Ellington grew residential investments, shrunk commercial in 3Q

Ellington Financial reported Wednesday that it generated a slightly lower-than-expected profit during a period in which volatility challenged its agency residential mortgage-backed securities strategy and one planned acquisition fell apart, while another progressed.

Although a pending deal with Great Ajax failed, a servicing-focused merger with Arlington is set to close next month, CEO Laurence Penn said during an earnings call in which EFC reported net income of $6.6 million.

"Steady performance from our credit portfolio, along with significant net gains on our interest rate hedges, exceeded net loss as an agency MBS and we delivered a positive economic return in an extremely volatile market," he said.

The third quarter was "arguably the most challenging environment for agency RMBS investors we've seen since March of 2020," added Penn.

Analysts said the company's 3Q earnings, which were up from $2.9 million the previous quarter and a net loss of $33 million a year earlier, were partly the result of market valuation changes, but noted that even after adjustment for them, EFC's numbers were slightly below consensus.

"We would expect a neutral reaction," Bose George and Alexander Bond, analysts at KBW, said in a report. The company's stock price of $12.51 at deadline Wednesday was around $0.20 lower than the previous day.

EFC executives said they have been repositioning in response to some of the concerns in the market by taking steps to reduce its exposure to loans on income-producing properties. But they're still building the residential investment segments that added to earnings in 3Q.

"We continue to ratchet down our commercial-mortgage bridge lending, given the ongoing headwinds in the commercial real estate sector," Penn said, adding, "This portfolio could expand again in future quarters. We remain patient as the cycle progresses, and we'll pick our spots."

That could include investment in some of Federal Deposit Insurance Corp. sales of commercial loans from the 2023 banking crisis.

"The FDIC Signature Bank portfolio sale is interesting to us and the teams here have been doing a lot of work on that," said Mark Tecotzky, co-chief investment officer, during the earnings call.

While residential investments like non-QM loans and credit-risk transfers overall were contributors to earnings, another subset of it aside from agency MBS had a mixed impact on the company's financials.

"While the Longbridge segment was profitable on a mark-to-market basis including hedges, the segment's contribution to our adjusted distributable earnings for the quarter turned negative," Penn said, referring to a reverse mortgage business that Elllington acquired last year.

"In a nutshell, challenging market conditions compressed our sale margins and low valuations, particularly in the back half of the quarter," he added.

EFC applied some more conservative valuation assumptions to certain types of reverse-mortgage servicing assets, which put pressure on earnings in the quarter but could have some future benefits, executives noted.

The Longbridge and agency portfolios accounted for a combined 37% of Ellington's assets during the period, at 12% and 25%, respectively, with the remaining 63% consisting of credit products like non QM and commercial loans.

The significant growth trajectory at the company is requiring adjustments that have now, and will likely in the future result in departures from past patterns in its earnings.

While the share of assets in some sectors like reverse mortgages is still relatively small, the company is managing a greater volume than it has in the past.

"We've owned non-QM and reverse mortgage servicing for years, but this is a much larger stake in a much bigger market," Tecotzky said.