Ellington Financial Inc (EFC) 2012 Q2 法說會逐字稿

Good day, ladies and gentlemen, thank you for standing by. Welcome to the Ellington Financial second quarter 2012 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, August 7. I would now like to turn the conference call over to your host, Sara Brown. Please go ahead.

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 the 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 "believe," "expect," "anticipate," "estimate," "project," "plan," "continue," "intend," "should," "would," "could," "goal," "objective," "will," "may," "seek" or similar expressions or their negative forms or by reference to strategies, 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 under Item 1A of our Annual Report on Form 10-K filed on March 14, 2012, and under Item 1A of our Quarterly Report on Form 10-Q filed on May 9, 2012 which 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 the reports that the Company files with the SEC, including reports on Form 10-Q, Form 10-K, and Form 8-K. We further caution you that 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, I have with us -- with me today on the call, Larry Penn, Chief Executive Officer of Ellington Financial, Mark Tecotzky, our Co-Chief Investment Officer, and Lisa Mumford, our Chief Financial Officer. We issued an earnings release yesterday following the close covering several relevant performance statistics for the quarter as well as some information on our portfolio. We also posted to our website an investor presentation which we will use during the call.

The presentation also contains more in-depth information on our portfolio. To better follow this call, it would be very helpful to have the investor presentation with you which you can access at www.ellingtonfinancial.com. With that I will turn it over to Larry Penn.

Thanks, Sara. It is once again our pleasure to speak with our shareholders this morning as we release our 2012 second-quarter and six-months results. As always, we all appreciate your taking the time to participate on the call today.

In keeping with the format we established last quarter, we have organized the call as follows. First, our CFO, Lisa Mumford, will run through our financial results. Then our Co-CIO, Mark Tecotzky, will provide greater color and detail on the MBS market, how we have been positioning the portfolio and the market outlook going forward.

Finally, I'll add some concluding remarks and then we will open the floor to questions.

In addition to our earnings release, yesterday evening we posted to our website a second-quarter earnings conference call presentation. Lisa and Mark's prepared remarks will track pages 3 through 7 of that presentation. So it will be helpful if you have this presentation in front of you and turn to page 3 to follow along.

Again, you will find it today right on the "For Our Shareholders" page or alternatively on the "Presentations" page of our website at www.ellingtonfinancial.com. While you're getting that in front of you I am going to turn it over to Lisa.

Thank you, Larry, and good morning, everyone. On page 3 of the presentation, you will find our earnings attribution table. On this table we break down for you the source of our earnings for both the second quarter as well as the six months ended June 30. You can see that we earned $10.8 million or $0.64 per share for the quarter and that our earnings were driven by contributions from both our core strategies -- Non-Agency MBS and Agency MBS.

When compared to our excellent first-quarter results, Non-Agency RMBS pricing increases moderated somewhat during the second quarter and a significant drop in interest rates weighed on our quarter results. Notwithstanding these two things, we are pleased with our performance. Our net income includes the full impact of mark-to-market investments on our bonds and derivative instruments.

In our non-Agency strategy, our income for the quarter before operating expenses was $12.9 million or $0.77 per share and included interest income, net gains from trading activity and asset appreciation.

During the quarter, we sold certain seasoned, subprime bonds and replaced them with other attractively priced residential as well as commercial mortgage-backed securities. The market yield on the portfolio as of June 30 was approximately 10.6% and the average price of our non-Agency assets was about $0.57 on the dollar.

Our average cost of borrowing over the quarter was 2.18% and our average remaining maturity on our non-Agency MBS was 81 days. Our hedging activities reduced our income mostly because of declining interest rates during the quarter. Given our views, we continued the trend to reduce our credit hedges. Our credit hedging reduced net income only $600,000 or $0.04 in the quarter.

Our Agency strategy generated $3.1 million in income before operating expenses or $0.18 per share for the quarter. This strategy, too, benefited from the net carry on the assets, realized trading gains and asset appreciation. Trading gains generated income of $5.2 million or $0.31 per share in the quarter. Our strategy to identify and invest in Agency pools with prepayment protection characteristics was again augmented by active trading. The use of TBAs to hedge interest rate and prepayment risks remains a staple of our interest-rate risk management strategy.

In our attributions table, because we use TBAs to hedge, we include gains and losses from them in the net interest rate hedges line. During the quarter, prepayment speeds on generic pools increased and because we effectively hold these securities short through TBA contracts, we actually benefited from the uptick in prepayments. Had we only used interest rate swaps to hedge our interest-rate risk, we would not have benefited from this uptick and our net interest rate hedges line would have shown greater expense.

In terms of financing the cost of repo remains relatively cheap. Our weighted average cost of borrowing over the quarter for our Agency portfolio was 37 basis points.

We continue to find repo financing readily available and our blended cost of financing averaged 80 basis points over the quarter, while our blended average remaining maturity was 45 days at the end of June, similar to what it was at the end of March. Our leverage ratio decreased slightly to 2.24 from 2.33 at the end of March.

Core expenses, which includes other operating expenses and base management fees, came in at 3% of average equity on an annualized basis and all things being equal, we would continue to expect them to remain in the range of 3% to 3.1% on average shareholders' equity for the year. We also incurred incentive fee expenses this quarter after posting returns of over 9% on a trailing four-quarter basis.

Finally, our diluted book value per share was $23.47 at the end of June. A very slight decrease from March's book value of $23.53 including the reduction for the first-quarter dividend of $0.70 per share that was paid in June.

On a six-month basis, our $42.8 million or $2.54 per share in net income equates to an annualized ROE of 22%.

With that, I turn the presentation over to Mark.

Thanks, Lisa. When we did our earnings call to discuss first-quarter results, we put together a slide to make the point that our expectation was that 2012 was shaping up to be a very different year than 2011, because both fundamentals and technicals were improving in 2012 and that securities pricing pretty fully reflected all the messiness of long foreclosure timelines.

As a result, this quarter we not only held onto our strong gains from quarter one, but we built on them. Adding almost another 3% returns this quarter despite a very challenging macroenvironment of lower stock prices and much higher yields on a lot of weaker European credits.

Housing data was marginally stronger for the quarter, but the consensus view on housing became much more bullish, which was supportive of non-Agency prices. So our positioning into lower dollar priced securities relative to a year ago benefited shareholders.

Turning to slide 6, on the Agency side we had another strong quarter without taking material interest-rate risks and hedging a lot of our prepayment risks. One significant difference between the whole pool strategy in EFC and what you find in most mortgage REITs is that EFC is able to simultaneously hedge its interest rate risks and much of its prepayment risks by shorting TBA Agency MBS.

There was a big move in interest rates in the quarter and prepayment risks increased materially from the drop in rates as well as the continued success of the government's HARP 2.0 program. This caused underperformance of higher coupon TBA pass-throughs, which benefited the Company.

Turning to slide 7. So what do we expect going forward and how are we positioned to generate returns to shareholders? We remain very constructive on non-Agency mortgage prices. Probably the biggest reason why distressed mortgage yields are so high is because rating agency downgrades created such a huge capital hole. While the big secular -- well, big secular changes in the insurance industry and on a smaller scale the banking industry is helping to fill that capital hole and should be supporting prices in the future.

Both housing fundamentals and forecasts have improved and we don't see any large visible sellers of non-Agency mortgages on the current horizon.

For Agency mortgages, we think the combination of very low mortgage rates and HARP 2.0 incentives will keep prepayment risks elevated and create numerous trading opportunities.

Slide 9. There were not any large changes in our portfolio positioning in the second quarter. We grew our portfolio by about 4%, much of that increase coming in CMBS and CMBX.

In CMBS, we have found some very good opportunities to put capital to work on some new issue deals. There is a robust new issue calendar on the order of $30 billion per year and we have been an active participant. We have also found some interesting capital structure trades in the CMBX indices, so part of that long exposure is in CMBX.

On slide 10, you can see the yields on different subsectors of the non-Agency portfolio. 10.59% with home price is flat on the non-Agency. It is this high yield, attractive financing, creating opportunities at prudent leverage that are some of the factors that support our $0.70 quarterly dividend.

On slide 11, -- you can see in the quarter we greatly reduced our ABX short. Recently credit markets have been strong, but if you think back to the middle of the second quarter, you had some big risk off days. ABX was fairly volatile in the quarter so we had some good entry points to partially cover that short.

Part of the CMBX short is paired up with CMBS longs, as I mentioned on page 9. So we have definitely positioned ourselves with a strong long bias.

Slide 13. On the Agency portfolio, we reduced our holdings in response to expanded pay ups on specified pools and more potential uncertainty around prepayment initiatives. And it is still a very effective strategy. But the pricing is not as attractive as in previous quarters. We have elected slightly reduced exposure here.

Slide 14. Interest rate hedges against our pass throughs were reduced as the portfolio size shrunk. We are still positioned to try to eliminate substantially all of our interest-rate risks. We decreased the TBA short a little bit on a percentage basis and positioned -- as portions of the TBA market most impacted by facts of faster speeds and policy risks underperformed other rate products in the second quarter.

With that I would like to turn the call back over to Larry.

Thanks, Mark. As you can tell, it is the non-Agency MBS market where we see the best opportunities. So looking forward, we expect to continue to deploy most of our capital in our non-Agency MBS strategies. As a result, they should continue to be the main driver of our earnings for the foreseeable future.

Market yields in that sector have compressed somewhat since our last earnings call, but our outlook for the prospects of the non-Agency MBS market are still extremely positive.

From a technical perspective, you have got pension funds, insurance companies, bond funds, and many other investors practically out of reasonable alternatives for any fixed income product that can reliably provide decent yield. And the non-Agency MBS market is still offering yields that are substantially above those of other alternatives.

As Mark alluded to on slide five of the presentation, pending under Dodd-Frank, there are regulatory changes known as the SSFA capital requirements that will start to allow some bank capital to return to the lower rated or unrated portion of the MBS market. Although it appears that these regulations will initially only apply to the trading books of US banks, and won't apply to the bank portfolios until sometime down the road, we think that this is a significant and positive development.

From a fundamental perspective, housing seems that it may have finally turned the corner in many regions, such as parts of Arizona and Southern California, just to name a couple. And frankly, even if home prices have to go down further in these or other regions, the non-Agency MBS market still provides excellent yields in all but the most severe of scenarios.

We also now have over five years of history on the vast majority of the non-Agency RMBS assets that we invest in and, in many cases, up to 10 or even 15 years of history on these assets. And so from all of that history, we gain a lot of confidence on predicting ongoing behavior of the underlying borrowers.

As you can see on page 13 of the presentation, our June 30 Agency RMBS portfolio was about 17% smaller than it had been at the end of the prior quarter. And this reflects our defensive posture in that market. We think that the recent rises in Agency RMBS asset prices elevate prepayment risk substantially so we expect to keep our allocation to agency RMBS relatively small, relative to non-agency RMBS and, frankly, we are positioning ourselves to take advantage more of short-term trading opportunities in the Agency market rather than long-term value plays.

The bottom line is just that we are as upbeat as ever about the markets we are in and our business model. At current market prices, I just love owning the positions that we're long, which I think not only offer great long-term yields, but also still have lots of near-term upside price potential. And I love being short the positions that we are short which, I think in many cases, are priced to near perfection. And so from a risk reward perspective, we are cutting our risk significantly without costing us very much.

As you can see on page 9 of the presentation, we have been able to maintain a nice low average dollar price on the overall non-Agency MBS portfolio and, furthermore, on the non-Agency RMBS side, we have actually reduced our average dollar price by continuing our rotation out of the most seasoned sectors into lower-priced sectors.

And as you can see on page 11 of the presentation, we substantially reduced that core ABX index short position. Both of these maneuvers reflect our very constructive view of these markets.

We think our portfolio is very well-positioned for the future. We think this is a great investment environment for us. We feel good about our dividend level, and we are very excited about the remainder of the year and beyond.

This concludes our prepared remarks. Before I open up the call to Q&A, I would just like to remind everyone that as usual will be happy to respond to your questions to the extent they are directed to matters related either specifically to 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.

And while we are happy to field any questions about overall market events and trends and our outlook on specific asset classes, as usual, 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 June 30, 2012.

Operator?

(Operator Instructions). Steve DeLaney, JMP Securities.

Good morning, everyone. Larry, you know, the presentation and the focus you continue to highlight both your concentration and your expertise in the non-Agency side. And I think given the rally in Agency, that's -- investors are going to be pleased to hear that given the relative opportunity.

But the new hot button now, and I'm sure you probably anticipated this question this morning, is this concept of eminent domain. And it seems to be focused on private label RMBS as opposed to bank portfolios or the GSEs. Could you just share the team's thoughts there and what you see of the probability of that concept moving forward?

Okay, sure. And just for background here, several counties around the country are considering and other municipalities are considering using eminent domain. So let me just talk about that.

The plan that is under the most serious consideration would work as follows -- you have the locality in question would seize performing but underwater mortgages using an eminent domain theory. Okay, to seize, not real estate, but to seize intangible property under a theory of expanded use of eminent domain. And they would transfer those mortgage loans to private investors who would then -- this would be sort of prearranged -- forgive principal on those loans down to the amount that was let's say slightly under what the fair market value of the home was. And then, refinance those homeowners into a high LTV FHA mortgage which, thanks to the FHA guarantee, could then be sold in the open market at a modest premium to the new lower principal balance.

So first of all, this opens up a hornet's nest of legal challenges. Not only on the legality of the seizures, because this is sort of a new use -- would be a new use of eminent domain, but also of the method that would be used or that is proposed to be used to calculate the required compensation to the holders of the seized mortgage loan. Because under the Fifth Amendment, you are entitled to just compensation for seizures like this.

So, the other thing that is controversial about this plan in addition to its legality is that it also transfers significant risks to the taxpayers. Since the FHA would assume the risk of another housing downturn since it's -- the refinanced loan -- is going to be an FHA loan.

So as you would expect, you have got industry groups for -- such as SIFMA, which is the Securities Industry and Financial Markets Association, up in arms on this. Basically that is the industry trade group for the bond market dealers. And they have already put down their marker against this plan and the bond market, as a whole, will surely fight this tooth and nail. It could be trench warfare on the local level and more general legal challenges on a global level.

So at this point, we think that the odds are that this is going to end up being probably more of an intellectual curiosity than anything else. But obviously, we are watching this closely.

And just to explain what the risks would be, the risks to the non-Agency MBS market which, Steve, as you correctly point out is the market that is targeted for this is that the compensation -- it is really a compensation issue -- the compensation to the holders of this seized mortgage loan, that securitization trust that holds these mortgages would be much less than what they would have eventually received without the seizure. Because the performing underwater borrowers which are the ones that are targeted here, the ones eligible for FHA mortgages, generally continue to make good on a large portion of their payment.

So this, we believe, and I think there is a consensus that this would hurt the securitization trust. So, this is going to be fought tooth and nail. A lot of industry groups are filing amicus briefs and doing everything they can to sort of stop this from happening.

So we think that it's at this point too early, really, to dismiss it entirely, but our prediction would be that it is not going to, in the end, have a significant effect on the types of securities that we invest in.

I appreciate that, Larry. And would you say is it -- do you think it is a fair statement to say that we know what the trade associations have done and their stance, but within the close-knit trading community, do you think that market prices are basically telling us that the actual traders who commit capital every day are pretty much discounting the probability of this becoming a reality?

Right. It has been discounted, meaning that right now the market views this as a low probability event. Or let's just say multiplying the probability of it happening by the impact -- that is a low impact expected outcome.

Okay. Thanks for the time today.

(Operator Instructions). Stephen Laws, Deutsche Bank.

Can you maybe talk a little bit about it looks like the CRE leverage increased sequentially, the opportunities you are seeing there and availability financing, where you see that number trending? Is it going to stay here where we are? Also I know you don't want to comment on any activities since quarter end, but we have seen a good amount of movement in rates on the 10-year. Could you maybe just talk about some of the larger picture issues or the macro things you guys look to or you guys consider to be key indicators that drive change in your portfolio composition?

Okay and I will give that to Mark. I just want to first understand the question on leverage. Was it a particular kind of leverage that you were talking about?

I am referring to page 21 in your slide deck where it looks like the CRE increased sequentially from 1.43 to 2.47.

Yes, okay, right. The commercial --

Leverage by strategy...

Perfect. Okay. Great. Mark, you want to handle that?

Yes, sure. So, in terms of commercial real estate, as I said in my comments, what -- we have found some really good opportunities having Ellington Financial participate in some of the new issue deals, lower down in the capital structure. You know, in our non-Agency mortgage portfolio, we typically buy the most senior class of the deal. On the commercial mortgage on the CMBS portfolio, there we are typically buying lower down in the capital structure. Say BBB, BBB plus. And we have just found that some of the new issue deals get priced at very, very attractive levels on an outright basis and also very attractive levels relative to a CMBX. You can put them together on a pair trade.

So I think that what you'll see from us on CMBS, it will just be very opportunistic. Right? So I think that the amount of exposure we have there, it is going to be somewhat volatile. You know, with 6% in the previous quarter, now to 14%, I would not anticipate it going much higher. Part of the 14% you see on the pie chart in the top right of page 9, that is not all CMBS. Some of that is from CMBX.

And as I mentioned, we found some interesting capital structure trades on CMBX where we go long certain tranches, go short certain tranches, and we think those capital structure trades are going to have, you know, either they function as a hedge for us, they offer us some protection if you got a big risk off event. Or they might also offer us, they might create value for us if you see risk on continuing.

So those are kind of pair trades that we think are going to either function as a hedge for us or generate some additional income for us.

Great. And then maybe general comments about some of the -- what do you guys consider the key points you are watching with the economy here as far as the senior portfolio?

Okay, and before Mark answers that, I just want to add one more thing. Which is that because these capital structure trades, the way they work is they are pretty -- you don't need a lot of capital actually to put them up for one, your long trade and second, to short another. So the -- so you have seen the leverage, right, you'll see the leverage uptick a little bit as you said on the commercial real estate strategy. But we also hold more capital than we had before in the liquidity management strategy against that.

So you'll see on that same page 21, you'll see that our liquidity is a little greater. But keep in mind that a lot of that liquidity just reflects the fact that the way we manage our liquidity risk here is that if we are going to use a little more leverage in a particular strategy, then when all is said and done, we actually in a way aren't using necessarily more leverage because we are putting more liquidity aside, which doesn't go into that number that you see on the bottom left. But, as to the second question regarding the opportunities, I am going to turn it back to Mark.

Yes, I would say the metric we must focus on is we obviously look at home prices. We focus a lot on loss severities, and that is the process we undertake every month where we take loans that have been liquidated in different trusts, where we now know what the actual severity is and we do sort of a post predictive analysis on our model where we ask our model what recoveries to the trust would you have predicted on these different loans and now we can compare that to what actually happened.

And that is a very good discipline for us. Because if there is any aspect of your severity model that is missing, let's say that you have a regional bias or let's say you have a foreclosure timeline bias, you can pick it up by comparing your predictive results to the actual results each month. So, that is an important part of our analysis. Because as we rotated down into lower dollar type securities the second half of 2011, that meant more of our recovery, more of our return on capital comes from either liquidations of properties or short sales. So, it's critical to us that we have a high level of accuracy in our loss severity models.

The other thing we look at is we are constantly looking at how are the current borrowers doing. What rate are they going delinquent and how does that compare to the rate they had been going delinquent in the past. And then we will look at a lot of metrics of -- you know, the broad metrics of consumer leverage.

Great. Okay, well, appreciate those high level thoughts and thanks for the increased good disclosure on the presentation.

Thank you.

There appear to be no questions at this time. I would now like to turn the floor back to Larry Penn for closing remarks.

Okay, great. First of all, I just wanted to point out one thing before we go. Usually before we have this call in the past, we have usually already released an estimated book value per share for the prior month. And I just wanted to point out that, just based on a fluke of the calendar -- there was between sort of calendar days -- since the end of the quarter which is what we base our timing of the release of our 10-Q and our earnings release, just because the difference between the calendar date and the business days of this month and having a weekend just passed and also July having 31 days. Bottom line, those two events are flip-flopped this time around. So just be on the lookout for an upcoming release for July 31 book value per share.

Okay. Well, everyone, thanks for being on the call and we will see you again next quarter.

This concludes today's Ellington Financial second-quarter 2012 financial results conference call. You may now disconnect.