Ellington Financial LLC — Q3 2011 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2011; filed November 9, 2011. The registrant is Ellington Financial LLC, a specialty finance company externally managed by Ellington Financial Management. It invests primarily in agency and non-agency mortgage-related assets and derivatives.
Financial performance and position
- Q3: Interest income was $15.6 million, up from $10.9 million a year earlier. Net investment income increased to $11.0 million from $4.3 million, but net realized and unrealized losses of $12.1 million resulted in a $1.2 million operating loss, or $(0.07) per share. The comparable 2010 quarter generated $16.0 million of operating income, or $1.30 per share.
- Nine months: Interest income was $48.1 million versus $33.6 million; net investment income was $33.6 million versus $18.5 million. Net income fell to $8.6 million, or $0.51 per share, from $27.3 million, or $2.21 per share, chiefly as investment results weakened.
- Investment results: Q3 investment and derivative losses were $12.1 million; nine-month losses were $25.0 million. For the nine months, investment losses of $23.8 million were partly offset by derivative losses of only $1.3 million. Falling interest rates hurt interest-rate hedges and short TBA/Treasury positions; credit hedges partly offset non-agency losses.
- Balance sheet at September 30: Assets were $2.408 billion, liabilities $2.032 billion, and shareholders’ equity $376.7 million, down from $403.7 million at December 31, 2010. Book value was $22.84 per share versus $24.47. Cash and equivalents were $41.6 million.
- Leverage and liquidity: Reverse-repurchase borrowings were $884.2 million, and management reported debt-to-equity of 2.35:1, up from 1.93:1 at year-end. About 75.9% of reverse-repo debt financed agency holdings. Nearly half of borrowings matured within 30 days; average remaining maturity was 44 days. Nine-month operating cash flow was negative $64.2 million, while financing activities provided $70.0 million; cash increased $5.8 million.
- Portfolio: Non-agency MBS and commercial mortgage loans were valued at $414.6 million, up from $334.9 million at year-end; agency RMBS excluding TBAs were $833.8 million, down from $851.0 million. Net short TBAs narrowed to $491.8 million from $695.3 million. Level 3 assets included $421.0 million of investments and $59.9 million of derivative assets.
- Distributions and costs: The company paid $0.40 per share for each of Q1 and Q2 and approved a further $0.40 dividend for Q3, payable December 15, 2011. It repurchased 17,500 shares for $0.3 million under a $10 million authorization. The manager’s base fee was 1.50% annually of quarter-end equity; no Q3 incentive fee was incurred. The reported annualized net investment income ratio was 11.46% for Q3; total expense ratio was 4.82%.
Changes, outlook, and risks
- Higher interest income reflected a larger portfolio, capital raised in the October 2010 IPO, and increased leverage. Management increased non-agency exposure as lower prices raised expected yields and anticipated CMBS and commercial mortgage loans would become a larger strategy component.
- Q3 NAV-based total return after incentive fees was negative 0.31%; nine-month return was positive 1.94%. Market-based total return, including reinvested dividends, was negative 16.54% for Q3 and negative 14.99% for nine months.
- Management said its current capital resources and expected financing were sufficient for anticipated needs, but noted that loss of agency financing or sharp asset-value declines could force asset sales, margin postings, or portfolio restructuring. No numerical earnings or return guidance was provided.
- Key exposures include mortgage credit and severity, prepayments, interest rates, illiquid private-label securities, repo refinancing and margin calls, counterparty concentration, and fair-value estimates. The filing warns that Level 3 valuations rely on judgment and models and may differ materially from realizable sale prices.
- Market and policy uncertainties include the U.S. housing market, foreclosure delays, potential effects of expanded HARP refinancing on premium agency holdings, GSE reform, derivatives regulation, and the SEC’s review of the 3(c)(5)(C) Investment Company Act exclusion on which a subsidiary relies. Management reported no legal proceeding it considered material; indemnification exposure was described as unquantifiable but expected to be remote.
Important facts for investors to verify
- Whether non-agency asset marks and Level 3 valuation assumptions reflect prices that could be realized in stressed or illiquid markets.
- Repo renewal availability, near-term maturities, collateral and margin-call requirements, and actual borrowing terms.
- How interest-rate and credit hedges perform against the underlying mortgage portfolio, including the effect of a further rate decline or spread widening.
- Whether the approved dividend is supported by recurring investment income and cash generation, given negative operating cash flow and high leverage.
- Developments in SEC guidance on the 3(c)(5)(C) exclusion, HARP refinancing, and other regulatory changes that could require strategy or portfolio adjustments.