Ellington Financial Inc. quarterly report, Q3 FY2014

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Business context and reporting period

Ellington Financial LLC is an externally managed specialty finance company investing primarily in mortgage-related assets and derivatives, with additional exposure to asset-backed securities, loans, real estate, and corporate investments. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2014; balance-sheet comparisons are to December 31, 2013. Amounts below are in U.S. dollars.

Financial performance and position

  • Quarter: Interest income was $22.5 million, down from $24.1 million a year earlier. Net investment income was $12.6 million, versus $14.4 million. Net realized and unrealized gains were $0.5 million, compared with a $2.6 million loss; net increase in shareholders’ equity from operations was $12.9 million, or $0.46 per share, versus $11.7 million, or $0.45 per share.
  • Nine months: Interest income was $65.0 million, versus $62.8 million; net investment income was $39.7 million, versus $37.1 million. Net realized and unrealized gains were $17.5 million, versus $27.1 million. Net increase in shareholders’ equity from operations was $56.5 million, or $2.13 per share, versus $63.7 million, or $2.73 per share.
  • Margins and costs: Net interest margin, including periodic interest-rate swap payments but excluding other hedging costs, was 4.35% for the quarter and 4.34% year to date, compared with 4.22% and 4.29%, respectively, in 2013. Total expenses were $9.9 million for the quarter and $25.3 million year to date. Nine-month incentive fees fell to $1.4 million from $5.3 million; other investment-related expenses rose to $2.8 million from $0.4 million.
  • Assets, debt, and liquidity: At September 30, total assets were $4.075 billion, liabilities $3.262 billion, and equity $812.1 million. Cash and cash equivalents were $129.1 million, down from $183.5 million at year-end. Reverse-repurchase borrowings were $1.395 billion, up from $1.236 billion; reported debt-to-equity was 1.72:1, versus 1.98:1 at year-end, or 1.44:1 excluding Treasury-related borrowings. Most reverse repos had remaining maturities of 90 days or less.
  • Cash flow and shareholder returns: Operating activities used $341.7 million during the nine months, while financing activities provided $287.3 million; cash declined by $54.4 million. The filing attributes operating cash use largely to investment trading and portfolio activity. Dividends declared for the first three quarters totaled $2.31 per share, versus $3.06 in the prior-year period. The board subsequently approved a $0.77-per-share third-quarter dividend, payable December 15, 2014.
  • Per-share and capital: Period-end equity per common share was $24.08; diluted book value per share, including the effect of outstanding LTIP and OP units, was $23.79. The company issued 8 million shares in September, raising $188.2 million net. Period-end common shares outstanding were 33.44 million, compared with 25.43 million at year-end.

Material changes versus comparable periods

  • Quarterly operating earnings per share improved slightly, primarily because investment and derivative results shifted from a loss to a gain; quarterly net investment income declined.
  • Nine-month operating earnings per share and net increase in equity from operations declined, mainly because realized and unrealized investment and derivative gains were lower than in 2013, despite higher net investment income.
  • The portfolio and balance sheet expanded substantially from year-end, supported in part by the September share offering. Long investments at fair value were $2.441 billion versus $1.730 billion at year-end; reverse repos and short positions also increased.
  • The company increased diversification into CMBS, European assets, CLOs, consumer-backed assets, and private investments. Non-Agency RMBS remained the majority of the non-Agency portfolio.

Outlook, risks, and unusual items

  • Management expected to complete deployment of the September offering proceeds during the fourth quarter and anticipated continued diversification, while stating that non-Agency RMBS would likely remain most of the non-Agency portfolio in the near to medium term. No earnings or return guidance was provided.
  • Management described non-Agency markets as supported by housing fundamentals and investor demand, but cautioned that these markets could be vulnerable to an unexpected rise in long-term rates, fund outflows, and reduced dealer capacity. It reported a more cautious positioning entering the fourth quarter.
  • Interest-rate, prepayment, credit, currency, financing, and counterparty risks are material. Reverse repos are short-term and subject to collateral margin calls; 43.7% of borrowings were due within 30 days. The company reported $129.1 million in cash and $332.2 million of unencumbered investments on a settlement-date basis.
  • A new $150 million non-mark-to-market reverse-repo facility for certain non-Agency assets was entered into in September; $58.4 million was drawn at quarter-end. The facility limits additional collateral calls from market-value changes, subject to principal paydowns reducing the borrowing.
  • Fair value estimates involve significant judgment: $758.3 million of investments and $12.8 million of derivative assets were Level 3 at quarter-end. Management noted that actual values could differ materially from estimates. The company also reported $10.6 million of non-performing commercial loans.
  • Management stated that it believed liquidity resources would meet anticipated needs, but warned that loss of Agency financing or sharp collateral declines could create liquidity strain. No material legal proceedings or material changes to previously disclosed risk factors were reported; regulatory inquiries involving the manager or affiliates remain a potential concern.

Important facts for investors to verify

  1. Reconcile the reported $24.08 period-end equity per share with $23.79 diluted book value per share, and assess dilution from the 8-million-share offering and outstanding LTIP/OP units.
  2. Review reverse-repo maturity concentrations, collateral requirements, counterparty exposure, and the terms and utilization of the new $150 million facility.
  3. Assess the sensitivity of Level 3 valuations to prepayment, default, recovery, yield, and resolution assumptions, particularly for private-label mortgage assets and loans.
  4. Compare dividend payments with recurring net investment income and consider the board’s discretion over future dividends.
  5. Evaluate whether interest-rate and credit hedges adequately offset portfolio risks, including the potential for hedge results to differ from underlying asset performance.