Ellington Financial's (EFC) CEO Larry Penn on Q4 2016 Results - Earnings Call Transcript

| About: Ellington Financial (EFC)

Ellington Financial LLC (NYSE:EFC)

Q4 2016 Earnings Conference Call

February 14, 2017 11:00 AM ET

Executives

Maria Cozine - VP of IR

Larry Penn - CEO

Mark Tecotzky - Co-CIO

Lisa Mumford - CFO

Analysts

Doug Harter - Credit Suisse

Eric Hagen - KBW

Jessica Levi-Ribner - FBR and Company

Lee Cooperman - Omega Advisors

Jim Young - West Family Investment

Operator

Good morning, ladies and gentlemen. Thank you for standing-by. Welcome to the Ellington Financial Fourth Quarter 2016 Earnings Conference Call. Today's call is being recorded. At this time all participants have been placed on a listen-only mode. Then the floor will be opened for your questions following the presentation. [Operator Instructions]

It is now my pleasure to turn the floor off to Maria Cozine, Vice President of Investor Relations, you may begin.

Maria Cozine

Thanks, Paula and good morning. 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 fourth quarter earnings conference call presentation is available on our website 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 fourth quarter 2016 earnings call. We appreciate your taking the time to listen to the call today. The fourth quarter was an incredibly volatile one on numerous levels. Long-term interest rates surged as quickly as they had in many, many years and the equity markets had new highs, while the credit sensitive fixed income markets were similarly pulled in multiple directions. Ellington Financial was able to generate a modest amount of positive net income despite all the challenges presented in the markets this quarter and that was noteworthy. We are focused on executing our long-term strategy and this past quarter, we made steady progress towards completing the portfolio transition of the past several quarters. Mark and Lisa will run through our particular results for the quarter in more detail later. On this part of the call, I'm going to focus first on the full year that just ended and then more importantly the year that's ahead of us. We said going into 2016 that it was going to be a transition year for the company and it was. In fact I'm really optimistic on where the company is situated here today as I’ll elaborate on later on in the call.

But 2016 ended up being a tough year for us. Our assets performed well, but our credit hedges did not, specifically our results were significantly dragged down by our high-yield credit hedges which were positioned against all of the credit sensitive components of our portfolio including of course what has had historically been our biggest strategy by far our non-agency RMBS strategy. These high yield corporate credit hedges were very substantial in size during the entire first half of last year. Our positioning reflected our concern that the credit markets were vulnerable to a variety of possible shocks and we had to view first of all that high yield corporate credit was the most vulnerable of all the credit sensitive fixed income sectors. Second of all that being short high yield corporate credit would serve as a highly effective hedge in a credit market downdraft. And third frankly the high yield corporate credit would underperform our structured credit assets even if the overall credit markets didn't deteriorate. Going forward, we still firmly believe in many aspects of this thesis. However as we've always said our hedging strategy is dynamic and we will never hesitate to re-evaluate it as needed. We were genuinely surprised at how quickly albeit after initial significance wounds the credit markets shrugged off the plunging commodity prices that culminated early in 2016 and then Brexit midyear, in each case after heavy central bank intervention. While we still contend that the correlations between our structured credit assets and our high-yield corporate credit hedges have been strong both historically and even this past year in large market downturns, we can't ignore the decoupling between these two markets that occurred during this past year in so many other non-distressed market environments.

As a result of these observations and together with the steady reduction in our non-agency RMBS portfolio throughout the year which was the primary portfolio that we were credit hedging we took significant action. Namely starting with partway through the third quarter of last year and continuing throughout the fourth quarter we dramatically reduced the size of our high-yield corporate credit hedges. We are still currently maintaining similar levels of corporate credit hedges against our corporate credit sensitive assets such as CLOs and corporate debt. But those portfolios are much smaller than our structured credit portfolios where we have drastically reduced these hedges. Please turn to Slide 14 in the presentation. Our net corporate hedges which you can see by combining the first and fourth columns now amount to only about $40 million worth. By comparison at the beginning of 2016 that figure was over $500 million worth. On last quarter's earnings call, I pointed out that while credit hedging have been hurting us recently, credit hedging was actually the main reason that we outshone the competition in 2007 and 2008. But I also assured at the same time that the hedging dynamics that we had been struggling with up to that point in 2016 were moving into the rearview mirror. Now I can report that these dynamics are firmly in the rearview mirror for us. Again, our hedging strategy is adaptive and we will never hesitate to revaluate it as needed.

Despite the earnings drag from our credit hedges last year, our yield bearing assets driven by our growing allocations to our loan businesses had solid performance in 2016. As you know, one of our main goals for the company for 2016 was to continue to strategically shift and reallocate capital into assets where we see higher yields going forward. In the fourth quarter, we further allocated capital into the various loan pipelines that we have worked so diligently to create. Please turn back one page to Slide 13. The average market yield of our credit portfolio is now 10.66% that's 32 basis points higher than last quarter's figure of 10.34%. And meanwhile quarter over quarter our credit portfolio grew by over 10%. And keep in mind that this 10.66% average credit portfolio yield is before taking into account the leverage provided by our repo borrowings. We now have the luxury at Ellington Financial of allocating capital between a wide variety of high return on equity generating strategies. Within each strategy, we are also looking at every sub-strategy and position and assessing whether we can do better by holding that position or replacing that position with a higher yielding position. Now that our structured credit portfolio is no longer significantly exposed to high-yield corporate credit hedges. We hope that investors will be able to focus more on the yield and interest margin growth and performance of our loan portfolios.

Last year, our loan portfolio was not fully ramped up, but thanks to the extra capital that we freed up for loans after selling down on agency RMBS and other lower yielding assets. Thanks to our healthy loan pipeline and thanks to our multiplicity of financing options including the availability of the securitization markets I think we are in excellent shape to rectify that in the next couple of quarters. Hopefully our performance in January as reflected in the January 31 estimated book value that is usually announced earlier this month is a harbinger of things to come. We announced an estimated book value increase of around 0.87% which equates to around an 11% return on equity on an annualized basis. Similar to prior earnings calls, Lisa will run through our financial results and then Mark will discuss how our markets performed over the quarter, how our portfolio performed and what our market outlook is. Finally I will follow with some additional remarks before opening the floor to questions.

And with that I'll turn the call over to Lisa.

Lisa Mumford

Thank you Larry and good morning everyone. On our earnings attribution table on Page 4, you can see that in the fourth quarter our credit strategy generated gross income of $5 million or $0.15 per share and our agency strategy generated gross P&L of $1.8 million or $0.05 per share. After expenses of 5.1 million or $0.15 per share we had net income of 1.7 million or $0.05 per share. The following is a brief overview of the drivers of our credit and agency results. With respect to our credit strategy when you compare our third and fourth quarter results, you can see that our gross income increased to $0.15 per share in the fourth quarter from $0.05 per share in the third quarter. In the fourth quarter we had slightly higher interest income and other income which was partially offset by net realized and unrealized losses on our investments. Whereas in the third quarter, we had net realized and unrealized gains on our investments in addition to our interest income and other income but net losses on our credit hedges. During the fourth quarter, total interest income and other income and total realized and unrealized gains amounted to $0.20 per share which compares to $0.63 per share in the third quarter. The biggest contributors to the quarter over quarter decline of $0.43 were our translation and - foreign currency translation and transaction losses on our European investments as well as net valuation declines on consumer loans related to one low agreement.

In addition, we had a lower contribution from our US non-agency RMBS in the fourth quarter. Partially offsetting these declines were increased contributions from our small balance commercial loans, residential non-performing and sub-performing loans and CLOs. In the fourth quarter as I mentioned we had foreign currency translation and transaction losses that are included in net realized and unrealized losses but these were more than offset by net realized and unrealized gains from our foreign currency hedges. The impact of which is included in the line item net credit hedges and other activities. Obviously also included in net credit hedges and other activities are the financial results of our credit hedges which generated a loss in the fourth quarter. However losses related to our credit hedges were much less in the fourth quarter than those in the third quarter and these reduced losses were a significant driver of our overall quarter-over-quarter improved credit result.

As we continue to shift our credit portfolio away from securities and more to loans, we have also significantly reduced our credit hedges as these are generally more correlated to our security. With respect to our agency RMBS portfolio during the quarter as interest rates rose prices declined on our agency RMBS and resulted in net realized and unrealized losses. However those losses were significantly offset by net realized and unrealized gains from our interest rate hedges. The major components of our interest rate hedging portfolio are interest rates swaps and short TBAs. The fact that we generally aim to hedge out most of our interest rate duration risk helped us greatly this quarter as interest rates rose significantly. Consistent with our portfolio management style, we actively traded our agency RMBS portfolio. Portfolio turnover for the quarter was 14%. We took advantage of trading opportunities that we identified following the large interest rate move. In the fourth quarter, our interest income included a positive catch-up premium amortization adjustment in the amount of approximately $500,000 while in the third quarter we had a negative adjustment in the amount of approximately $1.4 million. If we exclude this adjustment in each quarter, our quarter-over-quarter interest income in our agency portfolio was relatively flat at approximately $6 million. Generally this adjustment can fluctuate significantly. Of course these negative and positive adjustments to our interest income do not affect our overall net income for the quarter since their impact is always offset in net realized and unrealized gains and losses.

Quarter-over-quarter our portfolio of investments increased. Our loan credit portfolio increased to 552 million in the fourth quarter, up from 490 million in the third quarter. The increase was principally attributable to our larger loan. Portfolio with most of the growth there coming from our non-QM mortgage loans, our residential non-performing and sub-performing loans, and our small balance commercial mortgage loans. We have added and continued to seek - and continue to seek to add borrowing facilities to support our growing loan business. Our loan agency portfolio also increased slightly quarter over quarter to $827 million from $808 million in the third quarter. Quarter over quarter, our expenses were up slightly to $5.1 million as compared to $4.9 million in the third quarter. Our fourth quarter annualized expense ratio was 3.1%. On a full-year basis, our expense ratio was 2.9% and all things being equal that's more in line with where we'd expect it to be. We ended the quarter with diluted book value per share of $19.46 which in addition to net income and our quarterly dividend includes the $0.04 per share accretive impact of our quarterly share repurchases. The quarter-over-quarter decline in our book value was 1.9% and we had a positive economic return of 40 basis points.

I will now turn the presentation over to Mark.

Mark Tecotzky

Thank you Lisa. During one of the most volatile quarters in years, EFC was able to generate positive economic returns. Our credit portfolio not only grew in size but also continued to replace lower yielding assets with higher yielding ones. Our agency strategy put in another good quarter with the return on capital for the quarter of about 2%, so about 8% on an annualized basis. Given what happened to interest rates, we view this is as extraordinarily good performance for an agency focused strategy. Meanwhile, our steady and deliberate focus on diversifying sources of revenue and securing through EFC a pipeline of proprietary investments demonstrated its value this quarter. Because we avoided overall losses this quarter, we were able to play offense. We added to our credit portfolio even while we continued to print some assets that have hit their targets spread and now offer less interesting total return. At EFC, we see portfolio management at simultaneously balancing two objectives. Firstly, source and managed high yielding assets to drive our dividend payment, and secondly, to keep a watchful eye on risk in every form to protect book value.

The risk to book value can come from internal risks, say poor delinquency performance on a credit sensitive asset or from external shocks [indiscernible] this quarter when the surprising election results led to a movement in financial assets that caught many investors off guard. In a matter of days, the lower for longer mindset which had driven asset pricing for years was called into question and then rejected. This past quarter, I'm particularly heartened to see that in this volatile market we had a positive economic return and we continued to grow the size of our portfolio. This positive momentum continued into January as you can see by our estimated book value. We had a approximate return of almost 1% for the month. So for us we never think the market is without either risk or opportunity. Clearly some markets have more opportunities than others and some have more volatility than others but there are always both. This quarter risk came from a difficult to predict macro event, a surprise election result and a quick 100 basis point move in interest rates.

In this market, even with relatively tight credit spreads we are able to source investments that we believe are very high expected total return. We have the two powerful levers, hedges and portfolio size to navigate through the various market environment where the company has operated since 2007. Figure 12 shows the diversification of our investment. Some of them exclusively the EFC. That long process of diversification is very important in a world where the QE firehose have been pouring out easy money for years. It's been a global reality from the Fed, the BOJ and the ECB. The result is that all big commoditized pools of debt have been pushed to nosebleed valuations. Maybe there will be a soft landing but many yields are so meager comprised of such perfection now that investors can't tolerate anything less than perfection. Case in point, investors who bought the safe ten-year notes in July are sitting on a nine-point loss wiping out over six years of investment income.

Let’s look how the portfolio evolved in the fourth quarter. We net added about 60 million in investments and that positioning has been well as credit spreads have continued to tighten since year end. Building the pipeline of high yielding assets that others cannot source is a much better strategy in this market than fighting with other investors for scraps of overpriced commoditized sectors that have run up in the price response to QE. Our residential loans and REO portfolio grew by 6%. We purchased two NPL pools in the quarter and monthly volume continues to grow at our non-QM originator. These non-QM loans are currently exclusive to EFC. In addition to strong credit performance, we have inked additional financing arrangements allowing us to efficiently leverage our loans. Over the long term there are two ways for EFC to win in the non-QM space. First, the company has the exclusive right to purchase on the flow basis to mortgages that are originated. Second, EFC could reap additional profit in the future of our ownership stake in the originator goes up in value and it could go up substantially in value as origination volume increases.

We actively focus on both sources of return. EFC’s flexible capital can take advantage of this and other niche lending opportunities in mortgage origination that pre-2008 were dominated by the big bank. Well, it's still too early to predict for sure, comments from the Trump administration including Treasury Secretary Mnuchin point to a bigger role for private capital in the mortgage market. In fact on Inauguration Day, when the administration's first official action was to camp to a planned reduction FHA insurance fee, we are said to have a seat at the mortgage origination table. Our CMPS and commercial mortgage loans were another area of growth last year and now comprise almost 20% of our portfolio. There are only a handful of investment complexes with aggressive capabilities necessary to make BP's investment. These are complex investments which require tremendous upfront due diligence and ongoing surveillance. Ellington has this expertise and the strategy has generated tremendous ROE for EFC. us Executing our small balance commercial loans strategy requires a similarly rare array of capabilities. We have a network of relationships that source these assets and over the years we've developed the diversified business strategy to maximize resolution.

Consumer loans are the one area where we hit a small speed bump this quarter. EFC has four flow relationships going into the quarter and during the quarter we terminated one of our floor arrangement. We have a loan performance that had fallen short of expectations. That's the bad news. The good news is that we had the foresight to build into our flow agreement, efficient protection to allow us to stop purchases whenever we saw fit. And with the positive contributions from our other consumer loan sellers, the entire loss of our consumer assets for the quarter was only about 0.5% of our equity. Obviously not the result we want, with the careful surveillance and purchase protections in place we’re able to limit the damage. And meanwhile all our other consumer loan flow partners have met or exceeded our expectations. The one we terminated was the outlier. Meanwhile we continue to selectively accrue non-agency holdings. The allocation dropped by 5% as we are selling securities that have reached target prices we consider fully priced and are deploying the capital we free up in strategies that we believe have a higher expected return. As Larry mentioned this reduction in the capital dedicated to the non-agency RMBS strategy has also been a big factor in reducing the size of our credit hedges.

Slide 12 really dramatically shows how many additional strategy we have added in the past three years and how much more diverse our sources of income are. The Slide 12 shows what we did, Slide 13 shows why we did it. The sectors that used to be the lion's share of our portfolio have evolved and now offer a cashless stability and predictability that trade to the lower yield than it used to. So we are now patiently harvesting gains in that sector and redeploying capital to newer strategies that have both the higher yield but also much bigger barriers to entry so these assets are less likely to be priced to lower yields in the near future which means the opportunities should be long lived. In 2009, EFC was opportunistic on subprime securities that the big banks didn't want to own and the fact we’re selling. The big banks couldn't take the headline risk of owning what the media referred to as toxic mortgages. We saw the value and they turned out to be anything but toxic, but generated great returns. For long-term investors what matters is price, cash flow and fundamentals not labels or ratings. Now the opportunity for EFC has evolved away from those individual MBS shun by the big banks. Now we're more focused on whole businesses shun by the big banks, non-QM, reverse mortgages, unsecured consumer loans. These are all good businesses if you have the right personnel, the right analytics and appropriate investment horizon.

There's nothing toxic about a reverse mortgage or non-QM mortgage or responsibly underwritten consumer loans. In our agency portfolio we have another strong quarter, it was obviously an incredible volatile quarter we generated over 2% return on invested capital. We take a bottoms up fundamental value approach generating returns in the agency CMBS markets that avoids big macro bet. This approach provided amazing stability and consistency of this year despite the roller coaster moving rate. Our agency portfolio expanded slightly, grown by about 2% quarter over quarter. Despite this growth in portfolio size, we actually bring into the quarter what I would consider a less risky agency portfolio. If you turn to Slide 17 or slide showing the composition of agency CMBS, you can why. For many years, in short, TBA mortgage securities has been an important way that EFC has controlled interest rate risks and reduced book value volatility. We simply don't ascribe to a belief that the best way to generate reliable long-term returns in the agency market is to always have a levered loan position in the mortgage basis.

We believe the best way to generate significant returns is by taking a more dynamic relative value approach. By owning more mortgage exposure when mortgages are cheap to treasuries and swaps and then less when they aren't all the while seeking the most affordable predictable prepayment protection. You can see that in the past quarter that our agency mortgage TBA hedges became a much more significant part of our total hedges. This happens organically as duration is extended to help EFC not only withstand but be profitable from the 100 basis point wage increase in the quarter. Our hedge dynamically increased and hedging power as rates increase. From my vantage point, the outlook for 2017 looks exciting. We came into the year with a low levered portfolio of high-yield assets and we like our pipeline of investments. Our agency CMBS strategy has demonstrated consistency in generating returns in both rising and falling rate environment. Performance was strong in January and we see strong underlying credit performance on our existing holding.

Now I'll turn the call back to Larry.

Larry Penn

Thanks Mark. Our focus 2017 will be on the growth of our loan portfolios. This depends not only on the strength of our pipeline but also on our long financing arrangements. Since the start of 2016 we have added facilities for small balanced commercial loans non-QM mortgage loans, residential NPLs and consumer loans. We tend to be pretty conservative on our use of leverage. But even for our standards, we're still underleveraged. The good news is that we've got lots of free cash in our balance sheet. We've got the ability to free up even more capital as needed. The pipelines of incoming loan assets look good and we already have the financing lines in place.

Let's review the status of our loan businesses starting with small balance commercial mortgage loans. These loans which we define as small and they’re under roughly $20 million in size have been a key driver performance like the financial strategy for the past several years. We have a financing line for both distressed loans and the bridge loans that we originate. With this line, we have more room to add assets and what has been our best performing strategy including originating more bridge loans that otherwise might not quite reach our ROE targets. We have an active pipeline of originations and expect that this will be a strong growth area for us going forward. For the next two years we estimate that there are almost $100 billion of CMBS loans originated during the pre-crisis boom that are scheduled to hit balloon payments at their maturity and we expected a significant portion of those will not be able to make those payments. This should provide ample opportunities to add to our portfolio, which as Mark described, is another area where we believe we benefit from significant barriers to entry. These small loans are headaches for banks and special servicers, but opportunities for us.

In addition to small balance commercial mortgage loans, the residential NPL markets are ripe with opportunities. And while our loan performance was strong in 2017 in this portfolio, we did it for much of the year without a financing line in place. Sorry, in 2016. Now that that's changed, we have additional room for growth and higher potential returns to boot. We closed on two distressed residential pools in the fourth quarter and expect to continue to ramp up this portfolio. Our CMBS strategy remains, for the time being, to purchase new issue B-pieces. On last quarter's earnings call, just four days before Election Day, we were joined on the call by Leo Huang, our Head CMBS portfolio manager.

Leo went into great detail about the risk retention rules that were about to go into effect. However in light of the election results and with the new administration indicating that it will push for significant rollback of Dodd Frank, our focus has stayed for now on our existing highly successful B-piece strategy. We had two B-pieces during the fourth quarter and five B-pieces during 2016. Of course, we'll see how potential changes in legislation play out and we still like to participate in risk retention as the sponsor, should the right opportunity arise. Our consumer loans and ABS strategy was a key area of growth last year and has grown to become the largest strategy in our portfolio at around 21% of credit assets as of year-end, as you can see on slide 12.

As Mark mentioned, we now have three origination partners who are performing well for us and we’re in active negotiations to add a new flow agreement. We have financed our consumer loans in a variety of matters and we expect to close on a new loan financing facility very shortly. After we close this new facility, a large majority of our consumer loan portfolio will be under term financing, which will free up even more capital for us to reinvest. In the next two quarters, we could easily add another $50 million to consumer loans to Ellington Financial’s portfolio. Another very interesting area of growth for us is in the reverse mortgage business, where we have a 49% joint venture stake in a growing originator as we described briefly on last quarter's earnings call. The originator continues to progress nicely and they recently hired a great group of loan officers from a competitor, increasing loan officer count by over 50%.

Ellington Financial’s objectives for this company are two-fold. First, to help build a significant portfolio of reverse mortgage servicing rights, which we think is a poorly understood asset class that can offer far higher returns than conventional MSRs. And second, for the company to increase retail origination in a space where we think that competition is low, that marginal profits are extremely high and that demographic trends are extremely favorable. And on a related note, our investment in the non-QM originator also is progressing nicely and we are actively monitoring the securitization market for potential issuance after our non-QM portfolio, which was around $72 million at year end, which is critical mass.

We are also working on a very interesting opportunity in the CLO space. With CLO risk retention rules taking effect only late last year, new CLO issuance has dramatically declined this year, creating a shortage in a market where demand remains strong. Meanwhile, some of the assets in which we invest, such as higher yielding syndicated bank loans, can be eligible collateral for CLOs. In response, we have begun accumulating certain CLO eligible assets and are exploring ways in which we can access the CLO market to take advantage of high CLO demand and thereby locking favorable long term financing on our portfolio. We believe that very high returns on equity can be generated in this manner, even after expected loss and hedging costs.

In summary we see no shortage of opportunities to capital work to grow our loan portfolios. Although there are many components to our loan portfolios, our overall strategy will become more simplified, since the common threat of all of these assets is capturing and leveraging net interest margin. Our stock price significantly lag the peer group in 2016. And to be frank, the main thing we need to do to correct this in 2017 is to deliver on our financial results. Nothing's more important than that. With our corporate credit hedges no longer a significant factor in our portfolio and with our loan portfolios ramping up nicely, we believe that we've finally turned the corner. In the meantime, given the magnitude of the discount to book where our stock was trading for most of the fourth quarter, we repurchased approximately 1% of our outstanding shares during the quarter. Since year-end, our stock price has rebounded by almost a point and we will continue to monitor our price to book ratio when weighing repurchases, recognizing also our need for portfolio growth and earnings growth. Our primary goal remains to generate long-term sustainable earnings for shareholders.

This concludes our prepared remarks. And we're now pleased to take your questions. Operator?

Question-and-Answer Session

Operator

Your first question comes from Doug Harter of Credit Suisse.

Doug Harter

Thanks. On the consumer loan agreement you terminated, can you talk about how much exposure you still have in terms of loans on your balance sheet?

Lisa Mumford

It’s approximately 13 million, Doug.

Doug Harter

Okay. And can you talk, I mean were there differences in underwriting quality that we're slipping or is it the loan performance. Just to understand a little bit more about your thinking and understand when you notice the difference, the performance and just how to think about that going forward?

Mark Tecotzky

Doug, it’s Mark. So we track the performance of all our loan agreement versus projections that we establish. And for this seller, we saw that their performance was tracking higher than our expectations. We suggested corrective actions. They took some corrective actions that didn't mitigate the problem, it didn't mitigate the problem to a significant enough extent that we wanted to continue the purchases. So we decided to terminate.

Larry Penn

We noticed with our originators, Mark, correct me if I'm wrong here, but we see sometimes a tendency for defaults to start out of the box low ramp up and then decline over time after that, right. Pretty typical in terms of a default curve. And that's what we've seen by and large in our other flow agreements. In this particular flow agreement, we saw that ramping up, but then we didn't see that ramping down afterwards. So basically the default rates were more persistent than we had projected and that we've seen in our other arrangements and that's what led to the termination.

Operator

Your next question comes from Bose George of KBW.

Eric Hagen

Thanks. Good morning. It's Eric on for Bose. I'm hoping you can expand a little on your comments around potential deregulation, specifically regarding any changes around bank capital requirements. I think a lot of folks are accustomed to seeing Ellington take advantage of some of the more esoteric areas of the credit market, which may have seen a reduced footprint from large financial institutions after the financial crisis. So I'm kind of curious how you might adapt to that if there are any changes on that front, on both the asset and funding side?

Larry Penn

Well, on the funding side, this is Larry, I think that we've mentioned on other earnings calls that the non-agency funding has actually continued to improve because that -- even with the new capital requirements that as it represents a good return on equity for the banks, if those capital requirements get reduced, then it will be even better and I think it will have the effect of compressing spreads there. In the agency sector, there, you've got low returns on equity and we've been both I would say pleasantly surprised that some banks, not all, some of the big banks have stayed in that sector and the slack has been for the banks that left, because the return on equities are low with current capital requirements, it’s been picked up by Asian banks, Canadian banks and other participants, including non-banks So again, we were concerned about the availability of financing when these rules were starting to take effect, but it turned out not to be an issue.

On the assets side, I think the big issue is the Volcker rule more than any other and you don't hear a lot about that. I think it's very hard to predict where Dodd Frank will be rolled back and to what extent in the place where it is rolled back. I think the Volcker rule clearly has benefited us and other non-insured capital basis. So we'll just have to wait and see. Again, I think there hasn't been a lot of talk about that as in my opinion, as a real target towards the regulation. I think the fact that lending has been curtailed, I think that's more of an issue and I think that there are a lot of clear steps from a regulatory standpoint that can be taken to increase the lending potential of banks and the lending activity of banks, but in terms of prop trading, sure, it could happen. But there hasn't really been a lot of talk on that and we're going to just have to take a wait and see attitude.

Mark, is there anything you want to add for that?

Mark Tecotzky

I would just add that there is a potential that government support for the agency mortgage market, that could change, right. I mentioned in the script how on inauguration day, the administration rolled back a -- would have previously been announced the reduction in the mortgage insurance premium. So if gee fees go up, mortgage insurance premiums go up, that makes long term a lot more interesting. So I think there's a lot of things that can happen, but to predict any of them or all of them is too difficult. So we need to sort of follow the situations closely and adapt as they occur.

Larry Penn

And some of these, I would just want to add one more thing, some of the things that you've seen where the banks have gotten out of spaces are not just regulatory reasons, but for a combination of regulatory shareholder and reputational reasons. Right? So I think that as you see banks get out of, for example, certain lending spaces or the reverse mortgage space for example where you're dealing with senior citizens, I mean, those are the types of things which I don't think are going away even if the regulatory environment relaxes.

Operator

Your next question comes from Jessica Levi-Ribner of FBR and Company.

Jessica Levi-Ribner

Hey. Thanks so much for taking my question. Around the originators on both the consumer loan and the non-QM loans, what's the outlook for adding more originators, how's the activity been since the election and what does the pipeline look like a couple months out even with maybe higher rates or something like that?

Larry Penn

I mean I think in consumer loans, we said 50 million is where our projection for the next couple of quarters and that's without that one new originator that we’re in active negotiations with. And in non-QM, we don't have any plans to add another originator there. We view our partner there as extremely capable in terms of their credit underwriting. So I think we said that at year end, we had about a little over 70 million in non-QM loans and that was up from 30 unchanged million at the end of the third quarter. So we think origination is ramping up. So we're looking at getting to 150 million critical mass for securitization. Obviously, that's going to depend upon where the debt is can be issued in the market at that time and other factors, but I think if you extrapolate those numbers with the growth that we expect, you can see hopefully something around mid-year there.

Jessica Levi-Ribner

Okay. Is there, I know that you just said that you’re happy with the credit quality and the underwriting from the resi originator?

Mark Tecotzky

It’s been pristine. I mean barely a hiccup. I mean it's quite amazing actually.

Jessica Levi-Ribner

Okay. So you’re not looking for another originator there?

Mark Tecotzky

We're not, we're not.

Operator

Your next question comes from Lee Cooperman of Omega Advisors.

Lee Cooperman

Thank you. I have four questions. I can get them out. The rule from like 30,000 feet, you guys are clearly very entrepreneurial in how you run the portfolio, which is giving difficulty to people in valuing the company. I'm happy with your entrepreneurial nature, because I think you’re very smart guys. But over a cycle, your 19.46 [ph] current book value, what is the reasonable return for investors to anticipate gross and net after expenses. That would be question number one.

Two, what does the board look at to determine the dividend payout in any one particular quarter going forward.

Third, if you could be more specific in terms of the repurchase attitude. It looks like, you kind of want to buy when it's 15% or 20% below book value, but what is the authorization and how much flexibility do you have. In other words, do you have a specific authorization or are you just going to keep buying until.

And fourth, if you could kind of have discussed your exposure to rising rates. If I said to you in two years, fed funds would be 2% and net income would be 4%. How would portfolio act in that environment? Thanks for the help it could be?

Larry Penn

All right. Thank you, Lee. Always great to take your questions. Okay. Let me hit these in, not necessarily the same order. So repurchase attitude, we are currently under a program that was established a while ago, 1.7 million shares. We still have, I think, let’s call it, 500,000 shares left, but I can’t speak for the board, but I have full confidence that as we get closer to hitting that authorization that we would that we would get reauthorization. You're right. In terms of where we have generally been repurchasing shares and we've been I think pretty transparent on this. So when we get to 85% and above, we haven’t repurchased shares recently and that’s certainly I think to be expected going forward. When we get below 80, I think we're very interested in repurchasing shares and I think we've also demonstrated that.

In between 80 and 85, it's very much, I think, you've got -- the curve is going to slope between those two numbers in terms of what our repurchasing activity is going to be and it's going to depend upon about a number of factors, even could include where the whole space is trading in terms of our competitors from sort of a timing perspective. It could depend obviously on the investment opportunities which we've seen. We want to be flexible certainly within that range and obviously I reserve the right and the board reserves the right to reevaluate that range. But I think those are, I think that's a good place to start from is that under 80, pedal to the metal, 85 and above, not purchasing and in between, kind of, we’ll see.

In terms of dividends and how the Board has done it, we've typically not liked to alter our dividend policy too often in that as we forecast where we think our portfolio performance yield, et cetera are heading. And we don't look at necessarily just the quarter coming up, we look a little bit further ahead than that. That tends not to move so much from quarter-to-quarter. And I will say that, right now, the way that our dividend is sized is it's roughly a 9 unchanged percent return on book value on equity, which we think based upon all the things we said on the call, I think, we are confident that when we're fully ramped up, which we said we should be hopefully by midyear, that's going to be something which we can absolutely achieve and then some. I will tell you that we also though listen to our shareholders in this regard. I mean it's not, we have a lot of flexibility. We're not a REIT as you know and we have a lot of flexibility on our payout policy. And it's always an interesting theoretical question, finance, know is that -- those dollars better in shareholders' hands or are they better in the company's hands?

And I think when you're trading at a discount, shareholders often put pressure on you to put it in their hands. I mean I understand that. We do need to avoid undue shrinkage of the company. There's no question that to be bad on a number of fronts. But we also need to balance is what we hear from shareholders in terms of what their desires are and you and others are not shy usually in expressing their interest there. So we’ve tried to balance what we hear, what we believe is best for the company and that's where we are today in terms of our $0.45 dividend. And I think that hopefully, what we'll do is establish to shareholders that we can get back to in 2017 a steady earnings stream and I think all the conversations around dividend at that point will be a lot easier. So my personal view is that in an ideal world, with the flexibility that we have, we would have a lower payout ratio on our earnings, nut again I just think our earnings are paramount above all things and the rest is gilding the lily and, but we're going to continue to listen to our shareholders, definitely in terms of what the payout ratios that they're looking for, because we work for you and our other shareholders.

Let's see, the other thing, rising rates. I'm going to let Mark speak to that and I think that was in terms of book value.

Lee Cooperman

You got them. Other than exposing it to the rising rates. You can discuss them more.

Larry Penn

So, Mark you want to hit what would happen to fed funds, 1% to 2% for example.

Mark Tecotzky

Yeah. Hi, Lee. So, I mean this quarter, rates went up about 100 basis points in two weeks and you can see that that move didn't damage the portfolio because we have not positioned with this belief that lower for longer is the way to pay the dividend and having a lot of interested with we think long term isn't going -- doesn’t give consistent earnings. So rates would go up to 4% and 10-year note and fed funds, 2%. The dividend stays where it is. I think it's actually easier to pay the dividend, because the non-agency holdings we have are primarily floating rate. They're just the rate mortgages in that six month to one year LIBOR. We saw all those coupons go up about 60 basis points last year as LIBOR rose. So presumably, those coupons would go up another 100 odd basis points. Same thing on our CLO debt positions. They're all indexed off a three month LIBOR, so they get another 100 to 150 basis point increase in coupon. The non-QM loans, our programs are, there are seven ones, so fixed are seven years and float thereafter.

And we generally move our pricing with movements in the 30-year mortgage rate. So we'd be able to get a little bit higher coupon there, probably 100 basis points higher there and we have enough tools between interest rate swaps, TBA mortgages, treasuries and treasury futures to manage the interest rate risk. So I think a movement up in rates would, if we kept the dividend the same, it’d be a little bit easier to hit the target. What you might see then is maybe you'd see a little bit slower turnover of investments, right that there might be lower refinancings and things like that. So maybe some of the loan origination volumes would drop, but that in and of itself, that's an environment I think we should be able to manage through.

Larry Penn

Yes. I think if you look at our performance last year over now our almost ten-year history at Ellington Financial, you look at even our other company, Ellington Residential EARN and how it performed last quarter. That's an agency portfolio which you would think would be extremely in straight sense and I think we've really distinguished ourselves in terms of our ability to really shrug off these large and straight moves. And as Mark mentioned, after the dust settles from a big in trade move, the assets that we have in the portfolio, including the ones the pipeline that's coming in and the ones we have are pretty elastic in terms of pricing. So I think we’ll do great.

Operator

Your next question comes from Jim Young of West Family Investment.

Jim Young

Yeah. Hi, on slide 13, you mentioned the estimated yield on the credit portfolio based on your Ellington’s HPA forecast and I'm curious as to what HPA forecast are you using at the end of the year to get to the 10.66% yield and what’s the sensitivity plus or minus 100 basis points and lastly have you changed HPA forecast in 2017? Thank you.

Larry Penn

Yeah and it’s so funny. We were just discussing that this was going to be the last quarter that we put in that qualifier, the Ellington HPA forecast because if you look at the -- in the weeds here, if you look at the footnote below, you'll see it talked about a lot of other things that go into those market yields, which are model based in many cases. But when our portfolio was much more non-agency RMBS based, that was a very, very significant factor in our models in terms of that it's your HPA forecast that's going to drive the severities on the loans and defaults in the underlying non-agency RMBS. Now as you look at the portfolio, the non-AG RMBS has shrunk, so yes, absolutely.

We update our HPA forecast, but that is so much smaller. Residential loans are largely, again these totally pristinely performing non-QM loans, yes, we have some NPLs in there as well but -- and they absolutely are going to be tied to HPA, but a very small portion of the portfolio right now. So not a, what I would say is that HPA is no longer really that significant a driver of our returns in most of these areas. Of course, HPA is correlated -- home prices are correlated with other things going on in the credit markets that could impact performance on all the other credit sensitive fixed sectors in which we participate, but at this point, it's not really -- we use our models for the sectors where it's relevant. It's becoming less relevant in obviously many other sectors, but we still rely on our forecasts and models in terms of where we see defaults and delinquencies going on all the sectors, even if they're not HPA driven. So I hope that answers your question.

Operator

At this time, there are no further questions. This will conclude today's conference call. Please disconnect your lines at this time and have a wonderful day.

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