Ellington Credit Company - Q4 2023

Transcript

Operator (participant)

Thank you for standing by, and Welcome to the Ellington Residential Mortgage REIT 2023 Fourth Quarter Financial Results Conference Call. Today's call is being recorded, and at this time, all participants have been placed in a listen-only mode. The floor will be open for questions following the presentation, and if you would like to ask a question at that time, please press star one on your telephone keypad. At any time, if your question hasn't answered, you may remove yourself from the queue by pressing star two. Lastly, should you require operator assistance, please press star zero. It is now my pleasure to turn the conference over to Alaael-Deen Shilleh, Associate General Counsel. Sir, you may begin.

Alaael-Deen Shilleh (Associate General Counsel)

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 Provisions 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 should not rely on these forward-looking statements as predictions of future events. We strongly encourage you to review the information that we have filed with the SEC, including the earnings release in the Form 10-K, 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. Joining me on the call today are Laurence 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 fourth quarter earnings conference call presentation is available on our website, earnreit.com. Our comments this morning will track to 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. With that, I will now turn the call over to Laurence.

Laurence Penn (CEO)

Thanks, Alaael-Deen, and good morning, everyone. We appreciate your time and interest in Ellington Residential. As with much of 2023, in the fourth quarter, markets gyrated between a sell-off and a rally, with tumultuous October giving way to a market rally in November and December. In October, interest rate volatility spiked as U.S. Treasury yields rose to 15-year highs, and that drove yield spreads sharply wider on most fixed income products. Markets then reversed course in anticipation of the conclusion of the Federal Reserve's hiking cycle, with interest rates and volatility both declining into year-end. With rates lower and trading in a more stable range, demand for spread products picked up and capital flowed into fixed income funds.

With the notable exception of CMBS, which has its own unique challenges, virtually all fixed income spreads tightened for the fourth quarter, including in the markets where EARN invests, namely agency and non-agency RMBS, and now corporate CLOs, where we've been investing to an ever-increasing extent after our recent pivot. Turning to the investor presentation. On slide three, you can see that medium and long-term interest rates, despite spiking to multi-year highs in October, actually declined overall for the quarter, and the 30-year Freddie mortgage survey rate, despite reaching a 23-year high mid-quarter, also finished lower on the quarter. Incredibly, despite all the fluctuations during the year, both the 10-year Treasury yield and the 30-year mortgage survey rate finished 2023 within one basis point of where they started the year, as you can see here on this slide as well.

As the backdrop for our mortgage-backed securities portfolio, you can also see on slide three that option-adjusted yield spreads tightened across agency coupons during the fourth quarter, and that the most pronounced price increases were on lower and intermediate coupons. Dollar prices on Fannie 2.5 through 4.5 were up more than five points sequentially. The outperformance of those coupons benefited EARN's agency MBS portfolio specifically, because coming into the quarter, roughly two-thirds of our agency MBS had coupons of 4.5% or less. Meanwhile, as the backdrop for our CLO portfolio, corporate credit spreads followed a similar pattern, first widening up in October and then tightening in November and December, and tightening overall for the quarter as an economic soft landing narrative permeated the market.

You can see on the bottom of slide three, that credit spreads on both high yield and investment grade tightened significantly over the quarter, while prices on the Morningstar LSTA Leveraged Loan Index rose. Turning now to EARN's results. In the fourth quarter, we generated net income of $0.75 per share and a non-annualized economic return of 7.7%, while our adjusted distributable earnings grew to $0.27 per share and more than covered our dividend. As with other market disruptions we've seen before, the key in the fourth quarter was to avoid forced selling when the market sold off in October in order to preserve equity and earnings power and be in a position to participate in the subsequent market recovery. In the fourth quarter, we again relied on EARN's risk management and strong liquidity position to accomplish this.

That said, we did sell pools in the fourth quarter to free up capital from MBS to CLOs, and the majority of our sales took place in November as yield spreads were tightening. We ended up increasing the size of our CLO portfolio by $13.6 million during the quarter. On slide 12 of the earnings presentation, you can see some of the underlying characteristics of our CLO portfolio as of year-end. The corporate loans underlying our CLO investments span a diverse array of industries, and the overwhelming majority are floating rate, first lien, senior secured loans. Our rotation into CLOs has continued into the new year, with our agency portfolio now incrementally smaller and the size of our CLO portfolio now up an additional 70% from year-end to approximately $30 million.

Even after the recent credit spread tightening in the sector, we still see returns on equity for new CLO investments in the high teens to low 20's. Besides contributing to and diversifying earnings gap results, our high-yielding CL- CLO investments have also helped drive the substantial growth of our net interest margin, and thereby have supported our ADE as well. In addition, because we employ less leverage on our CLOs compared to agency, the portfolio rotation has also driven down our leverage ratios. At year-end, our debt-to-equity ratio, adjusted for unsettled trades, declined to 5.3-to-1, down from 7.3-to-1 at September 30th. I'll now pass it over to Chris to review our financial results for the fourth quarter in more detail.

Chris Smernoff (CFO)

Thank you, Larry, and good morning, everyone. Please turn to slide five for a summary of Ellington Residential's fourth quarter financial results. For the quarter ended December 31st, we reported net income of $0.75 per share and adjusted distributable earnings of $0.27 per share. ADE excludes the catch-up amortization adjustment, which was positive $566,000 in the fourth quarter. During the quarter, positive net interest income and net gains on our agency MBS significantly exceeded net losses on our hedges, driving strong performance from our agency portfolio. Our CLO portfolio also generated strong returns, driven by net interest income and net gains, as did our non-agency RMBS and interest-only portfolios.

On slide five, you can see that our overall net interest margin expanded to 2.19% from 1.34% quarter-over-quarter, which drove the increase in ADE. Broken out by product, our agency NIM increased to 2.02% from 1.26%, driven by higher asset yields and a lower cost of funds. Meanwhile, our credit NIM, which includes CLOs and non-agency RMBS, increased to 6.28% from 4.55%, boosted by high asset yields on our larger CLO portfolio. Please turn now to our balance sheet on slide 6. Book value per share was $7.32 at year-end, compared to $7.02 per share at September 30th.

Including the $0.24 per share in dividends in the quarter, our economic return for the quarter was 7.7%. We ended the quarter with $61 million in cash plus unencumbered assets, which was approximately 45% of total equity. Next, please turn to slide seven for a summary of our portfolio holdings. Our agency RMBS holdings decreased by 8% sequentially to $728 million as of December 31st, as net sales and pay downs exceeded net gains. Our agency MBS portfolio turnover was 25% for the quarter. Our aggregate holdings of non-agency RMBS and interest-only securities also shrunk in size by 13% quarter-over-quarter. Over the same period, we increased our CLO holdings more than fourfold to $17.4 million as of December 31st, compared to $3.8 million as of September 30th.

At year-end, our deployed equity was allocated 89% to mortgage-related securities and 11% to CLOs. Our debt-to-equity ratio, adjusted for unsettled trades, decreased to 5.3x as of December 31st, as compared to 7.3x as of September 30th. The decline was primarily due to an increase in shareholders' equity and a significantly lower leverage on the CLO portfolio relative to our agency holdings. Similarly, our net mortgage assets to equity ratio decreased to 6.5x from 7.2x over the same period, despite our holdings holding a net long TBA position at December 31st, as compared to a net short TBA position at September 30th.

On slide nine, you can see the details of our interest rate hedging portfolio. During the quarter, we continued to hedge interest rate risk, primarily through the use of interest rate swaps. We ended the fourth quarter with a net long TBA position on a notional basis, but a small net short position as measured by 10-year equivalents. Lastly, on slide 12, you can see that nearly all of the loans underlying our CLO portfolio are floating rate, and as such, carry minimal interest rate risk. I will now turn our presentation over to Mark.

Mark Tecotzky (Co-CIO)

Thanks, Chris. The fourth quarter was really a tale of two markets. The first part of the quarter was characterized by a continued rate sell-off, wider spreads, fund outflows, and market uncertainty about how high the Fed would need to hike short rates before achieving a noticeable improvement on inflation. But then, starting in late October and early November, with economic indicators and comments from Chairman Powell pointing to a possible end to the rate hike cycle, markets started to make a U-turn. Rates dropped, spreads tightened, and there was a significant fund and bank buying of Agency MBS and other spread products. In Agency, sector outperformance in the second part of the quarter exceeded underperformance in the first part.

And overall for the quarter, agency MBS significantly outperformed hedging instruments. I'm happy to report that EARN was well positioned to capture this agency outperformance, posting a total economic return of almost 8% for the quarter. During the market sell-off in the first part of the quarter, we were able to manage the interest rate volatility and keep our agency MBS portfolio largely intact. We were confident that it was just a matter of when, not if, spreads would recover, and maintaining our portfolio allowed us to capitalize on the spread tightening when it did eventually occur. During Q4, the market pivot in Fed expectations was the catalyst that led to lower implied and realized volatility, which lowered actual and expected hedging costs and prompted capital inflows from banks and investment funds.

If and when the first rate cut occurs later this year, we think that could be another catalyst for continued outperformance for Agency MBS. We were able to take advantage of the market strength to shrink our Agency MBS portfolio incrementally and redeploy that capital into CLOs. That rotation not only enhanced our diversification, but it also took our leverage down significantly, and yet we were still able to grow ADE. In Q4, our CLO portfolio grew by $13.6 million, as we predominantly added seasoned CLO mezzanine tranches, but also longer duration CLO equity, shorter duration CLO equity, and newer vintage CLO mezz. Seasoned mezzanine investments outperformed throughout Q4 as prepayment speeds accelerated and CLO cash balances grew, driving expectations of a deal deleveraging in January, and that strong performance has continued into 2024.

CLO credit spreads tightened across the board in Q4, with BBBs generally rallying around 30-50 basis points, and BBs rallying even more, albeit with significant dispersion. However, these sectors lagged the high yield corporate bond market, whereby some measures spreads tightened to almost 100 basis points for the quarter. Q3 earnings were better than expected for many high yield borrowers, with J.P. Morgan estimating that 86% of high yield companies generated Q3 earnings that were either neutral or positive for their credit profiles. Investors generally grew more comfortable with non-investment-grade credits in Q4 as fundamentals improved. Improvements in the leveraged loan market drove strength in junior CLO tranches, given that they are more levered to credit performance than senior tranches are.

That said, the most credit-sensitive CLO profiles, that is, those with the lowest credit enhancement and/or most distressed portfolios, continued to lag as investors anticipated further credit losses. In Q1 of 2024, we anticipate further strength in our CLO portfolio due to declining credit market stress and continued pull to par in seasoned CLO mezz. Approximately 40% of the leverage loan index traded above par at the end of Q4, which has incentivized lots of borrowers to refinance their debt so far in 2024. This is benefiting both seasoned CLO mezz through faster deal paydowns and CLO equity through lower near-term default risk, as underlying corporate borrowers raise incremental liquidity.

We also expect the technical backdrop for the leveraged loan market to remain attractive, as many new CLOs are expected to ramp up portfolios in Q1, driving demand for loans with a forward calendar of loan supply that remains light. Looking ahead, we see lots of reasons to be optimistic about EARN's future performance. The most aggressive Fed hiking campaign ever is now behind us. SOFR went from zero to over 5% in 14 months. The Fed balance sheet has shrunk by well over $1 trillion since its peak post-COVID size.

Couple that with large bank failures, putting almost $100 billion of agency MBS and CLOs into the market, and you had the recipe for substantial spread widening, which we've seen over the past couple of years. But now the Fed should soon become a tailwind as opposed to a headwind. Looking ahead, in addition to this expected support from the Fed, we see five major factors supporting future MBS performance. First, spreads are wide, not as wide as October, but still much wider than historical averages.

And they should be. The Fed is a seller, not a buyer, and banks, while buying, are a shadow of their former selves. But being wide and staying wide works out just fine for EARN. We have a big levered NIM to capture. Second, supply is low, and it's especially low relative to the mountain of Treasury supply, so relative performance versus hedging instruments are supported by this technical. Third, prepayment risk for most coupons is benign, and the cost of prepayment protection is reasonable.

Fourth, flows into mutual funds that buy agency MBS, both active and passive, have been quite strong, as have fixed income annuity sales. Banks have also started to buy in Q4. And fifth, volatility is a lot lower, both actual and implied, so delta hedging costs are lower, and that makes option-adjusted spreads wider. We have room to add leverage at EARN, we have tools to further grow ADE, and CLOs are helping to deliver a diversified return stream. Now, back to Larry.

Laurence Penn (CEO)

Thanks, Mark. I was pleased with how we navigated the market gyrations throughout 2023 and finished the year on a high note. Now, with yield spreads still wide on a historical basis, with markets expecting cuts instead of hikes, and with volatility normalizing, Agency MBS are attracting incremental demand from investors, albeit tempered by uncertainty around the timing of cuts. When those rate cuts eventually come and we ultimately see a steep yield curve again, that should be a further tailwind to the sector. I'm excited about our growing corporate CLO portfolio. EARN's small size and liquid portfolio has been an advantage here, as we've been able to ramp up quickly in a terrific strategy where we see a big opportunity for EARN.

While Ellington has long-standing and deep experience managing CLO portfolios, EARN began investing in that product just this past September, and that pivot is already contributing nicely to earnings. Including investments through today, CLO investments are now a full 17% allocation of EARN's total equity. I expect them to be a significant driver of earnings and ADE moving forward. The CLO market has proven its ability to generate attractive returns over market cycles and over a long-term horizon. In the short term, and as Mark mentioned, credit spread tightening in some segments of the CLO market has continued to lag a larger rally in corporate bond credit spreads, and we expect that money manager inflows into high yield and leveraged loans will help narrow that gap.

As Mark also mentioned, we expect faster leveraged loan prepayment speeds to drive faster prepayments on many of our seasoned CLO mezzanine positions, which we hold at significant discounts to par. We've grown EARN's CLO portfolio by another 70% so far in 2024, and these discounted seasoned CLO mezzanine positions have continued to be a focus of ours, given their total return potential in an environment with this potential for higher loan prepayment speeds. The CLO market suits EARN extremely well. It not only offers high current interest income, but it has always been a fertile ground for both relative value and absolute value opportunities, as well as for trading opportunities, given the dispersion in collateral credit performance from deal to deal.

Going forward, Ellington's extensive expertise and track record in the CLO market should be a big benefit for EARN. Our CLO portfolio has continued to contribute nicely to our results so far in 2024, but net losses in Agency MBS have led to an overall economic return for EARN that we currently estimate at -1.9% year to date through February. The Agency MBS market has underperformed many other fixed income sectors so far in 2024, driven by higher rates and uncertainty around the timing of Federal Reserve rate cuts.

This, of course, follows a strong fourth quarter for Agency MBS, which led to the positive 7.7% non-annualized economic return that we generated last quarter. For the past few years, it's undeniable that Agency MBS has been a volatile strategy for all the agency mortgage REITs, including EARN. But I firmly believe that our CLO strategy will prove to be a less volatile strategy and thereby stabilize and enhance EARN's returns over time. With that, we'll now open the call to questions. Operator, please go ahead.

Operator (participant)

Thank you. And at this time, if you would like to ask a question, please press star one on your telephone keypad. You may remove yourself from the queue by pressing star two. And again, that is star one to ask a question. Our first question will come from Doug Harter with UBS. Please go ahead.

Doug Harter (Equity Research Analyst)

Thanks. Can you talk a little bit more about how you see the equity allocation to CLOs playing out? You know, kind of how much of equity could this be?

Laurence Penn (CEO)

Hi. Hey, Doug, how you doing?

Doug Harter (Equity Research Analyst)

Good morning.

Laurence Penn (CEO)

Morning. Yeah, so I guess, it's... I'm not gonna answer that question, you know, directly. I'm just gonna say that, you know, I love this strategy. We have a great team here and a great track record. The more, you know, the more, the better, as far as I'm concerned. We, you know, as you know, we have constraints that we operate under. You know, as a REIT, we have the REIT tests, which are, you know, effectively mostly income based. And at '40 Act, we have tests which are mostly more sort of capital allocation based, but it also depends on your sort of financing strategy and your subsidiary structure. So, you know, we continue to grow, and I don't want to try to forecast where it's going.

Doug Harter (Equity Research Analyst)

Okay, and then I guess just as you think about risk-adjusted returns, kind of comparing agency and CLOs, you know, how do you think about kind of the upside, downside in each to kind of the base case and, you know, kind of how that factors into kind of where you want to be?

Laurence Penn (CEO)

Sure. Well, first of all, from a NIM perspective, you can see that, you know, I think Chris mentioned our, the NIM on our agency portfolio was, you know, probably in the low 200s, something like that. And the credit portfolio, including CLOs, I think 600.

Doug Harter (Equity Research Analyst)

Yep.

Laurence Penn (CEO)

So even with a small bit of leverage, the CLO portfolio generates a greater leverage NIM, dollar for dollar. You know, spreads have tightened. You can sort of see. If you go back to slide three, you can sort of see it differs based on coupon, but if you look at 4.5, for example, in the Z-spread, I'm just looking at year round, you know, something around the 90-100 level. You know, even if you leverage that a fair bit, you're still not quite there, versus where you are on the CLO portfolio on a leveraged NIM basis. So, now, the CLO portfolio obviously has kind of tail credit risk, in, you know, especially in a deep recession or something like that. So that's a factor for sure.

It also has much fewer delta hedging costs, right? I mean, the thing that's been really tough for agency REITs, including us, for the last few years, is these, you know, big moves in the market, big gyrations in rates, cause, you know, and for us, we like to stay hedged in interest rates, and that's, you know, frankly, over a long period of time, that's been key to our success. But, you know, it really cuts into book value over time, those delta hedging costs, and ultimately, that's gonna cut into your dividend as well, right?

So yeah, the other thing, though, I would say is from a trading perspective, right, given the liquidity of agency, the opportunity for trading profits, including dialing up and down to what extent we hedge with TBAs, is probably greater in agencies. Because, you know, if you can make a point, just this is a hypothetical. If you can make a point on your assets by being, you know, timely in terms of when you add, when you take off, how you hedge, you know, that's leveraging that seven or eight times, I mean, that's a massive amount of boost to earnings.

So, you know, there's a lot of pros and cons, right, for each sector. And there are opportunities for trading gains as well in, in CLOs. But, you know, it's not, I wouldn't say that the assets that we're buying there are super liquid. So it's, they're different. And, you know, like I said, you know, I love the strategy, and I'd love to continue to see this grow as much as possible in CLOs.

Doug Harter (Equity Research Analyst)

I appreciate that. Thank you.

Operator (participant)

Our next question will come from Mikhail Goberman with Citizens JMP. Please go ahead.

Mikhail Goberman (VP of Equity Research)

Hey, good morning, everybody. Hope everyone's doing well. First question, I guess, is, did I hear correctly that you said, book value was down about 1.9%, thus far this year? Was that total economic return?

Laurence Penn (CEO)

Total economic return.

Mikhail Goberman (VP of Equity Research)

Okay, cool. Thank you,

Mark Tecotzky (Co-CIO)

Yeah, I think that was the, through the end of February.

Mikhail Goberman (VP of Equity Research)

Right. So including the two dividends. What are you guys targeting a sort of leverage ratio range going forward, given the sort of dip, the pretty dramatic dip that the leverage ratio took in the fourth quarter? Is there an area that you're sort of sort of trying to get to?

Laurence Penn (CEO)

It's just a blend of really the appropriate leverage for each asset class, right? So for agencies, you know, we've taken it up into the nines before in terms of leverage, and in, you know, in non-agencies and now in, you know, CLOs, we've had almost no leverage. But, you know, we'll start to add leverage to CLO portfolio at some point. Well, maybe I didn't mention it exactly in answering the first question, but, you know, you can comfortably have half a turn to turn a leverage on CLOs. So, you know, it's just gonna be a blend of, of, you know, where the capital allocation is.

You know, of course, in agencies, we also, depending on the opportunity, that kind of upper limit of something in the nine-to-one leverage area, yeah, we can always go lower than that. As I said a few seconds ago, you know, sometimes we do that because we do want to take advantage of the spread volatility to sort of buy low and sell high, if you will, throughout the year.

Mikhail Goberman (VP of Equity Research)

Gotcha. Thank you for that. And one more, if I could. This is sort of a longer-term question. What are you guys' thoughts on what kind of interest rate environment it would take for to see a meaningful pickup in, in prepayment speeds, sort of back towards, I guess, historical levels of a few years ago?

Laurence Penn (CEO)

Mark?

Mark Tecotzky (Co-CIO)

Yeah. So it's sort of interesting. We got a, you know, we get the prepayment reports monthly, and we got one last night. And what I would say is that while prepayment speeds sort of in aggregate have been benign, you know, technological improvements, including AI, is definitely something that is being embraced by some of the big non-bank lenders. And so there are pockets of the market. If you look at sort of, there are Ginnie pools out there now that pay over 80 CPR from these real high coupon ones with a lot of VA. What we were getting at, or what I was getting at in the prepared remarks, is that there's, you know, the vast majority of what's out there is still a couple hundred basis points away from being refinanceable.

You know, there's you have, you know, a lot of runway in rates for many of the coupons that we own that, and so you have to worry about prepayments. And the other thing I would say is that, it's not real expensive to buy prepayment protection. So it's not as though prepayments don't exist, and mortgage bankers aren't going to be aggressive about trying to solicit refis when they can. They certainly will be. It's just the vast majority of the market and the vast majority of what we own, you still have a lot of it would take still a significant move in rates to get it refinance able. And so, but, you know, still, look, rates are unpredictable, implied volatility is high.

So even though the forward curve predicts rates are coming down, there's a lot of dispersion around it. So, you know, still, for most coupons, we're saying, you know, some of the higher coupons, we're still choosing to buy pools with prepayment protection. We think it's relatively affordable. And one thing that was a big part of last year was looking for pools. I think we mentioned it a few calls ago, looking for specified pools that have faster than market projected prepayment speeds, and that certainly helped us. When you get into things like 2.5s and 3s and 3.5s, we have big discounts. Even finding pools with one or two CPR faster makes a huge difference in yield. So prepayment modeling, prepayment speeds, prepayment risk, it's still out there.

It's just right now, given the current distribution of coupons in the market, the real scary prepayments are only affecting a very small subset of what's out there, and it's the sectors that we have, you know, avoided. But I'm not surprised to see some of these very fast prepayment speeds, because there's still a lot of capacity within the mortgage banking community, and the technology has gotten better. And so we look for them to be aggressive whenever they have opportunities to be aggressive on refis.

Mikhail Goberman (VP of Equity Research)

Got you. Thank you, Mark, and as always, best of luck, guys, going forward. Thanks.

Mark Tecotzky (Co-CIO)

Thank you.

Laurence Penn (CEO)

Thank you.

Chris Smernoff (CFO)

Thank you.

Operator (participant)

Our next question will come from Matthew Erdner with JonesTrading. Please go ahead.

Matthew Erdner (VP)

Hey, guys. Thanks for taking the question. Kind of following up on that CPR. You guys took off some of the lower coupons, during the quarter. You know, could you kind of talk through the thoughts there?

Mark Tecotzky (Co-CIO)

Yeah, we just saw opportunities during the quarter to rotate up in coupon. You know, I think our portfolio went up about 10 basis points or so in coupon. The relative performance of lower coupons versus current coupons is really impacted by flows into the big bond indices, right? So if you look at the mortgage index, or you look at the distribution of mortgage coupons in something like the Barclays Agg, it's heavily weighted to 2s and 2.5. And so the relative performance of those coupons is very much impacted by flows into the Agg.

And there's a couple of real big, you know, $100 billion+ ETFs that track the Agg. So we, we saw opportunities where a lot of flows came in to Agg type portfolios, where lower coupons outperformed. We saw an opportunity to go up in coupon. We thought it would add, you know, it certainly adds ADE. We thought it would also add total return. So we'll continue to be opportunistic about that.

Matthew Erdner (VP)

Yeah, that's helpful there. And then, you know, allocating capital to CLOs, you know, continuing that strategy, are there any other places where you feel like you guys could opportunistically deploy, additional capital for total return?

Mark Tecotzky (Co-CIO)

That's where we're focusing on now, now.

Matthew Erdner (VP)

Okay, thank you.

Operator (participant)

Our next question will come from Eric Hagen with BTIG. Please go ahead.

Eric Hagen (Managing Director)

Hey, thanks. Hey, thanks. Good morning. Hope all is well. One more on just kind of the market dynamics. I mean, what do you feel like would support more dollar roll specialness in the market? Do you feel like it's reasonable to expect that that could come back if there's any changes to Fed policy?

Mark Tecotzky (Co-CIO)

You know, I would say that for some of these higher coupons, I think the dollar rolls have predictably gotten weaker because you've sort of built up now an array of kind of, you know, faster paying pools. If you look at things like Fannie 6.5, now that they've been in production for a few months, you have some pools that have come up the seasoning ramp. So I don't look for specialness to be there.

In the lower coupons, you can get specialness if you get a lot of flows, like I was talking before, about into these Agg indices, because, you know, when money comes into an Agg index and whoever's managing it wants to buy a bunch of Fannie 2s and 2.5s to get there to minimize tracking error, you really need to get that from other investors, right? They initially will buy from the primary dealers, but the primary dealers are then going to want to buy that from other portfolios, and a lot of those bonds are locked up in the Fed and locked up in, banks.

There was obviously, you know, news on Truist a week or so ago, and when that news came out, it caused lower coupons to underperform. So I think in the lower coupon stuff, you can see some more volatility in the rolls, but still there, we tend to find if you're thoughtful about fast paying pools, you can find pools that pick up carry versus the roll. So I don't, I don't see a lot of specialness going forward for the, for the higher end production coupons, where you're starting to see a float that's faster.

I think for the lower coupon stuff, you can see it, but it's kind of month-to-month. Like there was, you know, a month ago, I think the Ginnie 2.5, the Ginnie 2.5 roll was special. So you get sort of these one-off things, but where most of the production is centered, you know, I don't think you're going to have a lot of specialness, which is really a big difference from the 2021 period, where production was Fannie 2s and 2.5s, and they were routinely special, and everyone spoke about that.

And they were special because the Fed and banks were buying so much, and they weren't rollers. That, we don't have that dynamic right now. So the way the rolls work out, I think it favors, you know, in aggregate, having more specified pools and less TBA. I think broadly, that's sort of how the industry has moved, you know, the REIT industry.

Eric Hagen (Managing Director)

Yep. Hey, that's a good perspective. As far as running the portfolio, I mean, what do you guys feel like is the minimum level of liquidity you feel comfortable with having it at these spread levels? Like, how much do you feel comfortable with the head of the Fed cut versus, you know, like, a cut actually taking place. Do you feel like that would be a catalyst to carry more leverage, or is it potentially conditional on other factors?

Mark Tecotzky (Co-CIO)

You know, we mentioned in the prepared remarks that, you know, if you look at work on Bloomberg or whatever else, people are predicting cuts this year. I think when it, you know, if and when they actually happen, I do think that will be a catalyst for some incremental buying, so I do think that will be supportive. In terms of how we manage our cash, we don't. That is sort of sacrosanct, in that we're gonna manage our cash according to market stresses and according to, you know, the repo roll calendar. We won't change sort of the guardrails we have around minimum levels of cash as a function of, you know, what the Fed is gonna do.

That we just... That's how we run, you know, that's how we run EARN, that's how we run EFC, it's how we run private funds, that there's a certain amount of cash we're gonna keep on hand. And the way we determine that is, you know, it's sort of a, you know, it's a -- you know, it looks at the portfolio, it looks at the leverage, and looks at where things can go in a shock. And then with the agency stuff, you have to look at there's a calendar to it, so you get new factors, when the prepayments come out. So we got new factors yesterday.

Repo lenders did margin call you versus the lower balance, but you don't actually get that cash till the 25th, so there's a calendar component to it. But we have room to add leverage. We mentioned that in the prepared remarks, but it's not because we're gonna change the way we manage the cash. But I'd say sort of the way we manage the cash is something that we've been doing for a long time, and I think it's served us very well. Certainly served us extremely well in stresses, like during COVID. But away from that, EARN has plenty of liquidity to... You know, it's been putting, you know, more capital into CLOs we've spoken about, but it still has more room to leverage just the general pool strategy as well.

Eric Hagen (Managing Director)

Yep. Hey, thank you guys so much.

Mark Tecotzky (Co-CIO)

Thank you, Eric.

Operator (participant)

That was our final question for today. Thank you for participating in the Ellington Residential Mortgage REIT Fourth Quarter 2023 earnings conference call. You may disconnect your line at this time, and have a wonderful day.