Ellington Financial Inc. Q1 FY2020 Earnings Call

Good morning, everyone, thank you for waiting. Welcome to the Ellington Financial First Quarter 2020 Earnings Conference Call. This call is being recorded. I will now hand it over to Jason Frank, Deputy General Counsel and Secretary. You may begin.

Thank you. Before we start, I would like to remind everyone that certain statements made during the 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 13, 2020. 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, our Co-Chief Investment Officer of EFC; and JR Herlihy, Chief Financial Officer of EFC. As described in our earnings press release, our first 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. After a quiet start to the year, the COVID-19 pandemic and the associated measures to contain the pandemic brought the global economy to a virtual standstill in March, which resulted in extreme volatility and widespread market dislocations, including a collapse of asset values and liquidity. Economic activity plunged as countries around the world implemented social distancing restrictions, unemployment claims surged, consumer spending plummeted, and GDP growth rates turned negative. In March, equity sold off across the globe as the 11-year bull market ended in spectacular fashion. Yield spreads on most fixed income assets widened sharply and a flight to safety drove record low yields on long-term U.S. Treasuries. Portions of the yield curve inverted, and the interest rate volatility surged. On Slide 3, you can see the extraordinary quarter-over-quarter declines in Treasury yields. Repo financing stresses alongside a drop in asset prices severely reduced liquidity and prompted forced selling across virtually all credit-sensitive fixed income asset classes. Many leveraged mortgage investors, in response to margin calls from the lenders, had to unwind portfolios quickly at inopportune times and at their fire sale prices. While at the same time, many mutual funds and ETFs that offer daily liquidity also had to sell urgently in their case to meet mounting investor redemption requests. A vicious cycle ensued as these forced sales put additional pressure on prices, which prompted further stress and liquidations, and so on. The selling pressure extended even to perceived safe havens like agency RMBS, where yield spreads skyrocketed to levels not seen since the 2008-2009 financial crisis. The downward spiral finally started to subside, though it didn't end right away, when the Federal Reserve stepped in to restore some stability. The Fed slashed short-term interest rates nearly to zero, injected liquidity into the repo markets, launched several credit facilities similar to what it had implemented during the financial crisis and stepped in with unprecedented levels of quantitative easing. All of which provided meaningful support, especially to more liquid sectors of the market. The U.S. Congress passed three rounds of stimulus packages during March, culminating in the $2 trillion CARES Act on March 27, the largest emergency spending bill in history. These actions were mirrored by central banks and governments around the globe. And the rollout of stimulus programs continued into April. As the Federal Reserve deployed its full crisis playbook, what we saw was in effect almost a full market cycle compressed into just a few weeks. U.S. equities bounced back sharply from the March 23rd lows, as what had been a 34% drop in the S&P 500 in less than five weeks was immediately followed by an 18% rise in just three days. The Federal Reserve's injections of capital eased liquidity stresses, and yield spreads in the sectors targeted by the Federal Reserve's asset purchase programs tightened sharply, particularly in agency RMBS, which recovered strongly during the last two weeks of the month. In the credit space, yield spreads in some sectors such as investment-grade corporate bonds also tightened significantly following the Fed's actions, while other sectors, including non-investment grade CMBS and CLOs noticeably lagged. Many measures of market volatility subsided from their highs, but still remain greatly elevated at quarter-end. What made March uniquely challenging was the magnitude and speed of the risk-off moves. And during the peak of the frenzy, the high degree of correlation across virtually all asset classes, irrespective of their actual underlying risks. As March progressed with the asset markets and financing markets looking more and more fragile, we proactively reduced the size of our agency portfolio in an orderly and measured way, which bolstered our liquidity and lowered our leverage. Most of the agency assets that we sold in March were sold either early in the month before yield spreads hit their wides or later in the month after yield spreads had already recovered strongly. In this way, we were able to avoid forced asset sales entirely, which would have exacerbated losses. During periods of acute distress, like what we saw in March, the performance of a leveraged portfolio can vary widely based not just on what you own, but also how you financed it and how you adjusted to the quickly changing market environment. So the crisis in March put a spotlight on our risk management, our liquidity, and the structure of our liabilities and our leverage. Ellington Financial entered March with a strong balance sheet and prudent leverage ratios. On the asset side, we had lots of liquid agency RMBS to help provide liquidity. And in credit, we have deliberately built a relatively short duration, highly diversified portfolio with an emphasis on first liens. In times of distress, whether it be distress in the financial markets or broader macroeconomic distress, maintaining a shorter asset duration can help a fixed-income portfolio in two very important ways. First, asset prices tend to be less volatile. And second, principal paydowns are incoming faster, thereby derisking your position faster. In fact, during March alone, we received proceeds from principal repayments of about $55 million on our small balance commercial mortgage loan, consumer loan, and residential transition loan portfolios, which represented about 8.5% of the aggregate size coming into the month of those portfolios. On the liability side, lessons learned from past market crises have taught us to limit our leverage, diversify our sources of funding, and to structure our financing arrangements to help us better withstand shocks in times of financial distress. Over the past few years, we have issued investment-grade-rated senior unsecured notes and have completed several securitizations, all of which provide locked-in term non-mark-to-market financing. Several of our secured financing facilities are committed and non-mark-to-market and have repayment schedules that more closely match the repayment schedules of the financed assets as compared to typical repo. Also, our objective has always been to stagger the roll dates over repo financings and to roll these financings in advance of maturity dates as a standard practice. Our disciplined interest rate hedging and opportunistic credit hedging have also provided additional book value protection in volatile markets. All of these measures combined with our strong liquidity management practices help lessen the impact of the March distress in our portfolios, granting us sufficient time to stay ahead of the curve, unlike many other market participants, who became forced sellers at distressed prices in March. With that, I'll turn the call over to JR to go through our first quarter financial results in more detail.

Thanks, Larry. And good morning, everyone. Please turn to Slide 7 for a summary of our income statement. For the quarter ended March 31st, EFC reported a net loss of $3.04 per common share, compared to the net income of $0.31 per share for the fourth quarter of 2019. Core earnings for the first quarter were $0.46 per share, up from $0.44 per share in the fourth quarter of 2019 and covered the common stock dividends declared during the first quarter of $0.45 per share. While total net interest income increased 24% sequentially, and gains on our credit hedges were meaningful, the significant net loss for the quarter was driven by losses on our long investment portfolio as the market dislocation in March led to wider yield spreads across virtually all asset classes. Next, please turn to Slide 8 for the attribution of earnings between our credit and agency strategies. During the first quarter, the credit strategy generated a total gross loss of $2.47 per share, while the agency strategy generated a total gross loss of $0.38 per share. These compared to gross income of $0.28 per share in the credit strategy and $0.32 per share in the agency strategy in the prior quarter. Most of our credit strategies generated net losses during the quarter. The largest losses occurred in CLOs, CMBS, non-agency RMBS, and non-QM loans, all markets where there was substantial distress selling during the quarter. Our long strategies with shorter durations had better performance, including small balance commercial mortgage loans, consumer loans, and residential transition loans where we received significant proceeds from principal payments, and in the case of small balance commercial mortgage loans, several profitable asset resolutions. The fact that most of our commercial mortgage loans have LIBOR floors was also valuable in the quarter since LIBOR declined sharply. We also had net realized and unrealized losses on the interest rate hedges in the credit portfolio as interest rates declined sharply during the quarter and were highly volatile, and a net loss from investments in unconsolidated entities. On many of our credit investments, we aren't anticipating some degree of eventual principal losses as a consequence of the economic impacts of COVID-19, especially in a prolonged shutdown scenario. As has been widely reported, there has been a significant nationwide increase in loan delinquencies and forbearances, and we are seeing the effects of this on our own portfolios. In the agency strategy, the precipitous declines in interest rates and high levels of interest rate volatility generated net losses on our hedges. And while our agency RMBS assets did appreciate in price during the quarter, they significantly underperformed our hedges. As a result, we experienced a net loss for the quarter in the agency strategy. Furthermore, TBAs outperformed specified pools during the quarter, depressing payoffs on our specified pool portfolio. The underperformance of specified pools relative to TBAs can be largely attributed to market-wide liquidity problems exacerbated by quarter-end balance sheet pressures, as well as to the implementation of the Federal Reserve's amplified asset purchase program during the quarter, which was generally limited to TBAs and generic pools, as opposed to specified pools and payoffs. With that said, while TBAs outperformed specified pools during the quarter, they severely underperformed interest rate swaps and U.S. Treasury securities. So we benefited by having a significant portion of our interest rate hedges and TBA short positions as opposed to interest rate swaps. Turning next to Slide 9, you can see the size of our long credit portfolio which is essentially unchanged quarter-over-quarter. We grew our credit portfolio in January and February, deploying the capital raised in our January offering. But these new purchases were offset by asset paydowns, payoffs, and net reductions in asset values related to the market dislocations in March. In light of the market volatility, we substantially suspended new investments in our credit strategies in March. And as Larry mentioned, it was our agency portfolio, not our credit portfolio that we used as a source of liquidity. On Slide 10, you can see that we strategically reduced the size of our agency portfolio by 48% to $1 billion as of March 31st, compared to $1.9 billion at the end of the prior quarter. These sales were orderly and enabled us to reduce leverage and bolster liquidity. Next, please turn to Slide 11 for a summary of our borrowings. As a result of the agency sales, our debt-to-equity ratio declined to 3.1 to 1 as of March 31st from 3.8 to 1 at December 31st, adjusting for unsettled purchases and sales. Similarly, our recourse debt-to-equity ratio also adjusted for unsettled purchases and sales decreased over the same period to 2.1 to 1 from 2.6 to 1. Our weighted average cost of funds decreased sequentially during the quarter to 2.58% from 2.86%, driven by lower short-term interest rates. As a result of the significant price declines and general price volatility, we received margin calls under our financing arrangements that were higher than typical historical levels. We satisfied all of these margin calls. At quarter-end, we had cash and cash equivalents of approximately $137 million, along with other unencumbered assets of approximately $279 million. For the first quarter, our total G&A expenses declined to $0.14 per share from $0.16 per share in the prior quarter, primarily due to our higher share count following the raise in January. Other investment-related expenses declined quarter-over-quarter to $0.09 per share from $0.16 per share, mainly because we incurred non-QM securitization issuance costs in Q4, but not in Q1. We have a small income tax benefit related to a decrease in deferred tax liabilities in our domestic taxable REIT subsidiaries. Our book value per common share at March 31st, was $15.06. On a more technical note, as of January 1, 2020, we applied the new credit loss standard known as CECL. Because we've always fair-valued our portfolio through the income statement, CECL had no net impact on our earnings or book value this quarter. The final note, in response to the challenges presented by COVID-19, the SEC has granted public companies an extension for certain filing obligations this quarter. With everything going on we intend to take advantage of this option and plan to file our 10-Q on or before May 22nd. Now over to Mark.

Thank you, JR. The markets for securitized products in the second half of March and throughout much of April were as challenging as I've ever seen in my career, including even 2008. Larry already gave some of the blow by blow, so I won't repeat it all now. But essentially COVID-19 created such a sudden and dramatic change to the outlook for U.S. economic growth and employment that almost overnight, both lenders and investors repriced virtually all credit assets to both much higher yields and much higher loss expectations, setting off a wave of selling for mutual funds, REITs, and hedge funds. If you had a portfolio that was highly leveraged, even with senior assets or if you had a portfolio that was only modestly leveraged but with subordinated bonds, either way, your balance sheet was under siege. And if you became a forced seller, the prices you realized were quite distressed. The policy response from the Fed was fast and enormous, with massive buying of agency MBS, health programs, lending programs, and the CARES Act all going a long way toward stabilizing the market. As we see it, the two big beneficiaries from the government intervention are the consumer and the residential housing market, which are both sectors we have long favored. Ellington Financial, with its diversified less leveraged portfolio, which included lots of liquid agency assets, and which in credit included a concentration of lower LTV loans, was able to weather the storm. While we absolutely have worked through resolving assets where either the borrower or the property are experiencing a loss of income, we are pleased with the performance of most parts of our portfolio. And while the agency CMBS market did not escape unscathed, our disciplined approach kept our net loss in our agency portfolio under 10% on allocated capital for the quarter. I wonder if you could how the team managed the portfolio when the crisis hit. Firstly, we recognized relatively early on that the spread of COVID represented the kind of scary unpredictable news the market really struggles to rationally price. This was not a string of terrible GDP reports, or even massive flooding in Houston. As bad as those events can be, they're much more quantifiable. In contrast, nobody has a crystal ball to accurately predict when and at what progression the economy will reopen. As you can see on Slide 9, we did not net sell credit assets into the distressed market in March, and the portfolio was essentially unchanged quarter-over-quarter. That's why it doesn't really tell the whole picture, because we grew the portfolio in January and February following our capital raise, and these purchases were offset by a lot of pay downs in March, specifically small balance commercial loans, residential transition loans, and consumer loans. All had a lot of principal pay downs in the quarter as Larry and JR mentioned. As you can see on Slide 10 coming into the quarter, you also have a large portfolio of liquid agency pools. Lots of agencies' specified pools had low payoffs that we can efficiently turn into cash. And that's exactly what we did as March progressed. As you can see on this slide, we cut our agency portfolio in half. Most importantly, we did this in a deliberate opportunistic way, in particular by selling early in March before spreads hit their wides or later in the month and thereby taking advantage of the strong Agency MBS rebound, driven by the Fed's unprecedented buying spree. Just like with other periods of QE, agency MBS recover first and then other structured products sectors follow. So as market volatility struck, our view was the most prudent way to raise cash was to sell the more generic MBS securities, especially our low pay-up specified pools. Now that the markets have become more stable, our focus has shifted more towards managing our credit exposure and taking advantage of tremendous opportunities available while considering the potential long-term consequences of COVID. For some sectors, such as credit risk transfer securities, in our opinion, the uncertainty seems too great to have sufficient confidence in asset values, while for others it seems pretty clear to us that even with conservative assumptions, yields are still very high. Turning now to our non-QM business. In response to March's volatility, we temporarily stopped new originations, but we are now planning to restart our lending programs with updated guidelines that take into account a potentially weaker economy with higher levels of unemployment and lower income levels, and including the effects of these factors on real estate prices. The reason non-QM lending was performing so well between 2015 and February 2020 is that there was a big borrower demand for the product. So capital providers like us could be disciplined on credit and still generate volume. The GSEs with their automated underwriting systems are the low-cost, low-rate mortgage producer for most borrowers where W2s and IOs Form 1040 provide a close to complete picture of their income and the ability to repay. That probably covers about 85% of residential mortgage applicants. For the other 15%, the non-QM business line makes a lot of sense, and COVID does nothing to change that. If anything, we think it makes the non-QM opportunity even more compelling and in demand. This other 15% of mortgage applicants includes many self-employed borrowers, many borrowers with a lot of K1 or rental income, and many borrowers who might be retired with substantial financial assets but limited to no 1099 income. It also includes many highly qualified borrowers who might want to buy an investment property through an LLC. These are the borrowers that non-QM responsibly serves. And the very strong credit performance in our non-QM securitization to date is a testament to the fact that when non-QM loans are thoughtfully underwritten, they are high-quality loans. Meanwhile, at the same time, we are predicting continued demand from the traditional non-QM borrower base, we also think that we'll see additional demand for some non-QM loans from another segment of the residential mortgage borrowers. Specifically, I'm referring to the large number of quite creditworthy borrowers who have certain characteristics that put them toward the edges of the GSEs current credit box. Faced with uncertainty about the future of the credit risk transfer market, the GSEs seem to be tightening their credit box and we expect that this will potentially exclude some very creditworthy borrowers who may become strong candidates for non-QM loans. Will there be headaches in our non-QM portfolio? Absolutely. Will there be borrowers that need forbearance? Yes. Will there be a delinquency spike? Yes. You can already see that in the data. So our focus right now on non-QM is two-pronged. First is partnership with our servicers. We're working with those borrowers who need time to pause their payment obligations because they are experiencing loss of income. Secondly, we are planning to resume originating high-quality loans with guidelines appropriate for the current and more uncertain economic environment. Although non-QM performance will be affected by the economic slowdown that COVID triggered, much of the price movements in the non-QM market in March related to market-wide financing issues, especially as the securitization market seized up, as opposed to fundamentals with the loans. The good news is that the non-QM market seems to be slowly returning to a more normal state. We expect the non-QM securitization market to reopen later this month, and we hope to be back in the market with our next securitization as soon as market conditions permit. We're thinking about residential transition loans in a similar way. The reason we entered the RTL market was because it made sense. The median age of the U.S. home is now 37 years, and many borrowers don't want to buy a home with a lot of deferred maintenance to deal with. So if we pick the right partners, pick the right geographic area, pick the right renovation projects, and be disciplined about LTVs and underwriting standards, we believe that we can have strong performance and very high leverage yield on that portfolio. Amazingly, between March 1st and April 30th, about a quarter of our RTL portfolio paid off at par. That was the kind of outcome we were hoping for when we underwrote those loans. It really shows the benefit of having shorter duration assets during the credit shock. Could we have sold those loans at par during the panic in March? I highly doubt it. But the combination of our experienced team and our careful underwriting got us that outcome. It's a far better outcome than being a forced seller in the third week of March. Will there be some headaches in that portfolio? Yes. Do we expect to see some credit losses? We do. But from the market color we have gotten, it looks like our portfolio is performing much better than many other RTL portfolios. Some of non-QM, we temporarily shut off new originations in March; we want to start buying again. We are reformulating our guidelines and looking for secondary packages to buy. The same thought process is guiding our consumer loan portfolio. Despite the COVID dislocation, we have continued to see substantial velocity of par payoffs, and we are working with our partners to appropriately help borrowers in need. Until we have more visibility, we have cut way back on new purchases. But so far, the performance numbers are very encouraging. Our small balance commercial strategy also had some great resolutions in the quarter. It will also have its share of headaches, as your outlook for the next six months is for things to get a lot messier in commercial real estate than in residential real estate. But again, our low LTVs and shorter duration should help them this strategy as well. All that said, we certainly took our lumps this quarter. As always, losses in the credit portfolio took one of two forms. First, we had mark-to-market losses on investments. We don't expect a big change in the cash flows, but the prices went down because the market yields widened. And second, we had some mark-to-market losses on investments that were not just due to wider market yield spreads, but also because we have witnessed or we project some degree of fundamental cash flow impairment; that kind of loss is likely to be permanent. So what did we learn from the crisis in March and how will it shape the direction of EFC going forward? One notable difference between what happened in March and previous financial crises is the speed at which prices dropped and the forced selling occurred. We did not anticipate that over the course of just two weeks, the yield spreads on Fannie fours, for example, could widen from a normal OAF to the widest level since the 2008 financial crisis. COVID is proving to be unpredictable; we have to expect more of the unexpected. The next shot could be weather-related, there could be another wave of public health crisis related to COVID or to something else, or there could be more tensions around global trade or something else geopolitical. But wherever the shot comes from, we need to be prepared to withstand volatility and hopefully thrive from it. So how do you do that? I think the experience of the past couple of months gives us even stronger incentive to do securitizations as a way to transform repo financing into non-mark-to-market term financing. There are plenty of times when the cost and time commitment of doing securitizations may seem like they are not worth it. In times like March 2020, having done them was well worth it. If all non-term loans that we had securitized over the past two years had been sitting on a balance sheet financed with repo, we would have had to reserve a lot more cash for potential margin calls. Secondly, so far the loans we've sourced from origination channels, where we've carefully chosen our partners and helped shape the underwriting guidelines seem to be performing well relative to their peer group. If you're more inclined to continue to look for partnerships, we're very aligned and work in tandem with the originator to make credit decisions. Thirdly, it reaffirms that liquidity of the agency MBS portfolio can be a great balance for the credit portfolio. Agency MBS is the primary sector of structured products that benefits from direct Fed buying, and this has been an important governor on spreads in times of stress. While agency MBS liquidity was absolutely awful at times in March, it was still much better than any fixed-income sector without a government guarantee, and we were able to efficiently raise cash in that market. So I like the balance EFC had between agencies and credit. Looking forward, I and the rest of the Ellington portfolio management team have been very focused on navigating these markets and doing the best to earn back losses sustained in March. Now back to Larry.

Thanks, Mark. While an economic return of negative 60% for a quarter is painful to say the least, I'm extremely proud of how our team managed through the unprecedented challenges of the quarter, especially given that leveraged credit portfolios were in the crosshairs of the distress in the financial markets. Our liquidity management, risk management, and hedges did what they are designed to do. They protected book value and they protected our shareholders. This past quarter, that meant protecting our shareholders, not only by avoiding any forced asset sales, but it also meant protecting our shareholders by avoiding any expensive or highly dilutive capital raises. In addition to our GAAP loss for the quarter, we also estimate a taxable loss for the period. For REIT purposes, a first-quarter taxable loss would technically lower our distribution requirement for the full year. The board has set the two most recently announced dividends at $0.08 per share. While our outlook for future core earnings for Ellington Financial is strong, these reduced dividend levels balance that optimistic outlook on core earnings against our now eased distribution requirement and our desire to preserve liquidity. Liquidity both to take advantage of investment opportunities and liquidity just to be prudent in these continued uncertain times. The board will continue to assess the dividend rate on an ongoing basis as market conditions and our financial position continue to evolve. Financial crises can also create opportunities. And as we look ahead, the diversified credit-sensitive sectors, which Ellington Financial has deep experience, particularly in many of our loan businesses, are facing a severe supply-demand imbalance, with net interest margins that are as wide as we've seen in years. We believe that this imbalance will present highly attractive asset acquisition opportunities for Ellington Financial for some time to come. All that said, while the global government and central bank responses have provided a boost to liquidity and meaningfully improved market performance in the short term, the path forward for the economy remains unclear. We don't know what the length and severity of the economic downturn will be, what the ultimate path to recovery will look like, and what the exact effects of all this will be on our current portfolio or on future investments. And on the liability side, it's unclear what the exact terms and availability of financing for these assets will be. In light of this uncertainty, our goal will be to balance defense that is building in a margin of safety to absorb additional market shocks with offense, that is the ability to capture what we see as great opportunities. Ellington's core risk management principles have served us well over many market cycles, including during Ellington Financial's very first years from 2007 through 2009, when Ellington Financial not only maintained book value stability through the financial crisis, but then absolutely thrived in its aftermath. We believe that these same risk management principles continue to be critical in both protecting EFC's book value and keeping EFC well positioned to capitalize on the opportunities that we are seeing and that we are anticipating. And as always, management remains strongly aligned with our shareholders with a significant co-investment in EFC. Before we opened the floor to questions, I would like to take this opportunity to thank the numerous members of the entire Ellington team for their hard work over the past weeks despite difficult circumstances. And for all of those listening on the call today, and to all of those in our communities and around the globe impacted, we hope that you and your family stay healthy and safe. With that, we'll now open the call to your questions. Operator, please go ahead.

Your first question comes from Trevor Cranston with JMP Securities.

Hi guys. Thanks. Hope you guys are doing well.

Thanks. You too.

A couple of questions on the financing side. You guys talked about the uncertainty that there remains about the terms and availability of financing for new asset purchases. I was wondering if you could talk about how much of the credit repo you guys have was actually rolled between sort of the middle of March and today, and repo that hasn't yet rolled to sort of what your level of confidence is that the lenders are going to be continuing to be willing to finance the assets going forward. Thanks.

Yes, I don’t have all the figures at hand, but I can assure you that we’re feeling optimistic. We did extend some repo, and we didn’t just stagger maturities; we also proactively rolled some repos ahead of their maturities instead of waiting until the last minute. We took significant steps forward, but I won’t disclose specifics about the counterparties or markets. We extended a considerable amount of credit repo well in advance of the August maturity back in March. After the quarter ended, we also extended substantial amounts of our loan repo, which might be what you are focusing on. Regarding securities, the situation has been clearer, and while I won’t say it has been business as usual, we haven’t encountered significant issues with rolling securities repo. We’ve been proactive with loan repo as well. When we consider non-QM, we currently have good term repo on it, and we believe there’s ample runway there. However, no one can predict exactly how that repo market will shape up, as it will be connected to the securitization market. There’s non-QM available in the marketplace awaiting securitization, and there have been some distressed sales, particularly in March. We need to see how that unfolds, as it will influence the rates that non-QM borrowers will pay. It’s all somewhat cyclical. To summarize, I think we’ve been very proactive on the loan side even during challenging times. Financing loans will be more expensive, that’s certain. However, the rates we can secure from borrowers and the yields we can earn on our loans will be considerably higher. We see this as a great opportunity, given the supply-demand imbalance between borrowers and lenders. I hope that answers your question.

Yeah, that was very helpful. Thank you for that. And then, next question. Mark talked a little bit about sort of the differentiation in the types of price movements among assets like some where you do expect a meaningful change in the actual cash flows and credit performance in some assets where there isn't necessarily so bigger change. I guess, as some liquidity returns to the credit markets. How are you guys thinking about the composition of the portfolio? Are there certain sectors where you might like to sell assets to the extent you feel that you can do that and reallocate into something else? Or how should we think about the mix of the asset classes?

Let me start with that question and then I'll hand it over to Mark for additional insights. In March, the credit markets were so illiquid that we couldn't really rotate our positions because the difference between the buying and selling prices was too high. Moving forward, you're correct in your assessment. We will need to carefully consider what we are selling compared to what we are buying or reallocating. When you think about Ellington Financial, the type of company we are, and how the market has historically rewarded us for generating sustainable core earnings, I believe we will sell some of our securities portfolios at the right time and when it makes sense from a relative value perspective. We aim to reinvest into asset classes where we anticipate a longer-lasting supply-demand imbalance. Currently, there is still a significant supply-demand imbalance across many securities markets, including non-agency RMBS, which performed well after the 2008-2009 financial crisis but is now a much smaller market. Those securities are trading at wide spreads. We’re not planning to sell immediately, but as markets decline, which we expect will happen, we will be looking to rotate out of some non-core assets as well as focus on achieving good total returns. We want to ensure we sell at the appropriate time and likely redeploy into more of a loan business, where we see sustainable opportunities going forward. Mark, do you have anything to add?

I guess I would just say that our interest is in sectors where the outcomes aren't binary, and the outcomes aren't contingent upon guessing right on potential policy moves. So if we think about hotels or we think about student housing, the outcomes and those kinds of loans are highly dependent on when the economy reopens and once it reopens, what consumer psychology is, when universities reopen. And so I think we have a great research effort here supported by vast amounts of data that we purchase. But that effort in that data doesn't give us an edge in predicting the sort of things that are going to drive outcomes for those two sectors. But I think it is very good in understanding for different levels of unemployment. What income loss is, how the CARES Act and more generous unemployment benefits offset income loss, and translating all that into what might happen with home prices. And so I'd say sectors where the outcomes aren't binary and it's not really contingent upon getting the policy response right, and sort of where we think not only do you get very attractive yields, but your downside is much more limited.

Okay, great. That's helpful. And then you guys talked about the amount of principal repayments you've had in March, which is obviously very helpful to have during that time period. Is there any way you can provide sort of an estimate of what your expectation would be for the average amount of monthly principal repayments looking forward?

Unfortunately, I don't think we can provide that with enough confidence. The portfolio, whether it relates to our small balance commercial or residential transition loan segments, is less statistical and more focused on individual loans, making it difficult to predict. Even during stable times before COVID, these loans were challenging to forecast. However, the maturities are short, so we are hopeful for a steady flow of repayments. Regarding the more statistical segments of our portfolio, such as consumer loans and long-term loans, we may not be able to be very quantitative, but there might be some qualitative insights we can share about those portfolios. We likely have a bit more data on them, and as we mentioned earlier, we are quite pleased with how these continue to pay down. Mark, do you have anything to add?

There are two factors to consider. First, the portfolio in some sectors, like RTL, is smaller now than it was two months ago. Because it's smaller, I would expect a slowdown in repayments. Additionally, as I mentioned on the call, we will face challenges to work through. As the easier loans to resolve are paid off, the remaining issues will represent a larger percentage. These are the reasons I expect repayments to decline somewhat. However, there are also aspects like consumer loan portfolios that involve straightforward amortization. If the portfolio remains stable without significant new purchases, I anticipate repayments to decrease gradually over time.

Okay, got you. And then, just the last question for me. You guys talked about focusing on the sort of core businesses going forward, along with origination partners. Of the investments you’ve made in the origination companies so far can you comment on how those companies are broadly faring and how they were able to come through the March and April time period? If they’re still reasonably healthy and continuing to operate or what their status is?

I don’t want to get into too many specifics. Our main equity investment is in a reverse mortgage originator, which we believe has a strong demand. This is an agency product, and there's demand for both agency and private label products. We have no doubt about the ability to securitize this product. The option to borrow money without needing to make monthly payments is very appealing right now for many people, so we are optimistic about that business. Our other investments, like in LendSure, are smaller. We’ve mentioned that we are preparing to re-enter the non-QM market and are looking for the right balance between attractive rates for borrowers and ensuring they work for us after leveraging. The competition in both areas has weakened significantly, and we are optimistic about the opportunities in that market. I'll leave it at that.

Okay. I appreciate the comments. Thank you, guys.

Your next question comes from the line of Crispin Love, with Piper Sandler.

Good morning guys. Hope you're doing well and staying safe.

Yes, thank you, Crispin. You too.

Thank you. Can you talk a little bit at some of the at-risk areas that you might have in your portfolio right now? I guess first what percent of your loans are currently in forbearance, and then also what percent of loans are in certain sectors, whether it's retail, hotels, restaurants, small business loans, or kind of any other areas you'd like to point out?

We have not traditionally provided that level of transparency regarding the commercial mortgage side, which is diversified across various sectors. Some areas, such as hotels and lodging, are definitely facing more challenges in the short term compared to others like multifamily housing. We won't disclose specific figures on forbearance at this moment, but when we release our quarterly report, which will be slightly delayed due to the SEC release, you'll find some information there, including insights on valuations. As mentioned, there are two key factors affecting those valuations: yield spread widening, which we will detail in the report, and anticipated future credit impairments. However, we don't have current details on what is in forbearance. We do believe, based on anecdotal evidence and reports we have received, that our portfolios are performing well in relation to these sectors overall.

Okay. That's helpful. One last one for me. What are your views on buying back shares right now? Are you more focused on preserving liquidity to buy other assets or do you see a good opportunity here to be buying back with the stock? I think it's around 70% of book. I know in the past you've talked about the 80% to 85% level as a threshold, but definitely different times here. Just sort of curious about what your focus is right now, whether it's buying back or investing elsewhere any color?

Yes, that's a great question. Before the crisis, an 80% level made sense, but now we are trading below that. We recently announced our book value, but our new threshold will be lower. I cannot predict how much lower exactly. Our typical window for repurchases opens after these calls, and we also need to consider if we have upcoming information to share. We haven't made any decisions about restarting repurchases yet, but our threshold will be higher given the significant investment opportunities available right now. The situation is quite different than when we were buying back at 80% of book value during a strong credit market. We will be monitoring this closely and will approach it as scientifically as possible. Additionally, we will need to balance this with liquidity preservation, which I mentioned is always a consideration. Like we reduced the dividend, we will have to make careful decisions. I apologize for not being able to provide more clarity, but I can assure you that the threshold will be lower than it was previously.

Okay, thanks for taking my questions.

Your next question comes from the line of Doug Harter with Crédit Suisse.

Hey guys, this is actually Josh on for Doug. Thanks for taking the questions. First on the agency portfolio seems like a great source of liquidity for you guys in the first quarter. Curious how you're thinking about that portfolio going forward? And if you could just talk a little bit about how you're thinking about the agency strategy in general fitting into the broader portfolio mix of the company? Thanks.

Mark?

Sure. So you know, I mentioned in my prepared remarks that there is a real benefit to having that balance between the agency portfolio and a credit portfolio. You really saw it in this quarter, right? The agency portfolio provides a lot of liquidity at times when the credit market can be less liquid. And the other benefit I mentioned in the prepared remarks is that it's really only agency MBS and to a lesser extent, agency CMBS benefit from direct Fed buying at a time of real stress. You saw that in Q1 and we availed ourselves of that opportunity. I think it was a thoughtful way for us to manage the portfolio. So historically, if you take the longer view of how Ellington Financial has partitioned capital between agency and credit, it's typically been somewhere between the low end 15% of our capital and agency strategy, up at the high end, maybe 23% or 24% in an agency strategy. So I don't see those guardrails changing that dramatically. I will say that now you have seen, really if you include April, a pretty material performance reversal in the agency market. So initially you saw TBAs turnaround and rebound from the substantial widening in March to very strong performance once the Fed started buying. We took advantage of that. And sort of the next leg of agency performance, which you saw in April and the new ones in the first week of May, is very strong performance of specified pools relative to TBA. So with both those legs of agency performance, the TBAs versus swaps, and then the pools versus TBA having recovered a lot of ground from the wide levels in the second half of March. The agency market, to our way of looking at things, is still a very attractive ROE. But its recovery has preceded a recovery we think is likely to happen should the economy reopen on sort of the projected path that you can see in the credit markets. I'd say right now, I don't see us being in a rush to rebuild the agency portfolio back to the size it was pre-COVID. But over the long-term view, I think we'll get back to sort of the capital ranges that we've seen historically for EFC. It still provides, even given the recovery of what you've seen through May, very meaningful ROE. It does have that distressed component to it, that you can see in some of the credit sectors where you can capture potentially very high yields, but also capture additional total return should asset prices on the credit side retrace some of the precipitous decline you saw in March and April.

And if I could just add. No, that was a great remark. Thanks. If I could just add, just keep in mind that we have those extra levers of how much we dial up and down our TBA shorts against our specified pools. And even whether we want to replace the specified pools with TBA loss. So we have those extra levers, especially on the TBA short side, that really I think makes Ellington Financial and Ellington Residential stand out in the marketplace to the extent to which we can vary those levers. So for example, and look, things continue to move around a lot, right? As Mark said, OAS is as wide as they've ever gotten since the financial crisis. And then, if you look at some of the material we provided, you can see that OAS has by some measures got incredibly tight on agency pools when you got to the end of the month. So these things are still moving around a lot. If we see an opportunity in specified pools, where we can buy stuff at extremely low pay-ups and hedge with TBAs, even if the overall agency RMBS market is tight at that point, perhaps because volatility is high, for example, and the market is not adequately taken into account. These are trades that we can put on there that necessarily take a lot of capital. But I agree wholeheartedly with Mark that longer term, we see more extraordinary opportunities on the credit side.

Great, appreciate the details, guys. Thank you.

Your next question comes from the line of Eric Hagen with KBW.

Hey, good morning, guys. Just following up on some of the commentary here. I mean, I guess we heard about some firming up in the market over the last couple of weeks on the credit side, and specify pools to your point has done very well relative to TBA. I mean any detail on what drove the book value a little weaker in April? And then within the unrealized loss bucket, where do you guys think things are most likely to bounce back on some sort of recovery? Thanks.

JR, do you want to take that one?

Sure. So in the unrealized part, a significant portion of that is the application of CECL this quarter actually. So I mentioned in the earnings script that for EFC it was mainly a non-event, because we've always valued our portfolio to the income statement. And CECL is I think, more designed for companies that don't do that. So part of the impact of CECL is that expected credit losses are appearing in unrealized rather than realized as they would have previously with impairments. I think that we have talked about in the earnings release and in the script, comments prepared remarks this morning that some of these sectors we expect to incur losses over time, some of them we don't. I don't know if Mark, you want to get into more specifics. I think we mentioned that CLOs and CMBS have lagged in the recovery, partly for technical reasons with the Fed purchasing other sectors and not those. But I think those would probably expect some credit impairments over time. Mark, if you want to elaborate on those points?

Yes, those were certainly the sectors. I guess our expectation is, and this will change as we get new information, that the default cycle you're going to see in commercial real estate is going to be a little bit more attenuated and will take a little bit more trying to sort through than what we currently expect to see in the residential market. And I do think that if you look at some of the CMBS indices, which function like the old ABX indices, right, where they referenced the different trenches on a basket of CMBS conduit deals, certain sectors of those indices are as low now as if they were in the depths of March. And if you look on sort of residential non-agency securities, I don't think there's any sectors that are trading now where they were in March. So I think that while we expect great opportunities on the commercial side, and it's been historically one of the highest ROE sectors for EFC, there's going to be a little bit more unpredictability there. If you think about retail, you think about hotels, student housing, and I think that unpredictability is factored into prices right now. But I think that unpredictability is going to create some fantastic opportunities. So if you ask me, where do you think going to be the best opportunities to deploy a marginal dollar three months from now, it may well be in some part of the commercial real estate world, either loans or CMBS securities. But it was the commercial side and CLOs that were the detractors somewhat from our April performance.

Yes. And I think just to add on April. I mean, of course it's just one month. But we also had sold down about half of our agency book during March. So we didn't get the same pop on the agency recoveries we otherwise would have, especially with specified pool pay-ups. Another point, an important one, is we had much larger cash holdings going into quarter-end than we typically have for obvious reasons. We had deleveraged and built up our liquidity. So that gives us dry powder going forward. It helps us balance playing offense with playing defense, as Larry mentioned in his remarks. We think it's the right place to be. So I'd encourage you to, it's just a month, and we'll continue to give updates as we go along.

I want to add one more thing to amplify what JR just said. You've seen some agency mortgage REITs report their book value per share in April, showing significant increases. This aligns with JR's point about our agency portfolio being noticeably smaller than it was before, which means we didn’t experience the same gains, especially since it has been a smaller part of our capital allocation for quite some time. Additionally, I want to mention that some markets, specifically non-agency RMBS, which I previously noted, were very distressed in March, largely due to mutual funds selling, which intensified the situation. While they remain inexpensive, we believe this sector could be attractive from both total return and earnings perspectives, though this opportunity may be short-lived. However, valuations at the end of April are clearly higher than at the end of March. In contrast, for many other sectors, particularly our loan books, we won't be marking them up just because we feel more optimistic until we gain further visibility. I believe this explains a lot, in conjunction with the sectors that Mark and JR highlighted.

That was helpful color. Thank you.

Your next question comes from the line of Tim Hayes with B. Riley FBR.

Hey, good afternoon, guys. Hope you're all doing well. And thanks for taking my question. And just have a quick one since most have been asked. I know you've meaningfully reduced your non-REIT compliant strategies over the past year. But just curious if you feel the need to further reduce exposure there to give yourselves a little bit more cushion now that the agency portfolio has been meaningfully reduced.

Yeah. I think we have a lot of flexibility there actually. So I don't think we feel pressure from a retesting perspective. But I think I mentioned earlier that we're not going to sell at the wrong time and we're going to make sure if we sell the non-qualifying assets that it makes sense versus what we can replace that capital with. But I think when you think about, again, what businesses we see as having longer-term opportunities in terms of supply-demand and balance in terms of the competition being hobbled. It's in a lot of those loan strategies. So I don't want to make predictions in the short term. But in the long term, certainly I would think that that's where we would ultimately be heading the company. And I think that's consistent, frankly, with where we were pre-COVID.

Yeah, okay.

I would just add real quick. I'm sorry. I would just add to what Larry said. I mean, the majority of our assets are now requalifying even away from just the agency. So when you think about the size of our non-QM portfolio and small balance commercial and residential transition those are all and have leverage on and they're all real estate qualifying assets. So that helps as well.

Yeah. Fair enough. Appreciate the color there, guys.

Thank you.

Your next question comes from the line of Matt Howlett with Nomura.

Hey, guys. Thanks for taking my question. Hope you're staying safe. First, I got to come into any one of the more upbeat bullish calls that I've been on here in the earnings season. You seem to know exactly what you want and actually where you're going with the company. My question is, you have all these originators that you get proprietary flow product. What's the trade-off between finding something that you want that's in the secondary market that may be more of a distressed price? And I will follow up.

Yeah, no. We want to do that too. Mark, you want to take that where we're all for looking at good opportunities in the secondary market if the price is right. Mark, you want to talk about what you're seeing?

That's a very good question. I think we want to do both. And I think we've worked very hard through March into April, getting ourselves in a position where it's prudent for us to take advantage of those opportunities. So I think we talked about we're restarting non-QM origination, but in the short one we expect volumes to be significantly smaller than where they were running in January and February. So while we start that we don't anticipate that being a big capital drain. So I think we'll be in a position to be able to do both. And I think that we can price appropriately. When we look at potentially a secondary package of non-QM loans. We have to really carefully analyze the underwriting standards that were used to originate those loans and compare that to the underwriting standards that we have enforced with LendSure, and think about the consequences for potential performance if we see gaps in the underwriting guidelines. So we can do all that. So I think both opportunities are compelling. If there's secondary packages from people that need to raise cash, and it looks like they're well underwritten, or we can get a subset of them that are well underwritten. And to very high loss-adjusted yield that'll make sense. They also think restarting our own non-QM origination with guidelines that are similar to what they were like a couple years ago. And pricing to reflect generally higher credit yields in the marketplace, makes sense as well. So I think they're both good opportunities, and I don't think we have to choose one or the other. I just think we need to price them appropriately and take into account all sort of relevant factors. But that's a good question. And they're both good opportunities for this company.

I think the small balance commercial mortgage space is quite intriguing for us. We've been following this strategy at Ellington for a long time, especially since the financial crisis, when we initially focused on the secondary market non-performing loans. There were many loans facing maturity defaults at that time. Over the years, our approach evolved into more of a bridge loan business as we noticed fewer distressed products in the secondary market. We have found more opportunities to originate bridge loans, and this business has remained constant. I don’t expect a complete shift back to non-performing loans, but I do believe that many commercial properties in certain sectors and regions will face distress. Our strategy in the small balance commercial non-performing loan area has always centered on the fact that most banks prefer to manage larger loans, typically over $50 million, and see smaller loans as a regulatory burden. Over the years, we have established various sourcing channels like brokers and joint venture partners to tap into this market. I am optimistic about seeing an increase in secondary market non-performing loans and small balance commercial opportunities. Historically, this has been a lucrative business for us, as it allows us to take on challenges that others find cumbersome. We also have the chance to collaborate with borrowers while acquiring loans at a discount. Many banks avoid discounted payoffs because it can create moral hazards for their clients, making them prefer selling loans at a discount. This gives us greater flexibility to negotiate with borrowers based on discounted payoffs. So, regarding your question about pursuing opportunities in the secondary market rather than focusing solely on origination, we are very hopeful for continued opportunities, particularly following this financial crisis, similar to what we experienced in the aftermath of the 2008-2009 crisis.

And certainly with the GSE agreement, because GSEs are going to be coming out with stuff the banks as well. Just getting back to Mark's comment on the LTVs tightening. Your standard could even raise the GSE. How interested are you guys in taking another step finding an originator? I'm sure, there's a lot of shifts out that they're taking bigger stakes than what you own. Getting ready for maybe tighter GSE window and being on that new origination down the road take a bigger piece of it?

Yes, I cannot make any predictions, but I can tell you that we have similar thoughts. We are identifying numerous opportunities to pursue this. I cannot foresee which of these will come to fruition, but I believe we have a mutual understanding.

Great. Thanks everyone.

And that does conclude today's conference. You may now disconnect.