Ellington Financial Inc. Q2 FY2024 Earnings Call

Good morning, everyone, and thank you for being here. Welcome to the Ellington Financial Second Quarter 2024 Earnings Conference Call. This call is being recorded. Currently, all participants are in listen-only mode. There will be a question-and-answer session after the presentation. I will now hand the call over to Alaael-Deen Shilleh. Please proceed.

Thank you. 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 non-historical in nature. As described under Item 1A of our annual report on Form 10-K and Part 2, Item 1A of our quarterly report on Form 10-Q. 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. 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 first quarter earnings conference call presentation is available on our website at 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, Alaael-Deen, and good morning, everyone. As always, thank you for your time and interest in Ellington Financial. I'll begin on Slide 3 of the presentation. In the second quarter, broad-based contributions from our diversified credit and agency portfolios as well as from a reverse mortgage platform, Longbridge, drove strong results for Ellington Financial. For the quarter, we generated an economic return of 4.5% non-annualized. We grew our book value per share after paying dividends, and we increased adjusted distributable earnings per share by a full $0.05 to $0.33 per share, and we see momentum for our ADE to keep increasing from here. I'm very pleased with these results. I'll first highlight the strong performance of our non-QM loan business in the quarter. In April, we completed our first non-QM securitization in 14 months, taking advantage of the tightest AAA yield spreads we've seen in two years and booking a significant gain as a result. In the months leading up to that April deal, we've been taking advantage of strong whole loan bids in the marketplace by selling many of our non-QM loans rather than securitizing them. While the whole loan bid for non-QM loans remained very strong, we saw AAA securitization spreads tighten back to early 2022 levels, so in April, we decided to securitize some of our non-QM loans rather than sell them. That securitization transaction not only provided attractive economics, but it also provided us with high-yielding residual retain tranches to boot. Following that April securitization, we proceeded to sell other non-QM loans into that strong home loan bid. As you can imagine, given the recent risk-off move in the financial markets, all this activity turned out to be extremely well-timed. In addition, the continued strong demand for non-QM loans drove improved origination volumes and gain on sale margins industry-wide, which generated excellent results at our affiliate non-QM loan originators, LendSure and American Heritage Lending, and led to market-to-market gains on our equity investments in those affiliates. Meanwhile, Longbridge also contributed robust earnings for the quarter, led by both strong origination volumes and strong performance of proprietary reverse mortgage loans. Similar to the boost in industry non-QM volumes, HECM origination volumes were also significantly up for the quarter including for Longbridge. But unlike non-QM, we saw wider yield spreads in the HMBS securitization markets. As a result, gain on sale margins for Longbridge's HECM business actually compressed in the quarter, which mostly offset the benefit of their high origination volumes. Finally, following quarter-end, but prior to the recent market volatility, we successfully completed our second securitization of proprietary reverse mortgage loans originated by Longbridge, achieving incrementally stronger execution than our inaugural deal that we executed in the first quarter. This securitization converted another slug of short-term repo financing into long-term, locked-in non-market to market financing. Again, given the risk-off move we've seen in August, this was another well-timed transaction. That transaction also provided us with high-yielding residual retain tranches. On last quarter's earnings call, we predicted a second quarter turnaround at Longbridge, and Longbridge did a great job and delivered both on a GAAP basis and ADE basis. Longbridge is an important part of that ADE momentum I mentioned earlier. Also in the second quarter, Ellington Financial's results benefited significantly from the very solid performance of residential transition and commercial mortgage loan strategies, as well as non-agency RMBS. Both for the second quarter and continuing into the third, we have added attractive high-yielding investments over a wide array of our credit strategies, especially HELOCs and closed-end second liens, commercial mortgage loans, residential RPL NPL, CMBS, and CLOs. The growth of the commercial mortgage portfolio has included both new originations as well as the purchase of two additional non-performing commercial mortgage loans. At the same time, we have continued to call securities in lower yielding sectors, including agency and non-agency RMBS. Since we generally utilize higher amounts of leverage in our MBS portfolios, especially our agency MBS portfolio, these MBS sales coupled with the non-QM securitization drove down our leverage ratios overall in the second quarter, despite the increased capital deployment in our credit strategies. Moving forward, we have plenty of cash and borrowing capacity to drive portfolio and earnings growth with significant unencumbered assets plus other lightly leveraged assets. That dry powder is particularly valuable given recent spread widening. And with that, I'll turn the call over to JR to discuss the second quarter financial results in more detail. JR?

Thank you, Larry, and good morning, everyone. For the second quarter, we reported GAAP net income of $0.62 per share on a fully marked to market basis and adjusted distributable earnings of $0.33 per share. On Slide 5, you can see how net income is attributed between the credit agency and Longbridge. The credit strategy generated a strong $0.80 per share of GAAP net income this quarter, driven by robust net interest income and net gains from non-QM loans, retained non-QM RMBS, non-agency RMBS, and commercial mortgage loans. We also had mark-to-market gains on our equity investments in LendSure and American Heritage Lending due to strong performance from increased origination volumes and solid gain on sale margins for those originators. Similar to the previous quarter, we received a substantial cash dividend from LendSure in the second quarter. Additionally, with a slight increase in interest rates quarter over quarter, we realized net gains on our interest rate hedges. However, we faced a modest net loss in residential RPL NPL. In the Longbridge segment, we generated GAAP net income of $0.05 per share for the second quarter, supported by net interest income and net gains on proprietary reverse mortgage loans, alongside positive results from servicing. Higher volumes in HECM originations were mostly countered by a drop in gain on sale margins due to wider yield spreads on newly originated HMBS. In servicing, tighter yield spreads on seasoned HMBS improved execution on tail securitizations, boosting the positive results from servicing. Notably, Longbridge contributed $0.06 per share to our ADE, in contrast to a negative $0.01 per share last quarter. In a generally down quarter for the agency mortgage basis, our agency strategy still produced positive net income of $0.01 per share for the second quarter, as net gains on our interest rate hedges, along with net interest income, slightly exceeded net losses on agency MBS. Our quarterly results also included a net gain from the increase in interest rates on our senior notes, partially offset by a net loss from the sixth receiver interest rate swaps that hedge the fixed payments on our unsecured long-term debt and preferred equity. Turning to Slide 6, you can see the breakdown of ADE by segment, highlighting the strong $0.06 per share contribution from Longbridge, which led to an overall increase in EFC's ADE, rising from $0.28 to $0.33 per share sequentially. Concerning loan performance, in our residential mortgage loan portfolio, after adjusting for our purchase of one non-performing loan portfolio and our consolidation of another, the percentage of delinquent loans increased slightly quarter over quarter. In our commercial mortgage loan portfolio, including loans reported as equity method investments, the delinquency percentage dipped sequentially. We also recorded a significant mark-to-market gain on one of our non-performing commercial mortgage loans due to progress in the resolution process. We are continuing to address two non-performing multi-family bridge loans mentioned last quarter. While not significantly increasing quarter over quarter, loans in non-accrual status and REO expenses continued to impact ADE in the second quarter. Please turn to Slide 7. In the second quarter, our total long credit portfolio decreased by 2.5% to $2.73 billion as of June 30th, driven by the cumulative effect of the non-QM securitization completed during the second quarter and net sales of non-agency RMBS, retained non-QM RMBS, and non-QM loans, which more than outweighed net purchases of commercial mortgage bridge loans, HELOCs, closed-end second lien loans, residential RPL NPL CMBS, and CLOs. In our RTL, commercial mortgage, and consumer loan portfolios, we received total principal paydowns of $381 million during the second quarter, which represented 21% of the combined fair value of these portfolios at the beginning of the quarter, as these short-duration portfolios continue to yield capital steadily. This steady stream of principal payments should provide liquidity to capitalize on opportunities, particularly if we enter a risk-off environment. On Slide 8, you will see that our total long agency RMBS portfolio declined by another 31% in the quarter to $458 million. We are progressively reducing the size of that portfolio and reallocating capital into higher-yielding investments. Slide 9 demonstrates that our Longbridge portfolio grew by 18% sequentially to $521 million, primarily due to proprietary reverse mortgage loan originations. In the second quarter, Longbridge originated $305 million in HECM and proprietary loans, nearly a 50% increase from the previous quarter. As mentioned by Larry, shortly after the quarter's end in July, we successfully completed our second securitization of proprietary reverse loans from Longbridge, securing term non-marked market financing at an attractive cost of funds. Please move on to Slide 10 for a summary of our borrowings. For our recourse borrowings, the total weighted average borrowing rate rose by 11 basis points to 6.98% as of June 30th. We continue to benefit from positive carry on our interest rate swap hedges, where we generally receive a higher floating rate while paying a lower fixed rate. The net interest margin on our credit portfolio experienced a slight decline quarter over quarter, whereas the NIM on agency assets improved. Our recourse debt equity ratio decreased to 1.6 to 1 at June 30th, down from 1.8 to 1 as of March 31st, driven by the non-QM securitization conducted in April and a reduction in borrowings on our smaller but more highly leveraged agency RMBS portfolio. Our overall debt to equity ratio also slightly declined to 8.2 to 1 from 8.3 to 1. By June 30th, our combined cash and unencumbered assets totaled approximately $764 million, an increase from $732 million at March 31st. Our book value per common share was $13.92 for the quarter, up from $13.69 at March 31st, while our total economic return was 4.5% non-annualized for the second quarter. Now, I will turn the call over to Mark.

Thanks, JR. This is a very solid quarter for EFC. Not only did we have a strong economic return, which drove book value higher per share, but we also had a sequential improvement in our ADE, which I expect to continue. Our earnings this quarter showed the value of EFC's vertically integrated platform. It's been a challenging couple of years for the mortgage origination business with mortgage rates so high, housing affordability so bad, existing home sales so low, but LendSure and American Heritage Lending have persevered and have both posted solid earnings in Q2, driven by a higher gain on sale margins and increased origination volumes, which led to an increased valuation for our equity stakes in them. Longbridge also contributed strongly to the ADE this quarter driven by profits in their proprietary reverse business. But at EFC, we don't just own the originators. We also buy their loans, collaborate with them on credit decisions, maximize proceeds via securitizations when the ADE is attractive, and retain what we expect to be high-yielding assets from those securitizations for our portfolio. All that helped this quarter. The power of vertical integration was on full display for us. We did another securitization of Longbridge's proprietary reverse mortgages in July and we expect Longbridge's loan origination volumes as well as their securitization volume to continue to grow in that sector. In the second quarter, we also completed a non-QM securitization and opportunistically sold more of those loans as well. Credit spreads were relatively tight in Q2, so we took some gains in a few different parts of the portfolio. Now, we are well-positioned for some wider spread opportunities that we are seeing this week with the recent volatility. We had another strong quarter from our commercial mortgage platform as well. Our affiliate originator servicer, Sheridan Capital, has a like-minded approach to commercial mortgage credit risk. They have been fantastic at not only sourcing opportunities, but also working with our EFC commercial team to help manage our few delinquent loans. Sheridan Capital has deep property management expertise to closely monitor construction progress, CapEx expenditures, and renovation quality control. This expands EFC's capabilities to manage non-performing loans in REO when necessary to maximize proceeds. While Q2 was a quarter of tight spreads and strong demand for structured products, this past week should serve as a reminder that market consensus can change on a dime, often leading to violent repricing in a matter of days. Look at Slide 19, we've kept many of our credit hedges in place. In Q2, they provided insurance we didn't end up needing, but they are once again showing their value in August. Hedges provide multiple benefits to us. We use them to minimize the risk of spread widening for upcoming securitizations, stabilize our NAV in times of volatility, and potentially help offset some of the impact of increased corporate and consumer stress if the economy weakens. We've been adding to our portfolio of high-quality closed-end seconds in HELOCs and even picked up an attractive pool late last week amid the selloff. As opposed to our non-QM loan portfolio, where we lent to borrowers who aren't served by the GSEs, these second liens and HELOCs are generally offered to borrowers with low note rate Fannie and Freddie, Ginnie Mae loans and provide a way for high-quality low LTV borrowers to extract equity from their homes when having a low note rate first lien, making a cash-out refi inefficient. We think this is a large and exciting opportunity for us and we have invested the time and resources to build out our prepayment and credit models and develop our sourcing capabilities. With their higher note rates, this sector adds a lot of ADE for Ellington Financial. As for the rate and spread volatility of the past week, while I wouldn't be surprised if it led to market-to-market losses in some parts of the portfolio, we also see this volatility as recharging the opportunity set with wider spreads and some price dislocations to capitalize on. Furthermore, the lower interest rates we're seeing if they stick should lead to increased loan origination volumes in both non-QM and at Longbridge. Given that all these platforms have excess lending capacity, greater volumes should be supportive of bottom-line economics. EFC is in a good position to add assets here and we're really excited about the current opportunity now. Back to Larry.

Thanks, Mark. I was very pleased with our performance in the second quarter, where we saw strong results across our credit portfolios and took advantage of tight spreads to monetize gains. In particular, it was great to see the strength in our non-QM and reverse mortgage loan platforms, which drove the sequential growth in our book value per share and ADE. At Longbridge, we have more work to do to grow origination volumes further, but the positive developments in the proprietary reverse securitization markets and a strong July in originations should bode well for Longbridge going forward. Lower long-term interest rates could also provide a big boost to Longbridge's origination business. Since the size of the loans that borrowers are able to take out generally increases as long-term interest rates decline, it is loan size more than loan interest rate that is the key driver of origination volumes in the reverse mortgage market, both for purchases and for refinancing. Meanwhile, both during calmer times and more volatile times, we continue to rebalance our portfolio and direct capital to where we see the best opportunities. So far in the third quarter, we've added scale in non-QM RTL, proprietary reverse, commercial mortgage bridge, and closed-end seconds in HELOCs growing each of those portfolios meaningfully. At this point, we are still trimming in some lower yielding sectors, but I expect the pace of that trimming to slow going forward. We are also working on adding to our financing lines specifically for our forward MSR portfolio, and I see that getting done around the end of Q3. As we've been detailing today, our investment pipeline across our diversified proprietary loan origination channels is strong and the loan originators in which we have invested are not only providing healthy flow into that pipeline but generating operating income themselves because we have equity investments in those same originators. This in turn also helps drive our results. We continue to actively pursue making small but strategic investments in other non-QM and RTL originators, and in fact, we closed on another one following quarter-end helping lock in another strategic sourcing channel. In light of the recent market volatility, I'm particularly happy to have executed on our recent asset sales and securitizations in different parts of the portfolio ahead of that sell-off. These moves locked in gains when spreads were tighter and they also freed up additional borrowing capacity and capital to redeploy. We have ample dry powder and just in the past few days, we've been putting that dry powder to good use. I believe Ellington Financial is well-positioned for continued portfolio and earnings growth over the remainder of the year. With that, we'll now open the call up to questions. Operator, please go ahead.

We'll now take questions, starting with Bose George from KBW.

The first question was just about capital deployment. How would you characterize the level of capital deployment? Is there still you mentioned some dry powder, but just how much upside to ADE just from fully optimizing the balance sheet?

The first way I had to approach the question would be to look at the unencumbered and cash imbalance sheet. So, we had $565 million of unencumbered and I think close to $200 million of cash, and typically, we'll keep, call it, 10% of equity in cash. So, that's maybe $150 million. If we add, so the recourse leverage on credit was 1.5x. If we took that to 2x, that takes our overall recourse debt equity back to two times and adds a few hundred million more of borrowings, or $600 million more, I guess in that example. So, I would say in this quarter, there are a few moving pieces in the portfolio, but we continue to trim and cull lower yielding assets. So, that's been offsetting. We went through the laundry list of credit portfolios that we grew in Q2 and into Q3, but then we also sold agency and non-agency RMBS. So those are kind of working in opposite directions. But suffice to say at 1.6 overall leverage, we have lots of room both from excess cash on the balance sheet and those unencumbered assets to add leverage, and then other assets like our forward MSRs that are levered but lightly leveraged. You could draw several hundred million additional buying capacity just from those different numbers. That would still take us just a 2x recourse debt to equity.

This is Larry. As we trim that agency portfolio and more is focused just in the credit sectors, you could sort of think of that 2 to 1 leverage ratio I think as kind of a fully invested as being fully invested. So probably again, as we trim agency, probably not going to get all the way to two to one in terms of being fully invested, but at 1.6 we have hundreds of millions of dollars of room to add even before we get close to that.

And we're really focused on secured financing. Longer term, we have several tranches of unsecured debt at Ellington Financial and pricing for recent deals has been wider than it had been in prior years. But I think it's fair to say over the longer term, we see adding more unsecured debt to the liability structure as another step that we would consider. So that would also take up the recourse debt to equity ratio, but again, I'd say a longer-term period.

While you hedge your portfolio very closely, can you just talk about how the portfolio potentially benefits from a steeper yield curve, if the forward curve is correct and the Fed is cutting quite a bit over the next year?

In terms of interest rate hedging, we have aimed to hedge across the curve without making predictions about the future shape of the yield curve related to our hedges. Essentially, the first-order impact of a steeper or flatter yield curve is neutralized by these hedges. There are additional factors to consider. When the notional balance of our repo exceeds the notional size of our swaps, a decrease in financing costs becomes advantageous. If our swaps match the size of the repo and the market anticipates a 50-basis point cut in September, then a 50 basis point drop in our repo costs would also reduce the floating leg we receive on swaps by the same amount, which balances out. However, if the repo outstrips our swap notional amounts, it benefits us. We're also noticing that when a cutting cycle begins, investors show a preference for fixed-rate assets over floating-rate ones. As a result, we've been adjusting some of our hedges to focus more on loan indices rather than high-yield bond indices. Moreover, recent fund flows indicate a shift towards lower short-term rates, exemplified by the recent $11 billion AAA CLO ETF, JAAA, which just experienced its first outflow. We're considering how to position our portfolio accordingly. Additionally, steeper yield curves typically support agency and non-QM mortgages, leading us to consider these second-order effects in our strategy. However, any significant change in ADE for the portfolio will largely depend on whether our repo borrowings exceed the notional amount of our swap hedges.

I agree with everything Mark mentioned. If you examine our large second-level portfolio, which consists of residential transition loans, you'll notice they are short, and we don't significantly hedge them against interest rate changes. I believe that if there is a drop in short-term rates, as many are anticipating, we will experience a wider net interest margin on that portfolio. Our repo rates will decrease almost point for point with any cuts from the Fed. However, the rates we can secure on RTLs tend to remain more stable.

That's the opposite that we saw when rates were rising.

Exactly. We've had some NIM compression in that sector versus where we were a few years ago when short-term rates were a lot lower. So, I think that's one good thing to look forward to. And then, Bose, I think some of the things that I've seen you've written would echo this as well, which is that let's say we fast forward to a year, a year and change from now, and we've got long-term rates and short-term rates with a three-handle. That's going to be good for mortgage rates going down across the board just on an absolute basis. That should be really good for originators; you'll see a lot more refi activity, et cetera.

We'll go next to Crispin Love with Piper Sandler.

First just on HELOCs and closed-end seconds, is this an area that you expect to see a lot of runways just given home affordability, higher HPA, higher rates with many mortgages in the 3% to 5% range? Or if we do get a sizable rate rally, could this opportunity diminish in coming quarters, but then you'd get the benefit from higher originations as you've indicated? Just curious on your thoughts there.

Hi, Crispin, it’s Mark. If you just look at how many Fannie 2s and Fannie 2.5 and Fannie 3s that are out there in existence, all the stuff that was created in 2020, 2021, first half of 2022, that is an enormous pile of Fannie, Freddie, Ginnie loans. For the second liens in the HELOCs we've been buying, the originators are targeting borrowers with those really low note rate first liens. So, if rates were just to stay where they are, that opportunity looks pretty big. You're exactly right. If you saw a big rate rally and mortgage rates came down a lot, then all of a sudden doing a cash-out refi is going to start to look to be comparable economics to people who are saying, I'm going to stay put with my fixed-rate first lien mortgage, and if I want to borrow $70,000 for some home renovation or something, I'm going to take this closed-end second lien. There is a trade-off between first lien mortgage rates and how big that opportunity set is. But you're exactly right. We've positioned ourselves to have at the origination table, not in Fannie Freddie space, but in the non-QM space with our originators. And so, lower mortgage rates across the board I think would definitely support the origination volume. We don't think about it explicitly as sort of a hedge on origination volumes, but it certainly functions that way. We're attracted to it now because you get a really high note rate. It's very supportive of ADE. We think we understand the prepayment function, and the credit quality is really strong. So, that's what's driving us. It just looks like an attractive asset to add to the portfolio to complement already what we're doing in RTL and non-QM and the private label reverse.

If I could just add to that Mark. Just want to add that. Based on what Mark said right about, but rates would have to drop a lot for all those low coupons that were originated pre-2022 especially to become refinanceable. If mortgage rates are maybe getting close to 6% now, that's still 200 basis points away. So, you're going to need quite a big drop, I think before HELOCs and closed-end seconds are going to make as much sense for people. The thing that I'm a little more sort of on the radar screen about is what's going on with the agencies? So, I don't think volume is necessarily going to be an issue for a very long time in terms of that market. But the question is with this agency pilot program coming out and all that could obviously lead to some serious competition. I mean, it's not a big pilot program, but if it becomes more than a pilot program, there could be some serious competition there. We don't want to be competing with the agencies, but we're going to keep going. The assets that we're seeing now are looking great as Mark said, and we'll see what happens.

And then just one last question from you. Are you seeing single assets, single borrower security opportunities in the current landscape? Is this an area where you're adding, and would that fit well within EFC’s credit portfolio on the commercial side? And just kind of curious what kind of returns you think you might be able to get right there if you are interested.

I believe the initial SASB question is related to a segment we've been concentrating on in a smaller scale. The portfolio increased from $22 million to $42 million quarter over quarter in CMBS, which still represents a minor portion of the overall credit portfolio. However, SASB remains an area of attention for us. Previously, SASB components constituted a larger share of our CMBS portfolio, but now they are reduced. Regarding the potential deals we're considering and their yields, I’m unsure if Mark would like to add anything. We will provide more detailed disclosures on this matter in the queue. Mark, do you want to share any insights about the incremental yields on SASB CMBS you are observing?

Yes, it's been a wild sector, right. For years, we had almost no SASB exposure. It was a market where sort of BBB's and above all kind of traded in a tight spread range and everything came at par and just didn't look that interesting to us. Now, as you have this tremendous divergence of outcomes in commercial space as a function of property type, we've seen some really interesting opportunities. There have been bonds that are still investment-grade SASB that have been down dollar price in the 30s and 40s. That's been an interesting opportunity for us. The other interesting thing is you're getting a lot of new issue SASB and it's been a pretty big volume and it's pushed spreads a little wider. So, from a leveraged spread basis, it certainly looks as attractive to us or maybe even slightly more attractive to us than some of the other sort of bread-and-butter sectors like CRT or legacy non-agency on the CUSIP side. So, yes, what's been going on in SASB has really been a lot of the focus of our CMBS team. As JR mentioned, for years, we were very active in the BPS market and just that market with not a lot of conduit issuance. It doesn't have the same opportunities yet as it used to, but the SASB opportunity on either lower dollar-priced distressed SASB requires very detailed analysis of the properties, and then up the capital stack to some of the bigger SASB deals that we think are coming at very attractive spreads. I definitely think you can see more capital get allocated there.

We'll go now to Douglas Harter with UBS.

Given the market volatility, can you talk about your appetite for potentially looking at more liquid assets versus your recent strategy of more proprietary created loans?

I think it's both. Like I think we've been opportunistic about that, and you've followed us for years. You look at what we did in 2020. We added a lot of legacy non-agency when a few months before that we were adding a lot of non-QM loans. So, we're constantly looking at the tradeoff between securities and loans, and we take into account the difference in financing levels and the difference in liquidity. So, I would say for this market volatility, what that means to me is that maybe you're looking for incrementally a bigger pickup in loans relative to CUSIPs than you might normally look for. And that's typically what happens when you see this volatility that sort of liquidity bases tend to accordion out and you see it everywhere. Less liquid sells versus more liquid sells, unrated seniors versus rated seniors, all those things had been kind of going one way this year up until the last week or so. Liquidity spreads had been coming in, and we did some loan selling and loan monetizing to take advantage of that. Now you're seeing it start to go the other way. So that relative value tradeoff is something we always look at. When I sit down and discuss things with the PMs, that means to us that the threshold for adding loans relative to securities is incrementally a little bit wider now than it was a couple of weeks ago.

And the other thing I would add, this is Larry, is that we happen to be looking last week at a second lien portfolio and we pulled the trigger on that in the face of this sell-off, which was great and got a better price. But in general, when you have these big market moves for example, we saw some mutual fund selling or ETF selling, CUSIPs tend to trade more obviously and be a little more volatile in terms of just what you're actually able to buy. So, I think when stuff like that happens, the first opportunities that arise are in CUSIPs and absolutely if it looks like there's some forced selling, we'll gobble those up. It's a little harder to dial up your proprietary pipelines immediately. That's just something that is going to kick in longer. So, as you have this big risk-off move, and now in the last couple of days you have risk-on moves, you're going to see more activity just in CUSIPs and be able to pounce on those. But longer term, as Mark said, I think our expectation is that it's going to be on the private side of the portfolio, the non-CUSIP, where we're going to continue to see driving our ADE.

We'll go now to Eric Hagen with BTIG. Please go ahead.

I wanted to follow up and ask about non-agency securities repo, specifically your outlook for spreads to remain stable, along with the overall supply of capital from the major banks that usually provide that funding, and your thoughts on their willingness to continue supporting the market.

We've seen the same thing you've seen. The big banks now are very interested in repo as a balance sheet asset; it doesn't have price volatility, and it has a healthy spread. So, it contributes to NIM. So, it's not only traditional banks, but you also have some very large sort of investment banks that converted to banking charters during the financial crisis. So, we've gotten a lot more inbound calls from people wanting to add repo, not on the agency side, where that's been stuck at like, SOFR plus anywhere between 5 and 10, but it's been on the loan side and on the CUSIP side. So, anything sort of, I'd say, SOFR plus 125 to SOFR plus 2.25, those kinds of asset classes. There's been a lot of interest in lenders trying to get more borrowings on their balance sheet. We have been able to negotiate better financing terms on loans this year than what we had in place last year. I think that'll keep going because I think what would stop that would be if you saw SOFR really come down a lot. But it's SOFR at five and three-quarters now. If SOFR comes down 50, 100 basis points, I think that's still going to be attractive for the banks. So that's another way I think at the margin we're going to grow some ADE is just by continuing to negotiate and be opportunistic about the best financing levels we can get. One thing that is sort of helping that is the securitization spread. Larry mentioned tighter non-QM spreads this year that have given the lenders a little bit more confidence to come down on their SOFR spread. So, that has been across the board better, whether it's CUSIPs or whether it's loans. But for the CUSIPs I'm talking about, it's sort of like SASB that Chris was asking about or CRT or legacy non-agency and the agency stuff; that's been fine for years. It didn't really widen in ‘22. It hasn't come in; that sort of stuck where it is. But for anything else, we've gotten better financing terms and I do think that's going to continue.

And I think especially in repo on fixed-income CUSIPs, I think it has further to come down given how much spreads have tightened. When was the last time you heard about a lender having a loss on fixed-income CUSIP repo? I mean, it's been a really long time. They're much better at managing that risk. The haircuts are high, much higher even than in a lot of loan side repo as opposed to the CUSIP side. So, I think that actually has room to come down more.

One more. Can you share how much capital you have allocated to the credit hedges and how you think about maybe scaling that opportunity? Do you rotate more capital into the credit portfolio?

On Slide 19, we give an overview of the credit hedges and you could see on a, what's not exactly the capital allocation but a high yield equivalent $120 million notional is our CDX, which is where most of our corporate hedges are. We have a small amount in CMBX and then European related to currency risk for the most part. So, it's meaningful and Mark went through kind of the different uses and benefits it provides. But relative to the size of our several billion dollars credit and agency portfolios, it’s small. But it does help on the margin in the ways that he mentioned. We have taken the size of these credit hedges down over time as we move more toward loans and away from CUSIPs that don't always have hedging instruments available or the need to hedge with low short spread durations, for example.

They really take minimal capital to put on and maintain and they're in fact risk-reducing. So, in terms of when we think about, they don't take any capital away, certainly from our ability to add assets.

We'll go now to Matthew Erdner with JonesTrading.

Could you talk about current and expectations for credit performance? And then if recent economic data has kind of made you shift asset allocation, but I do know you're going more so into credit and away from the agency.

Mark, why don't I take the first half of that and you can go second if that works.

Sure.

So, on the performance of our loan portfolios, we mentioned in our prepared remarks in the earnings release that in commercial, the delinquency percentage declined quarter to quarter. We do still have the two multis delinquent loans that we're working through. But overall, the percentage of delinquencies relative to fair value declines between the two quarters. In resi, it ticked up slightly by 10 basis points, call it, when you exclude NPLs that we bought during the quarter. Credit realized losses continue to be small, but we do highlight those two non-performing multi-family products that we’re working through.

Remember, and also remember that we mark to market through our income statement. So, we've marked those two non-performers down. When those resolve, we do not expect that to affect our net income in any negative way. In fact, what it will do is free up capital to redeploy so that we can continue to boost our ADE.

And the second half of your question about, I think an economic slowdown and how that might change our perception of adding credit assets, would you mind repeating that and maybe Mark, if you wouldn't mind tackle with that, please?

Just kind of if we were to kind of go into a recession, how you guys would think about asset allocation and if it would change from your current stance?

In the early days of non-QM, we expected losses and our originators prepared for them by setting aside loan loss reserves. However, performance turned out to be surprisingly good, leading to a buildup of reserves since there were minimal losses. Now, while we're seeing some delinquencies and losses, this aligns with our underwriting practices. The same applies to residential transition lending. We have noticed an uptick in unemployment rates. Although we don’t forecast the economy, we closely monitor indicators. There has been discussion about FICO score inflation, suggesting that a 700 FICO today is similar to a 680 FICO from four years ago. This insight has influenced our credit eligibility criteria. We have adjusted our FICO requirements accordingly. As an originator, we actively collaborate with our data scientists and research team to establish optimal underwriting practices. If we detect decline in performance across certain portfolio segments, we use this feedback to modify our eligibility criteria. Continuously analyzing data and updating guidelines in response is crucial to our role. This was significant ten years ago, a time when delinquencies were rare. Back then, we could overlook minor delinquencies. Now, we are in a more typical environment where home prices have risen, interest rates are higher, and consumers are taking on larger payments. Some delinquencies will occur, so we’re monitoring the situation, pricing accordingly, and are well-prepared to address these challenges.

I want to add one thing. If you turn to page 12 of the presentation, you can see the various segments of our loan origination business and those pipelines that we've been talking about. Consumer loans are a very small segment compared to the others. I mean, tiny, and if you look at our portfolio generally, we are a residential-focused company in terms of the credit risk that we're taking. Let's include also multi-family in that because that's most of our commercial mortgages are on multifamily properties. You can see that on another slide in the presentation. As to your question, if we go into a recession, you'll see rates come down. Even though there are definitely issues right on affordability of housing, there are also a lot of issues on supply. You have very little supply versus the demand and you've got an affordability problem. Those two things are counteracting each other. If we go into a recession again to your question and rates go down, all of a sudden, you're really helping the affordability issue because you're going to have mortgage rates lower. On the multifamily side, you'll help the cap rate issue. Remember, these are bridge loans in terms of the vast majority of our commercial mortgage loan portfolio. You're really talking about valuations at the end of that 12 or 18-month term. With cap rates, if they come down. I really feel good about how our portfolio, again, being very residential-based is poised to withstand that scenario.

You're next from Lee Cooperman with Omega Family Office.

I tuned in a little bit late since I had a doctor's appointment. I have three questions. Most people own the stock for income. Given everything you had to say, do you think you will restore your dividend before the end of the year to the $0.15 per month level?

I feel confident about keeping the dividend at its current level. At this time, I do not expect an increase. However, we have a history of maintaining stable dividends for a long period, so I wouldn't anticipate raising it.

You would think the dividend would sustain it the $0.13 a month level?

Yes, absolutely.

The second question. You guys have been active in capital management. What is your attitude towards that presently?

I think JR kind of alluded to it earlier. I think our next kind of big move on the capital management side is going to be unsecured debt. Rates have come down and those way to look at baby bonds or other types of offerings; they tend to be a little sticky. So, we're being patient and watching that market. I think adding unsecured debt to the portfolio is important. It's also a little bit of a healthy cycle as you do that because ultimately, look, we're not rated by any of its like S&P and Moody's right now. We have a great Egan-Jones rating. At some point, that's something we might want to look into: to get a rating from let's say S&P and Moody's and the like, to enable us to issue even more unsecured debt. Of course, as we add things like baby bonds which aren't rated, that helps the capital structure and can help us get those other ratings. The next move, I think significant move, again, this is just a prediction. I can't predict where the capital market's going and they're not there yet for us; I think would be some sort of an unsecured deal.

I need you to help me out since you guys are smarter in the credit markets than me. Everyone seems to think interest rates are too high. I actually think they're low. The evidence I would use is the stock market is near a high. There's a lot of speculation in the market. Prior to the great financial crisis in 2008, the 10-year bond yield in line with nominal GDP. If you have inflation of 2% to 3% and real growth of 2% to 3%, the tenure would not be undervalued at a 4% or 6% yield. So, I think interest rates are going to go up, and I read the Democratic platform, which was 80 pages long. I read the Republican platform, which was 22 pages long. Nobody seems to care about the debt they're creating in the system. I think we're heading to some kind of financial crisis, and I don't know if it hits us in five years, ten years, or it doesn't hit us at all. What's your view of what's going on in the country fiscally?

Again, as Mark said, I just want to reiterate, we try not to color, and this is just us, I understand that other companies, and of course, you with your own portfolio, Lee, are going to take a different approach, but we try not to color our interest rate hedging. We focus more on, okay, here's where long-term interests are, here's where short-term interests are. What can we buy just given those realities as opposed to and then hedging appropriately? I absolutely agree with you, not on short-term rates necessarily, but I do agree with you on the longer-term rates. Given the increasing size of the debt, budget deficits, nobody's talking about really cutting in any meaningful way. It’s not so clear that notwithstanding what we've seen, a report or two that wage inflation is really behind us, which is the thing that I look at most closely. I think in terms of where all of this could go, I agree with you. I think long-term rates, it’s going to be challenging for the Fed to get even not 2% or 2.5% whatever. I think it's going to be challenging for long-term rates ultimately to get where at least maybe the forward curve the markets are predicting. I agree with you.

Thank you everyone. That was our final question for today. We would like to thank everyone for participating in the Ellington Financial second quarter 2024 earnings conference call. You may disconnect your line at this time, and everyone have a wonderful day.