Ellington Financial's (EFC) CEO Larry Penn on Q2 2016 Results - Earnings Call Transcript

| About: Ellington Financial (EFC)

Ellington Financial LLC (NYSE:EFC)

Q2 2016 Earnings Conference Call

August 05, 2016 11:00 AM ET

Executives

Maria Cozine - IR

Larry Penn - President & CEO

Lisa Mumford - CFO

Mark Tecotzky - Co-CII

Analysts

Steve Delaney - JMP Securities

Douglas Harter - Credit Suisse

Jessica Levi-Ribner - FBR Capital Markets

Eric Hagen - Keefe, Bruyette & Woods

George Bahamondes - Deutsche Bank

Brock Vandervliet - Nomura Securities

Robert Martin - Echelon Partners

Jim Young - West Family Investments

Operator

Good morning, ladies and gentlemen. Thank you for standing-by. Welcome to the Ellington Financial Second Quarter 2016 Financial Results Conference Call. Today's call is being recorded. At this time, all participants have been placed in a listen-only mode and the floor will be opened for your questions following the presentation. [Operator Instructions] It is now my pleasure to turn the floor over to Ms. Maria Cozine, of Investor Relations. Please go ahead ma'am.

Maria Cozine

Thanks, Crystal. Before we start, I would like to remind everyone that certain statements made during this conference call may constitute forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical in nature.

As described under Item 1A of our Annual Report on Form 10-K filed on March 11, 2016, 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 have on the call with me today Larry Penn, Chief Executive Officer of Ellington Financial; Mark Tecotzky, our Co-Chief Investment Officer; and Lisa Mumford, our Chief Financial Officer. As described in our earnings press release, our second quarter earnings conference call presentation is available on our Web site ellingtonfinancial.com. Managements prepared remarks will track the presentation. Please turn to Slide 4 to follow along.

With that, I will now turn the call over to Larry.

Larry Penn

Thanks, Maria. And welcome everyone to our second quarter 2016 earnings call. We appreciate you are taking the time to listen to call today. On our first quarter earnings call back in May we described the current positioning of our credit portfolio as broadly speaking, long consumer credit risk and short high yield corporate credit risk. During the second quarter, we maintained our credit hedges, which are still primarily composed of short positions and high yield corporate bond indices. Our view remains that consumers will have had to adapt to more stringent lending standard since the financial crisis are a much profitable credit as compared to many high yield corporate borrowers vulnerable to a variety of genuine risks such as an economic downturn, a weakening commodity or energy prices.

During the second quarter, assets in both our credit and agency strategies performed well. In particular, we continue to be pleased with our performance of our loan portfolios, which have been growing at a healthy rate under our flow agreements. We believe that the strong combination of our securities portfolio which offers not only yield but also the ability to generate trading gains. And our high yielding consumer and mortgage loan portfolios which provide a steady flow of sustainable income creates a potentially powerful earnings opportunity for shareholders. As Mark will elaborate on later an overarching theme of many of these opportunities is that the banks are no longer willing or able to participate in certain sectors like they once could.

While our credit hedges did cost us money in the second quarter, the market reaction to the Brexit vote is a good example of why we have these hedges in place. We believe that many credit markets remain vulnerable to a whole host of exogenous shocks. And at the post crisis structural changes in these markets such as the increase in dominance of daily liquidity mutual funds and the constraints on banks holding large risk inventories, increase the likelihood of exaggerated downward moves. We are confident that the fundamental value on our loan portfolio with its concentrations in legacy securities and consumer and mortgage loans will greatly outperform our credit hedges in a large downward move in global credit.

Consistent with this thesis, our credit hedges performed extremely well immediately following the Brexit referendum vote as corporate credit spreads widened dramatically, it initially appeared that investors were concerned that Brexit could serve as the catalyst for a major global credit event. However, as central banks quickly reacted to the ensuing market fallout, and promised further accommodations in monetary policy, the herd reversed course and credit spreads snapped back even past where they had been pre-Brexit. The net tightening and high yield corporate bond index spreads over the course of the quarter led to net losses on our credit hedges.

We believe that many investors are actually extremely vary of the fundamentals of high yield corporate bonds, but because there are very few sources of yield available due to the negative interest rate policies of global central banks, they have piled into riskier asset classes such as high yield credit just to meet unrealistic return targets. Maintaining a disciplined hedging strategy has served us well over many market cycles including even 2007 and 2008 when we preserved our book value. That being said, the size and composition of our hedge portfolio may change. We continually evaluate position and our goal is to be thoughtful and adaptive in reaction to changes in global markets.

Overall, EFC produced positive performance in what was a challenging quarter of historic volatility for markets globally. Growth in our consumer loan portfolio contributed substantially to our success this quarter, and later on the call today, I'll provide more detail on the strategy reallocation of capital within our portfolio and how our long-term business plans are unfolding. With that, I'll turn the call to Lisa who will provide more detail on our financial results for the quarter.

Lisa Mumford

Thank you, Larry and good morning everyone. On our earnings attribution table on Page 4 of the presentation, you can see that in the second quarter our credit strategy generated growth income of $6.8 million or $0.20 and our agency strategy generated growth income of $3.2 million or $0.10 per share. After expenses of $5.1 million or $0.15 per share we had net income of $5 million or $0.15 per share. Within our credit strategy, we had solid contributions from our assets in the form of interest income and net realized gains, net of financing costs and investment related cost, but losses on our credit and interest rate hedges suppresses our results.

On a quarter-over-quarter basis, our interest income and other income increased approximately 4%. We have increased interest income from our loans specifically our consumer and non-QM residential loan portfolios which each grew in size. The increase in interest income from our loans was partially offset by decreases in interest income from our non-agency RMBS and distressed corporate debt, as those portfolios declined in size. Excluding the hedging side of the portfolio, we had net realized and unrealized gains in the second quarter of 841,000 as compared to net realized and unrealized losses of $5.4 million in the first quarter.

The big driver here was lower mark-to-market loss this quarter-over-quarter with the bulk of this positive variance coming from our distressed corporate loans, non-agency RMBS and CMBS, generally tighter spreads for the these asset classes relative to the first quarter led to these improvements. We also had increased net realized gains in the second quarter and this increase was principally due to sales of our non-agency RMBS, as well as sale of REO related to our small balanced commercial mortgage loan portfolio.

Our credit hedges suppressed our results for the quarter as most of these hedges are in the form of credit default swaps and other instruments referencing high yield corporate bonds indices. The net spread tightening that occurred during the quarter on high yield corporate debt indices had a significant impact on our results for the quarter given that we hold a net short position. Also impacting our credit results for the quarter were declining interest rates which led to losses on our interest rate hedges which are principally in the form interest rate swaps.

On a quarter-over-quarter basis borrowing costs increased for our credit strategy driven by an increase in the proportion of our credit portfolio borrowings related specifically to our loan portfolio. As of the end of the second quarter repo and securitized debt related to our loan portfolios represented approximately 52% of our outstanding credit related borrowings, while as of the end of the first quarter debt related to our loan portfolios represented 47% of our credit related borrowings.

As of June 30th our debt related to our loan portfolios have a weighted average borrowing rate of approximately 3.24%, where as our repo debt on our securities portfolio including our non-agency RMBS had a weighted average borrowing rate of 2.27%. During the second quarter, our interest expense included expenses related to the upfront cost of establishing our loans and securitized debt related facilities. Our agency RMBS portfolio produced solid results for the quarter as yield spreads were much more stable than they had been especially relative to the last few quarters.

In the second quarter our interest income included the impact of a $1.5 million negative catch-up premium amortization adjustment related to increased expected prepayment activity given the drop in mortgage rates. In the first quarter this adjustment was a positive amount of 400,000. Of course these negative and positive adjustments to our interest income do not affect our net income for the quarter, since their impact is offset in net realized and unrealized gains or losses.

Also contributing to this decline in agency RMBS interest income was a drop in our average holding quarter-over-quarter in the amount of approximately 40 million, excluding the catch-up premium amortization adjustments quarter-over-quarter the weighted average yields on our agency portfolio declines from 3.04% to 3%. Our agency related borrowing rates has increased steadily since the second half of last year, however during the second quarter repo rates were relatively stable and repo financing has remained readily available.

Quarter-over-quarter our expenses were flat at $5.1 million although our annualized expense rate still increased from 2.8% to 3%. During the quarter, our share repurchases were $0.02 per share accretive to our diluted book value per share and since the end of the second quarter our continued repurchases has resulted in another $0.01 per share accretive benefit. We ended the quarter with a diluted book value per share of $20.31 down from $20.63 as of March 31, 2016 a decline of 1.6%.

I'd like to now turn the presentation over to Mark.

Mark Tecotzky

Thank you, Lisa. This is a quarter of mixed results for us. On the positive side the performance of our assets was strong and we continue to see further development and maturation of our platforms to deliver high yielding assets to the company, but the cost of credit hedges muted our gains. In the second quarter the credit markets were a tug of war between two competing forces the Brexit vote and concerns about slower global growth argued for wider spreads, but Central Bank QE in response to these concerns lifted and stabilized financial assets. It was also a quarter where more liquid sectors outperformed less liquid ones. In the face of volatility where price discovery is more opaque, more liquid assets and indices attract capital because of their transparent pricing. In addition with macro events dominating the headlines correlations between asset classes were high and fundamentals within asset classes took a back seat.

While in the long run this dynamic creates relative value opportunities, it did serve as a headwind this quarter. While our results were constrained by losses on our hedges and led the reduction in our non-agency RMBS portfolio to continuing shift of our portfolio to less macro sensitive assets and the post Brexit credit widening reduced the magnitude of our credit hedges during the quarter. You can see that on Slide 15 that our overall credit hedge portfolio was reduced substantially. However the surprise Brexit vote and more recently the weakness in oil prices serving as a reminder that macro volatility is still with us. Our incremental investment dollars are generally going to higher yielding strategies and even with some potential drag from credit hedges our portfolio can generate a healthy yield.

We show this on Slide 10, you can see it is a combined impact of higher yields on our assets together with lower implied yields on our hedges short positions has made the yield spread differential between the two the widest we have seen in some time. We continue to believe this structured credit is a much better fundamental credit risk than high yield. So we keep credit hedges in place. Since quarter end we have seen improved prices on our credit portfolio as the relative stability of the last month now has many investors focusing on cash investments over indices. The recent positive technical development in non-agency RMBS is the country wide sentiment, which flows through the deals in the end of June and returned $8 billion to investors, much of which we believe will be reinvested in structured credit further supporting prices in that sector.

In our view is that the spread gap shown on Slide 10 is unlikely to persist. We expect that either assets will get priced to lower yields or our hedges will get priced at higher yields. This conviction is rooted in our view of the strong position of the U.S. consumer, consumer balance sheets have benefitted from substantial home equity build up since 2010 coming from two directions, strong home price depreciation and declining debt load. Turn to Slide 12 to see portfolio evolution, one trend we have been focusing on for the last several years it's how QE is flooding the market with capital would drive down yields in any area of fixed income that was big liquid and could absorb large capital flows. So not surprisingly we now have a market with tight corporate spreads, tight high yield spreads and low long-term treasury yields.

In our non-agency portfolio with its small investment sizes, idiosyncratic deal waterfalls and inconsistent volumes, yields have come down but still remain attractive because these hurdles deter large scale capital inflow. In the response to trend of lower yields in response to QE for the past few years we are focused on building an investment pipeline in sectors that have significant barriers to entry. Those efforts are starting to be source of significant asset flow, take our consumer loan strategy which grew in the quarter. These investments come in through a forward flow agreement they are difficult and time consuming to replicate and require a lot of infrastructure to execute.

Our small balance commercial mortgage loan purchase required very specific investment expertise in addition to broad based commercial real estate understanding. The same is true with our RPL, NPL loan purchases in the U.S. and Europe. Having created not only an investment pipeline, but also infrastructure to buy these high yield assets is very valuable to the Company because these sectors can maintain their yields even in the face of easy money from central banks, there was a barrier to entry for other investors and these sectors cannot be commoditized.

The non-QM consumer loan opportunities exist because the regulatory and capital burden on banks has led them to stop lending to all but the most pristine borrowers. Many of our non-QM borrowers have FICOs well into the 700s but they don't fit neatly into Fannie/Freddie box. Pre-crisis banks extended credit to these consumers bank but post-crisis after writing 100 billion in legal settlement checks banks have exited the business. EFC with permanent capital and a flexible hedging strategy is well suited to fill the void. Pre-crisis many borrowers could meet short-term borrowing needs with a second lien mortgage or a cash-out refinancing.

Post-crisis only the pristine consumers’ credit can get an ELOC from a bank. Here to, EFC can fill the void by stepping up to support borrowers that aren’t quite good enough for the big banks. With Ellington's experience and expertise in the credit investor entering these lending markets is a great opportunity for the EFC to secure proprietary pipeline of assets and create franchise value at the same time.

Turning to Slide 12, the portfolio did contract some in the quarter as we sold some non-agencies with a plan to deploy the proceeds into higher yielding sectors. Our non-QM effort is building momentum, and we project a healthy supply of consumer loans in other pipeline assets for the quarter so we're focused on continuing to increase our portfolio yield. In our agency portfolio we had a very strong quarter despite a drop in interest rates has brought mortgage rates to the lowest levels in the years and caused material increase in prepayment speeds agency mortgages are well bid benefiting from strong overseas demand. We came into this rate move with a lot of prepayment protection which is helping us keep higher coupon pools on the books.

Hedging costs have dropped a lot both in swaps and TBAs so we see a very healthy net interest margin right now. We trimmed the portfolio some as we harvested some gains, but we held on to much lower prepayment protection which is continuing to appreciate post-quarter end. Going forward I am confident that the yield in our structured credit portfolio can deliver cash flows supportive of our dividends. Our diversified suite of strategies allows us to cast a broad net for investment that meet our yield targets, despite the move to lower yield in many parts of fixed income.

Ellington brings significant resources to the task build with over 160 people, research teams, proprietary models and strong risk management. We think the big yield-gap between the assets and credit hedges should allow us to perform in both risk-on and risk-off moods. We're trying to construct a portfolio that can simultaneously deliver healthy dividends, but with substantial downside protection should spreads widen as they did back in February or post-Brexit. We cannot be complacent and assume that any spread widening will be quickly reversed.

Going into the quarter, we were sufficiently concerned that credit spreads could widen that we thought it is prudent to protect the portfolio. As it turned out a big spread widening did not occur but the macro landscape is still a volatile one with so many assets dependent upon central bank QE. You need to only consider the $10 trillion in bonds that yield less than zero to realize that QE has had a profound impact on many asset prices. We are constructive about our earnings potential going forward, focusing on assets with sound credit fundamentals and a high enough yield to support our dividends which we view is significantly higher than other investments with similar risks.

Now, I'll turn the call back Larry.

Larry Penn

Thanks Mark. Last quarter, we spoke about our progress in building a proprietary investment pipeline in consumer loans, non-QM mortgage organization and distressed commercial mortgage loans. Our portfolio is becoming more simplified as we are reducing some other strategies in favor of yet others that view as having greater long-term sustainable growth, and more predictable earning streams. We believe that this will also provide shareholders better visibility into EFC’s business model and long-term performance expectations.

Consumer loan and ABS performance was a key driver of EFC’s earnings this quarter. In the second quarter, the size of our consumer loan portfolio increased to $152 million, which is now 27% of our total portfolio and now even if that is large as our non-agency RMBS portfolio. Our expectation is that the size of this portfolio will increase meaningfully going forward, as it is performing well and within our models’ expectations. Increased loan flow in the near-term will likely come from the existing strategic partnerships we have already made, as the performance of loans made to-date from these originators has met or exceeded our expectations. Additionally, we expect to begin permanently financing this business to reach securitizations which will be accretive to returns and portfolio performance and which will free up capital to reinvest even further in the strategy. As the size of our consumer loan portfolio grows it could become more and more instrumental in producing steady and sustainable income for our shareholders.

The pace of purchases from our non-QM mortgage pipeline is promising, as evidenced by the portfolios growth this quarter to $39.4 million. Post quarter end we purchased an additional $10 million of non-QM mortgages in July and expect to see another 10 million plus of purchases for August. Performance on our non-QM mortgage portfolio has been excellent so far, and as the pace of originations picks up we hope that this business will become a steadily growing part of our overall strategy.

Although the securitization markets are not yet open for us in non-QM mortgages, we believe that as origination eventually picks up securitization pricing may fall in line in which case securitization could be a part of our long-term strategy. Meanwhile they are earning an attractive spread between a yield on our non-QM mortgage portfolio and the cost of funds of our non-QM financing line. It is our view that the continued excellent performance nationwide of the small but growing non-QM mortgage space will open up the securitization markets down the road.

Looking ahead into the second half of 2016, our goal is clear, which is to continue to focus on executing on long-term business plans including strategically reallocating capital into those strategies we find most compelling. Last quarter I mentioned that at some point soon we may start comparing ourselves to the REITs and more accurately described as a highly diversified specialty finance company. This quarter with the further growth of our proprietary loan pipeline we are getting closer to that point. If you take a look at Slide 13, in the presentation you can see in the pie chart on the right that RMBS at the end of 2013 was 82% of our credit portfolio. The pie chart on the left illustrates just how much we have reshaped our business model.

Additionally on Slide 14, you can see that the average yield of our credit portfolio increased to 10.3% for the second quarter from only 7.29% at yearend 2013. As the opportunity set is changed Ellington has evolved as well to take advantage of the new opportunity set and market dynamics. While the price to book ratio of our stock has risen from 77% at the beginning of the year to 86% as of yesterday, it has still been trading at a significant discount to book value. In light of this discount we continue to execute under our share repurchase program announced last August. Including post quarter end repurchases, we have repurchased to-date under the current program a total of 821,810 shares at an average price of $17.29 for an accretive effect of about $0.09 to our book value per share. As our stock trades at higher price to book ratios, share re-purchases become much less attractive to us less accretive for our shareholders. And as a result we have recently reduced the pace of our re-purchases. Going forward our share re-purchase strategy will continue to be opportunistic.

Ellington Financial seeks to create lasting value for shareholders through strategic portfolio allocation and disciplined hedging strategies. Our structure provides us great flexibility that allows us to invest in assets like select consumer loans, that we think have some of the greatest performance potential in this market. Although the low to negative interest rate policies of central banks are weighing on investors globally as they search for sources of yield. The consumer stands the benefit from lower interest rates. At the same time we recognize the important and prudence of maintaining a hedge, against significant yield spread widening, as well as the necessity of being active in a diverse array of sectors. This view has served Ellington well over the 21 plus year history of enduring market cycles and is one that we believe we will continue to drive returns going forward.

This concludes our prepared remarks and we are now pleased to take your questions, operator?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Steve Delaney from JMP Securities.

Steve Delaney

Larry, over the last couple of years, Ellington has made some strategic equity investments in platforms. And I was curious if any of those investments are yielding you some of this flow in these diversified credit products that are now coming on the balance sheet. Is there any sort of correlation between the relationships where you became a strategic partner in the actual flow of paper coming onto your balance sheet, is really the question. Thanks.

Larry Penn

Yes, so far it's really just been in the non-QM product. And in the other sectors, I would say no, nothing, nothing significant yet. No, I -- yes, I'd rather not speculate in terms of going forward. But we are hopeful that some of those in particular will be approved of saving for any assets?

Steve Delaney

And the NQM, is that -- I believe one of the platforms was called Skyline. Is that correct?

Larry Penn

No -- no actually hold on one second. No LendSure actually is the [Multiple Speakers].

Steve Delaney

LendSure, okay, thank you. And on that end, when we go to NQM, and I know there's a lot of confusion in the market about the difference between NQM or non-prime or Alt-QM. It's a pretty vague -- any that's not conforming Freddie/Fannie, I guess, is getting thrown in a bucket. I'm just curious if you guys paid much attention to that Caliber Homes securitization, and is that -- they define those loans, I believe, as nonprime, or the rating agencies did. Was there anything meaningful in that transaction as far as the opportunities that your current NQM flow program might provide you, going forward?

Mark Tecotzky

So yes, the pricing on that deal was a little bit stronger than what we saw on the two non-QM deals that price in December of 2015. So I think that’s a good sign, where we look at that pricing compared to where we have repo in place, the repo right now to us still looks a little bit more attractive, but -- so that field garnered significant demand and the pricing was tighter, so it's moving in the right direction.

Larry Penn

Yes, these assets are performing well I think all across different origination platforms, it's still small obviously but I think that as people see its track history, its track history is getting better and better in terms of longer and longer in terms of good performance. I think that the securitization markets are going to tighten up more I can tell you how long that's going to take, but that’s kind of our plan as to hold the product until we can get that really execution in the securitization market.

Steve Delaney

Got it, okay. And your financing facilities allow you to do that because you would probably have to get up to what, a couple hundred million, $300 million, to be efficient in the securitization?

Larry Penn

Yes I think you can do something smaller than that. I think the transactions at the end of last year were all smaller than that. You have to [Multiple Speakers].

Mark Tecotzky

But there is nothing about our financing arrangements to that sort of -- a lot of warehouse lines have finite gestation periods things like that. We're not -- that's not the case for us.

Steve Delaney

Okay. And your consumer loans, I can see on Page 14 that your coupons are over 10%, or at least your yield is over 10%. So I assume that those are installment -- fixed pay installment-type loans. What is the average term of those loans?

Mark Tecotzky

They range between a 1.5 and 5 years I think you have to just probably right around 4 years and you are right it is amortization they are not -- so they pay down pretty at a pretty healthy rate just from the amortization.

Steve Delaney

Which obviously feeds nicely that structure those loan terms would feed nicely into an ABS deal, right?

Mark Tecotzky

Yes, that's exactly right.

Steve Delaney

Because you would have a sort of a defined duration of the security, okay. I guess, well, thank you for the comments.

Operator

Our next question comes from the line of Douglas Harter with Credit Suisse.

Douglas Harter

Thanks. As you're growing the non-QM loans and the consumer loans, which are less liquid, does that change the hedging strategy or the amount of hedges against liquid indices that you would put on? How do you think about that?

Larry Penn

Yes, so each asset, each asset class we believe has a different correlation and we're focused on big moves, right. A different correlation and a big move especially a big downward move in credit, so absolutely that informs our hedges and in fact you saw last quarter that as we were selling non-agencies and some of the distressed depositions things like that, that we were reducing hedges accordingly and some of the portfolios for examples like the consumer credit portfolio and things like have a less of a correlation in a big downward move. So yes that will definitely -- you definitely should see changes in the size of that credit hedge as the portfolio continues to shift.

Douglas Harter

And then I guess also, how do you think about, right -- I would imagine that the loans are -- or do you mark-to-market the loans and the non-QM loans? And does that change the way you think about hedging from a book-value perspective?

Larry Penn

Absolutely we mark them to market and absolutely we are concerned with changes in market value that's what our hedges are there to protect this book value so yes.

Douglas Harter

Okay. And I think you correct me if I'm wrong you said you're doing around $10 million a month right now in the non-QM loans?

Larry Penn

Yes that is about right yes.

Douglas Harter

And what is the rough pace on the consumer loans?

Larry Penn

Well I think we -- right we have the increased but that includes yes that is a net number. I don’t have that number for you now. Sorry.

Douglas Harter

Well, what was the, I just don't have it in front of me what was the amount that you added during the second quarter? And is that an appropriate run rate level?

Lisa Mumford

Right about 10 million [indiscernible].

Larry Penn

Yes, net of pay downs.

Lisa Mumford

Right.

Larry Penn

I mean terms of our -- the flow that we're seeing from all the originators that we have that is definitely going up. There is no question about it so.

Lisa Mumford

Yes I mean they are amortized a bit more fit, some of them are 1.5 and 2 years so they are starting to amortize as well.

Larry Penn

Yes, I mean one question that we are always discussing right is where do we want that slice of the pie chart to end up? So that's it's been increasing it's not going to increase intimately at some point they are going to say this is a good allocation in terms of the overall portfolio. I'm not now prepared to say where that could end up, but that's something that we discussed and are always thinking about, so it's not like this slice to the pie is just going to maybe just continue to increase at indefinitely at the expense of the other at the other things that we do as well go ahead Mark.

Mark Tecotzky

Yes, I just want to add one point that it's for the reason Larry said that there is a maximum amount of our capital we put in the strategy that the securitizations important because the securitization allows us to take a block of loans retain a what were our expectation would be a high yielding residual and then clear out some balance sheet to buy more loans and do the same thing.

Larry Penn

So, if we do a securitization right then we would expect that now the way that they will show up in our financials will depend upon whether we account for that investment on a consolidated basis and show all the loans on our balance sheet or whether we don’t and we just show the equity investment if you will in the lower rate of the pieces of that securitization. So in terms of how that shows up actually on our scheduled investments or whatever that might vary but of course the idea is that by doing securitizations we will be able to increase the exposure our overall exposure to the sector without increasing our capital base I mean it's essentially increasing our leverage but it's long-term locked in leverage so -- and you see the yields in the stuff so that can really-really boost our ROE even if we maintain the same capital allocation.

Douglas Harter

Got it. And then just to be clear, on the Slide 14 where you show the yield, is that a loss-adjusted yield for the loans?

Larry Penn

Yes.

Lisa Mumford

Yes.

Douglas Harter

Okay, thank you.

Larry Penn

Yes, that was absolutely and that is net of servicing cost and all that. The -- and kind of I think Mark mentioned that Slide 10, and I just want to reemphasize if you look at Slide 10 as the way we look at things in terms of long-term we like the overall position that we have those yields on the loan portfolio are loss adjusted and yields on this high yield index which is a pretty good proxy for our short portfolio are not loss adjusted right so we believe that the actual spread is actually is wider, even, than what's on this graph on Slide 10.

Operator

Your next question comes from line of Jessica Levi-Ribner with FBR Capital Markets.

Jessica Levi-Ribner

On the consumer loan side, right now the portfolio has about an above 10% yield. Is that, do you think, sustainable over the next several quarters, especially given where Treasuries are trading, and then your comments about overall yields in the market?

Mark Tecotzky

Yes that’s a good question, this is Mark. I think over the next several quarters exceptionally sustainable because that strategy has gotten the big boost from some of the turmoil that has impacted LendingClub. So our partners -- LendingClub raised the rates they are offering consumers and some other names in the space did as well. And so our partners were able to do the same in addition to tightening up guidelines a little bit. So over the short run yes, I think that yields could even increase. Now over the long run I think that you are definitely going to see your products out there that are collateralized by mortgages the way you see a lot of second liens, the way saw the a lot of home equity lines of credit pre-crisis. I think you will see some of mortgage platform start to more aggressively market those products which can compete because then there is tax advantage for the borrower as opposed to the unsecured consumer loans. It doesn’t have tax advantage but that could be few year it is hard to predict, but over the short run yes I think the yields could actually increase.

Larry Penn

Yes. And this is sort of I think the beauty of a lot of the sectors where we are now emphasizing greater is that the yields that are available there as market conditions change are definitely more inelastic than a lot of other products that absolutely are swept down. So if you look at agency mortgage yields obviously that’s very, very tied to treasury rates and I things like that. But when you look at the non-performing loans that we buy which for example in the commercial mortgage space are on -- they're idiosyncratic. They are on particular commercial properties and with unique circumstances than in order to be able to have this strategy you have to not only have a good work out strategy and be able to assess the value of the underlying real estate you also -- you need to understand the legal risks there is just a lot of these asset classes the consumer loans as Mark mentioned that is where the yield movements are just not going to be as elastic as they are in other sectors, so I think it actually helps us, because our funding costs are tied obviously to market interest rates.

Jessica Levi-Ribner

Okay. And then just more broadly in the non-QM market, what kind of market trends are you seeing? Are there more non-QM loans being originated less because the banks are under more pressure from the regulators? How do you think about that, and maybe also talk a little bit about the demand for non-QM product.

Larry Penn

That is a good question, so I would say that just from our own platform we've been growing and hiring, so our volumes have been increasing but I don’t know if that's emblematic of an increase in volume across the industry or it's just our platform has gotten bigger. If you look at the overall origination volumes relative to the agency market, there is still attributable. The agency market will probably have organization volumes this year of 1.4 trillion, right. So non-QM is just, it's so small, so I think it will grow. I think a lot of the non-QM origination is purchased and new home sales have been relatively slow. So think you can see growth in new home sales increase. From the demand side, I think there is pretty broad-based investors demand for these products. What we offer is primarily is 71 to a short duration which fits a lot of investors’ want right now. And as the legacy non-agency market amortizes down, there is fewer non-agency bonds out there so definitely some seem to investors that look to non-QM as a similar yielding replacement to a legacy non-agency.

Mark Tecotzky

And let me add one more thing to that which is that, so first of all it's not the banks right that are originating the non-QM, it's the non-bank lenders. And you're talking ultimately about mortgage brokers who have to -- right now for example right, we maybe in the middle of refi wave, so this is a harder product right for a mortgage broker necessarily to sell. Some of them have to get out to their learning curve in terms of understanding what we or other providers are looking for. I think success will breed success, right. So as these brokers understand what the program and they understand okay now I understand how to identify a borrower who will be actually will be eligible for the program for the non-QM program that my company is offering and they then see the success of that come through that will I think again sort of breed more success. And then of course the other brokers see that that broker made these types of loans and that will catch on. But when you're in the middle of a refi wave when everyone, it's pretty easy to sometimes pick up the phone and do a quick refi, it's sometimes harder to get brokers’ attention. So that's part of the dynamic as well right and when things are slower then I think that's when you have got a better chance to get more traction for this. But there is no question that the trend is going in the direction that it is and I think that it's going to continue to catch. But it's taking longer for everyone in the industry than they thought.

Operator

Your next question comes from the line of Bose George with KBW.

Eric Hagen

It's Eric on for Bose. I was hoping to rotate into more of the agency conversation. Can you tell us how much agency premium you amortized last quarter ex the catch-up charge?

Lisa Mumford

So the catch up adjustment was a negative $1.5 million.

Eric Hagen

Yes, exactly. I think I just heard Larry say I wanted it back that up. That's right. What is it ex that charge?

Lisa Mumford

So we had 5.3 million so it was 7 million [Multiple Speakers].

Eric Hagen

$7 million got it. And then just on your outlook for prepays, we all saw the report come in last night. It was a bit lower month-over-month. And Larry, you were just talking about the refi wave or wavelet that we're all expecting. Do you expect that to happen next month in reaction to the Brexit rate rally from the end of June?

Mark Tecotzky

Hi Eric this is Mark. It’s a very good question. So the speed report we came out last night speeds were muted they were down about 8% but that was nearly a function of a lower day count. There were two pure business days in this cycle than the previous cycle. Now next month so the prepayment report will get fifth business day of a September that is higher day count month and it also reflects a lower rate environment so we expect a material increase in prepayments that you will see in the next report. And the other thing about the amortization I’d point on Slide 17. You can see the a change in the three month CPR on our portfolio the very bottom went from 8.9% up to 10.3%. So we think that next month and this is in line with projections you would see from other research department. Speeds are going to go up materially and I think the speed report we got last night had it not been for lower day count would have been roughly unchanged from the previous month.

Eric Hagen

Interesting, interesting. So I feel like I can ask a Ouija question, since you have your own OAS model. What is the yield on a low loan balance call it a Fannie 3.5%, today? And how do you expect it to change, given that material increase that you're expecting next month?

Mark Tecotzky

Well the thing with low loan balance paper and we have a slide that sort of goes over this in the EARN presentation it is not in the EFC presentation is what is attractive best low loan balance paper is that the change in prepayment fees you see is the result of changes in mortgage rates are changing borrower refi incentives is much more muted than what you see on more generic tools.

Larry Penn

Yes. Actually if you look at the 10-Q for EARN for example might have been EFC as well for that was just filed you will see there is a chart in the MD&A section in the trend section that shows you this very-very clearly in terms of when there is a movement in the refi index a quick movement how much of that is concentrated in the higher balanced loans as opposed to lower balance loans it is really quite dramatic so if you look at that it's a great slide go ahead Mark sorry.

Eric Hagen

That's interesting.

Mark Tecotzky

Yes, so just that stability in cash what you get some lower loan balance it's one of the reasons why we generally see it as higher net interest margin than more generic tools if you look at our pool composition in this company as well as in EARN we for years have had big concentration of low loan balance even at times when there was no refi wave so we look at the agency market now, and not just low loan balance but there is some other form of prepayment protection we like as much and maybe a little bit more right now. We think we can generate very healthy net interest margins. Right so I think the return on capital in the agency strategy and EFC this month is probably in the probably 3-odd percent. So annualized it would be 12%. We think that that is, definitely producible we see a lot of opportunities now. What's nice about a refi wave is there's lots of pools coming out to pick and choose from And they come sort of fast and furious. So if you're paying attention and you can respond, there is definite opportunities.

Eric Hagen

Right. I want to get a sense for your trading patterns around Brexit, and especially what the bid looked like on pay-ups pools.

Mark Tecotzky

So with Brexit there was -- the Brexit what's interesting, when you go back to Brexit right it was a sort of classic whipsaw thing that yields backed up materially before Brexit and it went from like 155 to 175 and then it went immediately back down. So we do not make macro interest rate calls, so we have tried to maintain roughly a zero-duration exposure in both the agency and the credit sensitive side of the company. So going to Brexit we didn’t have a view as to whether that would pass or not pass. We weren't set up to the benefit from a drop in interest rates or benefit from a further increased interest rates and then when it came out and caused a big move in rates we definitely had to adjust our portfolio durations in response to that whatever the pay-ups. So pay-ups post Brexit they went up but I think what's been the most interesting is that tenure got to a low of about 140 a few weeks ago and now it’s backup not more today. And pay-ups does not really come off in this sale off, so pay-ups has been extremely well post quarter end and we have been outperforming duration.

Operator

Your next question comes from line of Stephen Laws with Deutsche Bank.

George Bahamondes

This is George Bahamondes on for Stephen. My question's related to the dividend. You declared a $0.50 dividend on August 1. Can you walk us through what makes you comfortable leaving the quarterly dividend at $0.50, given your results during the first half of 2016?

Mark Tecotzky

It’s a forward-looking as opposed to a backward looking dividend and if you look at the yields on our portfolio and the various asset classes especially the ones that are increasing. Our view towards -- we have established these new financing lines in many of these asset classes especially the loan classes that are growing the consumer loans the non-QM mortgage loans the distressed slow balance commercial mortgage loans. We are looking ahead to a place where our leverage yield on our loan portfolio is going to be able to cover that and of course. Look the credit hedges are always going to be a question mark and it’s worked against us in a material way in the first six months of the year. But I am not only -- so we think that’s rate is going to work in our favor going forward. But we have to -- even if it doesn’t if you look at the run rate and if you look at that Slide 10 I believe it was in the presentation I think you can see that we can -- it's very reasonable for us to assume that going forward that -- again not day to day, but longer term that hedge portfolio is going to be cost us less and less and if you think about the way the portfolio is migrating as well as I think I mentioned this before in the Q&A that the portfolio was migrating to sectors where the size of the hedge will naturally decrease as well because we're moving into things that are less macro-economically sensitive. So that's again it is more forward-looking, but absolutely if you look backwards, we didn't need the dividend.

Operator

Your next question comes from the line of Brock Vandervliet with Nomura Securities.

Brock Vandervliet

I guess this may be related to some of your responses to the previous one. If I look at Slide 27, your net interest margin direction, it's been edging pretty consistently downward. What would you say in terms of the puts and takes, and how should we be thinking about that margin trajectory, given some of the changes that you're making on the asset side in particular, but also with respect to hedges?

Lisa Mumford

One thing that's a factor on that slide is the premium catch up adjustments that I talked about a little bit ago that we were discussing, so that waiting down the agency yields for sure. If you were to add that adjusted back it would be 53 basis points on the 165 net, so that number would be well over a 2%. The other factor there that is at play is with our credit net interest margins, we had some upfront expenses related to our loan facility that we have put into place and those are coming through in the first quarter. So I think the 875 is more indicative of the portfolio sort of a run rate and the net margins are affected by those couple of things.

Brock Vandervliet

Okay, great. And I guess one addition to the prior question…

Mark Tecotzky

Yes and by the way these are booked yields, market yields are…

Larry Penn

They are based on cost, so sometimes that has -- I think the stuff we bought right after the financial crisis but didn’t sell until last quarter let's just say that sort of have been topping that up if you will on this slide of amortized cost. So that's why we focus more on the Page 14 with the market yields.

Brock Vandervliet

Got it, okay. And just, I guess an additional one on the pile of questions you've had on non-QM, you mentioned a 7.1% type product. What's this step-up rate for this kind of product in terms of just the yield of the consumer versus a conforming agency product?

Mark Tecotzky

This is Mark. So different platforms target different credit profiles and at different rates our rate is typically on average somewhere between 6.5% to 7%.

Larry Penn

Versus 7.1

Mark Tecotzky

Yes versus 7.1 in the agency space you are going to be 2.5 to 2.75 type rates. So it's a 400 basis point difference or so.

Operator

Your next question comes from the line of Robert Martin with Echelon Partners.

Robert Martin

Mark, you mentioned LendingClub and dislocation in cost in the market a bit on the consumer side. And given you guys are so broadly bullish on the consumer, you see a couple of deals now, just in the last day or two, LendingClub in talks with Western Asset and Prosper prospectively doing a deal with Jefferies, Fortress, Third Point and others. Just trying to get a sense as to whether or not Ellington, whether through EFC or otherwise has evaluated those platforms, because it strikes me that you guys are probably best suited amongst many of the partners we're seeing out there with these guys to evaluate those portfolios and prospectively start buying those portfolios overtime.

Mark Tecotzky

The way we approach that business we like to have, we have strong opinions on underwriting and credit eligibility that the bigger platforms like a Lending Club or Prosper. They are not going to be as receptive to some of our views as the partner if you are working with so we haven’t bought from LendingClub or Prosper. We have evaluated the platform so and we've had various kinds of long positions short positions in the stock which has worked out for us. But I guess you might characterize a little bit it's control freak so the partner is being worked with we have a dialogue about performance and underwriting and eligibility which we enjoy and it gives us more confidence in projecting performance on what we buy, and the bigger platforms that just don’t think we'd have that as richer dialogue and our input wouldn’t be as impactful.

Robert Martin

Okay. So I've seen a couple of other of their partners actually re-underwrite their portfolios in total. So it strikes me there is some ability, if you wanted, assuming your low was significant enough, that they in theory would abide by whatever requirements you might have. Have you had further, I guess the volume's probably not high enough from perspective or from their perspective, that you would take on, to theoretically foster those conversations. Is that fair?

Mark Tecotzky

Yes. Another thing for us is we primarily bought from mortgage companies with a strong compliance culture which was important to us so I think that's another sort of preference we had.

Robert Martin

Yes, got it. Okay, and then just second question, more to the stock and how it trades. Larry, can you talk about the migration of the portfolio, which has been significant, and yet I continue to hear mostly talk, or mostly coverage of the stock by the mortgage REIT crowd, which is great. However, I'm trying to understand what the outreach might look like to get the message that this really is a transitional platform that's a broad-based financial service company, EFC that is -- to a broader investment crowd that could potentially start to pay attention to some of your efforts there.

Larry Penn

Yes, look I think it’s two things have to happen right one, we have to sort of complete this migration I mean I think we are getting close to that but two, I think we also need to put some good numbers on the board right. The first quarter was tough the second quarter was okay, so I think that our strategy is to -- I don’t think now is necessarily the right time to do that, but I think the right time will be soon. And we are and as you and I have discussed we are very interested in broadening our investor base to many ways. And I think that new story if you will be attractive to variety hopeful of different types of shareholders but we are trying to time it I think somewhat and we want to get some good numbers on the board before we really make the full-court press there.

Robert Martin

Got it. And just on that note, a last question with respect to the credit hedges and obviously hampering the portfolio year to date, and taking a much more conservative approach to traditional mortgage REITs for certain, but I'm just trying to get a sense as to whether or not you guys have discerned EFC specifically. What is the outlook or what is the view of the investor set in terms of your activity there? And are your underwriting standards and your broad-based credit standards high enough, frankly, to avoid a significant downdraft? And that just goes to a second question, which is what are the actual liquidity parameters around EFC, from your perspective, in terms of mark-to-market and the types of securities you can theoretically buy that might actually be less liquid and, in theory, while still marking to market, prospectively dampen volatility?

Mark Tecotzky

Well I think that’s right that some of the sectors that we are going into are less volatile than some of the sectors that are for example than high yield credit. But we absolutely so for example in the consumer loan portfolio, we are not the only one that are buying these loans. We are very much we believe are marking things to current market conditions. So I think that I'd take a little bit of issue, sort of but with maybe a little bit of what you are saying but I think that fundamentally you are right. We do believe that these asset classes will be less volatile and that will inform the hedge side of the portfolio. And I think that in terms of comparing ourselves to the mortgage REITs I think because we do have the ability to credit hedge and have overtime and it was very important in '07 and '08 as you remember we are a different type of investment for our shareholder right. We are an investment -- other companies in the mortgage REIT space are maybe more suited it for an investor who just wants to be long credit right and I think we're possibly more of an investment for somebody who wants to have more stable book value and long-term earnings over the long cycle. So I think that does make us a little different and that's been part of what we have offered to investors for now a long time and that does make us different, right. We're much more focused on that than I think other companies are.

Operator

Your next question comes from the line of Jim Young with West Family Investments.

Jim Young

Your team has always been known for doing very thorough and extensive research, fundamental research into the asset categories and the like. I'm curious; as you expand your exposure into the consumer area, what type of -- on what basis are you so bullish on the outlook for the consumer as your willingness to expand your exposure to that area? And are there parts of the consumer markets that you're avoiding at this stage and you're concerned about?

Mark Tecotzky

Hi Jim, it's Mark. So before we got involved in the consumer loans, the two big platforms out there LendingClub and Prosper stay, make their data available so we analyze the data, we purposed a couple of people on our research team and made some additional hires there, so we've built a kind of like a traditional loss model using a lot parameters that you might assume your credit score and income and debt to income. And then in addition to that it's a product where you get so much data that we also did in addition, we did some machine learning analysis and built out a machine learning model too. So we did extensive research on it and it's not that that sector is not without loses right we assume there are loses and material loses just that what's important to us in sort of some of the things we saw when we analyzed data and I don't want to give away everything but there are certain type of loans and types of borrowers that perform materially better than the population as a whole that we're primarily interested in.

So I guess what we focused on is when we look at a prime borrower can borrow a yield lock at 3 odd percent if we get another borrower who is in the 700s FICO is not quite as good as good prime. It doesn't seem appropriate to us that they're paying 14%-15%, it's too big a gap right. They're going to have higher losses than the prime person. But the additional coupon you get more than compensates you for that. Another thing we think about a lot with the consumer is how much equity has been built up in homes, so I mentioned this in my prepared statements about there it has been a combination of home prices going up but also debt loads going down, but it's really significant. So there is a group I like to call the urban institute it is a very good research on housing policy and public policy and it contained a paper, a paper that came out a couple weeks ago where their estimate that homeowners is now sitting on roughly 7 trillion of untapped equity.

So you brought everyone up for 75 LPD people that don’t have a first or people that have a first below 75 LPD and 75 is not a high LPD you can certainly borrow at much higher rates than now it is 7 trillion in built up equity and to me that is sort of a book end to what we saw pre-financial crisis that is in 2000-2007 through second liens and cash out refis and all that stuff borrowers or estimates you've taken out between 4 trillion and 5 trillion of equity from their homes so it's sort of gone on reverse now so that's one of the reasons why we like to consumable we think that. Many of the borrowers have -- are sitting on untapped equity that is very hot that...

Larry Penn

Not going to want to lose that.

Mark Tecotzky

Yes so that's one thing and just we've seen across the board credit scores drift up I think the medium cycle is up by 15 to 20 points since credit crisis so it is a combination of factors but it's not the sector is not without risk if you got a big shock on unemployment you definitely going to see an increase in defaults but we run stress something so I think they we are pretty well compensated now.

Jim Young

Okay, thank you. And the second question is a little bit more of a macro one. As we look at the markets post-Brexit, which they've had a sharp snap-back, and credit spreads have tightened, there's a potential for some complacency coming into the markets. And I'm just curious. From your perspective, when you think about the risks out there in the marketplace, is there anything that you feel is just woefully mispriced at this point in time?

Mark Tecotzky

We have this high yield short so we definitely think that has more down side than upside and we're definitely keenly aware of interest rate risk I think that that things can change quickly right we got a good employment number today the last thing from the bank at Japan in the last week they were doing more infrastructures stimulus as opposed to buying bonds so I guess we worry a lot about asset prices that we think are only sustainable if you get the amount of clearly you've seen where increase come out to QE and if that gets pulled away from the market there is certain assets that it doesn’t seem like their price is sustainable. So that risk is relatively easy for us to control it is the pride interest rate hedging instrument but we think those are the two sectors.

Operator

There are no further questions at this time. Ladies and gentlemen, this concludes Ellington Financial’s second quarter 2016 financial results conference call. Please disconnect your lines at this time and have a wonderful day.

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