Ellington Financial LLC — Q3 2017 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2017. The filing identifies the registrant as Ellington Financial LLC; the company is an externally managed specialty finance business investing mainly in mortgage- and consumer-related assets, alongside CLOs, corporate credit, derivatives, and real estate.
Financial performance and position
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Total investment income | $22.4 million | $17.5 million | $68.9 million | $59.6 million |
| Net investment income | $7.9 million | $6.4 million | $28.1 million | $26.7 million |
| Net increase in shareholders’ equity from operations | $6.2 million; $0.19/share | $0.5 million; $0.02/share | $26.5 million; $0.81/share | $(17.7) million; $(0.53)/share |
| Dividends declared per share | $0.45 | $0.50 | $1.35 | $1.50 |
Q3 net interest margin, including periodic interest-swap payments, was 3.21%, versus 3.26% a year earlier; the nine-month margin was 3.70%, versus 3.59%. Interest expense rose to $8.2 million for the quarter and $21.8 million year to date, primarily reflecting higher LIBOR-linked financing costs, increased short-sale expense, and the new senior notes.
At September 30, total assets were $2.73 billion, liabilities $2.10 billion, and equity $629.7 million, compared with $2.41 billion, $1.77 billion, and $644.8 million, respectively, at year-end 2016. Reported book value per common share was $19.24, down from $19.75. Cash and cash equivalents were $111.4 million, down from $123.3 million.
Borrowings comprised $1.03 billion of reverse repos, $89.6 million of other secured borrowings, and $86.0 million par value of unsecured senior notes. Debt-to-equity was 1.91:1, compared with 1.64:1 at December 31, 2016. The notes carry a 5.25% coupon (5.55% effective rate) and mature in September 2022; the company reported compliance with their covenants.
For the nine months, operating activities used $123.9 million of cash; financing activities provided $112.1 million, and cash declined $11.9 million. These cash flows reflect substantial investment purchases, sales, and financing turnover and should be read alongside the balance sheet and liquidity disclosures.
Material changes versus comparable periods
- Operating results improved: shareholders’ equity from operations was positive in Q3 and for the first nine months, versus a small profit in Q3 2016 and a nine-month loss in 2016. Management attributed the year-to-date improvement chiefly to lower derivative losses, particularly reduced exposure to high-yield credit hedges.
- Net investment income increased, supported by higher interest income and a larger Credit portfolio, but higher financing costs absorbed part of the increase. Nine-month interest expense rose from $11.8 million to $21.8 million.
- The Credit portfolio grew 8.3% quarter over quarter to $741.3 million; long Agency RMBS declined 2.1% to $816.2 million. Management reported profitable Credit performance, with hedges reducing returns in a tightening-spread environment.
- The company issued $86.0 million of senior notes in August 2017 and expanded secured borrowing: other secured borrowings increased from $24.1 million at year-end to $89.6 million.
- Quarterly dividends were reduced to $0.45 per share from $0.50 a year earlier; after quarter-end the board approved a Q3-related dividend of $0.41 per share, payable December 15, 2017.
Outlook, risks, contingencies, and unusual items
- Management said current capital resources and expected credit availability should meet short- and long-term liquidity needs, but disclosed that loss of Agency RMBS financing could cause significant liquidity strain. Reverse repos are short-term, largely LIBOR-linked, and expose the company to refinancing, collateral, and margin-call risk.
- Management described slower-than-expected Credit deployment, although the portfolio grew during the quarter. It favored U.K. non-conforming RMBS relative to U.S. counterparts and reported additions to CLOs, consumer loans, and non-QM mortgage loans.
- Market risks include interest-rate and spread changes, mortgage prepayments, credit defaults and loss severity, foreign-currency movements, and valuation uncertainty. About $541.2 million of investments were classified as Level 3 at quarter-end; fair values depend on models and significant assumptions, including projected yields, prepayments, losses, and recoveries.
- The company received an SEC subpoena in January 2017 concerning a loan originator, related loans, analyses, purchases, securitizations, and servicing. It reported responding and cooperating; management said it knew of no contemplated material proceeding, while warning that further investigation or proceedings could adversely affect the company.
- Related-party exposures warrant attention: consumer loans purchased through an Ellington affiliate had an estimated remaining contingent purchase obligation of approximately $173.5 million in principal balance. Guarantees of mortgage-originator repo obligations had caps of $125 million and $30 million; outstanding guaranteed borrowings were $0.7 million and $8.1 million, respectively, and estimated guarantee fair values were zero.
- Other notable items: $44.3 million of dividends were paid during the nine months; $4.8 million was spent on share repurchases. The company reported no material legal proceedings and no material change in previously disclosed risk factors.
Investor verification priorities
- Confirm the quality and valuation assumptions for Level 3 assets, especially loans, consumer assets, non-Agency securities, and real estate.
- Review near-term reverse-repo maturities, lender concentration, collateral haircuts, margin requirements, and the effect of rising financing costs on net interest margin and liquidity.
- Assess the SEC subpoena and any subsequent developments, including potential implications for related loan originators, securitizations, and servicing.
- Examine related-party transactions, the $173.5 million contingent consumer-loan purchase obligation, originator guarantees, and affiliate-managed CLO investments.
- Evaluate dividend coverage against reported earnings, financing costs, leverage, and cash generation; the filing reports $0.81/share of nine-month operating results and $1.35/share of dividends declared.