Ellington Financial Inc (EFC) 2010 Q4 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Financial Fourth Quarter 2010 Financial Results Conference Call.

During today's presentation all parties will be in a listen-only mode. Following the presentation the conference will be opened for questions.

(Operator Instructions)

This conference call is being recorded today, February 16. I would now like to turn the conference over to your host, Ellington Financial Vice President, Neha Mathur. Please go ahead.

Thank you operator. Good morning, all, and welcome to our fourth quarter 2010 Ellington Financial earnings call. I am Neha Mathur, Vice President of Ellington Financial.

Before we start I would like to read the following cautionary statement. Certain statements made during this conference call may constitute forward-looking statements within the meaning of Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical in nature and can be identified by words such as anticipate, estimate, will, should, expect, believe, intend, seek, plan and similar expressions, or their negative forms, or by references to strategy, plans or intentions.

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.

Factors that could cause the Company's actual results to differ from its beliefs, expectations, estimates and projections include, among other things, the risks described in Exhibit 99.2 to the Company's Current Report on Form 8-K filed with the SEC on November 17 of 2010. The Form 8-K can be accessed through the Company's website at www.ellingtonfinancial.com or the SEC's website at www.sec.gov.

Other risks, uncertainties and factors that could cause actual results to differ materially from those projected may be described from time to time in reports the Company files with the SEC, including reports on Form 10-Q, 10-K and 8-K. We further caution you that the statements made during this conference call are made as of the date of this call and the Company undertakes no obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

Okay, with me on the call today are Larry Penn, Chief Executive Officer of Ellington Financial, Mark Tecotzky, our Co-Chief Investment Officer and Lisa Mumford, our Chief Financial Officer. First, we would like to provide some prepared remarks highlighting the events of the quarter and then we would happy to answer any questions you may have.

We issued an earnings release yesterday which covers several relevant performance statistics for the quarter, as well as some information on our portfolio. To better follow this call it would be very helpful to have the earnings release with you. You can access this release on our website and we will be going over several details of that release on this call.

With that, I will turn it over to Larry Penn.

Thanks Neha. It's our pleasure to speak with our shareholders this morning as we released our first year-end results as a public company, and we all appreciate your taking the time to participate on the call today.

It has now been just over four months since our IPO and as the first matter of business, I am pleased to announce that we have fully deployed the proceeds from the IPO in what we continue to believe is an extremely attractive investment climate. Mark Tecotzky will discuss this in more detail, but in the subprime and other distressed sectors we continue to favor securities backed by more seasoned mortgages where borrowers have more equity in their homes.

We've seen pricing improve in the non-Agency RMBS sector, which has brought yields down a bit, but it has also favorably impacted our book value. We are still seeing hundreds of millions of dollars worth of securities in for the bid every day and the opportunities are exciting.

We mentioned on our last earnings call that we would be modestly increasing our leverage and you will see that we did so during the quarter. Even with the additional capital infusion from our IPO, our debt-to-equity ratio increased from 1.54 at September 30th to 1.93 at year-end. With the financing environment continuing to improve, we expect to continue to increase leverage modestly in the near term.

In the bond portfolio table on page three of the earnings release, you will notice that we more than doubled our investment in Agency whole pools quarter-over-quarter from $414 million to $851 million. The Agency RMBS market is a liquid and fast-moving market, and we tend to trade and turnover our Agency RMBS portfolio quite actively. So as we see opportunities come and go, you may see our holdings of Agency RMBS fluctuate quite a bit from quarter to quarter.

Now, in the fourth quarter, there were lots of opportunities in this sector and to see that I would like to direct you to our new Earnings Attribution table on page two of our earnings release. Lisa Mumford will discuss this table in a little more detail later, but for now I would just point you to the row in that table entitled "Total Agency RMBS Profit (Loss)", where you will see that our Agency RMBS strategy contributed 100 basis points to our return on equity for the quarter.

This is just tremendous performance considering the relative proportion of our risk capital that was deployed in this strategy. Generally, it has been between about 10% and 20% of our total capital, and considering that we achieved this performance in our Agency RMBS strategy without taking significant interest rate bets. In fact, we achieved it in a rising rate environment!

Recent prepayment volatility has continued to benefit our Agency RMBS strategy as we keep our focus on security selection, and as we find premium pools that we think will prepay more slowly than what the market seems to be pricing in. Now, all that being said, and while the Agency strategy has certainly been ROE contributor, we are still very much focused on the non-Agency RMBS credit strategy as our primary driver of earnings.

We still believe that we are in the midst of an historic opportunity in the non-Agency RMBS market with compelling, and we believe sustainable, economics on new investments. The large overhang in the housing market, mostly the shadow inventory of millions of delinquent mortgages, will we believe lead to additional home price declines over the next 12 to 18 months. This is a view that we have had for a while, even when it was unpopular, and we believe that the market will continue to come around to this view, and that ultimately both our long and short security selection in non-Agency RMBS will benefit.

I will direct you again to our Earnings Attribution table on page two of our earnings release where you will see that in our non-Agency RMBS strategy, we were solidly profitable in the fourth quarter, both on the investment side and on the derivative side, including both credit derivatives and interest rate hedges. In our non-Agency RMBS strategy, you will see that gains on our investments contributed $0.14 a share to earnings, while gains on interest rate hedges contributed $0.21 a share and gains on credit derivatives contributed $0.11 a share.

This "triple play" was only possible because the non-Agency RMBS is still fundamentally a distressed and inefficient market. We firmly believe, as do so many market participants, that the non-Agency mortgage sector is still easily the most attractive asset class out there, especially with the run up in asset prices in so many sectors, and with Treasuries and similar instruments still yielding next to nothing.

I would also like to mention our fourth quarter dividend, which we just declared a few days ago. We will be distributing $1.31 a share on March 15th, to shareholders of record on March 1st, and you will find the backup for the $1.31 in our earnings release.

As you know, the Company's dividend policy targets quarterly and special dividends so that approximately 100% of net income each calendar year is distributed prior to April of the subsequent calendar year. Compared to our mortgage REIT peers, while we expect our dividends to be choppier in the short run with our greater emphasis on maintaining book value, we would like to think that over the long run our dividends will be more reliable and more stable.

Before I turn it over to Lisa, I would like to announce an important addition to the Ellington team. Early this year Ellington hired Leo Huang as Portfolio Manager for commercial real estate debt investments. Leo joined Ellington from Starwood Capital Group where he was Head of Real Estate Fixed Income and oversaw investment activity for Starwood Property Trust, one of the largest commercial mortgage REITs.

Leo is extremely well known and well respected in the commercial real estate debt space and we are very pleased that he is joining Ellington. We feel the time is right to expand this area of our business and Leo is the perfect person to lead the effort.

And now I will turn it over to Lisa to discuss some of the financial highlights of the fourth quarter.

Thank you, Larry, and good morning everyone. I will begin my remarks by quickly reviewing the impact of our October 7, 2010 Initial Public Offering and the fourth quarter activity on our equity.

In the IPO we sold 4.5 million shares and raised net proceeds of approximately $95 million, bringing our total post-IPO shareholders' equity to approximately $404 million, or $23.95 per diluted share, on a September 30th pro forma basis. During the fourth quarter we earned $13.2 million and paid a dividend related to the third quarter of $13.5 million, or $0.80 per share, bringing our December 30, 2010 shareholders' equity back to approximately $404 million, or $23.91 per diluted share. As of December 31, 2010 we had 16.5 million shares outstanding plus 385,000 long-term incentive plan units.

As I mentioned, for the fourth quarter we earned a total of $13.2 million which equates to $0.81 per average share. Of that amount $6.3 million, or $0.39 per share, was attributable to net investment income and $6.9 million, or $0.42 per share, was attributable to net realized and unrealized gains on our investments.

As a reminder, we apply investment company accounting which means, among other things, that all gains and losses, both realized and unrealized, flow through our income statement. In an effort to provide more detail of the sources and character of our earnings for the quarter, as Larry mentioned, we have added an Earnings Attribution table on the second page of the earnings release. In this table we bifurcate our net income before expenses into Agency-RMBS -related and non- Agency-RMBS -related, and then layer on expenses to arrive at our total net income.

This reporting also breaks out the impact of our hedges on both our Agency and non-Agency portfolios. For example, our interest rate hedges, including TBAs, interest rate swaps and Eurodollar futures are assigned to one of the two portfolios at the time of the individual hedging trade. Our credit hedges are always associated with our non-Agency holdings.

As you can see from this table, our non-Agency portfolio contributed $14 million, or 79% of our total non-Agency and Agency RMBS net income before expenses, while our Agency portfolio contributed $3.8 million, or 20%. While we use Agency RMBS in part to help maintain our exemption from the Investment Company Act of 1940, this has also been a profitable portion of our business in its own right.

For the fourth quarter, in addition to net interest earned on our Agency and non-Agency holdings, our interest rate and credit derivatives performed well, added $7.3 million, or $0.45 per share to our net income. Again, our interest rate hedges include interest rate swaps, Eurodollar futures and TBAs. We were well protected from the move up in rates during the quarter as we continued to maintain a very modest duration.

Our credit derivatives include principally our short, as well as long, credit default swap transactions on both ABS single names and ABS indices. Our short positions on late vintage subprime RMBS indices also did well during the quarter.

While we did see some contraction in the yields of our RMBS, we continue to see an improving climate for borrowing. For the quarter, our average cost of borrowing declined to 69 basis points from 77 basis points, yet our weighted average remaining term extended and the weighted average haircut related to our repo borrowing dropped to 12.3% at year-end from 15.9% at September 30th.

Finally, because we like the opportunities in Agency RMBS and because of their very liquid nature, we refined our cash management strategy by using some of our excess cash to purchase Agency RMBS without financing. At the end of the year we held $113 million in unencumbered Agency RMBS.

For the quarter, on an annualized basis, our operating expenses, defined as total expenses excluding interest expense and incentive fees, were 3.3% of average equity. We are very focused on this number and the management of our expenses. Assuming no increase in our capital base, we would like to see that number be closer to 3% to 3.1% of equity and that will be our goal over the 2011 year.

With that, I would like to turn the call over to Mark, our Co-Chief Investment Officer.

Thanks, Lisa. This quarter on the asset side we maintained portfolio concentrations in many of the same asset classes we have liked in prior quarters. At the end of the fourth quarter, as Larry mentioned, we still had a substantial long position in seasoned subprime RMBS with the rest of our long portfolio spread across manufactured housing, Alt -A/Jumbo A and PrimeX.

As opposed to some of the ABX indices we use as credit hedges to our portfolio, we've liked PrimeX as a long investment and source of carry. We expect this to provide a favorable risk-adjusted return going forward.

I would like to take a minute to point out some important portfolio and performance -related information for this quarter. Throughout our marketing efforts before the IPO, we told investors that our hedging strategy, and the flexibility our structure provides with respect to hedging, was a key part of our investment philosophy.

Specifically, we try to hedge out risk that we don't want to take, or don't think we are getting adequately paid to take. Hedging downside risk is critical to protecting book value, but also has the potential to add to our returns in a given quarter. This quarter was a case in point.

We made money on every long segment of our portfolio, but we also made money in our two categories of short positions - interest rate hedges and credit hedges. To get specific, our senior Alt -A and subprime bonds in the long portfolio performed well this quarter, contributing more than half of our total profits from non-Agency securities during this period.

At the start of the quarter, interest rates were very low. For example, the five-year swap rate was about 1.5%. We viewed paying that rate on swaps as very cheap insurance to protect the book value of the Company from a sharp rise in interest rates.

Taking a lot of risk on interest rates when they were as low as they were in the fourth quarter, against a backdrop of a gradually improving economy, was not a good risk/reward for the shareholders. We concluded that, for the Company, hedging interest rate risk had lots of upside, limited downside and would have only had a trivial impact on earnings if rates didn't move.

The move in interest rates in the fourth quarter actually ended up contributing to our returns. The Earnings Attribution table on page two of our earnings release further illustrates the point. While obviously we are not going to make money on both our long and short segments in our portfolio in every quarter, we are disciplined when it comes to making investments and protecting book value for investors, and the recent rate increases, coupled with our performance numbers for the quarter, show how hedges can contribute to performance.

As Larry and Lisa both mentioned, we have seen yields come in a bit on the portfolio. The yields on a typical subprime bond in our portfolio have dropped over 50 basis points in the fourth quarter. Our modest increase in leverage should offset some of that drop in yields.

Markets in the fourth quarter presented the Company with many opportunities and we are optimistic that the opportunity set for the Company will continue to be rich as the impact of Basel III works its way through the financial system. We have already seen banks beginning to take action in the non-Agency RMBS market in an effort to improve their capital ratios, and the widely reported State Street sale at the end of last year was a great example. Many banks may want to sell non-Agency RMBS securities - or buy protection on them - as they adjust to Basel III, and this creates opportunities for EFC.

Looking out longer term, GSE reform may present another set of opportunities for the Company. The recently released Treasury White Paper is the first step in a major secular change in both who will own Agency mortgage-backed securities and who will get paid to take credit risk on Agency securities. As the footprint of the GSEs shrinks, private capital will have to be enticed to pick up the slack.

Fannie Mae, Freddie Mac and Ginnie Mae together are taking the credit risk on over 90% of the new mortgages that are originated in this country. That number is going to drop, possibly significantly. Taking some of that credit risk may provide excellent returns in the future. EFC with its experience in infrastructure is excited about the possibilities.

Lastly, you may have also seen quite a bit of press on the recent foreclosure-related court rulings in Massachusetts and some other states. We think that one of the biggest risks during the quarter, and subsequently, has been uncertainty around the timing and ability of servicers to remove delinquent borrowers from their homes and then liquidate properties to pass cash through the securitization trusts. This risk is very difficult to quantify and it has been magnified by some of these court cases.

Through careful security selection we have consciously built a long portfolio that we think has limited exposure to a lot of the foreclosure and documentation problems in the news recently. On the short side we hold an ABX position to capture the upside from higher delinquency pools and we expect that position to be profitable should ultimate pool loss severities increase. Thanks to our flexible structure and ability to strategically re-orient our portfolio we continue to take advantage of market opportunities through security selection and active trading of the portfolio.

Thank you. And with that I will turn it back over to Larry.

Thanks, Mark. That concludes our prepared remarks.

Before we open up the call for Q&A, I would like to remind everyone that we will be happy to respond to your questions to the extent they are directed to matters related to either specifically Ellington Financial or more generally to the mortgage and asset-backed marketplace in which it operates. We will not be responding to questions on Ellington's private funds or other activities.

Also, as you may have seen, during the first week of February we released an estimate of our January month-end book value per share. While we are happy to discuss overall market events and trends, we won't be answering any questions concerning Ellington Financial's performance or portfolio composition beyond the period covered by yesterday's earnings release, namely December 31, 2010. Operator?

Thank you, sir. We will now begin the question-and-answer session. (Operator Instructions). And our first question is from the line of Steve DeLaney with JMP Securities. Please go ahead.

Thank you. Good morning, everyone. First, I want to compliment you guys on this new Earnings Attribution table. That is extremely helpful to all of us out here and so thanks for that.

My question is really very general and it has to do with the GSE reform and specifically how you view, and I know this, you don't have a crystal ball, but we have seen the CMBS market kind of come back like gangbusters. I mean we are talking, what, at least $50 billion projected this year, but last year to my knowledge there was only one new RMBS deal, new issue. So do you guys have a view on sort of the pace since the plan is to rely almost exclusively on the private sector?

How do you see sort of the pace of the new issue RMBS market opening up and creating opportunities for EFC? I think, specifically I think we saw a second term sheet from Redwood filed last night, so any comments you have on that would be very helpful. Thanks.

Sure, yes. This is Mark.

Good morning, Mark.

Good morning. So, yes it is interesting with CMBS that you saw that Deutsche/UBS $2 billion plus deal priced last week which was I think very well subscribed, and obviously a lot of other CMBS built in the pipeline. It seems to me that one prerequisite for securitization in the CMBS market, or in the residential market, we do need to have consistent capital structures that come out of the rating agencies that aggregators of risk are confident in their ability to predict --

Right.

-- and that buyers of risk, the investors, are confident produce ratings that accurately reflect the risk on the securities. So I think one thing in the CMBS market is that, for a number of reasons, aggregators of CMBS loans are reasonably comfortable with their ability to predict what sort of capital structure those loans will generate.

And there are different kinds of risk that dealers are willing to take, and they are very willing to take risk on betting on the future level of spread, and they are willing to take interest rate risk because they can hedge it, but they are generally not willing to take a lot of risk on predicting how the rating agencies are going to behave if they don't feel like they have a consistent model. So I think in CMBS it has been easier for aggregators of risk to put together deals, because I think they feel like they have more predictive powers on the capital structures that are ultimately going to drive the economics of the deal.

I think in the residential sector that's been harder for aggregators of risk. So I think one prerequisite you need in the residential market before you see securitization which, as you mentioned, is the key to having the GSEs pull back, right? You have to have originators -

Right.

-- that are going to recycle their capital, so I think it is going to take a little while longer before the rating agencies feel comfortable that if someone gives them a loan tape they can give them a capital structure that is relatively predictable for whoever is aggregating that risk, so the aggregator of that risk has a sense of what the economics of the deal are going to be, assuming the spread on the different securities in the capital structure.

There are a lot of different models out there. I think it is interesting what Blackrock is trying to do, right, so they raised that warehouse fund and I think part of the thought process behind that is they are attempting to take out some of what investors in the market perceive as conflicts of interest, right, let's say you have an originator of loans that's originating the first lien and the second lien and they securitize the first lien and they hold the second lien, or you have servicers that are associated with the originator, so I think one thing they are trying to do is put out a set of guidelines, have people originate to those guidelines, have a servicer who has no economic interest in the originator of the loan and then potentially demonstrate some skin in the game by potentially holding some of those securities in their own fund.

So I think you will see attempts like that and models like that. If you think back three, four years ago, so that "originate/distribute" model is very successful for people like RFC, so I think if the GSEs step back, if it is done in lockstep with predictable capital structures from the rating agencies I think you will see the growth of entities that try to do sort of what RFC used to do.

That is very helpful, Mark, and I don't want to put words in your mouth, but it sounds like what you are saying is that structural or mechanical need for consistency with the rating agencies is probably more the issue than a lack of demand by potential AAA investors. Is that the way you would see it?

Yes. I totally agree. I see where this small set of non-Agency bonds that are still AAA, that has met with incredible demand. You mentioned that Redwood --

The Redwood deal.

-- deal done with Citi last year, right. That was incredibly high quality securities and, yes, I don't think the issue is that where investors want to buy AAA securities isn't at a low enough yield where someone can profitably originate the loan. They think it is at a low enough yield, right?

Yes.

I think the issue is more on the mechanics of getting things rated and also people having a better understanding of what sort of retained risk entities need to keep and what entity needs to keep it. Is it who originated the loans? Is it who aggregated the loans?

So I think some of those issues, right, but from where I sit when I look at the yields in the marketplace I think that the bids for AAA securities right now should be tight enough to drive some new originations if you had these other factors worked out.

Very good. Thanks very much for the time and the comments.

And this is Larry. I would just like to just add one more thing as far as Ellington Financial is concerned, and just looking back historically first. If you look at what some of the great opportunities have been in the mortgage market over the years, I think that obviously people remember the RTC liquidations.

They remember the '94 bond market crash. They remember of course the current crisis starting in 2007/2008, but one thing that actually isn't remembered that well, but that we remember very well here, was that after 1998 a lot of the lower quality originators went out of business, especially in what was then the subprime space and similar products like 125% LTV mortgages and whatnot.

So there was a several year period when a segment of the market that had been catered to as far as consumers are concerned were not able to get mortgages. And then, -- so again there are a lot of analogies to today. And then finally in the early part of the 2000s, starting in 2001 especially, that market started to come back and subprime originations started to come back again.

And for the first few years, from I would say '01 to '04, the opportunities for a buy side firm were tremendous. The quality of the mortgages, again, as a market that hadn't been catered to for awhile, so there was huge demand. The originators could be very selective and originate high quality mortgages.

The investors who had been burned in '98 and whatnot were loath to get back in, especially at the lower end of the capital structure. So -- and those were just tremendous buying opportunities back then.

So I see the same thing happening and you will see the first securitizations in the prime space of course, and then you will see capital start to come back to other parts of the lending space and the underwriting guidelines will be much better, as you have seen.

So I think there will be a lot of opportunities, and as Mark has mentioned on several occasions including today mentioning Basel III, the capital requirements and just the technicals of the market have created a huge vacuum in the lower rated parts of the sector, including when there is new origination and you are not going to be originating only AAA tranches, you are going to be originating lower rated tranches, as well.

So we see that as an opportunity which maybe isn't there obviously today, but this will be the next step in the evolution of the market and should create great opportunities for Ellington Financial.

Thanks, Larry.

The next question is from the line of Daniel Furtado with Jefferies. Please go ahead.

Hey, thanks for taking the time to answer my question. I am just trying to get some commentary on what you are seeing in the non-Agency side from a sub-senior cash flow in terms of investor demand and liquidity for that type of paper?

For the lower rated --?

Yes, well anything that is -- I know AAA doesn't really matter anymore. There really isn't any, but anything that is below senior - that are subordinated cash flows I should say.

Yes. This is Mark. So I guess one thing is just to be clear there are a lot of securities that are originally the most senior classes of securitization that are now rated below AAA and in most cases they are not even investment grade. That is sort of one sector.

And for that sector there has been a very active market, right? There has been a lot of trading activity. I think we saw over the course of 2010 probably $600 million, $700 million a day in bid-list activity and that's continuing into 2011. And those securities, securities that are no longer rated AAA, but were the most senior class of their securitizations and retained the structural protections that go with that class, Ellington Financial is very active in.

And then there is a whole other set of securities that are below AAA, but weren't AAA at issuance, those securities that are subordinate and they typically represent relatively thin slices within the capital structure. And for those securities Ellington Financial has had less exposure. We haven't viewed the risk/return as good in those securities, but away from Ellington Financial, those securities are trading actively and those are securities that have an appeal to people that are optimistic about the housing market, optimistic about the economy as a whole because through securities like that you are able to sort of like almost place like a recovery bet. Those securities have done well.

Got you. And how about financing for those types of securities?

Financing is available. As I said, we don't have as much exposure there, so we really haven't been working with our lenders on securing financing, on securities that might have potentially more price volatility as a function of changes in the underlying assumptions, but it is out there and it has definitely improved like everything else.

Got you, okay. Well thanks for the time.

You're welcome.

(Operator Instructions). There appears to be no further questions at this time. I would now like to turn the floor back over to Larry Penn for any closing comments.

Thank you, operator, and just thanks everyone for joining us this morning and we will see you next quarter.

This concludes today's Ellington Financial fourth quarter 2010 financial results conference call. You may now disconnect.