Ellington Financial Inc. (NYSE:EFC) Q3 2022 Earnings Conference Call November 8, 2022 11:00 AM ET
Company Participants
Jason Frank – Deputy General Counsel and Secretary
Larry Penn – Chief Executive Officer
Mark Tecotzky – Co-Chief Investment Officer
J.R. Herlihy – Chief Financial Officer
Conference Call Participants
Bose George – KBW
Doug Harter – Credit Suisse
Trevor Cranston – JMP Securities
Eric Hagen – BTIG
Crispin Love – Piper Sandler
Operator
Please standby. Your program is about to begin. Good morning, ladies and gentleman. Thank you for standing by. Welcome to the Ellington Financial Third Quarter 2022 Earnings Conference Call. Today’s call is being recorded. [Operator Instructions]
It is now my pleasure to turn the call over to Jason Frank, Deputy General Counsel and Secretary. Sir, you may begin.
Jason Frank
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, forward looking statements are subject to a variety of risks and uncertainties that could cause the company’s actual results to differ from its beliefs, expectations, estimates and projections.
Consequently, you should not rely on these forward looking statements as predictions of future events. Statements made during this conference call are made as of the date of this call and the company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
I am joined on the call today by Larry Penn, Chief Executive Officer of Ellington Financial, Mark Tecotzky, Co-Chief Investment Officer of EFC; and J.R. Herlihy, Chief Financial Officer of EFC.
As described in our earnings press release, our third quarter earnings conference call presentation is available on our website, ellingtonfinancial.com. Management’s prepared remarks will track the presentation. Please note that any references to figures in this presentation are qualified in their entirety by the end notes at the back of the presentation.
With that, I will now turn the call over to Larry.
Larry Penn
Thanks, Jay, and good morning, everyone. As always, thank you for your time and interest in Ellington Financial. After a challenging first half of the year, July started the third quarter on a constructive note, with volatility, interest rates and most yield spreads reversing much of their second quarter increases.
The rally proved short-lived, however. Over the course of August and September, continued elevated levels of inflation and hawkish messaging from the Fed drove interest rates sharply higher.
Volatility shot up to record levels, fears of a recession intensified and the yield curve inverted, stressing equity and fixed income markets alike. Market sentiment steadily weakened and we saw widespread selling across sectors, particularly towards the end of the quarter.
In some cases, this included forced selling by asset managers to meet margin calls or redemptions. Liquidity declined and yield spreads widened in virtually every fixed income sector, with many sectors reaching their widest levels of the year.
Against this difficult backdrop, Ellington Financial generated a net economic loss for the quarter of 3.4%, driven by losses on non-QM, Agency RMBS and originator stakes. Nevertheless our diversified portfolio, stable sources of financing and dynamic hedging significantly limited the magnitude of that loss.
During the quarter, we had strong performance in our residential transition loan, small balance commercial mortgage loan, CLO and CMBS portfolios. And we benefited from significant net gains on our interest rate hedges and non-QM interest-only securities. We also completed our third non-QM securitization of the year during the quarter.
Turning now to the investor presentation. On slide three, you will see that we are reporting adjustable distributable earnings of $0.44 per share, which is a $0.03 sequential increase and which nearly covered our dividend. The increase resulted from our continued rotation of capital into higher reinvestment yields and from a larger credit portfolio, as we got more invested.
With interest rates rising so dramatically this year, especially in the short end of the yield curve, we have been playing a bit of catch up with our adjustment distributable earnings. The purchase yields on many of our assets, especially our agency pools, still reflect the much lower interest rate environment that we had earlier this year.
So as we continue to rotate out of that lower yielding portfolio, we should get a boost to our ADE. In addition, keep in mind that a lot of our credit portfolios are quite short in duration. So those will rotate more or less by themselves, naturally.
The bottomline is that we are still constructive on where our ADE is heading. Meanwhile, as you can see from our cash and unencumbered asset figures, we have continued to maintain a strong liquidity position, even as we have grown the credit portfolio.
Finally, I’d like to move to the Longbridge transaction. With all required regulatory approvals finally obtained, we closed on the acquisition of the other half of our affiliate reverse mortgage originator, Longbridge Financial, shortly after quarter end.
The final purchase price of $38.9 million was substantially lower than the initial estimated price of $75 million that we announced in February and reflected a discount to Longbridge’s book value rather than a premium as originally estimated along with a lower book value.
With the closing of this transaction, Ellington Financial now holds a controlling stake in Longbridge and so we will fully consolidate Longbridge onto our financials beginning with our fourth quarter financials. J.R. will elaborate on that later.
From a business perspective, we believe that Longbridge’s future earnings prospects are strong, even with the challenging market conditions we have seen so far this year. Given the substantially lower final purchase price that we paid, we believe that the stage is set for an excellent return on equity on our investment going forward.
Well, it’s been a really tough market for all mortgage originators, Longbridge actually managed to turn a profit in the third quarter and with much of its competition hobbled, Longbridge also became the second largest issuer of new issue HECM, HMBS, with a 20% market share.
That said, the surge in interest rates has driven HECM volumes lower so far in Q4 and the Ginnie Mae HMBS outlet for Longbridge’s HECM production is still trading at wide levels. Those are going to be headwinds for the business in the near-term.
But make no mistake the situation in the reverse mortgage market is quite different from that of the forward mortgage market. The reverse mortgage market is still largely untapped. Longbridge’s market share has been rising and the demographic trend trends are extremely favorable.
So we are definitely constructive on Longbridge’s long-term prospects. Furthermore, the income stream that we expect to see from the Longbridge acquisition should also enhance the diversification and quality of the EFC’s earnings stream.
The reverse mortgage origination business can flourish in an economic downturn for example, because reverse mortgages provide liquidity to borrowers without the requirement to make monthly principal and interest payments.
In fact the, last peak in HECM originations was in the wake of the global financial crisis in 2009, when home prices were falling rapidly. And Longbridge’s origination profits soared in the second quarter of 2020 during the depths of COVID, when other fixed income businesses were teetering. There is definitely a counter cyclical component to the reverse mortgage business.
With that, I will pass it over to J.R., to discuss our third quarter financial results in more detail.
J.R. Herlihy
Thanks, Larry, and good morning, everyone. I will continue on slide three of the presentation. For the quarter ended September 30th, Ellington Financial reported a net loss of $0.55 per share on a fully mark-to-market basis and adjusted distributable earnings of $0.44 per share. These results compared to a net loss of $1.8 per share and ADE of $0.41 per share for the prior quarter.
On slide four, you can see that we further increased our capital allocation to credit investments during the quarter to 88%, up 1% point from June 30th. Based on the opportunities that we are currently seeing in credit, including the recently closed Longbridge transaction, I expect this allocation to continue growing slowly relative to agency.
You can also see on this slide that average market yields are up on both our credit and agency portfolios considerably as compared to last quarter. As Larry mentioned, the purchase yields on many of our assets still reflects a much lower interest rate environment that we had earlier this year. As we continue to turnover our assets, we expect that the gap between our purchase yields and market yields will narrow and that should be supportive of our net interest margin.
On slide five, you can see the attribution of earnings between our credit and agency strategies. During the third quarter, the credit strategy generated a gross loss of $0.19 per share, while the agency strategy generated gross loss of $0.17 per share. These results compare to gross loss of $0.80 per share in the credit strategy and a gross loss of $0.20 per share in the agency strategy in the prior quarter.
Net interest income on our credit portfolio increased significantly quarter-over-quarter, driven by the larger portfolio, while we also had strong performance from our CLO and CMBS strategies, and significant net gains on interest rate hedges and retained non-QM tranches, driven by the appreciation of our non-QM interest-only securities.
On the other hand, rapidly rising interest rates, widening yield spreads and weak securitization economics generated losses on our unsecuritized non-QM loan portfolio and continued to pressure gain on sale margins and origination volumes for our loan originator affiliates.
Both LendSure and Longbridge were profitable in the third quarter, but the valuation for each declined significantly. For Longbridge, that was due to lower earnings compared to prior periods. And for Longbridge, the valuation decline reflected the reduction in our final purchase price for the other half of the company. As a result of these valuation declines, EFC booked a significant mark-to-market loss on its investments in these loan originators for the quarter.
Agency RMBS continue to face fierce headwinds in the third quarter as durations extended in response to higher interest rates and as elevated volatility contributed to yield spread widening. In our portfolio, net losses on Agency RMBS exceeded net interest income and net gains on interest rate hedges, while we also incurred double the hedging costs stemming from the volatility. As a result, we had a significant net loss for the quarter in our agency strategy.
Turning now to slide six. During the third quarter, our total loan credit portfolio grew by 3% sequentially to $2.74 billion at September 30th. The increase was driven primarily by a larger RTL portfolio, partially offset by opportunistic sales, paydowns and mark-to-market losses elsewhere in the credit portfolio.
Larry alluded to the short duration of many of our loan portfolios and these portfolios continued to return significant capital during the quarter. We received principal paydowns of $205 million on our RTL, SBC and consumer loan portfolios, which represented 14% of the combined fair value of those portfolios coming into the quarter.
On slide seven, you can see that our total long Agency RMBS portfolio decreased by 15% to $1.14 billion, resulting from net sales paydowns and price declines.
Please turn next to slide eight for a summary of our borrowings. Our weighted average borrowing rate increased by 115 basis points sequentially to 3.76% at quarter end, driven by higher short-term rates and a greater proportion of our borrowings secured by our loan portfolios, which carry higher borrowing rates and agency assets.
For both our credit and agency strategies, our cost of funds increased sharply during the quarter, driven by higher short-term interest rates. Book asset yields for both strategies also increased over the same period, thanks to portfolio turnover to buy a lesser amount.
As a result, the NIM on our credit and agency portfolios declined quarter-over-quarter to 2.34% and 1% from 2.75% and 1.76% in the prior quarter, respectively. Despite this NIM contraction, we were able to increase our ADE by $0.03 per share quarter-over-quarter.
Our recourse debt to equity ratio adjusted for unsettled purchases and sales was unchanged at 2.6 to 1, as lower recourse borrowings on our smaller Agency RMBS portfolio and the maturity of our $86 million of old senior notes was roughly offset by higher recourse borrowings on our credit portfolio and a decrease in total equity.
I will note that the availability of secured financing has continued to hold up well amid the market volatility, but we have seen haircuts increase and our financing spreads widen on several of our credit loan facilities. In fact, we were able to further expand our loan facilities during the quarter, we added a new facility for residential loans and we extended the term of one loan facility by 24 months.
On a technical point concerning our liabilities, you will see on our balance sheet that we marked down or 5.78% senior note liability by a fair amount, but since we are hedging that liability was SOFR swaps, which were also marked down. Those two mark downs largely offset each other this quarter.
Total G&A expenses for the third quarter were $0.14 per share, unchanged from the prior quarter, while other investment related expenses increased by $0.02 per share to $0.10 per share.
During the quarter, we were opportunistic with our capital management strategy. In August, we issued approximately 517,000 common shares under our ATM program at an average price of $15.55 per share, and later in the quarter, we repurchased 40,000 shares at an average price of $12.38 per share.
As of September 30th, our book value per common share was $15.22, down 6.2% from in $16.22 per share at June 30th. Including the $0.45 per share of common dividends that we declared during the quarter, our total economic return for the sort of third quarter was negative 3.4%.
Finally, as Larry mentioned, we will consolidate Longbridge beginning in Q4 and we are planning to report Longbridge as a separate operating segment in our GAAP and non-GAAP financial reporting.
Because Longbridge does not achieve true sale treatment on its HMBS securitizations, it consolidates all of those non-recourse securitization for GAAP reporting purposes. As a result, the gross size of EFCs balance sheet will more than double next quarter, even though Longbridge’s equity is quite small relative to EFCs.
The $38.9 million purchase price for the other half of Longbridge was less than 3.5% of EFC’s total equity at September 30th. I will also point out here that Longbridge is recourse debt to equity ratio was 2.3 to 1 at quarter end, which was marginally lower than EFC’s.
We are excited to assimilate the reverse mortgage business into Ellington Financial and we believe that the investment will be accretive to both our GAAP earnings and ADE over time. Here, I’d like to make an important note about how consolidation will impact EFC’s earnings going forward.
Until now, Ellington Financial only owns a minority stake in Longbridge. Like virtually all of our other investments, EFC’s fair valued that minority equity stake in Longbridge each quarter and the change in that fair value flow directly through EFC zone net income through our income statement in earnings from investments and unconsolidated entities.
Of course, Longbridge’s own earnings were a primary driver of that fair value change. So Longbridge’s own earnings did impact EFC’s earnings, but other factors came into play on the fair value determination, including earnings multiples and book value multiples prevailing in the M&A and stock market.
Starting next quarter, fair value determinations of our investment in Longbridge will no longer be factored into our financial results and instead Longbridge’s GAAP earnings will simply flow directly into EFC’s earnings.
I will also note that similar to EFC, historically, Longbridge has also fair valued virtually all of its assets. So the book value that we acquired was effectively based on fair value, not historical costs.
In addition, the calculation of our adjusted distributable earnings will change upon consolidation. In the past, when we calculated our own ADE, we did not incorporate any adjusted distributable earnings generated locally at Longbridge, but upon consolidation in Q4, EFC’s ADE will include the ADE generated by Longbridge going forward.
Now, over to Mark.
Mark Tecotzky
Thanks, J.R. This is truly an extraordinary quarter, given the magnitude of the moves in interest rates, the twist of the yield curve and the widening of spreads. What made it unprecedented is how long the volatility lasted. We have certainly seen more violent market moves before, for example, in March 2020 and at times during 2008, but during those periods, the volatility didn’t last day-after-day for months on end as it did this quarter.
I think an economic return of down 3.4% for Ellington Financial is pretty good given what we had to manage through. We saw bouts of forced selling in the third quarter, especially in September around the U.K. turmoil, where managers weren’t selling because they wanted to, but rather because they were forced to. And while I don’t think all of the market volatility has passed us by any means, things are starting to feel marginally better in some sectors.
Agency MBS, for example, is against functioning as a relative value market, not just the market absorbing forced liquidations and unlike some days in the third quarter, there is good two-way flow now, spreads are moving predictably, with liquid credit indices and balance sheet constraints no longer seems to be the overriding concern, and with spreads extremely wide, the forward-looking opportunity looks attractive.
However, we have not yet achieved that balance in other structured product sectors. Non-QM was clearly one of those strategies near the eye of the storm in the third quarter. Rapidly rising mortgage rates have caused prepayments to plummet in non-QM and AAA bonds issued any time before Q3 face a lot of extension risk.
Along with changes in call assumptions, we saw a substantial price declines in non-QM AAAs. But we don’t own those in EFC, we own loans and we own the retained tranches. Even taking into account incremental credit concerns, our retained tranches have actually appreciated in value this year, given their large IO component and how much CPRs have declined.
We have also had hedges in place in our unsecuritized loans, including being short MBS via the TBA market. We have also had credit hedges against those positions and those hedges all helped offset losses in our non-QM strategy in the third quarter.
Non-QM has borne the brunt of a lot of widening as now a push pull between repo spreads and AAA spreads as the market continue searching for a footing and sustained investor demand for bonds.
We didn’t predict that the securitization market for non-QM would remain quite this dysfunctional for this long, but we certainly thought it possible, which is why way back in Q1 we started terming out our repo and adding additional repo counterparties.
We have spoken many times on these calls about the benefits of non-mark-to-market term securitization financing over repo, but sometimes the pricing relationship is so extreme that additional repo makes sense for a quarter or two and you want to have the flexibility to delay a securitization if necessary.
The non-QM market is now showing nascent signs of recovering, supply is slowing as repo activity slows and as many originators have pulled back or exit the market and new capital primarily from insurance companies have showed up with incremental demand. Meanwhile, yields on new originations are very attractive.
There are some other things on our radar. First let’s talk about commercial mortgage bridge loans. As these loans hit their maturity dates market wide, the property owners are being forced to refinance at much higher rates and the result that DSCR is now typically the limiting factor on new loan sizes, as opposed to LTV being the limiting factor. This issue can be so severe that even on some properties that have nailed their business plans, the size of new loans offered will be less than what is required to pay off the existing loan.
This creates a situation where the capital structure might be upside down even though property level performance is not, and that problem can only be solved with new equity or mezzanine capital. But it also creates an opportunity to be part of the solution, where we can provide that requisite capital at attractive yields.
Aggressively lowering LTV, limiting the, sorry. Furthermore, this dynamic could also generate significant NPL volume, a product type that we haven’t seen in meaningful size and years. So far, performance in our commercial mortgage bridge loan portfolio has been very good and valuations on the underlying properties are holding up well, but we are preparing to manage through mortgage delinquencies.
Given the opportunities we are seeing in other sectors, our lending volume for the quarter was down, EFC participate five new originations and had four loans resolved, and our portfolio size was roughly constant quarter-over-quarter.
Second, let’s talk about fix-and-flip. If mortgage rates stay at their current levels, the most likely outcome is a continued decline in home prices to get back to some reasonable level of affordability.
In many MSAs, we are seeing all time lows in housing affordability. Also with so many borrowers locked in low-cost mortgages below 3.5%, we think existing home sales will continue to slow.
That’s a challenge for fix-and-flip, where operators need homebuyers to pay off their loans. We are seeing clear evidence of this dynamic as time on the market for new home listings is extending nationwide.
In our portfolio, we continue to see a healthy volume of paydowns and performance remains very strong. In fact, our operators are generally still selling homes above the value that we have underwritten.
On new loans, we have been aggressively lowering LTVs, limiting the scope of work we lend against, limiting the value of the homes we lend against and being more selective about the regions where we lend.
Unlike last year, it’s a loan buyers market now and we can really clamp down on terms, raising lending rates and still get the volume we want, there just aren’t many alternatives for these operators.
Looking at our portfolio overall, we grew our credit portfolio incrementally during the quarter, primarily in RTL and shrunk our agency portfolio, which now constitutes just 12% of our capital, as you can see on slide four. Both strategies now have incredible return potential, but the agency strategy relies on a lot more leverage, so we are continuing to shift the incremental dollar away from agency to credit.
As we mentioned in the press release, we marked down our originator stakes this past quarter. For LendSure, it’s just a case of lower origination volumes and smaller gain on sale margins, though they were still profitable for the quarter, which I think speaks volumes about the quality and discipline of the management there.
The next few quarters will be tougher loan originators across the Board, but the competition has been greatly reduced and the opportunity is exciting. In addition to managing EFC’s own portfolio of loans and retained tranches, we are in constant dialog with our loan origination partners to keep them informed about secondary market levels, and meanwhile, they keep us informed about changes in the origination landscape, there’s tremendous value in that dialog.
On page seven, you can see the agency portfolio shrunk by $200 million through a combination of net sales, paydowns and price declines. So we took a page out of our COVID playbook by shrinking the agency portfolio to free up liquidity when credit markets were stressed.
Q3 was not like the COVID liquidity crisis though. In 2020, Agency MBS recovered before credit because the Fed came in to buy and credit didn’t recover 12 months later. But in Q3, while both agency and credit were assessed, the agency market remained liquid throughout.
Looking ahead, where do all the recent market moves leave us now? What opportunities have been created and what risks are posed by sharply higher interest rates and an elevated risk of recession? We are respectful of what can happen to rates and spreads when the Fed hikes at the fastest pace in 40 years and simultaneously shrinks its balance sheet and how severe and sustained the consequences could be.
We have an experienced senior management team, experienced PMs and a great risk management team, who have seen many other shocks and managed through many bear markets before.
When the dust settles, I am confident that we will find ourselves in an environment where yields are so high on assets relative to the hedge — relative to hedging financing costs and the pricing assumptions are so bearish that the opportunities will usher in a period of very high returns.
The outlook going forward looks as good as it has in years. Spread widening, there has been a headwind for book value lately, spread widening has been a headwind for book value lately, but we believe that the opportunity for going forward earnings has improved dramatically.
Spreads are wider and yields are way up. Even if yields stay here, we think many queues of investments in RMBS and CMBS has the potential for multiple points of price upside just from spread tightening. Spreads are also incredibly widening the agency market and that market is showing better stability and balance since the end of the quarter.
Meanwhile, competition in origination markets is way down. So you have the pricing power to tighten investment guidelines and charge higher rates. There’s still a lot to worry about and we will keep our discipline, lots of new capital is starting to come into the market and take advantage of the yield opportunity.
Now, back to Larry.
Larry Penn
Thanks, Mark. As we move into the final weeks of 2022, I think, you can tell that we are excited about the ample investment opportunities in both securities and loans. But we continue to weigh the deployment of additional capital against maintaining adequate liquidity buffer to guard against a deeper market downturn. We also sense an opportunity to help our loan originator affiliates to continue adding market share just as many of their competitors withdraw from the market.
Finally, with recession fears looming, I will note that the credit performance of our loan portfolios, as measured by delinquencies, defaults and credit losses, continues to be strong. But with the increased risk of an economic slowdown, we are focused on tightening our underwriting guidelines, with a particular emphasis on keeping LTVs low and being even more selective about geography and property type.
For our residential transition loan and commercial mortgage bridge loan borrowers, sharply higher interest rates are stressing re-financings and takeouts, so a lower starting LTV point helps insulate against property value declines. We are now seeing clear evidence of home price weakness, given deteriorating housing affordability and so we are preparing for meaningful price declines in some regions of the country.
With that, we will now open the call up to questions. Operator, please go ahead.
Question-and-Answer Session
Operator
[Operator Instructions] Our first question comes from Bose George from KBW.
Mike Smith
Hey, guys. This is actually Mike Smith on for Bose. My first question, can you just help us get a sense for run rate, core earnings kind of relative to that $0.44, just given your outlook for capital deployment and then the addition of Longbridge?
Larry Penn
Okay. Sure. Thanks for the question. So to the second point, the addition of Longbridge, I did mentioned that, ADE will start to be captured from Longbridge beginning in Q4. We are going to present that as a separate operating segment and also give detail of how we are calculating it.
The components of ADE at the originator are different than the components of EFC, given that its core business is origination oriented and gain on sale oriented, whereas we exclude that portion from realized and unrealized from EFC side. So the components will be different but we will show them both.
As a consequence of the gain on sale component at Longbridge, their ADEs tends to be a bit more volatile than EFCs. But again we think it’s — we project it to be accretive over time and so just adding that incremental piece to EFCs today looks very good relative to our current dividend. So that’s the second part.
And then the first part, the run rate, I think 44 is, probably, which is almost 12% of our book value is a pretty good run rate estimate from here. There are different pieces that I guess a lot of moving parts into the calculation. One is the overall size of the portfolio and so we talked about this quarter, part of the sequential increase was because the credit portfolio increased in size even as Agency declines. That was a big driver.
We also have the asset yields. We are talking about how as purchase yields turnover into higher reinvestment yields, that will lead to — it should lead to topline growth on the NIM. Cost of funds have been marked to market much more quickly and so we have had a short — what we think will be short-term contraction of NIM and then we have the swap component, which is also adjusting with interest rates.
So I guess that’s a longwinded answer to your question, that I think 44 is probably a good run rate. But we think that we are going to be covering the dividend, which is $0.45, we are kind of right on top of it now. And then you are going to have the additional effect of folding in Longbridge to the equation.
Mike Smith
Any expectation there.
Larry Penn
Yeah. A few — and that — and I am sorry, that could also be a few cents per share per quarter at least.
Mike Smith
Great.
Larry Penn
Yeah.
Mike Smith
That’s helpful. Thanks. And then maybe just one on book value, do you guys have a sense for how much of the decline over the last few quarters has been realized versus unrealized? Just kind of wondering how much potential for recovery there is in your book?
Larry Penn
Sure. So I think the unrealized — a portion — I can give you better numbers, but big picture, a good chunk of our losses to date have been unrealized year-to-date, whether that’s in the agency strategy, where there is a component that’s unrealized, whether it’s on our originator stakes, where we took those stakes down to the point, Longbridge’s mark, below book representing the transaction value of LendSure, we took down, which the company has big cash — sizable balance sheet with cash balances and I think there’s upside there. And then non-QM has been another source of losses year-to-date, where there is a significant unrealized component.
If you look at our income statement year-to-date, you can see that through the nine months ending September 30th, we had unrealized losses of almost $2.50 per share, compared to realized losses of about a $1.18 per share. So just that proportion there, two-thirds or so, that combined is unrealized and we think the prospects of recovering a good portion of that are high if spreads tightened from here, which we think they can even if yields stay high.
Mike Smith
Great. That’s really helpful color. Thanks for taking the questions.
Larry Penn
Thank you.
Operator
And the next question comes from Doug Harter from Credit Suisse.
Doug Harter
Thanks. Can you just talk a little bit about how you are thinking about balancing deployment of cash versus kind of holding liquidity for volatility in the near-term and kind of what you are looking for that might move you one way or the other in that decision?
Larry Penn
Mark, do you want to take that?
Mark Tecotzky
Sure. So that push and pull between taking advantage of high yields, but managing the portfolio so that you are prepared for whatever lies ahead tomorrow, be it another Fed statement or something from the Bank of England, that was a big part of, really like high level discussions we had on managing the company in Q3.
I don’t think things have changed a lot. I mean there is certainly, maybe some green shoots, right? If you look at market expectations and if you follow what the Fed said, but just looking sort of just at — just what market expectation is telling you is that, the magnitude of the hikes is supposed to come down a little bit and I think the market will perceive that as good news.
I mentioned in my prepared remarks that some markets are starting to function with a better balance of supply and demand. I think I pointed to the agency market, we are now like daily spread moves are sort of following more closely credit indices, investment grade indices and high yield indices, which is sort of I think to us, we take it is an indication of a better balance, that you are not just absorbing for selling.
Now if you look back at Q3 and even into October, you had certain parts of securitized product market, let’s say, if you look at legacy non-Agencies, where you would have days where liquid credit indices tightened and the bonds actually wide, right? To us, that is indicative of markets that supply and demand is not in balance and you are still seeing forced selling from money managers.
So think we look at a lot of those indicators. I think things certainly feel a little bit better than how they did in parts of the third quarter. But there still definitely parts of the market where we see imbalances, right? We still see forced selling at prices that on a given day are disconnected from how you would have predicted those securities would have move.
Now the other factor we look at is, what other capital is coming into the market. And so I think one thing that’s been interesting about 2022 and it’s going to really distinguish it relative to other years is it going to be the lack of bank buying of securities and that’s been on Agency MBS, it’s been AAA CLO, it’s been across the Board, so it’s been a lot written how banks are struggling with diminished capital as they have had to absorb a lot of mark-to-market losses in available for sale portfolios. They have also had some deposit erosion.
So you haven’t seen banks being meaningful participants in securitized products the way they historically are. But what you have seen, the sort of the new, the new sort of player at the wheel that is showing up with substantial amounts of capital are some of the insurance companies. So we take that as another positive sign.
But I think when we put it all together, I would say that, we are cautiously optimistic, but the caution part of that cautiously optimistic is still going to lead right now for I think conservatism on how much cash you have on hand, right? So we are starting to see some green shoots, but it’s not enough for us to sort of sound the all clear.
Larry Penn
Yeah. So if I could just elaborate on that. We only grew the credit portfolio by around 3% last quarter. I think looking forward in the near-term, it’s going to be more about replacing the assets that are running off with higher yielding assets.
We have a lot of different strategies as you know. RTL is definitely one of our higher yielding ROE strategies right now. So I think we are going to continue to see flow there, very healthy flow.
On the other hand, as we mentioned in the prepared remarks, small balance commercial mortgage that we have slowed down quite a bit and so more sort of just as loans payoff, sort of replacing that, so not really growing that portfolio.
So we can be very selective in terms of where we are deploying those dollars of capital as other dollar of capital are coming in. We mentioned that the agency portfolio, we think is going to continue to shrink a little bit. We think that makes sense.
We always try to keep our cash positions typically in that, I will say, $100 million to $200 million range. Recently, obviously, that’s a wide range, sometimes it’s been a little lower, little higher depends upon the nature of our unencumbered asset portfolio.
But the other factor would be non-QM securitization, right? We did one in the third quarter, but we mentioned that — Mark mentioned that we have been choosing to hold more loans on repo, while we haven’t like the spreads that we have seen in the non-QM securitization market.
So that could be a catalyst for certainly bringing in more credit assets should we completed securitization there. So there’s a lot of factors, but bottomline is, I wouldn’t expect huge overall growth in the gross size of the credit portfolio in the near-term.
Doug Harter
Great. Thank you.
Operator
Our next question comes from Trevor Cranston from JMP Securities.
Trevor Cranston
Hey. Thanks. You guys talked a little bit about seeing some forced selling towards the end of September. Can you talk a little bit about kind of what you guys are seeing in terms of secondary market investment opportunities and how you are evaluating deploying capital there potentially versus the more proprietary loan you guys have come in?
Mark Tecotzky
Hey, Trevor. It’s Mark. That’s a great question because that’s very topical. We — you saw it in 2020, how we saw a big drop in security prices in 2020. In many instances, the drop in securities is greater than the drop in loan prices. So we added securities to the portfolio.
We are always looking at the relative value trade-off between securities and loans. And yes, securities look interesting to us. We think in some cases, if you are selective, they can — they are very compelling relative to loans.
The other thing about securities that is, matters a lot in this market is that, when you are originating loans, you are locked into November 2022 property valuations, right? When you buy securities, you are buying season securities. I think credit risk transfer is a good example.
You can buy CRT bonds that were originated in 2018, 2019, where the borrowers could have been 30%, 40% of home price appreciation since they took out their loans. So they are at a substantially lower LTV than what they were at origination.
So we think about all those factors. And yeah, we have seen instances where we believe that prices in securities have dropped to the point where it makes them very compelling versus loans. So I would say, we are actively looking at both sectors.
On the loan side, it’s been about tightening guidelines and we sort of went through a list of some of the metrics that we have been — we become more cautious on. And so, yeah, I think, the securities are a really big opportunity for EFC right now.
Trevor Cranston
Got it. Okay. Thanks for that. And then you also mentioned you are utilizing repo financing more for loans, while the securitization market is somewhat dysfunctional. Can you remind us sort of how much available repo capacity you have for loans and I am sort of, if there is any — and if there’s any sort of limitations in terms of how long loans can be held on those lines or anything like that? Thanks.
Larry Penn
Yeah. No. There is no limit on how long loans could be held on those lines. But sort of total capacity is not something that we disclose. But we do have now a wide variety of facilities and we are not concerned about capacity at this point.
Trevor Cranston
Okay. Fair enough. Thank you, guys.
Operator
Our next question comes from Eric Hagen from BTIG.
Eric Hagen
Hey. Thanks. Good morning. I hope you as well. I think I just have maybe three questions here. Can you say what the balance of non-QM retained tranches including the IO strips that you have on the balance sheet is? And can you maybe talk about the repo financing for those subordinate tranches and other subordinate non-Agency RMBS and how stable the haircut looks there? Can you also say what — give a sense for how your dividend will be characterize this year, like a break down between the return of capital in many ordinary dividend that you accept to pay? I think I heard you guys mentioned that you are going to shrink the agency portfolio, what’s the reason for that?
Larry Penn
No. No. Just in terms of we are — I mean, we think that the agency relative value is excellent right now. Spreads are very wide and especially if you look at discounts for example there, they are not really subject to extension risk at this point.
And in fact, if anything, specified pools, we think we can find and we have been trying to accumulate specified pools that should have faster turnover speeds. So, the opportunities in agencies are very good, nothing against agencies. Just…
Eric Hagen
Okay.
Larry Penn
Just where we see the better leveraged ROE and also just keeping our cash position healthy. And as Mark mentioned, taking — quote unquote, taking the page out of our COVID playbook, that’s just always a good source of liquidity to keep and we like to keep our liquidity up high.
Eric Hagen
Okay.
Larry Penn
Yeah.
Eric Hagen
All right. Thanks for clarifying that. Hopefully my…
Larry Penn
Thank you.
Eric Hagen
…Hopefully my other two questions came through. Thank you, guys.
Larry Penn
Yeah.
Mark Tecotzky
Why don’t I…
Larry Penn
Yeah. So why don’t I — I will hit on the first two and then maybe Mark, if you could comment on the financing on the retained tranches after I go? So you are your second question about the guidance on return of capital versus taxable income on our re-dividend.
It’s an interesting quite, I don’t have a good answer on guidance for you. We haven’t really given current estimates of taxable income on a regular basis. But I will give you a little color. The first one is, we make a 475 election on our securities.
None of the loans run on securities, which in a normal a normal market, keeps taxable income somewhat close to the GAAP earnings component coming from those investments. I am caveating though because this is not necessarily in the ordinary market that we have seen so far this year.
One thing that’s happening is, we have our domestic blocker, which contains our originator investments, where we have had some unrealized losses that impacts the provision. We also securitize for the most part, through that blocker, where there have been some losses.
So there have been some losses of the domestic blocker that won’t necessarily be reflected in our re-taxable income. So put it another way, we might have some re-taxable income at the top level that doesn’t take into account losses that we have in our corporate blocker, if that makes sense? So there could be a dichotomy this year between GAAP income and taxable income, more so than it than in a normal functioning market, right?
Mark Tecotzky
I would still expect that our dividend will have a return of capital component. It just won’t be as great as you might think given the spread between our GAAP and our tax, taxable income. Does that make sense?
Eric Hagen
Yeah. That’s helpful detail.
Mark Tecotzky
Okay.
Eric Hagen
That’s good.
J.R. Herlihy
Your first question.
Eric Hagen
Yeah.
J.R. Herlihy
Yeah. So the retained non-QM tranches, the fair value of those at September 30th was $138.5 million. That — we detailed that on our portfolio summary slide and we break out that component versus non-QM.
Mark Tecotzky
Slide four. Yeah.
J.R. Herlihy
Slide four. Mark, do you want to — he asked about how financing on those retained tranches has changed haircut wise and I guess availability this year, do you want to comment on that?
Larry Penn
I think — this is Larry. I think Mark tell me if, correct me if I am wrong, but I believe that the haircuts are still around that 50% level in terms of what’s available in the market and I — and we — still we haven’t had any issue in terms of continuing to finance those. So I haven’t seen any material change in sort of the terms that we are seeing in terms of haircuts or availability.
Mark Tecotzky
Yeah. The point I wanted to make though is that, while the haircuts cuts can be stable, they are haircuts to your current market levels, right? So you still have to, you still have to live with and manage through the mark-to-market volatility even with stable haircuts and stable repo spreads, right, because they are essentially lending you, let’s say, they are lending you 50%, 60% of fair market value and the fair market value changes, you are either going to get margin call if it goes down, you are going to be positioned to margin called lender, if it goes up.
So the retained pieces, it’s interesting, what we had going into this year was sort of IO heavy and we think about that by figuring out sort of what’s the dollar price relative to principal. And so we mentioned in the prepared remarks, that sector — that part of the overall portfolio has done well this year. There has been a dramatic slowdown in non-QM speeds.
So it hasn’t been — so to us the issue in the non-QM market this year, it hasn’t been one of financing costs, it’s been a really big changes in spreads, really big widening in spreads on investment grade bonds, AAA, AA, A and BBB.
It’s probably, you are seeing that across the Board in fixed income, you are seeing that in BSL CLOs and you see it in NPL RPL securitizations that, top of the capital structures have widened out a lot this year, a lot more than investment than IG indices or things like that.
And so that movement in investment grade spreads, primarily AAA spreads they have widened a lot relative to repo. And so while repo spreads have come up a little bit, they haven’t come nearly as much as the spreads on securities. The spreads on securities, there’s been you know, money managers and banks are typically supporters of top of the capital structure.
As I mentioned before, we were talking about the banks earlier, when Trevor had a question about their role in the market, how it’s been diminished this year on the security side and money managers have had a lot of redemptions.
So top of the capital structures had to widen out to attract some new buyers. It’s done it, it’s functioning, but it has moved a lot. And so that was sort of why for us, we are living with or managing the portfolio with more loans on repo than we normally do. At — it’s at a time where the term financing that’s available to us through the securitization market is its spreads were slightly wider than what we think we will be able to achieve in the future.
Larry Penn
And let me just add one more thing, which is something we really haven’t talked about before, but you can actually get even higher haircut or, sorry, lower haircuts higher advance rates on retained tranches, if you do vertical retention, right, because then you are getting a strip that consists of a lot of the rated securities as opposed to just the bottom horizontal piece.
So that’s actually something that we are considering for our next deal may or may not do it. Obviously, it’s been a few months. So I think July was the last time that we did a non-QM securitization.
But our next one, we could see vertical retention there being the way to go and that would also give us the ability to even sell some of our IOs that we produce from that securitization, right? And that could be interesting, too, because the market, especially in a high rate environment could be very receptive to buying IOs at strong levels.
So this is — there securitization market gives you a lot options. Obviously, right now it’s not giving us as many given that it’s in this strange state. But we could see — bottomline we could see higher advance rates, lower haircuts on vertical retention and other participants have done that.
Eric Hagen
Yeah. Great perspective. Thank you guys very much.
Larry Penn
Thank you.
Operator
Our last question comes from Crispin Love from Piper Sandler.
Crispin Love
Thanks. Mark, you talked about the opportunity in securities, but I am curious on the potential for distressed loan acquisitions, is this an area that you would expect to be more active in the next couple of quarters. And I guess have you started to see banks start to shed some CRE and non-core assets and are there any other areas where there could be an opportunity here for you in early 2023, if not already?
Mark Tecotzky
No. It’s a great question. So I would say, yes. So the first thing is commercial loans,, right? When we started the small balance commercial strategy in Ellington Financial, it was 100% non-performing loans and it was buying things that came from the old Washington Mutual portfolio, the old GreenPoint portfolio that had big — those companies, those banks had — were both acquired during the financial crisis and they both had a lot of headaches in their fall balance commercial portfolio and the acquirers, we are selling a lot of delinquent loans and so.
So that was a great strategy for us and we loved it and we probably started that in 2010, but then it dried up, right? There just wasn’t any distress. So I do think and we kind of talked about it in the prepared remarks, this issue that debt service coverage ratios on new loans are going to limit balance of new loans.
And in many cases, the balance of a new loan could be smaller than the balance of a loan that wants to get paid off despite a property performing well. So, yeah, I think, we will see more of those opportunities. We are just starting to see it now.
The other area, when you talked about on the bank side is, I think you are going to see it in unsecured consumer loans, uncon financially used to buy a fairly — we used to have fairly consistent acquisition programs on unsecured consumer loans. That’s not what we are — it’s not something we have been doing the last several quarters.
So I think — and we kind of — the reason why we stopped buying the unsecured consumer loans is we were essentially getting priced out of the market by credit unions and banks. And I talked about the capital challenges bank faced.
So we are starting to see unsecured consumer loan originators showing us packages of loans, many of which are coming at big discounts to par. So there is potential there. The other area where there is potential is on the auto side, right, packages of auto loans and that’s something that we have been participating in.
So now –and then on the residential side, Ellington Financial has been participating in either NPL or RPL sales from the GSEs, whether this you are starting to see a modest decline in home prices, if that accelerates, whether you are going to see more delinquent loans on the residential side, I think, maybe a little bit. I don’t think it’s going to be anything close to what you saw in 2008 for a lot of reasons.
But distressed opportunities in the loan side is something that, I think it’s one of the more exciting sectors that Ellington Financial can participate in going forward that and lot of these sectors have been great drivers of returns in the past but just 2018, 2019, 2020, 2021, there was no distress and so we really weren’t seeing much. So, no, we are ready for that, we are looking for that and we will certainly allocate capital to those opportunities.
Crispin Love
Thanks, Mark. All very helpful there. And then just one last question from me, so you are CMBS hedging position increased from about $15 million or so to over $50 million, if I am looking at the chart on slide 17 correctly, I am just looking at that. Are there any cracks that you are beginning to see in any CRE sectors, where you have worries or is it more just general uncertainty right now in the current environment?
Mark Tecotzky
I think, there’s been a lot written about office, right, with work-from-home. There’s certainly been for years, issues with retail. I just think it’s more of an issue that to get a new loan, operators are looking at interest rates in some cases up 400 basis points from what it was when they first bought the property if you took out a bridge loan, right?
If you didn’t turn out your loan with conduit with a 10-year loan and you were living with a floating rate loan, you could have been paying, if you look at CRE CLOs, people are paying LIBOR SOFR plus 350 and our bridge the spreads are higher. But you are taking those things out when LIBOR was essentially zero and now you might get to a point where you know, SOFR, LIBOR is 4.5%, 5% net.
So it’s just your debt costs are going to double or in some case — double in some cases. And so if that property — if you haven’t been able to grow the income side of that property proportionately with your increasing debt cost, then your debt service coverage ratio is going to drop and it can drop to a point where when you come up to the maturity date on your existing loan, lenders might not be willing to lend you the full amount of the existing loan and that is — it’s something, the market is going to have to grapple with. I think it’s opportunity for us and it’s something that we are very focused on.
Larry Penn
Yeah. And I think you should view that hedge — CMBS hedge as against our small balance commercial portfolio, which is sizable and it has been steady in terms of its size. Now look close to 70% of that I believe is multifamily and we still think that there is good support for multifamily values, but you have got the other 30%, right? And you have got some things like against smaller categories like office and things like that, that could see some challenges.
So, it’s a hedge, largely a hedge against that portfolio and it’s something that I think again differentiate Ellington Financial, in terms of our willingness to put on credit hedges like that against the portfolio when in the face of an uncertain environment.
Crispin Love
Thanks, Larry, Mark. I appreciate the comments there.
Mark Tecotzky
Sure. Thank you.
Operator
That was our final question for today. We thank you for participating in the Ellington Financial third quarter 2022 earnings conference call. You may disconnect your line at this time and have a wonderful day.
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