down the road.

Speaker 4

It's a great question. It's a great question. We actually just got the new you get these monthly prepayment reports, 5th business day of the month. So we got the prepayment report last night and it showed a very modest uptick, maybe 10% from extremely low levels. So I think about it 2 ways.

Speaker 4

There is some very small portion of the mortgage market where people have note rates 7.5%, 7.25%, bigger loans. We think those borrowers I'm going to be very responsive to refinance opportunities if the forward curve is borne out and you see mortgage rates drop. And you have still there's been layoffs Industry wide among mortgage originators, but you still have excess capacity. So if you saw 20, 30, 40 basis point drop in mortgage rates, You're going to see that very small portion of the market that has high note rates. So people that took note rates Q4 last year, those are going to be responsive.

Speaker 4

And this actual this recent prepayment report yesterday, you saw a little bit of that behavior Because this prepayment report referenced mortgage rates a little bit lower than where we are now. But now If you think of it the market in aggregate, to get a real prepayment wave, you need to get big portions of the market refinanceable. And I don't think you see that until you get well below 5%. Even you move things 75, 100 basis points here, The percentage of loans that have a refinance incentive is very low. The first thing I think you'd see is that if you got mortgage rates, let's say, to 5.25, Now all of a sudden people with 4.25%, 4.5%, 4.75% note rates, they're going to be more willing to do cash out refinance.

Speaker 4

So that can happen. That'd be sort of incremental. But to get a real a big portion of the market refinanceable with Great, rate refi. You're going to have to be well under 5%. But I think you'll see sort of you have little pockets of faster speeds along the way.

Speaker 4

And if you hold those pools, you can get hurt on those pools, but it doesn't change the supply demand dynamic for mortgages Until you get significantly lower

Speaker 7

rates. Got it. Thank you for that. Thank you very much guys. Best of luck going forward.

Speaker 4

Thank you.

Operator

Thank you. Our next question comes from Jason Stewart with Jones Trading.

Speaker 6

Hi. Thanks guys. Just wanted to know a little bit further on your thoughts on investing across the agency coupon stack visavis the dividend.

Operator

I guess,

Speaker 4

kind of where we see the most value now is like a sweet spot, like it's coupons that are high enough where you're getting enough coupon that you're sort of like going to be close or getting close to your financing costs, But aren't so high that a little bit of drop in mortgage rates, you can see a big pickup in speeds. So I would say 4, 4.5, 5, even 5.5, that to us looks I think that's where you want to be. I think you want to be positioned such that if you have a drop in rates, if the forward curve turns out to be right, you have at least A few points of room before you get to par and before you really have to start worrying about prepayments. So I'd say that those coupons kind of fit that bill, but they also You also have the nice property that you're not seeing new production say in 4s and 4.5s. So each month, If you own pools or even if you own TBAs, it's sort of you own pools, everything sees the month by month, but even if you have TBA exposure there, The assumptions to what's deliverable is getting older each month.

Speaker 4

So you're getting kind of the benefit of seasoning there. And I think that It serves the very higher coupons. We have really big loan balance that have a small drop in rates. You're going to have an army of people trying to refi those loans. That to me is I think an area that will have challenging performance if the forward curve is born out and you do have lower rates 2nd half of this year and next year.

Speaker 2

And if I could just add, if you look at our net interest margin And you leverage that, given you can look at our debt to equity, you can look at our net mortgage exposure, which we dial up and down. You can see that The dividend should be well covered from that perspective, especially given where short term rates are, because that's a tailwind as well. But it's really a spreads have been so volatile lately. I mean, we talked about how They gapped out in September, tightened in November. Now obviously this year, saw sort of a similar thing, January tightening in February March widening.

Speaker 2

So it's definitely a market where we feel that by dialing down up and down that net mortgage exposure, We can generate incremental earnings. And so I think with that as well, which obviously came into play in a big way in the 4th quarter. We can absolutely cover the dividend.

Speaker 6

Got you. Great. Thanks guys.

Operator

Thank you. That was our final question for today. We thank you for participating in the Ellington Residential Mortgage REIT 4th Quarter 2022 Earnings Conference Call. You may disconnect your line at this time and have a wonderful day.

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