Ellington Financial LLC — Q1 2018 Form 10-Q
Reporting period: Three months ended March 31, 2018. The filing identifies the registrant as Ellington Financial LLC. It is an externally managed specialty finance company investing in mortgage securities and loans, consumer credit, CLOs, corporate debt and equity, and derivatives.
Financial performance and position
- Income and earnings: Total investment income was $28.8 million, up from $23.8 million in Q1 2017. Net investment income declined to $10.2 million from $11.8 million as higher interest and investment-related expenses more than offset increased interest income. Net increase in shareholders’ equity from operations was $21.0 million, or $0.67 per share, compared with $15.3 million, or $0.47 per share.
- Returns and distributions: Net-asset-value-based total return was 4.30%, versus 2.48% in Q1 2017. The declared dividend was $0.41 per share, compared with $0.45 a year earlier. Book value per share rose to $19.56 from $19.15 at year-end 2017; diluted book value per share was $19.25.
- Interest and margins: Interest income was $28.1 million, versus $22.9 million; interest expense increased to $11.6 million from $6.0 million. Management reported net interest margin of 3.09%, down from 4.46% in Q1 2017 (3.15% versus 3.86% excluding catch-up premium amortization adjustments). Average secured-funding cost rose to 2.45% from 1.48%.
- Cash flow and liquidity: Operating activities used $124.7 million of cash, compared with $107.6 million used in Q1 2017. Financing activities provided $103.2 million; cash, cash equivalents, and restricted cash declined $21.5 million to $26.1 million. Management attributed the decline in cash chiefly to purchases of liquid, lower-risk investments and said expected resources were sufficient for anticipated liquidity needs.
- Balance sheet and leverage: At March 31, total assets were $3.196 billion, liabilities $2.586 billion, and equity $610.0 million, versus $2.993 billion, $2.372 billion, and $621.0 million, respectively, at December 31, 2017. Reverse repos were $1.331 billion; other secured borrowings were $185.7 million, including $113.8 million of fair-value debt associated with the non-QM securitization; senior notes were $86.0 million. Total debt-to-equity was 2.63:1, up from 2.38:1.
- Portfolio: Long investments at fair value were $2.344 billion, compared with $2.072 billion at year-end. Long Credit investments grew 11.8% to $1.146 billion; long Agency RMBS grew 6.5% to $928.2 million. Net short TBAs were $306.3 million. Credit assets were the primary earnings driver, while Agency RMBS experienced price pressure.
Material changes and management commentary
- Year-over-year earnings improved primarily because derivative results excluding currency hedges moved from a $2.7 million loss to a $4.1 million gain. Net investment income nevertheless fell as funding costs and other investment expenses rose.
- Management cited growth in residential mortgage loans and REO, European non-conforming RMBS, and consumer loans. It also reported participation in a second Ellington-sponsored CLO and said it was optimistic about further securitizations in non-QM and leveraged-loan strategies later in 2018; no quantified earnings or return guidance was provided.
- Q1 market conditions included higher interest rates and LIBOR, a flatter yield curve, greater equity and rate volatility, wider spreads in many credit products, and weaker Agency RMBS prices. Management said Credit performed well and Agency losses were mostly offset by portfolio interest income and interest-rate hedges.
- The Board approved a $0.41-per-share Q1 dividend payable June 15, 2018. The company repurchased 943,897 shares during the quarter for $14.0 million at an average $14.80 per share.
Risks, contingencies, and unusual items
- The business uses substantial leverage and relies heavily on short-term, collateralized reverse repos. Rising funding costs, declining collateral values, margin calls, or reduced access to financing could pressure liquidity and force asset sales. Reverse repo balances were spread across 24 counterparties, but the filing notes collateral and counterparty exposures.
- Key investment risks include interest-rate, prepayment, credit, property-value, foreign-currency, and model-based fair-value risks. Level 3 assets totaled $755.7 million; valuations depend in part on unobservable assumptions about yields, prepayments, defaults, recoveries, and resolution timing.
- Related-party activity includes affiliated CLOs, loan participation trusts, mortgage originators, and financing arrangements. The company reported an estimated $114.5 million principal balance of contingent consumer-loan purchases under agreements with an affiliated purchasing entity.
- The company guarantees a mortgage originator’s third-party repo obligations up to $30.0 million; $15.4 million was outstanding under the guaranteed arrangements at quarter-end, while the recorded fair value of the guarantees was zero.
- The company disclosed a 2017 SEC subpoena concerning a loan originator, related loans, purchases, securitizations, and servicing. It had responded and intended to cooperate; management said it was not aware of a contemplated material proceeding but could not assure that inquiries would not lead to further investigation or proceedings.
- The filing says the company was evaluating possible structural changes following the Tax Cuts and Jobs Act. No material change to previously disclosed risk factors was reported, and the company stated that it was in compliance with senior-note covenants.
Important facts for investors to verify
- Reconcile the increase in reported earnings with declining net investment income, higher funding costs, and the contribution of realized and unrealized gains.
- Track leverage, repo maturities and haircuts, collateral and margin requirements, counterparty concentration, and the cash available to meet potential calls.
- Review the assumptions and sensitivity of Level 3 valuations, especially for loans, consumer assets, non-Agency securities, and related-party investments.
- Assess credit performance, delinquencies, defaults, recoveries, and foreclosure progress in loan portfolios, along with the risks retained in securitizations.
- Verify the status and potential consequences of the SEC inquiry, guarantees, related-party arrangements, and management-fee terms.
- Confirm the share-repurchase activity and remaining authorization: the filing presents repurchase figures in multiple sections that merit reconciliation.