Ellington Financial Inc. (EFC) Q1 2015 Earnings Report, Transcript and Summary

Welcome to the Ellington Financial first-quarter 2015 Financial Results Conference Call. Today’s call is being recorded. [Operator Instructions] It is now my pleasure to turn the floor over to Lindsay Tragler, Investor Relations. You may begin.

Thank you. Thank you. Before we start I would like to remind everyone that certain statements made during this conference call may constitute forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical in nature and they are based on management’s beliefs, assumptions and expectations. As described under item 1A of our Annual Report on Form 10-K filed March 13, 2015, forward-looking statements are subject to a variety of risks and uncertainties that could cause the Company’s actual results to differ from its beliefs, expectations, estimates and projections. Consequently, you should not rely on these forward-looking statements as predictions of future events. Statements made during this conference call are made as of the date of this call and the Company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. I have with me on the call today, Larry Penn, Chief Executive Officer of Ellington Financial; Mark Tecotzky, our Co-Chief Investment Officer; and Lisa Mumford, our Chief Financial Officer. With that I will now turn the call over to Larry.

Thanks, Lindsay. Once again it is our pleasure to speak with our shareholders this morning as we release our first-quarter results. As always, we appreciate your taking the time to participate on the call today. First some highlights. Ellington Financial had a good quarter. We generated net income of $0.57 per share which equates to a total economic return of 2.5% for the first quarter or 10.4% annualized. Both our Agency and non-Agency strategies made positive contributions to our net income. Our non-Agency RMBS positions, which still comprise more than half of our non-Agency loan portfolio, had a strong quarter supported by both the absence of new supply and improving fundamentals, such as modestly increasing home prices and declining delinquency and foreclosure rates. We continue to diversify away from legacy RMBS and towards our other non-Agency strategies where we still see high profit and growth potential. Several of these other strategies are starting to have a more meaningful impact on our financial results. And as I will discuss later, we are getting closer to acquiring our first assets under our non-QM mortgage initiative, after signing our first flow agreement in this space at the end of the first quarter. We will follow the same format as we have been previous calls. First, Lisa will run through our financial results. Then Mark will discuss how the MBS market performed over the course of the quarter, how we positioned our portfolio and what our market outlook is. I will follow with some closing remarks before opening the floor for questions. As a reminder, we have posted a first-quarter earnings conference call presentation right on the homepage of our website, www.ellingtonfinancial.com. Lisa and Mark’s prepared remarks will track the presentation. So if you have this presentation in front of you, please turn to Page 4 to follow along. I am going to turn it over to Lisa now.

Thank you, Larry and good morning everyone. As you can see in our earnings attribution table on page 4 of the presentation, our first-quarter net income was $19.3 million or $0.57 per share. The major components of our net income for the quarter were non-Agency strategy gross income of $18.5 million or $0.55 per share. Agency RMBS strategy gross income of $6.1 million or $0.17 per share; and expenses of $5.2 million or $0.15 per share. As Larry mentioned, we generated a 2.5% return on average equity for the quarter or a 10.4% return on a compounded annualized basis. Within our non-Agency strategy our legacy non-Agency RMBS, net of associated credit hedges and interest rate hedges, generated approximately $10.5 million or $0.57 of our total non-Agency results. Our other non-Agency strategies, which include CMBS and small balance commercial mortgage loans, residential loans, consumer ABS and loans, CLOs, distressed corporate loans and our investments in mortgage-related entities in the aggregate generated approximately $6.5 million or 35% of our non-Agency gross income. The remainder of our non-Agency income was attributable to our smaller relative value trading strategies which include, for example, our mortgage REIT relative value, equity strategy and our interest rate arbitrage strategy. The contribution of some of these smaller relative value strategies can vary significantly from quarter to quarter as they tend to be more opportunistic in nature. While our legacy non-Agency RMBS portfolio appreciated in value during the quarter, net losses on our interest rate and credit hedges partially offset income from the net carry and asset appreciation. We actively traded this portfolio and it declined in size as we opportunistically sold assets to free up capital for investments in other non-Agency sectors. I mentioned that these other non-Agency strategies generated approximately $6.5 million or 35% of our total non-Agency gross income. Within this group, and to provide some sense of the relative contributions, the majority of our income for the quarter came from CBS and small (technical difficulty) loans which combined to contribute approximately $2.4 million; CLOs which contributed $1.5 million; and residential and consumer loans and consumer ABS which combined to contribute $3.1 million. Within CMBS and CLOs active trading augmented the net carry on our assets and enhanced returns. Within the small balance commercial loan strategy our results were driven by successful resolutions. We are continuing to ramp up our holdings of consumer and residential loans and they are performing well in line with our expectations. Our Agency RMBS strategy performed very well in the first quarter generating gross income of $6.1 million. This strategy utilized about 16% of our capital in the first quarter resulting in a return on allocated capital of close to 5% for the quarter or approximately 90% annualized. Our agency portfolio continues to be comprised predominantly of specified pools. These pools performed well net of interest rate hedges. Those hedges are still principally in the form of short TBAs and interest rate swaps. Interest income on our agency securities was also augmented by trading gains and unrealized gains. We turned over approximately 32% of our agency portfolio during the first quarter. At the end of the first quarter our total long non-Agency portfolio was approximately $792 million, down from approximately $882 million last quarter. And our agency portfolio decreased to $1.1 billion as compared to $1.2 billion as of the end of December. Our leverage ratio declined to 1.78 to 1 at the end of March from 1.96 to 1 at the end of December. However, as of the end of the first quarter we had not fully redeployed proceeds received from the net sales from our legacy RMBS portfolio. As those proceeds are redeployed we would expect our non-Agency asset holdings to increase. I will now turn the presentation over to Mark.

Thanks, Lisa. As Lisa mentioned, as you can see on page 11, our non-Agency portfolio decreased in size during the first quarter. We shrank the portfolio not because we no longer find the sector attractive; rather this is part of the evolution and diversification of our sources of return. In the non-Agency RMBS market certain sectors and bonds have reached spread targets where we think it makes sense to sell these assets. Despite high market volatility during the first quarter non-Agency RMBS showed little price movement, constrained supply resulting from the absence of a new issue market, as well as improving fundamentals, supported asset prices in the legacy market. So we opportunistically sold some of our legacy RMBS to free up capital for investments and strategies at consumer loans and distressed small balance commercial loans. Though we are still finding attractive returns in many sectors of the non-Agency RMBS market too. In the consumer space our strategy is typically to buy assets under flow agreements so we need to keep a little more cash on hand. Another dynamic here is that we haven’t yet put financing agreements in place for some of our newer strategies. As we scale these strategies we will borrow against our assets and redeploy the capital. This shift in our portfolio composition also helps to explain why our leverage is a little lower this quarter and why our cash positions increased on the balance sheet. So I think this should be a temporary drop in size and since quarter end we have already reversed about 20% of the reduction. As you can see, we now have many sources of return that can augment our core non-Agency and Agency RMBS strategies with multiple asset classes contributing meaningful income of $0.03 to $0.05 per share to each of our first-quarter earnings. Because we are externally managed we have also been able to add the expertise that we need to expand our reach without significantly increasing our expense ratios. I will elaborate a little more on our growth in some of these other non-Agency strategies. First, you will see that our CMBX and commercial mortgage loan position grew during the first quarter, but this was primarily attributable to growth (technical difficulty) small balance commercial loan portfolio, not purchases of securities. Because there has been an active originate to distribute model in CMBS with many large conduits active over the last few years, the credit and leverage cycle has moved back toward peak levels at a much faster pace in commercial real estate compared to the residential market. As a result commercial property values have risen faster and newly issued loans are more leveraged. Against this backdrop we continue to turn over our CMBS portfolio with valuation for new issue B-pieces higher in the first quarter as the acquisition process became more competitive due to lower new issue volume. So our pace of acquisitions declined. In CMBS securities, as opposed to commercial mortgage loans, we maintained our size as we added about as much as we sold. In small balance commercial loan space, in addition to the distressed loans we see in the secondary market, we are seeing attractive opportunities to lend on properties that don’t fit the underwriting guidelines for CMBS field and bank portfolios. These loans are generally short-term, under two years, typically offered (technical difficulty) interest rates and might include an upfront fee. Additionally, we continue to achieve profitable resolutions in our existing portfolio of distressed loans which we generally purchase at substantial discounts to face value. We have generally been redeploying the proceeds of these resolutions in purchases of similar loans. We have been active in small balance commercial loans for several years now and we believe that we have built a reputation as a reliable counterparty in a market where many bidders often to complete their purchases. As a result more and more sellers are approaching us with opportunity which is a significant advantage in this sector where sourcing product is a key to success. Many other sectors made contributions this quarter too and we continue to ramp our portfolios and newer strategies. For example, we were able to become much more active in our residential RPL and NPL market following successful exits from some of our earlier investments. By identifying undervalued properties, working with borrowers and servicers, and judiciously spending on repairs we have unlock the value that we originally identified and we can now harvest some gains as well. Our relative value credit hedging strategy also performed well during the first quarter. This initiative has been a significant area of focus for our research and analytics teams over the past 18 months. Our goal is to minimize hedging costs through active rotation among a suite of instruments that can protect book value in the deteriorating credit and spread widening environment. We look at corporate debt indices and traunches of these indices, high-yield bond ETFs, stock indices, puts on stock indices, etc. We have been able to identify dislocations in list pricings among various types of hedging instruments that we believe enable us to more (technical difficulty) credit risk. For example, during the first quarter we identified an attractive opportunity to begin shorting high-yield ETFs as the borrow, which is the cost to maintain the short position, fell to about one-third of its level one year ago. In addition to providing a cheaper hedge the ETFs enabled us to hedge a cash bond with a cash instrument eliminating the cash synthetic basis. Our Agency RMBS portfolio produced strong returns this quarter as well despite some very significant headwinds and extremely volatile interest rates. Yields at the beginning of the quarter weren’t dramatically different – I’m sorry. Yields at the beginning and end of the quarter weren’t dramatically different, but the distance traveled was big with the 10-year yield reaching a of [164] and peaking at [224]. The drop in interest rates drove a sharp increase in the refinancing index and ignited prepayment fears. And very fast prepayment speeds [did] materialize. As a result Agency [pool pay ups] spiked and many of the TBA [rolls] weakened. Our portfolio is well positioned to take advantage of this dynamic as most of our agency holdings are in specified pools that offer substantial prepay protection. And we controlled a lot of our prepay risk by hedging with short TBAs instead of swaps. On top of our favorable portfolio construction we also traded this portfolio very actively during the quarter. In virtually all of our strategies we continue to benefit from retrenchment in the banking industry as both commercial and investment banks are further reducing their capacity to buy and/or hold risk assets. The scope of businesses in which banks can participate continues to shrink and they are increasingly relegated to the role of assisting investors in purchasing and financing assets. We believe the state of the world is very favorable for us because we no longer have to compete with them for assets. And once we have made our acquisitions they are interested in providing financing and potentially securitizing assets at a later date. Given this landscape and the success of our diversification initiatives to date, we are excited about our opportunities to deploy capital across a broader range of assets in the coming quarters. With that I will turn the call back to Larry.

Thanks, Mark. As Lisa described, while legacy RMBS and Agency RMBS continue to generate the bulk of our income, several of our other strategies contributed quite meaningfully to our earnings in the first quarter; CLOs, residential NPLs, small balance commercial loans and consumer loans all generated strong returns. And as Mark pointed out, these strategies tend to share a common theme. They represent areas of the structured products universe where we are filling the capital void left by the banks who no longer participate and where we believe our research and analytical and modeling expertise give us an edge. Our CLO strategy provides a great example of this. In CLOs we have focused on older legacy deals that have exited or are about to exit their reinvestment periods. So we can analyze their cash flows and risks using similar tools to those we use for non-Agency RMBS. We have avoided the new issue, or CLO 2.0 market, for a few reasons. First and foremost, because we don’t think the risk-adjusted returns are attractive, particularly given that the underlying loans have generally been originated with relaxed underwriting standards and covenant light features. And second, because we don’t want to assume certain risks that are difficult to assess and hedge such as manager reinvestment risk. And also we don’t want to take energy-related risks where many of the more recent deals tend to have exposure. Our CLO investments have largely been in equity and mezzanine traunches where we see the best relative value and where our structured credit expertise benefits us most. Legacy CLO equity is a capital intensive asset under the Volcker Rule which has prompted banks to sell these assets. In the first quarter CLOs generated 11% of our gross non-Agency profits, or $0.04 per share, and that is after hedging costs. Meanwhile our consumer loan business is really ramping us up nicely. We are about to execute a flow agreement with a third consumer loan originator, so shortly we should have two flow agreements up and running for the purchase of unsecured consumer loans and one flow agreement for the purchase of auto loans. We are expecting high-single-digit and double-digit yields on our consumer loan portfolio even before leverage. In the mortgage origination space we made an equity investment in a third mortgage originator at the end of the first quarter, purchasing a substantial ownership interest in a company that is run by a highly experienced management team and that is focused on non-QM loan origination. Concurrent with the equity investment we signed a flow agreement to buy non-QM loans that meet our specifications. We expect to make our first non-QM purchases under this flow agreement in the early summer. Meanwhile, we are also working with other lenders to purchase non-QM loans. Consistent with our overall investing theme of filling capital voids left by banks, our non-QM programs target segments of the mortgage market that we believe will offer strong credit performance, but aren’t eligible for agency or bank lending programs. We are excited about the potential in non-QM origination and over time this could become a significant profit center for us. Our objective here is to build out a business that will enable us to manufacture a steady pipeline of investments and thereby significantly augment longer-term franchise value. In order to take advantage of these and other opportunities in mortgage loan origination we recently formed a REIT subsidiary inside Ellington Financial. Having a REIT subsidiary enables Ellington Financial to originate mortgage loans without having to pay corporate income tax on the income generated by those loans while still maintaining its PTP status. We expect to use our new REIT subsidiary for non-QM origination. But we’ve already put it to good use. We recently originated several commercial mortgage loans. Having a REIT subsidiary that can efficiently originate loans can also be a big advantage in working out many of the nonperforming and sub performing loans that we purchase, whether residential or commercial. From a shareholder’s tax standpoint, income from our REIT subsidiary will generally be passed through to our shareholders as nonqualified dividends, just like dividends you typically get from a REIT. Meanwhile, we continue to judiciously hedge and manage our portfolio to protect against potential downside risk. Liquidity gaps can arise more quickly than you’d expect so we try to be prepared for them. The markets are still extremely vulnerable to these types of events. And accommodative monetary policies are arguably masking much of this vulnerability. Although it is widely accepted that the Fed will increase its target rate, this may still have some surprising consequences when it occurs. Given the uncertainty around the timing of a future rate hike and the strength of near-term U.S. economic growth, we still see potential for high interest-rate volatility to continue in 2015. However, as we’ve said before, dislocations often present the best opportunities for us. And we believe that we are well-positioned for strong performance as we continue to manage our portfolio for strong total return over market cycles. This concludes our prepared remarks. We are now pleased to take your questions.

The floor is now opened for questions. [Operator Instructions] Thank you. Our first question is coming from Doug Harter with Credit Suisse.

Thanks. You had mentioned that you are hoping to start booking some of the – your first non-QM loans. Is there any way you can help us size or guide our expectations as to kind of the pacing of that and how we can think about that growing going forward?

Sure. As I mentioned, we have got a couple things going there, one with an originator that is going to be focused just on that space, and then we are working on others with originators that are already big in agency origination. I would expect – it’s, again, really hard to predict, but we are hoping I would say over the course of a year to originate a couple hundred million, I mean that would be I think a decent target. Originally we probably won’t use any leverage and then after we have ramped up a decent amount we will probably start using some leverage on that. We may turn over the portfolio a little bit, test the markets. I think the securitization market still isn’t there yet. But as we have mentioned before, if we can get 200 plus basis points on this stuff with probably better convexity characteristics than say agency loans, then if you look at what a typical warehouse might cost, we think that we can get double-digit returns after leverage on rock solid products. So that is kind of what we are hoping for. I think it is not going to be realistically for the next year – it is not going to use probably 20% of our capital. But I think looking forward it could be a big part of our strategy.

And just around that comment of initially sort of leaving it unlevered, is that more around that it will be relatively small and the sort of setup cost of a warehouse line would be relatively – would take away a lot of the return?

Yes, until we get to say $50 million I think somewhere close to that, probably not worth it for the borrower or the lender, frankly.

Got it, makes sense. Thank you.

Our next question comes in the line of Steve DeLaney with JMP Securities.

Thanks, good morning everyone. Larry, you talked about setting up the new REIT subsidiary as something that you need for holding these whole loans – a lot of sense from a tax efficiency. I am just curious, are you also thinking about the need for federal whole loan bank membership now that you are looking to go into more whole loan products? It seems that, and tagging onto Doug’s question, it seems like that would be an extremely efficient source of financing for your whole loan product that you are looking to bring on.

Yes, I agree. I think that for a while it looked like that was going away and now it looks like it is back. So we are seeing – all I can say is that we are seeing a lot of proposals or quasi proposals. We haven’t made substantial progress in that area, but it is something that we are looking at. And I think in conjunction with getting that portfolio larger right now, as you probably know, that really only works for performing loans. And in the residential space that hasn’t been our focus. So I think looking forward that could definitely be a great long-term funding source. But we are not there yet and I – there is really no progress to give there.

Okay, understand. But it is something on the radar. Going back to the strategic platform investments. So it sounds like this third one that you have signed up late in the quarter you are going to be very close to seeing flow. Looking back to the original, the Skyline investment and then the investment in the reverse mortgage company, is there going to be product flow coming on in the next quarter or two from those investments as well?

Not clear at this point.

Okay.

I mean the reverse mortgages are at this point more for just originate and sell. And the Skyline, again, nothing to report there.

Okay, so for now anyway we will look at those as more equity type investments to be determined how it blends into the platform operationally. Okay, fine. Small balance commercial, I totally get picking up the non-performers from regional Community Banks, etc. I was interested by Mark’s comment. It almost – it sounded like you were tapped into sort of new originations, making new loans there, not just buying stressed loans off a bank. I’m just curious how you are tapping into that. Is there an active loan broker market for those smaller balance commercial loans such as there is for larger loans?

Yes, hey, Steve, it is Mark. As I mentioned that there are many large active, aggressive, competitive commercial loan conduits that seek to originate commercial loans where the best execution is to securitize them into a new CMBS market. And most loans get originated, that is the route they go. But CMBS has pretty well defined attributes it looks for that are (multiple speakers) securitizations. And so we found opportunities with our contacts out in the commercial real estate world to be a lender on properties that, for whatever reason, don’t fit into CMBS securitizations. They might require a little bit of a construction (multiple speaker)

Right, transitional.

There might be some renovation that needs to get done. And then when you are in that realm you are not competing with CMBS conduits, you are not competing with banks. So it is just you and maybe a few other hard money lenders out there. So we try to get – we are looking for loans where there is substantial equity in the property, there is – the borrower has a long-term history in the real estate market, and it’s properties where we think if there is ever a problem with the lender we can take over the property and manage it or complete construction ourselves. Those are sort of three things we look for. And we are starting to see more of those opportunities come our way just from having – sort of like we’ve been hanging around the hoop in the space for a while. We have closed a lot of commercial loans. So people who know us, they know we have capital. They know we have an appetite for investments. And so, we have been a person that people have approached when these opportunities arise. And we have been seeing them for a while, but we hadn’t really seen ones that really made a lot of – that really seemed like solid investments for us until this past three or four months.

Interesting. And when you – go ahead, Larry.

I was going to add that it is great because, first of all, it has been opening up some new channels in terms of there are sometimes different brokers that do this stuff. But the – some of the same channels that we source our distressed product from in the small balance commercial space – as you can imagine, sometimes, for example, if there is a situation where somebody needs a short refi or something like that we can see origination opportunities as well from some of those same brokers and same channels. And we expect there to be synergies the other way as well, which is that as we get relationships with brokers that specialize more in origination we are going to start to see maybe some more distressed opportunities again on the other end, right. So if somebody makes a hard money loan and it goes bad maybe we will be there to buy it and that broker may show us that loan. So it is all really helping broaden our channel in these areas which really are quite related.

And when you say SBC, what is the rough range of loan size that you are really targeting?

$20 million and under I would say typically.

Okay, that is what I gather. Okay, thanks, guys, appreciate the comments.

Thanks, Steve.

[Operator Instructions] our next question comes in the line of Mike Widner with KBW.

Hey, good morning, guys, this is Eric Hagan on for Mike. I guess just one question. As you look to the middle and the back half of the year, which segment of the portfolio do you guys kind of see the most stability and book value coming from? I know you mentioned in the beginning remarks liquidity in some of the segments that you like to trade a lot and how do you sort of think about that going forward as well? Thanks.

This is Mark. I would say for stability of book value, I think our non-Agency holdings for the last several years have demonstrated a lot of stability in book value primarily because you have been in sort of a relatively similar state of the world for a lot of those borrowers, right.

Legacy RMBS.

Yes, legacy RMBS. Loans – securitizations backed by loans that were originated in the last 8 to 12 years where they are gradually responding to a few more refinance incentives. Their rollaway from the current to delinquent is gradually improving as home prices have been, on sort of a slow upward trajectory. We understand the servicer behavior extremely well. And because there is no new issue market for the legacy securities really by definition, you don’t get price volatility that comes from a big surge of new issue supply at quarter end, it can happen in CBS, it can happen in CLOs. So that sector I think will – has in this past quarter demonstrated remarkable price stability given the yields it throws off and I would expect that to be the case going forward.

Okay, yes, thanks a lot. That is helpful.

[Operator Instructions] There are no further questions at this time. Ladies and gentlemen, this concludes Ellington Financial’s first-quarter 2015 financial results conference call. Please disconnect your lines at this time and have a wonderful day.