Ellington Residential Mortgage REIT: Horrible Action But Continues To Pay Out (NYSE:EARN)

Ellington Residential Mortgage REIT (NYSE:NYSE:EARN) is a mortgage real estate investment trust, or mREIT, that we used to trade years ago. This company, like so many others in the sector, experienced a lot of pain during COVID and worked 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 drive markets, but it has resulted in extreme volatility in interest rates which has weighed on real estate companies like Ellington that buy and sell mortgages and bundles of mortgages.

This year has been very painful for mREITs, capped off in the month of September when mREITs and the markets got flushed. Ellington is in a tough sector. The rising rates have caused issues for mortgage-backed securities and related instruments. We have seen interest rate spreads widen, but the constant motion in rates has led to inversion. The actions the Federal Reserve has taken the last few months has weighed heavily on operations. The entire sector as a whole has fallen. Companies that are buying and selling mortgages and bundles of mortgages are struggling. It is the toughest environment for these companies in decades.

While prepayment risk has declined given the high rates on new mortgages, spreads are all over the place, and book values have been decimated. We are not out of the woods yet, as more rate hikes are coming and it is hard to navigate this sector when the Federal Reserve has increased its target rate for the federal funds rate 4 times in a row at 75 basis points. The pressure was reflected in the just-reported earnings, but the company keeps paying its bountiful dividend. Let us discuss.

The pain was felt on earnings potential

In the just reported Q3 earnings, we saw interest rates continue to surge and the interest rate volatility spiked to levels not seen in ages. In Q3, we saw liquidity issues and yield spreads widen, while prices fell across most fixed income sectors, including agency RMBS. That hurt. The declining value and spreads led to devastation in book value. The key metrics we watch have been crushed, but that dividend keeps getting paid. A summary of the critical metrics that you should be aware of 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 spread in Q3 2022	1.28%
Current dividend quarterly (yield)	$0.24 (15.7%)
Q3 2022 Net income (loss) per share	($1.04)
Q3 2022 distributable income per share	$0.23
Dividend covered?	No*
52-week share price range	$5.70-$12.02

Click to enlarge

Source: Ellington Residential Mortgage REIT’s Q3 2022 Results

Table created by BAD BEAT Investing

* As of 9/30/2022

** By distributable income

Dividend coverage is critical

If we go back in time, we will remind you that the dividend had been cut time and again with this firm in years past. We were not at all surprised here in Q3 2022, as the $0.08 monthly payout, or $0.24 per quarter rate, was not covered. We were, however, surprised that it was only a one-cent miss in coverage.

Now, last quarter the dividend was more than well-covered. As such, we do not see a cut coming yet, but another quarter or two like this and we will see pain. The good news is that it looks like rate hikes will be done in early 2023, and yield curve inversion should relax, particularly if we look to move past a possible recession. In short, better days are ahead, but we are not out of the woods yet. We saw a worse Q3 than Q2, for sure. Net income was a big loss, adding to losses last quarter, but we do not care so much about this measure for the dividend with an mREIT.

What do we mean? Well, in our estimation the most critical measure to look at here is the distributable income (formerly known as core income). This figure came up short, as we noted. This was a result of the fact that net interest margin narrowed heavily, and subsequent mREIT earnings power fell. The margins fell because the short end of the curve is seeing very high rates, causing a volatile spike in the cost of funds, which was greater than the movement in asset yields. It was tough. At the end of the day, this is still an income name, so that coverage matters. The distributable earnings are a solid gauge for dividend coverage, and EARN failed this quarter, but it was a horrible quarter for most all mREITs.

There was not much to like in the quarter. We will argue that prepayments will come down, reducing some volatility in the portfolio, given rates are so high. With rates so high, it does not make much sense to refinance a lot of mortgages. On the earnings front, as mentioned, there were net losses. No surprise here. The company saw 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 Q2.

But again, the better measure of the ability of the company to pay its dividend is its distributable earnings, and here we saw only a slight decline. Distributable earnings were $3.0 million or $0.23 per share. We targeted a print of $0.24 covering the dividend, but were not surprised when Ellington came up short, given the way the quarter went for the entire sector.

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

In August and September, however, markets took on a decidedly negative tone. Hawkish messaging from Fed officials, elevated inflation and recessionary concerns, and sharply rising interest rates pushed volatility higher and drove an inversion of the yield curve….. We saw widespread selling across asset classes, including forced selling by some asset managers to meet margin calls… Meanwhile, the increased pace of Fed balance sheet runoff and weak bank demand represented further headwinds to Agency RMBS. Against this backdrop, Ellington Residential experienced a significant net loss

So there you have it. The macro situation was horrible, and mREITs faced terrible losses. Ellington was no exception. With the devaluing of Agency RMBS, book value was devastated

Book value hit hard as spreads were volatile and RMBS values dropped

What happened here is common to many in the space. Book value fell a massive 14.2%, to $7.78 from Q2’s $9.07. It is further down from $11.76 in Q1. Just an ugly path, and Ellington stock followed suit. With shares at $6.70, we have a $1.08 discount-to-book. This translates to a 14% discount. With the extreme volatility here, we tend to like discounts of this size, but it will be tough for book value to stabilize.

Still, you have to ask yourself at what point the income is worth further devaluation of book value. We say that because the dividend has been maintained. Ellington pays $0.08 monthly, or $0.24 quarterly. It could be cut if we have severe pressure like September again, and earnings fall more. But for now, Ellington’s 15.7% yield is juicy. But be warned, performance will need to rebound or a cut could be coming.

Take home

Ellington Residential Mortgage REIT’s yield is over 15% now, and will be higher if EARN stock falls, giving you some protection to the downside. The extreme moves in rates should settle down in the next month or so. We need the yield inversion to relax to get back to making good money in this business model. But for now, Ellington Residential Mortgage REIT should be able to keep on paying. We just have to keep watching distributable earnings for coverage.