Kwarkot
~ by Snehasish Chaudhuri, MBA (Finance)
Ellington Financial Inc. (NYSE:EFC) is a mortgage based real estate investment trust (mREIT) that aims to generate return for its investors primarily in the form of current income. For the past 10 years, EFC generated a yield mostly in between 10 to 15 percent. Its current yield is 11 percent. EFC’s exposure to non-qualifying mortgages (non-QMs) enables it to generate high rates of returns. However, it also enhances the overall risk of its portfolio. This specialty finance company earns primarily through interest income generated from its diversified portfolio consisting primarily of Agency Residential Mortgage-Backed Securities (Agency RMBS), commercial mortgage-backed securities (CMBS), collateralized loan obligations (CLO) and mortgage servicing rights (MSR).
Ellington Financial Inc. Has A Well Diversified Portfolio that Mitigates Risk
Ellington Financial Inc., through its subsidiary, Ellington Financial Operating Partnership LLC, acquires and manages financial assets, mostly loans, in the United States. In addition to Agency RMBS, CBMS, CLO and MSRs, Ellington Financial Inc. also deals in alternative A-paper, subprime residential mortgage loans, mortgage-related derivatives, corporate debt and equity securities, commercial real estate (CRE) loans, consumer loans and asset-backed securities. Such a high degree of diversification helps in mitigating asset specific risks, and thus are preferred over pure play mREITs, which are encountering losses in RMBS. The company was incorporated in 2007, and used to pay quarterly dividends. However, for the past 15 quarters, the company has been paying monthly dividends.
RMBS are debt-based securities (quite similar to bonds) and are backed by interest payable on various residential loans. Interest on loans such as residential mortgage loans, subprime mortgage loans, and home-equity loans are generally higher and have low default risks. Agency RMBS are those residential mortgage-backed securities whose principal and interest payments are guaranteed by agencies such as Government National Mortgage Association (Ginnie Mae), Federal National Mortgage Association (Fannie Mae), or Federal Home Loan Mortgage Corporation (Freddie Mac).
CMBS is a form of fixed-income securities that is backed by mortgages on commercial real estate rather than residential properties. CMBS provides liquidity to commercial lenders as well as to real estate investors. CLO is a single security that is backed by a pool of debt. CLO is generally backed by loans issued to private equity firms in order to conduct leveraged buyouts or by corporate loans with low credit ratings. In a MSR agreement, the original mortgage lender sells its right to service an existing mortgage to another party that specializes in the various functions involved with servicing mortgages.
Ellington Financial Inc. Provides Hope Regarding Sustainability of High Yield
During Q2, 2022, EFC suffered an economic loss of 6 percent, due to losses suffered in its unsecuritized non-QM loans and agency RMBS. The rapidly rising interest rates and widening yield spreads are causing trouble for Ellington Financial Inc. As the values of assets are declining in an environment of frequently rising rates, the mREIT is suffering significant mark-to-market losses. Unrealized losses rose to $26.5 million or $0.44 per share during the same period. Its non-QM lending subsidiary, LendSure was again profitable in Q2, but it further revised downward its earnings projections for 2022, which led to a mark-to-market drop in the value of EFC’s equity stake in the company.
However, EFC’s short duration loan portfolios and retained non-QM interest-only securities performed much better. The company also benefited from significant net gains in interest rate hedges and credit hedges. So, while overall decline for the quarter was certainly significant, EFC’s diversified portfolio and discipline hedging helped in preventing further losses. The silver came from payoffs, particularly in CMBS and CLOs. The company received principal pay downs of $177 million during the second quarter, which represented nearly 15 percent of the combined fair value of those portfolios.
Ellington Financial Inc. took advantage of the market, and repurchased shares at an average price of $13.20 per share, which was about 78 percent of the then book value (BV) per share. Going forward, EFC will be in a position to take advantage of historically wide spreads and high asset yields to drive returns. EFC’s credit portfolio grew to $2.66 billion, and its credit performance statistics remained strong. As economic growth is slowing down, EFC, in my opinion, has adopted the right strategies to generate high interest income. EFC also possesses strong liquidity that surely will be helpful in spreading its asset base and also resisting a liquidity crisis. All these above factors, I believe, will enable this mREIT to sustain a double-digit yield.
Investment Thesis
Ellington Financial Inc. is trading between $12 and $13, which is a good gain from its recent bottom of $10.81. There is probably little chance of this stock going below $10. With a BV per common share of $16.22, this will mean the mREIT will trade at 0.6x to its BV. Buying at a 22 percent discount to its book value should be a justified price point to enter, if someone is of the opinion that the stock will perform reasonably well in the future. Investors, not optimistic about this stock should not buy, even if the price falls below $10. A price to cash flow ratio (P/CF) of 8 also suggests a possible undervaluation.
The macroeconomic situation is not conducive and there is pessimism in the broader market. However, EFC has a strong diversified portfolio, which should enable it to generate high interest income, even under the current circumstances. The company’s dividend is most likely to be sustained, so as the double-digit yield. Once the Federal Reserve completes the proposed series of interest rate hikes, something it has hinted this week, the situation will stabilize and mREITs like EFC will get back their attractiveness. Overall, in my opinion, better days are ahead for Ellington Financial Inc. and income seeking investors shouldn’t hesitate to invest at the current price point.
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