Ellington Financial Inc. (EFC) Q3 2018 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Financial Third Quarter 2018 Earnings Conference Call. Today’s call is being recorded. [Operator Instructions] It is now my pleasure to turn the floor over to Jason Frank, Corporate Counsel and Secretary. Sir, may begin.

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. As described under Item 1A of our annual report on Form 10-K filed on March 15, 2018, 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 on the call with me today Larry Penn, Chief Executive Officer of Ellington Financial; Mark Tecotzky, our Co-Chief Investment Officer; and JR Herlihy, our Chief Financial Officer. As described in our earnings press release, our third quarter earnings conference call presentation is available on our website, ellingtonfinancial.com. Management’s prepared remarks will track the presentation. Please turn to Slide 4 to follow along. Please note that any references to figures in this presentation are qualified in their entirety by the endnotes at the back of the presentation. With that, I will now turn the call over to Larry.

Thanks, Jay, and good morning, everyone. As always we appreciate your time and your interest in Ellington Financial. On our call today I will first give an overview of the quarter. Then our CFO, JR Herlihy, will summarize our financial results. And then Mark Tecotzky, our co-Chief Investment Officer, will discuss how the market has performed this quarter, our portfolio positioning and performance and what our investment outlook is going forward. Finally, I will provide some closing remarks, including more detail on our plans, which we announced last night on our earnings release, to convert to a REIT in the first half of 2019. Then we’ll open the floor to questions. Beginning with Slide 4, Ellington Financial continued its strong year-to-date performance through the third quarter of 2018. We grew our Credit portfolio another 15% in the quarter and generated net investment income of $0.38 per share and adjusted net investment income of $0.40 per share, which essentially covered our third quarter dividend of $0.41 per share. I’m extremely pleased with this progress and give our diverse sourcing channels and strong balance sheet, we should be able to continue to grow the credit portfolio from here to support further growth of earnings and ultimately the growth of our dividend. Overall, including realized and mark-to-market gains and losses, Ellington Financial generated net income of $6.7 million or $0.22 per share and an economic return of 1.1% for the third quarter. Adding back dividends paid, book value is now up 9.4% through the first nine months of the year or 12.6% annualized. We had excellent performance in several of our strategies in the third quarter including small-balance commercial mortgage loans, where strong origination volumes and favorable loan resolutions helped generate a high return on equity again for the strategy. In our corporate CLO strategy, we completed a successful reset of our first CLO, whereby we extended the remaining reinvestment period, lowered the cost of the liabilities and improved the capital structure. As a result, our projected equity yield on this investment increased significantly going forward. We have also begun accumulating assets for a potential fourth CLO. Finally, our CMBS portfolio also contributed significantly to our third quarter results, with both positive carry and trading gains. In our non-QM loan strategy, we reached critical mass for a second securitization, which I’m happy to announce we actually just priced earlier this morning. We also had a record quarter for non-QM purchases, as we closed on $109 million of loans during the quarter. As usual, we continue hedge interest rates as well as select credit risks in the portfolio. Our dynamic hedging strategies, along with a commitment to maintaining moderate leverage and a strong balance sheet, should continue to provide significant protection to book value in an environment of rising interest rates and increasing market volatility. These are core investment principles for us and significant differentiators that underpin our long-term performance. Turning to Slide 5, you can see an overview of our current portfolio across the various Credit and Agency strategies. At September 30, 2018, 85% of our equity was allocated to Credit strategies, where thanks to our proprietary sourcing and origination channels, we have assembled a portfolio of assets with a blended, unlevered market yield of 8.8%. As we did in the prior quarter, we rotated a portion of our lower yielding assets into higher yielding strategies. We continue to focus on sectors and strategies where we believe our analytics gives us an edge, where there are big barriers to entry and where big banks no longer compete due to post-crisis regulation. As you can also see on Slide 5, we finished the quarter with a debt-to-equity ratio of 3.04:1, with much of this leverage supporting our highly liquid Agency portfolio. This compares to a debt-to-equity ratio of 2.77:1 at the end of the second quarter. While all leverage is higher, the increase is a natural result of our overall portfolio growth and remains well below the sector average. And with that, I’ll turn the call over to our CFO, JR Herlihy.

Thanks, Larry, and good morning, everyone. Please turn to Slide 6 for a summary of our income statement. In the third quarter, EFC generated net income of $6.7 million or $0.22 per share, as compared to net income of $21.2 million or $0.69 per share in the prior quarter. Our third quarter net income breaks down as follows. Net investment income was $11.7 million or $0.38 per share. Net realized gains were $10.1 million or $0.33 per share. The change in net unrealized was a loss of $14.3 million or $0.46 per share and the downward adjustment from allocation to non-controlling interest was $813,000 or $0.03 per share. Net income was down sequentially not because net investment income was down, in fact, net investment income was up $0.02 per share; but rather because mark-to-market losses exceeded realized gains in the third quarter. Several strategies that generated significant gains last quarter had smaller gains or modest losses in Q3 and we also had net losses on our credit hedges this quarter as opposed to net gains last quarter. Including the $0.02 per share growth this past quarter, quarterly net investment income per share has now increased 57% year-over-year. After adjustments, net investment income was $0.40, which effectively covered our $0.41 dividend. Additionally, in conjunction with the expected REIT conversion that Larry will discuss in more detail in a moment, we would need to make certain portfolio adjustments to comply with the REIT rules. As a result of these adjustments, we would expect the growth rate of our net investment income to slow temporarily. Once our portfolio composition stabilizes however, we would expect to resume growing net investment income, earnings and ultimately the dividends. One more comment on adjusted net investment income, while we view adjusted net investment income as a good proxy for our earnings power, let us remind you that it has its limitations. A portion of our capital will always be invested in assets that do not generate current net investment income. Notable examples of this include our strategic investments in loan origination companies where appreciation is reflected in realized and unrealized gains, and real estate-owned assets where the primary driver of P&L occurs at disposition, so it gets reflected in realized gains rather than interest income. Moreover, net investment income doesn’t capture much of the total returns that we generate via opportunistic trading. Please turn to Slide 7 for details on the attribution of earnings between our Credit and Agency strategies. In the third quarter of 2018, the Credit strategy generated gross income of $11 million or $0.36 per share, while the Agency strategy generated gross income of $741,000 or $0.02 per share. These amounts compare to gross income from the Credit strategy of $24.9 million or $0.80 per share and gross income from the Agency strategies of $1.65 million or $0.06 per share in the second quarter. In the Credit portfolio, total net interest income increased to $17.7 million from $15.4 million, driven by our larger portfolio and higher net interest margins. Net realized gain and change in net unrealized loss together contributed a net zero to our results and included an offsetting realized gains and unrealized loss connected with a sale of a portfolio of European consumer NPLs that closed in the third quarter, but that we had marked up in the second quarter as the resolution was approaching. Net credit hedges and other activities produced negative $3.25 million to P&L, compared to a positive $1.7 million in the second quarter, as corporate credit performed well during the third quarter, which adversely affected our credit hedges. As you can also see on Slide 7, credit hedges at September 30 were only slightly negative year-to-date, about $0.01 per share and that’s before the significant value that our credit hedges returned during the market selloff in October. Other investment related expenses, the largest component of which is loan servicing expenses, increased to $3.9 million from $3.3 million in step with the larger loan holdings. Staying on Slide 7 and turning now to the operating results of the Agency strategy, gross income for the third quarter was $741,000 or $0.02 per share, compared to $1.65 million or $0.06 per share in the prior quarter. During the third quarter, interest rates rose and Agency RMBS prices declined again, which led to net realized and unrealized losses on our portfolio totaling $7.6 million or $0.24 per share. However, these losses were more than offset by net interest income and gains on our net interest rate hedges and other activities, which all together totaled $8.3 million or $0.26 per share. We view this net gain in our Agency strategy even after all mark-to-market adjustments, as representing solid performance in what was a difficult quarter for Agency RMBS in general and Agency mortgage REITs in particular. Please turn to Slide 8. Our Credit portfolio was approximately $1.29 billion as of September 30, 2018, which is a 15% increase from the end of the second quarter. Consistent with prior quarters, these totals are quoted before consolidating the non-QM securitization trust. The growth of our Credit portfolio primarily came from net purchases in the following target strategies: commercial mortgage loans and REO, European RMBS, non-Agency RMBS, residential mortgage loans and REO and consumer loans and ABS. During the quarter, we had net sales in the following strategies: European consumer loans and ABS, U.S. CMBS and U.S. CLO. Similar to prior quarters, we continued to hold a portfolio of more liquid lower-risk assets, such as certain U.S. non-Agency RMBS and CLO note investments. Please turn to Slide 9. Our long Agency RMBS portfolio decreased slightly to $944.4 million as of September 30, 2018 from $948.5 million as of June 30, 2018. Our asset mix was essentially unchanged quarter-to-quarter. Slide 10 shows a breakout of our borrowings and leverage. As of September 30, we had a debt-to-equity ratio of 3.04:1, up from 2.77:1 last quarter. Our recourse debt-to-equity ratio was 2.81:1 compared to 2.48:1 last quarter. The higher leverage resulted from increased borrowings in connection with new purchases, and in particular as we ramped up our non-QM portfolio and reached critical mass to securitize. We remain very comfortable with our leverage and liquidity. I would also note that the majority of our recourse debt supports highly liquid agency pools. During the third quarter, our other operating expenses and base management fee totaled $4.2 million, representing an annualized expense ratio of 2.7%, which was down 30 basis points from the prior quarter, primarily driven by higher rebates on our Ellington sponsored CLOs. We ended the quarter with diluted book value per share of $19.37 after payment of the $0.41 per share dividend in December of 2018. I will now turn the call over to Mark.

Thanks, JR. Q3 was generally a strong quarter for credit strategies. The S&P was up over 7% for the quarter, which set the tone for tightening credit spreads for both ABS and corporate credit. EFC stuck to its long-term plan in Q3, diligently growing the portfolio primarily through proprietary sourcing channels: consumer, non-QM, small-balance commercial and by manufacturing investments through our CLO program. You can track changes in portfolio size and composition on Slide 8. We continued to be less focused on the more commoditized credit sectors, which saw continued spread tightening in Q3. We opportunistically used some of these lower-yielding sectors to increase returns on corporate cash, but we are not excited about trying to generate double-digit returns on equity by increasing leverage on sectors where future spread tightening looks limited. As our portfolio size increased, we also added some credit hedges, as you can see on Slide 16. JR and Larry mentioned that our adjusted net income effectively covered our dividend for the quarter. That’s very important. But equally important in my opinion is the high quality of our net investment income. Much of our net investment income is coming from higher yielding shorter duration assets with predictable cash flows, oftentimes well collateralized and at a very low LTV. That positioning is looking particularly relevant now, given that financial markets have been a lot less hospitable since quarter end. Credit spreads have changed direction, widened with the extreme volatility in equities. Using a lot of leverage on assets that are dropping in price can wreak havoc on book values or worse. In contrast, we were pleased to report last night Ellington Financial had a positive economic return in October. Our conservative portfolio construction, including the proportional increase in credit hedges that I previous mentioned, both contributed to our October performance. Turning back to the third quarter, EFC had broad-based contributions across the four loan sectors shown on Page 11. Fundamental credit performance was good and despite stock market volatility, we are not seeing any deterioration in the credit metrics that we monitor. We also attained critical mass during the quarter for our second non-QM securitization, which as Larry mentioned was just priced this morning. In the non-QM space, our investment premise has always been that EFC can generate returns in 2 ways for shareholders; first, through its relationship with LendSure, EFC has secured a proprietary supply of high-coupon loans with limited credit risk. Since we started the program in 2015, we have now bought approximately $500 million worth of non-QM loans and we have had no credit losses to date. The second way that EFC is generating returns in the non-QM space is through our strategic equity stake in LendSure, where we own a 45% stake and where we work closely with management to increase franchise value. LendSure is a maturing company with a broad geographic footprint and monthly loan volume is growing, having recently exceeded $45 million monthly volume mark. We think that our equity stake in LendSure has tremendous upside. After the global financial crisis, we thought, where are the best opportunities in mortgage originations that EFC with its data, models and knowledge of the mortgage market can capitalize on? But when we looked at the residential jumbo mortgage market, we didn’t see an opportunity there, as banks were still active and too competitive in that market. They can afford to be much more aggressive than EFC in that market, given that they have better funding terms than EFC and a myriad of cross-selling opportunities to those excellent borrowers. So we avoided the jumbo mortgage origination market. Those REITs that did get involved in jumbo originations have by now largely exited the sector. We saw that even in 2013, Ginnie Mae and Fannie Mae were both doing very high LTV lending and lots of loans with FICOs below 650. So we didn’t see an opportunity in high LTV or low FICO lending. We designed our non-QM origination program to focus on low LTV and higher FICO and our assessment of the market was right. We have built the machinery to originate higher yielding loans and we haven’t seen any credit losses. Similarly, we saw an opportunity in reverse mortgages, where banks pulled out due to regulatory concerns, but where the demographics and the economics were compelling. As our October book announcement shows again, we’ve done a good job protecting book value from credit spread widening. We were largely unaffected in October, because we didn’t have a lot of exposure to tight spread commoditized sectors. In the past year, EFC has grown its portfolio the hard way, not the easy way. And by that I mean we have taken the time, deepened relationships and built out the infrastructure to secure assets that have a high yield and a short duration that are relatively unaffected by large exogenous shocks, unlike for example, credit risk transfer bonds that can have large price swings from unpredictable events like hurricanes, wild fires, et cetera. So that’s one of the reasons we had positive returns in October. We try to avoid growing assets in credit sectors that have tight spreads and are priced to perfection, since that exposes investors to sharp price declines and risk-off moves like we saw in October. While the markets appear to have stabilized for the time being in November, at EFC we remain focused both on the opportunities ahead and the future risks. Now, back to Larry.

Thanks, Mark. As we see new challenges emerge in the market, Ellington Financial’s focus remains the same. Our strategy of investing across a diversified mix of assets based on favorable risk reward, being nimble in our allocations and disciplined with our hedging strategies; positions us to drive superior risk-adjusted returns over market cycles. And 2018 has been a very good year for us. And as you can see on Slide 12, this strategy has been a differentiator for us in terms of the stability of our performance. Of course during the first weeks of the fourth quarter, we’ve seen increased volatility and we’ve seen virtually every fixed income sector widen relative to Treasuries. We believe that this environment again underscores the importance of our disciplined hedging and liquidity management, both in preserving book value and enabling us to take advantage of buying opportunities during market dislocations. We have been strategically growing our portfolio and utilizing a bit more leverage to drive earnings growth and set us up for the future. We also retain the ability to repurchase our own shares opportunistically when we believe they represent an attractive value. In fact, as you can see back on Slide 4, we’ve repurchased over 140,000 shares since quarter end with our stock price down. Finally, as announced last night in our earnings release and while we have not completed our analysis or made any final decision, we are now in a position to say that EFC expects to convert to a real estate investment trust or REIT during the first half of 2019, barring an unforeseen impediments. In connection with such a conversion, we would expect to take several steps to help qualify as a REIT, including selling certain non-real estate related assets and moving other non-real estate related assets into taxable REIT subsidiaries. A REIT conversion would also be facilitated by exchanging a portion of our public senior unsecured notes for private notes issued by one or more of our taxable REIT subsidiaries. Given the various steps required for us to convert including changes to our organizational structure and sales of certain non-real estate related assets, we are not prepared at this time to provide a more precise target completion date. That said, we are focused on completing this conversion quickly and our goal and expectation is to complete the conversion as early in the first half of the year as possible. As a REIT, Ellington Financial would continue to pursue a hybrid strategy. Namely EFC would continue to include a significant allocation of capital to the Agency mortgage strategy. That said, we still expect that the Credit strategy will continue to be by far the main driver of EFC’s earnings. As to the assets that EFC would sell in preparation for a conversion, we expect that they will predominantly consist of lower yielding non-core assets. We would expect to sell certain U.K. non-conforming RMBS which are generally not structured to qualify as good U.S. REIT assets, as well as many of the lower risk more liquid non-mortgage assets, such as CLO debt tranches which we have been using lately somewhat as a cash management tool. Importantly however, we expect to be able to maintain EFC’s current capital allocations to our higher yielding core strategies, even including many non-real estate related strategies, such as Ellington-sponsored CLOs and consumer loans, although we would likely need to limit the relative growth of these non-real estate related strategies in the future to maintain REIT compliance. As to EFC’s interest rate hedges, while there are some restrictions on a REIT’s use of interest rate hedges, we still expect EFC even as a REIT to be able to aggressively hedge its interest rate risk not materially different from what we’ve done historically. As to EFC’s credit hedges, there are limitations on how heavily a REIT can safely utilize credit hedges and not risk jeopardizing its REIT status. That said, we believe that EFC also won’t need to make any major changes to its currency credit hedging strategies to be able to qualify as a REIT. Part of the reason is simply that in the last couple of years we’ve been using a much lighter amount of credit hedges anyway compared to what we used to do in prior years. With the exception of a few select strategies, such as our CMBS strategy, there just aren’t credit hedges available that are correlated enough to our assets to make heavy credit hedging worthwhile. And for most of our loan assets, such as our consumer loans assets and our small-balance commercial mortgage loan assets, they tend to be shorter in duration and their credit risks tend to be more idiosyncratic. So heavy credit hedging isn’t usually appropriate there either. So overall, I don’t expect our credit hedging portfolio to change meaningfully if we were to convert. We are extremely excited about the potential conversion of EFC to a REIT. Becoming a REIT would bring with it big benefits, such as lower effective tax rates on our income for U.S. taxpayers, simplification of the tax reporting process for our investors and we believe a significant expansion of our investor base. We expect to finalize our plans over the remainder of 2018. As always, investor feedback on these issues is welcome. And this concludes our prepared remarks. We are now pleased to take your questions. Operator?

[Operator Instructions] Your first question comes from the line of Steve Delaney of JMP Securities.

Congratulations on the book value performance, especially here in October. We’re hearing down 3% to 5% from most of the hybrid residential REITs this week, as they’ve reported. Regarding the NQM program with LendSure, could you remind me the profile of your particular NQM product in terms of what it looks like and where the broadening of the agency credit box exists in your product? I assume there’s a degree of homogenization there if you’re able to continue to do securitizations.

This is Mark. So you can look at our first non-QM deal which is on Bloomberg, its ticker symbol EFMT 2017-1. The deal we priced this morning will be on Bloomberg shortly. So typically we’re around a 6.5% note rate. LTV is high 60s to 70s, FICOs low 700s. And where we have seen an opportunity to get to credit worthy borrowers that don’t fit into a Fannie-Freddie-Ginnie box, is for a lot of borrowers that are self-employed. Really Fannie, Freddie, FHA; post-crisis they’ve really been focused on documenting income with W-2s and 1040s. So to the extent borrowers have tax returns that are more complicated, maybe they have K-1s, maybe they have partnership income, rental income; they don’t fit neatly into the agency box. So those borrowers, we’ll look at years of bank statements. We’ve seen a good opportunity there. We’ve also seen opportunities with investor properties where the borrower is an LLC as opposed to an individual. Fannie and Freddie focus on just individuals. So it’s been a variety of niches like that, where we’ve been able to get our volume, but get it at sort of the lower LTVs, the better credit qualities that we like.

So the RMBS market is letting you blend owner-occupied self-employed loans in with business purpose investment properties in the same trust?

Yes. Yes, the rating agencies have a methodological framework for calculating expected losses. They have a lot of data on that.

Okay, and it sounds like most of what you’re doing is with LendSure. Are you working to develop additional sourcing as well?

Yes, so we have focused on purchasing LendSure production since they started originating. Recently we have some initiatives to buy from some other lenders that we think have the capability of similarly getting that combination of strong credit quality and relatively attractive note rates.

Got it, so your 45% equity interest, it sounds like there’s no exclusive connection there that requires that you only buy loans from them?

Yes, that’s correct. And also there’s no exclusivity that they can’t sell loans to others and they have on a small scale.

Okay great, and then lastly from me, Larry, I guess this is for you. You touched on it. Could you just review for us when you convert to a REIT – I’m not going to say if – but when you convert to a REIT in 2019, what would be the two or three most significant activities that you would have to move down into a TRS? I’m not sure. I understand that’s got to take place, but I’m not sure I understand exactly what activities will go down there. Thanks.

Sure. Hey Steve, it’s JR.

Hey JR?

How are you?

Good.

Yes, so I think that I mean big picture, as Larry mentioned, the Ellington sponsored CLOs and our consumer businesses we expect to maintain. The consumer businesses are already in a blocker. But we would move the Ellington sponsored CLOs as well as any secondary CLOs we continue to invest in. Those are probably the two largest categories. Larry also mentioned euro non-conforming RMBS that aren’t structured as REIT assets. I think perhaps some of those would be moved, but probably more would be sold. That would be maybe the third bucket to think about.

Okay, so if I’m hearing you there, then the way we should think about it is non-real estate related investments primarily would be what you would need to put into a TRS, because you need to have your – what is it – 80% test of good REIT assets.

Yes, that’s right.

Yes, the 20% TRS test and then 75% gross asset test. So, yes. But that’s the right way to think about it.

And then just we would also move some credit hedges as well, the majority I would think of our credit hedges would also move to one form of TRS or another.

Okay got it thanks for the comments for the commands guys.

Your next question comes from the line of Crispin Love of Sandler O'Neill.

Good morning thanks for taking my question. Can you comment on what you’ve been seeing in the CLO market recently and how your CLO investments have been performing? There’s been a lot of press recently about CLOs getting riskier and that they might be the next shoe to drop in the market. So I just wanted to kind of get your views on kind of if you agree with that and kind of how you are positioned there.

Hi Crispin, it’s Mark. So yes, there’s certainly been an erosion in the quality of covenants on the bank loans that typically go into broadly syndicated CLOs. Our program is a little bit different. We focus on primarily secondary loans, not new issue. But they’re a little bit wider spreads. They’re a little bit less leverage. We’ve been able to get stronger covenants. So I think this erosion of covenants and sort of erosion of credit quality is one of the reasons why we’ve designed our program the way we’ve designed it. So one consequence of this erosion of covenants is that for an entity like Ellington Financial or our other credit strategies, we generally have not been participating in third-party equity, because sort of the concerns you articulated.

And if you look at our deal structures and the kind of assets that we have in there, as Mark mentioned, we’re buying some fallen angels that there really isn’t technical support in the market from that your garden variety new issue CLO can’t buy them. They’re not distressed, so they’re not really the kind of thing that distressed fund managers would buy. So we think that there is actually a technical but real and inherent spread advantage on an after-loss basis in those assets versus I think a lot of the new issuance in the loan market that has been getting a lot of press And when you look at our deals in our equity tranches, the amount of future losses that you need to really dent those equity tranches to the degree where they wouldn’t look like a good investment is obviously you expect more losses than you do on your typical vanilla deal. But here we believe as we look at the yield profiles on these investments that given just how much losses would have to reach in order to make these investments as I say poor yielding investments, to us the investment looks very compelling.

Okay, great. Thank you. That’s helpful. And can you talk a little bit about what led you to choose to convert to a REIT rather than a C corp or staying a PTP? I understand that nothing is final yet. But I thought early on kind of within the past year, you may have been leaning towards a C corp. So I’m wondering how your decision and thought process has evolved over the last 10 or 11 months.

Right. Well, okay. So in terms of the decision to convert, we now this year have been I think – we think proving that the moves that we’ve made in our portfolio and our business model are not only headed in the right direction, but have succeeded. And yet, when you look at the stock price and when you look at the ability of investors to buy our stock because we’re a PTP, it’s so much more limited. We’re not able to reach that broad investor base. So that’s one reason. The other reason, of course, in terms of a REIT, is that with the tax law change in 2017, REIT dividends are effectively taxed at a 20% lower rate for U.S. taxpayer than are, say, other types of income, for example the PTP income that we were generating for our investors before ordinary income, by and large. So that also was a huge factor. We did look at a C corp, because we knew that a C corp would give us the most flexibility frankly of any structure, even more than a REIT and then even more than a PTP. But the effective tax rate that we would pay would go up too much. We got also excellent feedback from investors on that front that we had said that if we did that we would have to have a drop in our dividend to account for taxes that we’d have to pay. And with the REIT structure, we don’t think that there’s going to be a material change in our tax rate, at least not for a while. And you see this with all the REITs in the sector. So it’s tax efficient. The only negative really of the REIT structure, right, is twofold. And we addressed this, I think, on the call today. The first one is that you do lose some flexibility, right? We’re not going to be able to – if we wanted to be 75% in consumer loans, let’s just say, we’re not anywhere close to that now. But if that’s where we wanted to be at some years in the future, now being a REIT that would be extremely difficult to do that within the REIT framework. So we do lose some flexibility. But all of our core non-real estate related strategies seem to be – and again, we’re still doing our analysis and running all the numbers. But it seems like we really can fit them nicely into the REIT structure and still qualify with some room for growth, not infinite growth, but some room for growth in those strategies relative to the overall portfolio. And then the second thing that we also mentioned in the call today was it does limit at some point our ability to credit hedge to the extent that we in the past. So for example in 2008, when the asset-backed CDS market, so you could buy CDS on subprime pools and things like that; that was a very big liquid market and we used that extensively in addition with other markets to hedge a lot of the risks in our portfolio in 2008. And there’s a slide, there’s a supplemental slide in the back where you can see that those really helped us preserve book value in 2008, which was a tremendous accomplishment. So are we going to be able to be 100% credit hedged in the portfolio as a REIT? No. But we’ve also changed our strategy so much in the past few years and this is where we see ourselves going forward, to be more oriented towards strategies where frankly you wouldn’t expect anyway to be able to credit hedge those strategies. I’ll just pick one typical example. If we have a nonperforming loan, commercial mortgage loan that we bought on an office building in New Jersey; that’s a very idiosyncratic asset. And you’re not going to be able to hedge that asset with anything liquid in the financial markets. So as your portfolio has gotten more loan-oriented and moved away from the types of generic subprime non-Agency RMBS investments that we were making many, many years ago that were more easily hedged with asset-backed CDS; we don’t think that this is an important enough consideration with all everything in balance to stop us from converting to a REIT. So we’re very happy that we can accomplish what we’re going to accomplish in the REIT format.

Right that makes sense and thank you for taking my question.

Thank you.

Your next question comes from the Doug Harter of Credit Suisse.

This is actually Josh on for Doug. Just one follow-up on the REIT conversion, how are you guys thinking about allowing the non-core assets to run off versus outright sales and should we expect to see any uptick in agency investments during the process of redeploying that capital into target assets? Thanks.

Excellent question, thank you. So yes, so on the second one you hit the nail right on the head. So I think in the short term, we probably would have a modest increase in our Agency strategy. Those are good REIT assets, Agency RMBS. And as you know, we buy a lot of whole specified pools, home mortgage pools. So, yes. So I think we would see a little uptick there and I think JR alluded to the fact that while we don’t see our adjusted net investment income dropping materially as a result of this conversion in the short term, we do see our growth. And I think we mentioned that its net investment income per share grew 57% I think from a year ago. So we’re not going to see that kind of growth probably for the next couple of quarters, but maybe a little more stabilization there. And then after the dust settles on this conversion, I think we can then we would expect to be able to drop that increased Agency allocation again back to more normal levels for us, or closer to more normal levels and that will happen as we continue to fill the portfolio with all the good REIT assets that obviously are a major focus of what we’ve been doing anyway. So that’s your second question. And you first question is – I think it was sort of selling versus runoff. So most of the assets that we were talking about selling are pretty liquid. You’re talking about a lot of these – sometimes we call them the placeholder assets, some certain CLO debt investments, for example. So given that even – I mean the earliest that we would convert would be January 1, 2019. And under the REIT rules, the asset tests are measured at quarter end. So we have even under a January 1 conversion, we have until March 31 to basically satisfy the REIT tests on assets. So that gives us plenty of time – these are really liquid assets – to do that. And the second thing would be that there are some assets that we would probably look more to runoff, because they’re a little more liquid, some of the European assets potentially. But again, it’s a pretty modest portion of our portfolio. And so I think that for most of the stuff sale is really not an issue in terms of we have plenty of time and they’re plenty liquid. I think Mark or JR, you want to add something to that?

Yes, I would just say that in terms of a lower yielding asset we have in the company now that’s not a good REIT asset, say, like some seasoned CLO debt; we think about it more as a rotation. So a rotation out of that into CMBS debt, into non-Agency mortgage market; so there is a lot of sectors where we deploy some of this placeholder cash. A couple of them aren’t good REIT assets. Many of them are. So I think about it more as sort of an incremental portfolio rotation.

Good thanks guys.

Thank you.

Your next question comes from the line of George Bahamondes of Deutsche Bank.

Hey good morning. Just a quick on REIT conversion, how should we think about the expenses associated with the REIT conversion process?

Sure. It’s JR. There will be costs associated with the conversion. They will be one-time costs, mostly professional fees to get through the conversion. In fact, some of those costs have hit us this quarter, a couple hundred k. But to reiterate, they’d be one-time costs and then we would look to kind of stabilize expense ratios after, as Larry says, the dust settles on the conversion.

Got it okay that’s helpful all from me today thank you.

Thanks.

Your next question comes from the line of Tim Hayes of B. Riley FBR.

Hey guys good afternoon thanks for taking my questions. Just a follow-up on that last question, do you not have to pay an earnings and profit distribution in conjunction with the conversion? Sorry if just my understanding of the, I guess, rules around that are not there.

So if we were currently a corporation that would be correct. But given that we’re currently a partnership there are some little things that go on with some of our assets in certain subsidiaries. But we’ve looked at this and our preliminary analysis says that any one-time tax effect similar to what you’re alluding to would be extremely minor. And remember also, we take a 475 election, mark-to-market election on certain assets that might mitigate some of it. But in any case, we’re largely through that analysis and we don’t believe that there is going to be anything material along those lines.

Okay. That’s really helpful. Thanks for explaining that. And do you happen to have a book value estimate at this point during the quarter?

We have. We just published October last night.

Oh, I missed it. I apologize.

That’s okay, a lot going on. And that’s diluted or?

Diluted, yes. Fully diluted $19.44 per share as of 10/31.

That’s where– so we had a positive economic return in the month, which – and I think one of your colleagues alluded to earlier in the call, compares extremely favorable to some of the announcements on October book in the REIT sector otherwise.

Understood, thanks for the clarification. And then have you been buying back stock at all this quarter with shares trading kind of much closer to that 80% of book value range where allocating capital – that strategy is usually more attractive to you guys?

Exactly. So since we were in a blackout period basically until this call, we’ve been operating under our automated 10b-51 program. And as you can see on Slide 4 I think it is, yes, we’ve purchased 144,117 shares, so another 0.5% of our shares at an average price of $15.52 through November 6. So that gets you pretty up to date. And as you correctly remarked, that coincided with the drop in our stock price post quarter-end towards that 80% and even below that 80% price-to-book level. And there you go.

Okay appreciate all the comments.

Thank you.

That was our final question. We thank you for participating in Ellington Financial’s Third Quarter 2018 Earnings Conference Call, and you may now disconnect.