Ellington Residential Mortgage REIT (NYSE:EARN) Q2 2022 Earnings Conference Call August 11, 2022 11:00 AM ET
Company Participants
Jason Frank – Deputy General Counsel and Secretary
Larry Penn – Chief Executive Officer
Chris Smernoff – Chief Financial Officer
Mark Tecotzky – Co-Chief Investment Officer
Conference Call Participants
Crispin Love – Piper Sandler
Doug Harter – Credit Suisse
Mikhail Goberman – JMP Securities
Eric Hagen – BTIG
Operator
Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2022 Second Quarter Financial Results Conference Call. Today’s call is being recorded. At this time, all participants have been placed on a listen-only mode. The floor will be open for your questions following the presentation. [Operator Instructions]
It is now my pleasure to turn the floor over to Jason Frank, Deputy General Counsel and Secretary. Sir, you may begin.
Jason Frank
Thank you, and welcome to Ellington Residential’s second quarter 2022 earnings conference call. 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. As described under Item 1A of our annual report on Form 10-K, forward-looking statements 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. 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 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 second 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 end notes at the back of the presentation.
With that, I will now turn the call over to Larry.
Larry Penn
Thanks, Jay, and good morning, everyone. We appreciate your time and interest in Ellington Residential. To begin, please turn to Slide 3. The Federal Reserve’s aggressive response to high inflation continued to drive markets in the second quarter. The Fed twice increased its target rate for the federal funds rate, including a 75 basis point hike in June. That was its largest since 1994. And it also finally initiated the runoff of its treasury and MBS balance sheet. Meanwhile, geopolitical unrest and fears of a recession also weighed heavily on markets.
Interest rates continued to surge in the second quarter and implied interest rate volatility spiked to levels not seen since the onset of the COVID liquidity crisis in early 2020 and before that not seen since the global financial crisis in 2009. Liquidity dried up, yield spreads widened, and prices fell across most fixed income sectors, including agency RMBS.
On this Slide 3, you can see just how much interest rates moved, particularly at the very front end of the yield curve as the market reacted to an increasingly hawkish Fed. The 2-year and 10-year treasury yields were each up over 60 basis points during the quarter. Short-term benchmark rates such as LIBOR and SOFR were up over twice that amount. The yield curve flattened with some parts inverted.
As you can see on this slide, the 5-year to 10-year segment of the Treasury yield curve was inverted at June 30, and fast forwarding to today, the 2-year yield is now around 40 basis points higher than the 10-year. This slide also shows what’s happened with Agency MBS yield spreads and prices.
LIBOR OAS on Fannie 2.5s for example widened by nearly 50 basis points over the first six months of the year. Combine that spread widening with the move higher in rates and you can see that Fannie 2.5s dropped more than 12 points from year-end to June 30, from [102 and change] [ph], all the way down below 90.
As usual, mortgage rates surged in sympathy with Agency MBS yields. The Freddie Mac [third-year] [ph] survey rate ended the first half of the year at 5.7%, an increase of about 260 basis points since year-end and its highest level since 2008. And this recent sharp increase in mortgage rates suddenly eliminated the refinancing incentive for most borrowers.
With mortgage rates much higher, housing affordability has been absolutely pummeled and that’s now impacting home sale volumes. So, with low housing turnover and dramatically higher mortgage rates, it’s no surprise that prepayments have ground to a halt in the past few months. As a result, extension risk became the primary focus in the MBS market during the second quarter, as Mark will elaborate on later.
Please turn to Slide 4. For Ellington Residential, our specified pool portfolio is currently concentrated in what were recently considered current coupons, but of course, with the jump in rates, these are now discount coupons.
During the second quarter, losses on our specified pool portfolio exceeded net gains on interest rate hedges and net carry, and this was the primary driver of our overall net loss of $0.82 per share. Our interest rate hedging strategy, which included aggressive duration rebalancing throughout the quarter and a positive contribution from our short TBA positions help prevent further losses.
Next, you’ll see that we’re reporting $0.28 per share of adjusted distributable earnings or ADE for sure. We previously referred to this non-GAAP metric as core earnings. Our ADE was down $0.02 quarter-over-quarter, but it was still above our dividend run rate. The wider MBS yield spreads have clearly been a drag on book value, but on the positive side, they’ve also been a tailwind for ADE.
Our net interest margin or NIM held up relatively well during the quarter, despite the rising cost of funds. That said, we are seeing a few headwinds to ADE in the near-term. First, with the sharp uptick in short-term rates, our liabilities are repricing higher very quickly. Of course, asset yields available in the market have also increased, but that only gets captured into our NIM as we rotate our portfolio.
So, as a result, our NIM is compressing in the short-term. Now, we could accelerate our portfolio turnover to achieve a higher portfolio asset yield more quickly, but we happen to still strongly favor the relative value of many of the lower coupon pools that we’ve been holding.
We’re essentially waiting for the right exit point to turn over much of our portfolio. And by doing so, we’re choosing to protect and enhance book value per share as opposed to maximizing our ADE in the short-term.
By the way, this all underscores the limitations of focusing too much on ADE, which is a backward looking measure in market environments with large swings in interest rates and spreads such as we’re seeing today. But I have to emphasize that once we complete the portfolio rotation, we project that our ADE will again comfortably cover our dividend. As always, the relative liquidity and smaller size for portfolio should be an advantage in repositioning it.
I’ll now pass the call over to Chris to review our financial results for the second quarter in more detail. Chris?
Chris Smernoff
Thank you, Larry, and good morning, everyone. Please turn to Slide 5 where you can see a summary of EARN’s second quarter financial results. For the quarter ended June 30, we reported a net loss of $10.7 million or $0.82 per share and adjusted distributable earnings of $3.7 million or $0.28 per share. These results compared to a net loss of $17.5 million or $1.33 per share and ADE of $3.9 million or $0.30 per share for the first quarter.
ADE excludes the catch up premium amortization adjustment, which was a positive $1.6 million in the second quarter, as compared to a negative 488,000 in the prior quarter. Beginning this quarter, you’ll notice that we’ve renamed core earnings as adjusted distributable earnings consistent with the evolving industry practice. Please note that it’s a name change only and that the calculation itself has not changed. So, if – so you are able to compare current period ADE to historical core earnings metrics.
During the second quarter, as Larry noted, Agency RMBS significantly underperformed U.S. Treasury securities and interest rate swaps. For EARN, net losses on its Agency RMBS, concentrated in lower coupons, exceeded net interest income and net gains on our interest rate hedges, while we also incurred delta hedging cost stemming from the volatility.
Yield spread widening also drove negative results in our non-Agency RMBS portfolio. As a result, we had a significant overall net loss for the quarter. Our net interest margin decreased quarter-over-quarter to 1.66% from 1.76% as the higher cost of funds exceeded higher asset yields.
Our lower NIM combined with a smaller Agency RMBS portfolio caused our ADE to decline by $0.02 per share to $0.28. Meanwhile, average pay ups on our specified pools increased modestly to 1.09% as of June 30, 2022, as compared to 94 basis points as of March 31.
Please turn now to our balance sheet on Slide 6. Book value per share was $9.07 per share at June 30 as compared to $10.14 at March 31. Including the $0.26 of dividend in the quarter, our economic return was negative 8%. We finished the quarter with cash and cash equivalents of $37.5 million.
Next, please turn to Slide 7, which shows a summary of our portfolio holdings. In the second quarter, our Agency RMBS holdings decreased by 14% to $922 million as of June 30. The decrease was driven by a combination of net sales, paydowns, and mark-to-market losses. Over the same period, our interest rate – sorry, our interest only holdings and non-Agency RMBS holdings were roughly unchanged. Agency RMBS portfolio turnover in the second quarter was 24%.
Additionally, our debt-to-equity ratio adjusted for unsettled purchases and sales decreased to 7.9x as of June 30, as compared to 8.3x as of March 31. The decrease was due to a decline in borrowings on our smaller Agency RMBS portfolio, partially offset by lower shareholders’ equity. Our net mortgage assets to equity ratio also declined to 6.8x from 6.9x 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.S. Treasury securities, and futures. We ended the quarter with a net short TBA position both on a notional basis and as measured on – by 10-year equivalents.
Finally, on a capital management side, we were able to take advantage of the second quarter [turmoil] [ph] by repurchasing shares at an average price of $6.57 per share. which was about [68%]] of prior month’s book value per share.
I will now turn the presentation over to Mark.
Mark Tecotzky
Thanks, Chris. The second quarter was choppy in virtually every corner of the financial markets. We saw rate volatility, spread volatility, and yield curve shape volatility. Basically you name any financial metric and it was going haywire in the second quarter. EARN was down 8%, what really hurt us were two things. The first was just a basic underperformance of Agency MBS versus hedging instruments. And the second one was delta hedging costs.
Interest rate volatility was very high, much higher than what was covered by the yield spread of MBS over hedging instruments, and the cost rebalancing our hedges eroded returns. But as is almost always the case in Agency MBS, where there is no credit risk, a down quarter has recharged the opportunity set and created a very fertile investment landscape going forward. In fact, Ellington Residential had a strong July with an estimated economic return of plus 5.5% for the month.
As you can see on Slides 7 and 9, quarter-over-quarter, our net mortgage assets to equity ratio was relatively constant at 6.8x. We reduced the size of our portfolio and mortgage basis exposure roughly in proportion to our drop in equity. We sold some pools and we reduced our TBA short. When the markets are really moving, you have to keep ample cash on-hand so you can rebalance portfolios when you want to, not when lenders tell you to.
In most quarters, you have risk-on and risk-off days and Q2 was no different. So, to manage these portfolios, you try to de-lever during risk-on days when bid offer spreads are tighter and other participants are looking to add assets, and we were able to do that relatively well in the second quarter. When you look back at the whole quarter, it wasn’t uniformly bad during the month of May, Agency MBS actually performed quite well.
Despite weakness in the mortgage basis, specified pools actually performed quite well relative to TBA during the second quarter. That may seem counterintuitive, a lot of people think that the specified pool market is all about prepayment protection. And for basically all of 2021 it was. During those periods, we had historic lows in mortgage rates and historic highs in HPA.
It seems like Agency MBS were a 101 to 112 market and all that mattered was keeping prepayments at an absolute minimum to spare you from having to reinvest your precious high coupons into [indiscernible] [15-year 1.5] [ph]. But the specified pull market is a market where you can basically pay up to get several different kinds of advantages over TBA.
You can pay up for prepayment protection, which is what you typically pay up for in premium coupons or in near par coupons where [Technical Difficulty] can quickly turn them into premiums, but meanwhile, you can also pay up for extension protection on discount [pools] [ph].
For discount MBS, you’re looking for pools that either have fewer remaining years to maturity or prepay at faster speeds than other pools with similar note rates. Remember, for discount pools you’re looking for faster speeds. The faster speeds exhibited by certain specified pools might be explained by servicer behavior, they might be explained by geographic mix, might be explained by average borrower credit score, or they might be explained by any number of other factors.
The advantages of extension protection never seem to get the attention compared to prepayment protection because the absolute differences you see in payment speeds aren’t as great in the high rate environment, but it matters a lot in the market where you have so many lower coupon pools that are priced at deep discounts to par as we see today.
So, we have been active lately in lower coupon spec pool market looking for faster speeds, considered 30-year Fannie 2s. 2s were a huge part the mortgage market in 2021 with originations in that coupon exceeding a whopping trillion dollars. They even reached a nosebleed price of 104 and that was for TBA. The loan balance [pools] [ph] traded much higher than that.
Now, with the benefit of 2020 hindsight, it seems shocking that Fannie [Technical Difficulty] devices averaged about 101 during 2021, definite to high print, but it’s the average price over the entire year. While how the mighty have fallen, during Q2 of this year Fannie 2s traded as low as 83.5. Now consider the bond math for Fannie 2s at a price of 84.
At the same yield, the extra value for a pool paying at 6 CPR versus 5 CPR is over 1 point. That’s 1 full point for that tiny prepayment difference. If you’re targeting a [412 yield] [ph] on a Fannie 2 pool that you think will pay at 5 CPR, that pool’s worth 84 to you. But if you find a pool that you think will pay a [measly] [ph] 1 CPR faster at 6 CPR, the price goes up to 85 at the same [412 yield] [ph].
And if you know where to look, you can find that extra 1 CPR and that might only cost you a couple of ticks. And I think that’s the competitive advantage we have here at Ellington, given our 27 plus years of experienced modeling prepayment behavior, we know where to look. This example highlights just one of the reasons why this is such an alpha rich environment.
Meanwhile, prepayment protection still also matters, especially for higher coupon pools like 4.5 and 5s. The newly minted pools in those coupons tend to support giant loan balances over $450,000. They tend to have high FICO scores over 730 and they tend to have low LTVs. This makes these pools natural refinancing targets, should mortgage rates drop from here. If those pools get an incentive to refi, you’ll have all the excess capacity in the mortgage market laser focused on refinancing these exact borrowers.
These types of pools can start prepaying very fast on very short notice. And if you are already starting to see this in the past few weeks with mortgage rates having dropped from the recent highs. That said, you still have the vast majority of the MBS market prices significant discount where faster prepayments are the portfolio manager’s friend.
Prepayments on discount pools enhance your yield and effectively generate trading gains paying you back at par for principal that you own at a discount to par. In addition to these specific opportunities to generate alpha, the whole MBS sector is wide now on a historical basis, and that can drive our ADE or Adjusted Distributable Earnings.
We have a lot of seasoned pools we bought and a low yield environment that we can sell-out and replace with much higher yielding pools. As Larry mentioned, we plan to be methodical and pick our spots when it comes to turning over these pools.
Finally, Agency MBS have a distinct advantage that as recession worries grow, they provide excess yield without any credit risk. Unlike investment grade bonds or high yield bonds or bank loans, Agency MBS investors don’t have to worry about a downgrade cycle or [scary still] [ph] actual defaults. So what happened in the second quarter is that the Fed hiking cycle got pulled forward, which created lots of volatility. Yes, there can be more volatility, but the market is already pricing assuming that volatility will be extremely high.
So, spreads are wide, but can they get wider? Of course, they can. But we think they offer excellent value right now. We’re actually seeing a tightening trend recently. Look at the strong performance we had in July, up around 5.5%. You don’t want to miss months like July. We are now living in a world with a shrinking Fed balance sheet and only limited MBS buying by banks.
That’s why spreads are wide, but that’s also why spreads will probably continue to bounce around. A lot has been made in the MBS market about Fed balance sheet runoff, but a lack of bank participation is another huge deal. Banks loan to own a large part of the mortgage market, but right now they are struggling with capital hits, weak or negative deposit growth and increasing loan demand.
They are buying very few securities right now and that’s been another big technical headwind for the sector. But these technical factors are not news. Everybody knows this and spreads are wide as a result. So, that’s why I think MBS prospects look pretty good. There are still material headwinds, but the market knows about those. So, the question is, will the new information that hits the market be positive or negative?
I think the biggest open question for MBS is whether the Fed will opt for outright portfolio sales, especially come September when the portfolio run off cap step-up. So, we are prepared for some spread volatility. We think we are compensated for it. We don’t have a crystal ball in the Fed. Most market participants don’t expect Fed asset sales this year. And in a recessionary environment, they could even slow down the pace of runoff. We see a very rich opportunity set to add returns with pool selection both on premiums and discounts.
Now, back to Larry.
Larry Penn
Thanks, Mark. To put the first six months of 2022 in perspective, by most metrics, Agency RMBS actually performed much worse over this period than during the infamous taper tantrum in 2013. And that was despite the Fed’s best efforts at telegraphing its tighter monetary policy.
However, moving ahead to July and early August so far, markets have had a noticeably better tone compared to the second quarter. Interest rate volatility, while still quite high, has subsided somewhat. and Agency yield spreads have retraced a portion of their second quarter widening.
As Mark mentioned, this led to Ellington Residential’s strong performance in July. We estimate that EARN’s book value per share at the end of July was approximately $9.49, which translates into an economic term of about 5.5% for the month, but even with the better market tone and even with the recent drop in interest rates since their mid-June highs, it’s clear that we’ve entered a new market paradigm with extension risk having taken center stage over prepayment risk.
As Mark explained, we believe that Ellington Residential has a distinct advantage in taking advantage of this new dynamic. In fact, despite the surge in mortgage rates in the second quarter, average pay-ups for the specified pools that we held throughout the quarter actually increased quarter-over-quarter.
As the increase in the value of the extension protection provided by this portfolio relative to TBAs more than offset the reduction in the value of its prepayment protection. And we think that these specified pools, especially many of the lower coupon pools, could benefit further from here. If we can identify discount pools where borrower mobility and turnover will exceed market expectations going forward, that can present significant upside for us, both from a book value per share and an ADE perspective.
Looking ahead to the remainder of the year, we believe that with yield spreads wide, with prepayment risk low by historical standards and with net mortgage supply likely to be much lower, Agency RMBS continue to offer excellent investment value.
Furthermore, our recession fears could also boost the sector because Agency RMBS have no credit risk and in a recession, the Fed might slow down or even stop shrinking its Agency RMBS balance sheet, which would be a supportive technical for the Agency MBS market. With that, we’ll now open the call to questions. Operator?
Question-and-Answer Session
Operator
Thank you, sir. [Operator Instructions] And our first question will come from Crispin Love with Piper Sandler.
Crispin Love
Thanks. Good morning, everyone. So, just given higher rates and the extension risk that you talked about on some of your lower coupon investments, can you speak to how duration changed in the second quarter relative to prior quarters? And then just how your extension protection has helped to mitigate that?
Mark Tecotzky
Sure. Hey, Crispin, it’s Mark. So, you can look at, I think, good place to look is Slide 8. So, Slide 8, you can see here right, so we shrunk the portfolio, we shrunk the mortgage, we shrunk sort of our mortgage exposure, sort of consistent with change in our equity base. We referenced that as we went from 6.9 to 6.8, so roughly kept the mortgage exposure the same.
So, smaller portfolio because of the drop in equity, but you can see that we increased total amount of duration of our hedges, right? And that was a function of rates going up and mortgages extending. So, now a lot of the mortgage market now, if you talk about Fannie 2.5s and Fannie 2s, they’re kind of already fully extended and you’ve been seeing a rally, right.
The [10] [ph], you know got to about 350 at some time in the second quarter. Then it’s rallied back to 275 and you slowed off a little bit from there, but those fully extended securities now don’t have a lot of difference in duration as a function of, sort of interest rates moving around where they are right now because if the regular mortgage rate is 5%, and maybe it got up to a high of [5.70 or maybe it goes down to 4.50] [ph] for someone sitting there with the Fannie 2, maybe they have a [2.75 note rate] [ph], they’re not getting in the money or out of the money.
So, their prepayment expectations are now driven primarily by turnover. So that’s cash out refinancings, it’s people moving. So, a chunk of the portfolio doesn’t really have a lot of negative convexity now and by that it means it doesn’t require a lot of delta hedging now for changes in rates. We had those delta hedging needs when you know Fannie 2s were over par and then they go down to 84, so, then in that whole sort of passed down that their duration extended a lot.
So, now I’d say where we see most of the delta hedging needs has to do with some of the higher coupons, primarily Fannie 4.5, 5 and a little bit 5.5.
Crispin Love
Thanks, Mark. I appreciate the color there. And then on the call and also in the release, you said that you expect some near-term net interest margin compression just given the financing cost a little bit quicker than the [asset side] [ph], so I’m just hoping if you can drill into that just a little deeper. Is that a third quarter phenomenon where you would expect NIM to continue to soften from the second quarter levels driven by those financing costs prior to really taking advantage of the wider spreads on the asset side, whether it’s like later 2022 or into early 2023?
Larry Penn
I think it’s really hard, Crispin to give guidance on that because it really depends if – as you said, we’re going to sort of wait for our spots in terms of selling the discount pools that we’ve held, pretty much this year, so – and it’s really early in the quarter. If we sold them in the next couple of weeks that would have a very different impact on recharging that NIM and ADE than if we held on to them. So, it’s really hard to predict.
If we did nothing, there’s no question that the third quarter NIM would be lower and the ADE would be lower than it was in the quarter per share, but we’re not known for doing nothing. So, it’s just really hard to predict. It’s very market dependent.
Crispin Love
Okay. Thank you, Larry and Mark for the comments. That’s it for me.
Operator
Thank you. Our next question will come from Doug Harter with Credit Suisse.
Doug Harter
Thanks. As you think about the market opportunity, do you think the wider spreads are likely to persist, kind of allowing you to, kind of continue to layer them into the portfolio or do you see opportunity or paths where maybe those spreads tighten, kind of resulting in better book value, but maybe less opportunity to, kind of add to wider spreads?
Mark Tecotzky
Hey, Doug, it’s Mark. I think, look, we’re in a new world, right. You have the Fed balance sheet shrinking and now it’s shrinking 17.5 billion a month on the mortgage side. That steps up to a maximum of 35 billion come September, right now their paydowns are between those two numbers. So, unless they were to engage in sales, they won’t be able to shrink it to 35 billion given the current prepayment dynamics.
So, you have no Fed. You also don’t have Fannie and Freddie support. I mean Fannie and Freddie used to operate like giant, giant 30x levered hedge funds, right. And they bought lots of mortgages and would issue lots of [agency debt] [ph], [indiscernible] and they sort of policed the mortgages OAS’s. Whenever mortgages wide versus their debt, they would buy a bunch, and so those portfolios are in runoff mode and they’ve shrunk a lot.
So, they’re out of the picture now. And I mentioned in my prepared remarks that banks, which are enormous presence in the mortgage market have been very quiet in terms of buying securities this year, not just Agency MBS, but also AAA CLOs. So, you have an environment now where other investors, money managers, REITs insurance companies can, sort of reap the benefits of substantially wider spreads. And you’re seeing a big decline in volume, but I think spreads, they’re going to bounce around. They’ve done well the past couple of days.
We got that inflation report yesterday, which is very supportive of all spread product, but I think they’re going to stay relatively wide, right. There’s going to be volatility around it, but with the Fed in runoff mode and banks quiet, I just think you have an environment where spreads are wide. They stay wide. You can buy things at par or a little bit below par that have a widespread that don’t have a lot of prepayment sensitivity.
So, you have a lot of confidence in net interest margin, even the “premiums on these markets” are kind of like $1 or $2 type price premiums, not at all like what you saw in 2021. So, you’re not dealing with having to take on a lot of prepayment risk. And then we talked in the prepared remarks, you have this whole universe of things that are 10 points below par where the market is, sort of assuming very slow prepayments and that may come to fruition, but with the right analytic tools, you can find some things that are going to prepay faster than market expectations and that difference, the faster prepay is relative to expectations [transition into] [ph] higher yields.
So, I don’t think the reason to like mortgages from here is because you think you’re going to get this big outperformance, that may come, I just think it has a relatively widespread to hedging instruments, widespread to a lot of parts of the SOFR curve, which are now materially inside the treasury curve, does a relatively widespread, and you can capture it. It doesn’t require huge prep – it doesn’t require big premiums. It doesn’t require assuming fast prepayment speeds on discounts. You can price things to relatively conservative assumptions and they look pretty good.
Doug Harter
Helpful. Thank you.
Mark Tecotzky
Sure.
Operator
Thank you. Our next question will come from Mikhail Goberman with JMP Securities.
Mikhail Goberman
Hi, good morning, gentlemen. Most of my questions have already been answered, but I was just kind of curious, going forward, this perpetually inverted yield curve, if it were to persist, let’s say into a good chunk of 2023, what are your thoughts, sort of on how that would affect the housing market and in-turn the construction of your portfolio going forward?
Mark Tecotzky
So Mikhail, it’s Mark. So, it’s a great question. So, in terms of the housing market, Larry alluded to it in his prepared remarks that you’ve had these this double barrel shock to affordability. So, one shock is just home prices are way up, right. They’re up 20% from where they were a year ago, and granted the pace of home price appreciation has slowed dramatically, it’s not negative, right.
So you’re still at all-time highs in home prices and things were up 10% or 11% this year. And people going back a couple of years, things were up 30%. So, the same house, if you want to take out an [indiscernible] loan from a person a year ago, your loans got to be at least 20% more, right, just because the home price went up. And then the other thing now is you’re having to qualify at a much higher mortgage rate.
We talked about this trillion dollars, enormous number, trillion dollars of [30-year] [ph] Fannie 2s created last year and we didn’t even talk about Ginnie 2s, which is another big volume, but just trillions of dollars of 2% mortgages, which on average probably had like a [275] [ph] mortgage rate. The difference between a [275] [ph] mortgage rate and a [5 and change] [ph] mortgage rate, that’s a big shock even if your balance is the same. But now when you shock your balance up 20%, you’re talking about 30%, 40% payment shocks.
So, I think these higher mortgage rates and part of it is spreads, mostly it’s just interest rates. It really challenges affordability. Fewer people are going to qualify. They are people that are reluctant to very low mortgage rates that now are going to be more reluctant to, sort of do discretionary moves, your family size changes, you want an extra bedroom or you only need one fewer bedroom in a lot of those, kind of moves that you used to see take place, I think some of that stuff will slow down.
You’re already starting to see it in existing home sales, you’re starting to see time in the market leak out a little bit, especially in some of the high flyer cities, like a Phoenix or a Boise, you know time of the market is still short, but it’s inched up a little bit, still very short by historical standards and much shorter than what it was pre-COVID. So, that’s one thing.
You’ve just slowing down the mortgage market. Now, the inverted curve, there’ll be a timing issue for the distributable earnings, Larry was talking about before, but it’s totally hedgeable. So, for us, what kind of matters is the repo rates we’re paying on our pools, how does that compare to the rate we’re receiving when we enter into a SOFR swap.
So, if we’re hedging let’s say a Fannie 3 and we’re hedging that interest rate by paying fixed on 5-years SOFR and we’re getting SOFR on the floating rig, what we’ve seen from mortgage repo is it’s been SOFR plus about 5 basis points. So, it’s tracked it really consistently. And that to me is the biggest thing, and like the fact that the silver curve, parts of it are well inside the treasury curve, that’s another tailwind for mortgages.
So, there’s going to be a timing issue potentially, but just long-term an inverted curve. I think it tends to make mortgages a little cheaper you don’t tend to get a lot of CMO activity, but in terms of the ability to hedge and the ability to capture net interest margin, the way we manage our portfolios, I don’t see an inverted curve as a big headwind. And then by the [same token] [ph], I’ve never seen an incredibly steep curve as a big [Technical Difficulty] to us.
Mikhail Goberman
Got it. So, it’s more of – if the inverted curve stays stable, it’s more of this stability is what helps you guys hedge. If everything remains, kind of sort of stable, than it’s much easier to continue to hedge the way you’ve been hedging.
Mark Tecotzky
Yes, and where Repo is versus SOFR.
Larry Penn
Right. Exactly. That’s really important. I’d just add one thing, the – it’s really more of the stability of the longer-term rates. If you turn to Slide 8, you can see on the left hand side of the page, the interest rate hedging portfolio. So, I just wanted to make a couple of points there.
So first of all, only 18% of that is TBAs, right. So, you’ve got over 80% of our hedges are basically in instruments that are going to be more tied to the swap market. And in the swap market, we’re receiving the short-term rate, and paying the long-term rate, you can see [74 and change percent] [ph] of our hedges measured by 10-year equivalents are in the longer part understandably now with rates where they are, you know longer part of the yield curve.
So, on those we’re paying fixed at a lower rate than we’re receiving on the SOFR. And then as Mark said, to the extent that we can finance, not going to be able to finance below SOFR, but close to SOFR, that’s another headwind, another tailwind and the financing market is still good. So, in terms of the delta hedging though, which cost us in the second quarter and the first quarter, that’s more of a function of the rebalancing, which is more a function of movements in the long-term rate.
So, even if the short-term rates bounce around a lot, it’s really not going to affect our durations that much, because durations of mortgages are more dictated by where the market thinks the future rates are going and that’s going to be more based upon longer-term rates. So, I hope that helps too.
Mikhail Goberman
Yeah, thank you. That’s really good color. And one more if I may, just a quick small question. Mark, I think you mentioned July economic return around 5.5% does that include the July dividend paid?
Mark Tecotzky
Yes. It does.
Mikhail Goberman
All right. Thanks, guys. Appreciate it.
Operator
Thank you. Our last question will come from Eric Hagen with BTIG.
Eric Hagen
Hey, thanks. Good morning. I think I have a couple. Just picking up on the conversation around spreads, when you think about the level of spreads and the catalyst for spreads to tighten, realistically how tight do you think spreads could get if interest rate volatility remains relatively high? And just how to interpret option adjusted spreads going forward if volatility does cool down? And then maybe you can talk about the approach to the relative value approach between financing with TBAs versus financing off balance sheet – I ‘m sorry, on balance sheet with Repo? Thanks.
Mark Tecotzky
Sure. So, Eric, it’s Mark. So, OAS and how to think about OAS if you get changes and realize your implied vol, so what you’ve had this year is you’ve had incredibly high levels of realized volatility in any way you look at it, just how much is the 10-year note moving on a given day or the 5-year note or the 2-year note? All those measures Q2, I think, is going to set a record for a long time. And I think a lot of people have the gray hairs to prove it.
So, actual volatility has been really high. Now, what’s priced into the market, the market all this year has priced in very high levels of implied volatility. And you saw that really spiked in Q1 and it stayed high through Q2. So, that’s kind of when you take the spread on a mortgage bond, and what a model thinks its cash flows are going to be then it runs all these scenarios, sort of the range of scenarios your model is going to run is a function of what’s the implied volatility in the market.
So, implied volatility in the market is really high, but realized volatility has been higher. So, if the market, kind of settles down and it thinks all right, the Fed – you’re starting to see inflation respond to the Fed’s blunt instrument of raising short rates and shrinking the balance sheet. And all right, we got that better print and you’re going to see more better prints and you can see light at the end of the tunnel from this hiking cycle and vol comes down. It came down a bunch yesterday.
Then I think what you’ll see is realize volatility, how much bonds move around on a given day that comes down and then implied volatility comes down and that feeds into models and then all of a sudden for the same price of mortgages versus say SOFR swaps, you magically see higher OAS, right? They just look cheaper.
I think it’s probably more likely than not that realized volatility will come down. And I’m only saying that just because it was just so shockingly high in Q2. I think it’s already come down a little bit. So, we tend not to explicitly have volatility hedges in the form of swaptions. We’ve preferred more to delta hedge. I think if you look at the long history of EARN going back to, I guess 2013, that’s been the right thing. And generally that realized vol, I don’t think has been high as implied vols.
We’ve been better off delta hedging. That was absolutely not the right thing this year. So, I think that volatility coming down is a bit of a tailwind for Agency MBS and whereas like the corporate market other than like callable corporates and things like that, this kind of vol agnostic so is treasury.
So, I think that’s one kind of thing you will see from money managers that if they think that we’re more of in a rate range, you think they’re going to be less surprised with fewer surprises from this Fed and they’re going to have vol come down, they tend to favor Agency MBS over corporates.
Now, the first – I forgot what the first question was.
Larry Penn
By the way, I just want to add one more thing to that, Mark. So, first of all, we do hedge with TBAs as well, and that has sort of a built-in, sort of delta hedging or volatility hedging as well. So, you can see, we did increase, went from 13% to 18% from the end of the first quarter, the end of the second quarter. So that – the extent that we hedge with TBAs, we tend to do that as opposed to, as Mark said, explicitly go to the swaption market to hedge volatility.
The second thing I just wanted to mention is if you turn to Slide 3, I mean, this is just very rough, but you can get some idea of what could happen if vol drops. So, if you look at the December 31, 2021 column, all the way at the bottom and you compare the ZSpread, I mean, this is really rough, but if you compare the ZSpread of Fannie 2.5s to the OAS, you can see that the ZSpread at year-end was 61.3 and the OAS was negative 4.1. That was for a $102 price security.
So, you can see very roughly speaking that the cost of the volatility in the option adjusted spread was about 65 basis points. Now, if you look at a higher volatility environment, right, higher volatility is going to obviously cost you much more in OAS because the value of the option you’re short when you are on mortgages is much more valuable.
So, if you look at – now you’ve got a par coupon in Fannie 4.5s at $100.39, you can see that there the ZSpread was 124.5 and the OAS was 27.9. So, that’s a difference of almost 100 basis points, right. So, you’ve got over 30 basis points differential in terms of what the option cost is. And if volatility drops, from the June 30 level to where it was at year-end 2021.
Again, this is really, really rough, but you can imagine that could lead to tightening on a ZSpread basis and that translates right into dollar price appreciation on the pools of over 30 basis points, which would be well over a point. And you can see how leveraged we are. Our net mortgage exposures that would translate into quite a good tailwind for our book value per share.
Now, we’ve experienced some of that already in July in terms of vol coming down a bit, but it’s still got a long way to go before it gets back to the year-end levels. So, I just wanted to sort of give you that a little bit of color. I think the second question Mark was about financing with TBAs, which maybe is more of like a [dollar roll] [ph] question, was that the – as opposed [indiscernible], because obviously sometimes if you have specified pools, you’re going to finance those with Repo. And I think the question related to, how do we compare that strategy with just rolling TBAs? Am I right about that?
Eric Hagen
That’s right. That is the question. Yes.
Mark Tecotzky
Dollar rolls has been with a couple notable exceptions of short squeezes or new coupon becomes production, there hadn’t been production like the Fannie 5 [indiscernible] spiked at one point, but like in general dollar rolls have been pretty weak and I think it’s not all that surprising. You’re not having the Fed gobbling up all these pools on balance sheet and you’re not having banks, which your banks are typically pool buyers, they’re not TBA buyers, right?
So, the two big agents of buying pools on balance sheet haven’t been there this year. And so, rolls have been pretty weak. When you look at like money managers, they’re much more likely to make use of TBAs as a surrogate for pools on balance sheet. So, rolls have been pretty weak, but you’re shorting an asset that is at a pretty widespread, either zero vol spread or OAS, but in terms of the roll cost, that’s been very manageable on pools.
And I think, you know, Larry hit the nail on the head, right, that one thing about pools is shorting that. You even get back more volatility than what you – shorting a TBA and being a long specified pool, now all of a sudden you’re in a vol loving position, right. You’re in a position where you actually want volatility because the pools tend to be more stable than the TBA.
Eric Hagen
Good stuff. I think I’m about in there. I appreciate it. Thanks.
Mark Tecotzky
Sure.
Operator
Ladies and gentlemen, thank you for your questions and for joining us on today’s call. We appreciate your participation and you may disconnect at any time.
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