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Edited Transcript of EFC earnings conference call or presentation 21-Feb-19 4:00pm GMT

Q4 2018 Ellington Financial LLC Earnings Call

GREENWICH Feb 26, 2019 (Thomson StreetEvents) -- Edited Transcript of Ellington Financial LLC earnings conference call or presentation Thursday, February 21, 2019 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jason Frank

Ellington Financial LLC - Secretary & Corporate Counsel

* JR Herlihy

Ellington Financial LLC - CFO

* Laurence Eric Penn

Ellington Financial LLC - CEO, President & Director

* Mark Ira Tecotzky

Ellington Financial LLC - Co-CIO

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Conference Call Participants

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* Crispin Elliot Love

Sandler O'Neill + Partners, L.P., Research Division - VP

* Eric J. Hagen

Keefe, Bruyette, & Woods, Inc., Research Division - Analyst

* Joshua Hill Bolton

Crédit Suisse AG, Research Division - Research Analyst

* Mikhail Goberman

JMP Securities LLC, Research Division - Research Analyst

* Timothy Paul Hayes

B. Riley FBR, Inc., Research Division - Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Financial Fourth Quarter 2018 Earnings Conference Call. Today's call is being recorded. (Operator Instructions)

It is now my pleasure to turn the floor over to Jason Frank, Corporate Counsel and Secretary. Sir, you may begin.

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Jason Frank, Ellington Financial LLC - Secretary & Corporate Counsel [2]

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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 filed on March 15, 2018, 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 statement, whether as a result of new information, future events or otherwise. I have on the call with me today, Larry Penn, Chief Executive Officer of Ellington Financial; Mark Tecotzky, our Co-Chief Investment Officer; and JR Herlihy, our Chief Financial Officer. As described in our earnings press release, our fourth quarter earnings conference call presentation is available on our website, ellingtonfinancial.com. 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.

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Laurence Eric Penn, Ellington Financial LLC - CEO, President & Director [3]

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Thanks, Jay, and good morning, everyone. As always, thank you for your time and interest in Ellington Financial.

On our call today, I'll start with an overview of the fourth quarter. Next, our CFO, JR Herlihy, will summarize our financial results. And then, Mark Tecotzky, our Co-Chief Investment Officer, will discuss our portfolio positioning and performance, recent market trends and what our investment outlook is going forward. Finally, I will discuss our REIT conversion, which we've now completed, and which is retroactive to January 1, 2019. Then we'll open up the floor to questions.

During the fourth quarter, a confluence of factors steadily weighed on the market, including fears of a looming trade war, recessionary and global growth concerns and worries that the Federal Reserve and other central banks were finally ending their accommodative monetary policies. Market volatility spiked, including interest rate volatility. All this led to a flight to quality. The 10-year treasury declined 55 basis points over the last 7-odd weeks of the year, and yield spreads in virtually every fixed income sector widened relative to treasuries and interest rate swaps, with many sectors finishing the year at or near their 2-year widest levels.

Despite this challenging market environment, Ellington Financial preserved its book value, thanks to our hedging strategies and diversified portfolio. These 2 attributes, our disciplined hedging and our diverse sources of income, continue to be differentiators for EFC in the fourth quarter. We registered a slightly negative economic return of minus 20 basis points for the quarter, which we believe represents an outperformance in what was a very difficult quarter for the credit markets.

During the fourth quarter, we had strong results from several of our loan strategies, including consumer loans and non-QM loans, where we completed our second non-QM securitization in November. We believe that many of our loan strategies, in addition to providing us with a pipeline of investments over which we have greater control and visibility, had the additional benefit of being relatively insulated from interest rate movements and global macroeconomic events.

We also took steps to further solidify our proprietary pipeline of loans. In December, we closed on another strategic equity investment, this time in a consumer loan originator from which we have been steadily purchasing loans since early 2015. In conjunction with this strategic investment, we expanded our forward flow purchase agreement with this originator, thus locking in a steady supply of high-yielding, relatively short duration loans. And with this strategic equity investment, we will also be able to participate in the upside of this originator as their overall business grows.

Additionally in the fourth quarter, we continue to participate in the asset ramp-up for Ellington's fourth sponsored CLO. And moving into 2019, we have also begun participating in the asset ramp-up for the first planned Ellington-sponsored CLO transaction in Europe. I'm very excited about the growth of our CLO business and believe it will be an important contributor to EFC's earnings going forward.

Turning to Slide 4. You'll see that our credit portfolio actually decreased in size quarter-over-quarter, which was its first sequential decrease in more than 2 years. The 2 main drivers of this were the closing of our non-QM loans securitization in November along with sales of some of our non-REIT-qualifying assets in preparation for the REIT conversion, which JR will get into in more detail.

But while the portfolio was slightly smaller and our net investment income declined due to some onetime expenses, we were still able to continue growing our adjusted net investment income. So our adjusted net investment income continued to grow, and in fact, it covered our $0.41 quarterly dividend for the quarter. Finally, during the quarter, we also took advantage of our discounted stock price by repurchasing more than $5.5 million of our common shares.

Looking back on the 2018 full year, I am very pleased with our performance. In a year marked by extreme and sudden credit spread widening, both in the very beginning of the year and throughout the fourth quarter, our credit portfolio still delivered positive economic returns each and every quarter. We ended up delivering a very solid overall economic return of 9.2% and grew book value per share even after payment of $1.64 in dividends. Our shareholders were rewarded with a 17% total return on our stock, outperforming virtually the entire mortgage REIT sector. We successfully realized our objective, are prudently growing our credit portfolio and our adjusted net investment income, all while setting the stage for our conversion to a REIT.

And with that, I'll turn the call over to our CFO, JR Herlihy, to go through our financial results for the quarter in more detail.

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JR Herlihy, Ellington Financial LLC - CFO [4]

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Thanks, Larry, and good morning, everyone. Please turn to Slide 6 for a summary of our income statement. For the quarter ended December 31, 2018, EFC recorded a GAAP net loss of $2.2 million or $0.07 per share as compared to GAAP net income of $6.7 million or $0.22 per share in the prior quarter. Net investment income declined to $10.2 million or $0.33 per share from $11.7 million or $0.38 per share last quarter.

Net income was down sequentially due to the decrease in net investment income, which was related to the issuance cost of our non-QM securitization and onetime cost associated with the REIT conversion, and also because net unrealized losses increased quarter-over-quarter, driven by markdowns on our interest rate hedges and on several of our credit strategies connected to the market weakness of the fourth quarter. These net unrealized losses exceeded net realized gains in the fourth quarter and were also up quarter-over-quarter. After adjustment, net investment income was $0.41 per share, up $0.01 from last quarter and covered our quarterly dividend.

Please keep in mind that while we view adjusted net investment income as a good proxy for our core earnings power, it does have its limitations as a portion of our capital will always be invested in assets that we hold for capital appreciation as opposed to generating current net investment income. Net investment income also does not capture much of the total returns that we generate with our opportunistic trading.

Please turn to Slide 7 for details on the attribution of earnings between our Credit and Agency strategies. In the fourth quarter of 2018, the Credit strategy generated gross income of $8.1 million or $0.26 per share, while the Agency strategy generated a gross loss of $4.9 million or $0.16 per share. These amounts compare to gross income from the Credit strategy of $11 million or $0.36 per share and gross income from the Agency strategies of $741,000 or $0.02 per share in the third quarter.

In the Credit strategy, total net interest income was $17.7 million, while net realized and unrealized loss was $12 million, as weakness in the credit markets caused many of our security strategies to underperform. However, much of this underperformance was offset by our net credit hedges and other activities, which generated a net gain of $8.4 million for the quarter. Other investment-related expenses increased to $5.5 million this quarter from $3.9 million due to issuance cost of $1.6 million related to the non-QM securitization completed in November 2018.

In the Agency strategy, declining interest rates generated net realized and unrealized gains on our Agency assets of $8.5 million while net interest income totaled $2.6 million. Losses on our interest rate hedges and other activities exceeded these gains, however, as declining interest rates and higher levels of interest rate volatility generated net realized and unrealized losses of $16 million.

Turning next to Slide 8. At year-end, you can see that the size of the Credit portfolio decreased about 8% sequentially to $1.1 billion. Consistent with prior quarters, these totals are quoted before consolidating the non-QM securitization trusts. In the 2 charts on this slide, you can see smaller allocations quarter-over-quarter to residential loans and REO, which reflects the effects of the non-QM securitization; and to CLO and Non-Dollar MBS, ABS, CLO and other, which reflects rotation out of non-REIT-qualifying assets and preparation for the REIT conversion.

At the same time, you can also see the tremendous quarter-over-quarter growth of our REIT-qualifying small balance commercial loan portfolio as reflected in the CMBS and commercial loans and REO slides. As a final point, as of mid-February, our non-QM loans portfolio had already grown back to about $160 million.

Turning to Slide 9. You can see that our long Agency portfolio increased to $975 million from $944 million during the quarter with the asset mix essentially unchanged.

Next, please turn to Slide 10 for a breakout of our borrowings and leverage. At year-end, we had a total debt-to-equity ratio of 3.36:1, up from 3.12:1 last quarter. Our recourse debt-to-equity ratio actually declined however to 2.68:1 from 2.81:1. Because we consolidate the non-QM securitization trust for GAAP reporting purposes, all of the non-retrained -- non-retained tranches of those deals, while not recourse to us, do constitute liabilities on our balance sheet and thus increase our total debt-to-equity ratio, but they don't impact our recourse debt-to-equity ratio.

For the fourth quarter, our total G&A expenses were $4.7 million, up from $4.2 million last quarter, driven by costs associated with the REIT conversion. In the fourth quarter, REIT conversion costs were $615,000 compared to $236,000 in the previous quarter. We estimate that all remaining expenses related to the conversion would total approximately $1.2 million. Excluding the costs associated with the REIT conversion, our annualized expense ratio for the fourth quarter was 2.7%. We ended the quarter with book value per share of $18.92.

I will now turn the call over to Mark.

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Mark Ira Tecotzky, Ellington Financial LLC - Co-CIO [5]

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Thank, JR. Against the backdrop of extreme market volatility, EFC performed very well in Q4. Despite a double-digit percentage drop in the S&P and several point drops in high-yield bonds and leverage loans, EFC's Credit strategy has made money for the quarter. I attribute much of the strong performance of our credit portfolio: first, to the benefits of short spread duration relative to our yields; and second, to the benefits of diversification with an asset mix that is generally seasoned or low LTV and in many cases, both.

We consistently evaluate how assets will perform in good and bad markets before we invest, and that discipline in asset selection has given us a very stable portfolio. The asset mix of EFC's Credit portfolio is now largely in non-QSub investments, many sourced through proprietary relationships. The Credit portfolio value has less correlation to liquid credit indices, such as high yield. It is precisely for this reason that EFC has gradually reduced credit hedges over the last 3 years. We just don't need the same amount of hedge changes in book value as we used to have when our portfolio mix was more correlated to liquid credit indices.

If you look on Slide 23, you can see that quarter-over-quarter, we did not need to make any major adjustments to our credit hedges to ensure their effectiveness this quarter. Q4 is a great example of how our current portfolio does not have a lot of price volatility that requires a lot of hedges to neutralize. Our current basket of hedges did a great job and is appropriately sized as is to be comfortably REIT compliant, which is one factor that shaped our thinking about -- with the REIT conversion.

Turn to Page 8 to see how our asset mix evolved during the quarter. The first thing to note is that the drop in portfolio size was largely the result of the successful completion of our second non-QM securitization of LendSure loans. We launched the deal in November, just as spreads were beginning to widen, so we got ahead of the December volatility. LendSure now has over 100 employees, and its monthly loan volume continues to grow. Our non-QM loan strategy was a significant contributor to earnings this quarter.

We also continued to deploy more capital on our commercial real estate strategies, mostly new originations. The commercial real estate strategy within EFC historically has had a great ROE, but the pipeline can sometimes be irregular. This quarter, the market came to us and we were able to put a lot of money to work.

As outlined in the supplemental slides detailing the REIT conversion, we opportunistically sold some non-REIT-qualifying assets, specifically CLO debt and some non-dollar investments. As implied by the dotted line on Slide 20, we expect that rebalancing out of some lower yielding non-qualifying assets into REIT-qualifying assets will continue at a gradual pace throughout the year without any reduction in projected portfolio yield.

Our Agency MBS portfolio underperformed during the quarter, and in fact, more than 100% of our overall net loss during the quarter came from this strategy. The volatility in financial markets was extreme in Q4, and dramatic spread widening caused the Agency MBS to underperform hedging instruments significantly. However, as is often the case with Agency MBS losses that are caused by volatility-induced spread widening, the loss is earned back as spreads revert to the mean. That's exactly what we've seen so far in 2019, as our Agency strategy has already earned back well over half its Q4 loss.

Agency MBS have been a consistent and diversifying source of returns for EFC since our inception more than 10 years ago. Nothing about Q4's performance changes our perception of the earnings power of our Agency strategy. In fact, seeing some of the best investment opportunities in more than 2 years with the wider spreads, we grew our Agency portfolio in Q4. That's shown in Slide 9.

The high-level asset portfolio asset breakdown on Slide 11 explains a lot about our stable credit performance in Q4. In our loan strategies, we frequently target shorter spread duration assets. Our consumer loan portfolio was very short duration, about 1 year. Our non-QM loan portfolio consists mostly of 7-year adjustable-rate mortgages. So again, it has far less price volatility than 30-year fixed rate mortgages.

Most of our commercial mortgage loan originations have had 1 to 2-year terms and very high coupons. So again, they've had limited price volatility.

Our NPL strategy is focused on quick resolution as opposed to long-term workout plans. We focus on maximizing yield while reducing price volatility, which we achieve in large part by reducing duration. As a result, when credit spreads widen market-wide, which is exactly what you saw in Q4, our asset price declines tend to be more modest than in longer duration credit-sensitive strategies.

I and the other EFC portfolio managers are excited about the REIT conversion, which should open up new avenues of capital to us. It also gives us enough flexibly to generate significant income and, importantly, enough flexibly with our hedges to mitigate price swings from either rising interest rates or credit spread volatility.

Now back to Larry.

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Laurence Eric Penn, Ellington Financial LLC - CEO, President & Director [6]

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Thanks, Mark. Before we open the call to questions, I'd like to take a few minutes to discuss our tax conversion away from a publicly traded partnership to a REIT, which is now complete and effective retroactive to January 1, 2019.

Our new tax structure should provide substantial benefits to Ellington Financial and its shareholders and won't require us to materially change our investment or hedging strategies. While management had, from time to time in the past, thought about the potential benefits of converting away from a publicly traded partnership, the changes in the tax law implemented towards the end of 2017 along with the evolution of our portfolio in recent years made this the right time for Ellington Financial to take this strategic step.

We have included a few slides on the REIT conversion as an appendix to our Q4 earnings presentation, beginning on Slide 15. Here, we list the major benefits of operating as a REIT rather than as a publicly traded partnership, including an expanded investor base, better liquidity for our stock, simplified tax reporting for shareholders as well as a 20% REIT tax deduction for domestic shareholders. Crucially, we will be able to maintain our core investment and hedging strategies as a REIT, while -- which we viewed as a prerequisite to any conversion.

Now I'll touch on each of these benefits in a bit more detail. Please turn to Slide 16. Converting to a REIT should expand our potential investor base and improve the liquidity of our stock over time. Historically, the size of EFC's potential investor universe was limited by the publicly traded partnership structure and the K-1 it generated. As a REIT, we solved this problem. We'll generate a 1099 instead of a K-1, starting with this tax year. And by doing so, we can appeal to a larger investor base, including traditional REIT buyers, institutional investors whose mandates preclude buying partnership interests or just the many investors who prefer not to buy partnership interests.

The REIT structure also opens the door to our inclusion in many indices, which is particularly appealing, given the tremendous growth in passive index-based investing. As a REIT, we will also be able to access additional sources of financing that were not feasible under our previous structure, including convertible notes and preferred stock. And finally, our tax structure now matches that of the hybrid mortgage REITs to whom we've always been compared, which should simplify investor analysis and comparability.

Slide 17 reiterates the point about simplifying tax reporting. Our tax conversion is effective retroactive to the beginning of the year. So for the entire 2019 tax year, shareholders will only receive a Form 1099.

Turning to Slide 18. As a REIT, our ordinary dividends should qualify for the 20% pass-through deduction for U.S. individuals, which was a big component of the 2017 tax legislation. By the way, in a recent development, this tax advantage now also applies to U.S. individuals who hold our shares indirectly through mutual funds. Again, this provides a substantial new benefit to our shareholders and, importantly, levels the playing field for us when competing with other mortgage REITs for investment capital.

Finally, turning to Slide 19. The key to all of this was that we could convert to a REIT and still maintain all of our core investment and hedging strategies. Over the past few years, our portfolio had evolved in response to market opportunities, with a result that our proprietary loan strategies, most of which are real estate related, were driving a bigger and bigger portion of our earnings. As this was happening, we were naturally getting closer and closer to being REIT qualified.

In addition, most of our loan strategies don't involve large credit hedges, and this also made REIT conversion easier. That said, we do continue to maintain credit hedges on certain assets. And in a quarter like the one we just had, where credit spreads widen substantially, you can see their importance in protecting book value. The bottom line is that we believe that we can comfortably satisfy the REIT tests, while still maintaining our interest rate, credit and currency hedging discipline.

Over the past several months, as we prepared to become a REIT, we have sold a sizable portion of our non-REIT-qualifying assets and shifted this capital into REIT-qualifying assets. But most of the assets we've sold were merely placeholder assets, that is to say they were temporary, lower-yielding assets that were not part of our core strategies anyway. Additionally, we intend to continue to invest in our highest conviction non-REIT-qualifying strategies, including consumer loans and Ellington-sponsored CLOS at amounts that still allow us to comfortably satisfy the REIT tests.

Looking forward, starting with our first quarter 2019 releases and similar to other mortgage REITs, we plan to report core earnings as an alternative non-GAAP earnings metric instead of adjusted net investment income, which we've been reporting as a PTP. That said, we believe that these are quite comparable metrics. Given what we're seeing in terms of the current opportunities in our core strategies, we think that our prospects for core earnings growth are excellent.

In summary, we are extremely excited to have completed our conversion to a REIT. The benefits of being a REIT should be real and significant. And I want to thank our entire team for all the hard work achieving this milestone for Ellington Financial, as planned and on time.

With that, we'll now open the call to your questions. Operator, please go ahead.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from line of Doug Harter of Crédit Suisse.

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Joshua Hill Bolton, Crédit Suisse AG, Research Division - Research Analyst [2]

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This is actually Josh on for Doug. Larry, now that the REIT conversion is behind you, can you talk a little bit about the next steps needed in order to be eligible for inclusion in some of the indices that you've mentioned previously? And as a follow-up, what kind of timing could we possibly see until those additions?

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Laurence Eric Penn, Ellington Financial LLC - CEO, President & Director [3]

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Sure. So one prerequisite, which we hope to complete shortly, is -- it turns out is to actually change the state law structure or corporate structure, some might call it, from a limited liability company, which we currently are, Delaware limited liability company, to a corporation for state law purposes, so a Delaware corporation. So that's in the works. And we plan to do that shortly in the next couple of weeks. That is our goal there. And the Russell Index, just to name one, is -- goes through its rebalancing later in the second quarter. So we believe that we should be on track for inclusion in some of the Russell indices that exclude publicly traded partnerships or companies that are limited liability companies or partnerships for state law purposes.

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Operator [4]

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Our next question comes from the line of Crispin Love of Sandler O'Neill.

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Crispin Elliot Love, Sandler O'Neill + Partners, L.P., Research Division - VP [5]

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I'm just curious about the trajectory of the credit portfolio that you would expect over the next couple of quarters. I understand the 8% sequential decline in the fourth quarter, mostly because of the non-QM. But do you guys still think you have room to grow that portfolio? Or would it be kind of more repositioning within the credit portfolio?

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Laurence Eric Penn, Ellington Financial LLC - CEO, President & Director [6]

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Yes. I think -- we think that we still have room to grow the portfolio and certainly replacing that 8%, but we think that our leverage is prudent and we can continue -- we certainly have access to ample financing. We have assets that we're not currently financing that we could finance. So we think that we have continued room to grow the portfolio. The Agency part of the book also has room to grow. That's a little bit higher leverage obviously. But we think the Credit part of the book also has room to grow as well.

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Crispin Elliot Love, Sandler O'Neill + Partners, L.P., Research Division - VP [7]

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And are you expecting any more REIT conversion expenses in the first quarter?

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Laurence Eric Penn, Ellington Financial LLC - CEO, President & Director [8]

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Yes. So we -- I think, JR, right, you mentioned that we're projecting $1.2 million of expenses that have not yet been included in the financials that you've seen, namely the Q4 that we just released that showed $0.02 of expenses. We think that there's about $1.2 million left as of December 31st of last year.

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JR Herlihy, Ellington Financial LLC - CFO [9]

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Crispin, it's JR. That's right. And I would expect that a good portion, not all, but a good portion of those to come in Q1. I think that's our acumen right now.

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Crispin Elliot Love, Sandler O'Neill + Partners, L.P., Research Division - VP [10]

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Okay. Sounds good. And then can you just talk a little bit more about the consumer strategic relationship? Kind of -- and I know it's been a relationship since 2015 that you've been getting loans from, but is it personal loans, home improvement, auto? And then do you have any kind of

(technical difficulty)

the equity partnership relative to size to Longbridge and LendSure?

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Laurence Eric Penn, Ellington Financial LLC - CEO, President & Director [11]

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Okay. So I'll -- I'm only going to comment -- I'm not going to give you all that detail. The size of the investment was more comparable to the LendSure investment, so it's small relative to the Longbridge investment, for example, and under $5 million. The -- in terms of the space that it's in, I don't want to get into details there. It's been a steady partner of ours as we -- as I said, since 2015, but -- or as we said earlier in the call, but the size of the flow has not been -- it's not our biggest consumer loan provider by any stretch. So we're certainly hoping that with -- partly with this capital from us and with other plans that we have and that they have that the flow is going to grow substantially over time. But I am not in a position right now to provide any more details on that new investment of ours.

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Operator [12]

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Our next question comes from the line of Eric Hagen of KBW.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [13]

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Congrats on the conversion, looks excellent. The minority investments that you have in companies like LendSure, as a REIT, will there be anything preventing you guys from acquiring the entire company, if you wanted to ever do that down the road?

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Laurence Eric Penn, Ellington Financial LLC - CEO, President & Director [14]

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Yes. So the answer technically is no. We can do that. There -- just like with all the other REIT tests, right, it would have to satisfy -- we have to continue to satisfy the REIT tests. And generally, right, an investment in an operating company would be held in taxable REIT subsidiary. And so -- and as I'm sure you're familiar, the size of your taxable REIT subsidiaries in aggregate can't exceed certain limits so -- about 20% basically, so that would be a long way to go. And if Ellington expands and grows, then that would increase all these limits. So I don't see the REIT test as really getting in the way there, obviously, given the size of these investments. But we certainly have no plans, and there've been no discussions about -- just to be clear about acquiring any larger interest than the minority interest that we currently have in any of these companies.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [15]

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I didn't mean to suggest that there was anything like that taking place in the future. Just -- maybe just the option.

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Laurence Eric Penn, Ellington Financial LLC - CEO, President & Director [16]

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Right. And we, yes -- so -- and we -- but -- and we do have some options in connection with some of these investments, but again it would never be to acquire majority interest, at least at this point. That hasn't been discussed and that's not on the table.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [17]

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Got it. Okay, great. And then just a market-based question. On the non-QM side, how deep is the market for whole loan sales? Are you guys engaging in any whole loan sales? Or is it really just -- is that not the intention of that strategy?

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Mark Ira Tecotzky, Ellington Financial LLC - Co-CIO [18]

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So this is Mark. By and large, when we have sold loans, by far, the dominant outlet has been securitizations. From time to time, we have been involved in some smaller whole loan sales. But if you think about the market broadly, there are -- there is whole loan sale activity going on. There are certainly banks that are interested in these shorter duration, higher coupon, higher yielding non-QM securities. And I would say that we're also seeing a broadening and a little deepening in the investor base for non-QM securitizations. The volume of securitizations was up last year. There's been, I would call it, robust issuance this year. So non-QM and other post-crisis mortgage securitization vehicles, say, jumbo deals that are getting done, it is getting a burgeoning sponsorship from a lot of investors that have seen the legacy non-agency market shrink, right? That market has gone from $1 trillion down to $350 billion, $400 billion. So between the credit risk transfer deals, non-QM, RPL deals, jumbo 2.0 deals, mortgage originations post financial crisis with more credit enhancement, more conservative underwriting, that's getting to be a bigger and bigger part of the market.

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Operator [19]

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Our next question comes from the line of Tim Hayes of B. Riley FBR.

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Timothy Paul Hayes, B. Riley FBR, Inc., Research Division - Analyst [20]

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Mark, you made some comments around the credit hedges, and we saw them increase in the quarter a little bit. Just wondering how you see this portfolio trending as you allocate more capital to non mark-to-market loan strategies.

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Mark Ira Tecotzky, Ellington Financial LLC - Co-CIO [21]

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I think for some of the loan strategies, like the consumer loan strategy, we typically don't do credit hedges there. Where you're more likely to see some credit hedges is when we retain investments from the Ellington-sponsored and Ellington-managed CLOs and also some of the CMBS investments, CMBS B-pieces. Sometimes, we think it's optimal to have a credit hedge on those. So I would say that as the portfolio grows, non-QM that is so low LTV and has had really no losses, that we typically don't have credit hedges on. Same thing with the consumer loans. CMBS B-pieces and CLO equity, that, you might see credit hedges go on. So we'd just really be pro rata with the investments.

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Laurence Eric Penn, Ellington Financial LLC - CEO, President & Director [22]

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I'd like to just add one thing, which is just to clarify. Our loan strategies -- in fact, all of our strategies are mark-to-market. We mark-to-market through the income statement and that's just very important to note. We -- obviously, when you've got a concept like core earnings or adjusted net investment income, which we, historically, were publishing, that doesn't take into account, generally speaking, unrealized gains and losses. But when we have, for example, a loan that becomes nonperforming, it hasn't happened in non-QM, but it certainly has happened, for example, in consumer loans, we absolutely do take a mark-to-market hit on that through the income statement. So I just wanted to make that clarification, and that won't change just because we are a REIT now. We're going to continue to use mark-to-market GAAP accounting through the income statement. So I just wanted to clarify that.

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Timothy Paul Hayes, B. Riley FBR, Inc., Research Division - Analyst [23]

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Okay. Appreciate the clarification there and the color around that. And then, just -- since you touched on adjusted NII, you covered the dividend this quarter with adjusted NII, and you've made some comments around your outlook for NII and portfolio growth going forward. Is your expectation you'll be able to cover the dividend with NII going forward?

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Laurence Eric Penn, Ellington Financial LLC - CEO, President & Director [24]

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Yes.

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Timothy Paul Hayes, B. Riley FBR, Inc., Research Division - Analyst [25]

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Okay. Got it. And then just a quick housekeeping question. On Slide 5, you gave the weighted average market yield for the different asset classes in your portfolio, and they seem to jump around a decent amount. Just wondering, this quarter, if that was related to market volatility or if there's any impact from portfolio repositioning or leverage in there at all.

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JR Herlihy, Ellington Financial LLC - CFO [26]

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Tim, it's JR. So some of that dynamic will be the mix of assets within a given loan. So as an example, CMBS -- the first one, CMBS and commercial mortgage loans, at various points of time, that will have different portion of CMBS versus small balance commercial. And then within commercial loans, sometimes those will be originations, sometimes those will be NPL. So I think a lot of the movement quarter-to-quarter you're seeing is probably related to the composition of the unusual categories. Residential mortgage loans has non-QM. It also has some resi NPL/RPL. So I think you've probably seen that dynamic across a few different roads. If there's any specific deals you know that you want to talk about, we can get into detail there as well.

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Operator [27]

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Our final question comes from the line of Mikhail Goberman of JMP Securities.

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Mikhail Goberman, JMP Securities LLC, Research Division - Research Analyst [28]

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Congrats on the REIT conversion, well done. Just a 2-part question, kind of related. Within the credit space, given the spread widening that we saw in the fourth quarter, where do you guys see the most attractive returns in that space? And also kind of within that, what's your outlook on growth in non-agency residential loans for the year?

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Mark Ira Tecotzky, Ellington Financial LLC - Co-CIO [29]

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Yes. So non-agency residential loans, if I think about just what we expect out of LendSure, I'd expect that we'll see their volumes probably grow 40%, 50% this year. They've been adding staff. They've been adding market share. That's our projection there. In terms of where is the best sort of risk-adjusted ROE, I'd say that we value diversification. So when you look at how the portfolio changes quarter-to-quarter, it's generally incremental. We certainly saw in Q4, a lot of interesting opportunities on commercial real estate side, so I think that's likely to persist. JR talked about how we've been ramping up the non-QM portfolio, so that has an attractive ROE right now. Consumer loan strategy has been performing very well. And Larry talked about our fourth CLO. So all those sectors, I expect, are going to contribute assets.

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Operator [30]

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And ladies and gentlemen, that does conclude our Q&A session and today's conference call. Thank you for your participation. You may now disconnect, and have a wonderful day.