Ellington Financial LLC — Q2 2017 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2017. The filing identifies the registrant as Ellington Financial LLC.
Business context
Ellington is an externally managed specialty finance company investing in mortgage-related and consumer assets, including agency and non-agency securities, mortgage and consumer loans, CLOs, real estate, corporate debt and equity, and derivatives. It uses leverage and hedges selected credit, interest-rate, and currency risks. Results are reported under investment-company accounting, with investments generally measured at fair value.
Financial results and position
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Investment income | $22.7 million | $20.0 million | $46.5 million | $42.1 million |
| Net investment income | $8.4 million | $8.5 million | $20.2 million | $20.3 million |
| Net increase (decrease) in equity from operations | $5.4 million | $5.0 million | $21.2 million | $(18.2) million |
| Shareholders’ result from operations per share | $0.16 | $0.15 | $0.62 | $(0.54) |
| Dividends declared per share | $0.45 | $0.50 | $0.90 | $1.00 |
- Balance sheet at June 30: Assets $2.80 billion; liabilities $2.16 billion; total equity $637.0 million; cash and cash equivalents $134.5 million. Common-share equity value was $19.49 per share, versus $19.75 at December 31, 2016.
- Debt and leverage: Reverse repos were $1.119 billion and other secured borrowings $88.1 million, for total borrowings of about $1.207 billion. Debt-to-equity was 1.90:1, up from 1.64:1 at year-end; excluding U.S. Treasury securities, leverage was 1.85:1. Reverse-repo weighted-average borrowing rate was 1.66% excluding Treasury financing, versus 1.32% at year-end.
- Cash flow: Six-month operating activities used $115.1 million, while financing activities provided $126.3 million; cash increased $11.2 million to $134.5 million. The filing attributes funding needs and cash movements to portfolio trading, financing, distributions, and other activity.
- Margins and returns: Q2 net interest margin, including periodic interest-rate-swap payments, was 3.50%, versus 3.57% a year earlier. Six-month margin was 3.93%, versus 3.79%. NAV-based total return was 0.82% for Q2 and 3.32% for six months, assuming reinvested distributions.
Material changes versus comparable periods
- Q2 net investment income was nearly flat year over year: higher interest income was offset by higher expenses, particularly interest expense, which rose to $7.6 million from $4.2 million.
- For the first half, operations moved from an $18.2 million loss in 2016 to a $21.2 million gain in 2017. Management attributed the reversal mainly to substantially smaller derivative losses, especially from reduced exposure to high-yield credit hedges.
- Interest income increased, but six-month net investment income edged down. Six-month interest expense rose to $13.6 million from $7.7 million as short-term rates and borrowing costs increased and financing shifted toward higher-cost credit loans.
- Portfolio and financing expanded: total assets increased to $2.80 billion from $2.41 billion at December 2016; reverse repos rose to $1.119 billion from $1.034 billion; other secured borrowings increased to $88.1 million from $24.1 million.
- The credit portfolio grew and was reallocated toward loans, REO, CLOs, and corporate debt. The company reported a 6.9% quarterly increase in its long credit portfolio to $684.7 million; long Agency RMBS was $834.0 million, slightly below the prior quarter.
Outlook, commentary, risks, and unusual items
- Management reported generally tighter credit spreads, low market volatility, and strong demand for floating-rate debt. It described opportunities in credit, loans, CLOs, and selected CMBS, while noting that competition and compressed yields had curtailed recent purchases of new-issue CMBS B-pieces.
- Management expects to continue using reverse repos as its primary financing source and said current resources should meet anticipated liquidity needs. It warned that inability to finance Agency RMBS, declines in credit-asset or derivative values, margin calls, or faster mortgage prepayments could strain liquidity and force asset sales or new financing/equity issuance.
- Key exposures include credit/default and loss-severity risk, mortgage prepayment risk, interest-rate and spread movements, foreign-currency movements, short-term refinancing and counterparty risk, and fair-value uncertainty. The filing notes substantial judgment in Level 3 valuations; Level 3 assets were $532.2 million at quarter-end. Sensitivity analysis estimated total portfolio value declines of $3.0 million and $8.6 million for immediate parallel rate increases of 50 and 100 basis points, respectively, under stated assumptions.
- Reverse-repo financing is short-term: 27.9% of outstanding borrowings matured within 30 days and 78.4% within 120 days. About 15% of open reverse repos were with one counterparty. The company reported $1.27 billion of investments pledged as collateral.
- In June, the company participated in an Ellington-managed CLO securitization, sold corporate loans into the transaction, and purchased $35.9 million of subordinated notes plus a $5.6 million interest in its risk-retention vehicle. Related-party transactions and affiliated management/structuring interests are disclosed.
- The company disclosed an SEC subpoena received in January 2017 concerning a loan originator, related loans, analyses, purchases, securitizations, and servicing. It said it had responded and intended to cooperate; it could not assure that the inquiry would not lead to further investigation or proceedings. No material legal proceedings were otherwise reported, and management said there were no material changes to previously disclosed risk factors.
- After quarter-end, the board approved a $0.45-per-share Q2 dividend, payable September 15, 2017 to holders of record September 1. No incentive fee was incurred for the reported periods because income did not exceed the contractual hurdle.
Most important facts for investors to verify
- Whether rising funding costs and higher leverage will continue to pressure earnings and net interest margins.
- Near-term repo maturities, collateral haircuts, lender concentration, and liquidity sensitivity to margin calls or reduced financing availability.
- Valuation assumptions and sensitivity for the substantial Level 3 portfolio, including credit losses, recoveries, prepayments, and resolution timing.
- Performance and credit quality of growing loan, consumer, CLO, and related-party exposures, including the new CLO and loan-originator arrangements.
- Status and potential consequences of the SEC inquiry, as well as the company’s ability to sustain distributions relative to operating results and cash needs.