Andrei Popov

Ellington Residential Mortgage REIT (NYSE:New York stock market :TO WIN) is a mortgage real estate investment trust, or mREIT, that we used to trade years ago. This company, like so many others in the industry, has been through a lot of pain during COVID and has been working to emerge in 2021. Here in 2022, rates have skyrocketed and these stocks have been crushed. The Federal Reserve’s super-aggressive response to high inflation continues to boost markets, but it has led to extreme interest rate volatility that has weighed on real estate companies like Ellington that buy and sell mortgages and housing lots. mortgages.

This has been a very painful year for mREITs, culminating in September when mREITs and the markets were flushed. Ellington is in a difficult area. Rising rates have caused problems for mortgage-backed securities and related instruments. We have seen interest rate spreads widen, but the steady movement of rates has led to a reversal. Actions taken by the Federal Reserve in recent months have weighed heavily on operations. The whole industry as a whole fell. Businesses that buy and sell mortgages and mortgage packages are struggling. This is the toughest environment for these companies in decades.

While prepayment risk has diminished given high rates on new mortgages, spreads are everywhere and book values ​​have been decimated. We are not off the hook yet as more rate hikes are coming and it is difficult to navigate this sector as the Federal Reserve has raised its target rate for the fed funds rate 4 times in a row to 75 basis points. The pressure has been reflected in just-released earnings, but the company continues to pay out its bountiful dividend. Let’s talk.

The pain felt on the earning potential

In what has just been reported Third quarter results, we have seen interest rates continue to soar and interest rate volatility has reached levels not seen in ages. In the third quarter, we saw liquidity issues and yield spreads widen, while prices fell across most bond sectors, including agency RMBS. It hurts. The decline in value and spreads led to devastation in book value. Key metrics we monitor have been overwritten, but that dividend continues to be paid. A summary of the critical metrics you need to know for Ellington Residential Mortgage is shown below for Q3 2022:

Key metric

Most recent data*

Q3 2022 book value and % change from Q1 2022

$7.78(-14.2%)

Net interest rate gap in Q3 2022

1.28%

Current quarterly dividend (yield)

$0.24 (15.7%)

Net earnings per share Q3 2022

($1.04)

Q3 2022 distributable earnings per share

$0.23

Dividend covered?

Nope*

52-week stock price range

$5.70-$12.02

Source: Ellington Residential Mortgage REIT Q3 2022 Results

Jable created by ADB BEAT Investing

* As of 09/30/2022

** Per distributable result

Dividend coverage is essential

If we go back in time, we will remind you that the dividend has been cut many times with this company over the past years. We weren’t surprised at all here in Q3 2022, as the monthly payment of $0.08, or $0.24 per quarter, was not covered. We were surprised, however, that only a penny of cover was missing.

Last quarter, the dividend was more than well covered. As such, we don’t see a cut coming yet, but another quarter or two like this and we’ll see the pain. The good news is that it looks like rate hikes will take place in early 2023 and the yield curve inversion should ease, especially if we look to outrun a possible recession. In short, better days are coming, but we are not out of the woods yet. We saw a worse Q3 than Q2, that’s for sure. Net income was a big loss, adding to last quarter’s losses, but we don’t care so much about that metric for the dividend with an mREIT.

What do we mean? Well, in our view, the most critical metric to look at here is Distributable Income (formerly known as Basic Income). This figure is insufficient, as noted. This is because the net interest margin narrowed sharply and the earning power of mREITs subsequently fell. Margins have fallen because the short end of the curve is seeing very high rates, causing a volatile spike in the cost of funds that outpaces the evolution of asset returns. It was hard. Ultimately, it’s still an income name, so coverage matters. Distributable earnings are a strong indicator of dividend coverage, and EARN failed this quarter, but it was a horrible quarter for most mREITs.

There wasn’t much to like about the quarter. We will argue that prepayments will decrease, which will reduce some of the volatility in the portfolio, given that rates are so high. With rates this high, it doesn’t make much sense to refinance a lot of mortgages. On the earnings front, as mentioned, there were net losses. No surprise here. The company reported a net loss of $13.7 million, or a loss of $1.04 per share, compared to a loss of $0.82 per common share in the second quarter.

But again, the best measure of a company’s ability to pay its dividend is its distributable earnings, and here we only saw a slight drop. Distributable earnings were $3.0 million or $0.23 per share. We targeted a print of $0.24 covering the dividend, but weren’t surprised when Ellington went short given how the quarter played out for the sector as a whole.

The drivers of the quarter were discussed by CEO Laurence Penn, who said:

In August and September, however, the markets took on a decidedly negative tone. Belligerent messages from Fed officials, elevated inflation and recessionary concerns, and sharply rising interest rates pushed volatility higher and led to an inverted yield curve. Margin calls… Meanwhile, the accelerating pace of Fed balance sheet liquidation and weak bank demand provided additional headwinds for agency RMBS. In this context, Ellington Residential recorded a significant net loss

So this is it. The macroeconomic situation was horrendous and mREITs suffered terrible losses. Ellington was no exception. With the devaluation of agency RMBS, the book value was devastated

Book value was hit hard as spreads were volatile and RMBS values ​​fell

What happened here is common to many in space. Book value fell 14.2% to $7.78 from $9.07 in Q2. It is down from $11.76 in the first quarter. Just an ugly path, and Ellington’s stock followed suit. With shares at $6.70, we have a $1.08 discount on the book. This translates to a 14% discount. With the extreme volatility here, we tend to like discounts of this size, but it will be difficult for the book value to stabilize.

Still, you have to wonder when the income is worth a further devaluation in book value. We say this because the dividend has been maintained. Ellington pays $0.08 per month or $0.24 per quarter. It could be reduced if we have strong pressure again like in September and earnings fall further. But for now, Ellington’s 15.7% return is juicy. But beware, performance will have to bounce back or a cut could come.

Bring back home

Ellington Residential Mortgage REIT’s yield is now above 15% and will be higher if the EARN stock falls, giving you some downside protection. Extreme movements in rates should subside over the next month. We need the yield inversion to relax to start making big money again in this economic model. But for now, Ellington Residential Mortgage REIT should be able to keep paying. We just need to keep watching distributable earnings for hedging.