Earnings Call Transcript - EFC Q4 2022

Operator, Operator

Good morning, everyone. Thank you for being here. Welcome to the Ellington Financial Fourth Quarter 2022 Earnings Conference Call. This call is being recorded. I will now hand it over to Tara, Vice President of SEC Reporting. Please proceed.

Tara, Vice President of SEC Reporting

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 and Part 2 Item 1A of our quarterly report on Form 10-Q for quarter ended September 30, 2022, 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 fourth 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, Tara, 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 fourth quarter, we are reporting net income for the quarter of $0.37 per share and adjusted distributable earnings of $0.42 per share. Excellent performance from Longbridge Financial, our reverse mortgage originator, and from our Agency RMBS strategy, in addition to another positive quarter from our loan portfolios, drove Ellington Financial's results. I'll start with Longbridge Financial, since that's driving a change now and going forward to our financial reporting. We had a minority stake in Longbridge, dating all the way back to 2014. And this past October, we acquired a controlling stake in the company. As a result, we are now consolidating Longbridge's balance sheet and results of operations into EFC's financials, beginning with the fourth quarter. During the fourth quarter, Ginnie Mae HMBS yield spreads tightened and that increased the value of the HECM reverse mortgage loans and mortgage servicing rights that Longbridge holds on its balance sheet and which by consolidation, we now hold on our balance sheet. The tighter yield spreads also expanded Longbridge's gain on sale margins on new originations. But as expected, origination volumes were down seasonally, and that led to modest net loss on originations. Putting it all together, Longbridge generated strong results for the quarter. On the middle of Slide 3, you can see Longbridge contributing $0.24 to our net income per share. You can also see on this slide the significant contribution from our Agency strategy in the quarter. Driven by a more benign outlook on inflation and Fed monetary policy, the Agency mortgage basis rebounded sharply in the fourth quarter, following three consecutive quarters of dismal underperformance in the sector. Our Agency strategy delivered net income per share of $0.19 for the quarter as we were able to recover a portion of our losses in the strategy from earlier in the year. We took advantage of the strong Agency market to sell some specified pools, especially around the yield spread tightening in November. And we rotated that capital to further expand and diversify our credit portfolio, where we see strong earnings potential and attractive net interest margins going forward. Our adjusted distributable earnings, or ADE, did decline quarter-over-quarter, but that was not surprising for a quarter where short-term interest rates spiked so substantially. Most of our borrowings float off of either SOFR or LIBOR, and those indices have skyrocketed with the multiple recent Fed hikes. So our cost of funds spiked as well. Meanwhile, the purchase yields on some of our existing investments still reflect the lower interest rate environment from the early part of 2022. This includes many of the agency pools that we still hold as well as many of the fixed-rate RTL loans that we originated before the rate hikes. The good news is that our RTL portfolio is very short in nature, with average lives of well under a year, but they do have fixed rate coupons, whereas the financing is floating rate. So there's a natural drag in our NIM in a market where interest rates are rising and yield spreads are widening, but that should be a short-term drag, since we are originating new RTL loans at yields that are often 200-plus basis points above the rates on the RTL loans that are paying off. So turnover in this portfolio should be a big boost to our NIM and our ADE in 2023. In addition, the contribution to Ellington Financial's ADE from the Longbridge segment was just $0.01 per share for the fourth quarter. The contribution was modest, mainly because of lower origination volumes. But as I mentioned, that was due to seasonal factors. Once spring comes, I expect Longbridge to start contributing to our ADE in a significant way. Keep in mind that while the fourth quarter appreciation in Longbridge's MSRs contributed to EFC's net income in the fourth quarter, that appreciation isn't factored into ADE. Another highlight of the fourth quarter was the completion of our fourth non-QM securitization of 2022 in December. We had originally intended for this deal to come to market in September, but securitization spreads were wide in September. So we decided to postpone the launch and instead keep those loans on balance sheet. That patience was rewarded as we were able to take advantage of a more constructive market in December to achieve stronger deal execution. I think it's important to understand how we have the flexibility to delay because this gets to a core tenet of our risk management. At EFC, we stress maintaining a diversity of borrowing sources as well as keeping extra borrowing capacity and liquidity available so that our hand is enforced. In this case, we didn't want to be forced to securitize these non-QM loans and lock in poor long-term financing rates just to get the loans off of repo lines. Our strong balance sheet and liability management enables us to be opportunistic about when we launch our securitizations. And in fact, by waiting, we estimate that we were able to price the AAA debt around 30 basis points tighter than what would have cleared the market in September. Looking at how this year has progressed so far, the securitization markets have continued to improve, and we were able to close another non-QM securitization earlier this month with even more attractive long-term financing costs. In fact, our blended cost of funds on this most recent securitization was even lower than our cost of repo. So we got that benefit in addition to all the important benefits of financing through securitizations. Combined, our last two non-QM securitizations have provided us with an incremental $406 million of nonrecourse, non-mark-to-market long-term locked-in financing. Finally, we continue to maintain a strong liquidity position during the fourth quarter. As you can see from our cash and unencumbered asset figures, and we were also able to access the preferred equity market earlier this month, which I'll discuss in my concluding remarks. And with that, I'll turn it over to JR to discuss our fourth quarter financial results in more detail.

J. R. Herlihy, CFO

Thanks, Larry, and good morning, everyone. For the fourth quarter, we are reporting net income of $0.30 per share on a fully mark-to-market basis and adjusted distributable earnings of $0.42 per share. These results compare to a net loss of $0.55 per share and ADE of $0.44 per share for the prior quarter. You'll notice some changes to our disclosures this quarter around the consolidation of Longbridge Financial. As Larry mentioned, we acquired a controlling interest in Longbridge Financial in October. And beginning with our fourth quarter results, we consolidate Longbridge. In the earnings presentation on Slide 5, you can see the attribution of earnings between Longbridge and our existing credit and Agency portfolios as well as corporate level expenses. And on Slide 29, you can see each strategy's contribution to EFC's adjusted distributable earnings. If you turn next to Slide 27, you can see the impact that the consolidation has on our balance sheet. Longbridge's largest business is the origination of home equity conversion mortgage loans, or HECM, which are insured by the FHA and eligible for inclusion in Ginnie Mae guaranteed HMBS pools. When issuing these Ginnie Mae HMBS pools, Longbridge retains the mortgage servicing rights and the servicing-related obligations that come with those rights. And even though these HMBS pools are sold to unrelated third-party investors, those sales transactions are not treated as true sales under GAAP. This is a well-known idiosyncrasy of the reverse mortgage industry. In any case, under GAAP, the HECM loans remain on balance sheet even after the HMBS pool is sold with the HMBS pool treated as a long-term financing of those HECM loans. Since July 2017, Longbridge has securitized roughly $9.5 billion of HECM loans into HMBS pools. Of course, many of those loans have paid off since origination. But as you can see here on Slide 27, Longbridge's GAAP liability associated with these HMBS pools stood at $7.8 billion as of December 31. Now that we consolidate Longbridge, we brought these GAAP liabilities onto EFC's balance sheet, and this more than doubled our total GAAP liabilities. This is the case, even though Longbridge's equity only represents a small portion of EFC's total equity, only about 10% at year-end. And that includes all of the reverse MSRs and loans that Longbridge holds on balance sheet. And in fact, EFC's recourse debt-to-equity ratio actually declined quarter-over-quarter after the Longbridge consolidation because, among other reasons, Longbridge itself had a lower recourse debt-to-equity ratio than the rest of EFC at year-end. As Larry mentioned, Longbridge generated strong performance for the fourth quarter as tighter yield spreads led to net gains on its HMBS MSR and HECM loans. EFC's results for the fourth quarter also benefited from a bargain purchase gain that resulted from the Longbridge acquisition. Because the transaction occurred at a discount to Longbridge's book value at the time of closing, and also because the fair value of our existing noncontrolling stake reflected that same discount to book value at September 30, the closing of the transaction generated a bargain purchase gain, which you can see on our income statement. Our Agency strategy also had a strong quarter as tighter yield spreads and increased pay-ups drove significant net gains on our portfolio, which, combined with net interest income exceeded net losses on our interest rate hedges. The credit portfolio had positive results as well, driven by net interest income, primarily from our proprietary loan portfolios and net gains, most notably mark-to-market gains on our non-QM retained tranches as well as that bargain purchase gain in the Longbridge acquisition. These gains were partially offset by net losses on interest rate and credit hedges and mark-to-market losses on certain equity stakes and loan originators and certain commercial mortgage-related investments. Finally, our affiliate originator LendSure was profitable for the fourth quarter and for 2022 overall, but the fair value of our stake in LendSure did not change meaningfully for the fourth quarter. Turning back to Slide 4, our portfolio summary. You can see that we are now showing the underlying holdings at Longbridge and towards the top of the page, we are listing the RTL and non-QM portfolio separately so you can see some more detail on our two largest portfolios. As of year-end, average market yields on the credit portfolio were significantly higher as compared to September 30. As Larry mentioned, the original purchase yields on many of our assets still reflect the lower interest rate environment that we had earlier last year. As we continue to turn over our assets, we expect that the gap between our purchase yields and market yields will narrow, and that should be supportive of our net interest margin in ADE. Turning next to Slide 6. During the fourth quarter, our total long credit portfolio decreased by 7% to $2.54 billion at year-end. The decrease was due to the closing of the non-QM loan securitization in December, significant paydowns in our small balance commercial mortgage portfolio that we did not replenish with new originations and because we no longer include our investment in Longbridge as part of the long credit portfolio. These factors were partially offset by a larger RTL portfolio. For the RTL, SBC and consumer loan portfolios, we received principal paydowns of $335 million during the quarter, which represented 19% of the combined fair value of those portfolios coming into the quarter. On the next slide, Slide 7, you can see that we reduced the size of the long Agency portfolio by 15% to $968 million driven by opportunistic sales and principal repayments. Slide 8 is a new one. Here, we illustrate the components of the Longbridge portfolio. At December 31, the Longbridge portfolio totaled $328 million and mainly consisted of reverse MSRs, unsecuritized HECM loans and proprietary reverse mortgage loans. For the fourth quarter, Longbridge originated $341 million across proprietary, about 85% through its wholesale and correspondent channels and 15% through retail. Please turn next to Slide 9 for a summary of our borrowings. Our weighted average borrowing rate increased by 107 basis points to 4.83%, driven by sharply higher short-term rates and a greater proportion of our borrowings secured by our loan and now our MSR portfolios, which carry higher borrowing rates than the Agency assets. Book asset yields for both our credit and Agency strategies also increased over the same period, thanks to portfolio turnover, though by a lesser amount than their respective cost of funds. Our recourse debt-to-equity ratio adjusted for unsettled purchases and sales declined to 2.5:1 from 2.6:1 in the third quarter as a result of a smaller investment portfolio as well as an increase in total equity. Also, as I mentioned, Longbridge's stand-alone recourse debt-to-equity ratio declined sequentially and was also marginally lower than the rest of EFCs at year-end. On the other hand, our overall debt-to-equity ratio adjusted for unsettled purchases and sales increased to 10.1:1 at year-end from 4:1 at September 30, driven by consolidation of Longbridge's HMBS-related obligations, which I discussed earlier. This increase was partially offset by the fact that we recognized true sale treatment on our fourth quarter non-QM securitization, which means those loans truly came off the books. G&A expenses increased due to the expenses associated with Longbridge's substantial operating business and investment-related expenses also increased as we now consolidate Longbridge's subservicing expenses and certain loan sourcing expenses onto our income statement. Finally, at December 31, our combined cash and unencumbered assets totaled approximately $495 million, and our book value per common share was $15.50, down 1.1% from September 30. Including the $0.45 per share of common dividends that we declared during the quarter, our total economic return for the fourth quarter was 1.8%. Now over to Mark.

Mark Tecotzky, Co-Chief Investment Officer

Thanks, JR. Over the first nine months of 2022, we had seen elevated volatility and that continued to be the case in October. In November and December, however, volatility came down considerably and interest rates ended the year significantly off their intra-quarter highs. Agency MBS, which had been the first sector to widen, was not surprisingly also the first sector to materially outperform hedging instruments, which we saw in Q4. You often see spread tightening and spread widening cycles for Agency MBS and credit-sensitive parts of fixed income that are out of phase with each other. We've seen this numerous times, most notably in late March 2020 when Fed buying of Agency MBS initially led to extreme outperformance for Agency to see credit sectors catch up and outperform Agency one or two quarters later. In 2022, we saw a different scenario play out. When money managers, pension funds and insurance companies need to raise cash quickly to meet redemptions or address other cash needs, they often sell Agency MBS first because MBS are liquid and these investors typically have large MBS holdings. This kind of selling is a negative technical for Agency MBS, and because prices for MBS are highly transparent, the underperformance these abrupt sales can cause are very visible to the market in real time. We saw this scenario play out for much of 2022 as selling that was concentrated in Agency was at least one of the reasons that Agency significantly underperformed many credit-sensitive fixed income sectors. But Q4 felt like an inflection point for the bond market and for Agency MBS specifically. Beginning in the second half of the quarter, money manager outflows stabilized and then turned into inflows and what had been a technical headwind for Agency MBS for much of '22, suddenly turned into a tailwind. And drove Agency outperformance for the fourth quarter overall. You can see that EFC's Agency strategy posted some very strong results as a result after three challenging quarters. Given the elevated risks of recession, we have been very focused on underwriting and closely monitoring performance of residential and commercial mortgage loans. So far, performance has remained strong. And given the size of our holdings, we have surprisingly few headaches to work through. Recently, there have been a lot of headlines about increased current expected credit loss or CECL reserves on commercial loans as well as some high-profile defaults on office buildings. CECL is not a concept that applies to EFC in the same way as it does for many others because we are already fully mark-to-market and always have been. So any credit reserves or impairments are automatically reflected in fair value adjustments, which flow through our income statement. But putting aside the CECL nuances, we are not seeing big performance issues in our commercial and bridge loan portfolio. Part of that is sound underwriting and appropriate LTVs, and part of that is property type concentrations. As you can look on Slide 10, you can see that less than 10% of our portfolio is in office, which is where many of the recent headlines have been concentrated. With more employees working from home, the economics for office buildings are challenging, especially with greatly increased costs of tenant improvements when replacing an existing tenant. Rising interest rates are predictably pressuring cap rates higher, and we don't think prices fully reflect that yet. Also with SOFR marching higher, debt costs have exceeded NOI on many properties. Of course, rising interest rates impact all sectors of the commercial space, but we think multifamily, which is more than 70% of our portfolio, will hold up the best in a recession. So far, we have very few headaches in our commercial mortgage bridge loan portfolio. We are watching things very closely, staying in very close contact with our borrowers and monitoring the progress on implementing their business plans. Thinking more about the dynamic where our recovery in Agency MBS sector leads to recoveries in other sectors by the end of '22, we have also seen a material recovery in non-QM liquidity and pricing. In fact, what happened to the non-QM sector overall in 2022 had many parallels to what happened in the Agency mortgage sector. Yields rose, so prices dropped, then bonds extended because prepayments slowed, so prices dropped even more, then spreads widened on the newer longer duration bonds, so prices dropped even more. We were by no means unscathed, but our disciplined cash management and focus on longer-term staggered financing arrangements was very helpful. We had ample repo capacity and ample cash to remain disciplined, and we were actively buying loans opportunistically that turned out to be very advantageous levels in many cases. Working with our financing team, we saw storm clouds potentially gathering way back in Q1 of 2022, and we added more repo capacity to both non-QM and RTL, both by adding new lenders and by increasing capacity on our existing lines. Eventually, by Q4, the non-QM sector was cheap enough relative to Agency MBS and other sectors to attract new capital to take advantage of the opportunity. First, insurance companies started buying, which drove securitization liquidity to improve. Then spreads started to narrow. We did one deal in Q4 and have done one deal so far in 2023. And now with securitizations and now with securitization spreads tight again and coupons and new originations very attractive, we have come full circle and it’s back to being a battle to buy loans. One thing I think will play out in 2023 for both Agency and non-QM is a big drop in loan volume, resulting from much slower new and existing home sales and almost no refinancing. Existing home sales dropped again this month for the 12 months in a row that hasn't happened since the '90s. Okay. So now for what worked and what didn't this quarter for EFC. I talked about the recovery in Agency, and we were well positioned for it as we came into the quarter with fewer TBA shorts than we typically hold, and we were able to make back a good portion of 2022's losses. Despite a reduced capital allocation, our debt strategy was a significant contributor to EFC's results in the quarter. If you look on Slide 6, RTL is now our largest credit portfolio. We grew that strategy significantly during the year. We added sellers, and we added dedicated staff and has been a great performer for us. In contrast to non-QM, the loans are so short that even in a rising short-term rate environment, any drags on NIM tend to be short-lived. And because the tenors of our repo financing closely match the expected maturity of the loans, we don't need to securitize so we aren't writing up and down with securitization spreads. At some point in the future, if economics are sufficiently compelling, we could opt to securitize these loans, but it's not at all necessary. With their short average lives, these loans are typically maturing before the repo lines mature and that gives us a lot of flexibility. We are watching performance here very closely. With home prices slumping, this is the first time that the RTL sector is confronting an environment where home prices are lower nationally at the time the builder is intending to sell the property as compared to when they bought it. That is a clear and obvious headwind. What have we done to protect ourselves? Well, we're focusing on lower loan-to-cost ratios, and we're favoring projects on more affordable properties and properties with lower cost renovations. We have an immense amount of data that we pour over every month, and we leverage that data in conjunction with our own origination experience in the business, information drawn from our boots on the ground as well as the analytics that are Ellington's specialty. Data is our North Star, and it helps inform our underwriting. For example, we've been reducing exposure in some areas, most notably certain parts of California, where some cities have seen price declines that are a multiple of what the declines have been nationally. We did see some weakness in our consumer business in the quarter, and we have been tightening underwriting there, too. If you look at the data, you can clearly see that consumers have been spending down their COVID savings given elevated inflation, so they are not as flush as they have been. So how is 2023 shaping up? So far, we are off to a good start. Liquidity and securitizations is much better, and we've had numerous financing counterparties reach out to us about growing existing and initiating new lending facilities. But home prices are still too high for many buyers given a 6.5% mortgage rate. We've seen a modest correction in the second half of the year, but not enough yet to bring housing affordability back to historical norms. And just as there were a lot of regional differences in HPA on the way up, you're seeing a lot of regional differences on the way down. We think some of the post-COVID high-flyer markets like, for example, we've have corrected 20% or more already. So being really granular in understanding home prices is crucially important now. Thanks to our originator stakes, we are well positioned to originate, generate gain on scale and securitize high ROEs. Given the short duration in equity cushions, our RTL portfolio has limited mark-to-market volatility. Our origination team is joined that they help with our capital markets desk, which allows us to lean in when markets are wide and pump the brakes when they tighten, but we have to keep a laser focus on performance and stay vigilant in our underwriting. Now back to Larry.

Larry Penn, CEO

Thanks, Mark. 2022 certainly had its challenges. We had to navigate periods of extreme volatility and market dysfunction with interest rates rising rapidly and yield spreads widening along the way. In the Agency MBS sector in particular, there was truly nowhere to hide. As you can see on Slide 24, our Agency strategy was responsible for more than half of our portfolio losses for the year, even though it only represented a small fraction of our capital allocation. But most importantly, we were able to largely avoid crystallizing mark-to-market losses in our credit portfolio. We were patient with our securitization activity, opportunistic with capital management and disciplined with hedging and leverage. We were able to limit our book value decline during the year. We maintained our dividend throughout, and we capitalized on the market volatility to add attractive assets and add origination market share, growing the credit portfolio significantly over the course of the year, while strategically downsizing our Agency portfolio. We took advantage of some extreme stock market sell-offs last year to repurchase our common shares at a big discount to book value. And then when markets rebounded, we efficiently raised capital through our ATM program to provide just-in-time capital to fund attractive investment opportunities. We also extended several loan facilities throughout the year, including in the fourth quarter. We acquired Longbridge, a top 3 reverse mortgage originator, at a very attractive level. And I believe that acquisition gives us huge upside as well as great synergies, including access to Longbridge's attractive loan pipeline. We really accomplished a lot last year. We closed out the year well. We entered 2023 with strong liquidity and a balanced portfolio positioned to drive earnings growth going forward. On last quarter's earnings call, we discussed our excitement about the ample investment opportunities in both securities and loans and also the opportunity for our loan originator affiliates to continue adding market share in a consolidating market. Earlier this month, we raised $100 million of dry powder in the preferred equity market to help us access these opportunities. Our newly issued Series C preferred equity, along with our existing Series A and B, carries the only NAIC-1 preferred equity rating in our sector. I believe that this rating rightly reflects Ellington Financial's effective risk management and long-standing protection of book value across market cycles, principles that are as important now as ever. Thanks to strong institutional demand for the offering, we were able to price the transaction at a similar spread to where we priced our Series B preferred in December 2021, which was priced in an environment where yield spreads on our targeted assets were much tighter. This new capital should allow us to take advantage of the tremendous opportunities that we are seeing across our diversified set of investment strategies. I expect our loan origination businesses to continue to provide much of the asset sourcing, and that now includes access to some new investment strategies such as proprietary reverse mortgage loans that are now available to us at the source as a direct consequence of our acquisition in Longbridge. I'm hopeful that the timing of our Series C preferred equity issuance will follow in the footsteps of other recent well-timed capital transactions for EFC, including our March 2022 issuance of $210 million of single A-rated senior unsecured notes. We priced that transaction inside a window of stability right before all the second quarter market turmoil. While I think EFC is known as a fast deployer of capital, we'll be as patient as we need to be, picking our spots as always within the wide range of sectors that we manage well. Once the proceeds from this preferred offering are fully deployed and as we continue to rotate the portfolio into higher reinvestment yields, we believe that the offering will be accretive to both earnings and adjustable distributable earnings and that both metrics will again cover the dividend. And with that, we'll now open up the call to questions.

Operator, Operator

Our first question comes from Eric Hagen with BTIG.

Eric Hagen, Analyst

I have a couple of questions. Regarding the 1.8x recourse leverage at Longbridge, does that apply to the origination pipeline or the MSRs? Can you clarify what that funding is supporting and the cost of funds, as well as how many counterparties you have for that funding? Additionally, in the residential transition loans, are you purchasing loans directly from brokers or from other originators who cannot hold the loans themselves? It would also be helpful if you could share some details about the credit characteristics, the profile, including the average balance and the LTV.

J. R. Herlihy, CFO

Eric. Okay. Let me tackle the first one. So on Longbridge, the recourse leverage we cite, so that has to do with the holdings at Longbridge, not the HECM loans that have been securitized, but it's really two major principal categories that HECM loans are waiting, securitization and other prop loans on balance sheet that are on these loan facilities and then the MSRs have financing themselves. So those are the three categories. The amount is summarized on Slide 9. You see $238 million of Longbridge recourse financing on the page. You divide that by the equity in Longbridge, the capital allocated to Longbridge, and that's where the ratio comes from.

Larry Penn, CEO

Yes. And buyouts don't represent a significant factor at all for Longbridge. Their MSRs are relatively new and young, I should say, and don't experience much buyout activity at all, right?

J. R. Herlihy, CFO

The weighted average borrowing rate was 7.86% combined on those portfolios at year-end, involving four or five counterparties.

Eric Hagen, Analyst

Okay. That's very helpful.

J. R. Herlihy, CFO

And the next question was?

Eric Hagen, Analyst

Resi transition loans...

Mark Tecotzky, Co-Chief Investment Officer

We do not purchase individual loans from brokers. Instead, we partner with several originators, some of whom we have an equity stake in, and others with whom we have long-established relationships. We are aligned in our approach to underwriting and property improvements. In terms of attributes, this market resembles non-QM, focusing on a specific loan-to-value ratio. One key metric for risk control in residential transition loans involves two loan-to-value assessments. The first is the loan to cost, which compares how much we are lending to builders against what they paid for the property, usually one that requires renovation to enhance its value. The second LTV is considered at loan origination, which reflects how much we are lending versus the anticipated value after repairs. Typically, we fund either the entire amount or a portion of renovation costs, and we assess the total debt extended to the builder in comparison to our expectations of the property's post-renovation value. A critical aspect we analyze monthly is how current property sales compare to our predicted as-repaired values. This product offers quick feedback since it involves shorter terms. For instance, we can see if properties sold above or at our anticipated values, and we can analyze this data regionally and by property size. As home prices are decreasing, it's likely they will continue to decline, with significant regional variations evident during both price increases and decreases. It is essential to focus on lending in areas with active housing markets since repayment is often dependent on property sales. Currently, we are observing a significant drop in existing home sales, which is another area of focus for us.

Operator, Operator

Our next question comes from Crispin Love with Piper Sandler.

Justin Crowley, Analyst

It's actually Justin Crowley, here for Crispin this morning. Looking at the credit and Agency portfolios this quarter, both experienced declines due to paydowns and other factors. You mentioned in the prepared remarks that there might be an inflection point on the Agency side. Considering that, along with the preferred issuance this month, I’m curious about where you see the most investment opportunities at the moment, how you expect the deployment of preferred to progress, and how you anticipate a wait-and-see approach fitting into that.

Mark Tecotzky, Co-Chief Investment Officer

Yes, I would say that while the markets are not as volatile as they were in Q3 and early Q4 of 2022, they still exhibit volatility. When markets are volatile, it's wise to invest at a more measured pace. There are times, like today, when markets experience sudden drops, providing opportunities for solid investments. This volatility and uncertainty regarding the Federal Reserve's interest rate hikes suggest a more cautious approach to deployment, as there is a higher chance of encountering advantageous investment options in such conditions compared to a stable market. Regarding the sectors we favor, we have seen significant paydowns in small balance commercial, and we are exploring new opportunities there since we believe it’s a favorable area. We anticipate getting chances to acquire nonperforming loans, which were a major contributor to EFC returns in 2010, 2011, and 2012, but supply has been limited recently. We expect that situation to improve. We have also discussed residential transition loans and the tightening of non-QM securitizations, and we see promising levered returns on retained pieces in that area as well as some QSIP opportunities. Moreover, now that we own all of Longbridge, we anticipate new opportunities that were not available to us previously. Larry, would you like to elaborate on that?

Larry Penn, CEO

Thank you, Mark. I'd like to add that this market is quite volatile, shifting between risk-on and risk-off sentiments. Today we see inflation remains a significant concern, which has been a persistent risk. We aim to maintain a balanced perspective. When it comes to raising capital, it's crucial to seize opportunities as they arise since such deals aren't frequent. We encountered an opportunity to execute a deal at a spread similar to December 2021, in a much tighter investment environment, which we felt we needed to take advantage of. As Mark mentioned, the market may experience sudden downturns, presenting us with chances to acquire more assets. Patience will serve us well as we prepare for potential non-performing loan (NPL) opportunities in commercial real estate, particularly with the ongoing distress in office and retail sectors. If capital is raised when spreads are wide, we'll end up raising at those higher levels; therefore, it’s best to capitalize when conditions are favorable. We're looking to take advantage of these opportunities at attractive spreads, and while we're prepared for the long-term with preferred equity, we'll proceed cautiously. There are various strategies at our disposal, like the Longbridge acquisition and new asset classes such as prop, which hasn't received much attention due to its small scale. Our main competitor in reverse mortgages is focusing on this area as well. With Longbridge's acquisition, we can now enhance our efforts in prop and integrate them into our balance sheet. We have numerous sectors to explore, and we’ll find the best opportunities. RTL continues to bring significant inflows, while the non-QM market fluctuates. We have the flexibility to either sell or securitize depending on the conditions.

Justin Crowley, Analyst

Okay, that's helpful. Considering the capital deployment strategy to leverage higher rates for increased ADE, what are your thoughts on ADE in relation to covering the dividend in the near term? Do you think it might take a few quarters given that funding costs remain high? I would like to hear your perspective on this.

Larry Penn, CEO

It's a great question. It really depends on how quickly we deploy our capital. We probably won't see any significant changes in Q1 due to the amount of capital we've raised, but that's not an issue. We have no plans to cut the dividend. We're looking at the long term and are confident we can cover it. Could the inflection point occur in the second quarter? Yes, it could happen then, but we aren't going to rush it. That would certainly be a good target to aim for.

Justin Crowley, Analyst

Okay. Got it. Helpful...

Larry Penn, CEO

The second quarter should be quite different for Longbridge as well. While I don’t want to imply that past performance guarantees future results, if we refer back to 2021, their net income for that year was over $30 million. So, we need to verify that, but it could significantly contribute to our core earnings, potentially starting in the second quarter. As I noted, there is a seasonal pattern, so in spring, we can expect to see strong origination income again from Longbridge in the second quarter.

Justin Crowley, Analyst

Okay, I understand. Shifting topics, you mentioned credit quality across the portfolio. Are there specific areas where you're noticing signs of stress and becoming more cautious? I know you've touched on the office portfolio and retail to some extent. Could you provide broad insights on the credit signs you are monitoring? Also, I'd appreciate it if you could elaborate further on the office sector and your predictions for how that asset class will evolve in the coming years.

Larry Penn, CEO

I'll let Mark take that. However, I want to stress that our portfolio, as Mark pointed out and as shown on Slide 10, has a strong focus on multifamily with minimal investment in office and retail. I can confirm the $30 million figure for Longbridge in 2021, but I believe we are not experiencing significant issues in those sectors that are facing challenges elsewhere in the market. Mark, please share your thoughts on the areas you believe will be problematic in the market.

Mark Tecotzky, Co-Chief Investment Officer

The first thing to note is that when we look at affordability, the cost for consumers and home buyers who are borrowing at near the Fannie-Freddie rates indicates that homes are not affordable. This could improve in a few ways: home prices might decrease—having already fallen about 5% from their peak, and in some regions, by as much as 20%. Alternatively, it could improve if mortgage rates decline or if incomes rise. Likely, it will be a mix of these factors. Currently, homes are generally unaffordable for most, contributing to the decline in sales numbers. We need to be cautious and protect ourselves through careful loan-to-value ratios and by investing in sectors likely to perform better, while also adapting to market changes. We launched our non-QM initiative back in late 2014, and after several years of steadily increasing home prices, the situation has shifted dramatically. Focusing on credit risk has become essential. On the commercial side, for stable properties with long-term fixed-rate loans, the outlook is more optimistic. However, our portfolio primarily consists of floating rate debt. Although we're seeing higher note rates, this can create burdens for borrowers when their debt costs exceed their property income. This imbalance may necessitate corrections, which could arise from rising rents in multifamily housing, declining SOFR rates, or decreasing property values. It’s imperative to remain vigilant of these risks. We are proactively assessing potential housing shocks by examining how much fluctuation in home prices our credit risk transfer bonds can withstand, basing our preparations on past scenarios where prices fell significantly. The consumer landscape is also evolving; borrowers initially increased their savings during COVID but are now depleting them. We've observed a rise in used car prices, leading individuals to finance older vehicles with lengthy loans, which could lead to higher delinquency rates especially in the subprime sector. While these trends pose risks, they also present opportunities. A balanced market with no significant challenges produces tighter spreads, but as we are currently in a more variable environment, there will be numerous investment opportunities. A motivation for our recent preferred deal was to secure capital in a more stable market, enabling us to face reasonable borrowing costs. We believe we are now positioned to take advantage of forthcoming market dislocations.

Justin Crowley, Analyst

Okay. I appreciate that color. And then sort of taking that and looking at multifamily, which has been a pretty resilient asset class and squaring that with some of the home affordability hurdles that you mentioned. Do you see demand starting to pull back just given cap rates compared to that cost? Or are some of those other factors as far as single-family homeownership? Do you anticipate that continuing to lend support to the strength of multifamily?

Mark Tecotzky, Co-Chief Investment Officer

One aspect of our strategy in the multifamily sector is that we have not focused on Class A properties. Instead, we primarily deal with Class B and Class C workforce properties, with rents ranging from $600 to $800. The reason we favor this market is the significant shortage of affordable housing in the country, which creates both a need and a demand for lower-cost apartments. There is very little new construction in this segment. The year 2023 is notable because there will be an influx of multifamily construction, but it will mostly be aimed at the higher end of the market, as developers are not building units for $700 rent. Consequently, we are providing loans on Class B multifamily properties at a lower valuation compared to replacement costs, which gives us a safety cushion. Buyers of these properties are acquiring them at market prices significantly below the cost of new construction. Thus, we believe this offers us a double layer of protection. While I anticipate that some operators may struggle to increase rents as they initially expected, especially as rates rise since they secured their loans, it’s our responsibility to assist them through these challenges. This shift in rates is significant, and we all anticipate facing difficulties, including us. However, I believe that our challenges will be minor compared to the substantial opportunities that this market is offering us.

Operator, Operator

Our next question comes from Trevor Cranston with JMP Securities.

Trevor Cranston, Analyst

You guys mentioned the potential opportunity to add more in the proprietary reverse mortgage space after the acquisition of Longbridge. Can you elaborate a little bit on what the terms of the proprietary reverse loans look like compared to the sort of standard Ginnie Mae product and how you guys would look to sort of utilize the financing structure around investments in that space?

Larry Penn, CEO

Yes, it's quite straightforward. These loans are generally fixed rate and have wider spreads compared to the HECM product. They can be securitized, but we would likely wait until we achieve a certain scale before proceeding with that. The primary reason a borrower might choose a proprietary loan over a HECM loan is the loan size. From an underwriting standpoint, the loan-to-value ratios will be significantly lower than those on HECM products. HECM loan-to-value ratios are determined by the principal limit factors set by the FHA, which specifies the loan-to-value they will guarantee. In the proprietary sector, we have greater flexibility, allowing us to adopt a more conservative approach to loan-to-value ratios. Overall, it's quite similar to the fixed rate product seen in Ginnie Mae securities.

Trevor Cranston, Analyst

Got it. Okay. And then on the book value update you guys gave for the end of January. I was just curious, credit spreads and Agency spreads seemed to have done pretty well in January. So I was wondering if you could maybe provide some color around sort of what drove the kind of flat book value performance over the month.

Larry Penn, CEO

Sure. The Agency and non-QM segments performed well this month. We announced a $0.15 dividend, which will be deducted from our figures. We were also active in the ATM, contributing to some dilution reflected in the $15 a share. However, once you account for that last adjustment, it lines up closely with the dividend amount.

Operator, Operator

That was our final question for today. We thank you for participating in Ellington Financial Fourth Quarter 2022 Earnings Conference Call. You may disconnect your line at this time, and have a wonderful day.