Ellington Financial LLC — 2017 Form 10-K Summary
Business context and reporting period
This annual report covers the year ended December 31, 2017; it is not a standalone fourth-quarter filing. Ellington Financial is an externally managed specialty finance company investing in mortgage-related, consumer, corporate-credit and other financial assets. Its Credit portfolio, which excludes Agency RMBS, was the primary driver of risk and return. All amounts below are U.S. dollars.
Financial performance and position
- Investment income: $94.0 million in 2017, up from $80.2 million in 2016. Interest income was $89.6 million versus $74.3 million.
- Net investment income: $35.2 million, slightly below $35.8 million in 2016, as higher interest and other expenses offset increased investment income.
- Profit: Net increase in equity from operations was $36.0 million, compared with a $15.7 million decrease in 2016. After non-controlling interests, the increase attributable to shareholders was $34.0 million, or $1.04 per share, versus a $16.0 million loss, or $0.48 per share, in 2016. Net realized and unrealized gains across investments, derivatives and foreign currency were $0.8 million, compared with a $51.5 million loss in 2016.
- Margins and returns: Net interest margin was 3.56%, compared with 3.59% in 2016. Net-asset-value-based total return was 6.14% (6.16% on a diluted basis, per management), versus negative 1.83% in 2016.
- Portfolio: Long Credit assets grew 85.7% to $1.025 billion; long Agency RMBS increased 5.4% to $871.8 million. Total investments at fair value were $2.072 billion, versus $1.505 billion.
- Equity and book value: Shareholders’ equity was $600.1 million, down from $637.7 million. Book value was $19.15 per common share, or $18.85 diluted, versus $19.75 and $19.46, respectively.
- Debt and liquidity: Total borrowings were approximately $1.478 billion, and debt-to-equity was 2.38:1, up from 1.64:1. Cash and cash equivalents fell to $47.2 million from $123.3 million. Operating activities used $462.7 million of cash; cash decreased $76.0 million overall.
- Funding costs: Average cost of secured funds rose to 1.83% from 1.23%, while interest expense increased to $31.1 million from $16.3 million. The company issued $86.0 million of unsecured 5.25% Senior Notes due 2022; effective interest cost, including issuance costs, was 5.55%.
- Dividends: 2017 dividends declared were $1.76 per share, down from $1.95 in 2016. The fourth-quarter dividend was $0.41 per share, compared with $0.45 for the 2016 fourth quarter.
Material changes versus 2016
- Results returned to profit, principally because derivative losses were substantially lower and investment gains improved. Credit-hedging losses remained a drag, but were much smaller than in 2016.
- The Credit portfolio expanded substantially, including growth in CLOs, residential and commercial mortgage loans, non-Agency RMBS and consumer assets. Management said Credit performance was led by non-performing residential loans, small-balance commercial loans, CMBS and secondary CLOs.
- Interest expense and secured borrowing costs rose as LIBOR increased, borrowing levels grew, and a larger share of financing supported higher-cost Credit and loan assets.
- Leverage increased while cash declined. Management attributed the cash reduction in part to fourth-quarter purchases of more liquid, lower-risk assets and portfolio financing activity.
- Net interest income, rather than trading or unrealized gains, represented most Credit portfolio income. Management identified growth in recurring Credit interest income, particularly from loans, as important to a steadier earnings stream.
Outlook, risks and unusual items
- Outlook: No specific earnings, return or dividend guidance is provided. Management described a flexible, opportunistic strategy and expected the Credit portfolio to remain a primary risk-and-return driver. The filing noted Federal Reserve rate increases and balance-sheet runoff, a flattening yield curve and market expectations of further rate hikes in 2018.
- Market and financing risks: Rising rates can reduce asset values and increase borrowing costs. Short-term reverse repos expose the company to refinancing, collateral and margin-call risk; most year-end reverse-repo borrowings matured within one year. A forced asset sale could crystallize losses and impair liquidity.
- Credit, valuation and hedging risks: Non-Agency securities, loans, consumer assets and subordinated investments carry default and loss-severity exposure. Some assets are Level 3 and valued using estimates and unobservable inputs; actual sale values may differ. Hedges can be costly, imperfect or counterparty-dependent. Management’s modeled parallel 100-basis-point rate increase showed an estimated $10.0 million portfolio-value decline, subject to significant assumptions.
- Regulatory and tax risks: The company must maintain exclusions from Investment Company Act registration and partnership tax treatment, which constrain investment choices. Following the Tax Cuts and Jobs Act, management was evaluating possible changes to its tax structure or investment strategy.
- Related parties and management: Ellington externally manages the company and manages overlapping accounts; asset allocation and related-party transactions may create conflicts. The base management fee is 1.50% of equity; no incentive fee was incurred in 2017 or 2016. In March 2018, the management agreement was amended to permit independent directors to waive specified fee reductions.
- Contingency: The company received an SEC subpoena in January 2017 concerning a loan originator and related loans, analysis, purchases, securitizations and servicing. It said it had responded and would cooperate; it reported no material legal proceeding then pending, but could not assure that inquiries would not lead to further investigation or proceedings.
- Subsequent events: The board approved the $0.41 fourth-quarter 2017 dividend and a new authorization to repurchase up to 1.55 million shares. Through March 9, 2018, the company reported repurchasing 790,648 shares in 2018. The filing also noted a subsequent appellate ruling overturning CLO risk-retention requirements, which management believed could improve liquidity if not successfully challenged.
Important facts for investors to verify
- Whether the Credit portfolio’s growth and loan income can sustain earnings as financing costs and leverage rise.
- Cash-buffer adequacy, near-term reverse-repo maturities, collateral haircuts, counterparty concentration and sensitivity to margin calls.
- The quality and realizability of Level 3 asset valuations, including assumptions for defaults, recoveries, prepayments and loan resolution times.
- Progress and any outcome of the SEC inquiry, and any related disclosures or contingencies.
- Management’s decisions following the tax-law changes, and the company’s continued ability to meet partnership-tax and Investment Company Act requirements.
- The sustainability of the dividend relative to earnings, liquidity needs, leverage and the board’s discretionary repurchase activity.