Ellington Financial LLC — Q3 2012 Form 10-Q
Reporting period: Three and nine months ended September 30, 2012. The filing identifies the registrant as Ellington Financial LLC. It is an externally managed specialty finance company investing primarily in mortgage-related assets and derivatives.
Financial results and position
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Interest income | $15.4m | $15.6m | $47.2m | $48.1m |
| Net investment income | $0.7m | $11.0m | $20.5m | $33.6m |
| Net realized and unrealized gains (losses), investments and derivatives | $28.8m | $(12.1)m | $51.8m | $(25.0)m |
| Increase (decrease) in equity from operations | $29.5m | $(1.2)m | $72.4m | $8.6m |
| Operations per share | $1.59 | $(0.07) | $4.15 | $0.51 |
- Q3 gains reflected improving valuations in Agency and non-Agency mortgage-backed securities (MBS); net investment income fell sharply, principally because of a $9.5m incentive fee. Nine-month incentive fees were $11.8m, versus $0.6m in 2011.
- At September 30, total assets were $1.865bn, liabilities $1.366bn, and shareholders’ equity $498.7m, compared with $1.968bn, $1.597bn, and $370.9m at December 31, 2011. Book value per share was $24.34, up from $22.55.
- Cash and cash equivalents were $69.2m, versus $62.7m at year-end. Nine-month operating cash flow was $185.3m; financing cash outflow was $178.8m, including $235.3m net repayment of reverse repos, offset in part by $88.1m net share issuance. Cash increased $6.5m.
- Reverse-repurchase borrowings were $660.9m, down from $896.2m at year-end; securitized debt was $1.4m. Management reported debt-to-equity of 1.33:1, excluding liabilities other than debt financing. Reverse-repo rates averaged 1.07% at quarter-end; average borrowing cost for the quarter was 1.01%, versus 0.71% a year earlier.
- Long investments at fair value were $1.166bn, including $616.3m Agency RMBS and $508.4m non-Agency MBS, CMBS, and commercial mortgage loans. The net Agency RMBS position, after short TBAs, was $210.7m, down from $317.6m at year-end. Non-Agency MBS and commercial mortgage holdings rose to $511.8m from $438.0m.
- Level 3 assets totaled $547.1m, largely private-label mortgage securities and asset-backed credit derivatives, and depend on significant unobservable assumptions. The filing states that valuation estimates could differ materially from realizable market values.
Material changes and distributions
- The company issued 4.025m common shares in August and September, generating about $87.8m net proceeds. Shares outstanding rose to 20.48m from 16.45m at year-end; the filing reports a dilutive per-share effect from the issuance.
- Non-Agency MBS fair value increased to $454.5m from $410.1m at year-end; CMBS and commercial mortgage loans increased to $53.8m from $20.5m. Management said it rotated out of some fully valued 2006/2007 subprime assets and into securities it viewed as better relative value.
- Dividends of $0.70 per share were paid for each of the first three quarters of 2012. On November 2, the board approved another $0.70 dividend, payable December 17 to holders of record November 30. The board retains discretion over future dividends.
- Book-value total return after incentive fees was 4.25% for Q3 and 16.31% for the first nine months; market-based total return was 11.30% and 44.75%, respectively.
Outlook, risks, and unusual items
- No specific earnings or return guidance was provided. Management expected most proceeds from the share offering, when deployed, to support the non-Agency MBS strategy, and expected to continue opportunistic allocation to CMBS and commercial mortgage loans.
- Management remained generally optimistic about longer-term non-Agency MBS prospects but highlighted higher valuations, the need for selective security analysis, and possible distressed selling by European investors. It intended to continue adjusting credit and interest-rate hedges as conditions changed.
- Federal Reserve QE3, announced September 13, called for $40bn monthly Agency RMBS purchases and an exceptionally low federal funds rate at least through mid-2015. Management noted that lower rates could increase refinancing and prepayments, reducing yields on Agency holdings; short TBA positions were used to hedge prepayment and interest-rate exposure.
- Key risks include mortgage defaults and loss severity, foreclosure delays, prepayments, fair-value model uncertainty, interest-rate and credit exposure, leverage and margin calls, short-term repo renewal and counterparty concentration. About 64% of reverse repos were with three counterparties; 21% matured within 30 days and 79% within 90 days.
- Management said financing remained available and liquidity was sufficient for anticipated needs, but warned that inability to refinance Agency holdings or sharp collateral-value declines could create serious liquidity pressure and force asset sales. Housing recovery, fiscal-cliff uncertainty, GSE changes, eminent-domain proposals, and the European debt crisis were additional market concerns.
- A small January resecuritization provided approximately $1.5m of long-term financing. The company reported no material legal proceedings and no material change in previously disclosed risk factors. Management reported disclosure controls effective as of September 30, 2012.
Important facts for investors to verify
- Whether reported MBS marks and Level 3 valuations remain supportable under updated prepayment, default, loss, recovery, and home-price assumptions.
- Repo renewal terms, collateral haircuts, margin-call exposure, counterparty concentration, and liquidity available if financing markets tighten.
- How the share issuance proceeds are deployed and whether portfolio returns exceed dilution, management fees, incentive fees, and funding costs.
- The sustainability of the $0.70 quarterly dividend relative to recurring investment income, realized gains, and cash requirements.
- Whether QE3-driven refinancing, housing conditions, or policy changes alter asset yields, credit losses, and hedge effectiveness.