Ellington Financial Inc.
Q2 2013 Earnings Call Transcript

Published: 6 Aug 2013

[Operator:]

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Financial Second Quarter 2013 Financial Results Conference Call. Today’s call is being recorded. At this time, all participants have been placed in listen-only mode and the floor will be opened for your questions following the presentation. (Operator Instructions). It is now my pleasure to turn the floor over to, Sara Brown, Secretary. You may begin.

[Sara Brown:]

Before we start I’d like to remind everyone that certain statements made during this conference call including statements concerning future strategies, intentions and plans 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 and can be identified by such words as belief, expect, anticipate, estimate, project, plan, should, or similar expressions or by reference to strategies plans, or intentions. As describe under item 1A or our annual report on Form 10-K, filed on March 15, 2013, forward-looking statements are subject to a variety of risks and uncertainties that could cause the company’s actual results to differ from its belief, expectations, estimates and projections. Consequently, you should not rely on these forward-looking statements as predictions of future events. Statements made during this conference call are made as of the date of this call and the company undertakes no obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise. I have with me today on the call, Larry Penn, Chief Executive Officer of Ellington Financial; Mark Tecotzky, our Co-Chief Investment Officer; and Lisa Mumford our Chief Financial Officer. Turn it over to Larry.

[Laurence Penn:]

Thanks Sara. Once again it’s our pleasure to speak with our shareholders this morning, as you release our second quarter results. As always we appreciate you are taking the time to participate on the call today. We will follow the same format as we have on previous calls. First, Lisa will run through our financial results. Then Mark will discuss how the MBS market performed over the course of the quarter, how we positioned our portfolio, and what our market outlook is. I will follow Mark and then we’ll open the floor to questions.. As a remainder we have posted a second quarter earnings conference call presentation to our website www.ellingtonfinancial.com. You’ll find it right on our shareholders page will alternatively on the presentations page of the website. Lisa and Mark’s prepared will track the presentation. So if you have this presentation in front of you please turn to Page 3 to follow on. I’m going to turn it over to Lisa now.

[Lisa Mumford:]

Thank you, Larry, and good morning everyone. For the second quarter we generated net income of $11.6 million or $0.49 per share we can see this on Page 3 of the presentation. Our diluted book value as of the end of June was $24.51 compared to $24.78 as of the end March for a very modest decline of 1.1% and that of course not giving credits to our payment during the quarter of a $0.77 dividends. In both our non-agency and agency strategies, our interest rate hedges offset much of the impact of pricing declines in our investment portfolio at interest rates sharply increased over the course of the last half of the quarter. Our non-annualize return on equity for the first half of the year which includes the impact of all mark-to-market adjustments of 9.4%. In our predominant non-agency strategy we earned $17.7 million dollars of growth P&L for the quarter or 3% of total average equity for the quarter non-annualize. This strategy utilize about 80% of our capital during the quarter and on that basis to quarterly non-annualized return was closer to 4%. Over the course of the quarter we increased our non-agency portfolio approximately $189 million on a cost basis. Our average holdings based on amortized costs increased to $584 million in the second quarter, up from average holdings of $514 million in the first quarter and our weighted average book deals for the second quarter was $8.6% down from 9.4% in the first quarter. As of June 30, 2013 net unrealized gains in the portfolio were approximately $58 million and as measured by value the bond portfolio was approximately $766 million. The weighted average yields as of June 30 for 6.8%. In our agency strategy, we generated a slight loss of $600,000. Our agency strategy utilized approximately 15% of our capital and a relative small loss was notable again given the sharp increased in interest rates and relative under performance during the quarter of specified agency pools relative to U.S. treasuries and interest rate sharp. Our interest rate hedges generated gains of $20.6 million or $1 per share significantly reducing the impact of net realized and unrealized losses up $31.1 million. We held the size of the agency portfolio relatively constant as of the end of June compared to the end of March had about $860 million and as Mark will get into when he reviews the portfolio our TBA hedges extended in duration as rates rose and this provided a tremendous benefit. They actually provided over half of the income from our interest rate hedges in this strategy. The increase in our interest income in this strategy with largely the results of an approximately $1.5 million adjustments to our premium amortization which was made in light of higher interest rates in a corresponding decline an expected prepayments. This increase in interest income is offset on our income statement by corresponding reduction in net realized and unrealized gains and losses on investments. Core expenses which we defined as other operating expenses in base management fees, but excludes incentive fees, financing cost and other direct investment related expenses came in at 2.8% of average equity on an annualize basis and were inline with our expectations. Other investment related expenses is a new line on our statement of operations and an includes items such as dividend expenses on our short equity position. We incurred incentive fee expense during the quarter since on a rolling four quarter basis our results were in excess of the return hurdle. Our overall average cost of funds on repo increased nine basis points compared to last quarter, as of the end of June we increased a relative five in composition of our outstanding repo as compared to that of March 31. As of the end of June almost a third of our repo borrowings before our non-agencies were as of the end of March this net amount was about 25%. In the aggregate we increased our leverage ratio a bit [2.02 to 1] as of the end of June up from [1.86 to 1] as of the end of March. In connection with the increase in our leverage ratio in the latter parts of quarter, and we increased our cash position for both defensive and offensive reasons. On the defensive side, we want to hold more cash in light of the higher market volatility and on the offensive side we wanted to be in a position to purchase assets that we found attractive. We continued to find repo readily available. In May, we completed a follow on offering where we raised net new capitals of a $125.3 million and the offering was slightly accretive to diluted book value. Proceeds from the offering were principally deploys to our predominant non-agency strategy. Finally our Board of Directors recently declare our second quarter dividend of $0.77 per share which will be paid on September 16th to shareholders of record as of August 30, our dividend are paid quarterly in arrears and at the end of each year our Board will consider our earnings and other factors to determine the amount of a special dividends if any. For the first six months of the year we earned $51.9 million in net income and after payment of the second quarter dividends in September, we will have paid out approximately $40.1 million in total dividend. Based on our closing price yesterday of $22.76 our annualized dividend yield is 13.5%. I will now turn it over to Mark.

[Mark Tecotzky:]

Thanks Lisa. So last talk about this quarter and I'm going to be discussing a lot of the headwinds and challenges of the quarter. I think just think it fairs repeating despite these challenges we made money this quarter. So taken together the effectiveness of the hedges, the income earned on the portfolio and the trading opportunities combined to overcome all the challenges. Slide 10. On the hedge adjusted basis non-agency MBS did okay for the quarter. It didn’t do okay everyday or every week and there were times when they had pretty large priced outs, but for the non-agency bonds that we hope start at the quarter and at the end of the quarter prices only moved by a small amount less than a point. Part of that performance was by design of the portfolio we owned mostly floaters or hybrid ARMs that are now past that fixed rate period. As the interest rates moved up these bonds get priced to the expectations of higher coupons in the future, where as fixed rate bonds don’t get that benefit. As rates rise that is a kind of bonds many investors want. This quarter the way we made most of money was on interest rate hedges, carry income and realized gains. And that is a lot different than many of the quarters of the last few years. We grew the portfolio, there were periods of great distress in the quarter, there were selling from European banks, selling from Fannie Mae and Freddie Mac and by the time June [rolled] around many of their investors weren’t in the position or the mind set to commit capital. We grew the portfolio because of our capital rates and the opportunities. I think this quarter is a good example of our belief that no single strategy works all the time. We have had lots of quarters where we made money, because non-agency prices went up, this quarter we made money because they didn’t go down in prices, but the things were sort our hedging position did go down in price. Slide 12. More reasons were front in center of the second quarter sell off. Bond redemptions and lease deleveraging led to a lot of force selling of MBS. We increased our credit hedges of the portfolio grew in size and in deference to the strong housing market most of our hedges are no longer been ABX. Slide 14, the agency portfolio. For this quarter, I really think it’s helpful to think about splitting the three months period into two sections. The first part you had the tenure note between 1.6% and 2.2% and for the second part it was between 2.2% and 2.7%. In the first period, Agency MBS preformed well, recovering much of their first quarter weakness and the biggest risk market participant seem to want to the control with prepaid risk, kindled by some 160 prints on the tenure note. The second part of the quarter was dominated by a violent rate sell off, driven by series of less accommodative Fed policy, here are some context. In the quarter from peak to trough, Fannie Mae creates ranged from price of 104.5 down to 96, that’s an 8.5 point range. From the start to the end of the quarter, they dropped 5.75 points. This quarter really highlights the importance of hedging. On your nine times (inaudible) on assets that are moving at 8.5 point range and you want to be basically flat, that means you’re appropriately hedged. Even though we roundup basically flat for the quarter, a lot went into that performance. It’s instructive to partition the price decline in agency pools into three pieces, the first piece is that mortgages under performed swap and treasuries. So even if swap yields didn’t move at all, the spread widening caused mortgages to go down in price. That underperformance is worth of pointing to. The second and biggest part was the interest move, at the start of the quarter, 30 year Fannie 3.5 had a duration of about four-years. The full year swap moved about 50 basis points. It started at about 70 basis points and ended at a 120 basis points. So that rate move on a full year duration cost about two points. But the real killer and this why you have to dynamically hedge, as interest rates increased throughout the quarter the duration of Fannie 3.5 extended from about four years to almost seven years. And by the end of the quarter the seven years swap we yield was [2.15], so that’s a 145 basis points higher yield than where the four years swap started the quarter. So that was a trip event you want to avoid. Too much interest rate risk, assets on the long into the curve hedge with swap on the sort end of the curve and too much spread risk. And this is really the beauty of TBA hedge, it gets longer as your asset gets longer and extends on a very steep yield curve and that also cuts down your spread length. So what did we do? The [tax] we thought were too expensive at the start of the quarter came crashing down and started to look very cheap to us by the end of the quarter. To we sold out a bench of pools we had bought the low pay, and bought a bunch of pools where the (inaudible) has dropped materially and I'm talking two point swap in pay-ups in some cases. We were active, we took almost $6 million of realized losses, there were pools that had two points’ pay-ups mid way through the quarter that we bought (inaudible) points by the end of the quarter. That’s sort of opportunity volatility and distress creates. Slide 15. The hedges extended were measured by 10-year note equivalent, but most of that happened organically as the TBA sort extended in duration. We did not have to be in the market hedging interest rate risk or selling assets after price that already moved that four points. So what’s the outlook for agencies? We think it looks very good, people equipped forget, but one of the biggest risks in this stage is pre-paid risk. And now from many coupons that risk is over a 100 basis points out of the money and for other coupon it is very cheep to mitigated by buying pools of favorable characteristics. The spreads to treasuries provided agency pools was relatively wide and over time the fact that repo generated supply is down significantly and the Fed has shown to tradable floats creates a very good tactical. And with that I would like to turn the presentation back over to Larry.

[Laurence Penn:]

Thanks Mark. So the second quarter of 2013 was filled with extreme volatility in both our non-agency and agency strategies. But once again Ellington Financial was able about capture upside and control the downside. Resulting a net income of $11.6 million on a fully mark-to-market basis. As you know, we’ve always been extremely disciplined about hedged our interest rate risk. However, since interest rates had done nothing but steadily declined since we launched Ellington Financial in 2007; those interest rate hedges have actually reduced our returns every year until this year. But that’s okay. We’ve always felt that our job is not to bet on interest rates or even passably sit back and net interest rates movement dictate our returns. Instead we’ve always felt that our job is to use our expertise and experience in the mortgage market to deliver superior returns over market cycles, and to do that we’ve always felt that we needed to be disciplined about hedging most of our interest rate risk. As the results have shown, our discipline really paid off this past quarter. We’ve been talking for years about the advantage of being able to hedge our MBS with short TBA positions, but the importance of hedging dynamically as interest rates move and about the importance of hedging over the entire yield curve as appose to just hedging the short end of the yield curve. Over the past few years, our interest rates were declining. Our philosophy might have seeing purely theoretical to some, but after this past quarter, I think our results should convince you that this all extremely real, tangible, and in the end prudent. Of course Ellington Financial status as a PTP helps a lot. There are virtually no tax driven or regulatory driven constrains on our ability to manage our interest rate risk. So the bottom line is that where many other market participants ended the quarter with significant losses. We at Ellington Financial not only weathered the storm, but we made money, and as a result we’re positioned that we remain positioned to capitalize and the dislocations caused by the surge in interest rates and sharp decline in price. In our non-agency strategy thanks to no small part to our interest rate hedging activities, we were actually able to deliver solid returns for the quarter, in the first half of the second quarter with the U.S. housing market continuing to recover strongly and with home prices such an important factor in the performance of distressed residential mortgage backed securities, we saw a strong total returns in the non-agency residential market through Mae. However, the strong housing market was also a key factor in the Fed’s decision to begin the discussion on QE tapering, sparkling surge in interest rate that [Lloyd’s] the bond market and the non-agency RMBS market was not spared. As we discussed in our last earnings call, earlier this year we had been taking profits in some of our more distressed lower-price non-agency RMBS. As we felt that they had risen too far in price relative to many of the less distressed higher priced non-agency RMBS and we continue this rotation in the first part of this past quarter. However, in the second part of the past quarter interest rates surged the Lloyd’s bank portfolio hit the market and the RMBS market dislocated. And as is often the case in times of market distress, many dealers and market participants found themselves under great pressure to reduce their risk. And high-risk securities in particular now became over sold. When this happened, we actually reversed our previous sector rotation and so we started to rotate back into certain beaten down riskier lower price securities that dramatically underperformed in the sell-off. As Lisa mentioned earlier, we have significantly increased our cash positions to be able to take advantage of what we think are excellent opportunities to purchase long-term assets at very favorable prices and yields, basically we are positioning ourselves to play offense when many of our peers are stuck playing defense. Okay, on to our agency strategy now even though this strategy represents only about 15% of our capital I'm going to spend a little more time than usual discussing the strategy. Since so much happened in the sector during the quarter, and since I believe our performance in the strategy reveals a lot about how we think about managing risk and generating returns and how we differentiate ourselves from our peers. In our agency RMBS strategy once again Mark Tecotzky and his agency pool team did an absolutely superb job, and the last part of quarter was undoubtedly the toughest market for agency RMBS in years. As you see on our earnings attribution table on Page 3. We only lost around $600,000 in the strategy during the quarter. This was not only merely a 12 basis point drag in Ellington Financials’ ROE for the quarter, but it was also less than the three quarters of a percent loss on the average capital you deployed in our agency strategy. I'm sure that I don't have to remind you and many of you on this call that the typical agency mortgage REIT dropped around 18% in book value during the second quarter. As you can see on Page 22 of the presentation, our assets to capital ratio in our agency RMBS strategy has been around 9 to 1 for a while. Now this past quarter really indicates what we have been asserting for some time, that our agency RMBS strategy even though we employ an extra turn of sold leverage compared to many others agency RMBS strategy actually had lower risk and offers a better quality return. From time-to-time we’ve spoken about the advantages of using TBA short positions to hedge our specified pools. Put simply most effective way to hedge mortgage pools is by establishing short positions and other similar mortgage pools, such as the generic pools that underlie TBA. That's what we always highlight our net agency premium and our earnings releases. TBA short positions help to reduce prepayment risk in ways that interest rate swaps just can’t, since the mortgages underling the TBA short hedges are exposed to so many of the same types of non-interest rate related prepayment forces as our specified pool assets. However, as Mark described, this past quarter highlighted two other extremely important advantages in using TBA short positions. First they protect against a widening of the mortgage basis. And by that I mean that if the whole mortgage-backed security sector is weakening, relative to treasuries or interest rate swaps, our book value will be better preserved and for short TBAs instead of interest rate swaps. Second, our TBA short portions dynamically hedge our duration in a way that ordinary interest rate swaps don’t, and by that I mean, that they just naturally extend or contract in duration, following in interest rate shock in much of the same fashion as do our specified pull assets that they are hedging. In effect, using TBA short positions to hedge is a very rough one of match funding. Now I don’t want to give the impression that our specified pools are always 100% hedge with TBA short positions. They are not. Depending on how we feel about the absolute value of our specified pools, and their relative value when compared to TBAs, we might have a very small or a very large TBA short position. For example, if you look on the Page 15 of the presentation, you’ll see that for the past two quarter ends, roughly 50% of our hedges have been TBAs, as appose to in swaps and treasuries. At the end of the fourth quarter of last year, however, our specified pools were roughly 70% hedged with TBAs. Since that’s when the agency mortgage sector overall, which trading at what we felt were fairly tight levels. Okay, moving on. On last quarter’s earnings call, I’d mentioned that Ellington Financial was actively evaluating opportunities in the mortgage originations markets. Our research store require mortgage originator is progressing nicely. And with many originators struggling and this higher rate environment where refinancing activities plummeting, we are seeing some excellent buying opportunities. Our recent hire, Steven Abreu, has been leading our effort. Steve is a highly respected veteran in the mortgage banking business and comes to most recently from GMAC Mortgage, where he was President. We are really excited to have Steve on board. In early May we completed our second follow on common stock offering since our IPO. Resulting in net proceeds of approximately $125 million, from an asset acquisition standpoint our timing was excellent. And we are able to deploy all of this fresh capital over the reminder of the quarter taking full advantage of all the opportunities discussed earlier that arose from the severe dislocations. As you can tell I fervently believe that this past quarters has further indicated our strategy and has further differentiated Ellington Financial from its peer group in a very positive way. Once again the mortgage market finds itself as of center of the action in the fixed income market. We look forward to taking in advantage of what shaped up to be a great market for us. This concludes our prepared remarks. Before I open up the call for Q&A, I would just like to remind everyone that, as usual, we’ll be happy to respond to questions to the extent they are directed to matters related either specifically to Ellington Financial or more generally to the mortgage and asset-backed marketplace in which it operates. We will not be responding to questions on Ellington’s private funds or other activities. Operator.

[Operator:]

(Operator Instructions) Your first question comes from Steve DeLaney of JMP Securities.

[Steve DeLaney:]

Good morning and congratulations guys on a just a superior job in preserving book value in the second quarter. We thoughts you would do a good job but down 1% is remarkable, so great job. You didn’t common on this, but I thought since it is a recent development. I wanted to ask if you looked at the Freddie Mac risk sharing offering and if you had any interest and if you’ve participated in that.

[Mark Tecotzky:]

Hey Steve, it’s Mark.

[Steve DeLaney:]

Hey Mark.

[Mark Tecotzky:]

So we didn’t look at it, and we think it’s interesting. We didn’t participate, but there’s going to be a lot more of those coming down the line. Fannie is going to be doing one after Labor Day, I think you know to us the structure makes a lot of sense for the GSEs to start buying some protection on the credit risk they take and as oppose to their traditional way of getting protection from MRIs this is a much better diversified pool of capital, they can get credit protection from. It came at a time when there was a (inaudible) dislocation in the market. There were a lot of other assets that have gotten pretty badly beaten up by the time that deal came.

[Steve DeLaney:]

Right.

[Mark Tecotzky:]

And also in terms of how those securities will perform, it’s a little bit different than the bread and butter of security we’ve been putting into EFC. So most of what we have in EFC are securities that are the most senior part of the capital structure, this structure had 30 basis points of credit enhancement below one of the bonds and 1.65 basis points to credit enhancement below the other bond, and each trench was 135 basis points of that.

[Steve DeLaney:]

Right.

[Mark Tecotzky:]

So they have a very thin slumbers and the valuation process for that has to do with evaluating sort of this out of the money put, right the advantage of collateral they chose to back this was performing extremely well, had almost no losses, and it’s a kind of thing its just how big a shock in home prices would you need to start taking losses on these securities, but given how thin slice they are, when you start taking losses on the securities, you can get wiped out quickly. So I would say that from evaluation standpoint, it’s different that what we normally deal with where most of the securities we buy the amount of write down they’re going have is going to be basically linear with deal losses, with (inaudible) securities it’s very norm linear versus deal losses for a while. And then you start to taking losses roughly hundred times, relative to your tranche size, whereas the actual loss, so I think it’s something that we will watch and we will definitely analyze and I could see it having a place on a portfolio in the future just the first transaction we didn’t participated in.

[Steve DeLaney:]

Got it. And I mean, as you look forward to may be Fannie offering or a revised offering, do you think you might play more if they do multi-trench deals, you might play more at the senior part than at the lower part given what you said of it?

[Mark Tecotzky:]

It all depends on pricing.

[Steve DeLaney:]

Okay.

[Mark Tecotzky:]

The other development in the quarter from Fannie and Freddie is that we are each sellers of securities, each are relatively large legacy portfolios.

[Steve DeLaney:]

Exactly.

[Mark Tecotzky:]

So as they were selling securities and I can’t remember if it was at the end of the quarter or that took place in July, but they were sells of securities that were in the other area we were able to put capital work.

[Steve DeLaney:]

Good. And my last question is…

[Mark Tecotzky:]

(Inaudible).

[Steve DeLaney:]

Yeah, my last – it sounds like just if it had been a time when that wasn’t good value in the market you might have gotten involved but there were too many other attractive things to look at, given the dislocations. Just looking forward, my final question is on the RMBS 2.0 markets and your effort in holdings. So it sounds like there you’re focus is going to be on the new originations, in clean paper. I assume prime jumbo rather than either MPLs are re-performing. Just curious if you guys working with Steve, if you’ve been tracking the issuance and the spreads and if you feel like the market right now – if you hedge your platform all up and running do you feel that in with today’s primary pricing that you could actually, execute transactions in the market that exist today. Thanks.

[Mark Tecotzky:]

I actually think that where we going to find things that are more interesting to us will be in the sectors that aren’t as pristine so I don’t think it will be in the prime jumbo sector.

[Steve DeLaney:]

Okay.

[Mark Tecotzky:]

Because in the prime jumbo sector you have to compete with the big banks that have – as good as our funding is the big banks have better funding and that’s where their appetite really is especially on the ARM side. So I think it could be in non-performing re-performing potentially some of these had auctions. We haven’t bought anything yet, but we have been putting a lot of resource into it, we are tracking closely, I do they just in the second quarter when there was so much volatility in regular (inaudible) are pretty liquid you can trade among the trading 1 so bit offer. Liquidity premium will be extra yield to be want for going down and liquid into loans with higher than say would have been in the first quarter when things are little bit more stable. That’s another thing that we think but I think that you are going to have a lot of supplier loans a lot of the big banks have been selling and that’s sort of strategy that we have been say a lot of time in our models and I think there going to be time when Ellington Financial will benefit from that effort, but it we didn’t buy anything in the second quarter.

[Laurence Penn:]

Yeah and I just want to differentiate, so I want to manage expectations here right you mentioned Steve on the origination platform. So I think that it’s way premature to be talking about that especially in the near-term, what Mark was talking about is, our participation could be in the form of buying whole loans that’s away from, say any origination subsidiary that we might end up acquiring or participating in the lower parts of the capital structure and other peoples originations and securitization. So, I just want to make it clear that, I just think its way premature to be talking about those strategies now as applied to a mortgage origination subsidiary that’s ...

[Steve DeLaney:]

Yeah I appreciate that. Definitely appreciate that clarity which you – because it sounds like in terms of the whole loan you going to look at multiple avenues to get involved not just building a platform of conduit and but to me more opportunistic as well?

[Laurence Penn:]

Absolutely, yeah go ahead.

[Steve DeLaney:]

Okay, Yeah thanks.

[Mark Tecotzky:]

I was just going to say one thing, you clearly see and they accelerated in second quarter is that Fannie and Freddie are changing, right they are doing the stacker deals, they are more aggressively selling non-Agency securities, they were selling CMBS securities and that is going to be opportunities for private capitals that understands the mortgage market, how and when it actually manifest itself, I cant tell you, but given how big their footprint is that when they step back just a little bit, it creates a lot of opportunity.

[Steve DeLaney:]

And we’re confident you guys, whatever opportunities are there you probably, could be right all over it. So thanks for the color and again great quarter.

[Mark Tecotzky:]

Thanks Steve.

[Operator:]

Your next question comes from Mike Whitener of KBW.

[Mike Whitener:]

Good morning guys.

[Mark Tecotzky:]

Hi, good morning.

[Mike Whitener:]

Let me follow up on some of the comments you made on the agency segment. Particular, I guess, you’re sort of wrestling with, as you describe the TBA being short TBA as a hedge instrument. There’s a whole bunch of reasons that can be very effective and more effective than swaps in many ways. On the other hand, we hear peers and we just actually look at there and see what the dollar role opportunity is in the discount for buying forward and so much. So I just wondering if you could talk a little bit more about that contrast and then certainly getting 25 basis points or so effective monthly discount in buying TBA’s that would seemingly work against you in being short TBA so…

[Mark Tecotzky:]

That’s very true. It’s all the question of timing, right. It’s all the question of – as I can not think to me this quarter the main thing about it is that you can’t be static in your strategies. The strategies have to revolve in relation to the opportunities, your hedging strategies, what assets you buy, because the pricing of non-agency securities, agencies securities has been incredibly dynamic, right. So in this quarter, giving the pricing structure of pools and TBAs and swaps, and swaps since you put it all together, during this quarter it made sense to us to have a substantial TBA hedge on such high type pools. Now mortgages have helped re-priced, TBAs have cheapened a lot, a lot of TBAs now are sort of fully extended in duration versus the forward curve. So they don’t – to being a short-term doesn’t give you as much volatility benefit as they give at the start of the quarter. So we look at all those things. And we also look at, first and foremost the roles, right. And as the Fed has changed the coupon for their buying, exchanged the pricing dynamics of the roles on a lot of coupons. So you’re exactly right, there are certain coupons now where begin long TBA is the most effective, might be the most effective strategy, better strategy than owning the pools. But I just think that it’s the kind of thing where everyday the world changes a little bit and you have to try the best you can to look at the world with a fresh pair of eyes each day, and think each day was a bit less risk-adjusted return in the marketplace and then try to migrate the portfolio there. But you’re absolutely right, that large roles argue are a big argument for reducing TBA short to being long TBAs.

[Mike Whitener:]

Thanks, appreciate that. And I guess may be just more broadly on the agency fees, for all practice of purpose as I call it roughly certain break even this quarter which is I think for what you guys said. I mean that’s sort of a triumph relative to what it might as well, might have otherwise been, given the sharp rise in rates. I mean how should we think about the relative and attractiveness of both capital and returns across the agency versus non-agencies, given that for you guys I think we usually think of the agency piece is kind of, it’s there but it’s not what drives the business. But is it more interesting now, given the (inaudible)?

[Mark Tecotzky:]

I would say that, with Ellington Financial, we have traditionally kept at a minimum 80% of capital in non-agency strategy. And I think that the returns, the expected returns for both strategies improved over this quarter, mortgages widened and you got rid of a lot of prepayment risks. So if you look at refined index of metrics like that, it is very, very down. So a lot of securities that had a lot of prepayment risk at the start of the quarter, now that prepayment risk is at least 75 basis points out of the money. But on the non-agency side you saw certain sectors cheep in up materially. You have higher rates, higher forward rates which gives in the expectation of higher coupons on floating rate securities and hybrid securities. We saw a good amount of distress selling this book with the GSEs, there are also bank portfolios and we saw the buyer base step back a little bit and response to a tremendous volatility. So, I think the expected returns for each strategy are up. I also think it’s going to come with more volatility that the Fed even do anything. They just sort of gave people the impression that they were considering doing something and that was enough to cause tremendous price volatilities. So I think that the opportunities are better but it’s going to – there is potential, lot more volatility too.

[Mike Whitener:]

So, let me ask you just one final one then and I suspect I know the answer of this, but if we just sort of run out what your current dividend rate is? It implies a, if I multiply by four and divide by the book value are basically get, ROE implication of that12.5 I believe so, some degree that’s the threshold. You feel better or worse about that looking forward in the evolution of the market and your opportunities in non-agencies and so on and so forth as we look into the rest of this year and perhaps going forward?

[Laurence Penn:]

Yeah. I think, Its Larry. I think this last quarter really set the stage for us feeling better about it. If you look as Mark said in the recent, we didn’t increase. The only reason we didn’t increase substantially, our agency, the amount of capital we have in the agency strategies suppose non-agencies is that the non-agency sector weaken as well. We’re able to buy non-agency securities now, we are back to being able to buy things at close to 9% yield. So that’s and keep in mind of course we always as a part of how we generate returns right, we keep our leverage lower, we keep our cash positions higher and but our key component of our generating returns is this active portfolio trading that we do. So given the volatility that we seen and we think that if anything that aspect is better for us in terms of volatile market. Spreads of wide non-agency so we feel better about it.

[Mike Whitener:]

Well thanks guys I appreciate all the comments and nice job.

[Mark Tecotzky:]

Thank you, Mike.

[Laurence Penn:]

Thanks.

[Operator:]

Your next question comes from Douglas Harter at Credit Suisse.

[Douglas Harter:]

Thanks. When you guys look at the credit landscape, can you talk about the relative attractiveness of non-agency RMBS versus CMBS?

[Laurence Penn:]

No if you look at the portfolio composition on a 2011 and 2012. You can see we did we grew the CMBS a little bit, right. We just think like a CMBS market is opposed to the non-agency market, it is CMBS market. the new issue market is big, right big relative to the legacy market. So what that means is that you have all these entities their originating loans and then, have the securities to get them off their books, and that process has to happen every quarter, that’s most of these entities originating these loans don’t have to where with all to step back in the market and not to be securitization for a couple of quarters if spreads widened out. So it’s sort of forces the CMBS market to find the level where security is clear, with the non-agency RMBS market, prices dropped a lot, you can to sell this thing I am just going to wait and that sell until prices recover. And then what happens is, you just have wider bid offers spread and not a lot transaction activity. So the oldest distress in the market, you know that we saw in our non-agency market you definitely saw in the CMBS market, especially if you look at some of the CMBX industries like a CMBX BB. These things have been in a 14 point range already this year. So we have found very attractive opportunities in CMBS and at times they were compelling enough to increase the capital allocation there. And I think you can see that going forward too.

[Mark Tecotzky:]

In our approach to that market is different from many. We’ve taken – we’re not, this is not set us stone. But we’ve had pretty far belt strategy, so where we’ve had a portion of the portfolio that returned over incredibly actively to take advantage of this volatility, some of which is pushed around by the new issue market. And but the other part of the strategy has been to identify from time-to-time much higher yielding assets. So for example, we’ve now become known as significant player in the BPs market and those are not trading bonds, right, those are holding bonds. And so that’s – we see that position as building up over time. We buy these are sometimes on our own, sometimes in partnership with some of the big service or so. This is, we expect over time this to continue, to have this core portfolio growing at very high yielding assets that we have performed a lot of underrating on and we feel good about is as long-terms hold, but also to have this very actively turned over capital in a very different type of strategy that’s working very well for us so far.

[Douglas Harter:]

Great. And then on the agency side, can you just talk about how you are viewing the hybrid ARM market and sort of some of the spread widening we’ve seen there whether that makes it attractive to you guys?

[Mark Tecotzky:]

Well, I would say this best. We used to own to lot of ARMs. For a while we thought they we very cheap. Cheaper then fixed-rates and they are great. This a prior are great risk asset, right because there’s shorter duration and they start turning into a floater after a certain number of years. They reviewed to hedge, but then what happened is, at least the way do you look at the world is that, they got very expensive into a logical asset for banks to buy, and banks recovered from 2008 and they were basically funding themselves at zero as deposit. So they were the marginal buyer, and that’s all that we’ve couldn’t really effectively compete with them. We didn’t see expect to returns on that to us looked as compiling as the fixed rates. Given that for the fixed rates you can put on hedges that are very tightly correlated and you run your portfolio as being long convexity and the way that you can’t from the ARMs right. And the thing of that the ARMs is that, they are relatively a liquid, in some ways they are not that much more illiquid than non-agencies. There was a big widening, we’ve start to look at them again, we thought just a very small amount. I think it’s a little frustrating in getting invested in that sector, because they still only represents may be 3% to 4% of new production in the agency market, so they’re small. But yeah we keep our eye on them, we can get to our target level, we would definitely buy more it’s just difficult to get investment. But the one thing I’m mindful of is that, they aren’t nearly as liquid you’re going to take, even though they are shorter rate duration, they are going to have a lot more tracking area versus their hedged being pools versus TBAs, they won’t have much tracking or fixed rate pools versus swaps. And I would say that the rich posturing from the investment banks and how they trade them is I don’t see them wanting to take large positions on them one way or another, which means, if you want to move that portfolio around, it can come at the expense of the price execution you get. But no, I mean, they have widen to those point where you think they look attractive, lets say we bought a small amount you would look to add more, it’s just sort of a painful process to be able to get invested in them.

[Douglas Harter:]

Great, thank you for that color.

[Mark Tecotzky:]

Thanks.

[Operator:]

Your next question comes from Ken Bruce at Bank of America Merrill Lynch.

[Kenneth Bruce:]

Hi, good afternoon, or good morning.

[Mark Tecotzky:]

(inaudible).

[Kenneth Bruce:]

I guess the second quarter was probably a pretty good advertisement for your active management strategy. So congratulations on a very good quarter. I’m hoping you might be willing to maybe review your strategy as it relates to the mortgage origination platform that’s you are looking to acquire or build I guess, looking at Steve he has been involve with some other premier all pay platforms in the past and very interested in terms of what you are trying to grow there if this is a away that generate gain on sale income, if you see this as manufacturing your on securities over time and in terms of the non-agency your non-qualify mortgage arena, what’s your real kind of strategy is there if you could elaborate on that please.

[Laurence Penn:]

Sure so we definitely have Steve has and we have big plans for this, but you realize that we could start small and we probably we will start small and grow something. So I thing that the reasons that we are getting into this business aside from being able to partnering up with somebody like Steve is that we want to have all these options that many of that you just listed open to us. So absolutely if we think that there is a type of mortgage that should be originated, but isn’t, we absolutely would want to cut off the middle man there and be in that business and that by the way could apply not just to non-agency mortgages, what Mark describe before, say non-prime mortgages so we are competing directly with the bank, but also on the agency side even where if we get big enough, we could create specified pools that and by them at cost essentially. Transfer them up essentially transfer them up to the parents just the way that many REITs used to do it in the old days. So we absolute are looking all that, we are also looking at just a business that if run properly we think, can be very profitable on its own right. Obviously the cyclical business, but we probably we’ll start small and grow it and you know but we’re looking at all things we mentioned looking at securitization, again not so much for anything that we are going do any time real soon, but definitely as we look at potential business to buy, we have a eye toward that and we say okay is this something that we can help a build in that direction. So you know it’s really adjust at this point we don’t want to rule out any options we don’t want to acquire a platform we build platform where those things just couldn’t be possibility eventually.

[Kenneth Bruce:]

And it’s servicing in vision to be those one of those your capabilities and one of those new asset that you would be involved in?

[Mark Tecotzky:]

Yeah, so I think the answer is that’s it probably wouldn’t be the primary acts if will they were looking for, I think that obviously when you have an originator one of the way is that you recognize your profits by taking back servicing at attractive levels. I think that if we had a small platform with that a big without servicing capabilities in the beginning that would be fine too, you can sub service, loans at extremely low cost, just few hand full of basis points and you know were two hand full what ever, you can sub-service so we would have to achieve I think a pretty big scale before we thought about having that deal of big portion of why we are in this business but excess servicing absolutely that’s an asset that Ellington Financial could acquire now, and for various reasons haven’t done it but there is noting wrong with the asset class per say, but primary servicing I think is something that will require much bigger platform, you can out source it so cheaply to some of the big players.

[Kenneth Bruce:]

Right, right and then just in terms of the how you’re thinking about that the timing around this I mean is it something that’s multiyear strategy, you pointed out that its cyclical where seemingly coming off of a [refi] cycle, although there is a lot of different contours around that I think you could argue the direction, but it seems like there is going to be some uncertainties as to what the volumes are for at least next few quarters just with rates having backed up, how are thinking about that the time of growing this business.

[Mark Tecotzky:]

Yeah I mean if we start small then absolutely it will be multiyear process before we – lets say we will be top 20 originator or something like that that would be not we could develop in just a year, but its something that we believe we could develop in just potentially in three years and so it does the tend to little bit on how big we start and we are looking at different size players. I don’t want to get too specific year, but we definitely have a long-term view year in terms of there are plenty of opportunities obviously right now for Ellington Financial to deploy its capital in lot of these legacy assets and lot of these (inaudible) markets and this was something, this is really building for the future. So we are not a facility in a huge hurry to be there in six months.

[Kenneth Bruce:]

Great, thank you for your comments. I appreciate it.

[Mark Tecotzky:]

Thank you.

[Operator:]

There are no further questions at this time. I would now like to turn the floor back over Larry Penn for closing remarks.

[Laurence Penn:]

Okay well just thanks everyone for participating on the call today and enjoy the rest of your summer and we look forward to speaking with you all next quarter.

[Operator:]

Thank you ladies and gentlemen; this concludes Ellington Financial’s second quarter 2013 financial results conference call. Please disconnect your lines at this time and have a wonderful day.