Ellington Financial LLC — Q3 2013 Form 10-Q
Business context and reporting period
Ellington is an externally managed specialty finance company investing primarily in mortgage-related assets, including agency and non-agency residential mortgage-backed securities (RMBS), commercial mortgage assets, other asset-backed securities and derivatives. It uses repurchase-agreement financing and hedges selected credit and interest-rate exposures. This unaudited filing covers the three and nine months ended September 30, 2013; comparisons are with the corresponding 2012 periods unless otherwise noted. Amounts below are in U.S. dollars.
Financial and operating highlights
- Q3 results: Interest income was $24.1 million, up from $15.4 million. Net investment income was $14.4 million, versus $0.7 million. Net realized and unrealized losses on investments and derivatives totaled $2.6 million, compared with gains of $28.8 million. Net increase in shareholders’ equity from operations was $11.7 million, or $0.45 per share, versus $29.5 million, or $1.59 per share.
- First nine months: Interest income was $62.8 million, versus $47.2 million; net investment income was $37.1 million, versus $20.5 million. Net realized and unrealized gains were $27.1 million, down from $51.8 million. Net increase in shareholders’ equity from operations was $63.7 million, or $2.73 per share, versus $72.4 million, or $4.15 per share.
- Margins and funding costs: Q3 portfolio yield was 5.80%, compared with 5.90% a year earlier. Management’s net interest margin measure, including interest-rate swap payments but excluding other hedges, was 4.22% versus 4.62%; for the nine-month periods it was 4.27% versus 4.28%. Average reverse-repo borrowing cost in Q3 was 0.96%, and was 1.58% including swap payments.
- Balance sheet at September 30: Total assets were $3.123 billion, liabilities $2.493 billion and total equity $629.8 million. Cash and cash equivalents were $186.7 million. Reverse-repurchase borrowings were $1.345 billion; securitized debt was $1.0 million. Management reported debt-to-equity of 2.14-to-1, excluding liabilities other than debt financing.
- Portfolio and book value: Investments at fair value were $1.852 billion; investments sold short were $860.1 million. The portfolio included $946.1 million of agency RMBS and $736.2 million of non-agency RMBS, other ABS and commercial mortgage loans. Diluted book value per share was $24.19, versus $24.51 at June 30 and $24.38 at December 31, 2012.
- Cash flow and capital: Operating activities used $369.5 million during the first nine months, while financing activities provided $497.1 million; cash increased by $127.7 million to $186.7 million. The company issued shares for approximately $125.3 million net proceeds and paid $72.0 million in dividends. These cash-flow figures are affected by substantial securities trading and settlement activity.
- Distributions: Dividends declared for the first three quarters of 2013 totaled $3.06 per share. After quarter-end, the board approved a $0.77-per-share dividend payable December 16, 2013.
Material changes versus comparable periods
- Q3 operating results were lower year over year, principally because investment and derivative gains were much smaller; higher interest income and substantially lower incentive fees partly offset this. Q3 incentive fees were $2.0 million, down from $9.5 million.
- For the nine-month period, net investment income rose, but lower realized and unrealized gains reduced total operating results. Shareholders’ equity from operations per share fell to $2.73 from $4.15.
- Compared with December 31, 2012, assets increased by about $970.6 million, liabilities by about $847.1 million and equity by about $123.4 million. Management attributed the expansion mainly to deploying May offering proceeds and financing a larger portfolio.
- Reverse-repo borrowings rose from $905.7 million at year-end to $1.345 billion. The net short TBA position increased from $565.1 million to $696.2 million; net short interest-rate swaps also increased. Management said the larger hedge positions principally reflected portfolio growth.
- Cash was deliberately maintained at a higher level from late Q2 through Q3 as a volatility buffer and to preserve capacity for investment opportunities.
Outlook, management commentary and risks
Management provided no numerical earnings or return guidance. It remained generally optimistic on non-agency RMBS, citing improving home prices and declining delinquencies and foreclosures, while expecting near-term market volatility and trading opportunities. It also anticipated opportunities in agency specified pools, CMBS, non-performing commercial loans and CLOs, and said it expected to continue using varied instruments to hedge interest-rate and credit risks.
- Market exposures: Results and liquidity are sensitive to interest rates, mortgage prepayments, defaults and recoveries, asset values, financing availability and collateral margin requirements. Management’s static-portfolio sensitivity estimate showed a $9.6 million decline in portfolio value for an immediate 100-basis-point rate increase; management cautioned that model assumptions and actual portfolio changes could make outcomes materially different.
- Funding and liquidity: Reverse repos generally mature within 180 days; 35.4% of borrowings were due within 30 days and 62.7% within 60 days. A loss of financing access, falling collateral values or margin calls could create liquidity pressure. Management said it believed available resources were sufficient, but noted that inability to finance agency RMBS could force asset sales and portfolio restructuring.
- Valuation uncertainty: $800.1 million of assets and derivative assets were classified as Level 3, relying on significant unobservable inputs and models. Management stated that valuation estimates could differ materially from prices in an active market.
- Counterparty and concentration risk: The company had $1.345 billion of reverse repos across 13 counterparties; approximately 20% were with one counterparty. Receivables, collateral and derivatives also involve counterparty exposures. The filing reports no master netting agreements with counterparties.
- Other risks and contingencies: Management identified potential effects from changing Federal Reserve policy, bank-capital rules and repo availability, mortgage-servicing transfers, foreclosure delays and regulatory scrutiny. No material legal proceedings were reported; indemnification exposure was described as unknown, with no related liability recorded. The filing reported no material change in previously disclosed risk factors.
Most important facts for investors to verify
- Whether the increase in net investment income can persist as portfolio size, funding costs and incentive fees change.
- How much of reported results and book value depends on Level 3 valuations, and how those marks compare with realizable market prices.
- Whether reverse-repo financing remains available on acceptable terms, including the near-term maturity schedule, haircuts and potential margin calls.
- How the larger TBA, swap and credit-hedge positions perform under changing rates, prepayment speeds and credit conditions.
- Whether operating cash generation, leverage and future earnings support the quarterly dividend; the board retains discretion over distributions.