Ellington Financial LLC — FY2011 Form 10-K
Reporting period: Fiscal year ended December 31, 2011; filed March 14, 2012. The filing identifies the registrant as Ellington Financial LLC. It is an externally managed specialty finance company investing primarily in mortgage-related securities and derivatives.
Business context
The company seeks risk-adjusted total returns through an opportunistic portfolio of Agency and non-Agency RMBS, mortgage-related derivatives, and smaller commercial mortgage-related holdings. Management said non-Agency RMBS were the principal drivers of portfolio risk and return. The company uses leverage, short positions, and derivatives to finance and hedge investments.
Financial performance and position
| Metric | FY2011 / year-end 2011 | FY2010 / year-end 2010 |
|---|---|---|
| Interest income | $63.5 million | $45.6 million |
| Net investment income | $44.7 million | $24.8 million |
| Net realized and unrealized investment and derivative results | $(34.4) million | $15.8 million |
| Net increase in shareholders’ equity from operations | $10.3 million; $0.61 per share | $40.6 million; $3.04 per share |
| Total return after incentive fee, based on net asset value | 2.43% | 7.79% |
| Dividends per common share | $1.60 | $2.51 |
| Total assets | $1.968 billion | $2.334 billion |
| Shareholders’ equity | $370.9 million | $403.7 million |
| Cash and cash equivalents | $62.7 million | $35.8 million |
| Reverse-repo borrowings | $896.2 million | $777.8 million |
FY2011 net cash used in operating activities was $47.5 million; financing activities provided $74.4 million, including $118.5 million of net reverse-repo financing and $42.4 million of dividends paid. Cash increased by $26.9 million. The filing does not present a conventional operating margin measure; net investment income was $44.7 million on $63.5 million of interest income, before realized and unrealized investment and derivative losses.
At year-end, debt-to-equity was 2.42:1, excluding liabilities other than debt financing. About 73.7% of reverse repos were secured by Agency RMBS; nine counterparties provided financing. Average remaining repo maturity was 33 days, and 62.4% matured within 30 days. Management reported a weighted-average repo borrowing rate of 0.82% at year-end and 0.69% for the year.
Year-end holdings included $417.5 million fair value of non-Agency RMBS and $732.3 million of Agency RMBS other than TBAs. The company had $62.7 million cash and reported $118.0 million of unencumbered investments in custody on a settlement-date basis. Its assets included substantial Level 3 valuations: $443.4 million of investments and $61.5 million of derivative assets.
Fourth quarter: Net investment income was $11.0 million and net increase in equity from operations was $1.7 million, or $0.10 per share. The comparable fourth quarter of 2010 produced $6.3 million of net investment income and $13.2 million of operating increase, or $0.81 per share.
Material changes versus prior period
- Annual operating results fell to $10.3 million from $40.6 million, chiefly because investment valuations declined. FY2011 investment results were a net loss of $28.8 million, versus a $28.7 million gain in FY2010; derivative results were a $5.6 million loss versus a $12.9 million loss.
- Non-Agency RMBS fair value increased to $417.5 million from $333.1 million in the portfolio comparison, as the company bought into lower-priced sectors, including 2005–2007 subprime vintages. Management cited market price declines as the main source of the year’s weaker results.
- Agency RMBS and net short TBAs both declined: net short TBAs were $414.7 million versus $695.3 million, while other Agency RMBS were $732.3 million versus $851.0 million. Management said it relied more on interest-rate swaps for hedging.
- Reverse-repo borrowings rose to $896.2 million from $777.8 million, while reported equity fell by $32.8 million, reflecting operations, dividends, share repurchases, and equity awards.
- The company repurchased 60,980 shares for $1.1 million under a $10 million authorization. Its 2011 market-based total return was negative 13.03%; net-asset-value-based total return after incentive fees was 2.43%.
Outlook, commentary, and risks
Management provided no quantitative earnings or return guidance. It expected to continue allocating capital to non-Agency RMBS, Agency RMBS, and commercial mortgage strategies, and to keep hedging interest-rate risk. It described longer-term non-Agency RMBS market trends as positive but flagged potential distressed sales by European investors. Management expected low non-Agency prepayments and continued targeting of Agency pools it considered less vulnerable to refinancing.
- Funding and liquidity: Short-term repos, margin calls, collateral haircuts, counterparty concentration, and rising financing costs could force asset sales or constrain investment activity. Management said inability to finance Agency RMBS would create serious short-term liquidity strain.
- Mortgage and valuation risk: Non-Agency holdings bear credit, foreclosure-delay, loss-severity, prepayment, and illiquidity risks. Fair values for some assets depend on models and unobservable inputs; actual sale prices may differ materially.
- Rates and hedging: Rate movements can affect asset values, funding costs, and prepayments; hedges may be imperfect or costly. A static sensitivity analysis estimated total portfolio value changes of approximately +$2.7 million for a 100-basis-point rate decrease and −$1.1 million for a 100-basis-point increase, subject to significant modeling limitations.
- Regulatory and structural: The company’s strategy depends on maintaining exclusions from Investment Company Act registration and partnership tax treatment. SEC review of the mortgage-related 3(c)(5)(C) exclusion, GSE policy changes, and Dodd-Frank implementation could constrain operations.
- Manager and conflicts: The company has no employees and depends on its affiliated manager and Ellington. The manager receives a 1.50% annual base fee and a performance-based incentive fee; the arrangement includes potential conflicts and a substantial termination fee.
- Unusual matters: A $1.5 million resecuritization financing closed in January 2012, with an expected three-to-four-year term. The company reported no material legal proceedings against it or its manager, but disclosed prior SEC inquiries involving Ellington-affiliated CDO activities; it could not assure that further inquiries would not lead to proceedings.
PricewaterhouseCoopers LLP issued an unqualified audit opinion and reported effective internal control over financial reporting as of December 31, 2011.
Investor verification priorities
- Reconcile the large annual gap between net investment income and operating results, focusing on non-Agency RMBS and derivative valuation changes.
- Review repo maturity, collateral requirements, counterparty exposure, and available unencumbered liquidity against the short-term funding profile.
- Assess Level 3 valuation assumptions and the sensitivity of reported equity and earnings to changes in prepayment, default, severity, and market-price assumptions.
- Verify the sustainability and tax treatment of distributions; 2011 dividends of $1.60 per share exceeded reported operating earnings of $0.61 per share.
- Monitor developments affecting GSE guarantees, Investment Company Act exclusions, partnership tax qualification, and the affiliated management agreement.