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EARN > SEC Filings for EARN > Form 10-K on 21-Mar-2014All Recent SEC Filings




Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
In this Annual Report on Form 10-K, except where the context suggests otherwise, "EARN," "we," "us," and "our" refer to Ellington Residential Mortgage REIT and its subsidiaries, our "Manager" refers to Ellington Residential Mortgage Management LLC, our external manager, and "Ellington" refers to Ellington Management Group, L.L.C. and its affiliated investment advisory firms. The common shares outstanding and per share amounts discussed in this Management's Discussion and Analysis of Financial Condition and Results of Operations reflect the 3.7066% common share dividend declared by our Board of Trustees on April 18, 2013, resulting in the distribution of an additional 58,378 common shares which was retrospectively applied for financial statement reporting purposes.
Executive Summary
We are a Maryland real estate investment trust, or "REIT," formed in August 2012 that specializes in acquiring, investing in, and managing residential mortgage- and real estate-related assets. Our primary objective is to generate attractive current yields and risk-adjusted total returns for our shareholders by making investments that we believe compensate us appropriately for the risks associated with them. We seek to attain this objective by constructing and actively managing a portfolio comprised primarily of Agency residential mortgage-backed securities, or "RMBS," and, to a lesser extent, non-Agency RMBS. We also may opportunistically acquire and manage other types of residential mortgage-related and real estate-related asset classes, such

as residential mortgage loans, and mortgage servicing rights, or "MSRs." We believe that being able to combine Agency RMBS with non-Agency RMBS and other residential mortgage- and real estate-related asset classes enables us to balance a range of mortgage-related risks.
We were formed through an initial strategic venture among affiliates of Ellington, an investment management firm and registered investment adviser with a 19-year history of investing in a broad spectrum of mortgage-backed securities and related derivatives, with an emphasis on the RMBS market, and the Blackstone Tactical Opportunity Funds, or the "Blackstone Funds." These initial investors made an aggregate investment of approximately $31.5 million on September 25, 2012. On May 1, 2013, we priced an initial public offering of our common shares, pursuant to which we sold 6,450,000 shares to the public at a price of $20.00 per share. Concurrent with the initial public offering, we completed a private placement of 1,050,000 common shares to our initial investors at a purchase price of $20.00 per share which generated gross proceeds of $21.0 million. No further capital commitments from the initial investors remain as a result of this private placement. Total gross proceeds to us from the initial public offering and concurrent private placement were $150.0 million. Proceeds to us, net of offering costs, were approximately $148.5 million.
We are externally managed and advised by our Manager, an affiliate of Ellington. We use leverage in our Agency RMBS strategy and, to a lesser extent, in our non-Agency RMBS strategy as well. As of December 31, 2012, we had no outstanding borrowings; however, in April 2013, we began purchasing Agency RMBS on a leveraged basis. We have financed our purchases of Agency RMBS exclusively through repurchase agreements, which we account for as collateralized borrowings. As of December 31, 2013, we had outstanding borrowings under repurchase agreements in the amount of $1.3 billion.
We made the election to be taxed as a corporation effective for the short taxable period May 1, 2013 through December 31, 2013. In addition, we intend to elect to be taxed as a REIT for U.S. federal income tax purposes for the short taxable period May 1, 2013 through December 31, 2013. Accordingly, we generally will not be subject to U.S. federal income taxes on our taxable income that we distribute currently to our shareholders as long as we maintain our intended qualification as a REIT. We intend to conduct our operations so that neither we nor any of our subsidiaries is required to register as an investment company under the Investment Company Act of 1940, as amended.
As of December 31, 2013, our book value per share was $18.29, as compared to $18.96 as of December 31, 2012.
Trends and Recent Market Developments
Key trends and recent market developments for the mortgage-backed security, or "MBS," market include the following:
Federal Reserve and Monetary Policy-In December 2013, the U.S. Federal Reserve, or the "Federal Reserve," announced its intention to reduce, beginning in January 2014, the pace of its asset purchases under its accommodative monetary policies; the timing and degree of the Federal Reserve's reduction in asset purchases, or "taper," had been the subject of heightened market speculation since mid-2013;

Housing and Mortgage Market Statistics-Data released by S&P Indices for its S&P/Case-Shiller Home Price Indices for December 2013 showed that, on average, home prices had increased from December 2012 by 13.6% for its 10-City Composite and by 13.4% for its 20-City Composite, resulting in its best calendar year return since 2005; meanwhile, the Freddie Mac survey 30-year mortgage rate ended the year at 4.48%, up 34% from its 3.35% level at the end of 2012;

Prepayment Rate Trends-As mortgage rates have risen over the course of the last half of 2013, Agency prepayment rates have declined;

Government Sponsored Enterprise, or "GSE," Developments-On December 10, 2013, the U.S. Senate confirmed Mel Watt as the next head of the Federal Housing Finance Agency, or "FHFA,";

Bank Regulatory Capital-Recent proposed changes, if finalized, will increase regulatory capital requirements for the largest, most systemically significant U.S. banks and their holdings companies; this could potentially alter these institutions' appetite for various risk-taking activities, and could ultimately affect the terms and availability of our repurchase agreement, or "repo," financing; and

Portfolio Overview, Liquidity, and Valuations-During 2013, Agency RMBS experienced a heightened level of volatility as uncertainty and speculation around future actions of the Federal Reserve dominated the market, while non-Agency RMBS rallied for most of 2013 as underlying strength in housing market data continued to provide support to valuations.

Federal Reserve and Monetary Policy
In December 2013 and then again in January 2014, the Federal Reserve announced reductions in its purchases of Agency RMBS and U.S. Treasury securities under its monthly asset purchase program. Prior to these "taper" announcements, and since September 2012, the Federal Reserve had been purchasing long-dated U.S. Treasury securities and Agency RMBS assets at the pace of $85 billion per month-comprised of $45 billion of U.S. Treasury securities and $40 billion of Agency RMBS. Based on the December and January announcements, the combined monthly reduction in asset purchases amounts to $20 billion, split evenly between Agency RMBS and U.S. Treasury securities. The Federal Reserve continues to reinvest principal payments from these holdings into additional asset purchases. The decision to reduce the pace of monthly purchases to $65 billion was made by the Federal Reserve in light of its view that the broader economy has strengthened considerably. To the extent that labor market conditions continue to improve and inflation remains near desired levels, the Federal Reserve has noted that it will likely continue to reduce the pace of asset purchases in further measured steps at future meetings. Notwithstanding the improvements in the economy, the Federal Reserve continues to express concern that inflation persistently below its 2% objective could pose risks to economic performance.
In addition to announcing its intention to reduce its monthly asset purchases, the Federal Reserve reiterated its intention to maintain the target range for the federal funds rate at 0% to 0.25% as long as the unemployment rate remains above 6.5% and as long as the inflation rate over the next one to two years is projected to be no more than a half a percentage point above the Federal Open Market Committee's, or "FOMC," 2% longer-run goal. However, as the unemployment rate is actually approaching 6.5%, the Federal Reserve has noted that it would soon be appropriate for the FOMC to change its forward guidance in order to provide information about its decisions regarding the federal funds rate after that threshold is crossed. The asset purchase program and the maintenance of a low federal funds rate, among various other measures, were put into place by the Federal Reserve in response to the elevated level of U.S. unemployment and the slow pace of the economic recovery in the aftermath of the 2008 financial crisis. The stated goal of the Federal Reserve's actions, in implementing these policies, was to maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.
During the middle and second half of 2013, as the U.S. unemployment rate declined and the economy continued to show signs of improvement, market speculation about the timing of a decision by the Federal Reserve to taper its monthly asset purchases caused interest rates to rise and prices of long-dated U.S. Treasury securities and Agency RMBS to fall. In fact, all major fixed income sectors experienced substantial price declines during this period, including U.S. Treasury securities, Agency RMBS, and to a lesser extent credit-sensitive sectors such as high-yield corporate bonds and non-Agency MBS. Agency RMBS were especially hard-hit through the end of the year, as heavy selling by mutual bond funds, exchange-traded funds, and mortgage REITs exacerbated the price declines and overall volatility. By December 31, 2013, the benchmark 10-year U.S. Treasury yield had risen to 3.03%, up from 1.76% as of December 31, 2012.
Following the December 2013 and January 2014 taper announcements, interest rates declined significantly. By February 28, 2014, the 10-year U.S. Treasury yield had fallen back to 2.65%, and prices of Agency RMBS have rallied as a result. As an example the price of TBA 30-year Fannie Mae 3.5%, a widely traded Agency RMBS, rose to 101.42 as of February 28, 2014, up from 99.36 as of December 31, 2013. The decline in interest rates is likely due, at least in part, to a market perception of a lower level of uncertainty around future Federal Reserve actions.
Notwithstanding the recent decline in interest rates and the greater clarity around Federal Reserve asset purchasing activities, we believe that there remains substantial risk that interest rates could begin to rise again. This reinforces the importance of our ability to hedge interest rate risk using a variety of tools, including TBAs, interest rate swaps, and various other instruments.
Housing and Mortgage Market Statistics
The following table demonstrates the decline in residential mortgage delinquencies and foreclosure inventory on a national level, as reported by CoreLogic in its December 2013 National Foreclosure Report:

                                                 As of
Number of Units (In thousands)      December 2013    December 2012
Seriously Delinquent Mortgages(1)           1,978            2,637
Foreclosure Inventory                         837            1,217

(1) Seriously Delinquent Mortgages are ninety days and over in delinquency and include foreclosures and REO property.

As the above table indicates, both the number of seriously delinquent mortgages and the number of homes in foreclosure have declined significantly over the past year. This decline supports the thesis that as homeowners have re-established equity in their homes through recovering real estate prices, they have become less likely to become delinquent and default on their

Another interesting development can be seen in monthly delinquency roll rate statistics, as shown in the following table:

                                                 As of
Roll Rates (3 Month Moving Average)    October 2013    July 2013
Current to 90+                              0.37 %         0.35 %
90+ to Foreclosure                          5.06 %         4.51 %
Foreclosure to Current                      1.80 %         1.07 %

Note: Current includes loans that are 30 and 60 days delinquent; 90+ excludes foreclosures and REO property.
Roll rates represent the rates at which mortgages move from one category to another toward foreclosure. As can be seen in the table above, between July 2013 and October 2013, the rate at which mortgages have been rolling from current to 90+ days delinquent has grown from 0.35% in July to 0.37% in October. We view these levels as generally indicative of a healthy mortgage environment. The rise in transition speeds from 90+ days delinquent to foreclosure is mainly attributable to the declining supply of delinquent mortgages, rather than the ability of courts and servicers to initiate a greater number of foreclosure proceedings. The large increase in cure rates (foreclosure to current) for mortgages in foreclosure is in large part the result of increased loan modification rates that have accompanied large-scale servicing transfers in recent months from less efficient to more efficient servicers.
Data released by S&P Indices for its S&P/Case-Shiller Home Price Indices for December 2013 showed that, on average, home prices had increased from December 31, 2012 by 13.6% for its 10-City Composite and by 13.4% for its 20-City Composite, resulting in its best calendar year return since 2005. Compared to November 2013, the 10-City Composite remained relatively unchanged, while the 20-City Composite declined 0.1%. According to the report, home prices remain below the peak levels of 2006, but, on average, are back to their late-2004 levels for both the 10- and 20-City Composites. As additional evidence of an improving housing market, single-family housing starts have increased 9.8% as compared to one year ago, up from 620,000 starts in December 2012 to 681,000 starts in December 2013. Finally, as indicated in the table above, as of December 2013 the national inventory of foreclosed homes fell to 837,000 units, a 31% decline when compared to December 2012; this represented the twenty-sixth consecutive month with a year-over-year decline and the lowest level in six years. As a result, there are much fewer unsold foreclosed homes overhanging the housing market than there were a year ago. While the recent increase in interest rates and the slow and uneven pace of the recovery of the U.S. economy continue to create potential risks to the recovering housing market, mortgage rates remain near all-time historical lows and, recent trends continue to indicate, on balance, that the recovery in the housing market continues on a strong footing. We believe that near-term home price trends are more likely to be driven by fundamental factors such as economic growth, mortgage rates, and affordability, rather than by technical factors such as shadow inventory.
The Freddie Mac survey 30-year mortgage rate ended 2013 at 4.48%, up 34% for the year. Not surprisingly, the Refinance Index published by the Mortgage Bankers Association, or "MBA," declined approximately 63% from the prior year end, and similarly the Market Composite Index, a measure of mortgage application volume, declined approximately 48% from the prior year end.
Higher interest rates reduce housing affordability. Even with the rise in interest rates last year, housing is still inexpensive relative to historical averages based purely on debt-service-to-income ratios; however, after factoring in other metrics such as home-price-to-income ratios, U.S. housing affordability actually appears to be nearing equilibrium levels, implying that the potential for future home price increases may be limited. In fact, if mortgage rates were to unexpectedly rise significantly from current levels, the recent upward trend in housing prices could potentially even reverse.
On March 7, 2014, the U.S. Department of Labor reported that the U.S. unemployment rate was 6.7% in February 2014. While the consensus for future job growth is generally mildly positive, the recent declines in the unemployment rate are also partially attributable to a reduction in the labor force participation rate. While it is difficult to quantify the relationship between the unemployment rate and the housing and mortgage markets, we believe that current levels of unemployment do not represent a significant impediment to a continuing housing recovery.
Prepayment Rate Trends
The relatively muted level of prepayment activity as interest rates broadly declined in recent years has in large part been the result of: (i) home price declines during the financial crisis, which has left many borrowers with minimal or negative home equity; (ii) more restrictive underwriting guidelines, even for refinancings; (iii) increased origination costs, especially related to underwriting and compliance; and (iv) increases in Agency guarantee fees. These factors have resulted in substantial variations

in prepayment rates between Agency pools as a function of loan-to-value ratio, loan balance, credit score, geography, property type, loan purpose, and other factors. In recognition of the importance of these underlying characteristics on prepayment behavior, the MBS market continues to promote the creation of "specified" Agency pools that emphasize or de-emphasize many of these characteristics (such as pools where the principal balance of every underlying mortgage loan is below $85,000). The Making Homes Affordable, or "MHA," refinancing program, which was initiated in response to the housing market crisis, has facilitated the origination of many of these kinds of specified Agency pools. The extension of the MHA refinancing program into 2015 should sustain creation of such pools in the coming years. We expect that the ongoing origination of Agency pools with a wide variety of loan characteristics will continue to create opportunities for us to exploit the resulting differences in prepayments.
The recent rise in mortgage rates has, as expected, caused a significant decline in Agency RMBS prepayment speeds, with higher coupon RMBS impacted the most. To the extent mortgage rates remain at current levels, it is likely that prepayments speeds will remain somewhat muted. With respect to existing Agency RMBS, this introduces significant extension risk to a market that had only recently been focused almost exclusively on the risk of accelerated prepayments. GSE Developments
In late October, both Fannie Mae and Freddie Mac announced a slight relaxation of the May 2009 loan cut-off date for refinancing under the Home Affordability Refinance Program, or "HARP." The new terms now base eligibility on loan origination dates, as opposed to the dates that loans were originally delivered to the GSEs. There have been additional discussions regarding whether to extend the cut-off date even further, or relax other HARP requirements. On December 10, 2013, the U.S. Senate confirmed Mel Watt's nomination as the next head of the FHFA and he took office on January 6, 2014. The first impact of his appointment came in late December, when it was announced that he intended to delay and re-evaluate the implementation of departing FHFA Director Ed DeMarco's initiative to raise guarantee fees, or "g-fees," on new Fannie Mae and Freddie Mac business. G-fees are the fees charged by the GSEs to include mortgage loans in Agency pools, and thereby insure the mortgage loan against loss. Since these fees are passed on to borrowers whose loans are originated for inclusion in Agency pools, increased g-fees have the effect of reducing housing affordability for GSE borrowers, but potentially makes it more attractive for private lenders to replace the GSEs. The g-fee announcement hurt performance of near-the-money Agency coupons, such as 4.5% and 5.0% pools, as muted expectations of g-fee increases are suggestive of potentially faster prepayment speeds. Director Watt's confirmation has created a number of additional policy concerns in the Agency RMBS market, as he is perceived as likely to pursue policy agendas that will make the expansion of housing affordability a priority, potentially at the expense of Agency RMBS investors. For example, Watt is expected to seriously consider establishing some principal forgiveness programs for GSE-guaranteed loans; his predecessor Ed DeMarco was unwaveringly against principal forgiveness. If implemented, such principal forgiveness programs would likely start out by targeting the most at-risk borrowers, reducing default risk on high loan-to-value pools and pools concentrated in the most distressed geographies. In another departure from his predecessor, Watt is less likely to implement the loan-limit reductions for the GSEs that were proposed for comment by DeMarco in late 2013. Watt is also more likely to reduce loan-level price adjustments, or "LLPAs," and loosen other underwriting standards. Currently the GSEs apply various LLPAs to justify the cost of guaranteeing riskier loans. Lower LLPAs would make it easier for less creditworthy borrowers to obtain loans, whether for home purchases or for refinancings, thus helping promote Watt's likely agenda of assisting less creditworthy borrowers. The combination of the potential for increased prepayment speeds resulting from these potential policy changes, and a lack of clarity on specifically how FHFA policies might change, has cast uncertainty over the Agency RMBS markets. Bank Regulatory Capital Changes
Upcoming changes in banking regulations could impact MBS and ABS pricing, as well as the availability and cost of financing of MBS and ABS assets. The Federal Reserve's current implementation of the Basel III rules on bank Supplementary Leverage Ratios, or "SLRs," will significantly curtail the extent to which banks will be permitted to net certain repo and reverse repo agreements against each other when calculating their capital requirements. As a consequence, in an effort to maximize return on equity, banks may be incentivized to reduce their repo financing operations, especially for lower-cost financings such as those involving U.S. Treasury securities and Agency RMBS. Full implementation of Basel III regulations, in particular the carve-out rules related to accumulated other comprehensive income, or "AOCI," are likely to reduce bank demand for assets with higher duration, and as a result could hurt the liquidity of the tradable MBS market. Under AOCI carve-out rules, banks with more than $250 billion in assets will be required to include mark-to-market gains and losses on available-for-sale, or "AFS," securities when calculating their Tier 1 capital. This incentivizes banks to hold Agency RMBS in held-to-maturity, or "HTM," and other illiquid assets, effectively locking more bank-held Agency RMBS out of the tradable market, and thus reducing market liquidity. In addition, banks will likely want to reduce the risk of their AFS securities holdings, which will incentivize them to hold lower duration assets such as 15-year Agency RMBS. While our access to repo financing has not been adversely affected to date, it is still possible that certain of our lending institutions could, in the future, decide to curtail their

repo lending activities in response to these developments, particularly in connection with repo financing on Agency RMBS, which typically provides lower profit margins. However, it is also possible that these changes will create opportunities for smaller banks and/or non-bank lenders to enter the repo financing market, and in fact we continue to see smaller broker-dealers becoming more active in the Agency pool repo financing market. Portfolio Overview, Liquidity and Valuations Over the course of the late second quarter and the remaining months of 2013, the Agency RMBS market was among the most volatile and poorly performing fixed income sectors, as the market anticipated a tapering by the Federal Reserve of purchases under its asset purchase program. "Specified" Agency RMBS pools, or pools with prepayment protection characteristics were particularly hard hit. As interest rates have risen over the course of the year, prepayments have declined, thereby reducing the perceived value of the prepayment protection in many specified pools. These specified pools have generally underperformed TBAs, their generic counterparts. A big factor contributing to this underperformance is that the Federal Reserve, which is by far the largest purchaser of Agency pools, generally purchases TBAs, not specified pools. Specified pools have also suffered from reduced demand by Agency mortgage REITs, as these companies have lowered their leverage in response to increased interest rate volatility, and as they have been effectively unable to raise additional equity capital to increase their asset base. Finally, with interest rates higher, specified pools now have a longer duration (and therefore greater price fluctuation) than they have had in the recent past; as a result, they may become less attractive assets for large U.S. banks to hold in light of recent changes to regulatory capital rules, which will essentially force these banks to charge unrealized losses on AFS assets against their regulatory capital.
While the $10 billion taper announced by the Federal Reserve in December 2013 was considered modest, it removed some level of uncertainty from the market, and in response, Agency RMBS yield spreads re-tightened. Late in January, the Federal Reserve announced an additional $10 billion reduction in its monthly asset purchases, beginning in February 2014. Similar to the December 2013 reduction, this reduction will also be evenly split between Agency RMBS and U.S. Treasury securities. Notwithstanding the total $10 billion drop in the monthly pace of its Agency pool purchases-a 25% drop from its 2013 pace-the Federal Reserve continues to be the dominant force in the Agency pool market. In recent years, the majority of Agency pool issuance has been driven by loan refinancings, as opposed to mortgage loans for home purchases. However, with interest rates having risen so significantly since last May, refinancing activity has steadily declined over recent months, and in December the MBA Refinance Index hit a new multi-year low. Therefore, as refinancing activity has declined, so too has the production of new Agency pools. As a result, the Federal Reserve still provides overwhelming support to, and remains the dominant force in, the Agency pool market, given that the reduction in Federal Reserve purchases has been more than offset by the reduction in new supply. However, should the Federal Reserve continue, as is expected, to taper its monthly purchases, the Agency pool market may undergo a significant repricing over the course of 2014.
Over the course of 2013, we took advantage of depressed specified pool pay-ups
(price premiums for specified pools relative to their generic pool counterparts)
by buying higher coupon specified pools. Despite current low prepayment levels, we believe that certain sectors of the Agency pool market are still susceptible to prepayments, thereby making it attractive to buy pools with prepayment protection in those sectors, especially given the drop in pay-ups. We have also found attractive opportunities in seasoned specified pools, which have shorter remaining weighted average maturities relative to TBAs, and therefore can be hedged with a shorter, lower-cost basket of interest rate hedges. Given the . . .

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