Ellington Residential Mortgage REIT (EARN) Q4 2022 Earnings Call Transcript

Ellington Residential Mortgage REIT (NYSE:EARN) Q4 2022 Earnings Call Transcript March 7, 2023 11:00 AM ET

Company Participants

Larry Penn - Chief Executive Officer

Chris Smernoff - Chief Financial Officer

Mark Tecotzky - Co-Chief Investment Officer

Conference Call Participants

Eric Hagen - BTIG

Crispin Love - Piper Sandler

Mikhail Goberman - JMP Securities

Jason Stewart - JonesTrading

Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2022 Fourth 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 [indiscernible] with Associate General Counsel. Sir, you may begin.

Unidentified Company Representative

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 and 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. 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 fourth quarter earnings conference call presentation is available on our website, earnreit.com. Our comments this morning will track the presentation. Please note that any references to figures in this presentation are qualified in their entirety by the notes at the back of the presentation.

And with that, I will turn the call over to Larry.

Larry Penn

Thanks, Aladdin, and good morning, everyone. We appreciate your time and interest in Ellington Residential. During the fourth quarter, inflation continued to moderate, and the Federal Reserve ratcheted back the pace of its interest rate hikes. The market welcomed these developments and Agency RMBS rebounded sharply following three consecutive quarters of dismal performance. Volatility declined incrementally and investor demand for RMBS increased. Together, this drove nominal and option-adjusted yield spreads tighter, especially in November, and so the year ended on a more positive note.

Turning to the investor presentation. In the bottom section of Slide 3, you can see the significant yield spread tightening that occurred across Agency MBS coupons in the fourth quarter, which caused MBS prices to rise, even though long-term interest rates were actually moderately higher. Meanwhile, short-term interest rates spiked for yet another quarter. You can see on this slide just how much short-term interest rates moved, not during the fourth quarter but also over the course of 2022, in absolute terms as well as relative to long-term rates.

This trend has continued into 2023, and the yield curve is now the most inverted it's been since the early 1980s with a two-year tenure yield spread now more than 90 basis points negative. The inverted yield curve has pressured net interest margins industry-wide, and coupled with the extreme interest rate volatility that we've experienced since the beginning of 2022, it's really put the effectiveness of interest rate hedging programs under a microscope.

For EARN, we've hedged along the entire yield curve, and we balanced our hedges frequently, both of which can be more expensive at times, but also more effective across a wider variety of market environments. As interest rates surged last year, we were continuously rebalancing our hedges. The delta hedging costs associated with this rebalancing were high, but they were essential in preventing deeper book value declines. The yield group currently converted, we're at least getting the benefit of positive carry on our interest rate swap hedges, where we are receiving the higher sofa rate, while paying lower fixed rates. In the fourth quarter, these swaps serve the dual function of offsetting some of the impact of the higher long-term interest rates, while also boosting our net interest margin and adjusted distributable earnings.

Let's turn next to slide four for an overview of EARN strong results for the fourth quarter. MBS had weakened significantly in September of last year, and we had responded by buying MBS aggressively into that weakness. As a result, we entered the fourth quarter with a net mortgage exposure of 7.5:1, which stood toward the upper end of our historical range. That positioned us incredibly well for the spread tightening that occurred during the fourth quarter. And so we were able to recoup a good chunk of our unrealized losses from the prior quarter.

For the fourth quarter, we generated a nonannualized economic return of 11.1% and net income of $0.88 per share, which easily covered our dividends for the quarter. We're able to be positioned this way, because we have been patient about portfolio turnover, and we've been opportunistic about adding new investments. Throughout 2022, reinvestment yields were surging, but yield spreads were widening as well, especially on the lower coupon pools, where we saw the best relative value.

Larger portfolio sales of our discount pools might have boosted ADE in the near term, but as a potential longer-term cost to book value per share. Instead, we were selective in turning over those portions of our portfolio that we viewed as offering superior relative value, particularly those lower coupon pools and we continue to prioritize total return over short-term ADE growth.

Meanwhile, our strong liquidity position enabled us to add pools opportunistically in September when spreads gapped out. Over the course of the fourth quarter, we continue to be opportunistic, in this case by opportunistically selling, when we felt that the mid-quarter rally had run its course. As a result, by year-end, our net mortgage exposure has declined by a full turn to 6.6:1, which brought it closer to our historical norms.

I'll now pass it over to Chris to review our financial results for the fourth quarter in more detail. Chris?

Chris Smernoff

Thank you, Larry, and good morning, everyone. Please turn to slide five, where you can see summary of EARN's fourth quarter financial results. For the quarter ended December 31, we reported net income of $0.88 per share and adjusted distributable earnings of $0.25 per share. These results compared to a net loss of $1.04 per share, an ADE of $0.23 per share in the third quarter. ADE excludes the catch-up premium amortization adjustment, which was positive $658,000 in the fourth quarter, as compared to a positive $1.4 million in the prior quarter.

During the fourth quarter, tighter Agency RMBS yield spreads and increased pay-ups drove significant net realized and unrealized gains on our specified pools, which combined with net interest income exceeded net realized and unrealized losses on our interest rate hedges. Our net interest margin increased slightly quarter-over-quarter to 1.37% from 1.28%, as higher asset yields exceeded the increase in our cost of funds, and that included the positive carry that Larry mentioned on our interest rate swap positions.

Our higher NIM drove the sequential increase in ADE, even as our average holdings declined quarter-over-quarter. Meanwhile, pay-ups on our specified pools increased to 1.26% as of December 31 from 1.02% at September 30.

As prepayment rates continue to decline market-wide, specified pool investors are increasingly focused on extension protection rather than prepayment protection. This has been a tailwind for the pay-ups on our specified pools, because the market is recognizing the significant extension protection they offer relative to their TBA counterparts.

In addition, the pools that we did sell during the quarter had lower pay-ups relative to our overall portfolio. The combination of these factors led to the sequential increase in payouts.

Please turn now to our balance sheet on slide six. Book value was $8.40 per share at December 31 as compared to $7.78 per share at September 30. Including the $0.24 of dividends in the quarter, our economic return was 11.1%. We ended the quarter with cash and cash equivalents of $34.8 million, up from $25.4 million at September 30.

Next, please turn to slide seven, which shows a summary of our portfolio holdings. In the fourth quarter, our Agency RMBS holdings decreased by 5% to $163.3 million. The decrease was driven by net sales and principal payments of $57.9 million, which exceeded net realized and unrealized gains of $11.8 million.

Agency RMBS portfolio turnover in the fourth quarter was 18%. Over the same period, our non-Agency RMBS portfolio increased by $4.8 million to $12.6 million, while our holdings of interest-only securities were roughly unchanged.

Additionally, our debt-to-equity ratio, adjusted for unsettle purchases and sales, decreased to 7.6 times as of December 31 compared to 9.1 times at September 30. The decrease was primarily due to a decline in borrowings on our smaller Agency RMBS portfolio and higher shareholders' equity quarter-over-quarter. Similarly, our net mortgage assets to equity ratio decreased to 6.6 times from 7.5 times over the same period.

On slide eight, 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, US Treasury securities and futures. The size of our net short TBA position based on 10-year equivalents increased quarter-over-quarter.

I will now turn our presentation over to Mark.

Mark Tecotzky

Thanks, Chris. After a challenging nine months for Agency MBS, it's nice to be able to report a strong quarter and to make back some of the prior quarter's losses. Unlike most parts of securitized products, where investors take on credit risk, and the possibility of principal loss in exchange for excess yields, the Agency MBS market is unique in its ability to offer high yields without credit risk.

Most agency mortgage REITs hedge a good deal of their interest rate risk. So the primary driver of quarter-by-quarter economic returns for a hedged agency mortgage REIT is the relative total return of Agency MBS compared to hedging instruments, which are usually treasuries and interest rate swaps.

The total return of Agency MBS starts with the carry on MBS assets compared to the carry-on hedging instruments. But as interest rates and yield spreads move around, you also have to factor in delta hedging costs and the relative price performance of MBS assets, both pools and TBA, compared to hedges.

In quarters where yield spreads are very volatile, as we've seen for the past four quarters, economic return tends to be driven primarily by the relative MBS price performance, whether outperform or underperformance.

For the first three quarters of 2022, the relative price performance of Agency MBS was negative. Agency MBS dropped in price a whole lot more than a basket of similar duration treasuries in the face of heavy investor liquidations and soaring weights and volatility. But in Q4, that reversed dramatically.

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

You can see that in the price changes on slide 3. Across the board, Agency MBS prices significantly outperformed their hedges. Financial markets generally normalize whatever current pricing levels are. What I mean by that, is that the bond market participants and researchers, especially in spread sectors like MBS, typically start the assumption that current yield levels and spread relationships are fair.

I think it's worth reminding everyone of the magnitude of the repricing in 2022 and what was considered fair versus where we are versus today. We started 2022 with Fannie 2s a dollar price of $99.8 and we ended the year with them at 81.6%, down over 18 points. So at the start of the year, Fannie 2s and there are more than 1.5 trillion of them with a Bellwether coupon and they yielded about 2%.

Now we're buying Fannie 5.5s at a discount. And the nominal spread on the par coupon mortgage is significantly wider than the 20-year historical average. That's almost a 400 basis point move in a little more than a year undoing a 15-year bull market and bringing MBS yields back to their 2007 levels. Now mortgage rates are higher than before the Fed began its mortgage bond-buying program and the Fed is just sitting on a large portion of the market, which has reduced what's available to private investors.

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

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

Capital flowing into fixed income as opposed to out of it is very significant for MBS. Fixed income investors have not seen yields just high since 2007 and they are voting with their wallet. You can see funds flowing into ETFs and mutual funds, but there are two headwinds.

First, banks, which are normally huge Agency MBS investors, have been quiet. They are struggling with diminished capital, from held for sale losses and from weak deposit growth, given competition from money market funds. Commercial banks saw a year-over-year deposits shrink for the first time in 70 years. And second, of course, is the absence of Fed buying.

We get a lot of questions about what an inverted yield curve means for ADE and return expectations going forward. A sharp rise in the Fed funds rate is typically not only -- is typically only a short-term headwind. Spreads have widened on longer term repo and in response, we've shortened the average tenor of our repo, as you can see on slide 17.

As a result, our repo expense now goes up almost in lockstep with the Fed funds rate, but it takes at least a quarter or longer for our AD to normalize for a few reasons. The floating leg we receive on our swaps will also reset higher, but those only reset every three months. And the extent that our fixed pay swap portfolio is smaller than their asset portfolio, we need to raise asset yields to turnover to make up the difference.

But once the hike stop in our portfolio turnover continues, our asset yield should catch up and fully reflect the wider spreads currently in the market. Those wider yield spreads relative to financing costs and hedging instruments, hedging costs should drive ADE moving forward.

But what will it mean for Agency MBS if the forward curve is correct, and we get a mild recession and lower interest rates? That's probably the best case rate in CMBS. Nomura has put out some great research exploiting this dynamic. A 75 basis point drop in the mortgage rate does very little for getting coupons in the money, so it's not material for refi supply. But in a recession, banks typically favor securities over loans. So, in a mild recession, we would expect an incremental increase in bank demand.

Also, within fixed income, Agency MBS tend to outperform corporate in a recession, too. Finally, slightly lower rates are also probably support of further fixed income flows.

Right now, housing is relatively unaffordable, looking at monthly mortgage expense at current rate levels relative to median income. So, you are seeing existing home sales really drop like a stone.

The other powerful force that is slowing existing home sales is that mortgage researchers refer to as the lock-in effect. The lock-in effect is when a homeowner has a mortgage rate that is several hundred basis points below the current rate. They are locked in low payments significantly deter them from moving.

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

So, what did we do for the quarter and how are we currently positioned? And what is our future outlook? You can see on slide 14 that we shrunk our Agency MBS portfolio during the fourth quarter. Given their strong performance in the quarter, it made sense to reduce MBS holdings on a relative -- as the relative value was not as compelling. But it was our disciplined hedging process and cash management that allowed us to hold our portfolio intact, do some very volatile times in 2022, and that allowed us to capture returns in Q4 to offset some prior losses.

You can see on this slide that we reduced our holdings of 15-year mortgages given the inverted yield curve, that sector is seeing almost no new origination, so it's shrinking from paydowns. The net negative supply has driven prices to much tighter spreads relative to treasuries and 30-year MBS. That may will continue, but we are just finding better relative value in the 30-year market right now.

January was another month of strong performance. February reversed some of those gains, but we are still solidly up for the year. MBS spreads are currently attractive and the consensus path of a few more hikes followed by some better inflation news and weaker economic numbers, should be a very good backdrop for MBS performance. But experience has taught us that the forward curve is often wrong, we remain disciplined about hedges and are prepared for a range of scenarios. We see lots of relative value opportunities in the market that we look to exploit to drive incremental returns.

Now back to Larry.

Larry Penn

Thanks, Mark. 2022 was, by many measures, the worst year for MBS in at least 40 years and perhaps ever. In Ellington Residential's long-standing sector of focus, the agency MBS sector, it was truly nowhere to hide as the Bloomberg MBS index had its worst yearly performance on record on an absolute basis and its second worst year ever relative to treasuries. Throughout 2022, we had to navigate periods of extreme volatility and market dysfunction with interest rates rising rapidly and yield spreads widening along the way.

Despite these challenges, our risk and liquidity management enabled us to avoid realizing even larger losses. As a result, we were able to buy into extreme weakness late in the third quarter and then sell into strength in the fourth quarter. By doing so, we entered 2023 with reduced leverage and strong liquidity, which is now allowing us to play offense once again.

On last quarter's earnings call, we discussed that we are planning to selectively rotate a portion of our capital from Agency MBS to other residential mortgage sectors. And that's still very much on our radar screen. As we pointed out before, earn smaller size should enable us to be nimble as market conditions evolve. And as usual, absent a big yield spread widening event, where we want a pound, we plan to be patient and opportunistic picking our spots.

So far this year, January started the year off on a positive note with Agency RMBS enjoying an excellent month as agency yield spreads tightened further. The tide has turned a bit since then, with interest rates and volatility up both in February and so far in March, especially with Powell's comments this morning. Year-to-date, through the end of February, we estimate that earns book value per share was up close to 4%.

With that, we'll now open the call to questions. Operator, please go ahead.

Question-and-Answer Session

Operator

Thank you, sir. [Operator Instructions] Our first question comes from Eric Hagen with BTIG.

Eric Hagen

Hey, thanks. Good morning guys. I've got a couple here. I mean how are you thinking about volatility in the market, especially connected to a recession and the impact that it has on the flexibility from banks to support repo financing. Like are there good ways do you think, to hedge against the kind of credit risk at banks because of the transition to SOFR from LIBOR over the last couple of years? And then as a smaller cap mortgage rate, are you concerned about the access that you have to repo and banks as the Fed continues to raise? And then, how do you think mortgages would respond to any further backup in rates at the long end of the curve as well as the short end? I mean, we all know that most of the sensitivity is concentrated at the long end, but how sensitive do we think the basis is if Fed funds are meaningfully higher than what the forward curve currently projects? Thank you guys.

Chris Smernoff

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

Mark Tecotzky

Sure.

Chris Smernoff

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

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

Mark Tecotzky

Sure. So, I think the first question, Eric, was about volatility. Volatility has been pretty high this year, but the – realized volatility is certainly down from last year. And like to me, I think about sort of two types of volatility. One is what's the volatility in treasury yields, right? So how many basis points a day are they realizing versus what's kind of built into market expectations. And you've been sort of realizing about what it – what market expectations are priced in, which it sort of means that, if you think about things in OAS terms that your delta hedging costs are about what the OAS you thought you were buying is predicated upon.

So that has been definitely manageable. It's been more manageable than last year. Now the other part of volatility that, I think a lot about is, what's the volatility of mortgage spreads relative to treasuries and that's where you've really seen things come down. The amount by which mortgages outperform or underperform treasuries on sort of a given day this year versus last year, it's a lot less. So you've had kind of mortgages they've had this modest outperformance this year, but the oscillation has been between sort of their best performing days and the worst performing days are lot – there a lot closer than what they were last year.

And I attribute that to the flows in mortgages are a lot more balanced. So sort of like, anyone who needed to shed a lot of duration in response to Fed hikes last year, or outflows they have, let's say, it's a mutual fund or pension fund basing cash, I think you've seen those big outflows occur. And if you look at ETF data in mutual fund data, you've seen kind of modest inflows into fixed income and some inflows into mortgages specifically, especially through some of the ETFs. So the flows have been more balanced.

Now the second question you had about, how the mortgages perform, if rates go higher than what's currently built in the forward curve. So I mentioned that, sort of like mild recession, which is probably the best case for mortgages. And so I would say that, the case where, I think right now, sort of terminal Fed funds rate is expected to be at around 5.5%.

I think cases, where it's materially higher than that, and scenarios where you have, say, 10-year yields go materially through the highs of last year. I think last year, we got to 435 or 440. We sit a little bit below 4% now. So I think scenarios, where yields go up through last year's highs on the long end, and Fed funds rate is a lot higher than what it's currently built into expectations. I think, those are harder scenarios for mortgages, because I think in scenarios like that, you're more likely to see fixed income outflows.

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

Eric Hagen

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

Larry Penn

Thank you.

A – Chris Smernoff

Thanks, Eric.

Operator

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

Crispin Love

Thanks. Appreciate you guys taking my questions. Just first on looking at potential buyers of Agency MBS over the near-term. Mark, you talked about this a bit, but with banks stepping back in the sector in 2022, do you still view that there's an opportunity there for banks to be a meaningful buyer in agency in 2023 if bank loan growth pulls back, or could that be delayed into kind of 2024? And then just any other potential tailwinds for agency think are worth calling out?

Mark Tecotzky

Sure. So I think what -- what really turned the dial on Agency MBS performance in Q4 as opposed to quarters one, two and three was really money manager buying in response to inflows, right? Like investors like long-term pools of capital, pension funds, insurance companies are seeing yields they haven't seen since 2007, right? So that has been enough to get people when they see some modicum of stability in rates to commit capital to fixed income. So I think that was -- it was really money managers are the -- the type of buyers that really have driven performance in Q4 and so far this year.

Banks so far has still been on the sidelines. You've seen them basically sell some of the Fannie Freddie's. The buying they're doing is mostly in Ginnie's because it's a different capital weighting. And they've also been preferring loans over securities for lower mark-to-market impact on their balance sheet.

So I -- you did see some bank buying. Banks typically buy after they've seen a little bit of a rally. So they generally like -- they're not the kind of catch a falling knife type of buyer. They're, sort of, like they'd rather buy the bounce type buyer. So you did see a little bit of bank buying in earlier this year when we had valued some, but I think that's dissipated a lot.

So I don't think you're going to see material bank buying unless rates sort of stabilize, start going back down? And if concerns about credit performance or significant -- credit performance and loan portfolios is significant enough to cause them to favor securities over loans for credit reasons. You typically see that happen in a recession. You know, right now, the economic numbers have been strong.

The other thing which can also drive some of the bank behaviors, now everyone is under this CECL regime, right? So if you do have weaker credit performance in the consumer or credit performance in mortgage loans, then that can drive a revision to the capital you need to hold against loan portfolios for CECL. And if that starts happening, that's certainly something that would cause them to favor securities over loans.

Crispin Love

Thanks Mark. And then just one other for me. It's more of a numbers question from the quarter, but looking at core other income after making all the adjustments for ADE was pretty sizable in the quarter versus the previous quarter after backing out the adjustments, you still got to core other income about $2.7 million. I'm just curious if you can comment on the key driver in the change there and what's in there that drove the significant increase versus the previous quarter?

Chris Smernoff

Sorry, can you repeat the question? This is Chris.

Crispin Love

Yeah. So looking at core other income after making all the adjustments for ADE was about $2.7 million, which was a significant increase over the previous quarter after making the adjustments for different realized and unrealized gains. I'm just curious if you can comment on the key driver in what drove the higher core other income in the quarter? And we can definitely take this offline if you don't have it handy.

Chris Smernoff

Yeah, yeah. Cris, it's the swap payments, the swap benefit that we were talking about before.

Crispin Love

All right. Perfect. Thank you very much.

Chris Smernoff

Thanks, Crispin.

Crispin Love

All right. Thank you.

Operator

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

Mikhail Goberman

Hi. Good morning, gentlemen. Congrats on a solid quarter and appreciate the book value update. Just a quick question from me on what kind of opportunities are you guys seeing in the non-Agency space, I guess, you're mentioning here number two on your list of the annual objectives is to continue to rotate a portion of capital into that space. So I'm just curious about that. Thanks.

Larry Penn

Yes. So the two sectors in non-agencies that look to us most attractive right now are some of the more seasoned credit risk transfer bonds and the other one is the legacy non-Agency market. So that's sort of the pre-crisis bonds, 2007 and earlier, people have been in their homes for 15, 16 years. It's a fragmented market. It's a lot of smaller pieces. There is a lot of securities where you're back by maybe 15, 20 loans, so cash flows are lumpy.

But our analytics are very strong in that area. And because you really need to take a granular approach to looking at the individual loans, it's deterrent to people that just want to buy beta. So we see that sector as attractive now. It's now it's -- you have to counterpunch a little bit there. You have to wait for sellers because -- it's not like the non-QM market or another new issue market where there's new issue deals and you can just put in your order on new issue and get invested that way.

This you need to respond primarily to bid-list but those are the two sectors that we see the best relative value. And we're not looking to -- that portfolio is not designed to, or it's not contemplated taking a lot of credit risk. So what we're going to put to work there are securities that we think you can shop home prices like a great financial crisis shock, and you're going to get your capital back.

So it's not going to be way down the capital stack and things that are subject -- where small changes in loss expectations really change your expected returns things higher from the capital structure. It's not -- it's very similar to what we did in 2020 at a COVID, right? 2020 out of COVID, we raised cash once the Fed started buying and Agency RMBS tightened, and Agency RMBS, their tightening cycle preceded the tightening cycle in credit-sensitive assets. So after the Agency CMBS we are started to perform well. Post-March 2020, we rotated into some of the non-agencies and it worked out really well.

Mikhail Goberman

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

Mark Tecotzky

It's a great question. It's a great question. We actually just got the new -- get these monthly prepayment reports, fifth business day of the month, so we got the prepayment report last night, and it showed a very modest up-tick, maybe 10% from extremely low-levels.

So I think about it two ways. There's some very small portion of the mortgage market, where people have note rates, 7.5%, 7.25% bigger loans. We think those borrowers are going to be very responsive to refinance opportunities if the forward curve is borne out, and you see mortgage rates drop. And you have still -- there's been, layoffs industry-wide on mortgage originators, but you still have excess capacity.

So if you saw 20, 30, 40 basis point drop in mortgage rates, you're going to see that very small portion of the market that has high note rates. So, people that took note rates Q4 last year those are going to be responsive. And this actual -- this recent prepayment report yesterday, you saw a little bit of that behavior, because this prepayment report referenced mortgage rates a little bit lower than where we are now.

But now, if you think of it the market in aggregate, to get a real prepayment wave you need to get big portions of the market re-financeable. And I don't think you see that, until you get well below 5%. Even you move things 75, 100 basis points here the percentage of loans that have a refinance incentive is very low.

The first thing I think you'd see is that, if you got mortgage rates, let's say, to 5.25%, and all of a sudden, people with four, 4.5, 4.75 note rates, they're going to be more willing to do cash out refinance. So -- so that can happen. That would be sort of incremental.

But to get a real -- a big portion of the market re-financeable with straight rate refis, you're going to have to be well under 5%. But I think you'll see, sort of you have little pockets of faster speeds along the way. And if you hold those pools, you can get hurt on those pools, but it doesn't change the supply demand dynamic for mortgages until you get significantly lower rates.

Mikhail Goberman

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

Mark Tecotzky

Thank you.

Operator

Thank you. Our next question comes from Jason Stewart with JonesTrading.

Jason Stewart

Thanks guys. I just wanted to know a little bit further on your thoughts on investing across the Agency coupon stack, vis-à-vis the dividend.

Mark Tecotzky

I guess, kind of where we see the most value now is like a sweet spot, like it's coupons that are high enough where you're getting enough coupon that you're sort of like going to be close or getting close to your financing costs, but aren't so high that a little bit of drop in mortgage rates, you can see a big pickup in speeds. So I would say 4, 4.5, 5, even 5.5. That to us looks, I think, that's where you want to be. I think you want to be positioned such that if you have a drop in rates, if the forward curve turns out to be right, you have at least a few points of room before you get to par, before you really have to start worrying about prepayments.

So I'd say that those coupons kind of fit that bill, but they also -- you also had the nice property that you're not seeing new production, say, in 4 and 4.5. So each month, if you own pools or even if you own TBAs, it's sort of you own pools, everything season month-by-month. But even if you have a TBA exposure there, the assumptions to what's deliverable is getting older each month. So you're getting kind of the benefit of the seasoning there.

And I think that -- it serves a very higher coupons, you have really big loan balance that are in small drop in rates, you're going to have an army of people trying to refi those loans. That to me is, I think, an area that will have a challenging performance if the forward curve is borne out, and you do have lower rates second half of this year and next year.

Chris Smernoff

And if I could just add, if you look at our net interest margin, and you leverage that given you can look at our debt to equity, you can look at our net mortgage exposure, which we dial up and down, you can see that the dividend should be well covered from that perspective, especially given where short-term rates are, because that's a tailwind as well.

But it's really a -- spreads have been so volatile lately. I mean, we talked about how that gapped out in September, tightened in November. Now obviously, this year, we saw sort of a similar thing January tightening in February and March widening. So it's definitely a market where we feel that by dialing down -- up and down that mortgage exposure, we can generate incremental earnings. And so I think with that as well, which obviously came into play in a big way in the fourth quarter, we can absolutely cover the dividend.

Jason Stewart

Got you. Great. Thanks, guys.

Operator

Thank you. That was our final question for today. We thank you for participating in the Ellington Residential Mortgage REIT fourth quarter 2022 earnings conference call. You may disconnect your line at this time, and have a wonderful day.