Earnings Call Transcript - EFC Q3 2020

Operator, Operator

Good morning, everyone. Thank you for joining us for the Ellington Financial Third Quarter 2020 Earnings Conference Call. This call is being recorded. All participants are currently in listen-only mode. We will take your questions after the presentation. Now, I will hand it over to Jason Frank, Deputy General Counsel and Secretary. Please proceed.

Jason Frank, Deputy General Counsel and Secretary

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 not historical in nature. As described under item 1A of our Annual Report on Form 10-K filed on March 13, 2020, and under Part 2 item 1A of our quarterly report on Form 10-Q for the three months period ended March 31, 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, Co-Chief Investment Officer of EFC; and JR Herlihy, Chief Financial Officer of EFC. As described in our earnings press release, our third quarter earnings conference call presentation is available on our website, ellingtonfinancial.com. Management's prepared remarks will track the presentation. Please 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.

Larry Penn, CEO

Thanks, Jay, and good morning, everyone. As always, thank you for your time and interest in Ellington Financial. Ellington Financial had another excellent quarter, as we benefited from strong performance across virtually all of our strategies. As you can see on Slide 4, we generated net income of $1.06 per share, core earnings of $0.41 per share, and a non-annualized quarterly economic return of 6.7%. Earlier this week, the Board increased our monthly dividend for the second time this year, this time by 11%. And given that our core earnings this past quarter still comfortably exceed our new higher dividend run rate, and in light of our current earnings power, we should have ample room for additional dividend growth from here. With our investment activity back to normal levels throughout the entire third quarter, we methodically grew our credit portfolio, mostly in non-QM loans, but we still kept our overall leverage relatively low. Despite this conservative positioning, we were still able to grow core earnings and book value per share significantly this quarter. Given the continuing uncertainty around fiscal stimulus and economic recovery, we believe that our lower leverage and high cash balances position us well to withstand any additional market shocks and enable us to capitalize on new investment opportunities, whether in the credit sensitive sectors still grappling with the pandemic, or in agency RMBS where we're in the middle of a massive prepayment wave. During the third quarter, our loan portfolios continued their resilient performance, producing another solid quarter of ROEs, while continuing to return capital quickly for redeployment, often at higher reinvestment yields, I would note. Meanwhile, the securities portfolios in our credit strategy benefited from some nice spread tightening, and our agency portfolio had another very strong quarter and has now generated a positive return on equity on a year-to-date basis through September. With a part of our portfolio, I'd like to focus most on today is the strength and growth of our loan origination businesses. Ellington Financial's results this quarter were again boosted by strong performance from our strategic investments in loan originators, most notably Longbridge Financial, which continued its excellent performance this year. As we've discussed on past calls, because the reverse mortgage business provides liquidity to borrowers without the requirement of monthly principal and interest payments, borrower demand for the product has surged this year, amidst the economic turmoil drawn by COVID. Meanwhile, LendSure has done an extraordinary job restarting its loan production after the market stress has temporarily interrupted new originations earlier this year. LendSure's loan production in September and October exceeded production levels right before the pandemic-related volatility. And in fact, October was a record $80 million origination volume month for LendSure. Last week, Ellington Financial closed another securitization of LendSure loans, our second such securitization this year, and in fact, we achieved the tightest financing spread yet of any post-COVID non-QM securitization. The performance of our LendSure loans continues to be excellent and our entire non-QM business continues to be an important driver of earnings for Ellington Financial. Ellington Financial also has a strategic investment in the third loan originator, this one in the consumer loan space. This pipeline has generated and we expect it will continue to generate attractive risk adjusted returns for us. All three of these originators weathered the COVID-19 volatility successfully and emerged in a strong position to add market share. In addition to investments in these three originators, Ellington has been active in the small balance commercial mortgage loan sector for more than a decade now. And we've developed strong and reliable sourcing channels over the years. We benefit from several successful joint ventures in the space and we originate many of our bridge loans and source many of our commercial mortgage NPLs directly out of Ellington Financial using our own loan sourcing and origination teams here at Ellington. We have also well-established origination channels for residential transition loans, as well as flow agreements with other loan originators in the consumer space. We believe that our array of proprietary loan pipelines is a key differentiator for Ellington Financial, and they are critical for our business for at least two primary reasons. First and foremost, our loan pipelines are designed to provide a steady flow of high quality investments to Ellington Financial. The loans coming out of these pipelines have been a key driver of our portfolio and core earnings growth over the past few years. And we believe that they will continue to drive our growth going forward. At the same time, our loan pipelines enable us to leverage Ellington's core strengths of modeling and data analytics. We apply our analytics to help shape the underwriting criteria of the loans that we and our partners originate. And our goal is to manufacture and control our own sources of return, rather than passively accepting what the secondary markets have to offer. But there's also a second reason why I'm highlighting our proprietary loan pipelines. And that has to do specifically with our investments in loan originators that we've made to help build and broaden those pipelines. There's been a tremendous flow of public capital into loan originators recently at premium valuations. Several companies have gone public in recent months, and the mortgage originator sector is trading at a very significant premium to where the mortgage rates, including EFC are trading. But if you look at EFC's stock price, I think it's clear that the market is undervaluing our investments in loan originators. And therefore, this represents significant upside for EFC stock. Over time, we believe that the market will recognize not only the synergies but also the franchise value that these loan originators represent for Ellington Financial. One final note on our originator investments. We fair value these investments through our income statement. So any P&L that they generate for us is reflected in our GAAP earnings. However, the appreciation on these investments is not captured in our core earnings. Therefore, if we were able to continue covering our dividends with core earnings, as we've done every quarter since we started reporting core earnings, by the way, the appreciation on these loan originator investments can be a significant tailwind to our EPS and book value per share. Before I turn the call over to JR, I'd also like to highlight that we're not only keeping leverage low in anticipation of plentiful investment opportunities, we are also continuing to extend and improve our sources of financing. During the third quarter, we added another financing facility for our residential loan strategies. And just within the past two weeks, we not only closed our sixth non-QM securitization, but we also priced a securitization of unsecured consumer loans. These rate of securitizations add additional term, non-mark-to-market borrowings to our balance sheet. They also have significantly lowered borrowing costs relative to repo and other types of bank financing. It used to be that repo and other bank lines were coming with the serious disadvantages of shorter terms and mark-to-market margining generally provided lower cost financing than securitization financing. But lately, especially in those sectors where securitizations have become commonplace, it's the securitization market that provides lower borrowing costs, even while affording all the important advantages of long-term locked in and non-mark-to-market financing terms. With that, I'll pass it to JR to discuss our third quarter financial results in more detail.

JR Herlihy, CFO

Thanks, Larry, and good morning, everyone. Staying on Slide 4, where you can see a summary of our third quarter results. For the quarter ended September 30, Ellington Financial reported net income of $1.06 per common share and core earnings of $0.41 per share. These results compare to net income of $0.85 per share and core earnings of $0.39 per share for the second quarter. GAAP to core earnings comfortably exceeded dividends declared during the quarter of $0.27 per share, as well as our new quarterly dividend run rate of $0.30 per share. Next, please turn to Slide 7 for the attribution of earnings between our credit and agency strategies. During the third quarter, the credit strategy generated a total gross profit of $1.17 per share, while the agency strategy generated a total gross profit of $0.17 per share. These compare to $0.76 per share in the credit strategy and $0.33 per share in the agency strategy in the prior quarter. Net interest income in our credit portfolio increased quarter-over-quarter driven by a larger portfolio and lower financing costs. And we also had significant net realized and unrealized gains. Each of our credit strategies contributed positively to results. Prices increased for our non-QM loans, CMBS, CLO, and non-agency RMBS holdings during the quarter as liquidity continued to improve in those markets. In addition, the small balance commercial mortgage loan, consumer loan, and residential transition mortgage loan portfolios performed well and each experienced significant principal repayments. During the third quarter, we received proceeds from principal repayments of about $130 million on these loan portfolios, which represented more than 22% of the aggregate size of those portfolios coming into the quarter. Finally, as Larry discussed, we also benefited from extremely strong results for the quarter from our investments in loan originators. The sole detractor from results this quarter were credit hedges driven by the strong performance of many credit sectors in the quarter. Our agency strategy had another strong quarter performance, driven by increased net interest income and strong performance from our prepayment protected specified pools as mortgage rates declined further and actual and expected prepayments rose again during the quarter. Overall pay-ups in our specified pools actually declined slightly quarter-over-quarter. But this decrease only occurred because our specified pool purchases during the quarter were primarily of low pay-ups specified pools, which skewed the average downward. During the quarter, we also increased our holdings of long TBAs held-for-investment, which we concentrated in current coupon production. These investments performed well driven by Federal Reserve purchasing activity. Turning next to Slide 8, you can see that the size of our long credit portfolio increased approximately 12% in the third quarter to $1.4 billion at September 30. The increase in the credit portfolio was mainly driven by non-QM loan originations, as well as by purchases of CMBS and single-family rental RMBS. You can see the growth of non-QM here in the residential loans and REO slice, but the impact of the CMBS and single-family rental RMBS purchases are harder to see on this slide because we had offsetting paydowns and sales in the same slices. Overall, the CMBS and commercial loans in REO slice shrank sequentially because we had several successful resolutions in the small balance commercial loan mortgage strategy in the third quarter. I will also note that subsequent to quarter end, our two largest small balance Commercial Investments paid down or paid off completely both at par. And while we have also seen originations of new SBC loans pick up that portfolio is smaller today than it was at September 30. Importantly, as we've been receiving these paydowns, we've been able to reinvest the capital in new SBC originations at higher yields as compared to our pre-COVID origination. You can also see on this slide that the consumer loan portfolio decreased quarter-over-quarter driven by paydowns. A final note on the credit portfolio is that with the completion of our latest non-QM securitization last week, that portfolio has decreased relative to September 30 that we're quickly replenishing our portfolio with LendSure reaching a record level of loan production in October, as Larry mentioned. Earlier this year, in response to the significant volatility caused by the spread of COVID-19, we strategically reduced the size of our agency portfolio in order to lower leverage and enhance our liquidity position. On Slide 9, you can see that we kept the agency portfolio relatively small this quarter, which has kept our overall leverage ratios low, which you can see on Slide 10. Our debt-to-equity ratio was 2.7 to 1 as of both September 30 and June 30, adjusting for unsettled purchases and sales. Our recourse debt-to-equity ratio, also adjusted for unsettled purchases and sales increased quarter-over-quarter to 1.7 to 1 from 1.5 to 1 that remains well below pre-pandemic levels. The increase in our recourse debt-to-equity ratio was driven by increased recourse borrowings related to our larger non-QM loan holdings, partially offset by reductions in certain non-recourse borrowings. The recent non-QM securitizations converted more than $90 million of recourse borrowings into non-recourse term financing, which reduced our recourse debt-to-equity ratio below 1.6 to 1 as of October 31. Our weighted average cost of funds decreased significantly in the third quarter to 2.2% at September 30 from 2.48% at June 30. As our older higher-cost repo borrowings have matured, we've replaced them with repo borrowings priced based on current lower cost borrowing rates. At quarter end, we had cash and cash equivalents of approximately $127 million, along with other unencumbered assets of approximately $306 million, which remained elevated relative to pre-COVID periods. For the third quarter, our total G&A expenses per share were $0.16, up slightly from $0.15 in the prior-quarter. Other investment-related expenses decreased quarter-over-quarter to $0.08 per share from $0.12, mainly due to non-QM securitization issuance costs that we incurred in the second quarter but not in the third quarter. For the third quarter, we accrued income tax expense of $2.5 million, primarily due to an increase in deferred tax liabilities related to unrealized gains on investments held in a domestic TRS. Finally, our book value per common share at September 30 was $16.45, up 5% from $15.67 at the end of the second quarter. Now, over to Mark.

Mark Tecotzky, Co-Chief Investment Officer

Thanks, JR. We had another excellent quarter with a 6.7% non-annualized economic return, which equates to an annualized return of almost 30% and core earnings well in excess of our dividend. I was also glad to see portfolio growth, as we grew our credit holdings by 12%. We've certainly adjusted our underwriting given the persistent impact of COVID avoiding sectors most affected like lodging and student housing, but even with that discipline, we're finding high yielding investments. We were one of the early movers in non-QM origination post-COVID. With LendSure turning its origination machine back on before many others and that decision so far has really paid off. As Larry mentioned, LendSure's origination volumes are now exceeding pre-COVID levels, which I never would have predicted back in March. The economics on the assets and on the securitization execution are materially better now too. Larry also mentioned this before, but EFC gets a double dip from the strong origination platform. First, we drive core earnings with high coupon; high quality non-QM loans, and finance them through the securitization market. And secondly, we have a long-term benefit of a sizable equity stake in a profitable originator. Credit performance is strong across the board for us. But we're very focused on the prospects of further consumer stimulus and how that will affect our portfolio. We saw substantial benefits to consumer credit performance from both the CARES Act and broad-based mortgage forbearance, both enacted earlier this year. Now we're entering a period of time where the virus is spreading more quickly, enhanced unemployment benefits have been reduced, as some mortgage borrowers are exiting six-month forbearance plans; discipline in underwriting is critical for us. Despite it all, markets are functioning well. Take our small balance commercial mortgage loan business, for example. In March and April that market slowed. We actually continued getting loan resolutions, but we weren't seeing many interesting opportunities to lend against. As the second quarter progressed, we saw even more of our loans payoff as debt was refinanced and properties were sold. But we also began seeing some lending opportunities that we did find attractive and we took advantage of those. Now it feels like business is usual. Loans are getting paid-off, and we are seeing a steady flow of new properties looking for financing. This return to normalcy is allowing us to grow our portfolio and recycle our capital. As JR mentioned, our two largest commercial positions actually paid down or paid off during October. Excluding those two situations, I expect growth to resume in this portfolio. And in our consumer loan portfolio where many borrowers have exited forbearance, performance has remained very good. Everybody knows that housing has had great performance since the Spring. EFC was well-positioned to take advantage. Our non-agency securities generated both realized and unrealized gains this quarter, as did our NPL, RPL portfolio, and we continue to find things we like in residential credit. Let's look at how our credit portfolio evolved this quarter on Slide 8. While most of the net growth was in non-QM, there's a lot of activity in every sector. In our commercial mortgage strategy, which spans loans, investment-grade bonds, and BP's, we had loans pay-off, we originated new loans, we bought and sold CMBS securities, we acquired a new BP's investment, so we're definitely busy. The consumer loan strategy returned to capital essentially because loans paid down at a faster pace than we purchased new loans. One somewhat non-intuitive side effect of the CARES Act was that many consumers found themselves with more cash than normal given enhanced unemployment benefits, and they used that extra cash to pay down debt. So paydowns have been coming in quickly on our consumer loan portfolio. Another point to make is that our mortgage originations are up. I'm not sure if that's the result of fewer competitors, superior pricing, or both. But our market share seems higher. It's hard to measure scientifically, but I'm pretty sure it's true. Larry mentioned our recent securitizations, how they avoid the mark-to-market risks inherent in repo, how even their costs relative to term repo historically very wide right now. One additional advantage that our securitizations provide is it allows us to potentially acquire loans at below market levels in the future by exercising deal closes. We did this with our non-term deal that just closed where about half of the securitized pool represented loans to be reacquired at well below current market prices by calling a non-QM securitization we've done in 2018. Everybody loves to hate commercial real estate now and there's going to be no shortage of headaches there, but capital is flowing in that market. The new issue CMBS market is open. We had a lot of resolutions in our portfolio. I wouldn't have guessed that would be the case six months ago. So given the credit expertise of our commercial mortgage team and the great proprietary analytic tools we have, we're finding lots of opportunities to invest in high yielding assets with both high credit enhancement levels and limited exposure to COVID-affected sectors. Our agency CMBS portfolio had another strong quarter, our long agency portfolio continued to be concentrated in prepayment protected specified pools, and these assets performed well relative to their hedges, which drove results in our agency strategy. We also maintained our long position in current coupon TBAs, and by doing so, benefited from the strong dollar rolls driven by the Fed's purchasing activity. We're in the middle of the significant refinancing wave and origination bonds are at record highs. We just got the October prepayment report from the GSEs and prepayment speeds continue to increase to multi-year record levels, despite what some market participants were hoping. We believe that we're well-equipped to outperform our prepayment modeling, asset selection, and dynamic interest rate hedging. Thinking about the rest of the year and 2021, we want to continue to use the securitization market to term out financing and lower our borrowing costs whenever possible. Larry mentioned we already priced a consumer loan securitization that will close in the fourth quarter. Front and center in our minds right now is, once we know who the next President will be, what will that mean for additional stimulus? What will that mean for housing policy? And how will that impact GSE reform? Given our diversity of strategies and research-driven approach, we're excited about properly positioning EFC to take advantage of the new opportunities that will inevitably be created. We believe that our flow arrangements and origination partnerships give us a big advantage in sourcing high credit quality, low LTV loans to our portfolio. Now back to Larry.

Larry Penn, CEO

Thanks Mark. I'm very pleased with our performance in the third quarter and year-to-date. Ellington Financial fired on all cylinders in the third quarter and as you can see on Slide 23, we've now recovered all but just $15 million, or almost 90% of our portfolio losses from the first quarter. But this is not the time to be complacent. The ongoing economic uncertainty and credit and the refinancing wave that's fully underway in agency RMBS underscores the importance of risk management and liquidity management to protect earnings and book value in areas where Ellington Financial has shined. As you can see on Slide 13, EFC is unmatched among its peer group in the stability of its economic returns. We have achieved this stability through our diversified portfolio, prudent leverage levels, stable sources of financing, disciplined interest rate hedging, and opportunistic credit hedging. These principles continue to be critical in protecting book value and being in a position to capitalize on new opportunities. And as always, management remains strongly aligned with our shareholders with a significant co-investment in EFC. As we look to 2021 and beyond, our primary business objective is to continue to grow, broaden and refine our loan origination capabilities so we can continue to manufacture and control our own sources of return to an even greater degree. I believe that these businesses are key catalysts for the growth of our book value and stock price, as well as for the continued stability of our earnings. Before we open the floor to questions, I would like to thank the entire Ellington team for their hard work over the past few months despite the difficult circumstances and for all of those listening on the call today, we hope that you and your family stay healthy and safe. And with that, we'll now open the call to your questions. Operator, please go ahead.

Operator, Operator

Thank you. Your first question comes from Trevor Cranston of JMP Securities.

Trevor Cranston, Analyst

Hey, thanks. Looking at the securitization from the end of October, one thing that I noticed is the loan coupon was still up around 6.2%, which seems pretty stable from where things were pre-COVID. So I mean, obviously that means these spreads versus agency loans are significantly higher than where it was. Seriously, could you talk about if you think that type of loan coupon is sustainable, and more generally, if you can comment on how other loan characteristics have sort of evolved since March on new loans you guys are purchasing. Thanks.

Mark Tecotzky, Co-Chief Investment Officer

Do you want me to take that, Larry?

Larry Penn, CEO

Absolutely.

Mark Tecotzky, Co-Chief Investment Officer

Sure. So that's a great question, Trevor. I think note rates are certainly going to come down, right. So that securitization, we did the one that just priced was interesting because we mentioned in the script about half the loans came from a 2018 deal that we called, and half the loans were loans originated post-COVID. So we were one of the first originators to start buying loans again right after March. And we started originating them before any post-COVID securitization for price. So we had a fair bit of pricing power. The loans in that securitization that were post-COVID loans, as you mentioned had a note rate of about 6.20%. So interesting to me is the loans from the 2018 deal had a note almost exactly the same was right at 6.20%. But if you look at those two securitizations, I alluded to this in the prepared comments; the note rate on the AAA bond in this recent deal was about 1.2%. The note rate from that 2018 deal on the AAA bond was about 4%. So you were able to keep the same note rate, but have still hundreds of basis points, lower debt costs. So I think that note rate being 6.20%, even on the post-COVID originations, that had to do with that, when we were originating those loans, there were not a lot of competitors. The space isn't as competitive as it was pre-COVID. But it's certainly more competitive than what it was, say in May, right. So I think note rates will come down. But given the securitization execution, they can come down a lot. Now, in terms of the other attributes, LTV, credit score, they're not materially different than what they were pre-COVID. So I think those attributes will stay the same. I think the note rates absolutely are coming down. But they have room to come down, given the securitization execution.

Larry Penn, CEO

If I could add one more thing, Mark, to that, thanks which is that now, LendSure is pretty focused on non-QM obviously. And it may actually broaden its product suite in the near future. But for now, it's been very focused on non-QM. Some of its competitors have basically shifted their focus back more to agencies given where rates are there. And so that's created a tailwind for LendSure in that really, on a day-to-day basis, it's not competing as much with some of the other originators as it was before. So that's also helping pricing power as well. So I think that's been a phenomenon that's going to continue for a little while, yes. So it's just a good, really good space for us to be in right now. As Mark said, rates are going to come down; rates are extremely low, obviously versus where they were last year, for example. But I think we're still looking at really attractive net interest margins as we continue to purchase that product, even if the trend is going to be slightly lower note rates.

Trevor Cranston, Analyst

Okay, got it. That's very helpful. And then you guys also mentioned the SBC loan originations picking up. Can you provide some more color in terms of what sectors you're seeing the most activity and if there's anywhere in particular that you guys are avoiding in new originations? Thanks.

Larry Penn, CEO

Mark, I believe we can both handle that and you can add anything you feel is necessary. We're experiencing significantly more activity now, as you mentioned, with the third quarter returning to a sense of normalcy for the business. We have the flexibility to select our opportunities. It’s evident that some of the sectors that are under pressure will face ongoing challenges as we move past COVID and the forbearance measures unwind. This situation is likely to lead to an increase in non-performing loans, and I anticipate that our non-performing loan and bridge loan business will also grow as properties change hands. Currently, we're observing more activity in the multifamily sector compared to pre-COVID times, which was previously quite heated. Although it continues to perform better than other sectors, there have been significant setbacks for many specialty lenders. When discussing bridge loans, it's important to recognize that this falls under specialty lending, which is still recovering from the impacts of COVID. I expect to see a rise in originations compared to what we had before. In the long run, we are optimistic about the various market sectors. As I've mentioned, there are no bad bonds, just bad prices. We have maintained a strong focus on loan-to-value ratios and have predominantly dealt with first liens. As shown in our previous disclosures, we prioritize first liens and are careful about our LTV focus; we will not compromise our standards. However, we are open to exploring more distressed properties across different sectors. Mark, would you like to add anything?

Mark Tecotzky, Co-Chief Investment Officer

I would just say that since we've been operating in that market throughout COVID, in the beginning, we were able to be selective, primarily focusing on multi-family properties. Over time, as the market improves and more participants enter, it will become more challenging. For now, since we cannot predict the course of the virus or the timing of the vaccine, it makes sense for us to invest in sectors that are less affected by COVID, while being cautious with those that are more impacted. When assessing those properties, we underwrite them against very tough scenarios. So far, we haven't seen much activity in the sectors heavily affected by COVID when we apply strict underwriting criteria, but that could change. We have found the multi-family sector to be beneficial for us, with healthy spreads. Looking ahead to 2021, we expect some of these sectors to become more competitive unless conditions shift significantly. Currently, the margins are strong, so we are concentrating on investing more capital.

Operator, Operator

Thank you. Our next question is from Doug Harter of Credit Suisse.

Josh Bolton, Analyst

Hey, guys, this is Josh on for Doug. Thanks for taking the question. Just thinking about the incremental deployment of capital, given the attractiveness that we're seeing in the TBA market currently, how are you thinking about the equity allocation to the agency segment, in the context of the overall, how it fits in the overall portfolio? And specifically how TBAs fit into that strategy versus pools going forward? Thanks.

Larry Penn, CEO

Hey Mark, I'll start and then you can finish on the TBAs. Regarding the agency allocation, we've kept it lower since COVID. We believe this approach best maintains the liquidity we need to seize opportunities in credit and other sectors. So, I'll begin with a general allocation. As our credit portfolio expands, we will certainly prioritize that over our allocation strategy. Mark, would you like to discuss the TBA market specifically?

Mark Tecotzky, Co-Chief Investment Officer

Our positioning in TBA and EFC has significantly benefited us after COVID. We recognize how important the Fed's large and consistent purchase program is. On the long side of the TBA balance sheet, we've been exposed to coupons with strong rolls, which helped in Q2. Additionally, we've successfully maintained short positions in rolls that the Fed is not involved in, where fast speeds have led to negative roll levels. This strategy has allowed us to achieve hedging costs that are actually below zero. EFC has gained from long positions in TBAs with expiry rolls, as well as short positions in TBAs with negative rolls, which we have used for years to hedge some of our higher coupon specified pools. While returns on equity are currently healthy in the agency market, it's important to anticipate what the Fed plans to do rather than just knowing what they're doing now. In the third quarter, we noted that 30-year Fannie 3s lagged. This was due to it transitioning from a Fed purchase coupon to one that the Fed no longer buys, causing its roll and price to collapse. The Fed's purchasing list can change, and if you're caught holding a significant TBA position that has inflated in price due to a healthy roll, you risk seeing prices reverse if the Fed stops buying. We still find value in this strategy for a portion of our portfolio, and it has been successful for us. However, I view it as just one of several tools we have to generate returns. It contributed positively to our earnings this quarter, but I don't see it as without risk. A good roll is crucial, but we also need to assess whether the price of that TBA coupon makes sense and whether it will hold steady if the roll weakens.

Josh Bolton, Analyst

Great, that makes sense. Thanks for that color. And then, Larry, you mentioned in your comments and in the press release about ample room for dividend growth going forward. Just curious how you're thinking about when you think about the earnings power of the company, how you're thinking about appropriate dividend levels versus retaining those earnings and growing book value, or any general thoughts you have around that? Thanks.

Larry Penn, CEO

Yes, that's a great question. One of our differentiators is the 475 tax selection we made. One of the advantages is that this year, our first-quarter losses reduced any upward pressure on our dividend. Other companies that were losing money could still face pressure to pay dividends based on how they compute their taxable income, but we do not have that issue. This gives us a lot of flexibility regarding our dividend. We took a book value hit in the first quarter, but from a portfolio P&L perspective, we’ve recovered about 90% of that loss, and we hope to be in a positive position by December 31. There is a balance between offering a dividend that appeals to investors while also building back our book value. Given our economic returns over the last two quarters, we are effectively rebuilding our book value, which is significant. Our core earnings were at $0.41, which translates to about $0.13 to $0.14 per month, and we just raised our dividend to $0.10. We have room to grow it by another $0.03 or $0.04. Before COVID, our monthly run rate was approximately $0.15, and considering the opportunities available now, I believe we have ample room to increase our dividends once fully deployed. There will be interesting discussions with the Board regarding the timing of any increases, but I see significant growth potential. In the meantime, I predict we will be cautious, focusing on steady increases rather than adjusting our dividend immediately to match core earnings, as we want to continue building our book value.

Operator, Operator

Thank you. Your next question is from Crispin Love with Piper Sandler.

Crispin Love, Analyst

Good morning guys. Thanks for taking my question. First, can you talk a little bit about the credit quality that you've been seeing in your portfolio, and kind of the sectors that kind of you're more bullish or negative on from a credit perspective? In recent earnings calls, you have commented that there will be losses and some pain in the portfolio? So I'm just curious about how performance has been relative to your initial expectations from March and July to currently?

Larry Penn, CEO

Mark, you want to take that?

Mark Tecotzky, Co-Chief Investment Officer

Yes, hi Crispin. I think about it in sectors. In any housing-related sectors, such as non-QM, NPL/RPL, residential transition loans, and non-agency securities, the performance has been very strong. However, it's important to note that forbearance had a significant impact on homeowners who lost income due to COVID. The CARES Act was crucial for consumers facing income loss during that time, with enhanced unemployment benefits adding an extra $600 on top of state benefits, which helped replace much of the lost income nationally; these benefits are now being reduced. We need to see what happens with the upcoming election and how future stimulus might be shaped. While performance has been solid, we must maintain a balance between underwriting discipline and the volume of business, considering what our competitors are doing. Currently, we've managed to achieve substantial origination volumes while adhering to strict underwriting practices. Given the uncertainty surrounding future stimulus and the trajectory of the virus, we should not ease our discipline right now. Performance in the residential sector has been excellent, but the factors driving this success are somewhat unclear as we look ahead. In the commercial sector, performance has been surprisingly strong, despite my initial concerns about potential challenges. The rate at which loans are paying off has been unexpected; there’s noticeable activity in commercial real estate. One significant advantage for this sector is the existence of active securitization markets. Reflecting on the 2008 crisis, it took years for non-agency commercial real estate deals to be priced. In contrast, such activities resumed relatively swiftly following COVID. This allows those interested in buying real estate to access financing at low rates with appropriate leverage, facilitating capital flow. Although we’re not entirely out of the woods, we have enhanced our disclosures about the commercial real estate portfolio. The consumer loan portfolio has also shown strong performance, particularly interesting since the forbearance periods are generally shorter than those in 30-year mortgages. Many borrowers who opted for forbearance are now back on track with their payments. This situation offers a test case, though we won’t see similar data for the residential side for a few months. We're starting to gather more data on borrower behavior post-forbearance. Credit quality has been good overall, but we shouldn’t assume this trend will continue without considering the role of stimulus.

Larry Penn, CEO

I appreciate the opportunity to add to that, Mark. Our goal is to keep our disclosures transparent and straightforward, and I appreciate your honesty. As you might recall, back in March and April, we were transparent when many companies were claiming everything was fine, which was not the case. Regarding your question about expected credit losses, we evaluate them at the end of each quarter. If you review our upcoming quarterly report, you'll find detailed insights into expected credit losses across different portfolio sectors, which demonstrate significant stability. Our forecasts have proven to be quite accurate, and this applies not only to expected credit losses but also to our fair value assessments recorded in the income statement. These assessments will impact our net income, and we expect to maintain that stability due to the accuracy and honesty of our evaluations. The disclosures from June 30 and those coming out soon for September 30 show positive results. As Mark noted, our consumer-related portfolios, such as residential mortgages and consumer loans, are performing exceptionally well, demonstrating real resilience. Although we anticipate some credit losses on CMBS due to prior concerns from COVID, those numbers will be manageable and contained. We have already accounted for some of those losses, and things could improve from here. That captures our approach to disclosures. JR, would you like to add anything?

JR Herlihy, CFO

Yes. I would just add to that Mark had mentioned forbearances. And I would update on how deferments and forbearances have been in our portfolio in Q3. I mean, last quarter, we discussed how forbearances and deferments had increased in the months following the COVID outbreak, delinquencies increased and these have both declined considerably in the third quarter. You could see it most clearly in the non-QM portfolio where just by the numbers, forbearance, loans in forbearance was close to 9% at 6/30 and that's now close to 1% at 9/30. And even of that 1%, almost 40-plus percent are current despite being in forbearance and delinquencies are down sequentially in non-QM, but it's not just non-QM in small balance commercial, which Larry was just speaking to. Deferments are about cut in half from where they were at 6/30 and in consumer deferments are down as well. And the number of loans that are in deferment yet are still current are up from 6/30. And then finally in residential transition loans, we haven't had any loans subject to forbearance or deferment or modification. So that's been our experience in Q3 versus Q2 in terms of forbearance and deferrals.

Larry Penn, CEO

I want to add that during the call, we discussed a couple of loans, including significant pay-offs in our portfolio. One of these was a hotel loan. We underwrote it with a conservative loan-to-value ratio and relied on multiple appraisals, ensuring their accuracy with our origination partners. Due to this cautious approach, that loan was reduced from a 70% loan-to-value ratio to 50%. This illustrates our careful focus on loan-to-value and the reliability of our appraisal process, which gives me confidence in our position.

Crispin Love, Analyst

Thank you for the insights. Larry, you mentioned that the market undervalues Ellington's origination capabilities. Could you elaborate on that regarding your investments in loan originators? It was insightful. Considering the valuations of new mortgage originator IPOs and potential IPOs, many of which are being marketed as Fintechs, how does EFC position itself in the larger market? Some of the traditional public originators trade at three, four, or five times earnings, while newer companies enter the market at much higher valuations. So, my question is, which valuations are accurate, and how can EFC realize the value of its origination channels and investments?

Larry Penn, CEO

As I mentioned, in some cases like Longbridge, we don't have a lot of loan flow at this point. We do invest in Ginnie Mae HECMs, and our investment in Longbridge definitely helps us manage that portfolio. Currently, there appears to be a temporary dip in profitability, making it inappropriate to project that forward over multiple years. Some originators may be overvalued right now. The valuation of an originator depends on its book value, tangible book value, and franchise value, which is a multiple of earnings power. While we lack transparency on how our investments are valued, there is significant upside potential. LendSure just had a record month, and if this growth continues, our investment value will also increase. Longbridge is gaining market share in a now favorable market for reverse mortgages. They could eventually become a direct flow provider for us. For now, we'll support their growth as they support us, particularly with managing reverse mortgage bonds and the flow from LendSure in non-QM products. We're looking to expand LendSure's offerings, which could lead to significant opportunities in other markets, particularly given their expertise in residential transition loans and agency origination. We have yet to explore investments in other areas, like consumer loans. We're in a strong position with a vertically integrated structure, which makes us a good partner for these companies, and they are valuable partners for us as well. Currently, we have $57 million on our balance sheet, representing about 7% of our equity, which could grow over time, and we have the capacity to do so.

Operator, Operator

Thank you. We have no further questions at this time. This will conclude today's conference call. You may disconnect your lines at this time and have a wonderful day.