Ellington Financial Inc (EFC) 2016 Q3 法說會逐字稿

Good morning ladies and gentlemen. Thank you for standing by.

Welcome to the Ellington Financial third-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 Maria Cozine, Vice President of Investor Relations. Please go ahead.

Thanks, Crystal, and good morning. 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. We also have a special guest speaker joining us this quarter, Leo Huang, Ellington's Senior Portfolio Manager for Commercial Mortgage-Backed Securities.

As described in our earnings press release our third-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 third-quarter 2016 earnings call. We appreciate your taking the time to listen to the call today.

Unfortunately, what was a good quarter for structured credit ended up being a mediocre quarter for Ellington Financial. Losses on our credit hedges totaled $0.50 per share, which meant that a quarter where without our credit hedges we would have covered our dividend ended up being a quarter where we barely broke even.

For most of the past year EFC has generally been positioned in broad terms as long consumer credit and short high-yield corporate credit. Most of the high-yield corporate bond short positions that we initiated in the fall of 2015 were hedges against our non-agency RMBS book since that was by far our largest credit book. We believed, and we still believe, that non-agency RMBS and other consumer-based and structured credit assets are extremely well-positioned on a fundamental underlying credit basis and the past year has indeed shown that to be true.

We also believed and still believe that the high-yield corporate bond market was vulnerable to a variety of genuine fundamental risks such as an economic downturn, weakening commodity or energy prices and tightening of monetary policy. Remember, just last December the Federal Reserve hiked rates for the first time since the financial crisis. Commodity prices dropped and the market reaction in January and February in the high-yield corporate bond market wasn't pretty to say the least.

Since we knew that from a purely technical standpoint in the same scenarios where high-yield corporate credit was melting down yield spreads on non-agency RMBS and other consumer-based and structured credit assets would probably widen, not as much but still significantly. So we decided that establishing and maintaining a sizable high-yield corporate credit hedge was not only prudent from a risk management perspective but potentially alpha generating as well.

Obviously our credit hedges have removed alpha in the past 12 months instead of adding alpha. We are not happy about that performance. It turned out that global central banks responded to every major crisis whether the downdraft in energy and commodity prices earlier in the year or the Brexit crisis in June with seemingly endless support.

In the case of each downdraft we didn't want to try to call a bottom. It never seemed obvious to us that enough of the risk had been taken out of the market. So in each market downdraft we ended up being right until we were wrong.

Again, in the third quarter, even with a big and uncertain election looming and even with the resolve of many central banks now coming into serious question, our credit hedges ate into what was otherwise strong performance on our credit assets. Again, obviously, we are not happy about this performance.

But let's also put this in the proper perspective. Our year-to-date loss has been modest and we are in a much better position now in terms of our forward-looking business prospects. Furthermore, given what's been going on in our portfolio the past two quarters most of the recent hedging dynamics, for better or for worse, are moving into the rearview mirror now for Ellington Financial.

Please look at slide 15 of the presentation. As we've sold down our non-agency RMBS portfolio we've dramatically reduced our high-yield corporate bond credit hedges. In addition, based on recent relative value shifts in the high-yield corporate credit derivative markets, in the third quarter you can see that we replaced most of our older corporate credit derivative hedges with different, much smaller corporate credit cash market hedges which we believe will still provide ample portfolio protection in a significant market downturn.

We are continuing to make room for a healthy loan pipeline by selling down our securities portfolios. Free cash on our balance sheet went up from $140 million as of June 30 to $180 million as of September 30 and we have lots of buying power. Our leverage, as measured by our asset to capital ratio for example, is as low as it's been in years, especially in credit.

We have dry powder and we are adding high-yielding, leveragable assets at a terrific time. The timing of our credit hedges has been unfortunate so far but it looks like we are timing our asset acquisitions really well. More on that later.

Similar to prior earnings calls, Lisa will run through our financial results and Mark will discuss how our markets performed over the quarter, how our portfolio performed and our market outlook. But given some exciting new developments that EFC is planning to capitalize on in the commercial mortgage-backed securities market, following Mark today on the call will be Leo Huang, Ellington's Senior Portfolio Manager for Commercial Mortgage-Backed Securities.

After Leo I will follow with some additional remarks and then we'll open the floor to questions, including any questions for Leo. Lisa?

Thank you, Larry, and good morning everyone. On our earnings attribution table on page 4 of the presentation, you can see that in the third quarter our credit strategy generated gross income of $1.3 million or $0.04 per share and our agency strategy generated gross P&L of $4.1 million or $0.12 per share. After expenses of $4.9 million or $0.14 per share we had net income of $500,000 or $0.02 per share.

Within our credit strategy, when you look at the third quarter compared to the second quarter you can see that in the third quarter we had higher income from our investment portfolio which is in the form of interest income net of interest expense and investment-related expenses and net realized and unrealized gains but we also had higher losses from our credit hedges. Our credit hedges depressed our results for the quarter as most of these hedges are in the form of financial instruments tied to high-yield corporate debt. 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 net short positions.

As we have continued to shift our credit portfolio away from securities and more to loans, we have also reduced our credit hedges as these are generally more correlated to our securities. Excluding losses from our credit hedges, in the third quarter gross income from credit portfolio was $18 million or $0.54 per share compared to $10.1 million or $0.30 per share in the second quarter.

A significant factor in the quarter-over-quarter increase was net realized and unrealized gains from our non-agency RMBS, CLOs and distressed corporate debt portfolios. These each represent asset classes that benefited from tightening spreads in the third quarter.

In addition, as we continue to shift our credit portfolio toward our investments in consumer and mortgage loans with net sold assets from our non-agency RMBS, CLOs and distressed corporate debt portfolios which also generated net realized gains in the quarter. The principal driver of the decline in interest income in our credit portfolio was the decline in the size of our legacy non-agency RMBS, distressed corporate debt and CLO portfolios as we sold assets within these portfolios.

During the quarter we completed our first widely syndicated securitization of a portion of our consumer loan portfolio. We've securitized approximately $63 million of consumer loans and we retained a subordinated and residual interest in the amount of approximately $20 million.

Because the securitization was reflected as a sale, for accounting purposes the size of our consumer loan portfolio shows a decline in size on a quarter-over-quarter basis. Our credit-related borrowing costs include the cost of funds for our loans and securities.

While our annualized credit-related borrowing costs declined by 12 basis points quarter over quarter, we'd expect the average cost of funds on our credit portfolio to increase in the near to medium term as the portfolio continues to shift away from securities and towards loans. Our agency RMBS portfolio produced solid results for the quarter as interest rates were much less volatile than they had been earlier in the year. In the third quarter our interest income included the impact of a $1.4 million negative catch-up premium amortization adjustment related to increased expected prepayment activity given the drop in mortgage rates.

In the second quarter we had a similar adjustment. Generally this adjustment can fluctuate significantly. 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 and losses.

Also contributing to the decline in interest income was a drop in our average holdings of agency RMBS quarter over quarter. Our agency-related borrowing rates were stable quarter over quarter despite the increase in LIBOR and other short-term interest rates. New regulations related to prime money market funds increased the amounts of available repo during the third quarter and serve to hold agency repo rates lower than they may have otherwise trended, especially given the increase in short-term interest rates.

Quarter over quarter our expenses were down slightly to $4.9 million and our annualized expense ratio decreased to 2.9% from 3%. During the quarter our share repurchases were $0.01 per share accretive to our diluted book value per share. We ended the quarter with a diluted book value per share of $19.83, down from $20.31 as of June 30, 2016.

I will now turn the presentation over to Mark.

Thanks, Lisa. This was a disappointing quarter for us. We failed to capture the return opportunities in the structured credit market this quarter despite strong performance from our credit portfolio and our agency portfolio.

We were ultimately hurt by the impact that central bank QE outside the US had on the pricing of corporate credit risk inside the US. The magnitude of our credit hedges losses essentially wiped out the gains on our credit portfolio. Our agency MBS strategy performed extremely well, but it has a much smaller capital allocation so we had only a slightly positive economic return for the quarter.

We adjusted our portfolio construction both within the quarter and since quarter end to reduce the size and change the type of credit hedges. Post quarter end the US high-yield market where we have the vast majority of our hedges has repriced somewhat lower, so we expect that the benefit our October performance, an estimate of which we are scheduled to release after the market's close on Monday. Within the past quarter we continued to make substantial progress in developing both operating businesses within EFC and proprietary arrangements to source and manufacture our own high-yielding investments within EFC.

Our CMBS team headed by Leo Huang began manufacturing our own investments years ago as a buyer of CMBS B pieces where we take an active role in deciding which loans will be allowed in our deals and with what degree of leverage. This active role in creating B piece investments is much different from secondary market investing in non-agency securities where the only decision is whether to buy or not to buy and at what price.

This active role has made the CMBS strategy in EFC one of our strongest performers. However, the CMBS market is about to go through a massive structural change mandated by Dodd-Frank and we see exciting potential opportunities here for EFC which Leo will touch upon in a few moments.

In our consumer loan strategy, similar to what we've done in CMBS and RMBS we have adopted a data-driven, loan level, deep credit dive approach. We scrub and analyze the data, use the data to devise investment theses and prove their validity and then leverage our long-standing relationships to implement the strategy. Then when the economics are right we like to access the securitization market to manufacture our own investments and risk.

The industry has been tested this year with the turbulence at market leader lending club. Our loan portfolio has been making an increasingly significant contribution to our earnings and as Lisa mentioned we used the flexibility of the securitization market for the first time this quarter to manufacture our own leveraged investments.

Securitizations give us an important degree of freedom. We had already put in place repo financing ranges for our consumer loans last year. We are actively and continually looking to broaden and strengthen those financing terms.

Repo financing provides us with an alternative to securitization financing and vice versa. So look for us to use whichever market repo or securitization we think offers the best long-term returns to EFC.

Many sectors of this market are still relatively new. They have yet to have been thoroughly tested in a weakening credit cycle. We monitor extremely closely not only the performance of our own loans on practically a daily basis but also market-wide performance including those of different originators with different loan programs.

If we think that one of our flow partners isn't doing a good enough job we will move on from that partnership. We are certainly not overdependent on any one flow partner and no single partner drives the overall success of this business.

Non-QM mortgage origination is another area where EFC's flexible capital should be able to command high returns in a world of increasing regulation. We made a modest investment for a significant stake in a non-QM originator last year, partnering with a team with decades of credit experience.

We have been buying non-QM loans for over a year. Credit performance has been excellent and volume is really picking up. We have financing in place but we are always working to diversify our financings and bring the cost down.

Non-QM origination brings Ellington's expertise in many areas: our expertise in non-agency RMBS loans which brings with it a deep knowledge of mortgage credit and residential real estate, our expertise in the agency MBS market which brings with it a deep appreciation of the dynamics of mortgage originators and our expertise and securitizations. Non-QM is yet another example of a market where we opportunistically compare the economics of repo financing versus securitizations versus whole loan sales.

There was an additional non-QM securitization completed in the market this past quarter. So we are optimistic that the securitization execution will be advantageous for us by the time we have accumulated a critical mass of the product. Even if not, the repo market should enable us to earn our targeted ROEs.

We actually executed a non-QM whole loan sale this quarter. We really like the asset but in such a new market we thought it was important to do that to get authentic market feedback on the quality of our originations, the liquidity of the market and real-time market pricing. The feedback was excellent.

Our goal in non-QM is twofold. First, we want to create high-quality, non-QM loan assets for the Company that can be leveraged with repo or securitizations and, second, we want to create long-term franchise value for EFC through our ownership stake in the non-QM origination companies with the ability to generate high-quality, high-yielding assets in an otherwise low yielding world.

Similar to our investment in the non-QM originator, as mentioned in our earnings release, we've significantly increased our stake in a reverse mortgage originator and brought in a strategic partner. Like non-QM this is a way to leverage Ellington's mortgage expertise in the agency mortgage market where regulation is leading non-banks to gain market share from banks.

In fact, for the first time in the last 30 years non-banks now originate over 30% of the US mortgage loan production. EFC has long invested in agency reverse mortgages in its portfolio. It makes sense for EFC to leverage its knowledge, flexible long-term capital and regulatory advantages over banks to participate in origination in this market. Our goal here is not only to capture origination income in a burgeoning market but to see the value of our equity investment in this operating business grow substantially, enhancing the value of EFC.

We had a very strong quarter in our agency portfolio with a high return on capital. Agency MBS prices were supported by strong capital flows from non-US investors and a dearth of yield in G3 investment-grade bond markets. However, against the backdrop of these strong technicals we are seeing some worrying trends in fundamentals.

Prepayment speeds increased substantially in the quarter which is a threat to net interest margin. And the prepayment speed increase for many types of loans looked higher than what most analysts expected given the decline in mortgage rates. Employment in the mortgage banking industry has been on the rise in non-banks who tend to be more aggressive on refinancings are gaining market share and many of them have a lower cost structure with a call center model.

We have been longtime believers in the value of prepayment protection and during this past quarter that portfolio construction was key. You can see on slide 17 that our realized prepayment speeds barely moved in the quarter.

Before I turn the call over to Leo I want to reiterate that our goals for EFC has always been to capture the upside while protecting against the downside. This past quarter our protection against the downside ended up consuming our entire upside, but we enter the fourth quarter with what we believe is a great portfolio with dry powder, exciting market opportunities and a terrific pipeline. We look forward to reporting better performance in the coming quarters.

Now I will turn the call over to Leo Huang, Ellington's Senior Portfolio Manager for Commercial Mortgage-Backed Securities.

Thanks, Mark. EFC added two CMBS B pieces during the third quarter and there is one more B piece for 2016 that's in progress, which may be the last one or one of the last B pieces we close before the onset of CMBS risk retention mandated by Dodd-Frank regulations.

B piece investor pricing and collateral pool shaping power have been relatively favorable despite year-over-year declining issuance volumes. The strategy has performed well this year and over time.

I would note we have benefited significantly from the availability of CMBX which allows us to hedge our conduit CMBS exposure with relatively low basis risk. CMBX has been especially effective and important in an environment where CMBS credit spreads have generally widened during the course of 2016.

CMBS risk retention regulations go into effect December 24 and constitute a major structural change in the CMBS market. In the current pre-risk retention environment CMBS B pieces are simply tradable, double B, single B and non-rated securities. Consequently, we have added deals to our portfolio and have subsequently sold pieces of those deals at times in order to manage risk and monetize gains.

In the new risk retention regime securitizations will have two primary options to remain compliant. Under the first option, the sponsor of the securitization must hold for 10 years or the life of the securitization at least 5% of every single tranche in the securitization structure. The structure is referred to as vertical risk retention, and in this structure the CMBS B pieces are freely tradable.

Under the second option, which is referred to as horizontal risk retention, the most junior tranches of the securitization, representing at least 5% of the market value of the entire securitization, may be held by the sponsor or sold to a third party. But whoever holds these tranches must continue to hold them for at least five years. But the way the regulations are written limiting how and who it could be sold to we see it as effectively 10 years.

These mandated 5% retention amounts and long holding periods obviously entail a significant increase in the amounts and duration of capital required to securitize CMBS and may initially reduce the issuance volumes in 2017 as the market adjusts to the new regulatory environment. Just one risk retention compliant transaction has been completed so far using the sponsor retained vertical model with tradable B pieces. And there is a second similar deal in the market now. We expect to be able to continue investing in tradable B pieces in these vertical structures.

The horizontal model is more challenging. In fact, a test case horizontal deal recently fell through as sponsors and B piece investors have struggled to converge on a workable structure.

Despite being an active first loss B piece investor we don't think the horizontal retention structure will predominate since we think it will require a higher cost of funds for the securitization than under the vertical retention structure. In addition, from our point of view as a B piece investor, we would disfavor participating in horizontal retention structures as we would see any hindrance of our ability to sell our B piece as a major disadvantage since it would remove our ability as an investment manager to edit portfolio risks or to monetize gains when opportunities arise.

Ultimately, we see it is undesirable to choose to hold the riskiest first loss piece of the conduit CMBS structure on an untradable basis especially when a vertical retention option is available in which over three-quarters of the retained strip is conceptually safe AAA exposure and is prospectively financeable. Our intuition here is further confirmed by the fact that the vertical approach to satisfying risk retention guidelines is the prevailing approach in the CLO market. We expect that the CMBS market participants will follow suit over time, though various forms of CMBS risk retention may coexist especially initially as a sector adjusts to the regulatory regime.

Ultimately, we see this regulatory shift as an opportunity for our strategy. The CMBS sector is a $500 billion-plus space with over $100 billion of outstanding CMBS loans coming due over the next two years and EFC's permanent capital is well-positioned to earn attractive risk-adjusted returns as it gets compensated for providing the linchpin capital to enable securitizations to satisfy the new regulatory requirements. I expect that we will remain an active investor in the tradable CMBS B piece deals and we are actively evaluating a sponsor retention investment strategy, as well.

Thanks, Leo. I hope you can sense our excitement about all the opportunities we are seeing on the asset side. I'm going to run through some of these again before hitting on some more general points.

In CMBS, as Leo just mentioned, we are excited about CMBS risk retention. Leo was being modest. CMBS has been among EFC's best-performing strategies many years running, and Ellington has been one of the most active and successful investors of B pieces in the market.

Ellington was the third largest buyer of B pieces in 2014, the eighth largest in 2015 and year to date we are the fourth largest buyer. Our proprietary internal systems and analytics as well as our experienced CMBS team with their well-established relationships with the major underwriters, loan sellers and special servicers, along with EFC's long-term capital makes EFC an ideal candidate to capitalize on the opportunities presented by the new risk retention rules. This could be a very profitable business for EFC.

In our distressed small balance commercial mortgage business, which has also been a top performer for EFC for many years now, the prospects continue to be excellent. We have more sourcing capabilities than ever before.

And as far as supply is concerned, there are well over $100 billion of CMBS loans originated in the 2005 to 2008 boom that are scheduled to mature in the next two years. Many of those will hit maturity defaults and that's more supply of distressed loans for us.

Furthermore, earlier this year we gained the ability to leverage distressed small balance commercial loans. Thanks to that ability to leverage we can also do more high coupon bridge lending. Many high-quality commercial mortgage bridge loans that might not meet our ROE bogeys without a financing line now can meet our ROE bogeys. So we are really excited about ramping up our small balance commercial mortgage portfolio faster going forward, which should be a huge boon to our earnings.

NPL opportunities abound for us in other markets as well, not just US small balance commercial mortgages. Towards the end of the third quarter we began financing residential NPLs under a new facility with a large financial institution. This should not only increase our return on equity in this business but should also enable us to increase our presence in the residential NPL market. In the past we have turned down certain opportunities for lack of financability.

Another NPL growth area for us is Europe. We've closed on another NPL portfolio in October in EFC and we have more deals in the pipeline. These transactions are often quasi-exclusive situations and can be extremely profitable.

In our consumer loan and ABS business as Lisa and Mark both mentioned we participated in our first widely syndicated securitization. And going forward we expect to securitize more and more of our consumer loan flow, which should significantly increase the return on equity opportunities for us in this business. We expect to continue to see strong growth in our consumer loan portfolio as we absorb flow from our existing flow partnerships and as we continue to explore new flow partnerships. Notably, our consumer loan and ABS portfolio is currently larger than our non-agency RMBS portfolio, even after having completed the securitization.

As Mark mentioned this past quarter we also increased our investment in a reverse mortgage lender, this time with an additional strategic business partner. And we are really excited by the prospects in the reverse mortgage space where there isn't much competition and demographic trends are extremely favorable. We expect our investment not only to be accretive to earnings as we earn our share of origination income but also to grow in value as the origination platform grows.

Mark also mentioned our investment in a non-QM originator and our non-QM mortgage pipeline. That pipeline continues to strengthen and we expect fourth-quarter production to average more than $10 million per month.

Additionally, if the pace of agency mortgage refinancings ever slows, such as from an increase in interest rates, referring brokers should be more incentivized to focus on non-QM product which could boost the origination pipeline meaningfully. Credit performance of our non-QM loans has been excellent and we are expecting to further diversify our repo counterparties and reduce our cost to finance.

As we continue to evolve by shrinking our more traditional securities portfolios and growing our pipeline loan businesses such as consumer loans, non-QM origination and small balance commercial loans, our credit hedge will continue to naturally reduce and transition as well. Our portfolio will also become more simplified as we shift into strategies that are more about capturing and leveraging net interest margin.

As you can see on slide 14 through this transition we boosted the average yield of our credit portfolio assets to 10.34% for the third quarter. That's up from only 7.29% at year-end 2013.

On the capital management side we repurchased shares during the first part of the quarter but as the quarter progressed and our stock price increased into the upper 80s of book value our repurchase activity paused. When our stock price dropped later in the quarter repurchases resumed.

We continue to be opportunistic in repurchasing shares. Our stock closed yesterday at $15.74 a share, which is 79% of our most recently reported book value per share of $19.83.

We are not happy where we are trading but it does present an opportunity to repurchase shares at accretive levels and we plan to take advantage of that. We've been using 10b5-1 plans to increase the number of trading days when we can buy shares during a quarter. And we intend to continue to use these plans for maximum flexibility.

We recently announced the resetting of our dividend to $0.45 per share. The math was pretty simple here. When we had last reset our dividend level we had sized it to equate to a 9% return on equity, which was a level that we felt we could comfortably cover given where we saw our leveraged asset yields trending as we continued to realign our portfolio away from non-agency RMBS and more towards our pipeline loan businesses. Now one year later our book value is lower, in large part due to the credit hedging losses that Mark and I have discussed at great length today.

So our new dividend level just reflects that same 9% return on equity but applied to the new book value. Rather than pay dividends out of book value, our goal is to generate sustainable income that comfortably covers our dividend and helps us grow book value per share. We can also use and we expect to use the extra retained capital to execute under our share repurchase program.

Ellington Financial's primary goal is to create long-term sustainable earnings for its shareholders. When market conditions evolve around us we reallocate capital strategically to generate those earnings but preservation of capital is also always an important objective for us. Although our credit hedges have hurt us over the past couple of quarters, I think that we've proven over Ellington Financial's nine-plus-year history that our hedging strategy is dynamic and that we will not hesitate to change it when market conditions change or when there's a shift in our asset allocation in our portfolio.

As we further shift capital into our pipeline loan businesses we will continue to adjust our hedges accordingly and as a result we would expect our high-yield corporate bond hedges to continue to shrink, as well. Nevertheless, as you can see on slides 24 and 28 let's not forget that in 2007 and 2008 when many mortgage REITs and specialty finance companies were absolutely crushed credit hedges are what preserved Ellington Financial and set the stage for the many profitable years that followed.

This concludes our prepared remarks. We are now pleased to take your questions. Operator?

(Operator Instructions) Jessica Levi-Ribner, FBR & Company.

Hey guys, good morning. Thanks for taking my questions. Turning to the $180 million of free cash that you guys referenced on the call, how quickly do you think you can put that to work?

You know typically I would say in securities we can put that to work pretty quickly but in our loan portfolio it's really a function of the flow, the pipelines that we have. I don't want to be too specific because we have, obviously, multiple partners in our consumer loan businesses, non-QM, I think I mentioned that we are seeing now $10 million a month at least in fourth quarter, small balance commercial is something that is we see a great pipeline there but it varies a lot from quarter to quarter. And then with risk retention, as Leo has been mentioning, that could be very chunky in terms of how we deploy capital but in risk retention, for example, just one deal could use actually a significant chunk of that capital, or a few deals I should say.

So I guess in terms of the free capital we have I think six to nine months would be a reasonable time frame but, of course, in the meantime other assets are going to be resolving and things like that. But I think six to nine months is I think a good stake to put in the ground in terms of when we would get that asset to capital ratio more where we want to see it where our leverage return is where we want it to be.

Okay, thanks for that. And then just one more on the high-yield corporate hedges.

You mentioned that you are shifting those hedges from derivative to cash hedges. Can you explain a little bit the difference in the dynamic between those two?

Yes, again, without getting too specific on the instruments, the cash market outperformed the derivative market so far this year, so one of the rationales there was to shift to what we thought was the currently richer asset class. Cash bonds also tend to in a financial crisis, for example, or just in general in a downdraft tend to get hit a little harder because those people are scrambling to reduce their balance sheets at that point, and so cash assets when they get sold they hit the market more.

Derivatives don't have that dynamic as much. So it had to do with those factors and also the particular cash instruments that we're in are just dollar for dollar we believe have a greater beta to the overall high-yield credit market than the derivative instruments just based upon what's underlying there and how those instruments are structured. So they have a little more, I guess you could say the main reasons are we felt they had richened up relative to the derivative assets and the second reason is that they're giving us more bang for the buck dollar for dollar.

Okay great. Thanks so much.

Trevor Cranston, JMP Securities.

Thanks. First question on the non-QM opportunity, I think you characterized it as being near an inflection point. Can you comment on if you are seeing many new lenders start to bring products into that market and if that would have the potential for you guys to have some new partnerships that you could be acquiring loans from?

Also maybe just generally, if we do see refi volume in the more conventional conforming space start to slow down is that something that you guys think is a trigger for the inflection point and people starting to bring out new loan products? Thanks.

Hey, Trevor, it's Mark. So we set up a partnership over a year ago where we have a stake in a non-QM lender and there we are we are working with that partner to control the underwriting of the loans we buy. So we are not buying loans from other correspondence.

The way we have been growing our volume is to increase the broker network through which we buy the loans. So right at this point we are not looking at buying closed loans from other originators.

In terms of other originators rolling out programs, I guess when we do our competitive analysis we see three or four other lenders in this space that think about credit the way we do that have programs and credit boxes similar to ours. So I don't consider that really aggressive competition. Think back of how small the volumes are from what they were like pre-crisis.

There's opportunities for the volumes to increase a lot. I guess in terms of inflection point, what we have seen is getting this business off the ground now we're really starting to see the benefit of all the work, the systems work, the broker network, we've built out over the past year and a half. So we are starting to see our volume ramp up relatively quickly.

Got it. Okay, that's good color.

And then on the reverse mortgage opportunity that's not a market that we hear a lot about regularly from other companies in the space. Can you give us an update on what the trend has been over the course of the year in terms of origination volumes and lending profitability and so forth?

It's still a relatively small market in the sense that there are just a few originators that collectively have very high market share. So and we believe that this market really hasn't taken off the way that we believe it can. As you probably know a lot of this market today is driven by the late-night infomercial, and that's not what we are trying to accomplish with our partner.

We are trying to basically mainstream it a lot better and a lot more. So we think that it's based on getting customers, if you will, the ultimate borrowers from different channels we think that we can actually bring this to the next level. And that's what we are working with this partner.

The business is profitable. Every loan you originate in this business is extremely profitable but it's very hard to originate each individual loan. There is a lot of regulations, there is a lot of consulting with the borrowers.

Obviously it's a very important financial decision. So there's a lot of barriers to entry. It's not a business that generally the big banks want to be in for a lot of reasons.

Obviously, there's a lot of regulation these days. They tend to move away from those businesses. So the landscape is really terrific.

And with this new strategic partner that we've brought in and the new capital that we and our strategic partner have injected we just think that this Company can grow tremendously. And like I said there's only really a few, really a handful, literally a handful of companies out there that have a big presence in this market.

So we think this is a great opportunity. And it's really hard to predict right now when those other channels will start to bear fruit. But for now it's every loan is -- you originate every loan and it's tough.

So Mark, you want to have anything?

Yes, I want to add one thing. So the high-level investment thesis there is that the demographic tailwinds for this business are tremendous.

Baby boomers are aging, there's going to be a big pool of retirees and given how low interest rates are a lot of people have not saved sufficiently for their retirement, so a lot of retirements are going to get funded in part by monetizing equity in the existing homes. That's really the strong demographic, that's the strong demographic picture we look at to why we think this business can grow tremendously. Larry mentioned the banks aren't involved, there's not a lot of competition --

The FHA is extremely supportive of this. They really have it as a high priority for them to keep this product growing.

So this to us looks like an area where there can be significant growth.

Yes, that makes a lot of sense. Okay, thanks for the comments.

Douglas Harter, Credit Suisse.

Thanks. I was wondering if you could talk about how you see the relative returns, relative attractiveness of risk retention versus the consumer loans/non-QM loans?

I will take that. I think risk retention is locked-up capital. By definition, you have to retain that risk once you assume it for many years.

I think that the return on equity in that business could be a lot higher. But let's face it, it's with more risk, you are taking the junior most pieces of securitizations, you are taking a vertical strip as well. But we think that we can potentially leverage the vertical strips.

I think Leo quickly alluded to that. So I think it would be premature given that no deal has been done yet really in the new regime that can be measured in terms of the type of structure that we are talking about, which we refer to it as an L-shaped structure or we retain the vertical slice, hopefully finance it and then buy tradable junior pieces as well. But our return on equities and B pieces to date have been very high.

We are talking I would say our ROEs in the at least the upper teens, at least. So if anything one would think that the return on equities under this new stricter regulatory regime where there is not a lot of competition and huge barriers to entry in terms of long-term capital, expertise, etc., would be even higher. Now that's a high bar to set for yourselves.

Consumer loan business I don't think we can sit here and say that we expect to have 20% return on equity. That's just not probably not a realistic target. But in terms of establishing a steady flow as opposed to risk retention where you are always going to be in competition with the other market participants, here you have flow agreements where you have a steady flow, there's you wouldn't expect that.

On the other hand, consumer loans are short. That's one of the great things about them where our investments range from in some of our channels 18-month average maturity, other channels three years, sometimes as long as five years. But still you are talking about amortizing securities.

And so the risk is very contained as well especially from a time perspective. You are getting back lots and lots of cash flow right away and you are not holding these things for a very long period of time.

So there really are very different risks. I think risk reward basis I wouldn't want to rank them, but certainly the consumer loan business we would view as a shorter duration, lower risk, good yield but lower yielding opportunity than CMBS risk retention which would be higher return longer term and higher risk.

That's helpful. Thank you.

Bose George, KBW.

Good morning. It's Eric on for Bose.

I want to also ask about the B piece stuff. The comments at the beginning of the call were really helpful.

I think we've heard from some of your peers and, obviously, the industry has given a lot of attention to the issue to this corner of the market. Maybe you can elaborate, I think you started to mention it in the prepared remarks, but what gives you an edge over some of the other players in this space who've also devoted a lot of resources and attention on figuring this market out?

Sure. Well, I would say there's been a lot of focus in the CMBS risk retention strategy on the horizontal retention approach. And we have been pretty vocal against that format of the model for a few reasons but notably, for instance, a B piece today is only about 2.5% to 3% of market value.

If you go down the path of horizontal risk retention the regulations require 5% of market value and a B piece comes at a steep discount, a steeply discounted dollar price. So the effect of that horizontal retention is instead of having a B piece being the bottom 7% or 8% of the CMBS structure, it is going to have to be the bottom 14% or 15% of the CMBS structure. That's highly inefficient for the capital structure and the funding of the securitization.

So that causes a cost of funds that's much greater under the horizontal structure. So I think vertical has an embedded securitization math advantage over vertical.

And versus the vertical retainers I think it's just a question of capacity. What the market needs, I think, from CMBS risk retention is more risk retention capacity. And our model can coexist with bank issuers and vertical retainers because it's not clear that all the banks are going to be able to conduct a vertical retention.

In fact, it's relatively clear some of them are not. So while one of the major US money center banks has sponsored a couple of securitizations on the vertical format, that in and of itself isn't enough to cover the market where if you look at last year there was 62 securitizations. So what we see is the shift in risk retention is going to require a lot more capital and a lot more longer-dated capital.

The advantages that Ellington has, in particular, is as a firm that we purchased 23 B pieces over time. We're an active market participant in the space as Larry had alluded to in terms of our rankings. And as a firm we are in this process of aggregating loans, securitizing them and retaining risk in other spaces such as consumer loans and the like.

And by way of background, I ran the new issue business at Goldman prior in earlier stages of my career and have been an issuer, so I just think from an intellectual property perspective we have both the experience and the capital markets aspects and the real estate underwriting aspects that make us a viable issuer and retainer of risk versus other institutions. But certainly given the size of the CMBS market and the issuance capacity there is a need for risk retention capacity that I think can coexist with a number of other players and formats.

Yes, that's a helpful answer and looking forward to seeing the progress in future quarters. Thanks.

Lee Cooperman, Omega Advisors.

I have three questions if I may. First, are you suggesting that the normalized ROE for the way you want to run the business is 9% going forward and if yes, how long is it going to take you to get there? That's question number one.

Question number two, what is your buyback authorization and intention? In other words, I understand when we are 85% or 80% of book value you want to buy. What is the aggregate amount that you've authorized to repurchase?

And third, if I said to you the Fed was going to tighten in December and twice next year, what would that mean for us in our business the way we are structured presently? Any help you give me would be appreciated. Thank you.

Great. I'm going to let Mark answers the third question. I will hit the first two.

Okay, so in terms of the 9% ROE, I would say that, again, our goal is to have our earnings comfortably cover our dividend. So that's, if anything, a lower bound of where we see our leverage net interest margin going. So that's our target is definitely higher, we want to leave ourselves some breathing room.

How long it will take us to get there? Gosh, if you look at our credit, if you take out the losses from our credit hedges this past quarter we would have been there. But that's a counterfactual.

So we are certainly expecting the way that our portfolio transition is going that the drag that the credit hedges I've been saying are basically moving into the rearview mirror. So hard for me to predict. Since we are still going to have these corporate credit hedge, obviously, things could change, the market could, the dynamic could change where all of a sudden, let's say, we make a ton of money on our credit hedges and we take them off or we want to keep them on because we feel even more strongly about them.

I don't want to predict the next two quarters. But I will say that I think after a couple of quarters we will be at a stage where these won't be the types of credit hedges that will be a substantial part of the portfolio because of the fact that our portfolio will no longer have the types of securities that these things are hedging now, or at least not in as big numbers.

So I think that in a couple of quarters, in the next couple of quarters you are going to continue to have noise from the credit hedge. Hopefully it will be positive noise.

And then after that I see is absolutely, when you look at the pipeline and you look at our ROEs, I see us absolutely hitting and exceeding that 9% bogey. So that's the first question.

The second question was about the buybacks. And the Board authorized, and again this is only limits us until we ask for Board reauthorization, so let's be clear here, we are not -- we own over 10% of the stock ourselves. We want to do what's best for shareholders. We are it in this for the long term.

This does not limit us. We authorized 1.7 million shares, that was at the time probably $34 million worth, something like that, for repurchase. We are through more than half the program, so technically we might have only something between $700,000 and $800,000 available right now under current authorization.

But when that comes close to getting down to the last bits, there's just no question in my mind that I would ask for further authorization because we want to be opportunistic and we are not wedded to not repurchasing our shares. You said if price to book is certainly around 80% or less and, yes, above 85% it doesn't look so good, but between 80% and 85% that kind of depends upon what we are seeing on the asset side, but below 80% absolutely, that's a great that's an opportunity that we should take advantage of.

Let me ask you a question. If you reach a conclusion that the market was hostile to our kind of set up and that we were relegated to trade at 80% or less of book value for a long time, would you do consider winding up the Company, returning the money to shareholders? Because really what we've accomplished so far is it we've created ordinary income and capital losses.

I think we went public in 2010 at $22.50, we had an offering in 2012 of $22.45, another offering in 2014 at $23.92 and here we sit south of $16. And so what we've done is we've taken capital losses and we've had ordinary income through the dividends.

I realize some of your dividends are taxable in a very different manner. But essentially Wall Street has created a lot of companies in the BDC space, the MLP space, the agency space that only made sense if you sold at a premium to book because you were able to raise more money, put the money out and grow the dividend. But once you go to a discount NAV or you have a high cost of capital you can't grow anymore.

So the question is -- and you are doing the right things, I am not being critical in this slightest, I don't want anyone to read this as a critical comment. But to the extent if we are going to be relegated to sell at 80% or less of book value and unless we can earn a competitive return on book, which I would say would be 10% or something like that, maybe we should consider giving the money back to shareholders.

We are not they are yet. Don't get me wrong. I'm not advocating that because you guys have done a decent job, with the exception of the credit hedges.

But you have implied that there's a lot more money for buybacks if the market continues to misprice us. And maybe that's all you can say on the subject, which is fine with me.

No, I appreciate the frank question. Look, I think the absolutely responsible thing is fiduciary and everything else is to always consider all options. And I would never say that liquidation is never going to happen and it's never an option.

I feel like, obviously, so first of all, it's true that for the past, I would say, two years now we've traded at a discount to book. It hasn't been longer than that, and I would say that we are, obviously, looking forward to the day where we differentiate ourselves from the peer group that we are in right now, this mortgage REIT peer group. We think we are moving in that direction.

This year, this past 12 months because of the credit hedges has been lost in one sense from an earnings perspective but it's been gained in another in terms of how we continue to develop these pipeline businesses. If we did not believe that we could generate 10%-plus sustainably and we were -- and by the way, maybe even if we were trading higher than 80% of book, we were trading at 90% of book, but we've thought that we couldn't generate good yields for investors, then absolutely we would have to consider anything. But we are far from --

Good, I appreciate your response.

We are far from that at this point --

Yes, I would assume so.

And we feel great about the prospects. And we are going to do what we can to transition, to get this portfolio to the end of this transition and show the market that our leverage net interest margin is not only, in theory, achieving high returns but in practice is. And once we do that and once we put that track record together I think we are going to be trading back at book or above, I really do.

Good. If I can make one suggestion, I see a lot of companies getting ripped off in their repurchase activities because they have very predictable programmatic kind of purchase, blackout periods, etc.

IBM for some reason their buyback has been able to do it in a manner where they buy the day of earnings, the day after earnings, the day before earnings, etc., etc. But I would just suggest you sit with your attorneys and have the most flexible buyback when things get dislocated you are not locked out of the market that you are able to take advantage of it.

Yes, and I mentioned we have we had a 10b5-1 program in place. And we tend to -- what's the word, reload those I guess. As the old blackout period ends and the new blackout period begins we obviously the parameters of those we like to change every quarter.

But absolutely, we absolutely had a 10b5-1 program in place in the third quarter. And what happened was as it turned out later in the quarter was when our price to book got above that level. So it sort of naturally shut off.

And that's a good thing, right? You want it to naturally shut off based on the parameters that you set in the program.

So yes, we do that. I think we use absolutely state-of-the-art in terms of the parameters that we put in the program. But we do like to -- we do like to reset those parameters each quarter, obviously during usually during right after these calls, in fact, when we are now open to do so in light of what we are seeing.

So where we set those targets in terms of price-to-book where we are going to be buying in a 10b5-1 program you can set those when you are in your unrestricted phase and then you can let those run their course for the rest of the quarter. So we absolutely plan to continue to do that.

Good. Thank you very much for your response. And the third one is going to be tackled by somebody else?

Yes.

Hi, Lee, it's Mark. So if there's a Fed hike in December and then two more next year, I think it's a positive for us.

So we still have a decent portion of the portfolio where the coupons we're receiving are indexed to LIBOR and it's primarily non-agency mortgages where a lot of those are post-reset ARMs or the borrowers are paying a coupon that's indexed to one-year LIBOR or six-month LIBOR. So we've seen the coupons go up on those for the Fed hikes, we will see the coupons continue to rise, so that gives a little bit more interest income.

The other portion of the portfolio that benefits for the same reason are the CLOs where they are traditionally indexed off of three-month LIBOR. So further hikes in LIBOR gives us a little more coupon there.

The other benefit I see is that if the hikes in 2017 are contingent upon a gradually improving economy, which seems like the hikes contemplated for December are linked to further progress on wage growth and job creation, then I think our portfolio is has credit risk and it has a lot of consumer facing credit risk. So I would think that two hikes next year that would be a backdrop of improving credit performance which would help our portfolio yields.

Good. Thank you very much for your responses.

Lee, thank you. I actually wanted to add one more thing, sorry, about the repurchases. So one of the other parameters that we often set in our repurchase program when it's on autopilot, the 10b5-1, is what percentage of the daily volume do we want to be.

That's important, too, because we don't want to be the ones that are basically pushing our stock price up. That's not what -- that's not how we want to do it.

The volumes in our stock, unfortunately, have been lower this year than they were last year. So that also has lowered the amount of shares that our 10b5-1 program has been able to repurchase.

I will say one thing, gosh, my lawyers will warn me I'm sure, this is in no way construed to be a solicitation, but to the extent that we are ever presented with a block trade opportunity, so if an investor ever were to call the Company and say, hey, would you like to repurchase my shares, obviously that's a situation where those volume restrictions would no longer apply. But that just hasn't happened, so I just want to let you and everyone else on this call know that we just haven't been presented with those block opportunities that I think could move the needle. But obviously we would consider them if that were ever presented.

You also might want to think about at the right time and the right circumstances to do a tender offer.

I'll again have to consult with my attorneys on that. But I will take that as something to look into.

Well, the smartest guy I ever dealt with, unfortunately he's deceased, was Dr. Henry Singleton who founded Teledyne. And from 1972 to 1984 he did eight self tender offers and retired 90% of his company stock never selling a share of his own stock. And even though he was born poor in a farm in Haslet, Texas and never made more than $1 million EU, when he died he was worth over $1 billion from the wealth he created for his shareholders.

That's a great story.

Thank you. You guys are listening and that's all we could ask for.

Thank you, Lee.

We've reached our allotted time for questions and answers. This concludes today's conference call. You may now disconnect.