Ellington Financial LLC Reports Third Quarter 2014 Results

OLD GREENWICH, Conn., Nov. 5, 2014 /PRNewswire/ -- Ellington Financial LLC (NYSE: EFC) today reported financial results for the quarter ended September 30, 2014.

Highlights

• Net increase in shareholders' equity resulting from operations ("net income") for the third quarter was $12.9 million, or $0.46 per basic and diluted share.
• Book value per share as of September 30, 2014 was $23.79 on a diluted basis, after payment of a quarterly dividend in the second quarter of $0.77 per share, as compared to book value per share of $24.14 on a diluted basis as of June 30, 2014.
• Our non-Agency strategy generated gross income of $15.9 million for the quarter ended September 30, 2014.
• Our Agency strategy generated gross income of $3.8 million for the quarter ended September 30, 2014.
• Our Board of Directors declared a dividend of $0.77 per share for the third quarter of 2014, reflecting an annualized dividend yield of 13.8% based on the November 4, 2014 closing price of $22.30; dividends are paid quarterly in arrears.
• We raised net proceeds of $188.2 million through a follow-on offering of our common shares in September.

Third Quarter 2014 Results

For the quarter ended September 30, 2014, net income was $12.9 million, or $0.46 per share. This compares to net income of $20.9 million, or $0.81 per share, for the quarter ended June 30, 2014.

"During the third quarter, both our non-Agency and Agency strategies made positive contributions to our net income," said Laurence Penn, Chief Executive Officer and President. "While our overall results for the quarter moderated somewhat relative to the prior two quarters, we are very pleased with our continued progress in diversifying our asset base. Specifically, we've strategically expanded into adjacent sectors where we believe our analytical expertise, research, and systems give us an edge that enables us to capitalize on market inefficiencies and achieve attractive risk-adjusted returns. During the third quarter we made our first investments in several sectors, such as mortgage origination and consumer ABS, where we've been enhancing our capabilities, and we expect that over time these sectors will augment our sources of return in a significant way.

"In September, we announced that we had purchased a minority stake in a reverse mortgage originator. While this was our first strategic investment in a mortgage originator, we have several more investments in the pipeline. Earlier in the third quarter, we began investing in transactions backed by pools of consumer loans. Meanwhile, we continue to source MBS and ABS opportunities in Europe, and in the third quarter we bought our first European CLO. Just after the close of the quarter, we made our first purchases of distressed corporate debt, where we expect to increase our investments on an opportunistic basis. Even as we are actively expanding our efforts in these newer areas, we are still finding attractive opportunities to buy and sell legacy U.S. non-Agency RMBS. As I mentioned, our Agency strategy performed well during the quarter, and while it only utilizes a small part of our capital, it has consistently been a meaningful positive contributor to our returns. With the Federal Reserve clearly playing a lesser role in that market, we are optimistic that the opportunities in Agency RMBS will increase.

"In early September we successfully completed a follow-on common share offering whereby we raised net proceeds of $188.2 million. As of today, we have deployed the vast majority of the net proceeds received. We were also pleased to announce that our Board declared a third quarter dividend of $0.77 per share, the eighth consecutive quarter that our dividend has been at this level."

Non-Agency

Our non-Agency strategy generated gross income in the amount of $15.9 million for the third quarter, or $0.56 per share. Income from our non-Agency strategy was driven by positive contributions from interest income, interest rate hedges, and credit hedges and other activities, partially offset by net realized and unrealized losses on investments, interest expense and other investment related expenses. During the third quarter, we turned over approximately 12% of the portfolio, as measured by sales, excluding paydowns. Active portfolio trading is a key component of our strategy, and we actively trade our portfolio not only for the generation of total return, but also to enhance the composition of our portfolio. As a result of our trading activity, we monetized net realized gains of $6.1 million, or $0.22 per share, but these were offset by a reduction in net unrealized gains of $6.5 million, or $0.23 per share. As of September 30, 2014, our total long non-Agency portfolio was $719.7 million, as compared to $657.7 million as of June 30, 2014, representing an increase of 9.4%. This increase was due to the partial deployment of the net proceeds raised in our September follow-on offering.

Despite an increase in volatility in the broader financial markets in the third quarter, non-Agency RMBS exhibited relative resilience. By comparison, high yield credit, in which we have been carrying a net short position, widened significantly during the quarter. Data underlying non-Agency RMBS remained generally supportive of valuations, although the rate of national home price appreciation continued to decelerate as compared to the pace of 2013. Foreclosure activity ticked up slightly in the third quarter from the prior quarter, but continued to decline on a year-over-year basis. While we have reduced our overall non-Agency RMBS exposure since the beginning of the year, we are still finding attractive selective buying opportunities, most notably in discount Alt-A hybrid senior positions and in seasoned mezzanine bonds. As market yields for non-Agency RMBS have compressed, prudent and careful security selection, based on loan-level analysis performed on a security-by-security basis, remains of paramount importance.

While we believe that fundamental factors, such as continued home price appreciation and declining foreclosure inventory, remain supportive for non-Agency RMBS in particular, we also believe that on the technical side the entire non-Agency MBS market remains vulnerable, especially to a significant unexpected increase in long-term interest rates. The non-Agency MBS market has become dominated by large bond mutual funds, and is therefore now more heavily impacted by the large-scale behavior of retail investors. This behavior tends to be much more momentum-driven, as evidenced in mid-2013 when the increase in U.S. Treasury yields was followed by substantial retail bond fund outflows, placing downward pressure on prices as redemptions forced bond mutual fund managers to sell assets. This technical vulnerability has been heightened further by the fact that dealers, faced with regulatory requirements such as Basel III and the Volcker Rule, are no longer able to absorb large-scale selling by bond funds into their inventories. Even though demand for non-Agency MBS assets remained robust, we positioned ourselves a bit more cautiously going into the fourth quarter. Our publicly traded partnership structure affords us valuable flexibility, especially in our ability to reduce exposures nimbly through hedging.

The CMBS market was volatile in the third quarter, with active new issue volume. Over the course of the quarter, CMBS bonds generally outperformed the CMBX indices, and in response we sold certain CMBS bonds while continuing to add CMBS "B-pieces." While yield spreads have continued to tighten in CMBS B-pieces, we have continued to find attractive purchase opportunities, although at a slower pace compared to recent quarters. CMBS B-pieces are the most subordinated (and therefore the highest yielding and riskiest) tranches. Ellington has been among the most active participants in this market, and we believe that these assets represent an attractive complement to our legacy CMBS holdings, which tend to be lower yielding, but more actively traded than CMBS B-pieces. By purchasing new issue B-pieces, we believe that we are often able to effectively "manufacture" our risk more efficiently than what is broadly available in the secondary market, and better target the collateral profiles and structures we prefer. As of September 30, 2014, our investment in CMBS was $46.3 million, as compared to $28.0 million as of June 30, 2014.

We continue to source various private transactions in the commercial real estate space. For example, during the third quarter we closed a $5.0 million preferred equity investment in a private partnership focused on acquiring and managing equity investments in multifamily apartments and other housing-related properties.

We also continue to see compelling opportunities in distressed small balance commercial loans. As of September 30, 2014, we had investments in twelve loans with a value of $29.9 million, compared to ten loans valued at $37.4 million as of June 30, 2014. The number and value of our loans held may fluctuate significantly from period to period, especially as these distressed loans are resolved or sold. Our investments in this asset class have performed extremely well, and we continue to source new opportunities.

During the third quarter, we continued to expand our investing activities in European non-dollar denominated assets. We actively traded the portfolio, capturing net gains. Spreads on many European ABS tightened to pre-crisis levels during the third quarter, as the market was largely driven by anticipated European Central Bank, or "ECB," quantitative easing action, including the September announcement that the ECB plans to directly purchase ABS. While the majority of our European holdings have been in RMBS, we added investments in other asset classes during the third quarter. We purchased our first European CLO as an extension of our U.S. CLO strategy, and we purchased an interest in a pool of Spanish non-performing consumer loans. We expect to continue to add European CLOs to our portfolio in the coming months, and we expect to continue to bid on smaller portfolios of European ABS in Spain, given the lower level of competition for these assets. European banks remain under pressure to shed assets in order to strengthen their balance sheets, increase capital ratios, and divest non-core businesses. This could create buying opportunities for us, but this has also weighed on liquidity, especially in the sub-investment grade and mezzanine European ABS space, as banks and dealers are reluctant to hold inventories. As of September 30, 2014, our investments in European non-dollar denominated assets totaled $39.4 million, up from $33.6 million as of June 30, 2014. Our European holdings include securities denominated in British pounds as well as in euros.

As of September 30, 2014, we increased our holdings of CLOs relative to June 30, 2014. In the U.S. CLO market, we continue to find attractive opportunities in legacy securities, especially in equity positions. Banks have been net sellers of legacy CLOs, as increased capital charges resulting from Dodd-Frank regulations have made them unattractive holdings. We continue to find new issue CLOs to be expensive, especially as we view the underlying credit quality to be deteriorating rapidly. Many of these CLOs include underlying loans issued based on relaxed underwriting standards, or "covenant light" loans. Over the course of the third quarter, we increased our holdings of legacy CLOs, including our European non-dollar denominated CLOs, to $92.5 million, from $81.3 million as of June 30, 2014.

During the third quarter, we did not purchase any new non-performing or sub-performing residential mortgage loans, or residential NPL pools. Given the run-up in asset prices in this sector, we have acquired residential NPLs at a slower pace than we originally anticipated. While we continue to evaluate opportunities in some of the larger pool auctions, we are focusing more of our efforts on smaller and lower profile transactions, which typically originate from smaller community banks. We have found that these smaller transactions offer not only better potential returns, but also more attractive terms. As of September 30, 2014, we held $22.6 million in residential NPLs and related foreclosure property, and we have been pleased with the performance of these assets.

During the third quarter, we began investing in U.S. consumer backed loans and ABS, and as of the end of the quarter held assets valued at $11.1 million. We expect that over time this strategy will become a significant component of our overall non-Agency strategy. In addition, we made our first purchases of distressed corporate loans in October 2014. Both of these sectors represent asset classes that we believe serve as complements to our overall non-Agency strategy, and we believe they enable us to leverage our analytical and research-oriented capabilities.

In September 2014, we announced that we had purchased a preferred equity stake in a reverse mortgage originator. We plan to continue to make strategic investments in originators in need of equity and/or debt capital whereby we believe there is an opportunity to enhance longer term enterprise value, and hence the value of our investment. In certain cases, we expect that our investments will also provide access to desirable assets, such as non-QM loans through flow agreements. We believe that our significant expertise and contacts in the mortgage markets and extensive infrastructure will enable us to assist these entities in further developing and executing their business plans.

During the third quarter, our equities trading strategy generated a net loss of $2.3 million, or $0.08 per share. However, on a year to date basis through the first three quarters, this strategy has generated a net gain of $1.0 million, or $0.04 per share.

We also initiated two notable interest rate-related positions in the third quarter. First, we purchased a significant number of out-of-the money payer swaptions at a time when option volatility had dropped to what we viewed as highly attractive levels. As described above, we believe that credit-sensitive markets, including the non-Agency RMBS market, remain vulnerable from a technical standpoint to a significant unexpected increase in interest rates; these swaption positions were initiated in no small part for the additional income that they should provide to protect our non-Agency portfolio in a rising interest rate scenario. Second, we initiated a significant "swap spreads" position in the third quarter, whereby we purchased intermediate-term U.S. Treasury securities and simultaneously entered into short interest rate swaps with similar maturities. We initiated this position at a time when we felt that swap spreads (i.e., the difference between interest rate swap yields and U.S. Treasury yields) were abnormally tight; at the same time, we view this position as a hedge against credit spreads generally, including for non-Agency RMBS, since swap spreads and credit spreads have historically been correlated. With these new interest rate-related positions, we feel that we are better protected against "tail risks," (i.e., events that would create significant market dislocations, especially to the credit-sensitive parts of our portfolio, but to which the market seems to be ascribing a low probability of occurrence). As of September 30, 2014, we held long positions in U.S. Treasury securities with a total value of $545.3 million against a duration-matched portfolio of interest rate swaps. We may opportunistically enter into swap spreads trades, or other interest rate-related trades, either as hedges to our portfolio or business, or for speculative purposes.

At the end of the second quarter of 2014, we had increased our short position in credit default swaps, or "CDS," on high yield corporate bond indices as part of our non-Agency portfolio credit hedging strategy, given the very tight levels at which high-yield corporate CDX traded at that time. As high yield corporate credit spreads widened during the third quarter, we reduced some of our positions while rotating others. This activity contributed positively to our earnings during the quarter. Our credit hedges also include, among others, short positions (through total return swaps) in certain publicly traded REITs. We believe these instruments will provide protection in the event of a macro-economic downturn. The extent to which we utilize credit hedges in our non-Agency portfolio will increase or decrease based on our view of current fundamental and technical factors.

Agency

Our Agency strategy generated gross income of $3.8 million, or $0.13 per share, during the quarter. Income from our Agency strategy was driven by interest income partially offset by net realized and unrealized losses on investments, net losses on interest rate hedges, and interest expense. Consistent with our strategy, we actively traded our assets during the quarter, resulting in portfolio turnover of 27%. Through active trading, we believe we can take advantage of inefficiencies in the market while enhancing the composition of our portfolio.

As of September 30, 2014, our Agency RMBS are principally comprised of "specified pools." Specified pools are fixed rate Agency pools with special prepayment characteristics, such as pools comprised of low loan balance mortgages, pools comprised of mortgages backed by investor properties, pools containing mortgages originated through the government-sponsored "Making Homes Affordable" refinancing programs, and pools containing mortgages with various other prepayment characteristics.

As anticipated, the Federal Reserve continued to taper its monthly purchases of Agency RMBS and U.S. Treasury securities. The Federal Reserve ceased its monthly bond purchases at the end of October, but expects to continue to reinvest paydown proceeds from its held portfolio into additional Agency RMBS and U.S. Treasury securities.

During the third quarter, specified pools outperformed their TBA counterparts, notwithstanding the fact that Agency RMBS prepayment speeds remained low by historical standards. Contributing to the relatively positive third quarter performance of specified pools was the Federal Reserve's continued reduction in its purchases of Agency RMBS, which have been concentrated in TBAs. As a result, TBA roll prices weakened during the quarter, which in turn provided support to specified pool pay-ups. Pay-ups are price premiums for specified pools relative to their TBA counterparts. Many investors do not wish to take the prepayment risk associated with TBAs, but rather they prefer to buy specified pools. In contrast, the Federal Reserve, as purchaser of TBAs, is much less concerned with prepayment risk, and we believe that as the Federal Reserve continues to reduce its purchases of TBAs, specified pool pay-ups will increase. During the third quarter, our Agency RMBS purchasing activity continued to be focused primarily on specified pools, especially those with higher coupons. In addition, we reduced our holdings of reverse mortgage pools, where yield spreads remained tight during the quarter. Because prepayments remained low, our Agency interest-only securities also performed well, both from a cashflow and price perspective.

Over the course of the third quarter, longer-term interest rates were relatively range-bound. Volatility, while somewhat higher in the third quarter relative to the first and second, was still subdued. Despite intra-quarter upward and downward movements spanning approximately 0.4%, the ten-year U.S. Treasury yield ended the quarter at 2.49%, little changed from where it began. However, shorter-term and intermediate-term interest rates increased during the quarter, as market participants anticipated an eventual tightening of monetary policy by the Federal Reserve. We think it is unlikely that overall interest rate volatility will remain as subdued as it was in the first nine months of the year, and in the early part of the fourth quarter we have already seen an uptick in volatility. This reinforces the importance of our ability to hedge our risks using a variety of tools, including TBAs. Over the course of the third quarter and consistent with our strategy, we continued to hedge against the risk of rising interest rates, primarily with interest rate swaps and TBAs. We also believe that increased volatility can create opportunities for us, particularly given our active style of portfolio management.

One metric that we use to measure our overall prepayment risk is our net Agency premium as a percentage of our long Agency RMBS holdings. Net Agency premium represents the total premium (excess of market value over outstanding principal balance) on long Agency RMBS holdings less the total premium on related net short (TBA) Agency RMBS positions. The net short TBA position related to our long Agency RMBS had a notional value of $540.5 million and a fair value of $582.3 million as of September 30, 2014 and a notional value of $502.7 million and a fair value of $546.2 million as of June 30, 2014. The lower our net Agency premium, the less we believe we are exposed to market-wide increases in Agency RMBS prepayments. As of each of September 30, 2014 and June 30, 2014, our net Agency premium as a percentage of fair value on long Agency RMBS holdings was approximately 2.3%. Excluding TBA positions used to hedge our long Agency RMBS portfolio, our Agency premium as a percentage of fair value was approximately 6.4% and 7.0% as of September 30, 2014 and June 30, 2014, respectively.

Financial Results

We prepare our financial statements in accordance with ASC 946, Financial Services—Investment Companies. As a result, our investments are carried at fair value and all valuation changes are recorded in the Consolidated Statement of Operations.

We also measure our performance through net-asset-value-based total return. Net-asset-value-based total return measures the change in our book value per share and assumes the reinvestment of dividends at book value per share. For the three and nine month periods ended September 30, 2014, our net-asset-value-based total return was 1.32% and 8.44%, respectively. Our net-asset-value-based total return from our inception (August 17, 2007) through September 30, 2014 was 140.51%.

The following table summarizes our operating results for the quarters ended September 30, 2014 and June 30, 2014 and the nine months ended September 30, 2014:

Portfolio

The following tables summarize our portfolio holdings as of September 30, 2014 and June 30, 2014:

Investment Portfolio

Non-Agency RMBS and CMBS are generally securitized in senior/subordinated structures, or in excess spread/over-collateralization structures. Disregarding TBAs, Agency RMBS consist primarily of whole-pool pass through certificates. We actively invest in the TBA market. TBAs are forward-settling Agency RMBS where the mortgage pass-through certificates to be delivered are "To-Be-Announced." Given that we use TBAs primarily to hedge the risk of rising interest rates on our long holdings, we generally carry a net short TBA position.

Derivatives Portfolio⁽¹⁾

Our net short positions in RMBS and CMBS indices reference underlying exposures in several vintage years, including 2005-2008 and 2012. Net long and net short total return swaps on corporate equities are principally comprised of long and short equity positions in certain publicly traded REITs. The mix and composition of our derivative instruments may vary from period to period.

The following table summarizes, as of September 30, 2014, the estimated effects on the value of our portfolio, both overall and by category, of hypothetical, immediate, 50 basis point downward and upward parallel shifts in interest rates.

As shown in the Investment Portfolio and Derivatives Portfolio tables and as described further above, as of September 30, 2014 we had substantially increased our holdings of purchased payer swaptions and we held a large long position in U.S. Treasury securities against a duration-matched portfolio of interest rate swaps. We believe that these positions represent an attractive way to mitigate the risk to the market values of non-Agency credit-sensitive products in the event of a significant unexpected increase in interest rates and/or credit spreads. As reflected in the above table, we believe that our increased net holdings of these swaptions as of September 30, 2014 will provide significant income should interest rates rise precipitously.

Borrowed Funds and Liquidity⁽¹⁾

By Collateral Type

Our leverage ratio (excluding reverse repo borrowings on U.S. Treasury securities) declined to 1.44:1 as of September 30, 2014, as compared to 1.89:1 as of June 30, 2014. The decline was primarily related to the increase in our equity resulting from our September follow-on common share offering and the fact that a portion of the net proceeds was used to pay down our non-Agency reverse repo borrowings. Our leverage ratio may fluctuate period over period based on portfolio management decisions, market conditions, and the timing of security purchase and sale transactions.

By Remaining Maturity ⁽¹⁾⁽²⁾