Ellington Financial LLC — 2014 Form 10-K Summary
Business and period: The registrant is Ellington Financial LLC, an externally managed specialty finance company investing primarily in mortgage-related assets, including Agency and non-Agency RMBS, alongside commercial and residential loans, CMBS, CLOs, consumer assets and distressed corporate debt. This annual report covers the year ended December 31, 2014; audited comparisons are provided for 2013 and 2012. The filing also reports fourth-quarter 2014 results. Amounts below are in U.S. dollars.
Financial performance and position
| Metric | 2014 | 2013 |
|---|---|---|
| Investment income | $93.9 million | $85.7 million |
| Net investment income | $58.8 million | $49.7 million |
| Net increase in shareholders’ equity from operations | $59.2 million; $2.09 per share | $78.5 million; $3.28 per share |
| Net realized and unrealized gains on investments, derivatives and currency | $1.2 million | $29.7 million |
| Net interest margin | 4.57% | 4.19% |
| Net asset value per share | $23.38 | $24.40 |
| Cash and cash equivalents at year end | $114.1 million | $183.5 million |
| Total assets / total liabilities | $3.945 billion / $3.157 billion | $2.975 billion / $2.349 billion |
| Reverse repos and securitized debt at year end | $1.670 billion | $1.237 billion |
- Interest income rose about 9% year over year, supported by larger average holdings and improved yields in parts of the non-Agency portfolio. Portfolio yield was 5.61% in both years; non-Agency yield was 9.31% versus 8.88%, while Agency yield was 3.31% versus 3.40%.
- Net income declined as lower investment gains and larger derivative losses more than offset higher net investment income. Investment gains were $23.1 million versus $37.7 million; derivative losses were $19.5 million versus $8.0 million.
- Average cost of funds, including interest-rate swap payments, was 1.04% versus 1.42%. Reported net interest margin excludes costs of some other hedges, including TBAs and futures.
- Operating activities used $604.2 million of cash, while net reverse-repo financing provided $433.3 million. After equity proceeds, dividends and other financing flows, cash declined $69.3 million during the year.
- Year-end debt-to-equity was 2.12-to-1, or 1.96-to-1 excluding $123.6 million of U.S. Treasury borrowings. These ratios do not include liabilities other than debt financings.
- For 2014, the filing reports NAV-based total return of 8.77% and market-price total return of 0.15%, both assuming reinvestment of distributions. Diluted book value per share was $23.09.
Fourth quarter
For the quarter ended December 31, 2014, net investment income was $19.1 million and net income attributable to shareholders was $2.6 million, or $0.08 per share. Net realized and unrealized losses on investments, derivatives and foreign currency totaled $16.3 million for the quarter. The board approved a $0.65-per-share fourth-quarter distribution, payable in March 2015. The quarterly figures are unaudited.
Material changes versus prior year
- Total assets increased to $3.945 billion from $2.975 billion, and total equity rose to $788.5 million from $626.0 million. A September 2014 follow-on offering generated $188.2 million net proceeds, which the company said were fully deployed by year end.
- Agency RMBS fair value increased to $1.186 billion from $893.0 million; reverse-repo borrowings rose to $1.669 billion from $1.236 billion. The net short TBA position increased to $1.137 billion from $715.1 million.
- The company expanded its diversification: year-end holdings included $122.0 million of CLOs, $64.6 million of European non-dollar assets, $24.3 million of consumer loans and related ABS, and $37.2 million of distressed corporate debt. It also made initial investments in mortgage originators.
- Net income per share fell to $2.09 from $3.28, and NAV per share declined to $23.38 from $24.40. Distributions reported for 2014 were $0.77 per share for each of the first three quarters and $0.65 for the fourth quarter, versus $0.77 in each 2013 quarter.
Outlook, risks and unusual items
- Outlook: Management expected non-Agency RMBS to remain the principal driver of portfolio risk and return in the near to medium term, while continuing diversification into other assets. The filing provides no formal earnings or return guidance.
- Management cited improving housing-credit indicators and lower foreclosure inventory, but noted that home-price appreciation had slowed and market volatility increased late in 2014. The Federal Reserve ended its asset-purchase program in October 2014; management considered the future direction of interest rates uncertain. Lower rates and policy changes could also increase mortgage prepayments.
- Liquidity and financing: Most financing was through short-term reverse repos, which are subject to renewal, collateral haircuts and margin calls. About 42.8% of year-end reverse repos matured within 30 days. A $150 million non-mark-to-market facility for certain non-Agency assets was substantially utilized at year end. Management believed resources were adequate, but warned that loss of financing or sharp collateral declines could force asset sales.
- Key risks: Leverage, repo refinancing and counterparty exposure; interest-rate, spread, prepayment, credit and foreign-currency risks; illiquidity and model-dependent fair values; exposure to subordinated or distressed assets; and reliance on third-party servicers. The company also depends on its external manager, faces related-party conflicts, and must maintain its partnership tax treatment and Investment Company Act exclusions.
- Commitments and contingencies: The company had agreed to purchase eligible consumer loans, subject to a $70 million maximum amount held at any time; $11.8 million had been purchased by year end. It also could provide up to $4.0 million of additional subordinated debt to a mortgage originator if conditions were met and the borrower requested it. The filing reported no material legal proceedings and no liability recorded for its general indemnification arrangements.
- Fair-value estimates for less liquid investments rely in part on unobservable inputs and management judgment. The company transferred $284.7 million of non-Agency RMBS from Level 3 to Level 2 during 2014, citing greater market activity and price transparency.
- PwC issued an unqualified opinion on the financial statements and concluded internal control over financial reporting was effective as of December 31, 2014.
Most important facts for investors to verify
- Whether recurring net investment income and the 4.57% reported net interest margin can sustain distributions after accounting for all hedging and financing costs.
- The sensitivity of earnings, NAV and liquidity to higher rates, faster prepayments, credit deterioration, wider spreads and repo margin calls.
- The quality, valuation inputs and concentration of Level 3 assets, including loans, structured credit and distressed corporate debt.
- The maturity, renewal terms and counterparty concentration of repo financing, including capacity and terms under the non-mark-to-market facility.
- Whether diversification beyond non-Agency RMBS produces durable returns without materially increasing credit, liquidity or operational risk.
- The sustainability of distributions: the 2014 fourth-quarter per-share distribution was reduced to $0.65 from $0.77 in each of the prior three quarters, and distributions remain at the board’s discretion.
- Any developments affecting the company’s partnership tax status, Investment Company Act exclusions, manager relationship or disclosed contingent commitments.