Earnings Call
Ellington Financial Inc. (EFC)
Earnings Call Transcript - EFC Q3 2023
Operator, Operator
Good morning, everyone. Thank you for joining us. Welcome to Ellington Financial’s Third Quarter 2023 Earnings Conference Call. This call is being recorded. All participants are currently in listen-only mode. After the presentation, we will open the floor for questions. It is now my pleasure to hand the call over to Aladdin Chile. Please go ahead.
Unidentified Company Representative, Unidentified Company Representative
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 Part 1 Item 1A of our annual report on Form 10-K and Part 2 Item 1A of our quarterly report on Form 10-Q for the quarter ended June 30, 2023, 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 obligations 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 backs of the presentation. With that, I will now turn the call over to Larry.
Larry Penn, CEO
Thanks, Aladdin, 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. For the third quarter, we have reported net income of $0.10 per share and adjusted distributable earnings of $0.33 per share. Steady performance from our credit portfolio, along with significant net gains on our interest rate hedges exceeded net losses in agency MBS, and we delivered a positive economic return in an extremely volatile market. On this Slide 3, you can see the strong contribution from the credit portfolio, which was led by positive performance from our residential transition, non-QM and commercial mortgage bridge loan businesses and our credit risk transfer securities. Our agency strategy, on the other hand, contributed a loss of $0.16 per share for the third quarter in what was arguably the most challenging environment for agency RMBS investors we've seen since March of 2020. During the quarter, long-term interest rates rose sharply and volatility spiked as the market priced in a higher-for-longer interest rate environment and the uncertainty related to a possible government shutdown. While we did have a significant loss in our agency strategy, our interest rate hedging strategy, which included aggressive duration rebalancing throughout the quarter and a positive contribution from our short TBA positions helped prevent further losses. We had entered the third quarter with high levels of liquidity and additional borrowing capacity. And because of that, we were well-positioned to capitalize on the investment opportunities that the market volatility presented. With agency yield spreads near the historical wides, we took advantage by adding to our portfolio and we also captured attractive yield spreads by expanding our non-QM residential transition loan and reverse proprietary mortgage loan portfolios during the quarter. Moving forward, I expect that our loan portfolios will continue to grow. But for our agency portfolio, while we grew that opportunistically this past quarter to take advantage of wider spreads, I still expect that portfolio to shrink over time as we redirect capital to credit. Also during the quarter, we continued to ratchet down our commercial mortgage bridge lending, given the ongoing headwinds in the commercial real estate sector. Loan paydowns and payoffs continued to exceed new origination volume in our bridge lending business. While the share of our portfolio represented by multi-family grew to an even larger majority of our overall commercial mortgage portfolio. At September 30th, our commercial loan portfolio was as small as it has been in nearly two years. But considering the distressed opportunities that we are starting to see at the market now, this portfolio could expand again in future quarters. We will remain patient as the cycle progresses and we will pick our spots. Our Longbridge segment, meanwhile, generated positive results for the quarter despite the volatility. The segment had substantial interest rate hedging gains and those gains exceeded net losses and originations and on the proprietary reverse mortgage portfolio, as well as a net mark to market loss of $8.2 million on the reverse MSR portfolios. Taking a step back for a second and actually be a little confusing, however, reverse MSRs are shown on our balance sheet, and I am going to try to clarify that. Now, some of our MSRs appear on our balance sheet just as individual MSR assets, and those are straightforward enough. However, our biggest MSR comes from the billions of dollars of HMBS securitizations that Longbridge has done over the years. And since we consolidate those HMBS securitizations, those MSRs don't actually appear on our balance sheet as MSRs per se. Instead, those MSRs are basically represented by the difference between our on-balance sheet HMBS assets and our on-balance sheet HMBS liabilities. That's why in our public filings and financials, we refer to our HMBS related MSR as our HMBS MSR equivalent. From our GAAP financials, you compute the value of the MSR as the value of certain assets minus the value of certain liabilities, and that result is equivalent to the value of the HMBS related MSR. Okay. Getting back to that $8.2 million mark-to-market loss on our reverse MSR portfolios, let's dig a little deeper. That was actually a result of offsetting factors. The loss primarily reflected the difference between, on the one hand, a large markdown on our existing MSRs, including the HMBS MSR equivalent. And on the other hand, a less large markup on the MSR portfolio that we acquired out of a bankruptcy proceeding on July 1st. First, I will address the MSR markdown. To value our MSRs, we get input from two of the most widely respected reverse MSR valuation experts in the industry. Despite that fact, we concluded that a couple of their assumptions in their fair value assessments were too aggressive. First, we decided that it was appropriate to use a higher yield to discount the future projected MSR cash flows as compared to the yield that they used. Second, based on our observations of where HMBS tails have been trading, we decided that it was appropriate to assume lower exit prices for future tail securitizations as compared to the tail prices that they assumed. In addition, we also assumed that we would incur higher future sub-servicing expenses as compared to what we were told previously were the standard expense assumptions. In order reflect sub-servicing expenses that we think we’ll actually be able to obtain and maintain. So all these factors explain the markdowns on our existing MSRs. Second, as to the MSR market, we apply these more conservative MSR pricing assumptions to that MSR portfolio we acquired out of bankruptcy in early July. While this resulted in an evaluation that was considerably lower than our third-party experts valuation, the valuation was still considerably higher than the distressed price at which we acquired that MSR portfolio went to the markup. In summary, we believe that our more conservative assumptions more accurately reflect fair value. And our belief is further validated by several offerings of reverse MSR portfolios that we have seen recently in the secondary market. With the notable exception of that distressed acquisition of ours in July, these recent MSR offerings ultimately did not trade because reserve prices were not met. Back to Longbridge's results for the quarter. While our Longbridge segment was profitable on a mark-to-market basis, including hedges, the segment's contribution to our adjusted distributable earnings for the quarter turned negative. In a nutshell, challenging market conditions compressed gain-on-sale margins and loan valuations, particularly in the back half of the quarter. As a reminder, Longbridge's origination P&L is a component of our adjusted distributable earnings, creates volatility in our ADE. This past quarter, it was the negative ADE contribution from Longbridge that caused Ellington Financial's sequential decline in overall ADE. Looking ahead, with our updated MSR valuations and our growing proprietary reverse mortgage portfolio and with Longbridge's increasing market share in the industry, I believe that Longbridge is well positioned to make meaningful positive ADE contributions respectively. Looking to the remainder of the year, we finished the third quarter with a recourse debt to equity ratio of just 2.3:1, which is still towards the lower end of our historical levels. As you can see on Slide 3, our cash and unencumbered asset levels show that we still have substantial dry powder to invest. Meanwhile, we are full speed ahead on our merger with Arlington and expect to close next month. We have outlined several strategic benefits of the transaction, and I will briefly highlight a few of those again now. First, we will be adding a sizable portfolio of low coupon agency mortgages servicing rights, which gets us into the agency MSR business already at scale. These MSRs should perform well in a high interest rate environment, and function as a natural complement to many of Ellington Financial's existing investments. Second, we will be able to tap into significant additional dry powder to deploy in a market rich with investment opportunities, both by financing Arlington's currently unlevered agency MSR portfolio and also by monetizing Arlington's liquid assets and rotating that capital into higher yielding investments. We project the merger to be accretive to earnings per share and ADE by the second quarter of this coming year. Third, we will significantly increase Ellington Financial's capital base in a highly efficient manner, not only with common equity but also with low-cost preferred equity and unsecured debt. And finally, by significantly increasing our scale and bringing us a new group of shareholders, this transaction should enhance the liquidity of our common stock, while lowering our operating expense ratios. With that, I'll turn the call over to JR to discuss our third quarter financial results in more detail.
JR Herlihy, CFO
Thanks, Larry, and good morning, everyone. For the third quarter, we reported net income of $0.10 per share on a fully mark-to-market basis and adjusted distributable earnings of $0.33 per share. These results compare to net income of $0.04 per share and ADE of $0.38 per share for the prior quarter. On Slide 5, you can see the attribution of net income among credit agency and Longbridge. The credit strategy generated $0.37 per share of net income driven by an increase in net interest income sequentially and significant net gains on interest rate hedges. A portion of this income was offset by net realized and unrealized losses on consumer loans, non-QM loans, commercial mortgage bridge loans and CMBS. We also had small net losses on investments in unconsolidated entities and credit hedges and other activities. Notably, our loan originator affiliates, LendSure, American Heritage, and Sheridan, all posted strong quarterly profits. Although, the fair value marks for those investments on EFC's balance sheet, which are based on third-party valuations of these operating companies, did not increase given the challenging market environment. During the quarter, delinquencies again ticked up on our residential and commercial loan portfolios, but those portfolios continue to experience low levels of realized credit losses and strong overall credit performance. In non-QM, we still realized zero cumulative losses life to date on a population that now encompasses nearly 10,000 loans and $4.4 billion of total UPB dating back to 2015. Meanwhile, for RTL and Commercial Mortgage Bridge, realized losses remain low compared to the amount of capital we've invested in profits we've generated, which is largely thanks to our focus on first lien and low LTVs with built-in equity cushions. That said, recently, more loans have progressed to 90 plus day delinquency status and to REO and the story is still playing out on those. We remain very focused on credit performance and managing through resolutions on these sub-performers. Back to non-QM, where our delinquencies have been among the lowest in the entire sector. Recently, the third-party servicer of our non-QM loans was acquired by a much larger servicer and as a result, the servicing of those loans was transferred. Unfortunately, the new servicer's handling of that transfer has not been smooth. Given the situation, we do expect that delinquencies on our non-QM loans will temporarily increase in Q4, but we also expect that they will revert to more normalized levels in the coming months once all the transfer-related issues have been resolved. Meanwhile, the Longbridge segment generated $0.06 per share of net income, driven primarily by gains on interest rate hedges. As Larry mentioned, we had a mark-to-market loss on the HECM MSR equivalent, partially offset by a mark-to-market gain on the bankruptcy-related MSR portfolio purchase. The Longbridge segment also had mark-to-market losses on proprietary loans and a net loss in origination. In origination, the combination of higher interest rates and wider yield spreads reduced gain on sale margins on both HECM and proprietary loans, which more than offset a modest uptick in overall origination volumes. Our agency portfolio generated a net loss of $0.16 per share for the third quarter as agency RMBS faced the significant headwinds of elevated market volatility and rising long term interest rates. Yield spreads widened and agency RMBS significantly underperformed US Treasury securities and interest rate swaps for the quarter, with lower coupon RMBS exhibiting the most pronounced underperformance. Net losses on our agency RMBS and negative net interest income exceeded net gains on our interest rate hedges, while our delta hedging costs, which are tied to interest rate volatility, remained high. On Slide 6, you can see a breakout of adjusted distributable earnings among the investment portfolio, Longbridge and corporate overhead. Here you can see the negative ADE from Longbridge that Larry mentioned, driven by compressed margins and mark-to-market losses on proprietary loans. Apart from Longbridge, ADE from the investment portfolio segment net of corporate overhead actually increased incrementally. I'll note here that part of the increase was related to periodic payments on the interest rate swaps associated with Great Ajax that have since been neutralized, and also to the payment of past-due interest related to a commercial mortgage bridge loans that converted from a non-performer back to a re-performer during the quarter. Our accounting policy is to stop accruing interest income once loans become 90 days delinquent, and only to recognize interest income again, if the loan becomes contractually current and we expect a loan to be fully repaid. In the third quarter, we saw loans move in both directions into 90-day delinquency status and out of it across our residential and commercial mortgage bridge loan portfolios. Of course, all P&L catches up upon the ultimate resolution of the given loan. But prior to that, this dynamic can cause our interest income and thus ADE to be lumpy over time. Next, please turn to Slide 7. In the third quarter, our total long credit portfolio increased slightly to $2.48 billion as of September 30th. Our non-QM and RTL portfolios grew sequentially as net purchases exceeded principal pay downs, and we also net purchased non-agency RMBS during the quarter. Conversely, our commercial mortgage bridge loan portfolio continued to shrink as loan paydowns in that portfolio, again, significantly exceeded new originations during the quarter. For the RTL, commercial mortgage bridge and consumer loan portfolios, in total, we received principal paydowns of $393 million during the third quarter, which represented a remarkable 25% of the combined fair value of portfolios coming into the quarter. This steady stream of principal paydowns bolsters our liquidity and capital to redeploy where we see the best opportunities. On the next slide, Slide 8, you can see that our total long agency portfolio increased by 5% quarter-over-quarter to $964 million as opportunistic purchases exceeded sales, principal repayments and net losses. Slide nine illustrates that our Longbridge portfolio increased by 14% sequentially to $488 million as of September 30th, driven primarily by proprietary reverse mortgage originations and the acquisition of the bankruptcy-related MSR portfolio. These increases were partially offset by a smaller HMBS MSR equivalent, driven primarily by the markdown that Larry mentioned. In the third quarter, Longbridge originated $307 million across proprietary loans, which is a 3% increase from the prior quarter. The share of origination through Longbridge's wholesale and correspondent channels increased to 82% from 79%, while retail declined to 18% from 21%. Please turn next to Slide 10 for a summary of our borrowings. On our recourse borrowings, the weighted average borrowing rate increased by 21 basis points to 6.88% as of September 30th, driven by the increase in short-term interest rates. Meanwhile, book asset yields on our credit strategy also increased over the same period, and we continued to benefit from positive carry on our interest rate swap hedges where we net receive a higher floating rate and pay a lower fixed rate. As a result, the net interest margin on our credit portfolio expanded sequentially. However, an increase in the cost of funds on our agency strategy exceeded an increase in its book asset yields, which caused net interest margin on agency to decrease quarter-over-quarter. Our recourse debt-to-equity ratio adjusted for unsettled purchases and sales increased to 2.3:1 as of September 30th as compared to 2.1:1 as of June 30th. Our overall debt-to-equity ratio adjusted for unsettled purchases and sales also increased during the quarter to 9.4:1 as of September 30th as compared to 9.2:1 as of June 30th. At September 30th, our combined cash and unencumbered assets totaled approximately $569 million, roughly unchanged from the prior quarter, and our book value per common share was $14.33, down from $14.70 in the prior quarter. Including the $0.45 per share of common dividend that we declared during the quarter, our total economic return was a positive 54 basis points for the third quarter. I will shift now to our terminated transaction with Great Ajax, which we announced on October 20th. After careful consideration, both companies' Boards approved a mutual termination of the merger. As part of that termination, we paid Great Ajax a termination fee of $5 million in cash and also invested $11 million in the company by acquiring 1.67 million newly issued common shares for $6.50 per share. As discussed on last quarter's earnings call, we had established hedges upon signing the merger agreement with Great Ajax. With the deal terminated, we have now neutralized those hedges. But I will note that the gains related to the hedges covered all of our costs associated with the transaction, including mark-to-market losses on our termination-related investment and the common shares of Great Ajax. The results reported for the third quarter included the gains associated with the hedges that we had established related to the potential Great Ajax merger as well as net losses associated with the fixed receiver interest rate swaps that we used to hedge the fixed payments on our unsecured long-term debt and preferred equity. The quarterly results also reflected expenses related to the Arlington and Great Ajax transactions.
Mark Tecotzky, Co-Chief Investment Officer
Thanks, JR. This was a very volatile quarter, and EFC wound up with a slightly positive economic return. This was a quarter where it seemed like there were two completely disconnected fixed income markets, one for rate products and one for credit. Our credit portfolio had steady returns and maintained strong overall credit performance. Macroeconomic data released during the quarter supported the narrative of a surprisingly strong consumer and a resilient jobs market, which kept credit spreads well anchored. Ellington Financial's short duration portfolio of floating loans and bonds was largely immune from the really violent price movements in the rates market. Investment grade bond indices traded in a relatively narrow spread range and additive spreads on leveraged loans. That stable backdrop for credit spreads and continued strong credit performance of our portfolios drove solid results for our short duration credit strategies, specifically RTL, commercial bridge, non-QM and credit risk transfer. One exception for us, I would say, was in unsecured consumer loans. We see potential headwinds for that sector with student loan repayments restarted, persistent inflation for necessities like food and rent and potentially slowing wage growth. Our consumer loan portfolio underperformed during the quarter, but we have been shrinking that portfolio and don't have a lot of capital deployed in that sector. At September 30th, our consumer loan portfolio was about one-third the size it was pre-COVID. For rate strategies, it was a different story. The 10-year treasury yield was incredibly volatile, trading in a massive 85 basis point range with lots of twists and turns along the way, and it ended the quarter around its 15-year high. It was a terrible quarter for Agency MBS performance with most coupons underperforming treasury and swap hedges by well over a full point. Interest rate volatility, money manager redemptions and REIT deleveraging were all on the minds of the market and pushed spreads to some of the widest levels seen in years despite the tailwind of only modest supply from new home sales and cash-out refinancings. We had a loss in our agency strategy that shaved the full percentage point from EFC's book value per share for the quarter. Following quarter end, the underperformance of Agency MBS actually accelerated in October before posting a strong recovery in the past couple of weeks. The agency portfolio only uses a small slice of EFC's capital, about 10% at quarter end. But given the volatility we've seen all year, I'm happy to report that as of yesterday, our agency strategy P&L was almost flat for the year. Throughout 2023, we've remained disciplined in our approach to managing the agency portfolio, trying to manage negative convexity at a time of extreme rate volatility, taking advantage of relative value opportunities and keeping our net mortgage exposure roughly constant and leverage relatively low. Spreads remain extremely wide but are materially tighter than the widest spreads in October. Fundamentals look great and technicals are now starting to improve. But a lot has changed since quarter end. In October, the rate sell-off accelerated. But moving into November, rates now rallied significantly from their October highs. The Fed fund futures market now predicts that the Fed will be complacently sitting on its hands for the next few meetings and the prospect for capital to flow back into fixed income funds and ETFs feels much better with the recent decline in volatility. The Fed is trying to get inflation under control by slowing the economy, and recent data suggests that that slowdown is finally upon us. After years of strong macroeconomic performance bolstered by stimulus money and low mortgage rates that fueled price appreciation in residential and multifamily real estate, a much bumpier ride lies ahead. And we actually have been preparing for that bumpier ride since the spring of 2022. We have been more conservative in our RTL underwriting guidelines. We have pulled back from certain markets where we have seen signs of actual or potential pullback in home price from some of the COVID euphoria. Our commercial mortgage bridge loan portfolio has shrunk as paydowns have greatly exceeded new originations given our more stringent underwriting guidelines. Many of the new origination opportunities we've seen in commercial mortgage bridge just don't pencil out given the much higher debt cost, costly tenant improvements, higher insurance costs and slower rent growth. That said, we do think this market will ultimately come to us as cap rates slowly adjust to the new market conditions. Looking forward, I'm confident and really excited about the potential for EFC to thrive in this weaker economic backdrop. Our current loans and securities are overwhelmingly low LTV and collateralized by real estate that has lots of built-up equity. We've done a fantastic job avoiding the land mines in the CMBS. We have a lot of experience in using credit hedges to mitigate downside risk. Now we see the potential to play offense in the distress cycle for commercial real estate. Banks and their advisors are beginning to sell loan portfolios, and we expect the day of reckoning will come for many properties, including many good properties that won't be able to pay off their existing mortgage loans when they come due without a capital infusion or restructuring. JR and Larry spoke about the Arlington transaction. I'm looking forward to working with our portfolio managers to integrate and manage that portfolio. And I'm very happy that EFC will now have a stake in the agency servicing business. We've owned non-QM and reverse mortgage servicing for years, but this is a much larger stake in a much bigger market.
Larry Penn, CEO
Thanks, Mark. I'm pleased with Ellington Financial's positive third quarter results in a very challenging market. As usual, our interest rate hedging was key in achieving this. Going back to the launch of EFC in 2007, we've never tried to predict the direction of interest rates and have instead endeavored to hedge them. In this past quarter, with interest rates spiking, our interest rate hedges were again very profitable and that helped offset mark-to-market losses on other parts of the portfolio. The extreme pace of rate hikes since last year clearly caught a lot of the market off guard, but our hedging has kept EFC relatively unscathed. Our hedging program is one of our core strengths, along with our strong track record underwriting credit risk, our expertise in modeling consumer borrower behavior and our willingness to continually improve our portfolio through active trading and portfolio rotation. Looking ahead, whether we are in a higher for longer interest rate environment or not, I believe that Ellington Financial is well positioned, thanks to our hedging expertise and liquidity management, our short duration, high yielding loan portfolios and a highly diversified array of strategies, which will soon include agency MSRs as well. Thanks to Arlington's highly attractive MSR portfolio. Historically, we've concentrated our investment activities in sectors where banks are less active and where there's less competition, and we have built up deep and experienced teams and strong track records across market cycles in these businesses, especially in the residential mortgage and commercial mortgage sectors. Add to that, EFC now has access to servicing and workout platforms across a variety of loan businesses by virtue of our strategic equity investments. You can see these business lines on Slide 12. These platforms have significantly broadened the scope of potential investments that Ellington Financial can consider, as they allow us to deal more directly with any credit issues we encounter in our own portfolio and they provide us with the expertise to take over and stabilize distressed assets that we see in the secondary market. A recent example is the bankruptcy-related MSR portfolio that we acquired through Longbridge in July, which was only possible because of Longbridge's servicing platform and stellar reputation. That investment is already returning strong results, and we think it will be accretive to EFC's earnings in the quarters ahead. The ongoing dislocation of the banking sector should continue to generate compelling opportunities for Arlington Financial, both to buy distressed assets and to add market share at our originator affiliates. Banks are under pressure from regulators and from losses on their loans and securities. And with deposits leaving for higher yielding alternatives, we see an inefficient market getting even less efficient. Bank stepping back means less capital available to make or buy loans, which should put upward pressure on the spreads we can earn. The opportunities in distressed commercial mortgage loans and CMBS could be particularly compelling. Before I conclude, I'd like to reiterate that we here at Ellington Financial are all very excited to close on the Arlington merger next month. The Arlington shareholder vote is scheduled for December 12th and we would anticipate closing the transaction shortly thereafter. To Arlington shareholders, we hope you agree that this pending transaction will be highly attractive and accretive for you as well. We look forward to introducing ourselves and our company to more of you, and we sincerely hope that your ownership continues. With that, we'll now open the call up to questions. Operator, please go ahead.
Operator, Operator
We have our first question from Crispin Love with Piper Sandler.
Crispin Love, Analyst
First off, just with the majority of your small balance commercial portfolio and multifamily, which I believe is primarily bridge and grew meaningfully in 2020 and 2021. Would you expect a good portion of those loans to be extended given the current environment we're in, or would you expect more to roll off as you alluded to during the call?
Larry Penn, CEO
Mark, do you want to take that?
Mark Tecotzky, Co-Chief Investment Officer
The borrowers in our portfolio have been facing higher borrowing costs throughout the past year due to the Fed's rate hikes. Unlike conduit loans, which are generally structured as 10-year interest-only loans and can result in significant shocks at maturity, our borrowers have had to adapt to these higher rates over the entire life of their loans. To date, we have seen successful resolutions. In bridge financing, properties are typically in some form of transition, with some units needing repairs or renovations before they can be occupied. There is often a business plan aimed at increasing net operating income by getting these properties ready and bringing their rents to fair market levels. While the debt costs have been rising, our borrowers have successfully increased their net operating income. Thus far, our resolutions have been satisfactory, and the portfolio has been decreasing due to these resolutions, which I anticipate will continue.
Crispin Love, Analyst
And are they yes, go ahead.
Larry Penn, CEO
Yes, I just want to add one thing, which is that I think, we're not sort of the extend and pretend type. When we do extend a loan, we usually we'll demand something in return, right? Like we're very LTV focused, and so we'll expect if the loan is in maturity, we'll expect some additional principal pay down or something to compensate us for extending that loan. When we made these loans, we were very LTV focused, and that's something that we're not just going to just extend for because we're afraid to take any sort of more aggressive action, whether it's foreclosure or anything else. Now some of these loans do have extension options built in in those on the part of the borrower, and those will be extended per their contracts…
Crispin Love, Analyst
And the ones that are…
Mark Tecotzky, Co-Chief Investment Officer
I want to add that the decrease in our portfolio is partly due to the new origination process, where we are focusing on rising insurance costs, increasing property taxes, and slower rent growth expectations. We are noticing fewer deals that are financially viable given that SOFR is currently at 5.30% while these loans require SOFR plus 5.5% or 6%. This cautious approach in our underwriting has contributed to the portfolio shrinkage, as we want to avoid situations where property owners struggle to meet their debt service costs.
Crispin Love, Analyst
That makes sense…
Larry Penn, CEO
We mark our portfolio to market, which means we will adjust the value of our loans and recognize any losses in our income statement, reflecting issues such as potential loan defaults at maturity. If we anticipate a loss, it will be accounted for in that mark. This adjustment is already included in the mark, and for real estate, there is a lower cost to market.
Crispin Love, Analyst
Okay, that all makes sense. But on the loans that are maturing, are they receiving permanent financing through the agencies or elsewhere?
Mark Tecotzky, Co-Chief Investment Officer
Yes, some loans are coming from agencies, while others are being financed through longer-term loans from different credit sources. We believe there will be an opportunity in commercial real estate as loans reach maturity, especially for certain types of loans that will face challenges in refinancing. However, capital has also been raised to take advantage of this situation. Agencies are definitely active, but there are also other sources of capital available that are providing credit, filling the void left by regional banks.
Larry Penn, CEO
And a lot of the loans that we make in multifamily, right, why did they come to us in the first place? Often because they are making improvements to units, could be some sort of renovation, some sort of transition, right? We are a transitional loan for them. So a lot of the times, even with rates higher, they have done what they need to do and so they can get more permanent financing.
Crispin Love, Analyst
And then just one last question for me. The FDIC has announced that it’s selling some of Signature Bank's commercial real estate loans. Are these the types of assets that you would be interested in acquiring? And I guess if you can't necessarily speak to those specifically, just more broadly, have you begun to see opportunities for loan acquisitions on both the security and loan side?
Larry Penn, CEO
Well, on FDIC, in particular, we are absolutely seeing that, and we are considering putting a bid in for one or more of those portfolios. Mark, do you want to elaborate on that at all or talk about other opportunities?
Mark Tecotzky, Co-Chief Investment Officer
Yes, the FDIC Signature Bank portfolio sales are of interest to us, and our teams have been actively working on that. Beyond the widely recognized large public portfolios, we expect to see a consistent flow of properties. Many solid properties are approaching their maturity dates, and the new loans that will be appropriate given current income growth and existing debt levels will likely be smaller than the previous loans. The primary constraint isn't typically the loan to value but rather the debt service coverage. While there is significant attention on the signature portfolio, there will consistently be properties reaching maturity that may need capital infusions or restructurings. As we discussed in the previous call, this has been a fundamental aspect of our commercial loan strategy for years following the financial crisis. The team that has achieved exceptional results with this strategy remains in place, has shifted focus to bridging loans, and has enhanced their resources for sourcing and workout capabilities. Their extensive experience in handling these workouts positions us well, and we are genuinely optimistic about this being a key driver of returns for EFC in 2024 and beyond.
Operator, Operator
And we have our next question from Trevor Cranston with JMP Securities.
Trevor Cranston, Analyst
A question about the agency MSR asset class; as you look beyond sort of the initial acquisition of the Arlington portfolio. Can you talk about how you sort of envision being involved there, whether it's opportunistic bulk purchases or if you potentially look to have some sort of flow agreements on new production MSR?
Larry Penn, CEO
I think it could be both of those. So the agency servicing portfolio that we're acquiring, given where rates are, we think it is going to be a steady high return asset for us, and it gives us the capabilities. And we've always had sort of the capabilities on the modeling side, because modeling prepayments is so much a part of sort of our DNA. But now we're going to have more capabilities on all the necessary infrastructure. So it could be bulk purchases; it could be flow. If I had to guess, I'd guess in the beginning, probably more of our focus would be on bulk purchases, but that can be either way; we mentioned in the prepared remarks that we've been buying non-QM servicing for years, and it's flowed into the portfolio, and it's been a nice offset for some of the interest rate risk on non-QM loans. And so I think this acquisition gives us a lot of flexibility and a lot of capability on the agency servicing. And with banks potentially being less interested in having significant capital outlay there, I think it's a natural time for us to be able to acquire more portfolios.
Trevor Cranston, Analyst
And then on Longbridge, the portfolio there has been growing this year. I was curious if you could talk about specifically I guess with the proprietary loan bucket, how you think about sort of capital allocation there over time? And if the different cash flow characteristics of reverse loans sort of limit how much capital overall you'd be willing to allocate there?
Larry Penn, CEO
Sorry, could you repeat that? What would limit the amount of capital?
Trevor Cranston, Analyst
Just the different cash flow characteristics of reverse loans, not getting like the regular monthly payments, like if you want a forward mortgage, if that has any…
Larry Penn, CEO
I don't see that as a significant issue for us. One point we discussed on the call is the amount of principal payments we've received on the rest of the portfolio. It's actually beneficial to have an investment that is appreciating and yielding high returns, as opposed to something that is short-term and constantly amortizing principal. This combination works well for us and doesn't create any cash flow problems. However, this is a long-term product, and our strategy, much like in our other loan businesses such as non-QM, does not involve holding long-term loans and funding them with short-term financing indefinitely. As we consider our strategy moving forward, it makes more sense to view it as accumulating critical mass similar to non-QM, since those are also long-term loans. We are looking at gathering critical mass for securitizations and then executing those securitizations, retaining junior pieces, or engaging in home loan sales. There are different buyers for non-QM, whole loans, and proprietary reverse mortgages, although there might be some overlap. Insurance companies, for instance, have significantly increased their interest in non-QM over the past year. Given the long duration of these loans, which is attractive to insurance companies, along with the high yields of proprietary reverse mortgages, we see that as a fitting market for them. Therefore, I would frame this more in terms of accumulating critical mass rather than pursuing home loan sales or securitization directly.
Operator, Operator
And we have our next question from Eric Hagen with BTIG.
Eric Hagen, Analyst
I wanted to check in on conditions for non-agency repo, other term financing for retained securities that you guys retain office securitization. How stable the availability of that capital is and maybe even how rate sensitive you think that financing is going forward?
Larry Penn, CEO
I mean, go ahead, Mark…
Mark Tecotzky, Co-Chief Investment Officer
No, I was going to say in a word, it's been stable. Even with significant price and spread volatility in some credit products in 2022, there hasn't been much price volatility in spread products in 2023. But even last year and continuing this year, spreads have remained steady. So that financing for us is basically a spread to SOFR. The actual rate we're paying fluctuates as SOFR does. However, what has remained stable is the spread between SOFR and our overall borrowing costs. The number of capital pools interested in this financing has actually increased. Over the past couple of years, we've broadened our range of counterparties, especially for short-duration or floating rate loans. For example, if we have a loan that's SOFR plus six, we’re financing it at SOFR plus one and three-quarters. Each increase in leverage locks in that difference, roughly 425 basis points for general estimation. For fixed rate bonds, such as non-QM, we've generally used two types of hedges this year: paying fixed on SOFR swaps or short TBA, and recently it's been more about paying fixed on SOFR swaps. So we're paying a fixed rate and receiving a fixed rate from the loan, allowing us to capture that spread. The SOFR we receive on the floating leg of the swap offsets the floating leg we owe to repo counterparties. Thus, we're also locking in the spread there, which is the difference between the fixed rate on the loan and the rate we're paying on the SOFR swap. The capital pool and spreads to SOFR have been stable and, if anything, have been decreasing slightly. I believe the reason for this is that repo, given the curve's shape, has become a highly attractive asset. If you have a repo book at SOFR plus 175, you're essentially earning 7%, making it very appealing, especially for low LTV loans that are marked-to-market daily. There are many protections for repo lenders, which makes this a desirable asset for numerous capital pools. That’s why the financing has remained stable. In contrast, back when SOFR was close to zero, and during the LIBOR days, the overall yield on financing simply wasn't appealing, and the financing markets lacked the depth they have now.
Eric Hagen, Analyst
I wanted to go back to your comments around the consumer conditions. I think you gave some cautious commentary around the consumer loan portfolio. Like how does that outlook tie into other areas of the portfolio where there's maybe some more asset level risk, like obviously, the resi portfolio or some aspects of that portfolio?
Mark Tecotzky, Co-Chief Investment Officer
It's interesting. We were looking at charts today that tracked delinquencies across different loan categories based on whether borrowers had student loans, and we clearly see the impact of student loans. The weakness we have noticed is among lower credit score borrowers. The difference in performance between higher and lower credit scores has always existed, but the gap has widened. We believe this is largely due to high gas prices, particularly in some regions like California, in addition to rising rent costs. At the same time, wage growth has slowed, which is putting pressure on consumers. We have observed this trend, although it hasn't significantly affected Fannie Mae and Freddie Mac portfolios. In terms of credit risk transfer performance, you might see some indications of this in Ginnie Mae portfolios, which have a higher loan-to-value ratio and lower credit scores compared to Fannie Mae and Freddie Mac. The sub-prime auto sector is also showing similar trends. The borrowers we prefer to lend to are those who have secured low-interest 30-year mortgages, and this year, credit risk transfer performance, such as CAS and Stacker, has been outstanding. This is because investors are drawn to floating rate products tied to SOFR, which is currently high relative to other yield curves, while ultimate borrowers have locked in their debt long-term. These borrowers have exhibited the strongest and most stable credit performance. Non-QM borrowers follow, but there has been a slight increase in delinquencies among them, unrelated to servicing transfers. Lastly, renters dealing with rising rents over the past year are showing slightly weaker performance.
Larry Penn, CEO
I would like to add that if you look at Slide 4, the consumer loan row shows $90 million, which includes some ABS and equity investments. Essentially, you're looking at just under $90 million. I want to emphasize that the comments we made were somewhat retrospective rather than forward-looking, as we are projecting an 11.5% yield on that portfolio based on its current mark. We believe that this yield is promising going forward. After the mark-to-market adjustments we've implemented, I should also highlight that most of this portfolio consists of secured consumer loans rather than unsecured ones. While it's a relatively small portfolio under $90 million, we are confident that it's accurately valued and expect it to yield 11.5% on an unlevered basis. We feel optimistic about that portfolio going forward, and there's a possibility we might expand it if good opportunities arise.
Operator, Operator
And we have our next question from Matthew Howlett with B. Riley.
Matthew Howlett, Analyst
At a high level, when we analyze the results by segment, the credit performance was impressive and stable. There was, however, a negative impact from Longbridge and the agency side also showed negative contributions. If we normalize for those, Longbridge was contributing around $0.10 in the first quarter, and while the agency side is decreasing, it is expected to become a positive contributor. Regarding dividend coverage, considering the one-time events, how should we view this on a run rate basis going forward?
Larry Penn, CEO
I think we're close. One way to approach this is that Longbridge represented 14% of our allocated equity at the end of the quarter, and they have had periods where they contributed $0.05 to $0.10 per share of ADE. If they are contributing 6 to 7, that would be 14% of $0.45. Additionally, we generated approximately $0.38 from the investment portfolio after accounting for corporate overhead. The total of these contributions is quite close to the dividend. We included some caveats in our prepared remarks regarding how to model or think about ADE in the near term, as there are unique behaviors related to our interest income when loans become delinquent and we stop accruing interest, or when they reperform and we expect to be paid at par, which will then reinstate interest income. There will be some fluctuation in this area, and we anticipate it continuing. Overall, I believe we are on track in terms of our run rate. October continued to present some challenges similar to those seen in Q3, specifically with rates selling off and high volatility remaining. We haven't released October numbers yet, but I wouldn't be surprised to encounter similar obstacles that could impact ADE in Q4, particularly in the origination channels and agencies. That being said, I think on a normalized basis we should be on track, if not in Q4, then moving into next year. Plus, when we factor in contributions from Arlington and the deployment of additional resources, that should be beneficial. I realize I covered a lot of ground, but hopefully that clarifies things.
Matthew Howlett, Analyst
No, I'm glad you clarified. I'm thinking about it the same way you are. I'm focused on the stability of book value, which I believe was crucial this quarter. Regarding Longbridge, it's clearly one of the highest channels for gain on sale margins. What factors could affect margins and volumes? Is it similar to the conforming conventional side in terms of spreads? Do they track agency spreads or HECM spreads? Can you walk me through whether it's primarily about home price appreciation or lower rates, and what could positively or negatively influence Longbridge as we approach next year and some of the volatility decreases?
Larry Penn, CEO
I'll address that. Before I do, I want to highlight that this is a great question because it impacts what I'm about to say. As long as Longbridge continues to gain market share and does what we believe is necessary, we anticipate improvements. This quarter was challenging from an ADE perspective, but not from a market-to-market perspective. We believe that once the ADE normalizes with Longbridge, as JR mentioned, we will be aligned with our dividend. We have no intention of allowing our dividend to fluctuate due to changes in origination profits at Longbridge. From an analyst's perspective, you might consider our ADE excluding Longbridge as another metric to examine. The acquisition is positive and their growing market share adds to that. It's been a tough market, so getting back to what drives Longbridge, we now have the MSR, which is conservatively marked and should generate a strong yield. Unfortunately, we remain in a high-interest rate environment. This means long-term interest rates, especially around the 10-year mark, influence how much borrowers can access in a reverse mortgage, which is how the HECM program operates. This correlation makes sense since you are considering long-term indicators of inflation. With these borrowers not making payments, it's essential to earn a competitive market interest rate and more on the loan. As rates rise, the long-term curve affects the principal amount that borrowers can withdraw. This situation has been impacting the entire reverse mortgage sector differently than the conventional forward market has been affected. You’ve noticed a market contraction, but Longbridge and a few smaller players have managed to maintain their positions. We see Longbridge increasing its market share in a reduced market, while the proprietary business also has significant growth potential. This sector now includes borrowers with higher-value homes, which is more profitable on a per-loan basis, and these borrowers may not be as sensitive about withdrawing lower amounts. Looking ahead, we remain optimistic about Longbridge's long-term prospects and their ongoing market share growth. However, it has been a challenging market, with broad and volatile agency spreads affecting the execution on the HMBS that Longbridge and other operators issue monthly. Consequently, the gain on net sale margins isn’t as strong as it could be. If spreads stabilize, we expect that to normalize as well. Therefore, you may see short-term volatility in our ADE due to fluctuations in Longbridge's origination profits, which the market will need to adapt to.
Matthew Howlett, Analyst
I appreciate that; you clarify, it makes a lot of sense now. And not to get too complex on this call, but the MSR related to reverse, it has no prepayment. So just the higher rates negatively impacted that. I mean, going forward, is that going to perform the same way a conventional MSR performs? We get lower rates or…
Larry Penn, CEO
It is complex. A significant part of the value lies in a traditional servicing strip, which isn't as sensitive to prepayments as a forward mortgage strip. However, when interest rates decrease, some individuals do refinance their reverse mortgages to benefit from lower rates. Additionally, as home prices rise, they might refinance for cash-outs. Therefore, many similar factors influence this situation. There is a prepayment aspect, which is slightly negatively correlated with interest rates, making it advantageous for that segment of the MSR at high rates. There are also other factors, particularly future draws allowing borrowers to withdraw more from their reverse mortgages, which contributes significantly to the value of these MSRs, as the profit stems from converting them into Ginnie Maes, known as tails. This is sensitive primarily to spreads rather than rates, indicating a possible reverse correlation. So, several offsetting factors are at play.
Matthew Howlett, Analyst
I believe Longbridge is going to be very successful for you all, and I'm excited for next year. Quickly, did I understand correctly that you're planning to leverage bank lines with some of the MSRs they hold? I'm aware they have something called MSR financing receivable, which I assume is related to MSRs. What kind of leverage can you obtain from the banks on MSRs? Additionally, I think you mentioned wanting to incorporate some corporate debt, like preferred stock, once the deal is finalized. Could you elaborate on those two points?
Larry Penn, CEO
I believe that Arlington already has preferred stock and unsecured debt related to the merger, which we will inherit as our own preferred stock and unsecured debt. This is favorable for us, especially since we are operating in a different environment now, making financing more attractive for future needs. Regarding financing the MSRs, there is a lot of availability, and you can typically secure financing at rates above a 50% advance rate, although we would likely focus on around 50%. Essentially, this could be viewed as one turn of leverage.
Matthew Howlett, Analyst
We look forward to closing the transaction and to continued success. Thank you.
Operator, Operator
And we have our next question from George Bose with KBW.
Unidentified Analyst, Analyst
This is actually Frankie filling in for Bose. Just one question. On Slide 14, you provide interest rate sensitivity. Can you talk about how sensitive your agency MBS position is to the changes in spreads? And then just a follow up, how much do you hedge the agency spreads? Thanks.
Larry Penn, CEO
It’s sensitive to spreads or to rates?
Unidentified Analyst, Analyst
The spreads.
Larry Penn, CEO
You can't see that on this slide. But if you look at Slide 22, that is the right one. Okay, thank you… Yes, if you turn to that, I will elaborate. So you can see that when you net out our TBA shorts, which really had spreads dollar-for-dollar on the equivalent amount of longs, right? You can see that our net agency we call net agency pool assets to equity ratio was 5.4:1. So then you can go and basically say, okay, what does that mean? Well, actually, if you look on the slide, you can see there are net long exposure to agency pools of $698 million. And so if you think about 10 basis points in spreads on the portfolio. Mark, would you say that's 10 basis points is what, is it 0.5-ish? What do you think?
Mark Tecotzky, Co-Chief Investment Officer
Yes, that's exactly what I was going to say. Yes, five-year spreads…
Larry Penn, CEO
If spreads move by 10 basis points, half a percent of $690 million is approximately $3.5 million. A 10 basis point change represents a significant move in spreads. It’s possible we could see a 20 basis point change, but we are already close to all-time wide levels. In the context of our entire portfolio, this isn’t a large exposure, but we feel positive about it at this time since spreads are quite close on a notional basis and by other metrics. They are near levels seen right after COVID hit, which indicates that they are significantly wide.
Mark Tecotzky, Co-Chief Investment Officer
And another kind of rule of thumb or shortcut you could take is the prior Slide 21, you could see that 35% of our interest rate hedging portfolio is in TBA at September 30th, up a little bit from 32% at 6/30. But you can roughly say that, that 35% is also addressing the spread widening risk whereas the swaps don't. So as that fluctuates you can see how much of the mortgage basis were hedging through TBAs versus not through swaps.
Operator, Operator
And that was our final question for today. We thank you for participating in the Ellington Financial's third quarter 2023 earnings conference call. You may disconnect your line at this time and have a wonderful day.