Ellington Financial LLC — Q3 2016 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2016. The filing identifies the registrant as Ellington Financial LLC. Amounts below are U.S. dollars; financial statement amounts are generally in millions unless stated otherwise.
Business context
Ellington is an externally managed specialty finance company investing primarily in mortgage-related assets and derivatives, alongside consumer loans, CLOs, corporate debt and equity, and other credit assets. It pursues opportunistic, risk-adjusted returns and uses leverage and hedging. Management said credit investments were the principal driver of risk and return and expected this to continue in the near to medium term.
Key financial metrics
| Metric | Q3 2016 / September 30, 2016 | Comparable period / prior date |
|---|---|---|
| Investment income | $17.5 million for Q3; $59.6 million for nine months | $27.0 million and $80.6 million, respectively, in 2015 |
| Net investment income | $6.4 million for Q3; $26.7 million for nine months | $17.5 million and $52.7 million, respectively, in 2015 |
| Net change in shareholders’ equity from operations | $0.5 million for Q3; loss of $17.7 million for nine months; $0.02 and $(0.53) per share | $3.9 million and $36.3 million, respectively, in 2015; $0.12 and $1.07 per share |
| Net interest margin | 3.26% for Q3; 3.59% for nine months | 5.00% and 4.65%, respectively, in 2015 |
| Total assets / total liabilities | $2,651.8 million / $1,987.1 million | $2,991.6 million / $2,252.6 million at December 31, 2015 |
| Equity / diluted book value per share | $664.8 million / $19.83 | $739.0 million equity at December 31, 2015; diluted book value per share was $21.80 |
| Borrowings and leverage | $983.8 million reverse repos plus $30.8 million securitized debt; debt-to-equity 1.53:1 | $1,174.2 million reverse repos and 1.59:1 at December 31, 2015; no securitized debt then |
| Cash and cash equivalents | $179.6 million; restricted cash $5.6 million | $183.9 million and $4.9 million, respectively, at December 31, 2015 |
| Operating cash flow | $163.7 million for nine months; cash declined $4.3 million | $389.3 million operating cash flow; cash increased $25.3 million in 2015 |
| Dividends | $1.50 per share paid for the first nine months; $0.45 per share for Q3 approved after quarter-end | $1.95 per share for the first nine months of 2015 |
Material changes and management commentary
- Q3 investment income fell 35% year over year and net investment income fell to $6.4 million from $17.5 million. Management attributed the decline mainly to a smaller portfolio, lower average yields, and reduced Agency RMBS leverage as capital shifted from securities toward loans.
- Nine-month results swung from $36.3 million of shareholder operating gains in 2015 to a $17.7 million loss in 2016. Management cited lower net investment income and substantially larger losses on financial derivatives, especially credit hedges as high-yield corporate credit rallied.
- During Q3, the company continued selling non-Agency RMBS and reallocating toward consumer, commercial mortgage, and residential mortgage loans. The Credit portfolio excluding derivatives was $516.3 million at quarter-end, down from $570.5 million at June 30.
- In August, Ellington participated in its first widely syndicated consumer-loan securitization, retaining the most subordinated interests. The transaction was accounted for as a sale and provided long-term financing for the securitized pool. It also sold approximately $21 million of non-QM mortgage loans to test the market, and management said fourth-quarter non-QM production was expected to average more than $10 million per month.
- Agency RMBS remained a large, leveraged portfolio. Management reported rising mortgage prepayments, but said specified pools performed relatively well; it continued using short TBA positions and other instruments to manage interest-rate and prepayment exposure.
- Q3 net realized and unrealized investment gains were $7.7 million, while financial derivatives had losses of approximately $14.2 million. For nine months, investment gains of $6.0 million were outweighed by derivative losses of approximately $51.9 million.
Outlook, risks, and contingencies
- Management expected loan portfolios and leverage to grow as loan strategies ramped up, while noting that financing costs for loans generally exceed those for securities. It reported Q3 weighted-average funding cost of 1.26%, down from 1.31% in Q2, but warned that Credit-portfolio funding costs could rise as the asset mix shifts toward loans.
- Management said interest rates could rise and prepayment volatility remained a material risk. Its modeled portfolio sensitivity to a parallel 100-basis-point rate increase was a $6.2 million decline in value; management cautioned that the analysis depends on assumptions and may not predict actual outcomes.
- Liquidity depends substantially on short-term reverse repos: about 74% of reverse-repo borrowings matured within 60 days. A loss of financing availability, falling collateral values, margin calls, or elevated prepayments could pressure liquidity; management said available resources were expected to meet needs but acknowledged asset sales or new debt or equity could be required.
- Credit risks include defaults and loss severities in mortgage and consumer loans; many consumer loans are unsecured or secured by rapidly depreciating collateral. Management also highlighted interest-rate, foreign-currency, counterparty, and fair-value estimation risks. Level 3 assets totaled $476.3 million and rely on significant unobservable inputs.
- Commitments included a $120 million maximum aggregate guarantee of a mortgage originator’s warehouse and repurchase facilities; the borrower under a separate guaranteed repo facility had $164.3 million outstanding and the facility extension ran through November 30, 2016. The company also had consumer- and mortgage-loan purchase commitments. No material legal proceedings were reported, and the filing said there were no material changes to previously disclosed risk factors.
- The Manager had a $17.5 million loss carryforward; no incentive fee was incurred for the reported periods. The company reimbursed the Manager $5.2 million for operating and compensation expenses in the first nine months, versus $2.9 million a year earlier.
Most important facts for investors to verify
- Whether portfolio rotation into consumer and mortgage loans increases recurring income enough to offset lower securities income and higher loan funding and servicing costs.
- How much of the nine-month derivative loss reflects hedge performance versus exposures that may persist, and whether hedge positions remain aligned with the underlying portfolio.
- Reverse-repo renewal terms, collateral haircuts, counterparty concentrations, and the company’s capacity to meet margin calls and near-term maturities.
- Credit performance, valuation assumptions, and related-party exposures in loans, securitizations, mortgage originators, and Level 3 assets.
- Whether the $0.45 quarterly dividend is sustainable relative to recurring earnings, cash needs, and book-value trends; the filing reports nine-month operating losses and a decline in diluted book value per share.