Ellington Financial Inc. (NYSE:EFC) Q4 2023 Earnings Call Transcript February 27, 2024
Ellington Financial Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Financial Fourth Quarter and Full-Year 2023 Earnings Conference Call. Today’s call is being recorded. At this time, all participants have been placed in listen-only mode. The floor will be opened for your questions following the presentation. [Operator Instructions]. It is now my pleasure to turn the call over to Alaael-Deen Shilleh. You may begin.
Alaael-Deen Shilleh: 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 non-historical in nature. As described under Item 1A of our annual report on Form 10-K and Part 2 Item 1A of our quarterly report on Form 10-Q, 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. 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 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 fourth quarter earnings conference call presentation is available on our website at ellingtonfinancial.com. Management’s prepared remarks will track the presentation. Please note that any references to figures in the presentation are qualified in their entirety by the end notes at the back of the presentation.
With that, I will now turn the call over to Larry.
Laurence Penn: Thanks, Alaael-Deen 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 fourth quarter, we reported net income of $0.18 per share from a GAAP perspective, while our adjusted distributable earnings were $0.27 per share. From an economic return perspective, strong performance from our residential transition loan portfolio and our agency and non-agency MBS didn’t quite offset merger-related dilution and expenses together with net losses from Longbridge and other positions, leading to a small negative economic return overall for the quarter. Looking at our adjusted distributable earnings or ADE metric that did drop during the quarter, but it should recover as Longbridge continues to build towards profitability as we work out a few non-performing commercial mortgage loans and assets and REO assets, and as we continue to deploy new capital and rotate capital into higher-yielding sectors.
That said, management expects to recommend to the board, a reduction of the monthly dividend from $0.15 to $0.13 per share beginning in March. It being understood that all dividends are ultimately determined by the board. I would note that, this is just $0.01 below the $0.14 per share monthly dividend level we set the full five years ago when we first shifted from a quarterly to a monthly dividend. In mid-December, we completed the merger with Arlington, which immediately added scale, taking EFC’s equity base above $1.5 billion and which further strengthened our balance sheet as the merger included the assumption of Arlington’s low-cost long-term unsecured debt. Upon closing of the merger, we promptly got to work, freeing up capital in the Arlington portfolio both by monetizing its liquid assets and by beginning to add leverage to the MSR portfolio.
The closing of the merger happened to coincide with the market route, driven by unexpectedly dovish messaging from the Fed’s December meeting and it was an opportune time to be selling assets. Within 24 hours of closing the deal, we had sold essentially all of Arlington’s agency portfolio and most of its CMBS, all at prices above Arlington’s prior marks. We have been busy deploying the freed up capital into our targeted investments, which we expect to drive value to shareholders in 2024. During the fourth quarter, with yield spreads attractive, we continued to expand our RTL and proprietary reverse mortgage portfolios. And I expect to continue growing these and our other proprietary loan portfolios moving forward. Despite that growth, EFC’s recourse leverage actually ticked down sequentially to 2.0:1 from 2.3:1, driven first by the absorption of Arlington’s low leverage capital structure; second, by a smaller commercial bridge portfolio where we continue to allow loan pay-offs to exceed new originations as we gear up for the distressed opportunities we anticipate seeing shortly; and third, by reduced non-QM portfolio where we’ve recently opted for loan sales over new securitizations, capitalizing on a strong whole loan bid in the marketplace.
At just 2.0x leverage, we have plenty of additional borrowing capacity to drive incremental portfolio growth. And as you can also see on Slide 3, our high cash and unencumbered asset levels at year end represent further dry powder. Finally, I’ll note that our book value per share of $13.83 at year end reflected modest dilution from the Arlington merger of about 1.1%. We expect to earn back that dilution in relatively short order from the combined benefit of lower operating ratios and deploying the incremental capital at higher expected returns on equity. Until we fully redeploy that incremental capital, we view ourselves as effectively trading some short-term pressure on adjusted distributable earnings for longer term earnings accretion for shareholders.
With that, I’ll turn the call over to JR to discuss our fourth quarter financial results in more detail.
JR Herlihy: Thanks, Larry, and good morning, everyone. For the fourth quarter, we reported GAAP net income of $0.18 per share on a fully mark-to-market basis and adjusted distributable earnings of $0.27 per share. On Slide 5, you can see the attribution of net income among credit, agency and Longbridge. The credit strategy generated $0.18 per share of net income in the quarter, driven by strong net interest income and net gains on our non-agency RMBS investments. A portion of this income was offset by net losses on consumer loans in non-interest rate and credit hedges. The credit strategy results also reflects a net positive gain on our investments in loan originators as a mark-up, driven by a strong year for American Heritage as well as a modest mark-up on our state and LendSure exceeded a write-down on our consumer loan originator investment.
During the fourth quarter, delinquencies again ticked up on our commercial and residential loan portfolios. In commercial, that’s tied to a handful of non-performing assets that we are diligently working through. In residential, beginning with non-QM, much of the increase in delinquencies was a temporary event attributable to servicing transfer after the servicer we use was acquired by a larger servicer. The servicing transfer related issues have been largely addressed now and we’ve seen delinquency rates begin to normalize with total delinquencies declining to 3.5% today from 5.2% at year end. In RCO, most of the delinquency uptick is related to the 2022 origination vintage which has been a challenging vintage, given the volatility of home prices we’ve seen since the housing market reached its peak in mid-2022 and many markets we lend in.
By virtue of the short duration of our RCO portfolio, we’ve been able to identify and address issues early and have now worked through most of this vintage with minimal if any adverse consequences. Across our commercial and residential loan strategies, net realized losses continued to be low, but the effect of the higher delinquencies is more immediately seen in ADE as loans shifting to non-accrual status seized generating interest income and as REO expenses also weigh on ADE. Turning to Slide 6, we breakout our adjusted distributable earnings by segment. In the investment portfolio, the sequentially ADE decline was driven by higher delinquencies and by the absence of an ADE boost that we had benefited from in the third quarter when we had earned back interest on a previously non-performing loan.
In corporate/other, the ADE decline included some higher G&A. You can also see on this slide that ADE contribution from Longbridge was just $0.01 per share, mostly attributable to low origination volumes. In terms of net income, the Longbridge segment generated a net loss of $0.04 per share for the fourth quarter as net loss in originations and a drag from interest rate hedges exceeded net gains on proprietary loans reversed MSR-related net assets and servicing income. In originations, while Longbridge’s volume was lower quarter-over-quarter, mainly due to seasonal and macro factors, tighter yield spreads and lower interest rates did improve gain on sale margins on both HECM and prop. Looking forward, while we expect another quarter of slow originations in Q1, more constructive margins are improving the prospects for originations to turn profitable later this year and start contributing to EFC’s overall ADE as well.
In agency, after a tumultuous start to the fourth quarter, that’s how U.S. Treasury yields rise of 15-year highs and yield spreads widened sharply, markets subsequently rally through year end in anticipation of the conclusion of the Federal Reserve’s hiking cycle. Overall for the quarter, agency MBS, especially lower and intermediate coupons where EFC’s portfolio is concentrated, generally outperformed interest rate swaps and U.S. Treasury securities, which are our primary hedging instruments. As a result, our agency portfolio generated a net gain of $0.20 per share. Our net income for the fourth quarter also includes the bargain purchase gain associated with the closing of the Arlington merger, which was partially offset by merger-related transaction expenses, including certain compensation and severance costs that have been previously negotiated as part of the merger agreement.
Although the bargain purchase gain net of the related expenses contributed positively to net income during the quarter, overall, the common shares issued in connection with the merger were diluted to book value per share by approximately 1.1%. In addition, our Q4 net income was reduced by $5 million payment we made in October to Great Ajax and a mark-to-market loss on the 1.67 million common shares in Great Ajax we acquired as part of the termination of the merger, both of which were recognized in the fourth quarter, whereas our related hedging gains had largely been recognized in the third quarter. Our Q4 net income also reflects the net gain driven by the decline in interest rates on the fixed receiver interest rate swaps that we used to hedge the fixed payments on both our unsecured long-term debt and our preferred equity.
Next, please turn to Slide 7. In the fourth quarter, our total long credit portfolio increased by 10% to $2.74 billion as of December 31. The increase was driven by the addition of Arlington’s MSR portfolio and a larger residential transition loan portfolio where net purchases exceeded principal paydowns. A portion of the increase was offset by smaller commercial bridge loan and non-QM loan portfolios as loan paydowns, and in the case of non-QM, loan sales exceeded new originations during the quarter. For the RTL, commercial mortgage bridge and consumer loan portfolios, we received total principal paydowns of $302 million during the fourth quarter, which represented 20% of the combined fair value of those portfolios coming into the quarter as those short duration portfolios continue to return capital steadily.
On the next slide, Slide 8, you can see that our total long agency RMBS portfolio declined by 12% sequentially to $853 million as we took advantage of the market rally to monetize pools at attractive yields and rotate that capital into credit investments. More than three quarters of our net agency sales occurred in November and December after yield spreads had tightened considerably. Slide 9 illustrates that our Longbridge portfolio increased by 13% sequentially to $552 million as at year end, driven primarily by proprietary reverse mortgage loan originations. In the fourth quarter, Longbridge originated $262 million across HECM and prop, which was a 15% decline from the previous quarter. The share of originations through Longbridge’s wholesale and correspondent channels remained steady at 82% with retail, again, accounting for 18%.
Please turn next to Slide 10 for a summary of our borrowings. On our recourse borrowings, the total weighted average borrowing rate declined by 10 basis points to 6.78% at year end. We continue to benefit from positive carry on our interest rate swap hedges where we overall received a higher floating rate and pay a lower fixed rates. Although in the agency portfolio, the extent of this benefit declined quarter-over-quarter, which led to NIM compression in that part of the portfolio. However, as we continue to turnover our agency portfolio, we expect to see that NIM compression reverse. We also saw NIM compression in our credit portfolio, but in that case, it was caused by the shift of some delinquent loans to non-accrual status, which dragged down overall asset yields.
With both credit and agency experiencing compressed NIMs quarter-over-quarter, their contributions to ADE also declines. Our recourse debt-to-equity ratio excluding U.S. Treasury securities and adjusted for unsettled trades, decreased to 2.0:1 at year end from 2.3:1 as of September 30, driven by our larger capital base. Our overall debt-to-equity ratio also decreased to 8.4:1 as of year-end from 9.4:1 at September 30. I would also point out that because most of Arlington’s agency pools that we sold in mid-December settled regular way in January, we had an unusually large investment-related receivable on our balance sheet at year end. That balance has since normalized with the settlement of those sales in the new year. At December 31, our combined cash and unencumbered assets totaled approximately $645 million, up substantially from September 30, in part reflecting the incremental liquidity we added through the Arlington merger.
Through that merger, we added about $176 million of common and preferred equity and $88 million principal balance of unsecured debt. Ellington Financial now has about $300 million of unsecured debt with a laddered maturity schedule over the next three years. Meanwhile, we have only a small amount of borrowings against our large MSR portfolios. Clearly, we have lots of dry powder to deploy. At December 31, our book value per common share was $13.83, down from $14.33 at September 30. Our total economic return was a negative 35 basis points for the fourth quarter. Now, over to Mark.
Mark Tecotzky: Thanks, JR. Okay. There was a lot going on at EFC this quarter with the completion of the Arlington merger, the monetization of some of their assets and reinvestment of that capital and lots going on in the market with a pivot and expectations for Fed cuts instead of hikes and a strong recovery in agency MBS performance. As the quarter progressed, we finally got better news on inflation and some more dovish comments from the Fed. That caused the rates market to make a U-turn midway through the quarter. In mid-October the 10-year note nearly hit 5% and it then ended the year around 390, so we had an astonishing 110 basis point rally in a little over a month. The change in expectations with the market then believing that we had seen the peak in Fed funds for the second cycle let everyone to breathe a huge sigh of relief.
We went from wondering when hikes would end to asking when cuts were going to start. Like we have seen many times before, a pivot in the direction of interest rates combined with the drop in volatility that put rates back in a familiar and reasonable trading range is often very good for spread products. This was certainly the case in Q4. Some of the cash that was waiting on the sidelines in October to see how high rates would go got put to work in the second half of the quarter. Flows into fixed income funds were strong and fixed annuity sales were robust. With the notable exception of CMBS, which has its own unique challenges, virtually all spread products tightened in Q4, including agency MBS, investment-grade corporates, high yield bonds, CRT, non-QM, CLOs, et cetera.
Despite the rally, there are certainly still some fundamental challenges in several parts of structured products. Office vacancies are high, multifamily rents stagnating in some markets and overall economics for commercial real estate are challenging. Affordability in the housing market is still weak. We’ve seen a modest delinquency increase for lower FICO borrowers in most mortgage sectors. But our view is that yields and yield spreads are still very high in many sectors and most sectors are exhibiting very strong credit performance despite these challenges. I’m really excited to keep deploying capital at yields and spreads we could have only dreamed about two years ago. If and when the Fed executes its first rate cut, we think that will be a catalyst for book value gains and a tailwind for our ADE.
Meanwhile, housing has performed well despite skyrocketing mortgage rates. In October, agency mortgage rates nearly touched 7.8%, the highest level seen in over two decades before retreating into year end. The lock-in effect for tens of millions of borrowers who are unwilling to move because their low fixed rate mortgages as well as years of under building across the U.S. and seniors aging in place, all have been factors in supporting home prices. Our single-family residential-related strategies of RTL, non-QM and agency MBS, non-agency RMBS and CRT, all contributed positively to Ellington Financial’s returns. These strategies not only delivered meaningful spread income, but they also have price action that outperformed rate hedges. So that means they delivered gains above and beyond just the ADE they provided.
Our vertical integration where we team up with our origination partners in the loan underwriting process, and which is illustrated on Slide 12 has been a key factor in the success of our residential strategies. While gain on sale margins that our non-QM originator affiliates got a boost during Q4 from some spread tightening and higher loan prices, the high interest rate environment for most of 2023 was still a challenging time to be a mortgage originator. LendSure and American Heritage both managed things very well. In fact, both companies were solidly profitable in 2023. In our commercial bridge loan strategy, after years without material headaches, we do have two longer term multifamily work-outs now underway. It’s not at all unexpected in that business.
We have marked down those holdings appropriately through net income and book value, but the strategy still generated double-digit returns on capital for 2023. I believe that our partnership with Sheridan and our own in-house expertise gives us great capabilities to maximize values and work-out situations. These non-performing loans will generate negative ADE while we’re working them out, but we’re hopeful that we’ll see resolutions that generate significant income for us. And then of course, we’ll be able to recycle that capital into positive ADE generating investments again. Finally, I’ll note that results from our consumer loan strategy were negative for the fourth quarter. Performance for lower FICO borrowers has been weak. And while we don’t have a lot of exposure there by design, the exposure we do have was a drag on earnings.
Turning back to Slide 7. You can see how our credit portfolio evolved during the quarter. It grew a little over 10%, partially as a result of incorporating Arlington assets. RTL grew, but our non-QM shrunk as we sold some packages into a strong market. We continue to shrink our commercial bridge portfolio both overall in size and as a percentage of the pie. As you can also see on this slide that forward MSRs are now 6% of the credit portfolio and these serve as a risk-mitigant in a lot of ways. MSRs have a directionally opposite sign compared to many of our other holdings. They appreciate when rates go up, not down. They appreciate when MBS widened rather than tightened. And they may even appreciate when housing goes down not up. These MSR investments stand on their own as an attractive contributor to returns in ADE, but they are additionally attractive as a stabilizer to some of our other holdings.
On the agency portfolio, which you can see on Slide 8, we took advantage of substantially tighter mortgage spreads to sell-off $100-plus million of the portfolio, mostly in November and December. We continued to rotate out of some of our older holdings that were acquired when rates were lower, which should help recharge our ADE going forward. With the completion of the Arlington merger, forward MSRs are now in new return stream and diversifier for us and one that may grow in the future. This is a great sector to leverage the breadth and depth of EFC’s capabilities. Looking ahead, I believe that the current market environment is a great one for us to generate attractive risk-adjusted returns. Yield spreads while not at the October peak are still very wide.
Meanwhile, despite the recent uptick in CPI, the market is still predicting, albeit slightly delayed from prior predictions, a series of rate cuts by the Fed starting later this year eventually leading to a steepened yield curve. A steep yield curve pushes investors out of cash and also tends to lead to more securitization activity and demand for both agency and non-agency MBS. It’s also a catalyst for bank buying in these sectors as it becomes profitable again for banks to buy spread product and fund it with deposits. Therefore, a steeper yield curve generally leads to a more vibrant market and tighter spreads. A steeper yield curve with lower interest rates should also benefit Longbridge as reverse mortgages offer homeowners’ bigger lines of credit when rates are lower and reverse mortgage borrowers are generally very sensitive to the size of the credit line they can get.
While we have all the hedging tools we need to manage risk and generate returns in a flat and inverted yield curve, for all these reasons, we do think a steeper yield curve in the future, which the market is pricing in, would be a net benefit to our strategies. Now back to Larry.
Laurence Penn: Thanks, Mark. I’m pleased to have closed the Arlington merger and integrated its balance sheet into ours. Moving forward, our larger capital base, ample liquidity and additional borrowing capacity should allow us to capitalize on the many attractive investment opportunities we are seeing. Our diversified portfolio provides multiple sourcing channels. As I mentioned earlier, we’ve continued to grow our RTL and prop loan portfolios. We’ve also opportunistically added CLO investments and residential RTLs at attractive yield spreads in recent weeks. We continue to expect that the ongoing dislocation in the commercial mortgage and banking sectors will generate compelling opportunities for Ellington Financial, both to acquire distressed assets and to add market share at our originator affiliates.
While we haven’t been awarded anything yet in this sector, we expect to see more and more distressed commercial real estate debt put up for sale, including situations where otherwise high quality assets just have unsustainable capital structures. We are also seeing compelling opportunities in CMBS. So while our commercial mortgage loan and CMBS portfolios are small as they’ve been since late 2021, those portfolios should expand again in future quarters. As JR mentioned, we expect Longbridge’s origination platform to turn the corner back to profitability later this year, barring any unexpected increases in long-term interest rates. I expect this to happen around mid-year. As a reminder, we report Longbridge’s origination income as component of our adjusted distributable earnings.
So the return of their origination platform to profitability would be a significant boost to our ADE, since it’s been a drag on our ADE for the last three quarters or so. Overall, EFC’s stock delivered a total return to shareholders of 18% in 2023. And we look forward to driving additional value to both our existing and new shareholders in the year ahead. We’ve sized our new dividend consistent with where we see our ADE going in the near-term. We have plenty of dry powder to continue to grow our asset base, whether by using cash-on-hand or our untapped financing lines. There are lots of distressed investment opportunities on our doorstep. We also expect Longbridge to contribute to ADE again by mid-year. And our stock is back within repurchase range, which is another lever we can pull.
With that, we’ll now open the call to questions. Operator, please go ahead.
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