Ellington Financial Inc. — Q2 2019 Form 10-Q
Business context and reporting period
Ellington Financial is an externally managed mortgage and credit investment company. It invests in Agency and non-Agency mortgage securities, mortgage and consumer loans, CLOs, derivatives, real estate, and loan-originator equity. This unaudited filing covers the quarter and six months ended June 30, 2019.
Effective January 1, 2019, the company prospectively discontinued investment-company accounting as it prepared to elect REIT status for 2019. It continued fair-value accounting for eligible instruments, but the resulting financial-statement presentation is not directly comparable with prior-year GAAP statements.
Financial results and position
- Q2 earnings: Interest income was $38.5 million, interest expense $19.7 million, and net interest income $18.8 million. Net income was $13.7 million; $12.6 million was attributable to common stockholders, or $0.43 per share. Core Earnings, a non-GAAP measure, was $13.6 million attributable to common stockholders, or $0.46 per share.
- Six-month results: Net interest income was $37.2 million; net income was $30.1 million, including $28.1 million attributable to common stockholders, or $0.94 per share. Core Earnings attributable to common stockholders was $27.0 million, or $0.91 per share.
- Interest margin: Management’s net interest margin was 2.38% for Q2 and 2.57% for the first half, versus 3.13% and 3.10% in the respective 2018 periods. The metric includes interest-rate swap costs but excludes costs of other hedges.
- Other gains and losses: Q2 other income was $2.8 million, reflecting $17.0 million in net realized and unrealized gains on securities and loans, partly offset by $15.8 million in derivative losses. For the first half, securities and loans gained $38.0 million while derivatives lost $33.1 million.
- Balance sheet and leverage: At June 30, total assets were $3.13 billion, total liabilities $2.53 billion, and total equity $593.1 million. Book value was $18.91 per share. Secured borrowings were approximately $2.29 billion; senior notes had $86 million principal outstanding. Total debt-to-equity was 4.0:1, compared with 3.4:1 at March 31; recourse debt-to-equity was 2.8:1.
- Liquidity and cash flow: Cash and restricted cash totaled $42.8 million at quarter-end. For the six months, operating activities provided $43.3 million, investing activities used $304.8 million, and financing activities provided $259.2 million; cash, cash equivalents, and restricted cash declined $2.2 million.
- Distributions: Dividends declared totaled $0.42 per share for Q2 and $0.97 per share for the first half. A $0.14-per-share dividend was subsequently approved for August payment, with another $0.14 dividend approved for September.
Material changes versus comparable periods
- Management attributed higher interest income versus 2018 to larger portfolios and higher average credit-asset yields. Interest expense also increased, reflecting greater borrowings and higher average borrowing costs.
- Management-reported net interest margin declined year over year. Average secured funding costs rose, while the portfolio’s reported yields changed only modestly.
- Portfolio and financing expanded: total long Agency RMBS rose to $1.34 billion from $1.14 billion at March 31. Total borrowings and leverage also increased; management cited financing for larger Agency RMBS and consolidated non-QM holdings.
- The third non-QM securitization closed in June. Management said it was the primary driver of the quarter-over-quarter reduction in credit assets when non-retained securitization tranches are excluded. The company also shifted assets toward REIT-qualifying investments.
- Year-over-year GAAP earnings comparisons require caution because accounting and presentation changed. For example, 2018 was reported under investment-company accounting; the 2019 statement presents net income under operating-company GAAP.
Outlook, commentary, risks, and unusual items
- Management provided no numerical earnings or return guidance. It said current capital resources, cash, and expected credit availability should meet anticipated liquidity needs, while noting this assessment depends on financing availability and market conditions.
- Management described credit investments as the primary driver of portfolio risk and return. Q2 performers included residential non-performing and non-QM loans, residential transition loans, European and non-Agency RMBS, and CMBS; retained CLO tranches underperformed. Interest-rate and credit hedges generated losses as rates declined.
- Key risks include high leverage, repo refinancing and rollover needs, collateral margin calls, interest-rate and prepayment volatility, borrower defaults and loss severity, and counterparty exposure. Management warned that inability to finance Agency RMBS or sharp declines in credit collateral could strain liquidity and force asset sales or new debt/equity issuance.
- Valuation risk is material: $1.32 billion of recurring fair-value assets and $475.8 million of fair-value borrowings were classified as Level 3, relying on significant unobservable inputs. Management cautioned that actual realizable values may differ materially from estimates.
- The company intends to elect REIT status for 2019 and must meet applicable qualification and distribution requirements. Failure to qualify could result in corporate tax and jeopardize future REIT eligibility. The company recorded $0.4 million of income tax expense for the first half.
- Unusual items included $1.7 million of debt issuance costs expensed in Q2 for fair-value-option borrowings and REIT-conversion-related professional fees. The company also completed a follow-on offering after quarter-end, raising net proceeds of $69.8 million from 4.025 million shares.
- No material litigation was reported, but the filing notes an SEC subpoena received in 2017 concerning a loan originator and related loan purchases, securitizations, analysis, and servicing. The company said it had responded and would continue cooperating; it could not assure that inquiries would not lead to further investigation or proceedings.
Important facts for investors to verify
- Whether the reported $18.91 book value per share and 4.0:1 total debt-to-equity ratio remain appropriate after the post-quarter share offering and changes in portfolio size.
- The terms, maturity concentration, collateral haircuts, and refinancing availability of repos; about 76% of quarter-end repo borrowings matured within 90 days.
- How much of reported earnings and Core Earnings came from recurring net interest income versus fair-value changes, securitizations, and other adjustments.
- The assumptions and sensitivity behind Level 3 asset and liability valuations, including mortgage defaults, recoveries, prepayments, and resolution timelines.
- Progress toward REIT qualification, the related tax and distribution implications, and any developments concerning the SEC inquiry.