Ellington Financial Inc. — Q1 2019 Form 10-Q
Reporting period: Three months ended March 31, 2019. Ellington invests in mortgage-backed securities, mortgage and consumer loans, CLOs, derivatives, and related assets, using leverage and an opportunistic investment strategy. Effective March 1, 2019, it converted from an LLC to a corporation and changed its name to Ellington Financial Inc.
Financial results and position
- Income: Interest income was $36.0 million and interest expense was $17.6 million, producing net interest income of $18.4 million. Other income was $5.5 million; expenses totaled $9.2 million. Net income was $16.5 million, including $15.4 million attributable to common stockholders, or $0.52 per share.
- Core earnings: Management-reported non-GAAP Core Earnings were $14.4 million, or $0.45 per common share. The filing cautions that this supplemental measure is not a substitute for GAAP net income.
- Cash flow: Operating activities provided $21.0 million; investing activities used $64.6 million; financing activities provided $54.5 million. Cash, cash equivalents, and restricted cash increased $11.0 million to $56.1 million, including $0.2 million restricted.
- Balance sheet and liquidity: Total assets were $2.87 billion, liabilities $2.28 billion, and total equity $592.4 million. Cash and cash equivalents were $55.9 million. The filing does not provide a conventional current ratio.
- Debt and leverage: Total recourse and non-recourse borrowings were approximately $2.04 billion, including $1.55 billion of repurchase agreements, $399.4 million of other secured borrowings, and $86.0 million principal on senior notes. Debt-to-equity was 3.44:1 (3.39:1 excluding U.S. Treasury securities). Recourse debt-to-equity was 2.61:1. Senior notes bear 5.50% interest and mature in September 2022; the company reported compliance with their covenants.
- Margins: Net interest margin was 2.86%, compared with 3.09% in Q1 2018. Average cost of funds for secured borrowings was 3.52%, versus 2.45% in Q1 2018; management cited higher borrowing rates and a greater share of credit-asset financing.
- Dividends and capital: Dividends of $0.55 per share were declared for the quarter. The company repurchased 50,825 shares for $0.8 million at an average $15.39 per share. Book value per share was $18.90.
Changes versus comparable periods
Reported Q1 2019 results are not directly comparable with earlier periods because the company prospectively discontinued investment-company accounting under ASC 946 effective January 1, 2019. The financial-statement presentation and consolidation treatment changed; the company elected fair value accounting for eligible instruments. Management’s selected comparisons show interest income rising from $28.1 million in Q1 2018 and interest expense rising from $11.6 million. Common-stockholder earnings per share were $0.52, versus $0.67 of shareholder-equity increase from operations per share in Q1 2018; the different accounting bases limit comparison.
- Long Agency RMBS fair value increased approximately 17% from year-end 2018 to $1.14 billion. Management attributed gains to lower rates, tighter spreads, and higher specified-pool pay-ups.
- Total long credit portfolio was $1.47 billion, compared with $1.48 billion at year-end; excluding non-retained tranches of consolidated non-QM securitizations, it was $1.20 billion, up slightly from $1.19 billion.
- Credit assets generated strong returns, but corporate and mortgage-related credit hedges lost value as spreads tightened, and interest-rate hedges posted a slight loss as rates declined.
Outlook, risks, and unusual items
- Outlook: Management said it continued to see attractive risk-adjusted opportunities in both credit and Agency strategies, and expected to adjust allocations as markets evolve. The filing provides no specific earnings or return guidance. The company intends to elect REIT status for tax year 2019 and states it believes it will qualify; REIT status requires meeting complex tests, including distribution requirements.
- Market and liquidity risks: Falling mortgage rates may increase prepayments, affecting mortgage assets and interest-only securities. Repo maturities, collateral haircuts, counterparty exposure, and margin calls could pressure liquidity. Management said it expects available resources to meet liquidity needs, but inability to finance Agency RMBS could force asset sales and portfolio restructuring.
- Credit and valuation risks: Loan defaults, loss severity, servicer performance, property values, and consumer-loan collections may impair returns. A substantial portion of assets uses Level 3 inputs and unobservable assumptions; management notes that fair values could differ materially from realizable prices.
- Contingencies and related parties: The company guaranteed up to $25.0 million of a mortgage-originator’s financing; $9.4 million was outstanding under the guaranteed arrangements at quarter-end. Estimated remaining contingent consumer-loan purchase obligations were approximately $227.2 million in principal. Certain loan-originator, CLO, and other transactions involve Ellington affiliates.
- Regulatory matter: The company disclosed an SEC subpoena received in January 2017 relating primarily to a loan originator and associated loans, purchases, securitizations, and servicing. It had responded and intended to cooperate; it reported no material legal proceeding currently considered material, but could not assure that inquiries would not lead to further investigation or proceedings.
- Other developments: A $150 million at-the-market share offering program began April 3, 2019; no shares had been issued under it through May 3. The board subsequently approved $0.14-per-share dividends payable in May and June 2019. REIT-conversion-related professional fees contributed to higher operating expenses.
Investor verification priorities
- Review the accounting transition and consolidation changes before comparing 2019 results with prior periods; distinguish GAAP net income from Core Earnings.
- Assess leverage, repo maturities and haircuts, collateral availability, and potential margin-call or refinancing needs.
- Examine Level 3 valuation assumptions and loan-credit indicators, including $65.2 million unpaid principal of non-performing commercial mortgage loans and geographic concentration in residential mortgages.
- Track REIT qualification, required distributions, and the potential effects of the ATM program and dividends on capital and per-share measures.
- Monitor the SEC inquiry, guarantee exposure, contingent loan-purchase commitments, and affiliate-related transactions.