Ellington Financial Inc. (NYSE:EFC) Q1 2024 Earnings Call Transcript May 8, 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 First Quarter 2024 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 open 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 first 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 this presentation are qualified in their entirety by the end notes at the back of the presentation.
With that, I’ll now turn the call over to Larry.
Larry 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 first quarter, we reported net income of $0.32 per share and adjusted distributable earnings of $0.28 per share. The credit strategy was the primary contributor to our quarterly results, generating 48% per share of net income, led by steady performance from our non-QM and residential transition loan businesses, together with strong returns from our secondary CLO, CMBS and non-Agency RMBS. Our Agency strategy contributed a modest $0.03 per share. In a quarter where Agency MBS lagged the broader rally in credit, with market consensus shifting to a higher for longer expectation.
Finally, Longbridge generated $0.10 per share of GAAP net income. Though I’ll note that after taking out the mark-to-market gain on our reverse MSRs and certain interest rate hedges, ADE from Longbridge was still slightly negative for the quarter. That slightly negative ADE from Longbridge again weighed down EFC’s overall ADE for the quarter. But on a positive note, so far in the second quarter, origination volumes and submissions at Longbridge are pacing well ahead of first quarter volumes and second quarter projections. And so we expect Longbridge to contribute positively to our ADE in the second quarter. Meanwhile, in the first quarter, we made progress deploying the uninvested capital we held at year-end, following the closing of the Arlington merger.
Our credit portfolio expanded, driven by a larger RTL portfolio and opportunistic corporate CLO purchases. We also grew our commercial mortgage bridge loan portfolio after five consecutive quarters of payoffs exceeding new originations in that portfolio. With borrowers finally, more realistic about commercial real estate property valuations, we are seeing strong origination flow from our affiliate Sheridan Capital, which has also sourced a couple of NPLs so far for us in 2024. We also achieved some key portfolio objectives during the first quarter that I’d like to highlight. First, we successfully completed our inaugural securitization of proprietary reverse mortgage loans from Longbridge, which converted repo financing into term non-mark-to-market financing at an attractive cost of funds.
We expect that this securitization marks the beginning of an ongoing program for our proprietary reverse business, similar to the program we have established in our non-QM businesses. Second, we continue to cull lower yielding securities from our portfolio, selling Agency and lower yielding non-Agency RMBS and CMBS in order to free up capital for higher yielding opportunities. Since we generally use more leverage in our MBS portfolios, especially in our Agency MBS portfolio, than we do in our loan portfolios. These MBS sales drove down our overall leverage ratios in the first quarter, despite the increased capital deployment overall. So far in the second quarter, we further expanded our RTL and commercial mortgage bridge loan portfolios. We’ve originated more proprietary reverse mortgage loans on the heels of that March securitization, and we’ve also begun adding investments in closed end second lien mortgages and home equity lines of credit or HELOCs. While we haven’t focused on closed-end seconds HELOCs until recently, we are optimistic about the prospects of deploying significant capital in this sector going forward.
After several consecutive years now of home price appreciation, homeowners across the country are sitting on an enormous amount of home equity. But with mortgage rates up sharply, it doesn’t make sense for most borrowers to refinance their existing low rate mortgage. Closed-end seconds and HELOCs enable these borrowers to tap into that home equity without disturbing their low rate locked in first mortgage. We are seeing a surge of demand for these products from some of the highest credit quality borrowers with pristine pay histories and attractive yield opportunities. One wild card here is potential competition from Freddie Mac and Fannie Mae. As always, we’ll want to focus on products where we’re not competing with those agencies. Also in April, we completed our first non-QM securitization in 14 months, taking advantage of the tightest AAA yield spreads we’ve seen in two years and booking a significant gain as a result.
In recent months, we had been choosing to sell many of our non-QM loans rather than securitize them to take advantage of strong whole loan bids in the marketplace. But with AAA spreads finally back to early 2022 levels, we were able to achieve some great economics in the securitization market and retain some high yielding residual tranches to boot. With that, I’ll turn the call over to JR to discuss the first quarter financial results in more detail. JR?
JR Herlihy: Thanks Larry and good morning everyone. For the first quarter, we reported GAAP net income of $0.32 per share on a fully mark-to-market basis. And adjusted distributable earnings of $0.28 per share. On Slide 5, you can see the attribution of net income among credit Agency and Longbridge. The credit strategy generated $0.48 per share of GAAP net income in the quarter, driven by strong net interest income, net gains on our non-Agency RMBS and equity stake in LendSure, and net gains on interest rate hedges. LendSure has now posted several consecutive quarters of solid performance and it made a sizable distribution in the first quarter with EFC share of that distribution well exceeding our total cost basis in the investment.
A portion of the net income in our credit strategy was offset by net losses on credit hedges, negative operating income on certain commercial nonperforming mortgage loans, and REO, and net losses on residential REO liquidations. We also had a net loss on the Great Ajax common shares we had purchased in connection with last year’s terminated merger, which was partially offset by a net gain on the fixed payer interest rate swap hedges that we hold against those shares. Meanwhile, the Longbridge segment generated GAAP net income of $0.10 per share for the first quarter, driven by positive results from servicing and net gains on interest rate hedges. In originations, improved gain on sale margins in HECM, driven by tighter HECM yield spreads were mostly offset by a decline in overall origination volumes.
Tighter HECM yield spreads also led to net gains on the HMBS MSR Equivalent, as well as improved execution on tail securitizations, which contributed to the positive results from servicing. Partially offsetting these gains were net losses on proprietary loans. Finally, our Agency strategy generated GAAP net income of $0.03 per share for the first quarter. Despite lower interest rate volatility during the quarter, Agency RMBS lagged a broader rally in credit as market consensus for the timing of the first Federal Reserve rate cut was pushed back. This drove interest rates higher across the yield curve and pressured Agency yield spreads, particularly in February and particularly for lower coupons where many of our holdings were concentrated, while Agency yield spreads did recover meaningfully in March, driven by lower volatility and capital inflows.
Overall for the quarter, Agency RMBS generated a modestly negative excess return to treasuries. Despite that negative excess return, our Agency portfolio was modestly profitable for the quarter as net gains on our interest rate hedges exceeded net losses on our pools and negative net interest income. Our net income for the first quarter also reflects a net loss driven by the increase 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, partially offset by a net gain on our senior notes, also driven by the increase in interest rates. As a reminder, we have used interest rate swaps to effectively convert these long-term fixed rate obligations into floating rate obligations.
Turning to Slide 6, you can see the breakout of ADE by segment. Longbridge after excluding the mark-to-market gain on the MSRs and certain interest rate hedge gains generated ADE of negative $0.01 per share. Apart from the Longbridge segment, ADE from the investment portfolio net of corporate other expenses totaled $0.28 per share, which is an increase of $0.03 per share sequentially, but which was still weighed down by nonaccrual loans and REO expenses. During the first quarter, delinquencies ticked up modestly in our residential loan portfolio, driven by incrementally higher non-QM delinquencies, in line with broader market trends. Total delinquencies in our commercial mortgage loan portfolio also ticked up quarter-over-quarter, but that’s only because we bought a non-performing loan during the first quarter.
Also in commercial, we continue to work through the two non performing multifamily bridge loans that we highlighted last quarter. Next, please turn to Slide 7. In the first quarter, our total loan credit portfolio increased by 2% to $2.8 billion as of March 31, driven by larger residential transition loan and commercial mortgage bridge loan portfolios and net purchases of corporate CLOs. A portion of the increase was offset by a smaller non-QM loan portfolio, where principal paydowns and loan sales exceeded net originations and net sales of non-Agency RMBS and CMBS. For our RTL, commercial mortgage bridge and consumer loan portfolios, we received total principal paydowns of $384 million during the first quarter, which represented 23% of the combined fair value of those portfolios coming into the quarter.
As those short duration portfolios continued to return capital steadily. On Slide 8, you can see that our total long Agency RMBS portfolio declined by 22% sequentially to $663 million as we continued to shrink the size of that portfolio and rotate capital into higher yielding opportunities. Slide 9 illustrates that our Longbridge portfolio decreased by 20% sequentially to $441 million, driven primarily by the success successful completion of a $208 million proprietary reverse mortgage loan securitization in March. Please note that for this presentation, similar to how we present our consolidated non-QM securitizations, we only include the tranches we retained in the prop securitization, even though the entire securitization is technically consolidated on our balance sheet for GAAP reporting purposes.
In the first quarter, Longbridge originated $205 million across HECM and prop, which was a 22% decline from the previous quarter. The share of Longbridge’s originations made through its retail channel increased to 25% in the first quarter from 18%, with the share from its wholesale and correspondent channels declining to 75% from 82%. As Larry mentioned, Longbridge is on track to increase origination volume in Q2. Please turn next to Slide 10 for a summary of our borrowings. On our recourse borrowings, the total weighted average borrowing rate increased by 9 basis points to 6.87% at March 31. We continued to benefit from positive carry on our interest rate swap hedges, where we overall receive a higher floating rate and pay a lower fixed rate.
Asset yields increased for both credit and agency during the quarter, which drove NIM expansion in both strategies. Our recourse debt to equity ratio decreased to 1.8:1 at March 31, down from 2:1 as of year-end, driven by a decline in borrowings on our smaller but more highly levered Agency RMBS portfolio and a decrease in our recourse borrowings related to our securitization of proprietary reverse mortgage loans in March. As I mentioned, we do consolidate that prop securitization, so the sold tranches, which represent long term non-recourse financing for us, do stay on our balance sheet. So while our overall debt to equity ratio also decreased over the course of the first quarter from 8.4:1 to 8.3:1, that decrease was smaller than the sequential decrease in our recourse debt to equity ratio.
I’ll note here, too, that we added two new loan financing facilities in April. At March 31, our combined cash and unencumbered assets totaled approximately $732 million, up from $645 million at year end. Our book value for common share was $13.69 at quarter end, down from $13.83 at December 31. Our total economic return was positive 2.1% for the first quarter. Now, over to Mark.
Mark Tecotzky: Thanks, JR. The market backdrop in Q1 was a good one for many leverage structured spread products. Rate volatility declined during the quarter as uncertainty about the Fed shifted from wondering about how high they would hike to speculating about when they will cut. That’s a much more conducive environment for spread assets. Implied volatility came down and yield spreads across corporates and most structured products came in. RFC did what a REIT is supposed to do in that environment. We captured spread income, we converted some repo financing to tighter spread non mark-to-market financing through securitization, we selectively sold assets that we believed had reached their full potential and we sourced some high yielding assets for our portfolio.
For the quarter, we had broad based contributions across our strategies, including both commercial and residential, both loans and securities. We came into the year with ample cash to deploy from the Arlington merger that closed in mid-December and we put some of that to work growing our credit portfolio. One of the highlights was the growth of our commercial mortgage bridge portfolio, where both new originations and non-performing loan acquisitions have picked up even as we’ve substantially tightened our underwriting criteria. In recent quarters, we mentioned an approaching opportunity for EFC related to commercial real estate dislocation and regional bank derisking and that opportunity is here now, including a purchase in April, this year we’ve bought two non-performing loans at substantial discounts to par, which we believe are well secured by the underlying real estate, one of them coming from a regional bank.
Our partnership with Sheridan Capital and the deep experience of our in-house team leaves us well positioned to capitalize on these types of situations. Another big highlight for the quarter was a reverse mortgage prop securitization. The underlying loans for the securitization were not FHA insured HECM reverse mortgage loans, but rather private label loans. So this securitization is the non-agency version for reverses. Proprietary reverse mortgage is a sector with a lot of potential for growth and with few competitors. The securitization allowed us to both recycle our capital and create some very high yielding, long duration retained tranches. I’m hoping that this and future prop securitizations will lead to improved gain on sale margins and additional prop origination volume, and thus increased profits for Longbridge.
In addition, early in the second quarter we priced our first non-securitization in over a year. In 2023, we had slowed down securitizations in the face of relatively wide spreads on the debt tranches we could issue. These spreads have tightened significantly in 2024, however, making securitizations attractive again. Our securitization in April allowed EFC to leverage these tighter spreads and create high yielding retained tranches for our portfolio. Turning back to Slide 7, let’s look at how the portfolio evolved during the first quarter. You can see here that we had modest portfolio growth. We grew commercial bridge and also RTL, but working in the other direction, we took advantage of tighter spreads to harvest some gains in our non-Agency RMBS portfolio.
That portfolio has had tremendous returns over the past 12 months. Portfolio growth has continued following quarter end. We scaled up further in commercial bridge and RTL and we’ve also started buying some closed-end seconds in HELOCs. With so many homeowners sitting on both substantial equity in their homes and first mortgages with very low rates, we see equity extraction as a potentially large, high credit quality, high yielding opportunity. Both closed-end seconds in HELOCs can provide us with very high note rates, modest purchase premiums, substantial levered NIMs and potential securitization outlets to manufacture more high yielding retained investments. On Slide 8, you can see we continue to shrink our agency portfolio as we are seeing what we believe are more interesting opportunities in some other sectors, and we’ll continue to be opportunistic about sales in our Agency RMBS.
Looking ahead, the current market backdrop should continue to generate further investment opportunities for high returns and high ADE. Market expectations for interest rate cuts should both dampen rate volatility and continue to draw more capital into the market, which should support spread products. In addition, the Fed has recently announced a slowdown in their portfolio runoff, which should support bank balance sheets and by extension the assets they buy. We see several new exciting opportunities and EFC has been pouncing. First, the pace of sales of deeply discounted CMBS and commercial NPLs is increasing. We are well positioned to capitalize on those opportunities as last year we deliberately allowed our commercial mortgage portfolio to run off organically and as only a few of our bridge loans are currently in workout.
Securitization spreads have tightened significantly from last year, which is tailwind for our non-QM and prop reverse businesses. We’ll be exploring securitization financing in our RTL business as the first rated RTL securitizations recently got done, significantly improving financing economics. Finally, we are ramping up both in closed-end seconds in HELOCs. Now back to Larry.
Larry Penn: Thanks, Mark. As you can tell, we have a wide variety of high yielding loan strategies where we’re currently putting significant capital to work. For the second quarter so far, we’ve added meaningfully to our credit and Longbridge portfolios in April, and we’ve continued to make room for more loan flow by further trimming our agency specified pool portfolio and by securitizing a significant portion of our non-QM loan portfolio. From a leverage perspective, the net effect of our recent purchases and originations has been outweighing the impact of our agency sales and non-QM securitization. So our recourse debt to equity ratio is on the rise again. Moving forward, I expect leverage to continue to ratchet up, but as was the case in the first quarter, it won’t always be a linear progression given the push and pull from different elements of our portfolio management strategy.
As always, our aim is to balance the dual objectives of growing earnings in the near-term with preserving dry powder to capitalize on opportunistic situations such as what we are currently seeing play out in distressed commercial real estate debt. To that end, even after April’s activity, we continue to have ample cash and borrowing capacity with lots of unencumbered assets, plus other lightly leveraged assets such as our forward MSRs. Besides portfolio expansion, we expect ADE growth to come from two other principal areas. First, continued progress on the handful of non-performing commercial loans and REOs in our portfolio. So far this year, this progress has been slow but steady and second, Longbridge returning to profitability in originations.
As I mentioned earlier, origination volumes and submissions so far in the second quarter are well ahead of projections, despite higher interest rates, which partially reflects additional sourcing channels that Longbridge has successfully established. As a result, we’re expecting Longbridge to contribute positively to ADE in the second quarter. Before wrapping up, I’d like to comment on how EFC is positioned for interest rate changes from here. Over EFC’s almost 17 year history, we have always endeavored through active hedging to protect EFC’s book value per share against movements in interest rates, rather than speculating on the direction of interest rates. This philosophy was again important in the first quarter, where rising longer-term interest rates drove profits on our hedges, which offset losses on some of our longer duration investments.
Moving forward, if we are indeed in a higher for longer interest rate environment, as it seems, I believe that Ellington Financial is well positioned with our hedging expertise, short duration high yielding loan portfolios and mortgage servicing rights portfolios. With that, we’ll now open the call up to questions. Operator, please go ahead.
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