Ellington Financial Inc. (NYSE:EFC) Q3 2023 Earnings Call Transcript

Ellington Financial Inc. (NYSE:EFC) Q3 2023 Earnings Call Transcript November 8, 2023

Operator: Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Financial’sT hird Quarter 2023 Earnings Conference Call. Today's call is being recorded. At this time, all participants have been placed in a listen-only mode. The floor will be opened for your following the presentation [Operator Instructions]. It is now my pleasure to turn the call over to [Aladdin Chile]. Please begin.

Unidentified Company Representative: 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 Part 1 Item 1A of our annual report on Form 10-K and Part 2 Item 1A of our quarterly report on Form 10-Q for the quarter ended June 30, 2023, 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.

A finance executive with a satisfied smile reviewing a pile of documents in their office.

Statements made during this conference call are made as of the date of this call and the company undertakes no obligations to update or revise any forward-looking statements whether as a result of new information, future events or otherwise. I am joined on the call today by Larry Penn, Chief Executive Officer of Ellington Financial; Mark Tecotzky, Co-Chief Investment Officer of EFC; and JR Herlihy, Chief Financial Officer of EFC. As described in our earnings press release, our third quarter earnings conference call presentation is available on our Web site, ellingtonfinancial.com. Management's prepared remarks will track the presentation. Please note that any references to figures in this presentation are qualified in their entirety by the end notes at the backs of the presentation.

With that, I will now turn the call over to Larry.

Larry Penn: Thanks, [Aladdin], and good morning, everyone. As always, thank you for your time and interest in Ellington Financial. I'll begin on Slide 3 of the presentation. For the third quarter, we have reported net income of $0.10 per share and adjusted distributable earnings of $0.33 per share. Steady performance from our credit portfolio, along with significant net gains on our interest rate hedges exceeded net losses in agency MBS, and we delivered a positive economic return in an extremely volatile market. On this Slide 3, you can see the strong contribution from the credit portfolio, which was led by positive performance from our residential transition, non-QM and commercial mortgage bridge loan businesses and our credit risk transfer securities.

Our agency strategy, on the other hand, contributed a loss of $0.16 per share for the third quarter in what was arguably the most challenging environment for agency RMBS investors we've seen since March of 2020. During the quarter, long term interest rates rose sharply and volatility spiked as the market priced in a higher-for-longer interest rate environment and the uncertainty related to a possible gov shutdown. While we did have a significant loss in our agency strategy, our interest rate hedging strategy which included aggressive duration rebalancing throughout the quarter and a positive contribution from our short TBA positions helped prevent further losses. We had entered the third quarter with high levels of liquidity and additional borrowing capacity.

And because of that, we were well-positioned to capitalize on the investment opportunities that the market volatility presented. With agency yield spreads near the historical wides, we took advantage by adding portfolio and we also captured attractive yield spreads by expanding our non-QM residential transition loan and reverse proprietary mortgage loan portfolios during the quarter. Moving forward, I expect that our loan portfolios will continue to grow. But for our agency portfolio, while we grew that opportunistically this past quarter to take advantage of wider spreads, I still expect that portfolio to shrink over time as we redirect capital to credit. Also during the quarter, we continued to ratchet down our commercial mortgage bridge lending, given the ongoing headwinds in the commercial real estate sector.

Loan pay downs and payoffs continued to exceed new origination volume in our bridge lending business. While the share of our portfolio represented by multi-family grew to an even larger majority of our overall commercial mortgage portfolio. At September 30th, our commercial loan portfolio was as small as it's been in nearly two years. But considering the distressed opportunities that we are starting to see at the market now, this portfolio could expand again in future quarters. We will remain patient as the cycle progresses and we will pick our spots. Our Longbridge segment, meanwhile, generated positive results for the quarter despite the volatility. The segment had substantial interest rate hedging gains and those gains exceeded net losses and originations and on the proprietary reverse mortgage portfolio, as well as a net mark to market loss of $8.2 million on the reverse MSR portfolios.

Taking a step back for a second and actually be a little confusing, however, reverse MSRs are shown on our balance sheet, and I am going to try to clarify that. Now some of our MSRs appear on our balance sheet just as individual MSR assets, and those are straightforward enough. However, our biggest MSR comes from the billions of dollars of HMBS securitizations that Longbidge has done over the years. And since we consolidate those HMBS securitizations, those MSRs don't actually appear on our balance sheet as MSRs per se. Instead, those MSRs are basically represented by the difference between our on balance sheet HMBS assets and our on balance sheet HMBS liabilities. That's why in our public filings and financials, we refer to our HMBS related MSR as our HMBS MSR equivalent.

From our GAAP financials, you compute the value of the MSR as the value of certain assets minus the value of certain liabilities, and that result is equivalent to the value of the HMBS related MSR. Okay. Getting back to that $8.2 million mark-to-market loss on our reverse MSR portfolios, let's dig a little deeper. That was actually a result of offsetting factors. The loss primarily reflected the difference between, on the one hand, a large markdown on our existing MSRs, including the HMBS MSR equivalent. And on the other hand, a less large markup on the MSR portfolio that we acquired out of a bankruptcy proceeding on July 1st. First, I will address the MSR markdown. To value our MSRs, we get input from two of the most widely respected reverse MSR valuation experts in the industry.

Despite that fact, we concluded that a couple of their assumptions in their fair value assessments were too aggressive. First, we decided that it was appropriate to use a higher yield to discount the future projected MSR cash flows as compared to the yield that they used. Second, based on our observations of where HMBS tails have been trading, we decided that it was appropriate to assume lower exit prices for future tail securitizations as compared to the tail prices that they assumed. In addition, we also assumed that we would incur higher future sub-servicing expenses as compared to what we were told previously were the standard expense assumptions. In order reflect sub-servicing expenses that we think we’ll actually be able to obtain and maintain.

So all these factors explain the markdowns on our existing MSRs. Second, as to the MSR market. We apply these more conservative MSR pricing assumptions to that MSR portfolio we acquired out of bankruptcy in early July. While this resulted in an evaluation that was considerably lower than our third party experts valuation, the valuation was still considerably higher than the distressed price of which we acquired that MSR portfolio went to the markup. In summary, we believe that our more conservative assumptions more accurately reflect fair value. And our belief is further validated by several offerings of reverse MSR portfolios that we have seen recently in the secondary market. With the notable exception of that distressed acquisition of ours in July, these recent MSR offerings ultimately did not trade because reserve prices were not met.

Back to Longbridge's results for the quarter. While our Longbridge segment was profitable on a mark-to-market basis, including hedges, the segment's contribution to our adjusted distributable earnings for the quarter turned negative. In a nutshell, challenging market conditions compressed gain-on-sale margins and loan valuations, particularly in the back half of the quarter. As a reminder, Longbridge's origination P&L is a component of our adjusted distributor learnings, creates volatility in our ADE. This past quarter, it was the negative ADE contribution from Longbridge that caused Ellington Financial sequential decline in overall ADE. Looking ahead, with our updated MSR valuations and our growing proprietary reverse mortgage portfolio and with Longbridge's increasing market share in the industry, I believe that Longbridge is well positioned to make meaningful positive ADE contributions respectively.

Looking to the remainder of the year, we finished the third quarter with a recourse debt to equity ratio of just 2.3:1, which is still towards the lower end of our historical levels. As you can see on Slide 3, our cash and unencumbered asset levels show that we still have substantial dry powder to invest. Meanwhile, we are full speed ahead on our merger with Arlington and expect to close next month. We have outlined several strategic benefits of the transaction and I will briefly highlight a few of those again now. First, we will be adding a sizable portfolio of low coupon agency mortgages servicing rights, which gets us into the agency MSR business already at scale. These MSRs should perform well in a high interest rate environment, and function as a natural complement to many of Ellington Financial's existing investments.

Second, we will be able to tap into significant additional dry powder to deploy in a market reach with investment opportunities, both by financing Arlington's currently unlevered agency MSR portfolio and also by monetizing Arlington's liquid assets and rotating that capital into higher yielding investments. We project the merger to accretive to earnings per share and ADE by the second quarter of this coming year. Third, we will significantly increase Ellington Financial's capital base in a highly efficient manner, not only with common equity but also with low cost preferred equity and unsecured debt. And finally, by significantly increasing our scale and bringing us a new group of shareholders, this transaction should enhance the liquidity of our common stock, while lowering our operating expense ratios.

With that, I'll turn the call over to JR to discuss our third quarter financial results in more detail.

JR Herlihy: Thanks, Larry, and good morning, everyone. For the third quarter, we reported net income of $0.10 per share on a fully mark to mark basis and adjusted distributable earnings of $0.33 per share. These results compare to net income of $0.04 per share and ADE of $0.38 per share for the prior quarter. On Slide 5, you can see the attribution of net income among credit agency in Longbridge. The credit strategy generated $0.37 per share of net income driven by an increase in net interest income sequentially and significant net gains on interest rate hedges. A portion of this income was offset by net realized -- unrealized losses on consumer loans, non-QM loans, commercial mortgage bridge loans and CMBS. We also had small net losses on investments in unconsolidated entities and credit hedges and other activities.

Notably, our loan originator affiliates, LendSure, American Heritage, and Sheridan, all posted strong quarterly profits. Although, the fair value marks for those investments on EFCs balance sheet, which are based on third party valuations of these operating companies, did not increase given the challenging market environment. During the quarter, delinquencies again ticked up on our residential and commercial loan portfolios, but those portfolios continue to experience low levels of realized credit losses and strong overall credit performance. In non-QM, we still realized zero cumulative losses life to date on a population that now encompasses nearly 10,000 loans and $4.4 billion of total UPB dating back to 2015. Meanwhile, for RTL and Commercial Mortgage Bridge, realized losses remain low compared to the amount of capital we've invested in profits we've generated, which is largely thanks to our focus on first lien and low LTVs with built-in equity cushions.

That said, recently, more loans have progressed to 90 plus day delinquency status and to REO and the story is still playing out on those. We remain very focused on credit performance and managing through resolutions on these sub-performers. Back to non-QM, where our delinquencies have been among the lowest in the entire sector. Recently, the third party servicer of our non- QM loans was acquired by a much larger servicer and as a result, the servicing of those loans was transferred. Unfortunately, the new servicers handling of that transfer has not been smooth. Given the situation, we do expect that delinquencies on our non-QM loans will temporarily increase in Q4, but we also expect that they will revert to more normalized levels in the coming months once all the transfer related issues have been resolved.

Meanwhile, the Longbridge segment generated $0.06 per share of net income, driven primarily by gains on interest rate hedges. As Larry mentioned, we had a mark to market loss on the HECM MSR equivalent, partially offset by a mark to market gain on the bankruptcy related MSR portfolio purchase. The Longbridge segment also had mark to mark losses on proprietary loans and a net loss in origination. In origination, the combination of higher interest rates and wider yield spreads reduced gain on sale margins on both HECM and proprietary loans, which more than offset a modest uptick in overall origination volumes. Our agency portfolio generated a net loss of $0.16 per share for the third quarter as agency RMBS faced the significant headwinds of elevated market volatility and rising long term interest rates.

Yield spreads widened and agency RMBS significantly underperformed US treasury securities and interest rate swaps for the quarter with lower coupon RMBS exhibiting the most pronounced under performance. Net losses on our agency RMBS and negative net interest income exceeded net gains on our interest rate hedges, while our delta hedging costs, which are tied to interest rate volatility, remained high. On Slide 6, you can see a breakout of adjusted distributable earnings among the investment portfolio, Longbridge and corporate overhead. Here you can see the negative ADE from Longbridge that Larry mentioned, driven by compressed margins and mark-to-market losses on prop. Apart from Longbridge, ADE from the investment portfolio segment net of corporate overhead actually increased incrementally.

I'll note here that part of the increase was related to periodic payments on the interest rate swaps associated with Great Ajax that have since been neutralized, and also to the payment of past due interest related to a commercial mortgage bridge loans that converted from a non-performer back to a re performer during the quarter. Our accounting policy is to stop accruing interest income once loans become 90 days delinquent, and only to recognize interest income again, if the loan becomes contractually current and we expect a loan to be fully repaid. In the third quarter, we saw loans move in both directions into 90-day [DEQ] status and out of it across our residential and commercial mortgage bridge loan portfolios. Of course, all P&L catches up upon ultimate resolution of the given loan.

But prior to that, this dynamic can cause our interest income and thus ADE to be lumpy over time. Next, please turn to Slide 7. In the third quarter, our total long credit portfolio increased slightly to $2.48 billion as of September 30th. Our non-QM and RTL portfolios grew sequentially as net purchases exceeded principal pay downs and we also net purchase non-agency RMBS during the quarter. Conversely, our commercial mortgage bridge loan portfolio continued to shrink as loan pay downs in that portfolio, again, significantly exceeded new originations during the quarter. For the RTL, commercial mortgage bridge and consumer loan portfolios, in total, we received principal pay downs of $393 million during the third quarter, which represented a remarkable 25% of the combined fair value of portfolios coming into the quarter.

This steady stream of principal pay downs bolsters our liquidity and [Technical Difficulty] capital to redeploy where we see the best opportunities. On the next slide, Slide 8, you can see that our total long agency portfolio increased by 5% quarter-over-quarter to $964 million as opportunistic purchases exceeded sales, principal repayments and net losses. Slide nine illustrates that our Longbridge portfolio increased by 14% sequentially to $488 million as of September 30th, driven primarily by proprietary reverse mortgage originations and the acquisition of the bankruptcy related MSR portfolio. These increases were partially offset by a smaller HMBS MSR equivalent, driven primarily by the markdown that Larry mentioned. In the third quarter, Longbridge originated $307 million across [tecom and prop], which is a 3% increase from the prior quarter.

The share of origination through Longbridge's wholesale and correspondent channels increased to 82% from 79%, while retail declined to 18% from 21%. Please turn next to Slide 10 for a summary of our borrowings. On our recourse borrowings, the weighted average borrowing rate increased by 21 basis points to 6.88% as of September 30th, driven by the increase in short term interest rates. Meanwhile, book asset yields on our credit strategy also increased over the same period and we continued to benefit from positive carry on our interest rate swap hedges where we net receive a higher floating rate and pay a lower fixed rate. As a result, the net interest margin on our credit portfolio expanded sequentially. However, an increase in the cost of funds on our agency strategy exceeded an increase in its book asset yields, which caused net interest margin on agency to decrease quarter-over-quarter.

Our recourse debt-to-equity ratio adjusted for unsettled purchases and sales increased to 2.3:1 as of September 30th as compared to 2.1:1 as of June 30th. Our overall debt-to-equity ratio adjusted for unsettled purchases and sales also increased during the quarter to 9.4:1 as of September 30th as compared to 9.2:1 as of June 30th. At September 30th, our combined cash and unencumbered assets totaled approximately $569 million, roughly unchanged from the prior quarter and our book value per common share was $14.33, down from $14.70 in the prior quarter. Including the $0.45 per share of common dividend that we declared during the quarter, our total economic return was a positive 54 basis points for the third quarter. I will shift now to our terminated transaction with Great Ajax, which we announced on October 20th.

After careful consideration, both companies' Boards approved a mutual termination of the merger. As part of that termination, we paid Great Ajax a termination fee of $5 million in cash and also invested $11 million in the company by acquiring 1.67 million newly issued common shares for $6.50 per share. As discussed on last quarter's earnings call, we had established hedges upon signing the merger agreement with Great Ajax. With the deal terminated, we have now neutralized those hedges. But I will note that gains related to the hedges covered all of our costs associated with the transaction, including mark-to-market losses on our termination related investment and the common shares of Great Ajax. The results reported for the third quarter included the gains associated with the hedges that we had established related to the potential Great Ajax merger as well as net losses associated with the fixed receiver interest rate swaps that we used to hedge the fixed payments on our unsecured long term debt and preferred equity.

The quarterly results also reflected expenses related to the Arlington and Great Ajax transactions. Now over to Mark.

Mark Tecotzky: Thanks, JR. This was a very volatile quarter and EFC wound up with a slightly positive economic return. This was a quarter where it seemed like there were two completely disconnected fixed income markets, one for rate products and one for credit. Our credit portfolio had steady returns and maintained strong overall credit performance. Macroeconomic data released during the quarter supported the narrative of a surprisingly strong consumer and a resilient jobs market, which kept credit spreads well anchored. Ellington Financial's short duration portfolio was a lot of floating loans loans and bonds was largely immune from the really violent price movements in the rates market. Investment grade bond indices traded in a relatively narrow spread range [additive] spreads on leverage loans.

That stable backdrop for credit spreads and continued strong credit performance of our portfolios drove solid results for our short duration credit strategies, specifically RTL, commercial bridge, non-QM and credit risk transfer. One exception for us, I would say, was in unsecured consumer loans. We see potential headwinds for that sector with student loan repayments restarted, persistent inflation for necessities like food and rent and potentially slowing wage growth. Our consumer loan portfolio underperformed during the quarter, but we have been shrinking that portfolio and don't have a lot of capital deployed in that sector. At September 30th, our consumer loan portfolio was about one-third the size it was pre-COVID. For rate strategies, it was a different story.

The 10-year treasury yield was incredibly volatile, trading in a massive 85 basis point range with lots of twists and turns along the way and it ended the quarter around its 15 year high. It was a terrible quarter for Agency MBS performance with most coupons underperforming treasury and swap hedges by well over a full point. Interest rate volatility -- a high interest rate volatility, money manager redemptions and REIT deleveraging, were all on the minds of the market and pushed spreads to some of the widest levels seen in years despite the tailwind of only modest supply from new home sales and cash out refinancings. We had a loss in our agency strategy that shaved the full percentage point from EFC's book value per share for the quarter. Following quarter end, the underperformance of Agency MBS actually accelerated in October before posting a strong recovery in the past couple of weeks.

The agency portfolio only uses a small slice of EFC's capital, about 10% at quarter end. But given the volatility we've seen all year, I'm happy to report that as of yesterday, our agency strategy P&L was almost flat for the year. Throughout 2023, we've remained disciplined in our approach to managing the agency portfolio, trying to manage negative convexity at a time of extreme rate volatility, taking advantage of relative value opportunities and keeping our net mortgage exposure roughly constant and leverage relatively low. Spreads remain extremely wide but are materially tighter than the widest spreads in October. Fundamentals look great and technicals are now starting to improve. But a lot has changed since quarter end. In October, the rate sell off accelerated.

But moving into November, rates now rallied significantly from their October highs. The Fed fund futures market now predicts that the Fed will be complacently sitting on its hands for the next few meetings and the prospect for capital to flow back into fixed income funds and ETFs feels much better with the recent decline in volatility. The Fed is trying to get inflation under control by slowing the economy and recent data suggests that that slowdown is finally upon us. After years of strong macroeconomic performance bolstered by stimulus money and low mortgage rates that fueled price appreciation in residential and multifamily real estate, a much bumpier ride lies ahead. And we actually have been preparing for that bumpier ride since the spring of 2022.

We have been more conservative in our RTL underwriting guidelines. We have pulled back from certain markets where we have seen signs of actual or potential pullback in home price from some of the COVID euphoria. Our commercial mortgage bridge loan portfolio has shrunk as pay downs have greatly exceeded new originations given our more stringent underwriting guidelines. Many of the new origination opportunities we've seen in commercial mortgage bridge just don't pencil out given the much higher debt cost, costly tenant improvements, higher insurance costs and slower rent growth. That said, we do think this market will ultimately come to us as cap rates slowly adjust to the new market conditions. Looking forward, I'm confident and really excited about the potential for EFC to thrive in this weaker economic backdrop.

Our current loans and securities are overwhelmingly low LTV and collateralized by real estate that has lots of built up equity. We've done a fantastic job avoiding the land mines in the CMBS. We have a lot of experience in using credit hedges to mitigate downside risk. Now we see the potential to play offense in the distress cycle for commercial real estate. Banks and their advisors are beginning to sell loan portfolios and we expect the day of reckoning will come from many properties, including many good properties that won't be able to pay off their existing mortgage loans when they come due without a capital infusion or restructuring. JR and Larry spoke about the Arlington transaction. I'm looking forward to working with our PMs to integrate and manage that portfolio.

And I'm very happy that EFC will now have a stake in the ground in the agency servicing business. We've owned non-QM and reverse mortgage servicing for years but this is a much larger stake in a much bigger market. Now, back to Larry.

Larry Penn: Thanks, Mark. I'm pleased with Ellington Financial's positive third quarter results in a very challenging market. As usual, our interest rate hedging was key in achieving this. Going back to the launch of EFC in 2007, we've never tried to predict the direction of interest rates and have instead endeavored to hedge them. In this past quarter with interest rate spiking, our interest rate hedges were again very profitable and that helped offset mark to market losses on other parts of the portfolio. The extreme pace of rate hikes since last year clearly caught a lot of the market off guard, but our hedging has kept EFC relatively unscathed. Our hedging program is one of our core strengths, along with our strong track record underwriting credit risk, our expertise in modeling consumer borrower behavior and our willingness to continually improve our portfolio through active trading and portfolio rotation.

Looking ahead, whether we are in a higher for longer interest rate environment or not, I believe that Ellington Financial is well positioned, thanks to our hedging expertise and liquidity management, our short duration, high yielding loan portfolios and a highly diversified array of strategies, which will soon include agency MSRs as well. Thanks to Arlington's highly attractive MSR portfolio. Historically, we've concentrated our investment activities in sectors where banks are less active and where there's less competition, and we have built up deep and experienced teams and strong track records across market cycles in these businesses, especially in the residential mortgage and commercial mortgage sectors. Add to that, EFC now has access to servicing and workout platforms across a variety of loan businesses by virtue of our strategic equity investments.

You can see these business lines on Slide 12. These platforms have significantly broadened the scope of potential investments that Ellington Financial can consider, as they allow us to deal more directly with any credit issues we encounter in our own portfolio and they provide us with the expertise to take over and stabilize distressed assets that we see in the secondary market. A recent example is the bankruptcy related MSR portfolio that we acquired through Longbridge in July, which was only possible because of Longbridge's servicing platform and stellar reputation. That investment is already returning strong results and we think it will be accretive to EFCs earnings in the quarters ahead. The ongoing dislocation of the banking sector should continue to generate compelling opportunities for Arlington Financial, both to buy distressed assets and to add market share at our originator affiliates.

Banks are under pressure from regulators and from losses on their loans and securities. And with deposits leaving for higher yielding alternatives, we see an inefficient market getting even less efficient. Bank stepping back means less capital available to make or buy loans, which should put upward pressure on the spreads we can earn. The opportunities in distress commercial mortgage loans and CMBS could be particularly compelling. Before I conclude, I'd like to reiterate that we here at Ellington Financial are all very excited to close on the Arlington merger next month. The Arlington shareholder vote is scheduled for December 12th and we would anticipate closing the transaction shortly thereafter. To Arlington shareholders, we hope you agree that this pending transaction will be highly attractive and accretive for you as well.

We look forward to introducing ourselves and our company to more of you, and we sincerely hope that your ownership continues. With that, we'll now open the call up to questions. Operator, please go ahead.

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