Ellington Financial Inc (EFC) 2022 Q2 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Financial Second Quarter 2022 Earnings Conference Call. Today's call is being recorded. (Operator Instructions)

It is now my pleasure to turn the call over to Jason Frank, Deputy General Counsel and Secretary. Sir, you may begin.

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, 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 am joined on the call today by Larry Penn, Chief Executive Officer of Ellington Financial; Mark Tecotzky, Co-Chief Investment Officer of EFC; and JR Herlihy, Chief Financial Officer of EFC.

As described in our earnings press release, our second quarter earnings conference call presentation is available on our website, ellingtonfinancial.com. Management's prepared remarks will track the presentation. Please note that any references to figures in this presentation are qualified in their entirety by the end notes at the back of the presentation.

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

Thanks, Jay, and good morning, everyone. As always, thank you for your time and interest in Ellington Financial. The challenges of the previous quarter intensified during the second quarter of 2022. The Federal Reserve sought to slow inflation by accelerating its interest rate hiking cycle and initiating the runoff of its balance sheet, while recessionary and geopolitical concerns also weighed heavily on markets.

Interest rates continue to surge and interest rate volatility spiked to levels not seen since the COVID liquidity crisis in early 2020. And before that, not seen since the global financial crisis in 2009. Prices fell and liquidity dried up in most markets, including the securitization markets. Volatility really was the great equalizer across asset classes this past quarter, as most everything sold off in concept, even agency MBS and US treasuries.

Ellington Financial had an economic loss of 6% for the quarter. This was mainly the result of losses on our unsecuritized non-QM loans and Agency RMBS, where we were hurt by rapidly rising interest rates and widening yield spreads. We also sustained significant mark-to-market losses on our investments in loan originators, where unrealized losses totaled $26.5 million or $0.44 per share during the quarter.

LendSure was again profitable in the second quarter, but it further revised downward its earnings projections for 2022, which led to a mark-to-market drop in the value of our equity stake in the company. However, we believe that LendSure is well positioned to emerge from the current market volatility with increased market share and stronger earnings prospects.

The partnership between Ellington Financial and LendSure continues to be highly synergistic. We believe that LendSure's underwriting standards are absolutely top-notch. As demonstrated by the stellar credit performance of the $3-plus billion of loans we've bought over the years from them. Meanwhile, EFC provides a reliable takeout for the non-QM loans that LendSure originates. That's no small benefit from LendSure and rocky markets. And in return, EFC can buy at wholesale prices from LendSure, not retail, and have confidence in the underwriting.

In the second quarter, during our typical commitment and warehousing period while we were accumulating non-QM loans from LendSure and others, the non-QM securitization market widened substantially. In other words, our securitization takeout economics deteriorated between the time that EFC committed to buy loans from LendSure and the time that we actually completed the securitization of those loans.

So our timing was perhaps a bit unfortunate, but the good news is, that the origination market has now fully repriced to the wider securitization markets and then some. As a result, we now find ourselves in a market where we're again seeing very healthy net interest margins on the non-QM loans we're currently buying, both during the warehouse period and projected post-securitization.

In the reverse mortgage market, we have seen HECM yield spreads growing wider throughout the year, and that has weighed heavily on profitability at Longbridge. Longbridge had a significant net loss for the second quarter, driven by a further reduction in the value of its MSR portfolio and losses on its pipeline of committed loans. However, on the bright side, securitization spreads are showing signs of stabilizing, and Longbridge continues to add market share.

As we saw during the economic turmoil of 2020, demand for reverse mortgages can surge in a challenging economic environment because reverse mortgages provide liquidity to borrowers without the requirement to make monthly principal and interest payments. The challenging market conditions also adversely affected performance of some of our other loan originator affiliates, most notably in agency mortgage originator.

The Freddie Mac 30-year mortgage survey rate increased by more than 2.5 percentage points over the first half of the year, skyrocketing to its highest level since 2008. As a result, most of the existing mortgage universe now has no refinancing incentives, and so we've seen prepayment rates plummet. Furthermore, supply shortages have kept housing prices strong. So with mortgage rates much higher, housing affordability has been absolutely pummeled. Home sale volumes have been dropping fast to levels not seen since the depths of the COVID crisis.

Putting it all together, given the extreme weakness in both refinancing volume and home purchase volume, this environment is about as challenging as possible for conventional mortgage originators. For Ellington Financial, however, only a tiny fraction of our originator investments relate to conventional mortgage originators. The vast majority of our originator stakes are in more specialized sectors, reverse mortgages, non-QM mortgages, specialty consumer finance, residential transition loans, and commercial mortgage bridge loans. In these particular markets, we project stronger growth and more durable profit margins over the long term.

Meanwhile, we continue to see strong performance in the second quarter from our short duration loan portfolios and our retained non-QM interest-only securities. We also benefited from significant net gains on our interest rate hedges and credit hedges. So while our overall decline for the quarter was certainly significant, our diversified portfolio and disciplined hedging helped prevent further losses.

For silver lining of the market selloff (technical difficulty) and payoffs, particularly on our short duration loan portfolios. Between our residential transition loan, commercial mortgage loan and consumer loan portfolios, we received principal paydowns of $177 million during the second quarter, which represented nearly 15% of the combined fair value of those portfolios coming into the quarter.

During the second quarter, we deployed some of this dry powder. Our loan origination businesses provided much of our asset acquisition volume during the quarter, but we also took advantage of the market sell-off through secondary market purchases of discounted non-QM loans and credit securities, most notably, credit risk transfer bonds or CRTs. To illustrate just how much spreads have widened in CRTs since earlier this year, Ellington Financial itself bought a piece of Stacker2021-HQA1B2, a CRT bond at under $0.78 on the dollar in May. This bond has traded above $0.102 on the dollar in January. So that was a 350 basis points widening since January.

So while our net interest margin has recently compressed, our NIM should continue to recharge as we continue to deploy our dry powder and our recyclable capital into the much higher yields that are available today. At June 30, our credit portfolio stood at $2.66 billion, which was an increase of 29% from year-end 2021, but we still had significant available capital and borrowing capacity to expand our credit portfolio further.

As I mentioned earlier, the non-QM securitization market has not been immune from all of the credit spread widening we've seen. On the non-QM securitization that we completed last week, our execution on the AAA tranche was about 150 basis points wider as compared to our first deal of the year back in January. Nevertheless, I was still pleased to get last week's securitization priced and closed as it moved those non-QM loans off repo, it termed out their liabilities and have freed up incremental capital to invest in a market environment that's presenting great opportunities.

Not every securitization will be a home run, but they represent a stable source of financing that enhances our balance sheet, cushions us against the potential impact of market shocks and puts us in a position to react quickly to market opportunities. As such, securitizations continue to be an important component of our risk and liquidity management.

I'll move next to adjusted distributable earnings, or ADE, for short. We previously referred to this non-GAAP metric as core earnings. We're reporting $0.41 per share of ADE for the quarter, which is up $0.01 from the previous quarter. While there are a few reasons why it's not yet covering our dividend, which JR will get into, we do project that ADE will cover the dividend as we get fully invested and turn over the portfolio at today's higher reinvestment yields, but there will be a lag.

In any event, ADE, which is a backward-looking measure, has its limitations as a measure of the full earnings power of our portfolio, especially in a market with large swings in interest rates and spreads like we're seeing today, and where liabilities are repricing faster than assets, like they did this past quarter. But this is where the relatively short duration of so much of our credit portfolio comes into play in a big way.

Also, keep in mind that there is a portion of our portfolio that by design doesn't generate much ADE. This includes our short-term trading portfolio, including TVAs, and our equity stakes and loan originators. ADE is an important metric for us. But over the long term, our GAAP earnings per share and total economic return per share are probably the best measures of our success.

One final note. The market volatility has also enabled us to be opportunistic with our capital management strategy so far this year. Earlier this year, we issued shares out of our ATM mostly in March at an average price of $17.66 per share, which is right around book value at the time. In late March, we took advantage of a narrow window that had opened in the credit markets by launching a $210 million 5 7/8 coupon, 5-year unsecured debt deal. And finally, during all the second quarter turmoil, we took advantage of the market sell-off by repurchasing shares at an average price of $13.20 per share, which was about 78% of the prior month's book value per share.

I'll now pass it over to JR to discuss our second quarter financial results in more detail.

Thanks, Larry, and good morning, everyone. I'll start on Slide 3 of the presentation. For the quarter ended June 30, Ellington Financial reported a net loss of $1.08 per share on a fully mark-to-market basis and adjusted distributable earnings of $0.41 per share. These results compared to a net loss of $0.17 per share and ADE of $0.40 per share for the prior quarter.

Beginning this quarter, you'll notice that we renamed core earnings as adjusted distributable earnings, consistent with evolving industry practice. Please note that it's a name change only and the calculation itself has not changed. So it's valid to compare our current period in ADE to prior period's core earnings. There are a few reasons why adjusted distributable earnings did not increase proportionately with the growth of the portfolio in the second quarter and did not cover our dividend.

First, undeployed capital. We now have interest expense on the new $210 million of senior notes, which amounts to $0.05 per share per quarter. And with the ATM issuance in March and early April, our share count increased by 2.6 million shares. Until all of that capital is deployed, it will be a drag on ADE per share.

Second, our cost of funds increased sharply this quarter, primarily due to higher rates. And even though we have a lot of floating rate loans and other short-duration assets in the credit portfolio, the asset yields on our invested assets lagged the increase in financing costs this past quarter, especially for fixed-rate RTL and non-QM loans, and thus, our NIM compressed. Moving forward, however, I expect that asset yields will catch up with the higher financing costs as we continue to turn over the portfolio, and that should expand our NIM again and be a tailwind for ADE.

Moving back to the deck. On Slide 4, you can see that we further increased our capital allocation to credit investments during the quarter with 87% of our capital allocated to credit as of June 30, which is up from 82% in year-end, and it's about the highest split it's been for EFC historically. I expect credit to continue growing relative to agency based on the continued growth of our loan origination businesses. Average market yields are up on both our credit and agency portfolio sequentially by about 60 basis points for both categories. And as I mentioned, we expect our own portfolio to reflect these higher reinvestment yields as we continue to turn over the portfolio.

Moving to Slide 5, you can see the attribution of earnings between our credit and agency strategies. During the second quarter, the credit strategy generated a gross loss of $0.80 per share, while the Agency strategy generated a gross loss of $0.20 per share. These results compare to gross income of $0.28 per share in the credit strategy and a gross loss of $0.34 per share in the Agency strategy in the prior quarter.

As Larry summarized, the main drivers of these losses were unsecuritized non-QM loans, Agency RMBS, and originator stakes. A portion of these losses were offset by strong performance on our short duration loan portfolios, specifically residential transition loans and small-balance commercial mortgage loans, driven by net interest income, as well as by net gains on our nonperforming loan portfolios. In addition, our portfolio of retained non-QM tranches appreciated during the quarter driven by appreciation of our non-QM interest-only securities as rising mortgage rates again led to lower actual and projected prepayment speeds.

We also had significant net gains on our interest rate hedges and credit hedges during the quarter. Agency RMBS continued to face headwinds in the second quarter as durations extended in response to the higher interest rates and elevated volatility contributed to yield spread widening. Net losses on our agency RMBS concentrated in lower coupons, exceeded net interest income and net gains on our interest rate hedges, while we also incurred delta hedging costs stemming from the volatility. As a result, we had a significant net loss for the quarter in our Agency strategy.

Turning to Slide 6. During the second quarter, our total loan credit portfolio grew by 16% sequentially to $2.66 billion at June 30. The majority of the growth occurred in our non-QM residential transition and small balance commercial mortgage loan strategies where we continue to focus on multifamily. On Slide 7, you can see that our long Agency RMBS portfolio decreased by 11% to $1.3 billion due to net sales, paydowns and net losses.

Please turn next to Slide 8 for a summary of our borrowings. Our weighted average borrowing rate increased by 83 basis points sequentially to 2.61% at quarter end, driven by higher short-term rates and a full quarter of interest expense on the 5 7/8 senior notes issued on the final day of the previous quarter.

In addition, we had disproportionately more borrowings secured by our loan portfolios, which carry higher borrowing rates than agency assets. Financing has held up relatively well amid the market volatility, though recently, we have seen haircuts increase or financing spreads widen on some of our loan facilities. In conjunction with the larger portfolio, our recourse debt-to-equity ratio increased to 2.6:1 from 2.3:1 in the prior quarter.

During the second quarter, we marked down our 5 7/8 senior notes by 2 points to $96.50, as a liability, this markdown generated positive income. However, we had a corresponding loss on the SOFR swaps that we used to hedge that liability, which offset most of this income. At June 30, our combined cash and unencumbered assets totaled approximately $816 million, which was down from last quarter, but was still well above pre-COVID averages.

Slide 10 details our proprietary stakes in loan origination businesses. At June 30, the combined value of our originator stakes was $112 million or about 9% of our total equity. By sector, that $112 million was distributed as follows: 53% and reverse mortgage loan origination, 30% in non-QM loan origination, 10% in consumer loan origination, 3% in residential transition loan origination and 2% each in small balance commercial and conventional mortgage loan origination.

For the second quarter, total G&A expenses decreased sequentially by $0.03 per share to $0.14 while other investment-related expenses decreased by $0.07 per share to $0.09, driven primarily by the costs associated with the senior note offering that we fully expensed in the previous quarter. Also during the second quarter, we recorded an income tax benefit of $7.8 million due to a decrease in current and deferred tax liabilities related to quarterly losses at our domestic TRS, which related to our non-QM securitization activity, as well as our investment in Longbridge.

As of June 30, we had a net deferred tax asset of approximately $9.6 million, against which we took a full allowance. Our book value per common share was $16.22 at June 30, down 8.6% from $17.74 per share at March 31. Including the $0.45 per share of common dividends that we declared during the quarter, our economic return for the second quarter was negative 6%.

Now, over to Mark.

Thanks, JR. The second quarter had incredible volatility in every dimension; in interest rates, in credit and agency spreads and the expectations of Fed policy. There was substantial widening in most sectors across fixed income, and it was a very challenging environment. Our economic return was negative 6%, not a result you're used to seeing from us, not a result we want, but not a disaster either. And a lot of it, I think we can earn back because much of the loss was due to spread widening of nonterm loans and Agency MBS.

As is often the case after a quarter like that, the going-forward opportunity set looks really good. Today, we see very wide spreads, very high yields and stable financing, all with less competition for assets. Credit performance, as measured by delinquencies, defaults and credit losses continues to be very strong across our diversified portfolio. But with the sharply increased risk of an economic slowdown, we have been very focused on tightening our underwriting guidelines, with a particular focus on keeping LTVs low. HPA has been strong, but there are clear signs of housing weakness, and we have to be prepared for price declines in some regions of the country given poor housing affordability.

During the second quarter, any sector with a lot of interest rate risk, a lot of volatility exposure or where pricing is dependent on the securitization execution that hurt. Not surprisingly then, our non-term strategy was our biggest drag this past quarter. To put the spread widening on non-QM this year in perspective, consider these 2 data points. On January 14, we priced the first non-QM deal of the year. The AAA is priced at a spread of 97% to swaps, they added 2.2% fixed rate coupon and we priced to par.

On July 22, we priced our most recent securitization, and that deal, the AAA has had a fixed coupon of 5%, and they were priced below 99%. That's the spread of 250 treasuries are more than 150 basis points wider in spread in the AAAs compared to the January execution. Lower rated non-QM bonds widened even more. When you consider that investment-grade corporate bonds widened only about 35 basis points over the same period, you can appreciate how significant the widening has been in non-QM.

We've always been big believers in the benefits of securitization. But given how stable the repo financing market has become, repo is a viable alternative with non-QM securitization spreads currently so wide. One of those surprising things about this year has been the relative stability of repo spreads and repo availability in a market where everything else has been so unstable. For that reason, we have continued to expand and deepen our repo lines. I'm glad to report that we're currently close to adding yet another valuable loan financing facilities. Meanwhile, non-QM spreads has started to recover.

Another drag on Ellington Financial's performance in the second quarter was our investments in mortgage originators. Everybody knows that mortgage origination business is a cyclical. We know it. We've been through many of these cycles. Comparing the second half of last year on (technical difficulty).

Sorry. Yes, comparing the second half of last year to the first half of this year shows just how cyclical it can be. In the second half of 2021, you had record high loan prices, so big gain on sale margins and record high volumes for mortgage originators. The product of those 2 things essentially tracks originator profits. This year is the exact opposite. Distressed loan prices and lower volumes have squeezed profitability, and as a result, we have marked down our originator investments. All that said, I think it's noteworthy that LendSure was profitable this quarter.

A few things to consider on these investments for EFC. Our originator stakes are only a small part of our capital base, in large part because we know how cyclical those businesses are. We only want these stakes to be a complement to the rest of the portfolio as opposed to a disproportionate user of capital. And if you consider our cost basis in these investments, they are an even smaller part of our portfolio. We believe that LendSure is growing market share, and we think it's likely that loan prices will drift up as coupons have now been reset to reflect higher interest rates and wider spreads. Also, our stakes in both residential and commercial originators are critical because they enable us to control underwriting quality that's becoming more important given the recent economic slowdown.

The non-QM market is not going away because it's an important segment of today's overall mortgage market. Of course, Fannie and Freddie are the lowest rate option for most borrowers whose W-2 gives a fairly complete picture of their income and whose loan size fits within GSE limits, but not everybody fits in that box. Post financial crisis, beyond originating agency mortgages, banks are primarily focused on full doc jumbo mortgages. It's the non-QM originators who primarily serve self-employed borrowers and borrowers with substantial income in addition to their W-2.

We don't see this changing. We don't see Fannie Mae go into bank statement loans. Apart from non-QM and originator stakes, many of our other credit strategies performed really well in this past quarter. RTL continued with excellent performance. Those loans are not dependent on the securitization takeout. They just pay off, and they are so short, they don't have a lot of interest rate sensitivity. We have also been able to push up note rates on our recent originations, and it feels is that we have a lot of pricing power.

Credit performance remains excellent. Commercial bridge loans also continued with excellent performance. Our commercial bridge loans are all floaters, so interest rate movements and interest rate volatility doesn't affect them much. Despite the excellent performance, we're certainly becoming more conservative on LTVs at current property valuations.

So far, in the third quarter, the market environment has been much more favorable relative to the second quarter. Interest rates have come well off their highs, stocks are off their lows, and credit spreads are off their wides. Liquidity was poor in June and early July, but is substantially better now. New issue securitizations are priced quickly with many tranches multiple times oversubscribed. This is all a huge turnaround from the second quarter. Our agency MBS portfolio was also a drag on EFC performance in the second quarter with a loss of about $0.20 per share, but that too performed very well in July.

In the agency MBS market today, prepayments are manageable, yield spreads are wide and roles are attractive and higher coupons. Recession fears tend to help that sector because the sector has no credit risk and in a recession, the Fed may stop or slow down balance sheet reduction. So the market feels that it's in a much better place today as compared to the second quarter. Interest rates have retraced a lot of the second quarter sell-off. 5-year treasury yields are now over 60 basis points below the mid-June highs, for example.

While still elevated, implied volatility has also come down. In addition, spreads have tightened and the market tone is much better. We're seeing this pretty much across the board in fixed income, not just in structured products. IG spreads are in 20 basis points from their wides and high-yield spreads are over 100 basis points tighter. CRT is much tighter, and there was a deal last week with tranches 15x oversubscribed that tightened 60 basis points in the initial talk. Non-QM is tightened as well and some current deals have been over 5x oversubscribed.

Ever since the July Fed meeting, the market has had a different tone and has attracted a lot more capital from money managers and insurance companies. EFC is in a strong position. At quarter end, we had ample borrowing capacity and excess capital to invest. We have an array of proprietary flow arrangements. That gives a big say in loan underwriting, which has been critical to our success in the past and which will take an increased importance should the economy enter a deeper recession.

We are currently buying a lot of high-yielding loans in many sectors where note rates are 7% or higher. We estimate that July was a positive month for EFC, and the opportunity set is great. We benefit from diversified and deep financing and sourcing relationships. This year and every year, we have maintained our focus on protecting book value, maintaining strong liquidity, and managing our credit risk that has allowed us to get by with only moderate drawdown so far this year, down 7% for the year through June, which is not the result we want but not as (inaudible) either.

Now we plan to take advantage of historically widespread and high asset yields to drive returns going forward. We have grown the credit portfolio to $2.66 billion, which I believe is the right thing to do when spreads are so wide. EFC also has experienced management and portfolio managers, which are invaluable and volatile markets. We have to maintain our focus on credit quality.

We have to be prepared for the possibility of an economic contraction and with that higher default rates. So how do we do that? Spreads are so wide right now that there is no reason to stretch into higher LTVs or lower FICOs. We believe we can meet our return targets while focusing on loans with lower LTVs and higher FICOs and on securities with more seasoning and greater credit enhancement. We're seeing some of the best opportunities and the highest quality yield spreads that we've seen in the past 10 years and are focused on capturing those opportunities to drive our dividend and grow book value.

Now back to Larry.

Thanks, Mark. Hey, everyone. I hear that there have been some audio issues at the conference call hosting service, they are having some technical difficulties. So we're going to look into whether we can perhaps post the script somewhere or provide perhaps on the audio replay that will have all the content. So we're going to look into that. Okay. Just to conclude, though, so far in the third quarter, volatility has subsided a bit.

Interest rates have dropped somewhat, and yield spreads in most sectors have retraced a portion of their second quarter widening. Per our normal process later this month, we'll be putting out a book value per share estimate for July 31. So keep an eye out for that update. Meanwhile, time will tell how long the contraction in the origination markets will last and how much more of a shakeout will occur. In non-QM, lower whole loan price premiums and falling volumes have taken their toll, especially on those originators who did not properly hedge their locked loan pipelines or were undercapitalized or both. We have seen several mortgage originators severely scale back operations and even a couple of close shop.

While market dislocations have created a drag on EFC's book value in the near term, our strong balance sheet is enabling us to lean into the wider credit spreads. And together, this presents the opportunity for us to grow market share at our origination platforms. Long term, we believe that a thinning of the herd will be a net benefit for the stronger origination platforms remaining in their respective spaces.

A final note I'll make on our originator investments is that it's important to keep the size of our originator investments in perspective relative to the rest of our investment portfolio. These originator investments, which are currently spread across 9 companies in total, comprised only about 9% of EFC's overall equity, as JR mentioned. In fact, they've typically started out as small VC-type investments. These stakes often have the added benefit of locking in loan production underwritten to our credit specifications. So properly sized, these investments further diversify our earnings stream and should be a powerful differentiator for the Ellington Financial franchise.

We've spoken many times before about the benefits of being both a loan buyer and a loan originator as the profit pendulum swings between the 2. Non-QM is a great example. As a result of all the market turmoil, we've been able to acquire lots of non-QM loans this year, including not only from LendSure but also from certain originators who are burned by the big market swings and unloaded inventory at discounts. As I mentioned before, securitization spreads widened after we purchased some of these loans, and this hurt us in the second quarter. Nevertheless, we continue to lean in.

We have recently been able to purchase new non-QM loans with mid-to-high 7% coupons. And with interest rates lower over the past few weeks, the economics on these new loans look very attractive, especially relative to the stabilization we're seeing in the non-QM securitization market.

Going back to the earnings presentation for a minute, please turn to Slide 12. I pointed to this out on previous calls, but in this environment of rising rates and market turbulence, it's worth highlighting again our low level of interest rate sensitivity.

In the table on Slide 12, the fifth line down, non-Agency RMBS, CMBS, other ABS and mortgage loans, captures the vast majority of our long credit portfolio. As you can see, if rates shift up or down by 50 basis points, we estimate that the impact from the credit portfolio on overall book value would only be about plus or minus 1%. That translates to an effective interest rate duration of a little more than 2 years on this portfolio, and that's even before taking into account our interest rate hedges.

We've accomplished this by focusing a significant segment of this portfolio on products like 1- to 2-year commercial real estate bridge loans, sub-1 year average life residential transition loans, and short-term consumer installment loans, particularly as market volatility spikes and spreads widen, we're very happy to see our short-duration assets continue to run off naturally and quickly, enabling us to reinvest that capital at higher yields.

As we move into the back half of the year, we still have dry powder to deploy. In particular, I expect our recently raised 5.75% senior notes to be highly accretive to earnings once we fully invested the proceeds. We're trying to be patient to pick our spots, looking for the right levels on the security side while continuing to support our origination businesses.

Our credit performance statistics remain strong, but we're keeping vigilant on underwriting standards, especially with housing affordability down dramatically and with economic growth turning negative. Given the abundance of investment opportunities available today, we believe that our patients will ultimately be rewarded. With that, we'll now open the call up to your questions. Operator, please go ahead.

(Operator Instructions) Our first question from Trevor Cranston with JMP Securities.

A couple of questions on the non-QM market. First, I guess, after the substantial increase in rates on non-QM products, and the disruption to some of the originators in that space. Can you talk about kind of how much origination volume you're expecting to see in that product over the second half of the year compared to the first half of the year. And as a second part of the question, you guys clearly kind of laid out the opportunity on the loan side there. With the spread widening, are you guys also interested in buying some of the up in the sec securities from other non-QM deals or are you really more focused on the loan side at this point?

Trevor, it's Mark. So I'd say that the first question about change in volume, in terms of securitized volume for the second half of the year versus the first half of the year, I think that's going to be down a lot. But part of the reason is A lot of the securitized volume for the first half of the year with loans that were really originated back in 2021.

So there were a lot of platforms sitting on a lot of 4.5/5 note-rate loans. They didn't securitize in '21 that they put into the market in 2022. So if you take away that, I think my projection is that just at these higher note rates and alter higher HPA, you're probably just going to see organic non-QM volume drop by, I'd guess, at least 30%. I just think it's fewer borrowers qualify, fewer borrowers are looking to buy homes right now given what the payments are with is kind of double whammy of higher HPA and higher mortgage rates.

And if you look at a lot of housing metrics, if you look at like what's happening to views on Zillow and I think you're going to start to see it a little bit in listing times, that I just think there's sort of an overall slowdown that you're going to see in housing.

The other thing about buying pieces of other deals. So the way we think about the -- when we do securitizations, where we think about that is the bonds we sell are really sort of replacing the bots. We consider them for term financing. So we do our own deals depending on what tranches we retain. And some of it we're retaining because here there is potential obligation, but sometimes we'll retain in excess of the risk retention obligation. We look at those sort of as new investments that the company is making.

So to the extent that we can replicate those investments, and other people's deals, that's something that's of interest to us. One thing I would say is that the pieces you retain on securitizations are pretty low down in the capital structure. What's going to drive the returns on those things is going to really have a lot to do with loan performance as it's not like buying a more senior security where it's more like prepayment and what happened to spreads. You're down to capital structures, you're exposed to credit risk.

And Larry mentioned on the call, but one of the benefits of having these originator stakes is we have an active dialogue in terms of underwriting standards and how we should be reacting to changes in the market and changes in the housing market. So I think we have a level of comfort on the retained pieces as investments for the securitizations we do. But yes, I would just say that away from millions of financial in other pools of capital we manage, we are buying attractive things in non-QM space definitely.

You guys talked about the challenges that a lot of originators are facing and the impact on your investments in some of those companies. As you look at the originator landscape, are you guys looking at or pursuing any opportunities to maybe provide a capital injection to a good quality company who's a little bit beaten up right now? Or are you guys kind of comfortable with the investments you guys have at this point?

Yes, we're definitely seeing opportunities like that. And similar to what we've done in the past, I think a modest amount of capital, absolutely could be a great use of capital to do that, provide some sort of line of credit or capital infusion in exchange for -- and then getting forward flow, potentially warrants.

There's a lot of things that these companies that are struggling could help them basically get through this and provide a great opportunity for us. Again, we're not the type that usually writes big checks. So as we've said, but I think this could be a great opportunity to do that, and we are seeing a couple of opportunities presented.

And then last question on the agency portfolio. Can you talk about how you're thinking about the overall net long exposure kind of given where spreads are in the agency market and where volatility is that currently?

Yes. So we typically keep the net long in that portfolio significantly lower than what you'd see from sort of an agency REIT. And part of that is just a philosophical belief that shareholders in Ellington Financial are primarily looking to generate returns to credit investments. So historically, we haven't wanted to introduce some of the risk inherent in the levered agency portfolio about volatility and basis widening.

We haven't wanted that to really dominate returns for EFC given that it's really credit focused. So I think, and JR can correct me, I think the agency portfolio was down roughly 6% on its capital this quarter, right? So I think that's sort of like at the better end of what you're seeing from the agency peer group in part because it's fully hedged and also doesn't have as much mortgage exposure. Yes, mortgages are certainly wide right now, but they're wide for a reason everybody knows, right? You have the Fed stepping back their purchases. It's possible, even though a lot of market participants think less likely, but it's certainly possible that they could engage in sales.

And also, the other thing is Fannie and Freddie greatly increased their loan limit. So the new crop of agency mortgages that are originated in the higher coupons, 4.5s and 5s. They're really big loan balances. So there's going to be a lot of sort of potentially an unfavorable prepayment curve for some of those things. So all that kind of feeds into spreads. I mean, I'd say like right now, if you look at non-QM, or a lot of sectors of credit have sort of had spreads correlated with agency spreads a little bit.

So I feel like EFC, it's taking advantage of wider spreads right now in some of these other sectors. So I wouldn't say right now, probably that's where we'd add a lot of risk. Agencies had a very good quarter in July, so they recoup some of that widening.

But if we saw credit spreads tighten to the point where they weren't as attractive as they are now. And the agency spread is not, then I think at that point, it would be a time to really consider increase in the mortgage basis exposure in the agency portfolio and Ellington finance. But right now, we're in credit spreads so wide, I think we're going to sort of take more of the risk in the portfolio focused on the credit side.

And Mark, we are looking at the numbers here. Yes, the return on the equity that was allocated to the agency strategy was in the single digits. It was obviously a lot better than you've seen from the agency REITs in terms of their return on equity. And that's due to the fact that in no small part, as you mentioned, we hedge more of the basis risk via TVAs in that strategy. than typical agency REIT would.

We will take our next question from Doug Harter with Credit Suisse.

Can you talk a little bit more about your comments to hold non-QM loans (inaudible) longer. How you kind of think about the risk of that? And kind of do you plan to kind of just be more opportunistic around the securitization market? Just to kind of flesh it out a little bit.

So maybe I didn't phrase it properly, but I wouldn't say it's our intention to hold non-QM loans on repo because we see a lot of benefits of being securitizers. We certainly saw it when you went through COVID, how having securitized a lot of our production leaves less mark-to-market risk in the portfolio in volatile times. I also think you build a brand, you get tighter spreads over time, the sort of a virtuous cycle there.

I was just making the comment that you've got near a point in July where securitization spreads have widened so much relative to repo that for the first time in years and years, we at least said let's look at leverage returns just from keeping things on balance sheet. Since then, securitization spreads have come in. So I would say now, our expectation is that we're going to continue to securitize. But I would just say the stability in repo has sort of, for the first time in a long time, at least to us, and we're kind of dined to more securitizers been at least an alternative to consider.

And Mark, I just want to make one other point, which is that the one thing that, so yes, first of all, it's not like we have a gun to our head, right, and need to get these things off repo right away. One thing that we look at very closely is we look at the relationship between the securitization spreads and where we can buy loans, non-QM loans, right?

And so when we did the securitization, which we completed last week, one of the things that I think contributed to or wanting to do that securitization even though spreads are obviously a lot wider than they were early in the year, is that we can replace that risk, if you will, right? So we're derisking by doing the securitization, but we can replace that risk pretty much right away now with non-QM loans, right, that are priced very attractively relative to where securitization spreads are. That wasn't true a couple of months ago, the securitization spreads widened, and it took a while before the primary market where you could buy what you could originate where you could originate and purchase via forward flow agreements or whatever it is, there was a lag there.

So once that sort of renormalize what it should be, which is that it should be profitable to originate loans and securitize it. So once that got back, that was like, okay, let's do the securitization because we can now replenish that risk in a profitable way in terms of the loans that we are seeing available for purchase today.

And I guess on the commentary about the ability to source loans, I guess, how do you view kind of the time line to aggregate enough size to securitize? How does that compare kind of in the back half to kind of what you experienced in the first half?

Well, it's compressed a lot for us. First, we were a year between that, I think, 6 months, 4 months, 3 months now. I think we have enough flow on inventory, frankly, that we could be doing deals much more frequently. And a typical size deal for us is in the $300 million to $400 million range.

Yes. I mean last year was about $350 million, and we originated $550 million in the second quarter. Exactly right. Exactly. So I think you could definitely see now every 2 or 3 months as opposed to every 3 or 4 months.

We will take our next question from Bose George with KBW.

This is actually Mike Smith on for Bose. Maybe just one on leverage. If you look at total leverage currently at 3.8x. Just wondering if we get some macro clarity in the back half of the year, just wondering how high you could look to take leverage.

Sure. So thanks for the question, JR. I'll start out and then Mark and Larry obviously supplement as you see fit. So the $3.8 million includes all the non-QM securitizations that we consolidate for GAAP. So that's a total leverage statistic, but recourse debt to equity, which we talked about, that's the ratio we focus on because it excludes nonrecourse financing, which is largely the non-QM securitization. That measure did increase from 2.3:1 to 2.6:1 quarter-over-quarter. And 2.6 is higher than it's been kind of post-COVID, but not as high as it was pre-COVID.

We gave the statistic that unencumbered assets, about $600 million plus cash of another $2.25. So that's one of the ways that we measure dry powder. Larry mentioned that we closed on the senior notes on March 31. So that was $210 million of the dry powder as we think about it.

So I think the answer to this question is usually it depends on the opportunities. Having that many unencumbered assets and cash that is above the balance that we typically carry implies that we have more borrowing capacity. On the other hand, we did do a securitization that closed last week, and so that takes recourse financing off our balance sheet, but we've also continued to take advantage of investment opportunities.

So there are different moving pieces. But I think in short, we still have room to take leverage up further those unencumbered assets of about $600 million, if you say, let's just say 400 is readily financeable at attractive rates, and we leverage that 1:1 or thereabouts that would raise another $400 million plus another, say, $50 million of our cash. Cash is higher relative to NAV than it typically is. That math would get us to the high 2s before accounting for securitization. So we don't typically give leverage targets, but those numbers might give you a sense of how much borrowing capacity we have remaining if we choose to use it.

Yes. And just to reemphasize what JR said, when you think about where our leverage could go, I wouldn't focus on that recourse number because the non-QM securitizations do blow off the balance sheet but the amount of -- they don't blow up the balance sheet with incremental risk as far as that financing being pulled, right? That's locked in long-term financing.

So when we do a $350 million securitization and well, in the old days, we would retain $20 million worth of assets usually mostly IO, non-QM IO and some subordinated tranches as well, right? So that blows up your recourse leverage by $350 million, which is not a small number, given we have $1 billion of equity. But in terms of how many really sort of assets you've added to the balance sheet, that's a relatively small number.

We're retaining more now, so that percentage has increased, but still relative to the size of the balance sheet, the amount of retained tranches that we add when we do a securitization is still pretty low. So again, I think focusing on the recourse number, which is what we think of, especially in terms of our liquidity management and making sure that we can withstand market shocks and things like that is better to focus on.

That's really detailed and helpful color. And then maybe just one on strategy and the potential for M&A. I'm just wondering how strategic of an asset is earned to Ellington the manager? Just wondering if EFC could ever look to acquire, earn, and maybe to increase scale? Or could you ever look at any other strategic transactions. We saw a peer themselves up for sale as I'm just wondering if you can provide any color on the backdrop for M&A that would be helpful.

Yes. All I can say there is nothing has changed. People have asked us that. Of course, if it were right for both companies, it's something that we would absolutely have to consider, right? But it's not on the radar screen right now, and I wouldn't want to comment more than that.

We'll take our next question from Eric Hagen with BTIG.

I have a few here. Did you address the unsecured debt that's rolling over in September and how you'll handle that? It sounds like you have enough capacity on the balance sheet, but I just want to hear you kind of talk about it and say it. And then can you speak to some of the credit attributes to the quality of the non-QM portfolio? I think a lot of loans or some of them anyway, just for the market generally have been bank statement loans and how you think about that, including just how you think about it relative to the value of being able to lever something like the CRT.

Penn: So JR, why don't you handle the question about the, that deal coming due, and then Mark will handle the...

Yes. I think we see it as we planned liquidity-wise to pay it off here in a few weeks. And there's nothing really more nuanced about that. It's going to be ordinary of course, that we plan to pay off the maturity, and we've planned on the liquidity side to do so.

Yes. And if rates hadn't spiked and spreads tapped out right after we did that other secured note deal, we probably would have used those proceeds to pay off the 5.5 coupon even sooner. But 5.5 coupon, which was looking like an expensive short-term funding just in March, was now looking pretty attractive shortly thereafter. So we decided to keep it on. And we could have paid it off at any time, but it certainly looks like we're just going to pay it off the maturity with cash on hand. Eric, do you want to repeat maybe the second half of the question?

I got it.

But so with the bank statement loan, that's sort of I think that's sort of one differentiator among different non-QM originators is how they think about bank statement loans. And I think the non-QM originator, we own, LendSure, has a very good process there. It's a really deep dive into the (inaudible) self-employed is really deep dive into the economics of that business. It's looking at multiple years of bank statements.

And so the performance there has been excellent, and in a lot of ways, you wind up learning more about those borrowers financials than you do just on the regular full doc. So we're totally comfortable with bank statement underwriting at LendSure. When we start buying loans from other originators, then our team has to do a bunch of work to understand how they do the bank statement underwrite and sometimes we can get comfortable with it and there's times we can't.

When I think about sort of the opportunity set, I think you talked about in non-QM retained pieces versus CRT. CRTs more liquid, and it's got pretty good financing terms. I think they're both attractive, like for a long time, I'd say, like last year, the year before, we didn't find CRT particularly attractive because it wasn't that wide, things are at par. And it always sort of has a little bit of this cat bond, the catastrophe bond quality to it that the enhancement levels are so thin that flooding in Houston was an issue for CRT.

You could see wildfires being an issue for CRT. You could see a localized economic stress in 1 or 2 big MSAs related to a specific industry being an issue for CRT, whereas it's not when you have kind of just regularly diversified loan portfolio. So what's changed for us about the CRT market now and where we're finding more attractive investment is that it's season some.

So a lot of these deals that were done a couple of years ago, have had the benefit of very high HPA and also very high fast prepayments. So there are other instances where all of a sudden, bonds have 4x the credit enhancement now that they did an issuance because the deals have delevered so much, or are times where the LTVs are now mark-to-market 20 points lower than where it was when the deal got done.

And so there's significant enough enhancement levels in parts of the CRT market that sort of mitigates or sort of (inaudible) some of the that cat bond characteristics that was always an issue for us because we knew it was kind of like a blind spot or modeling. We don't have models to predict weather and fires and floods.

And so when we know the models are taking into something into account, but we know that they're not taking into account can be significant for that investment. Then a lot of times, it's just like, okay, we don't feel like we have the analytic tools to properly understand the distribution of outcomes of the security.

So it's better not to participate. So those changes though, the buildup and credit enhancement, the much lower LTV because of HPA. Now we're finding attractive opportunities there. Larry referenced one of them in his prepared remarks. So I like both of them for EFC. I like EFC having loans as volumes having securities. Loans are proprietary. They're a little bit more work.

So a lot of time, sort of the pilot goal at the end of the tunnel when you do everything is a little bit higher yield. But a lot of times, securitizations, securities can overshoot, they can get cheaper in loans, there's for selling or whatnot are terminals like you've seen this year? And when those are the times there, we think the securities offer is good or better relative value than loans, we'll buy a lot of security. They have liquidity to them. It's easier to monetize gains. So I think there is a big role for both those things in EFC.

That was a really good step to think about.

We'll take our next question from Crispin Love with Piper Sandler.

One question on the NIM for the credit portfolio. I saw it was about 2.75% second quarter, down from about 3.6% of the first. I'm just curious how you'd expect that to rebound in the third quarter and then should steadily increase off that base of investments with higher yields begin to make up a larger part of the portfolio as the portfolio turns over.

I think we mentioned in our prepared remarks that financing costs in our portfolio adjusted more quickly than asset yields overall as an average of both sides of the portfolio. And we expect NIM to expand going forward as asset yields pick up. And we do have a short duration portfolio, especially in loans where some loans are floating rate, and so those are adjusting real time.

But others are technically fixed rate but might have a 6-month average life, for example, many of our RTLs. And so if you have a 6-month loan that has a fixed rate, it's going to take that time to turnover, whereas its financing might be floating to sell for LIBOR. So hopefully, it's a short-term phenomenon in asset yields catch up. And we mentioned that we've been able to kind of push spreads, and we're seeing higher yields and spreads in the market. And certainly, the market yields on our portfolio were both up sequentially by 60 basis points give or take on the asset side. Again, we didn't see that yet in our cost yields in Q2, but we expect it to kind of catch up going forward.

And just one last one from me. I appreciate all of your comments that you've made on the securitization markets. I just have one clarification on what you said on the non-deal in July versus January. Did you say the 150 basis points wider? Correct?

Yes, in spread. So obviously, much higher on the AAA (inaudible).

In the coupon was at 2.2 coupon in January, and it was a 5% coupon in July. And the 5 coupon in July traded about 1 point lower than the 2.2 coupon.

Okay. Sounds good, Mark.

That's a big move. That's like, wow. And Crispin, just to add one more thing. While we definitely look at ADE when thinking about our dividend, we're also looking at looking forward, right, and seeing where we see these metrics going, including ADE and others and earnings, and so I wouldn't necessarily focus too much on that necessarily over the near term. We're looking at market yields are very high. We're going to turn over the portfolio.

We still have an agency portfolio that from a relative value perspective, we really like, but a lot of that was put on a lower yield. So I think you're going to see over the next quarter or 2, a lot of turnover and movement. Some of it is just the natural recycling of capital on those short duration loan portfolios we talked about. Some of it is just taking advantage of the right time to sell some of the agency pools that we have and replace them just naturally with whatever is in the market at the time, but that's going to recharge the NIM and the ADE.

The other thing I want to mention is that it hasn't been that long, and they're still going to be going on where short-term money market rates are higher. And that's also a boost because all that cash that we have and sort of, if you will, the benchmark off of which our floating rate assets are yielding us. Those are all going up and going up quite a bit, several hundred basis points from where they were literally last year. So that's also a good tailwind for that has not, absolutely, has not been fully factored in yet.

That was our final question for today. I would like to turn the call back over to Larry Penn for any additional or closing remarks.

Thanks, everyone. I just want to add, we're going to take a listen to the audio and if there was something that we considered significant in terms of a gap based upon this issue that the hosting company had, we will definitely look into posting the script, the prepared remarks on our website. And then for the Q&A, I think it seems like the audio didn't gap there. So I think we're going to be okay in terms of just the normal services that post those transcripts. But we will look at posting the prepared remarks if appropriate.

We thank you for participating in the Ellington Financial Second Quarter 2022 Earnings Conference Call. You may now disconnect your line at this time, and have a wonderful day.