Ellington Financial - Q2 2024

Transcript

Operator (participant)

Please stand by. We're about to begin. Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the Ellington Financial second quarter 2024 earnings conference call. Today's call is being recorded. At this time, all participants have been placed in a listen-only mode. The floor will be open for your questions following the presentation. If you would like to ask a question during that time, simply press the star, then the number one on your telephone keypad. If at any point your question has been answered, you may remove yourself from the queue by pressing star two. Lastly, should you require operator assistance, you may press star zero. I'd now like to turn the call over to Alaa Shalaby. Please go ahead.

Alaaeldin Shalaby (Head of Investor Relations)

Thank you. Before we start, I would like to remind everyone that certain statements made during this conference call may constitute forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical in nature, as described under Item 1A of our Annual Report on Form 10-K and Part II, Item 1A of our Quarterly Report on Form 10-Q. Forward-looking statements are subject to a variety of risks and uncertainties that could cause the company's actual results to differ from its beliefs, expectations, estimates, and projections. Consequently, you should not rely on these forward-looking statements as predictions of future events.

Statements made during this conference call are made as of the date of this call, and the company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. I am joined on the call today by Larry Penn, Chief Executive Officer of Ellington Financial, Mark Tecotzky, Co-Chief Investment Officer, EFC, and J.R. Herlihy, Chief Financial Officer of EFC. As described in our earnings press release, our second quarter earnings conference call presentation is available on our website, ellingtonfinancial.com. Management's prepared remarks will track the presentation. Please note that any references to figures in this presentation are qualified in their entirety by the endnotes at the back of the presentation. With that, I will now turn the call over to Larry.

Laurence Penn (CEO)

Thanks, Alaa, and good morning, everyone. As always, thank you for your time and interest in Ellington Financial. I'll begin on slide 3 of the presentation. In the second quarter, broad-based contributions from our diversified credit and Agency portfolios, as well as from our reverse mortgage platform, Longbridge, drove strong results for Ellington Financial. For the quarter, we generated an economic return of 4.5% non-annualized. We grew our book value per share after paying dividends, and we increased adjusted distributable earnings per share by a full $0.05 to $0.33 per share, and we see momentum for our EAD to keep increasing from here. I am very pleased with these results. I'll first highlight the strong performance of our non-QM loan business in the quarter.

In April, we completed our first non-QM securitization in 14 months, taking advantage of the tightest AAA yield spreads we've seen in 2 years and booking a significant gain as a result. In the months leading up to that April deal, we have been taking advantage of strong whole loan bids in the marketplace by selling many of our non-QM, QM loans rather than securitizing them. While the whole loan bid for non-QM loans remained very strong, we saw AAA securitization spreads tighten back to early 2022 levels, and so in April, we decided to securitize some of our non-QM loans rather than sell them. That securitization transaction not only provided attractive economics, but it also provided us with high-yielding residual retained tranches to boot. Following that April securitization, we proceeded to sell other non-QM loans into that strong whole loan bid.

As you can imagine, given the recent risk-off move in the financial markets, all this activity turned out to be extremely well-timed. In addition, the continued strong demand for non-QM loans drove improved origination volumes and gain on sale margins industry-wide, which generated excellent results at our affiliate non-QM loan originators, LendSure and American Heritage Lending, and led to mark-to-market gains on our equity investments in those affiliates. Meanwhile, Longbridge also contributed robust earnings for the quarter, led by both strong origination volumes and strong performance of proprietary reverse mortgage loans. Similar to the boost in industry non-QM volumes, HECM origination volumes were also up significantly for the quarter, including for Longbridge. But unlike non-QM, we saw wider yield spreads in the HMBS securitization markets.

As a result, gain on sale margins for Longbridge's HECM business actually compressed in the quarter, which mostly offset the benefit of their higher origination volumes. Finally, following quarter end, but prior to the recent market volatility, we successfully completed our second securitization of proprietary reverse mortgage loans originated by Longbridge, achieving incrementally stronger execution than our inaugural deal that we executed in the first quarter. This securitization converted another slug of short-term repo financing into long-term, locked-in, non-mark-to-market financing. Again, given the risk-off move we've seen in August, this was another well-timed transaction. That transaction also provided us with high-yielding residual retained tranches. On last quarter's earnings call, we predicted a second quarter turnaround at Longbridge, and Longbridge did a great job and delivered both on a GAAP basis and ADE basis. Longbridge is an important part of that ADE momentum I mentioned earlier.

Also in the second quarter, Ellington Financial's results benefited significantly from the very solid performance of our residential transition and commercial mortgage loan strategies, as well as Non-Agency RMBS. Both for the second quarter and continuing into the third, we have added attractive high-yielding investments over a wide array of our credit strategies, especially HELOCs and closed-end seconds, prop reverse, commercial mortgage loans, residential RPL/NPL, CMBS, and CLOs. The growth of the commercial mortgage portfolio has included both new originations as well as the purchase of two additional non-performing commercial mortgage loans. At the same time, we have continued to call securities in lower-yielding sectors, including Agency and Non-Agency RMBS.

Since we generally utilize higher amounts of leverage in our MBS portfolios, especially our Agency MBS portfolio, these MBS sales, coupled with the non-QM securitization, drove down our leverage ratios overall in the second quarter, despite the increased capital deployment in our credit strategies. Moving forward, we have plenty of cash and borrowing capacity to drive portfolio and earnings growth, with significant unencumbered assets plus other lightly leveraged assets. That dry powder is particularly valuable given recent spread widening. And with that, I'll turn the call over to J.R. to discuss the second quarter financial results in more detail. J.R.?

J.R. Herlihy (CFO)

Thanks, Larry, and good morning, everyone. For the second quarter, we're reporting GAAP net income of $0.62 per share on a fully mark-to-market basis and adjusted distributable earnings of $0.33 per share. On slide 5, you can see the attribution of net income between credit, agency, and Longbridge. The credit strategy generated a robust $0.80 per share of GAAP net income in the quarter, driven by strong net, net interest income and net gains from non-QM loans, retained non-QM RMBS, non-agency RMBS, and commercial mortgage loans. We also benefited from mark-to-market gains on our equity investments in LendSure and American Heritage Lending, which reflected strong performance from increased origination volumes and strong gain on sale margins for those originators. Similar to the prior quarter, we received another sizable cash dividend from LendSure in the second quarter.

In addition, with interest rates slightly higher quarter over quarter, we had net gains on our interest rate hedges. Offsetting a portion of all these gains was a modest net loss, a modest net loss in residential RPL/NPL. Meanwhile, the Longbridge segment generated GAAP net income of $0.05 per share for the second quarter, driven by net interest income and net gains on proprietary reverse mortgage loans, along with positive results from servicing. In HECM originations, higher volumes were mostly offset by a decline in gain on sale margins, driven by wider yield spreads on newly originated HMBS. In servicing, tighter yield spreads on more seasoned HMBS led to improved execution on tail securitizations, which contributed to the positive, to the positive results from servicing.

Notably, Longbridge also contributed $0.06 per share to our ADE, in contrast to its negative $0.01 per share contribution last quarter. Finally, in what was a down quarter for the agency mortgage basis overall, our Agency strategy nevertheless generated positive net income of $0.01 per share for the second quarter, as net gains on our interest rate hedges, along with net interest income, slightly exceeded net losses on agency MBS. Our results for the quarter also reflect a net gain driven by the increase in interest rates on our senior notes. This gain was partially offset by a net loss, also driven by the increase in interest rates, on the fixed receiver interest rate swaps that we used to hedge the fixed payments on both our unsecured long-term debt and our preferred equity.

Turning to slide 6, you can see the breakdown of ADE by segment. Here's where you can see that solid $0.06 per share contribution from Longbridge, which drove the overall increase in EFC's ADE, which rose $0.05 per share sequentially to $0.33. Turning next to loan performance. In our residential mortgage loan portfolio, after excluding the impacts of our purchase of one non-performing loan portfolio and our consolidation of another non-performing loan portfolio, the percentage of delinquent loans increased only slightly quarter-over-quarter. Meanwhile, in our commercial mortgage loan portfolio, including loans accounted for as equity method investments, the delinquency percentage also ticked down sequentially. We also had a significant mark-to-market gain on one of our non-performing commercial mortgage loans based on progress on the resolution process. That said, we continue to work through those two non-performing multifamily bridge loans that we referenced last quarter.

While not meaningfully higher quarter-over-quarter, loans in non-accrual status and REO expenses continued to weigh on the ADE in the second quarter. Next, please turn to slide 7. In the second quarter, our total long credit portfolio decreased by 2.5% to $2.73 billion as of June 30. The decline was driven by the cumulative impact of the non-QM securitization completed during the second quarter and net sales of non-agency RMBS, retained non-QM RMBS, and non-QM loans, which more than offset net purchases of commercial mortgage bridge loans, HELOCs, closed-end second lien loans, residential RPL/NPL, CMBS, and CLOs.

For our RTL commercial mortgage and consumer loan portfolios, we received total principal paydowns of $381 million during the second quarter, which represented 21% of the combined fair value of those portfolios coming into the quarter, as those short-duration portfolios continued to return capital steadily. That steady return, that steady stream of principal payments should provide lots of dry powder to take advantage of opportunities, especially if we are entering a risk-off environment. On slide 8, you can see that our total long agency RMBS portfolio declined by another 31% in the quarter to $458 million. We continue to shrink the size of that portfolio and rotate the capital into higher yielding opportunities.

Slide 9 illustrates that our Longbridge portfolio increased by 18% sequentially to $521 million, driven primarily by proprietary reverse mortgage loan originations. In the second quarter, Longbridge originated $305 million across HECM and proprietary, which was a nearly 50% increase from the previous quarter. As Larry mentioned, shortly after quarter end, in July, we completed our second securitization of proprietary reverse loans from Longbridge, which locked in term non-mark-to-market financing at an attractive cost of funds. Please turn next to slide 10 for a summary of our borrowings. On our recourse borrowings, the total weighted average borrowing rate increased by 11 basis points to 6.98% at June 30.

We continue to benefit from positive carry on our interest rate swap hedges, where we overall receive a higher floating rate and pay a lower fixed rate. The net interest margin on our credit portfolio declined modestly quarter-over-quarter, while the NIM on Agency assets increased. Our recourse debt-to-equity ratio decreased to 1.6 to 1 at June 30th, down from 1.8 to 1 as of March 31st, driven by the non-QM securitization in April and a decline in borrowings on our smaller but more highly levered agency RMBS portfolio. Our overall debt-to-equity ratio ticked down as well to 8.2 to 1 from 8.3 to 1. At June 30th, our combined cash and unencumbered assets totaled approximately $764 million, up from $732 million at March 31st.

Our book value per common share was $13.92 at quarter end, up nicely from $13.69 at March 31, and our total economic return was 4.5% non-annualized for the second quarter. Now over to Mark.

Mark Tecotzky (CIO)

Thanks, J.R. This is a very solid quarter for EFC. Not only did we have a strong economic return, which drove book value higher per share, but we also had a sequential improvement in our ADE, which I expect to continue. Our earnings this quarter showed the value of EFC's vertically integrated platform. It's been a challenging couple of years for the mortgage origination business, with mortgage rates so high, housing affordability so bad, and existing home sales so low. But LendSure and American Heritage Lending have persevered and have both posted solid earnings in Q2, driven by a higher gain on sale margins and increased origination volumes, which led to an increased valuation for our equity stakes in them. Longbridge also contributed strongly to the ADE this quarter, driven by profits in their proprietary reverse business. But at EFC, we don't just own the originators.

We also buy their loans, collaborate with them on credit decisions, maximize proceeds via securitizations when the arb is attractive, and retain what we expect to be high-yielding assets from those securitizations for our portfolio. All that helped this quarter. The power of vertical integration was on full display for us. We did another securitization of Longbridge's prop reverse mortgages in July, and we expect Longbridge's loan origination volumes, as well as their securitization volume, to continue to grow in that sector. In the second quarter, we also completed a non-QM securitization and opportunistically sold more of those loans as well. Credit spreads were relatively tight in Q2, so we took some gains in a few different parts of the portfolio. Now we are well-positioned for some wider spread opportunities that we are seeing this week with the recent volatility.

We had another strong quarter from our commercial mortgage platform as well. Our affiliate originator servicer, Sharestates, has a like-minded approach to commercial mortgage credit risk. They have been fantastic at not only sourcing opportunities, but also working with our EFC commercial team to help manage our few delinquent loans. Sharestates has deep property management expertise to closely monitor construction progress, CapEx, CapEx expenditures, and renovation quality control. This expands EFC's capabilities to manage non-performing loans in REO when necessary to maximize proceeds. While Q2 was a quarter of tight spreads and strong demand for structured products, this past week should serve as a reminder that market consensus can change on a dime, often leading to violent repricings in a matter of days. Look at slide 19. We've kept many of our credit hedges in place.

In Q2, they provided insurance we didn't end up needing, but they are once again showing their value in August. Hedges provide multiple benefits to us. We use them to minimize the risk of spread widening for upcoming securitizations. We use them to stabilize our NAV in times of volatility, and we use them to potentially help offset some of the impact of increasing corporate and consumer stress if the economy weakens. We've been adding to our portfolio of high-quality closed-end seconds in HELOCs and even picked up an attractive pool late last week amid the sell-off.

As opposed to our non-QM loan portfolio, where we lend to borrowers who aren't served by the GSEs, these second liens in HELOCs generally are offered to borrowers with low note rate Fannie, Freddie, Ginnie Mae loans, and provide a way for high quality, low LTV borrowers to extract equity from their homes when having a low note rate, first lien, which makes a cash out refi inefficient. We think this is a large and exciting opportunity for us, and we have invested the time and resources to build out our prepayment and credit models, and they've developed our sourcing capabilities. With their higher note rates, this sector adds a lot of ADE for Ellington Financial.

As for the rate and spread volatility of the past week, while I wouldn't be surprised if it led to mark-to-market losses in some parts of the portfolio, we also see this volatility as recharging the opportunity set with wider spreads and some price dislocations to capitalize on. Furthermore, if the lower interest rates we're seeing, if they stick, should lead to increased loan origination volumes in both non-QM and at Longbridge. Given that all these platforms have excess lending capacity, greater volumes should be supportive of bottom-line economics. EFC is in a good position to add assets here, and we're really excited about the current opportunity. Now, back to Larry.

Laurence Penn (CEO)

Thanks, Mark. I was very pleased with our performance in the second quarter, where we saw strong results across our credit portfolios and took advantage of tight spreads to monetize gains. In particular, it was great to see the strength in our non-QM and reverse mortgage loan platforms, which drove the sequential growth in our book value per share and ADE. At Longbridge, we have more work to do to grow origination volumes further, but the positive developments in the proprietary reverse securitization markets and a strong July in originations should bode well for Longbridge going forward. Lower long-term interest rates could also provide a big boost to Longbridge's origination business, since the size of the loans that borrowers are able to take out generally increases as long-term interest rates decline.

It is loan size, more than loan interest rate, that is the key driver of origination volumes in the reverse mortgage market, both for purchases and for refinancings. Meanwhile, both during calmer times and more volatile times, we continue to rebalance our portfolio and direct capital to where we see the best opportunities. So far in the third quarter, we've added scale in non-QM, RTL, prop reverse, commercial mortgage bridge, and closed-end seconds and HELOCs, growing each of those portfolios meaningfully. At this point, we are still trimming in some lower-yielding sectors, but I expect the pace of that trimming to slow going forward. We are also working on adding to our financing lines, specifically for our forward MSR portfolio, and I see that getting done around the end of Q3.

As we've been detailing today, our investment pipeline across our diversified proprietary loan origination channels is strong, and the loan originators in which we have invested are not only providing healthy flow into that pipeline, but generating operating income themselves. Because we have equity investments in those same originators, this, in turn, also helps drive our results. We continue to actively pursue making small but strategic investments in other non-QM and RTL originators, and in fact, we closed on another one following quarter end, helping lock in another strategic sourcing channel. In light of the recent market volatility, I am particularly happy to have executed on our recent asset sales and securitizations in different parts of the portfolio ahead of that sell-off. These moves locked in gains when spreads were tighter, and they also freed up additional borrowing capacity and capital to redeploy.

We have ample dry powder, and just in the past few days, we've been putting that dry powder to good use. I believe Ellington Financial is well positioned for continued portfolio and earnings growth over the remainder of the year. With that, we'll now open the call up to questions. Operator, please go ahead.

Operator (participant)

Thank you. At this time, if you would like to ask a question, please press star one on your telephone keypad. You may remove yourself from the queue at any time by pressing star two. Once again, that is star one to ask a question and star two to remove yourself. We will pause for just a moment to assemble the question queue. We'll go first to Bose George with KBW.

Bose George (Analyst)

Hey, guys, good afternoon. So the first question was just about, you know, capital deployment. How would you characterize your, you know, the level of capital deployment? Is there still... You know, you mentioned some dry powder, but just how much upside to ADE just from fully optimizing the balance sheet?

J.R. Herlihy (CFO)

Yeah. Hey, Bose, good morning. So I think that the first answer, the first way I'd approach the question would be to look at the unencumbered and cash on balance sheet. So, yeah, we had $565 million of unencumbered and I think close to $200 million of cash, and, you know, typically we'll keep, call it, 10% of equity in cash, so that's maybe $150 million. If we add—so the recourse leverage on credit was 1.5 times. If we took that to 2 times, that takes our overall recourse debt to equity back to 2 times and adds, you know, a few hundred million more of borrowings, or $600 million more, I guess, in that example.

So I would say in this quarter, that there are a few moving pieces in the portfolio, but we continued to trim and call lower-yielding assets, so that's kind of offsetting. We went through the laundry list of credit at portfolios that we grew in Q2 and into Q3, but then we also sold agency and non-agency MBS, so those are kind of working in opposite directions. But suffice to say, at 1.6 overall leverage, we, we have, we have lots of room, both from, you know, excess cash on the balance sheet, those unencumbered assets to add leverage, and then other assets like our forward MSRs that are levered, but lightly levered. So, you know, you could, you could draw, you know, $several hundred million of additional buying capacity just from those different numbers.

That would still take us just to 2x,

... you know, recourse debt to equity.

Laurence Penn (CEO)

Yeah, and as we, this is Larry, as we, trim that agency portfolio and more is, you know, focused just in the credit sectors, you could sort of think of that 2-to-1 leverage ratio, I think, as kind of a fully invested, you know, as being fully invested. So probably, you know, again, as we trim agency, probably not gonna get all the way to 2 to 1 in terms of being fully invested, but at 1.6, you know, we have hundreds of millions of shares worth of room to add even before we get close to that. Yeah. And then, and we're really focused on, you know, secured financing.

Longer term, you know, we have several tranches of unsecured debt at Ellington Financial, and, you know, pricing for recent deals is, you know, been wider than it had been in, in prior years. But I think it's, it's fair to say that over the longer term, we see adding more, you know, unsecured debt to the liability structure, as another step that we would consider. So that would also take up the, you know, the recourse debt to equity ratio, but again, over a, I'd say, a longer-term period.

Bose George (Analyst)

Well, okay, great. That's helpful. Thanks. And then, while you hedge your portfolio, you know, very closely, can you just talk about how the portfolio potentially benefits from, you know, from a steeper yield curve, if the forward curve is right and the Fed is, you know, cutting quite a bit over the next year?

Laurence Penn (CEO)

Mark.

Mark Tecotzky (CIO)

Hey, Bose.

Bose George (Analyst)

Mark.

Mark Tecotzky (CIO)

So, yeah, in terms of interest rate hedging, we've tried to hedge out across the curve, so we don't really express an opinion on what the future shape of the yield curve is gonna be through our interest rate hedges. So just kind of mathematically or on paper, just the first order effect of a steeper yield curve or a flatter yield curve, we kind of neutralize that with hedges. Now, I think there's a couple other things going on. Whenever you have when the notional balance of your repo exceeds the notional size of your swaps, then a drop in financing costs is gonna be beneficial, right?

Like, if the swaps exactly equal the size of the repo and the market's predicting now, I think the base case is a 50 basis point cut in September, the Fed cuts 50 basis points, okay, our repo costs go down 50 basis points. But the floating leg we receive on swaps goes down 50 basis points, too. So if your repo exactly equal your swaps, then it's kind of washes out. You know, when you have repo in excess of your swap notional amounts, then sort of that's a beneficial thing to you. I think the things we're thinking more about is, when you see a cutting cycle start, I do think you see investors express a preference for fixed rate assets as opposed to floating rate assets.

So we've been adjusting some of our hedges internally to be more focused on loan indices, as opposed to, say, a high yield bond index. So that's kind of one second order effect, I think makes sense. And it's kind of interesting, if you look at some of the recent fund flows, there's this, you know, $11 billion AAA CLO ETF, JAAA, that just came out of the blue this year. I think it's had its first outflow ever yesterday, right?

So the expectation of the market that you're gonna see lower short-term rates, that is starting to be reflected in fund flows. So we certainly think about in how we position the portfolio. And I also do think when you see steeper yield curves, that does tend to be supportive of agency mortgages and non-QM mortgages. So I think there's some second order effects for us, and we're positioning around it. But in terms of, like, a big move in ADE for the portfolio, I think you're only gonna see that really significantly to the extent that the notional amount of our repo borrowings exceeds the notional amount of the swap hedges.

Bose George (Analyst)

Okay, great.

Laurence Penn (CEO)

And I'll just add one thing, right? So, I agree with... Yeah, I echo everything Mark said. If you look at, though, you know, what's now a very large segment of our portfolio, which is residential transition loans.

So, we don't—you know, they're short. We don't really meaningfully hedge those from an interest rate perspective. And I do think that, if you see—you know, the rates tend to be a little stickier in that sector. I do think that if you see a drop in short-term rates, right, as everybody is predicting, I do think that you will actually have wider net interest margin on that, on that portfolio because I think, you know, the, our repo rates, they float. They'll absolutely ratchet down almost, you know, basis point for basis point with Fed cutting. But I think that the, the rates, the coupons that we'll be able to get on RTLs will be a little stickier. So... And, you know—Right, that's the opposite that we saw when rates were rising.

Exactly right. Yeah. Yeah, we've had some NIM compression in that sector, versus where we were a few years ago when rates were, you know, short-term rates were a lot lower. So yeah. So I think that's one good thing to look forward. And then, you know, Bose, I think, you know, I think some of the things that I've seen you've written would echo this as well, which is that, you know, let's say we fast forward to, you know, a year, a year and change from now, and we've got, you know, long-term rates and short-term rates, you know, with a free handle, right? That's gonna be good for... You know, you're gonna see mortgage rates go down, across the board just on an absolute basis, and that should be really good for originators, right?

Just, you'll, you know, see a lot more refi activity, et cetera. Sounds good. Great, very helpful. Thank you.

Mark Tecotzky (CIO)

Thanks.

Operator (participant)

We'll go next to Crispin Love with Piper Sandler.

Crispin Love (Analyst)

Thanks. Good morning, everyone. Appreciate you taking my questions. First, just on HELOCs and closed-end seconds, is this an area that you expect to see a lot of runway, just given home affordability, higher HPA, higher rates with many mortgages in the 3%-5% range? Or if we do get a sizable rate rally, could this opportunity diminish in coming quarters, but then you get the benefit from higher originations as you've indicated? Just curious on your thoughts there.

Mark Tecotzky (CIO)

Yeah. Hey, Crispin, it's Mark. If you just look at how many Fannie 2s and Fannie 2.5s and Fannie 3s that are out there in existence, you know, all the stuff that was created in 2020, 2021, first half of 2022, that is an enormous pile of Fannie, Freddie, Ginnie loans. And for the second liens in the HELOCs we've been buying, the originators are targeting borrowers with those really low note rate first liens. So that—if rates were just to stay where they are, that opportunity looks like it's pretty big. You're exactly right.

If you saw a big rate rally and mortgage rates came down a lot, then all of a sudden, doing a cash-out refi is gonna start to look, you know, to be comparable economics to people that are saying, "I'm gonna stay put with my, fixed rate first lien mortgage, and if I want to borrow, you know, $70,000, do some home renovation or something, I'm gonna take this, closed-end second lien." So yeah, there is a trade-off between, you know, you know, where first lien mortgage rates and how big that opportunity set is. But you're exactly right. We've positioned ourselves to have a seat at the origination table, not in Fannie Freddie space, but in non-QM space with our originators. And so lower mortgage rates across the board, I think, would be definitely supportive to, the origination volume.

So, this... You know, we don't kind of think about it explicitly as sort of a hedge on origination volumes, but it certainly functions that way. We're attracted to it now because you get a real high note rate, it's very supportive of ADE. We think we understand the prepayment function, and the credit quality is really strong. So that's what's sort of been driving us. It just looks like an attractive asset to add to the portfolio to complement already what we're doing in RTL and non-QM, and the, private label reverse.

Laurence Penn (CEO)

Yeah, and if I could just add to that, Mark.

Mark Tecotzky (CIO)

Yep.

Laurence Penn (CEO)

I just wanna add that, I really, you know, based on what Mark said, right, about... But rates would have to drop a lot for those, you know, all those low coupons that were originated, you know, pre-2022 especially, right, to become refinanceable. You know, if mortgage rates are, you know, maybe they're, you know, getting close to 6% now, but, you know, you're, that's still 200 basis points away, right? So you're gonna need quite a big drop, I think, before HELOCs and closed-end seconds are gonna no longer make as much sense for people. The thing that I'm a little more, you know, sort of on the radar screen about is what's going on with the agencies, right?

So I don't think volume is necessarily gonna be an issue for a very long time in terms of, you know, that, that market. But the question is with, you know, this agency pilot program, you know, coming out and all that, that could obviously lead to some serious competition. I mean, it's not a big pilot program, but, if it becomes more than a pilot program, you know, there could be some serious competition there. And, you know, we don't wanna be competing with the agencies, but, you know, we're gonna, we're gonna keep going. The assets that we're seeing now are looking great, as Mark said, and, you know, we'll see what happens.

Crispin Love (Analyst)

Great. Thank you. That all makes sense. And then, just one last question from me. Are you seeing single asset, single borrower security opportunities in the current landscape? Is this an area where you're adding, and would that fit well within EFC's credit portfolio on the commercial side? And just kind of curious, what kind of returns you think you might be able to get right there, if you are interested?

Mark Tecotzky (CIO)

Yeah, we

Laurence Penn (CEO)

Yeah.

Mark Tecotzky (CIO)

It's a great question. Do you want me to take it, J.R., or do you want to take it?

Laurence Penn (CEO)

Yeah. So, I think the first SASB question, yeah, that's a part of the market we've been focused on, in small size. I mean, you see that the portfolio grew from $22 million-$42 million quarter-over-quarter in CMBS. So it's still, you know, a small percentage of the overall credit portfolio. But yeah, certainly SASB is an area that we've focused on. I mean, in past years, B-pieces have been a much larger percentage of our CMBS portfolio, and now it's much, much smaller. So yeah, on the margin, SASB are the deals we're looking at. In terms of how those yields pencil, I don't know if, Mark, you want to address that. You know, we give the. I'm just thinking about in our disclosures where we would give more detail.

There will be more detail on, in the queue, on that question. But I know anecdotally, Mark, if you want to talk about some of the SASB CMBS incremental yields you're seeing.

Mark Tecotzky (CIO)

Yeah. It's been a wild sector, right? For years, we had almost no SASB exposure. It was a market where sort of triple Bs and above all kind of traded in a tight spread range, and everything came at par and just didn't look that interesting to us. And now, as you have this tremendous divergence of outcomes in commercial space as a function of property type, we've seen some really interesting opportunities. You know, there have been bonds that are still investment-grade SASB that, you know, have been down, you know, dollar price in the 30s and 40s. And then so there's that, that's been an interesting opportunity for us. And the other interesting thing is you're getting a lot of new issue SASB, and it's been a pretty big volume, and it's pushed spreads a little wider.

So from a levered spread basis, you know, it certainly looks as attractive to us or maybe even slightly more attractive to us than some of the other sort of bread-and-butter sectors like CRT or legacy non-agency on the CUSIP side. What's been going on in SASB has really been a lot of the focus of our CMBS team. As J.R. mentioned, you know, for years, we were very active in the B-piece market, and just that market with not a lot of conduit issuance is just not, you know, it doesn't have the same opportunities that it used to.

But this SASB opportunity on either the lower dollar price, distressed SASB, where you're really doing, you know, very, very detailed analysis of the properties, and then up the capital stack to, some of the bigger, SASB deals that we think are coming at very attractive spreads. I definitely think you can see, you know, more capital get allocated there.

Crispin Love (Analyst)

Great. Thank you for answering my questions. All, all super helpful.

Mark Tecotzky (CIO)

Thanks, Tristan.

Operator (participant)

We'll go now to Doug Harter with UBS.

Douglas Harter (Analyst)

Thanks. You know, given, given the market volatility, can you talk about your appetite for potentially looking at more liquid assets versus your recent strategy of, you know, more proprietarily created loans?

Mark Tecotzky (CIO)

Sure. I mean, I think it's both, right? Like, I think we've been opportunistic about that. If you know, and you followed us for years, right? You look at what we did in 2020, we added a lot of legacy non-agency when, you know, a few months before that, we were adding a lot of non-QM loans. So we're constantly looking at the trade-off between securities and loans, and we take into account the difference in financing levels, the difference in liquidity. So I would say for this market volatility, what that means to me is that maybe you're looking for incrementally a bigger pickup in loans relative to CUSIPs than you might normally, you know, look for. And that's typically what happens when you see this volatility, that sort of liquidity bases tend to accordion out.

So you see it everywhere, you know, less liquid shelves versus more liquid shelves, you know, unrated seniors versus rated seniors. All those things had been kind of going one way this year up until, you know, the last week or so. Liquidity spreads have been coming in, and we, you know, we did some loan selling and loan monetizing to take advantage of that, and now you're seeing it start to go the other way. So that, that relative value trade-off is something we always look at. And I think, you know, when I sit down, and we discuss things with the PMs, that means to us that the threshold for adding loans relative to securities is incrementally a little bit wider now than what it was a couple of weeks ago.

Laurence Penn (CEO)

Thanks, Mark. The other thing I would add, this is Larry, is that it was we happened to be looking last week at a second lien portfolio, and we pulled the trigger on that, you know, in the face of this sell-off, which was great. You know, got a better price. But in general, when you have these, you know, big market moves, and for example, we saw, you know, some mutual fund selling, right, or, you know, ETF selling. CUSIPs tend to trade more obviously and to be a little more volatile, right, in terms of just what you're actually able to buy.

So I think when stuff like that happens, you know, the first opportunities that are gonna arise are gonna be in CUSIPs, and absolutely, if it looks like there's some forced selling, we'll gobble those up. It's a little harder to kind of dial up your proprietary pipelines immediately, right? That's just something that is gonna kick in longer. So as you have these, you know, big risk off moves, and now in the last couple of days, you know, risk on moves, you're gonna see more activity just in CUSIPs and be able to pounce on those. But longer term, as Mark said, I think our expectation is that it's gonna be on the private side of the portfolio, you know, the non-CUSIPs, where we're gonna continue to see driving our ADE.

Douglas Harter (Analyst)

Great. Thank you.

Laurence Penn (CEO)

Thanks, Doug.

Operator (participant)

We'll go now to Eric Hagan with BTIG. Please go ahead.

Eric Hagen (Analyst)

... Hey, thanks. How you guys doing? I actually wanted to follow up right there and ask about non-agency securities repo and your outlook there for spreads over SOFR to stay stable, including just the general kind of supply of capital that's coming from some of the big banks that have typically supplied that capital, and maybe the appetite to continue supplying funding there for the market, your perspectives. Thank you.

Mark Tecotzky (CIO)

Yeah, we've seen the same thing you've seen. The big banks now are very interested in repo as a balance sheet asset, right? It doesn't have price volatility, it has a healthy spread, so it contributes to NIM. So it's not only traditional banks, but you also have some very large sort of investment banks that converted to banking charters during the financial crisis. So we've gotten a lot more inbound calls from people wanting to add repo, not on the agency side, where that's kind of been stuck at, like, SOFR plus anywhere between five and ten, but it's been on the loan side, right? Not on the CUSIP side.

So anything sort of, I'd say, SOFR +125 to SOFR +2.25, those kind of asset classes, there's been a lot of interest in, lenders trying to get more, get more borrowings on their balance sheet. And so we've seen... But, you know, it's like, what rate a lender is at is important, but it's not the only thing that matters on the repo side. It's how easy are they to work with? You know, what's their eligibility like? There's a million other things, but, we have been able to negotiate better financing terms, on loans this year than what we had in place last year.

I think that'll keep going because, you know, I, I think what would stop that would be if you saw SOFR really come down a lot, but it's 5 3/8 now. You know, if SOFR comes down, you know, 50 or 100 basis points, I think that's still gonna be attractive for the bank. So that's another way I think at the margin, we're gonna grow some ADE, is just by continuing to negotiate and take advantage and be opportunistic about the best financing levels we can get. One thing that is sort of helping that is the securitization spread. You know, Larry mentioned tighter non-QM spreads this year. That is sort of give the lenders a little bit more confidence to come down on their SOFR spread.

So that has been across the board better, whether it's CUSIPs or whether it's loans. But, you know, for the CUSIPs, I'm talking about, it's sort of like, you know, SASB, that Chris was asking about, or CRT, or legacy non-agency. And the agency stuff, it, you know, that's been fine for years. It didn't really widen in 2022. It hasn't come in this year. That's sort of stuck where it is. But anything else, we've gotten better financing terms, and I, and I do think that that's gonna continue.

Laurence Penn (CEO)

I think especially in repo on fixed income CUSIPs, I think it has further to come down, given how much spreads have tightened and just given how—I mean, you—when was the last time you heard about a lender having a loss on fixed income CUSIP repo? I mean, it's been a really long time. They're much better at managing that risk. The haircuts are high, you know, a lot higher even than in a lot of like warehouse, you know, loan repo on the loan side as opposed to the CUSIP side. So, I, I think, you know, I think that actually has room to come down more.

Eric Hagen (Analyst)

Always appreciate your detailed response. Hey, one more. Can you share how much capital you have allocated to the credit hedges and how you think about maybe scaling that opportunity to, you know, rotate more capital into the credit portfolio?

J.R. Herlihy (CFO)

Yeah, so on slide 19, we give an overview of the credit hedges, and you can see on a-- what's not exactly the capital allocation, but a high yield equivalent, $120 million notional is our CDX, which is where most of our corporate hedges are. We have a small amount in CMBX and then European related to currency risk for the most part. So it's meaningful, and Mark went through kind of the different uses and benefits it provides, but relative to the size of our, you know, several billion-dollar credit and agency portfolios, it's small, but it does help, you know, on the margin, in the ways that he mentioned.

We have taken, you know, the size of these credit hedges down over time, as we move more toward loans and away from CUSIPs that don't always have hedging instruments available or the need to hedge with, you know, low short spread durations, for example.

Laurence Penn (CEO)

Yeah, they, you know, they really take minimal capital to put on and maintain, and they're in fact, risk reducing. So in terms of, you know, when we think about... They don't take any capital away, certainly, from our ability to add assets. Yeah.

Eric Hagen (Analyst)

Thank you, guys, so much. Appreciate you.

J.R. Herlihy (CFO)

Thanks, Eric.

Operator (participant)

We'll go now to Matthew Erdner with JonesTrading.

Matthew Erdner (Analyst)

Hey, guys. Thanks for taking the question. Could you talk about, you know, current and expectations for credit performance, and then if recent economic data has kind of made you shift asset allocation? But I do know you're going more so into credit and away from the agency.

J.R. Herlihy (CFO)

... Sure. Mark, why don't I take the first half of that, and you can go second, if that works? So on the-

Mark Tecotzky (CIO)

Su- sure.

J.R. Herlihy (CFO)

So on the performance of our loan portfolios, we, we mentioned in our prepared remarks and earnings releases that in commercial, the delinquency percentage declined, quarter-over-quarter. We do still have the two multis, delinquent loans that we're working through. But overall, the percentage of delinquencies relative to fair value declines between the two quarters. And then in resi, it ticked up slightly by 10 basis points, call it, when you exclude NPLs that we, that we bought during the quarter. So, yeah, it's. And credit, you know, realized losses continue to be small, but we do highlight those two non-performing, multifamily properties that we're working through.

Laurence Penn (CEO)

Remember, and also remember that we mark to market, you know, through our income statement, right? So we've marked those, those two non-performers down, and so when those resolve, we do not expect to that affect our, you know, net income in any negative way. And in fact, what it will do is free up capital, to redeploy, so that we can, you know, continue to boost our ADE.

Matthew Erdner (Analyst)

Gotcha. Yeah, that's helpful. Thank you, guys.

J.R. Herlihy (CFO)

Sure. And the second half of your question about an economic slowdown and how that might change our perception of adding credit assets. Would you mind repeating that? And maybe, Mark, if you wouldn't mind tackling that, please.

Matthew Erdner (Analyst)

Yeah, just-

J.R. Herlihy (CFO)

Sure.

Matthew Erdner (Analyst)

Just kind of, you know, if we were to kind of go into a recession, how you guys would think about asset allocation and if it would change from your current stance?

Mark Tecotzky (CIO)

Yeah, I guess the way I think about it is, you know, in the early days of non-QM, we had loss expectations on it, and our originators would take loan loss reserves. And what we saw is that performance was so good, shockingly good, that, you know, they built up a war chest of loan loss reserves and, 'cause there weren't any losses, right? And so, to me, the aberration has been, you know, the really, you know, tailwind of home prices and really strong default performance from, you know, say, I mean, we started LendSure in 2014, you know. 2014 up to, you know, middle of 2022, I think performance was aberrationally good, and I think now we're going into, we're in a period of time where, you know, you're gonna see some delinquencies, you're gonna see some losses.

But I think it's absolutely consistent with sort of how we underwrite things, and the same thing is true for residential transition lending. You know, you've seen the unemployment rate tick up. Jay Powell was talking about it a lot at the press conference. You know, we make no predictions about the economy, but we watch things like a hawk, right? And so, you know, we slice and dice the data a million different ways. We've certainly seen, and a lot's been written about it, that there's been kind of FICO inflation, that a 700 FICO today is probably more like a 680 FICO four years ago, right? So that observation or that belief has informed our credit eligibility criteria, so we've matriculated up in FICO.

And I think, you know, as an originator, and this gets to the point I want to make in the prepared remarks about how it's not just we own originator and we're hands-off. We are collaborative, right? And so we give them access to our data scientists and our data and our research team to kind of come up with best underwriting practices, where you can be relevant to, you know, the brokers or the correspondents you're working with, but you're getting, you know, great quality loans. And so if we see, you know, performance deteriorations in certain parts of the portfolio, then that serves as a feedback loop, and you change your eligibility.

So that iterative process of analyzing the data and then updating and adjusting guidelines as a reaction to it, that's. I see that as a big part of our job, you know. And, you know, it was a big part of our job 10 years ago, but just 10 years ago, you didn't see a lot of delinquencies. You'd look at it, say, "Delinquencies are fine. Okay, let's go ahead." Now you're into sort of a much more normal regime. You know, home prices are more expensive, note rates are higher, people are signing up for bigger payments, and so, you know, there's gonna be some delinquencies. And so we monitor it, you know, we're pricing for it, and I think we're very well equipped to respond to it.

Matthew Erdner (Analyst)

Yeah, that's very helpful.

J.R. Herlihy (CFO)

Thanks, Mark.

Matthew Erdner (Analyst)

Thanks for calling.

Laurence Penn (CEO)

And I wanna add one thing. Just, if you turn to page 12 of the presentation, right, you can see kind of the various segments of our loan origination, you know, business and those pipelines that we've been talking about. And you can see, you know, consumer loans, it's a very small segment, right, compared to the others. I mean, tiny. And if you look at our portfolio generally, right? We are a residential-focused company in terms of the credit risk that we're taking. And let's include also multifamily in that, right? Because that's most of our commercial mortgages, in, you know, are on multifamily properties, and you can see that on another slide in the presentation. But, you know, as to your question, if we go into a recession, right, you'll see rates come down.

... And even though, there's definitely issues, right, on affordability of housing, there's also a lot of issues on supply, right? And you have those two things, you have very little supply, versus the demand, but you've got an affordability problem, right? And so those two things are kind of counteracting each other. But if, you know, if we go into a recession, again, to your question, and rates go down, and mortgage rates go down, which they would in that scenario, you're now all of a sudden, you're really helping the affordability issue, because then you're gonna have mortgage rates lower. And on the multifamily side, you're gonna really help the cap rate issue.

And remember, we're, you know, these are bridge loans that, you know, in terms of the you know, vast majority of our commercial mortgage loan portfolio. So you're really talking about valuations at the end of that, you know, 12- or 18-month term. So with cap rates, you know, if they come down. So, so I really feel good about how our portfolio, again, being very residential based and giving the technicals of that market, and in addition, what would happen if long-term rates came down. I feel very good about how we would withstand that kind of a scenario.

Eric Hagen (Analyst)

Got it. Great. Thank you very much.

Operator (participant)

We'll hear next from Lee Cooperman with Omega Family Office.

Leon Cooperman (Analyst)

Thank you. I'm on a cell phone. Can you hear me?

Laurence Penn (CEO)

I can. Thanks, Lee. Good to hear from you.

Leon Cooperman (Analyst)

Hi. I tuned in a little bit late because I had a doctor's appointment. So I have three questions. Most people own the stock for income. Given everything you've had to say, do you think you'll restore your dividend before the end of the year to the $0.15 per month level?

Laurence Penn (CEO)

I feel great about maintaining the dividend where it is. I, at this point, no, that's not something that I would expect to raise it. But, you know, we've tended to keep our dividend stable for a long time. You know, so I wouldn't, I wouldn't have that expectation of raising it.

Leon Cooperman (Analyst)

You would think the dividend would be sustained at the $0.13 a month level?

Laurence Penn (CEO)

Yes, absolutely.

Leon Cooperman (Analyst)

All right. The second question: You guys have been active in capital management. What is your attitude towards that presently?

Laurence Penn (CEO)

Yeah, I think, you know, J.R. kind of alluded to it earlier. I think our next kind of big move on the capital management side is gonna be unsecured debt. You know, rates have come down, and those, you know, whether you're looking at baby bonds or other types of offerings, they tend to be a little sticky. So we're being patient and, you know, watching that market. So I think adding unsecured debt to the portfolio, I think is important. And, you know, it's also a little bit of a healthy cycle as you do that, because ultimately, look, we're not, you know, we're not rated by any of, you know, let's like S&P and Moody's, for example, right now. We have a great Egan-Jones rating.

But at some point, you know, that's something we might wanna look into, is to, you know, get a rating from, let's say, S&P and Moody's and the like, and that will enable us to issue even more unsecured debt. Of course, you know, as we add things like baby bonds, which aren't rated, you know, that also helps the capital structure, and can help us get those other ratings. So, but anyway, the next move, I think, you know, significant move, again, this is just a prediction, I can't predict where the capital markets go, and they're not there yet for us, I think would be some sort of an unsecured deal.

Leon Cooperman (Analyst)

I and I need you to help me out, since you guys are smarter in the credit markets than me. Everyone seems to think interest rates are too high. I actually think they're low, and the evidence I would use is the stock market's near a high. There's a lot of speculation in the market. Prior to the Great Financial Crisis in 2008, the ten-year bond yield was in line with nominal GDP. If you have inflation of 2%-3% and real growth of 2%-3%, the ten-year would not be, you know, undervalued at a 4% or 6% yield. So, I think interest rates are gonna go up, and I read the Democratic platform, which was 80 pages long. I read the Republican platform, which was 22 pages long.

Nobody seems to care about the debt that we're creating in the system. So I think we're heading to some kind of financial crisis, and I don't know if it hits us in 5 years, 10 years, or it doesn't hit us at all. What's your view of what's going on in the country fiscally?

Laurence Penn (CEO)

Yeah. So, again, as Mark said, I just wanna reiterate, we try not to color... And this is just us. You know, I understand that other companies and, of course, you with your own portfolio, Lee, are gonna take a different approach. But we try not to color our interest rate hedging. We try to focus, you know, more on, okay, here's where long-term interest rates are, here's where short-term interest rates are. You know, what can we buy just given those realities, as opposed to... A- and then hedging appropriately. But I absolutely agree with you, not on short-term rates necessarily, but on-- I do agree with you on the longer-term rates. That, you know, given the increasing size, you know, of the debt, you know, budget deficits, nobody's talking about really cutting, in any meaningful way.

And not to mention that it's not so clear that, notwithstanding what we've seen, you know, a quarter or two, that wage inflation is really behind us, which is the thing that I look at most closely, I think, in terms of thinking about where, you know, all of this could go. I agree with you. I think long-term rates, I think it's gonna be challenging for the Fed to get, you know, even not 2%, but even 2.5, whatever. And so I think, you know, I think it's gonna be challenging for long-term rates, you know, ultimately to get where at least maybe the forward curve, the markets are predicting. I agree with you.

Leon Cooperman (Analyst)

I clearly, I'm on a conference call. Okay, thank you very much for coming, and good luck.

Laurence Penn (CEO)

Good luck to you, too. Thanks, Lee. Always a pleasure.

Operator (participant)

Thank you, everyone. That was our final question for today. We would like to thank everyone for participating in the Ellington Financial Second Quarter 2024-