Ellington Financial LLC — Q2 2016 Form 10-Q
Business context and reporting period
Unaudited quarterly report for the three and six months ended June 30, 2016; balance-sheet comparisons are to December 31, 2015. Ellington is an externally managed specialty finance company investing primarily in mortgage assets and derivatives, alongside consumer loans, CLOs, corporate debt and equity, and other credit assets. It seeks risk-adjusted total returns through an opportunistic, actively managed strategy. All dollar amounts below are U.S. dollars.
Financial performance and position
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Investment income | $20.0m | $26.8m | $42.1m | $53.6m |
| Net investment income | $8.5m | $17.7m | $20.3m | $35.2m |
| Net change in equity from operations | $5.0m | $13.2m | $(18.2)m | $32.6m |
| Per-share result from operations | $0.15 | $0.39 | $(0.54) | $0.96 |
- Quarterly drivers: Q2 net realized and unrealized losses were $3.5m, versus $4.5m of losses a year earlier. Investment gains were offset by losses on derivatives and foreign currency. Management attributed lower net investment income mainly to a smaller average portfolio and lower Credit portfolio yields.
- Six-month drivers: Net realized and unrealized losses were $38.5m, versus $2.6m of losses in the first half of 2015. Derivative losses were $37.7m, principally from high-yield corporate credit index CDS, interest-rate swaps, and total return swaps. Investment losses were $1.8m.
- Margins and costs: Q2 net interest margin, including periodic interest-rate-swap payments, was 3.57%, versus 4.70% in Q2 2015. Q2 average cost of funds was 1.31% (1.50% including specified swap payments), versus 0.75% (0.82% including swaps). Total expenses rose to $11.5m from $9.0m in Q2; higher interest and investment-related expenses contributed.
- Cash flow: First-half operating activities provided $89.3m, compared with $363.2m in 2015. Cash decreased $43.6m to $140.4m; restricted cash was $3.9m. Financing activities used $132.8m. Dividends paid were $33.6m and share repurchases were $6.6m.
- Balance sheet and leverage: At June 30, total assets were $2.753bn, total liabilities $2.074bn, and equity $679.2m. Cash was $140.4m. Reverse-repo borrowings were $1.070bn and securitized debt was $13.0m; debt-to-equity was 1.59:1. Reverse-repo weighted-average borrowing rate was 1.18%, up from 0.97% at year-end, with a weighted-average remaining term of 78 days.
- Equity and returns: Book value per common share was $20.58, versus $22.10 at year-end; diluted book value was $20.31, versus $21.80. NAV-based total return was 0.82% for Q2 and negative 2.38% for the first half, assuming dividend reinvestment. Market-based total return for the first half was 8.00%.
Material changes versus comparable periods
- First-half results reversed from a $32.4m increase in shareholders’ equity from operations in 2015 to an $18.2m decrease in 2016, driven mainly by substantially greater derivative losses and lower net investment income.
- Investment income declined as average portfolio holdings fell and the company reduced securities exposure while reallocating capital toward loans. Agency RMBS holdings and leverage were also lower than in the prior-year period.
- The portfolio continued shifting toward loans: management reported growth in consumer and non-QM residential loans, while reducing non-Agency RMBS and distressed-debt positions. Long Agency RMBS were reported at $849.7m and the long Credit portfolio at $570.5m at quarter-end.
- In March 2016, the company entered a commercial-loan and real-estate securitization financing transaction. First-half dividends were $1.00 per share, versus $1.30 in 2015; 382,656 shares were repurchased in the first half at an average $17.31 per share.
Outlook, commentary, risks and unusual items
- Management expects near- to medium-term portfolio growth to come largely from existing consumer-loan partnerships, and expects non-QM mortgage investments to grow meaningfully over the medium to longer term. It said consumer-loan performance was in line with expectations and growth exceeded expectations. The filing provides no numerical earnings or return guidance.
- Management described Brexit-related volatility in June, sharply lower Treasury yields, and generally tighter spreads for many credit assets by quarter-end, while CMBS spreads ended wider. It cited ongoing risks from potential spread widening and rising interest rates and intends to continue using credit and interest-rate hedges.
- Principal risks include credit defaults and loss severity, mortgage prepayments, interest-rate and market volatility, foreign-currency movements, and the availability and cost of financing. Repo maturities, margin calls, and reduced collateral values could create liquidity pressure; management noted that inability to finance Agency RMBS could require significant asset sales. The portfolio is highly leveraged and repo funding is predominantly short term.
- Valuations involve management estimates and, for some assets, significant unobservable inputs. Level 3 assets were $512.1m at quarter-end; changes in assumptions about yields, defaults, recoveries, and prepayments could materially affect fair values.
- Commitments and contingencies include consumer-loan purchase agreements, a $12.5m maximum guarantee of a mortgage-originator warehouse facility, and a guarantee and participation in a separate repo facility used by a borrower with approximately $196.6m outstanding. The company said it was considering renewal of that participation and guarantee. No material legal proceedings were reported; the filing notes regulatory inquiries involving Ellington and affiliates may lead to further investigation.
- The Board approved a $0.50-per-share second-quarter dividend on August 1, payable September 15, 2016. The company reported no incentive-fee expense for the periods presented because income did not exceed the management-agreement hurdle.
Most important facts for investors to verify
- Whether loan-portfolio growth and the shift away from securities improve recurring investment income enough to offset higher funding and servicing costs.
- The sources, duration, and potential collateral or liquidity impact of derivative losses; assess the company’s hedge effectiveness under different rate and credit-spread scenarios.
- Repo maturity, rollover, counterparty concentration, haircuts, and margin-call exposure, including the implications of a 1.59:1 debt-to-equity ratio.
- Fair-value sensitivity of Level 3 assets and the basis for key credit, prepayment, recovery, and resolution assumptions.
- Capacity to sustain dividends and share repurchases given first-half operating losses, declining book value, and financing needs; confirm subsequent dividend payment and any subsequent-event updates.
- Potential obligations under loan-purchase commitments and guarantees, including the repo facility and mortgage-originator arrangements.