Business context and reporting period
Ellington Financial LLC (the registrant named in the filing) is an externally managed specialty finance company investing across mortgage and consumer credit, CLOs, corporate securities, real estate-related assets, and derivatives. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2018. The company reports investments at fair value; results can be affected by market movements and model-based estimates.
Financial results and position
Amounts below are in U.S. dollars; financial statement amounts are in millions except per-share data.
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Total investment income | $33.0 | $22.7 | $61.8 | $46.5 |
| Net investment income | $11.0 | $8.4 | $21.2 | $20.2 |
| Net increase in shareholders’ equity from operations | $21.2 | $5.1 | $42.2 | $20.3 |
| Basic and diluted earnings per share | $0.69 | $0.16 | $1.36 | $0.62 |
| Declared dividends per share | $0.41 | $0.45 | $0.82 | $0.90 |
- Q2 interest income was $31.9 million, up from $21.8 million; higher portfolio balances drove the increase. Q2 interest expense rose to $13.4 million from $7.6 million, reflecting increased borrowing, higher LIBOR-linked financing costs, and Senior Notes expense.
- Net interest margin, as defined by the company and including specified interest-rate swap effects, was 3.13% in Q2 2018 versus 3.57% in Q2 2017; for the first half it was 3.10% versus 3.99%.
- At June 30, total assets were $3.672 billion, total liabilities $3.059 billion, and total equity $613.3 million, compared with $2.993 billion, $2.372 billion, and $621.0 million, respectively, at December 31, 2017. Common-share equity per share was $19.89 versus $19.15; diluted book value per share was $19.57 versus $18.85.
- Cash and cash equivalents were $22.1 million, with restricted cash of $0.4 million, versus cash and restricted cash totaling $47.7 million at year-end. Six-month operating cash flow was negative $223.7 million; financing activities provided $198.5 million, and cash, cash equivalents, and restricted cash fell by $25.2 million to $22.5 million.
- Total borrowings were approximately $1.704 billion, including $1.422 billion of reverse repos, $197.9 million of other secured borrowings and $86.0 million of Senior Notes at par. The company’s debt-to-equity ratio including recourse and non-recourse borrowings was 2.78:1, versus 2.38:1 at year-end. Senior Notes carry a 5.25% coupon and mature in September 2022; the company reported covenant compliance.
- Investment holdings at fair value grew to $2.625 billion from $2.072 billion at year-end. Long Credit investments were $1.224 billion at quarter-end, up approximately 7% from March 31; long Agency RMBS were $948.5 million, up approximately 2%. Derivative assets exceeded derivative liabilities by $5.0 million at quarter-end.
Material changes versus comparable periods
- Q2 operating results rose to $21.2 million for shareholders from $5.1 million a year earlier. Management attributed the improvement mainly to a reversal from derivative losses to gains, higher investment gains, and increased net investment income. First-half shareholder operating results more than doubled to $42.2 million from $20.3 million.
- Higher interest income reflected portfolio growth, particularly in Credit assets; however, the filing notes lower Credit asset yields and higher financing expense. First-half net investment income increased only modestly despite higher investment income.
- Credit assets expanded, including consumer loans and ABS and residential mortgage loans. Management said capital was rotated from some more liquid, lower-risk investments toward higher-yielding strategies. Borrowings and the debt-to-equity ratio also increased.
- Equity declined by $7.7 million from December 31 despite $43.5 million of total operating gains, principally due to dividends, joint-venture distributions, and $17.6 million of share repurchases. The company repurchased 1.186 million shares in the first half at an average $14.83 per share.
- Interest expense increased materially year over year, and the first-half expense ratio for interest and other investment-related expenses rose to 10.39% of average equity from 5.37%.
Outlook, management commentary, risks and unusual items
- Management reported that Credit portfolio performance was strong in Q2, with contributions from consumer loans, small-balance commercial mortgage loans, European non-performing loans, non-QM loans, CLOs, CMBS, and other strategies. Credit hedges modestly reduced quarterly profitability; interest-rate hedges in the Credit strategy had no material impact.
- Management said it was optimistic about completing a second non-QM securitization later in 2018, subject to market conditions. No earnings or return guidance was provided. The Board approved a $0.41-per-share Q2 dividend on August 1, payable September 17, 2018.
- Market backdrop included a Federal Reserve rate increase, higher LIBOR, a flatter yield curve, higher mortgage rates, and muted Agency RMBS prepayments. Management cited interest-rate, credit-spread, prepayment, default, recovery, foreign-exchange, and financing risks. Reverse repos are generally short-term and expose the company to refinancing, collateral haircuts, and margin calls; a loss of Agency RMBS financing could create serious liquidity strain.
- Fair-value estimates rely partly on unobservable Level 3 inputs; Level 3 investments totaled $813.9 million at June 30. Management cautioned that actual values could differ materially from estimates. The portfolio also has exposures to lower-rated or unrated assets, including investments where ratings may lag credit deterioration.
- Related-party activity includes loan purchases through an affiliate, affiliate-managed CLOs and securitizations, and related-party investments. Estimated remaining contingent consumer-loan purchase obligations were approximately $111.6 million in principal balance. Guarantees of a mortgage originator’s third-party repo borrowings were capped at $30 million, with $16.3 million outstanding under the guaranteed arrangements; their estimated fair value was zero.
- The company disclosed an SEC subpoena received in January 2017 concerning a loan originator and related loans, analyses, purchases, securitizations, and servicing. It said it had responded and intended to cooperate; no material proceeding was then known to be contemplated, but an adverse outcome could not be ruled out. The company reported no other material legal proceedings and no material change to previously disclosed risk factors.
- The company is evaluating potential actions following the 2017 Tax Cuts and Jobs Act, including possible changes to its publicly traded partnership structure. It also began a $150 million at-the-market share offering authorization but had issued no shares under it as of June 30.
Important facts for investors to verify
- Whether portfolio returns and net interest income can withstand further increases in LIBOR and secured funding costs, given rising leverage and declining net interest margin.
- Near-term reverse-repo maturities, counterparties, collateral haircuts, margin requirements, and the availability and terms of refinancing.
- The quality and valuation sensitivity of Level 3 assets, including loan default, prepayment, loss-severity, recovery, and resolution-time assumptions.
- Progress and economics of the proposed second non-QM securitization, and the performance of the existing securitized loans and related borrowing.
- Coverage and sustainability of the quarterly dividend relative to investment income, borrowing costs, and realized and unrealized results.
- Developments in the SEC inquiry, the related-party purchase commitments and guarantees, and any changes to the company’s tax or partnership structure.