Ellington Financial Inc (EFC) 2016 Q2 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Financial second-quarter 2016 financial results conference call. Today's call is being recorded. (Operator Instructions.)

It is now my pleasure to turn the floor over to Ms. Maria Cozine of Investor Relations. Please go ahead, ma'am.

Thanks, Crystal. Before we start, I would like to remind everyone that certain statements made during this conference call may constitute forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical in nature.

As described under Item 1A of our annual report on Form 10-K, filed on March 11, 2016, 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, 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.

I have on the call with me today Larry Penn, Chief Executive Officer of Ellington Financial; Mark Tecotzky, our co-Chief Investment Officer; and Lisa Mumford, our Chief Financial Officer.

As described in our earnings press release, our second-quarter earnings conference call presentation is available on our website, ellingtonfinancial.com. Management's prepared remarks will track the presentation. Please turn to slide 4 to follow along.

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

Thanks, Maria, and welcome, everyone, to our second-quarter 2016 earnings call. We appreciate your taking the time to listen to the call today.

On our first-quarter earnings call back in May, we described the current positioning of our credit portfolio as, broadly speaking, long consumer credit risk and short high-yield

corporate credit risk. During the second quarter we maintained our credit hedges, which are still primarily composed of short positions in high-yield corporate bond indices. Our view remains that consumers, who have had to adapt to more stringent lending standards since the financial crisis, are a much preferable credit as compared to many high-yield corporate borrowers vulnerable to a variety of genuine risks, such as an economic downturn or weakening commodity or energy prices.

During the second quarter, assets in both our credit and agency strategies performed well. In particular, we continue to be pleased with the performance of our loan portfolios, which have been growing at a healthy rate under our flow agreements. We believe that the strong combination of our securities portfolio, which offers not only yield but also the ability to generate trading gains, and our high-yield and consumer and mortgage loan portfolios, which provide a steady flow of sustainable income, creates a potentially powerful earnings opportunity for shareholders. As Mark will elaborate on later, an overarching theme of many of these opportunities is that the banks are no longer willing or able to participate in certain sectors like they once could.

While our credit hedges did cost us money in the second quarter, the market reaction to the Brexit vote is a good example of why we have these hedges in place. We believe that many credit markets remain vulnerable to a whole host of exogenous shocks and that the post-crisis structural changes in these markets, such as the increasing dominance of daily liquidity mutual funds and the constraints on banks holding large risk inventories, increase the likelihood of exaggerated downward moves. We are confident that the fundamental value in our long portfolio, with its concentrations in legacy securities and consumer and mortgage loans, will greatly outperform our credit hedges in a large downward move in global credit.

Consistent with this thesis, our credit hedges performed extremely well immediately following the Brexit referendum vote, as corporate credit spreads widened dramatically. It initially appeared that investors were concerned that Brexit could serve as a catalyst for a major global credit event. However, as central banks quickly reacted to the ensuing market fallout and promised further accommodations in monetary policy, the herd reversed course, and credit spreads snapped back, even past where they had been pre-Brexit. The net tightening in high-yield corporate bond index spreads over the course of the quarter led to net losses on our credit hedges.

We believe that many investors are actually extremely wary of the fundamentals of high-yield corporate bonds, but because there are very few sources of yield available due to the negative interest-rate policies of global central banks, they have piled into riskier asset classes such as high-yield credit, just to meet unrealistic return targets.

Maintaining a disciplined hedging strategy has served us well over many market cycles, including even 2007 and 2008, when we preserved our book value. That being said, the size and composition of our hedge portfolio may change. We continually evaluate the position, and our goal is to be thoughtful and adaptive in reaction to changes in global markets.

Overall, EFC produced positive performance in what was a challenging quarter of historic volatility for markets globally. Growth in our consumer loan portfolio contributed substantially to our success this quarter, and later on the call today, I'll provide more detail on the strategic reallocation of capital within our portfolio and how our long-term business plans are unfolding.

With that, I'll turn the call to Lisa, who will provide more detail on our financial results for the quarter.

Thanks, Larry, and good morning, everyone. On our earnings attribution table on page 4 of the presentation, you can see that in the second quarter our credit strategy generated gross income of $6.8 million, or $0.20 per share, and our agency strategy generated gross income of $3.2 million, or $0.10 per share. After expenses of $5.1 million, or $0.15 per share, we had net income of $5 million, or $0.15 per share.

Within our credit strategy, we had solid contributions from our assets in the form of interest income and net realized gains net of financing costs and investment-related costs, but losses on our credit and interest-rate hedges depressed our results. On a quarter-over-quarter basis, our interest income and other income increased approximately 4%. We had increased interest income from our loans, specifically our consumer and non-QM residential loan portfolios, which each grew in size. The increase in interest income from our loans was partially offset by decreases in interest income from our non-agency RMBS and distressed corporate debt, as those portfolios declined in size.

Excluding the hedging side of the portfolio, we had net realized and unrealized gains in the second quarter of $841,000 as compared to net realized and unrealized losses of $5.4 million in the first quarter. The big driver here was lower mark-to-market losses quarter over quarter, with the bulk of this positive variance coming from our distressed corporate loans, non-agency RMBS, and CMBS. Generally, tighter spreads for these asset classes relative to the first quarter led to these improvements.

We also had increased net realized gains in the second quarter, and this increase was principally due to sales of our non-agency RMBS, as well as sales of REO related to our small balance commercial mortgage loan portfolio.

Our credit hedges depressed our results for the quarter, as most of these hedges are in the form of credit default swaps and other instruments referencing high-yield corporate bond indices. The net spread tightening that occurred during the quarter on high-yield corporate debt indices had a significant impact on our results for the quarter, given that we hold a net short position. Also impacting our credit results for the quarter were declining interest rates, which led to losses on our interest-rate hedges, which are principally in the form of interest-rate swaps.

On a quarter-over-quarter basis, borrowing costs increased for our credit strategy, driven by an increase in the proportion of our credit portfolio borrowings related specifically to our loan portfolios. As of the end of the second quarter, repo and securitized debt related to our loan portfolios represented approximately 52% of our outstanding credit-related borrowings, while as of the end of the first quarter, debt related to our loan portfolios represented 47% of our credit-related borrowings.

As of June 30, our debt related to our loan portfolios had a weighted average borrowing rate of approximately 3.24%, whereas our repo debt on our securities portfolio, including our non-agency RMBS, had a weighted average borrowing rate of 2.27%. During the second quarter, our interest expense included expenses related to the upfront cost of establishing our loan and securitized debt-related facilities.

Our agency RMBS portfolio produced solid results for the quarter. Yield spreads were much more stable than they had been, especially relative to the last two quarters. In the second quarter, our interest income included the impact of a $1.5 million negative catch-up premium amortization adjustment related to increased expected prepayment activity, given the drop in mortgage rates. In the first quarter, this adjustment was a positive amount of $400,000. Of course, these negative and positive adjustments to our interest income do not affect our net income for the quarter since their impact is offset in net realized and unrealized gains or losses.

Also contributing to the decline in agency RMBS interest income was a drop in our average holdings quarter over quarter in the amount of approximately $40 million. Excluding the catch-up premium amortization adjustment quarter over quarter, the weighted average yields on our agency portfolio declined from 3.04% to 3%. Our agency-related borrowing rates have increased steadily since the second half of last year. However, during the second quarter, repo rates were relatively stable, and repo financing has remained readily available.

Quarter over quarter, our expenses were flat at $5.1 million, although our annualized expense ratio increased from 2.8% to 3%. During the quarter, our share repurchases were $0.02 per share accretive to our diluted book value per share. And since the end of the second quarter, our continued repurchases have resulted in another $0.01-per-share accretive benefit. We ended the quarter with a diluted book value per share of $20.31, down from $20.63 as of March 31, 2016, a decline of 1.6%.

I'd like to now turn the presentation over to Mark.

Thank you, Lisa. This was a quarter of mixed results for us. On the positive side, the performance of our assets was strong, and we continued to see further development and maturation of our platforms to deliver high-yielding assets to the Company. But the cost of credit hedges muted our gains.

In the second quarter, the credit markets were a tug of war between two competing forces. The Brexit vote and concerns about slower global growth argued for wider spreads. But central bank QE in response to these concerns lifted and stabilized financial assets.

It was also a quarter where more liquid sectors outperformed less liquid ones. In the face of volatility where price discovery is more opaque, more liquid assets and indices attract capital because of their transparent pricing. In addition, with macro events dominating the headlines, correlations between asset classes were high and fundamentals within asset classes took a backseat. While in the long run, this dynamic creates relative value opportunities, it did serve as a headwind this quarter.

Although results were constrained by losses on our hedges, in light of the reduction in our non-agency RMBS portfolio, the continuing shift of our portfolio to less macro-sensitive assets, and the post-Brexit credit widening reduced the magnitude of our credit hedges during the quarter. You can see that on slide 15 that our overall credit hedge portfolio was reduced substantially.

However, the surprise Brexit vote and more recently, the weakness in oil prices, serving as a reminder that macro volatility is still with us. Our incremental investment dollars are generally going to higher-yielding strategies, and even with some potential drag from credit hedges, our portfolio can generate a healthy yield.

We show this on slide 10. You can see that the combined impact of higher yields on our assets, together with lower implied yields on our hedge short positions, has made the yield spread differential between the two the widest we have seen in some time. We continue to believe that structured credit is a much better fundamental credit risk than high-yield, so we keep credit hedges in place.

Since quarter end, we have seen improved prices on our credit portfolio, as the relative stability of the last month now has many investors focusing on cash investments over indices. The recent positive technical development in non-agency RMBS is the Countrywide settlement, which flowed through to deals in the end of June and returned $8 billion to investors, much of which we believe will be reinvested in structured credit, further supporting prices in that sector.

In our view, our view is that the spread gap shown on slide 10 is unlikely to persist. We expect that either our assets will get priced to lower yields or our hedges will get priced to higher yields. This conviction is rooted in our view of the strong position of the US consumer. Consumer balance sheets have benefited from substantial home equity buildup since 2010, coming from two directions -- strong home price appreciation and declining debt load.

Turning to slide 12 to see portfolio evolution, one trend we have been focusing on for the last several years is how QE's flooding the market with capital would drive down yields in any area of fixed income that was big, liquid, and could absorb large capital flows. So not surprisingly, we now have a market with tight corporate spreads, tight high-yield spreads, and low long-term Treasury yields.

In our non-agency portfolio, with its small investment size and idiosyncratic deal waterfalls and inconsistent volumes, yields have come down but still remain attractive because these hurdles deter large-scale capital inflow. In response to the trend of lower yields in response to QEs, for the past few years we have focused on building an investment pipeline in sectors that have significant barriers to entry. Those efforts are starting to be a source of significant asset flow.

Take our consumer loan strategy, which grew in the quarter. These investments come into forward flow agreements that are difficult and time-consuming to replicate and require a lot of infrastructure to execute. Our small-balance commercial mortgage loan purchase required very specific investment expertise in addition to broad-based commercial real estate understanding. The same is true with our RPL and NPL loan purchases in the US and Europe.

Having created not only an investment pipeline, but also infrastructure to buy these high-yield assets is very valuable to the Company because these sectors can maintain their yields, even in the face of easy money from central banks. There is a barrier to entry for other investors, and these sectors cannot be commoditized.

The non-QM consumer loan opportunities exist because the regulatory and capital burden on banks has led them to stop lending to all but the most pristine borrowers. Many of our non-QM borrowers have FICOs well into the 700s, but they don't fit neatly into a Fannie/Freddie box. Pre-crisis banks extended credit to these consumers, but post-crisis, after writing $100 billion in legal settlement checks, banks have exited the business. EFC, with permanent capital and a flexible hedging strategy, is well suited to fill the void.

Pre-crisis, many borrowers could meet short-term borrowing needs with a second lien mortgage or a cash-out refinancing. Post-crisis, only the pristine consumer credit can get an ELOC from a bank. Here, too, EFC can fill the void by stepping up to support borrowers that aren't quite good enough for the big banks. With Ellington's experience and expertise in the credit investor, entering these lending markets is a great opportunity for EFC to secure a proprietary pipeline of assets and create franchise value at the same time.

Turning to slide 12, the portfolio did contract some in the quarter, as we sold out some non-agencies with a plan to deploy the proceeds into higher-yielding sectors. Our non-QM effort is building momentum, and we project a healthy supply of consumer loans and other pipeline assets for the quarter, so we are focused on continuing to increase our portfolio yield.

In our agency portfolio, we had a very strong quarter. Despite a drop in interest rates that has brought mortgage rates to the lowest levels in years and caused a material increase in prepayment speeds, agency mortgages were well bid, benefiting from strong overseas demand. We came into this rate move with a lot of prepayment protection, which is helping us keep higher coupon pools on the books.

Hedging costs have dropped a lot, both in swaps and TBAs, so we see a very healthy net interest margin right now. We trimmed the portfolio some as we harvested some gains, but we held on to much of our prepayment protection, which has continued to appreciate post-quarter end.

Going forward, I am confident that the yield in our structured credit portfolio can deliver cash flows supportive of our dividend. Our diversified suite of strategies allows us to cast a broad net for investments to meet our yield targets, despite the move to lower yields in many parts of fixed income. Ellington brings significant resources to the task, with over 160 people, research teams, proprietary models and strong risk management. We think the big yield gap between assets and credit hedges should allow us to perform in both risk-on and risk-off moves. We are trying to construct a portfolio that can simultaneously deliver a healthy dividend, but with substantial downside protection should spreads widen as they did back in February or post-Brexit. We cannot be complacent and assume that any spread widening will be quickly reversed.

Going into the quarter, we were sufficiently concerned that credit spreads could widen that we thought it prudent to protect the portfolio. As it turned out, a big spread widening did not occur, but the macro landscape is still a volatile one, with so many assets dependent upon central bank QE.

You need only consider the $10 trillion in bonds that yield less than zero to realize that QE has had a profound impact on many asset prices. We are constructive about our earnings potential going forward, focusing on assets with sound credit fundamentals and a high enough yield to support our dividend, which we view as significantly higher than other investments with similar risks.

Now I'll turn the call back to Larry.

Thanks, Mark. Last quarter we spoke about our progress in building a proprietary investment pipeline in consumer loans, non-QM mortgage origination, and distressed commercial mortgage loans. Our portfolio is becoming more simplified, as we are reducing some other strategies in favor of yet others that we view as having greater long-term sustainable growth and more predictable earnings streams. We believe that this will also provide shareholders better visibility into EFC's business model and long-term performance expectations.

Consumer loan and ABS performance was a key driver of EFC's earnings this quarter. In the second quarter, the size of our consumer loan portfolio increased to $152 million, which is now 27% of our total portfolio, and now even about as large as our non-agency RMBS portfolio. Our expectation is that the size of this portfolio will increase meaningfully going forward, as it is performing well and within our model's expectations.

Increased loan flow in the near term will likely come from the existing strategic partnerships we have already made, as the performance of loans made to date from these originators has met or exceeded our expectations. Additionally, we expect to begin permanently financing this business to reach securitizations, which will be accretive to returns and portfolio performance and which will free up capital to reinvest even further in the strategy. As the size of our consumer loan portfolio grows, it could become more and more instrumental in producing steady and sustainable income for our shareholders.

The pace of purchases from our non-QM mortgage pipeline is promising, as evidenced by the portfolio's growth this quarter to $39.4 million. Post-quarter end, we purchased an additional $10 million of non-QM mortgages in July and expect to see another $10 million-plus of purchases for August. Performance in our non-QM mortgage portfolio has been excellent so far, and as the pace of originations picks up, we hope that this business will become a steadily growing part of our overall strategy.

Although the securitization markets are not yet open for us in non-QM mortgages, we believe that as origination eventually picks up, securitization pricing may fall in line, in which case securitization could be a part of our long-term strategy.

Meanwhile, we are earning an attractive spread between the yields on our non-QM mortgage portfolio and the cost of funds of our non-QM financing line. It is our view that the continued excellent performance nationwide of the small but growing non-QM mortgage space will open up the securitization markets down the road.

Looking ahead into the second half of 2016, our goal is clear, which is to continue to focus on executing our long-term business plans, including strategically reallocating capital into those strategies we find most compelling.

Last quarter I mentioned that at some point soon, we may stop comparing ourselves to the REITs and be more accurately described as a highly diversified specialty finance company. This quarter, with the further growth of our proprietary loan pipeline, we are getting closer to that point. If you take a look at slide 13 in the presentation, you can see in the pie chart on the right that RMBS at the end of 2013 was 82% of our credit portfolio. The pie chart on the left illustrates just how much we have reshaped our business model.

Additionally, on slide 14, you can see that the average yield of our credit portfolio increased to 10.3% for the second quarter from only 7.29% at year end 2013. As the opportunity set has changed, Ellington has evolved as well to take advantage of the new opportunity set and market dynamics.

While the price-to-book ratio of our stock has risen from 77% at the beginning of the year to 86% as of yesterday, it has still been trading at a significant discount to book value. In light of this discount, we continued to execute under our share repurchase program announced last August, including post-quarter-end repurchases. We have repurchased to date under the current program a total of 821,810 shares at an average price of $17.29 for an accretive effect of about $0.09 to our book value per share.

As our stock trades at higher price-to-book ratios, share repurchases become less attractive to us and less accretive for our shareholders. And as a result, we have recently reduced the pace of our repurchases. Going forward, our share repurchase strategy will continue to be opportunistic.

Ellington Financial seeks to create lasting value for shareholders through strategic portfolio allocation and disciplined hedging strategies. Our structure provides us great flexibility that allows us to invest in assets like select consumer loans that we think have some of the greatest performance potential in this market.

Although the low-to-negative interest-rate policies of central banks are weighing on investors globally as they search for sources of yield, the consumer stands to benefit from lower interest rates. At the same time, we recognize the importance and prudence of maintaining a hedge against significant yield spread widening, as well as the necessity of being active in a diverse array of sectors. This view has served Ellington well over a 21-plus-year history of enduring market cycles and is one that we believe will continue to drive returns going forward.

This concludes our prepared remarks, and we are now pleased to take your questions. Operator?

(Operator Instructions.) Steve Delaney, JMP Securities.

Larry, over the last couple of years, Ellington has made some strategic equity investments in platforms. And I was curious if any of those investments are yielding you some of this flow in these diversified credit products that are now coming on the balance sheet. Is there any sort of correlation between the relationships where you became a strategic partner in the actual flow of paper coming onto your balance sheet, is really the question. Thanks.

Yes. So far, it's really just been in the non-QM product. And in the other sectors, I would say no, nothing significant yet. No, I -- yes, I'd rather not speculate in terms of going forward. But we are hopeful that some of those in particular will be (inaudible) for any assets.

And the NQM, is that -- I believe one of the platforms was called Skyline. Is that correct?

Well, no, actually. Hold on one second. No, LendSure actually is the --

LendSure, okay, thank you. And on that end, when we go to NQM, and I know there's a lot of confusion in the market about the difference between NQM or non-prime or Alt-QM. It's a pretty vague -- anything that's not conforming Freddie/Fannie, I guess, is getting thrown in a bucket. I'm just curious if you guys paid much attention to that Caliber Homes securitization, and is that -- they defined those loans, I believe, as nonprime, or the rating agencies did. Was there anything meaningful in that transaction as far as the opportunities that your current NQM flow program might provide you, going forward?

Hey, Steve, it's Mark. So yes, the pricing on that deal was a little bit stronger than what we saw on the two non-QM deals that priced in December of 2015. So I think that's a good sign.

Where we look at that pricing compared to where we have repo in place, the repo right now to us still looks a little bit more attractive. But that deal garnered significant demand and the pricing was tighter, so it's moving in the right direction.

Yes, these assets are performing well, I think, all across different origination platforms. It's still small, obviously, but I think that as people see its track history -- its

track record is getting better and better in terms of longer and longer in terms of good performance -- I think that the securitization markets are going to tighten up more. I couldn't tell you how long that's going to take, but that's our plan, is to hold the product until we can get that really good execution in the securitization market.

Got it, okay. And your financing facilities allow you to do that. Because you would probably have to get up to what, a couple hundred million, $300 million, to be efficient in the securitization?

I think you can do something smaller than that. I think the transactions done at the end of last year were a little smaller than that.

But there's nothing about our financing arrangements that -- a lot of warehouse lines have finite gestation periods, things like that. We're not -- that's not the case for us.

Okay. And your consumer loans, I can see on page 14 that your coupons are over 10%, or at least your yield is over 10%. So I assume that those are installment -- fixed-pay installment-type loans. What is the average term of those loans?

They range between a year and a half and five years. I think the average is probably right around four years. And you're right; they're all fixed amortization. They're not -- so they pay down at a pretty healthy rate just from amortization.

Which obviously feeds nicely that structure. Those loan terms would feed nicely into an ABS deal, right?

Yes, that's exactly right.

Because you would have a defined duration of the security, okay. I guess, well, thank you for the comments.

Douglas Harter, Credit Suisse.

As you're growing the non-QM loans and the consumer loans, which are less liquid, does that change the hedging strategy or the amount of hedges against liquid indices that you would put on? How do you think about that?

Yes, so each asset, each asset class, we believe has a different correlation, and we're focused on big moves, right? A different correlation in a big move, especially a big downward move in credit. So absolutely, that informs our hedges. And in fact, you saw last quarter that as we were selling non-agencies and some of the distressed debt positions and things like that, that we were reducing hedges accordingly. And some of the portfolios, for example, like the consumer credit portfolio and things like that, have less of a correlation in a big downward move. So yes, that will definitely -- you definitely should see changes in the size of that credit hedge as the portfolio continues to shift.

And then I guess also, how do you think about, right -- I would imagine that the loans are -- or do you mark to market the loans and the non-QM loans? And does that change the way you think about hedging from a book-value perspective?

Absolutely, we mark them to market, and absolutely, we are concerned with changes in market value. That's what our hedges are there to protect is book value, so yes.

Okay. And I think you -- correct me if I'm wrong -- you said you're doing around $10 million a month right now in the non-QM loans?

Yes, that's about right, yes.

And what is the rough pace on the consumer loans?

Well, I think we -- right, we had the increase, but that includes -- yes, that's a net number. I don't have that number for you now, sorry.

Well, what was the -- I just don't have it in front of me -- what was the amount that you added during the second quarter? And is that an appropriate run rate level?

Yes, so we --

It went up about $10 million in the second quarter.

Net of pay-downs.

Right.

But I mean, in terms of the flow that we're seeing from all the originators that we have, that's definitely going up, there's no question about it.

And they're amortized. Like Mark said, some of them are a year and a half, two years. So they are starting to amortize as well.

Yes. One question that we're always discussing is where do we want that slice of the pie chart to end up. So it's been increasing. It's not going to increase infinitely. At some point, we're going to say, this is a good allocation in terms of the overall portfolio. I'm not now prepared to say where that could end up, but that's something that we discuss and we're always thinking about. So it's not like this slice of the pie is just going to just continue to increase indefinitely at the expense of the other things that we do as well. Go ahead, Mark.

Yes, I basically wanted to add one point. It's for the reason Larry said, that there is a maximum amount of our capital that we'd put in the strategy, that securitization is important. Because securitization allows us to take a block of loans, retain what were -- our expectation will be a high-yielding residual -- and then clear off some balance sheets to buy more loans and do the same thing.

So if we do a securitization, then we would expect that -- now, the way that it will show up in our financials will depend upon whether we account for that investment on a consolidated basis and show all the loans on our balance sheet, or whether we don't and we just show the equity investment, if you will, in the lower-rated pieces of that securitization. So in terms of how that shows up, actually, on our schedule of investments or whatever, that might vary.

But of course, the idea is that by doing securitizations, we'll be able to increase the exposure, our overall exposure to the sector without increasing our capital base. I mean, it's essentially increasing our leverage, but it's long-term, locked-in leverage. And you see the yields in this stuff, so that could really, really boost our ROE, even if we maintain the same capital allocation.

Got it. And then just to be clear, on the slide 14 where you show the yield, is that a loss-adjusted yield for the loans?

Yes.

Yes. Net of servicing the loans.

Yes, and that was absolutely, and that's net of servicing costs and all that. And I think Mark mentioned that slide 10. I just want to reemphasize, if you look at slide 10, the way we look at things in terms of long term. We like the overall positioning that we have. Those yields on the long portfolio are loss-adjusted, and the yields on the high-yield index, which is a pretty good proxy for our short portfolio, are not loss-adjusted. So we believe that the actual spread is actually, is wider, even, than what's on this graph on slide 10.

Great, thank you.

Jessica Levi-Ribner, FBR Capital Markets.

On the consumer loan side, right now the portfolio has about an above 10% yield. Is that, do you think, sustainable over the next several quarters, especially given where Treasuries are trading, and then your comments about overall yields in the market?

That's a good question. This is Mark. So I think over the next several quarters, it's definitely sustainable, because that strategy has gotten a big boost from some of the turmoil that has impacted LendingClub. So our partners -- LendingClub raised the rates they're offering consumers. I think some other names in the space did as well. And so our partners were able to do the same in addition to tightening up guidelines a little bit.

So over the short run, yes, I think that yields could even increase. Now over the long run, I think that you're definitely going to see products out there that are collateralized by mortgages the way you see a lot of second liens, the way you saw a lot of home equity lines of credit pre-crisis. I think you'll see some of the mortgage platforms start to more aggressively market those products, which can't compete, because then there's a tax advantage for the borrower as opposed to the unsecured consumer loan. It doesn't have a tax advantage. But that could be a few years in the future. It's hard to predict.

But over the short run, I think deals could actually increase.

Yes, and this is, I think, the beauty of a lot of the sectors where we're now emphasizing greater, is that the yields that are available there, as market conditions change, are definitely more inelastic than a lot of other products that absolutely are swept down. So if you look at agency mortgage yields, obviously, that's very, very tied to Treasury rates and things like that.

But when you look at the nonperforming loans that we buy which, for example, in the commercial mortgage space are on -- you know, they're idiosyncratic. They're on particular commercial properties and with unique circumstances. And in order to be able to have the strategy, you have to not only have a good workout strategy and be able to assess the value of the underlying real estate, you also -- I mean, you need to understand the legal risks.

There's just a lot of these asset classes in the consumer loans, as Mark mentioned, where the yield movements are just not going to be as elastic as they are in other sectors. So I think it actually helps us, because our funding costs are tied, obviously, to market interest rates.

Okay. And then just more broadly in the non-QM market, what kind of market trends are you seeing? Are there more non-QM loans being originated? Less because the banks are under more pressure from the regulators? How do you think about that, and maybe also talk a little bit about the demand for non-QM product.

That's a good question. So I would say that just from our own platform, we've been growing and hiring. So our volumes have been increasing, But I don't know if that's emblematic of an increase in volume across the industry, or it's just our platform's gotten bigger.

If you look at the overall origination volumes relative to the agency market, they're still trivial. The agency market will probably have origination volumes this year of $1.4 trillion. So non-QM is just -- it's so small, so I think it will grow. I think a lot of the non-QM origination is purchased, and new home sales have been relatively slow. So I think you could see growth as new home sales increase.

From the demand side, I think there is pretty broad-based investor demand for these products. What we offer is primarily a 7.1%, so it's short duration, which fits what a lot of investors want right now. And as the legacy non-agency market amortizes down, there's fewer non-agency bonds out there. So you've definitely seen investors that look to non-QM as a similar-yielding replacement to legacy non-agencies.

Let me add one more thing to that, which is that -- so first of all, it's not the banks that are originating the non-QM. It's the non-bank lenders. And you're talking ultimately about mortgage brokers who have the -- right now, for example, we may be in the middle of a refi wave. So this is a harder product for a mortgage broker, necessarily, to sell. Some of them have to get up the learning curve in terms of understanding what we or other providers are looking for.

I think success will breed success. So as these brokers understand what the program is and they understand, "Okay, now I understand how to identify a borrower who actually will be eligible for the program, for the non-QM program that my company is offering," and they then see the success of that come through, that will, I think again, breed more success. And then of course, the other brokers see that that broker made these types of loans, and that will catch on.

But when you're in the middle of a refi wave, when everyone -- it's pretty easy sometimes to pick up the phone and do a quick refi -- it's sometimes harder to get a broker's attention. So that's part of the dynamic as well. And when things are slower, then I think that's when you've got a better chance to get more traction for this.

But there's no question that the trend is going in the direction that it is. And I think that's it's going to continue to catch on. But it's taking longer for everyone in the industry than they thought.

All right, fair enough. Thank you so much for your comments.

Bose George, KBW.

It's Eric on for Bose. I was hoping to rotate into more of the agency conversation. Can you tell us how much agency premium you amortized last quarter ex the catch-up charge?

So the catch-up adjustment was a negative $1.5 million.

He wants us to back that out, I guess.

Yes, exactly. I think I just heard Larry say I wanted to back that out. That's right. What is it ex that charge?

Oh, so we had $5.3 million, so it was $7 million.

$7 million, got it. And then just on your outlook for prepays, we all saw the report come in last night. It was a bit lower month over month. And Larry, you were just talking about the refi wave or wavelet that we're all expecting. Do you expect that to happen next month in reaction to the Brexit rate rally from the end of June?

Hey, Eric, this is Mark. It's a very good question. So the speed report came out last night. Speeds were muted. They were down about 8%, but that was merely a function of a lower day count. There were two fewer business days in this cycle than the previous cycle.

Now, next month, so the prepayment report will get fifth business day of September. That is a higher day count month, and it also reflects a lower rate environment. So we expect a material increase in prepayments that you'll see in the next report.

And the other thing about the amortization, I'd point on slide 17, you can see the change in three-month CPR on our portfolio. The very bottom went from 8.9% up to 10.3%, so another data point for you. But yes, so we think that next month, and this is in line with projections you'll see from other research departments, speeds are going to go up materially. And I think the speed report we got last night, had it not been for lower day count, would have been roughly unchanged from the previous month.

Interesting, interesting. So I feel like I can ask a Ouija question, since you have your own OAS model. What is the yield on a low loan balance, call it a Fannie 3.5%, today? And how do you expect it to change, given that material increase that you're expecting next month?

Well, the thing with low loan balance paper, and we have a slide that goes over this in the EARN presentation -- it's not in the EFC presentation -- is what's attractive about the low loan balance paper is that the change in prepayment speeds you see is the result of changes in mortgage rates or changes in borrow refi incentive, is much more muted than what you see on more generic pools.

Actually, if you look at the 10-Q for EARN, for example -- it might even be in EMC as well; it was just filed -- you'll see there's a chart in the MD&A section, in the trends section, that shows you this very, very clearly in terms of when there is a movement in the refi index, a quick movement, how much of that is concentrated in the higher-balance loans as opposed to lower-balance loans. It's really quite dramatic. So if you look at that, it's a great slide. Go ahead, Mark, sorry.

That's interesting.

Yes, so just that stability in cash flow you get from low loan balance is one of the reasons why we generally see it as higher net interest margins and more generic pools. If you look at our pool composition in this Company as well as in EARN, we for years have had a big concentration of low loan balance, even at times when there wasn't a refi wave.

So we look at the agency market now, and not just low loan balance, but there are some other forms of prepayment protection we actually -- we like as much, maybe a little bit more right now. We think we can generate very healthy net interest margins. So I think the return on capital in the agency strategy and EFC this month was probably in the (inaudible) probably 3-odd percent. So annualized, that would be 12%. We think that that's reproducible. We see a lot of opportunities now.

What's nice about a refi wave is there's lots of pools coming out to pick and choose from, and they come fast and furious. So if you're paying attention and you can respond, there's definite opportunities.

Right. I want to get a sense for your trading patterns around Brexit, and especially what the bid looked like on payout pools.

So with Brexit, Brexit, what's interesting, when you go back to Brexit, it was a classic whipsaw thing that yields backed up materially before Brexit, and it went from like 1.55% to 1.75%. And then it went immediately back down. So we do not make macro into straight calls. So we've tried to maintain roughly a zero-duration exposure in both the agency and the credit-sensitive side of the Company. So going into Brexit, we didn't have a view as to whether that would pass or not pass. We weren't set up to benefit from a drop in interest rates or benefit from a further increase in interest rates.

And then when it came out and caused a big move in rates, we definitely had to adjust our portfolio durations in response to that.

What happened to pay-ups?

So pay-ups post-Brexit, they went up. But I think what's been the most interesting is that 10-year got to a low of about 1.40% a few weeks ago, and now it's back up more today. And pay-ups have not really come off in the sell-off. So pay-up's done extremely well post-quarter end, and we've been outperforming duration.

Very interesting. Thanks for the color as always, guys. Really appreciate it.

Stephen Laws, Deutsche Bank.

This is George Bahamondes on for Stephen. My question's related to the dividend. You declared a $0.50 dividend on August 1. Can you walk us through what makes you comfortable leaving the quarterly dividend at $0.50, given your results during the first half of 2016?

Yes, so it's a forward-looking as opposed to a backward-looking dividend. And if you look at the yields on our portfolio and the various asset classes, especially the ones that are increasing, our view towards -- we've established these new financing lines on many of these asset classes, especially the loan classes that are growing -- the consumer loans, the non-QM mortgage loans, the distressed small-balance commercial mortgage loans. So we're looking ahead to a place where our leveraged yield on our loan portfolio is going to be able to cover that.

And of course, look, the credit hedges are always going to be a question mark, and it's worked against us in a material way in the first six months of the year. But not only do we think that that trade is going to work in our favor going forward, but even if it doesn't, if you look at the run rate and you look at that slide -- 10, I believe it was, in the presentation -- I think you can see that it's very reasonable for us to assume that going forward, that -- again, not day to day, but longer term -- that hedge portfolio is going to cost us less and less. And if you think about the way the portfolio is migrating as well, as I think I mentioned this before in the Q&A, the portfolio is migrating to sectors where the size of the hedge will naturally decrease as well, because we're moving into things that are less macroeconomically sensitive. So again, it's more forward-looking. But absolutely, if you look backwards, we did not meet the dividend.

Okay, great, that's helpful, I just wanted to get some additional thoughts there for looking at your results. Thank you.

Brock Vandervliet, Nomura Securities.

I guess this may be related to some of your responses to the previous one. If I look at slide 27, your net interest margin direction, it's been edging pretty consistently downward. What would you say in terms of the puts and takes, and how should we be thinking about that margin trajectory, given some of the changes that you're making on the asset side in particular, but also with respect to hedges?

One thing that's a factor on that slide is the premium catch-up adjustment that I talked about a little bit ago that we were discussing. So that's weighting down the agency deals, for sure. If you were to add that adjusted back, it would be 53 basis points on the 1.65% net. So that number would be well over 2%.

The other factor there that's at play is with our credit net interest margin, we had some upfront expenses related to our loan facility that we put into place, and those are coming through in the first quarter. So I think the 8.75% is more indicative of the portfolio run rate, and the net margins are affected by those couple of things.

Okay, great. And I guess one addition to the prior question --

Yes, and by the way, these are book yields. Market yields are --

Based on cost, so sometimes that has, I think, the stuff that we bought right after the financial crisis but didn't sell until last quarter. Let's just say that's been propping that up, if you will, on this slide for amortized costs. So that's why we focus more on the --

Page 14.

Page 14 with the market yields.

Got it, okay. And just, I guess an additional one on the pile of questions you've had on non-QM, you mentioned a 7.1% type product. What's this step-up rate for this kind of product in terms of just the yield of the consumer versus a conforming agency product?

This is Mark. So different platforms target different credit profiles and have different rates. Our rate is typically, on average, somewhere between 6.5% and 7%.

Versus 7.1%.

Yes, versus 7.1%. In the agency space, you're going to be 2.5% to 2.75% type rate. So it's a 400-basis-point difference or so.

Okay, great, thank you.

Robert Martin, Echelon Partners.

Mark, you mentioned LendingClub and the dislocation it caused in the market a bit on the consumer side. And given you guys are so broadly bullish on the consumer, you see a couple of deals now, just in the last day or two, LendingClub in talks with Western Asset and Prosper prospectively doing a deal with Jefferies, Fortress, Third Point and others. Just trying to get a sense as to whether or not Ellington -- whether through EFC or otherwise -- has evaluated those platforms. Because it strikes me that you guys are probably best suited amongst many of the partners we're seeing out there with these guys to evaluate those portfolios and prospectively start buying those portfolios over time.

The way we approach that business, we'd like to have -- we have strong opinions on underwriting and credit eligibility that the bigger platforms like a LendingClub or Prosper, they're not going to be as receptive to some of our views as the partners we're working with. So we haven't bought from LendingClub or Prosper.

We have evaluated the platforms, though, and we've had -- you know, at various times you have long positions or short positions in the stock, which has worked out for us. But I guess you might characterize us a little bit as control freaks. So the partners we work with, we have a dialogue about performance and underwriting and eligibility which we enjoy, and it gives us more confidence in projected performance in what we buy. The bigger platforms, I just don't think we'd have as rich a dialogue, and our input wouldn't be as impactful.

Okay. So I've seen a couple of other of their partners actually re-underwrite their portfolios in total. So it strikes me there is some ability, if you wanted, assuming your flow was significant enough, that they in theory would abide by whatever requirements you might have. Have you had further -- I guess the volume's probably not high enough from your perspective, or from their perspective, that you would take on, to theoretically foster those conversations. Is that fair?

I guess another thing for us is we've primarily bought from mortgage companies, whether it's a strong compliance culture, which was important to us. So I think that's another preference we had.

Yes, got it. Okay, and then just second question, more to the stock and how it trades. Larry, can you talk about the migration of the portfolio, which has been significant, and yet I continue to hear mostly talk, or mostly coverage of the stock by the mortgage REIT crowd, which is great. However, I'm trying to understand what the outreach might look like to get the message that this really is a transitional platform that's a broad-based financial services company -- EFC, that is -- to a broader investment crowd that could potentially start to pay attention to some of your efforts there.

Yes, look, I think two things have to happen. One, we have to complete this migration, and I think we're getting close to that. But two, I think we also need to put some good numbers on the board. I mean, the first quarter was tough; the second quarter was okay.

So I think that our strategy is to -- I don't think now is necessarily the right time to do that. But I think the right time will be soon. And we're, as you and I have discussed, we're very interested in broadening our investor base to many ways. And I think that the new story, if you will, will be attractive to a variety, hopefully, of different types of shareholders. But we're trying to time it, I think, somewhat, and we want to get some good numbers on the board before we really make the full-court press there.

Got it. And just on that note, a last question with respect to the credit hedges and obviously hampering the portfolio year to date, and taking a much more conservative approach to traditional mortgage REITs for certain, but I'm just trying to get a sense as to whether or not you guys have discerned EFC specifically. What is the outlook or what is the view of the investor set in terms of your activity there? And are your underwriting standards and your broad-based credit standards high enough, frankly, to avoid a significant downdraft?

And that just goes to a second question, which is what are the actual liquidity parameters around EFC, from your perspective, in terms of mark-to-market and the types of securities you can theoretically buy that might actually be less liquid and, in theory, while still marking to market, prospectively dampen volatility?

Well, I think that's right, that some of the sectors that we're going into are less volatile than some of the sectors that are, for example, that high-yield credit. But we absolutely -- so, for example, in the consumer loan portfolio, we're not the only ones that are buying these loans. And we very much, we believe, are marking things to current market conditions.

So I think that I would take a little bit of issue, but with maybe a little bit of what you're saying, but I think that fundamentally, you're right. We do believe that these asset classes will be less volatile, and that will inform the hedge side of the portfolio.

And I think that in terms of comparing ourselves to the mortgage REITs, I think because we do have the ability to credit hedge, and have over time, and it was very important in 2007 and 2008, as you remember, we are a different type of investment for a shareholder. We're an investment -- other companies in the mortgage REIT space are maybe more suited for an investor who just wants to be long credit. And I think we're possibly more of an investment for somebody who wants to have more stable book value and long-term earnings over long cycles. So I think that does make us a little different, and that's been part of what we have offered to investors for, now, a long time. And that does make us different. We're much more focused on that than I think other companies are.

Yes, got it. Thanks very much.

Jim Young, West Family Investments.

Your team has always been known for doing very thorough and extensive research, fundamental research into the asset categories and the like. I'm curious; as you expand your exposure into the consumer area, what type of -- on what basis are you so bullish on the outlook for the consumer as your willingness to expand your exposure to that area? And are there parts of the consumer markets that you're avoiding at this stage and you're concerned about?

Sure. Hey, Jim, it's Mark. So before we got involved in the consumer loans, the two big platforms out there -- LendingClub and Prosper -- they make their data available. So we analyze the data. We repurposed a couple of people on our research team and made some additional hires there. So we built out a traditional loss model using a lot of the parameters that you might assume -- credit score and income and debt to income. And then in addition to that, it's a product where you get so much data that we also did, in addition, we did some machine learning analysis and built out a machine learning model, too.

So we did extensive research on it, and it's not that that sector is not without losses. We assumed there are losses, and material losses. Just that what's important to us in some of the things we saw when we analyzed data, and I don't want to --

Give away.

Yes, give away everything. But there are certain types of loans and types of borrowers that perform materially better than the population as a whole that we're primarily interested in. So I guess what we focus on is when we look at a prime borrower can borrow ELOCs at 3-odd percent, if we can get another borrower who's in the 700s FICOs, not quite as good as prime, it doesn't seem appropriate to us that they're paying 14% to 15%. It's too big a gap. They're going to have higher losses than the prime person, but the additional coupon you get more than compensates you for that.

Another thing we think about a lot with the consumer is how much equity has been built up in the homes. I mentioned this in my prepared statements about how it's been a combination of home prices going up, but also debt loads going down. But it's really significant.

So there's a group I like called the Urban Institute that does very good research on housing policy and public policy, and they had a paper that came out a couple of weeks ago where they estimate that homeowners are now sitting on roughly $7 trillion of untapped equity. So if you brought everyone up to a 75 LTV, people that don't have a first or people that have a first below 75 LTV, and 75 is not a high LTV. You can certainly borrow at much higher rates than that now. It's $7 trillion in built-up equity. And to me, that's a bookend to what we saw pre-financial crisis. Between 2000 and 2007 through second liens and cash-out refis and all that stuff, borrowers are estimated to have taken out between $4 trillion and $5 trillion of equity from their homes.

So it's gone in reverse now. So that's one of the reason why we like the consumer. We think that many of the borrowers are sitting on untapped equity that --

They're not going to want to lose that.

Yes. So that's one thing. And just we've seen, across the board, credit scores drift up. I think the median FICO is up about 15 or 20 points since the credit crisis. So it's a combination of factors.

But these sectors are not without risk. If you got a big shock in unemployment, you're definitely going to see an increase in defaults. But we run stress (inaudible), so I think we're pretty well compensated now.

Okay, thank you. And the second question is a little bit more of a macro one. As we look at the markets post-Brexit, which they've had a sharp snap-back, and credit spreads have tightened, there's a potential for some complacency coming into the markets. And I'm just curious. From your perspective, when you think about the risks out there in the marketplace, is there anything that you feel is just woefully mispriced at this point in time?

You know, we have this high-yield short, so we definitely think that has more downside than upside. And we're definitely keenly aware of interest-rate risk. I think that things can change quickly. We've got a good employment number today. The last thing from the Bank of Japan end of last week, they were doing more infrastructure stimulus as opposed to buying bonds.

So I guess we worry a lot about asset prices that we think are only sustainable if you get the amount of QE we've seen or increasing amounts of QE. And if that gets pulled away from the market, there are certain assets that it doesn't seem like their price is sustainable. So that risk is relatively easy for us to control with a variety of interest-rate hedging instruments. But I would think that those are the two sectors.

Okay, thank you.

There are no further questions at this time. Ladies and gentlemen, this concludes Ellington Financial's second-quarter 2016 financial results conference call. Please disconnect your lines at this time, and have a wonderful day.