Ellington Financial LLC — Q2 2013 Form 10-Q Summary
Business context and reporting period
The unaudited filing covers the quarter and six months ended June 30, 2013. Ellington is an externally managed specialty finance company investing primarily in mortgage-related securities and derivatives. Its strategy includes agency and non-agency RMBS, commercial mortgage assets, asset-backed securities, and hedges. All amounts below are U.S. dollars.
Financial results and condition
| Metric | Q2 2013 | Q2 2012 | Six months 2013 | Six months 2012 |
|---|---|---|---|---|
| Interest income | $20.3 million | $16.0 million | $38.7 million | $31.8 million |
| Net investment income | $12.2 million | $8.8 million | $22.7 million | $19.8 million |
| Net realized and unrealized gains (losses), investments and derivatives | ($0.5) million | $1.9 million | $29.7 million | $23.0 million |
| Increase in equity from operations | $11.7 million | $10.8 million | $52.5 million | $42.8 million |
| EPS attributable to shareholders | $0.49 | $0.64 | $2.35 | $2.54 |
- At June 30, total assets were $2.73 billion, total liabilities $2.09 billion, and total equity $637.9 million. Cash and cash equivalents were $201.8 million, up from $59.1 million at year-end 2012.
- Reverse-repurchase borrowings were $1.288 billion, versus $905.7 million at December 31, 2012. Management reported debt-to-equity of 2.02:1; that measure excludes liabilities other than debt financings. The weighted-average repo borrowing rate was 0.91% at quarter-end.
- Quarterly net investment income as a percentage of average equity was 9.00%, compared with 10.72% a year earlier; for the six-month periods it was 8.83% versus 10.84%. These are the filing’s reported ratios, not conventional operating margins.
- Net asset value per common share was $24.92 at June 30, compared with $24.86 at December 31, 2012. Net-asset-based total return was 1.57% for Q2 and 9.57% for the first half; market-based returns were -4.93% and 11.13%, respectively.
- Cash from operating activities was a use of $317.4 million for the first half, while financing activities provided $460.1 million; cash increased by $142.7 million. The company paid $52.0 million in dividends during the half.
Changes versus comparable periods
- Q2 net investment income increased year over year as interest income rose, principally with growth in the non-agency portfolio. Total expenses also increased to $8.2 million from $7.2 million, including higher base management and interest expense.
- Q2 investment losses of $17.4 million were largely offset by $16.9 million of derivative gains, leaving a small combined net loss. Management attributed investment losses to the sharp rise in interest rates and resulting fixed-income price declines; interest-rate hedges offset part of the impact.
- For the first half, operating results rose to $52.5 million from $42.8 million, but per-share earnings declined to $2.35 from $2.54, and net-asset-based total return fell to 9.57% from 11.57%. Management cited a substantially larger average equity base.
- A May follow-on offering raised approximately $125.3 million net and added 5.0 million shares. Proceeds were deployed during Q2; the company subsequently increased cash holdings as a volatility buffer. Reverse-repo debt and the portfolio both expanded.
Outlook, risks, and unusual items
- No quantified earnings or return guidance was provided. Management expected elevated interest-rate volatility and saw potential buying and trading opportunities after Q2 price declines. It remained generally optimistic about non-agency RMBS fundamentals, citing improving home prices, and expected to continue investing selectively in agency RMBS, CMBS, commercial loans, and other assets.
- The Federal Reserve’s June communications prompted a sharp market repricing: the 10-year Treasury yield rose from 1.63% on May 1 to 2.49% on June 28, while mortgage rates also rose sharply. Management warned that further rate increases, reduced refinancing, and mortgage prepayment or extension changes could affect asset values and cash flows.
- Key exposures include credit and loss-severity risk in non-agency assets; prepayment risk; interest-rate risk; valuation uncertainty; leverage and repo refinancing; margin calls; and counterparty concentration. At June 30, approximately 58% of open reverse repos were with three counterparties. A modeled 100-basis-point rate increase implied a $10.2 million portfolio-value decline, but the filing cautions that actual effects may differ materially.
- Management said available cash, investment cash flows, financing, and equity access should meet liquidity needs, while warning that loss of agency-RMBS financing or sharp collateral declines could strain liquidity and force asset sales. About 55% of reverse-repo borrowings matured within 60 days.
- Most investments are carried at fair value; $793.2 million of investments were Level 3 at quarter-end and depend on significant judgment and unobservable inputs. The company had no material legal proceedings it considered pending, but noted potential regulatory inquiries involving its manager and affiliates. Indemnification exposure is unquantified, with no liability recorded.
- The board approved a Q2 dividend of $0.77 per share on August 1, payable September 16, 2013. The filing also notes that the company was reassessing whether it continued to qualify as an investment company for GAAP purposes under new guidance.
Important facts for investors to verify
- Whether repo financing remains available on acceptable terms, and how near-term maturities, collateral haircuts, and margin calls affect liquidity.
- How much of reported performance depends on Level 3 valuations, and whether valuation assumptions for prepayments, defaults, losses, and recoveries remain supportable.
- Whether derivative and TBA hedges continue to offset portfolio losses as interest rates, mortgage spreads, and prepayment expectations change.
- How the larger share count, leverage, management and incentive fees, and dividend payments affect per-share returns and the sustainability of distributions.
- Developments in mortgage rates, housing and loan performance, Federal Reserve policy, GSE policy, and any regulatory inquiries or changes in investment-company accounting status.