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EFC > SEC Filings for EFC > Form 10-K on 14-Mar-2014All Recent SEC Filings

Show all filings for ELLINGTON FINANCIAL LLC



Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
In this Annual Report on Form 10-K, except where the context suggests otherwise, "EFC," "we," "us," and "our" refer to Ellington Financial LLC and its subsidiaries, our "Manager" refers to Ellington Financial Management LLC, our external manager, and "Ellington" refers to Ellington Management Group, L.L.C. and its affiliated investment advisory firms. Executive Summary
We are a specialty finance company that acquires and manages mortgage-related assets, including residential mortgage-backed securities, or "RMBS," backed by prime jumbo, Alt-A, manufactured housing, and subprime residential mortgage loans, RMBS for which the principal and interest payments are guaranteed by a U.S. government agency or a U.S. government-sponsored enterprise, residential mortgage loans, mortgage-related derivatives, commercial mortgage-backed securities, or "CMBS," commercial mortgage loans and other commercial real estate debt, as well as corporate debt and equity securities, and derivatives. We also may opportunistically acquire and manage other types of financial asset classes, such as securities backed by consumer and commercial assets, or "ABS," non-mortgage-related derivatives, and real property. We are externally managed and advised by our Manager, an affiliate of Ellington. Ellington is a registered investment adviser with a 19-year history of investing in a broad spectrum of mortgage-backed securities, or "MBS," and related derivatives. Effective January 1, 2013, we conduct all of our operations and business activities through Ellington Financial Operating Partnership LLC, our consolidated operating partnership subsidiary (the "Operating Partnership"). As of December 31, 2013, we have an ownership interest of approximately 99.2% in the Operating Partnership. The interest of approximately 0.8% not owned by us represents the interest in the Operating Partnership that is owned by an affiliate of our Manager and certain related parties, and is reflected in our financial statements as a non-controlling interest.
Our primary objective is to generate attractive, risk-adjusted total returns for our shareholders. We seek to attain this objective by utilizing an opportunistic strategy to make investments, without restriction as to ratings, structure, or position in

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the capital structure, that we believe compensate us appropriately for the risks associated with them rather than targeting a specific yield. Our evaluation of the potential risk-adjusted return of any potential investment typically involves weighing the potential returns of such investment under a variety of economic scenarios against the perceived likelihood of the various scenarios. Potential investments subject to greater risk (such as those with lower credit ratings and/or those with a lower position in the capital structure) will generally require a higher potential return to be attractive in comparison to investment alternatives with lower potential return and a lower degree of risk. However, at any particular point in time, depending on how we perceive the market's pricing of risk both generally and across sectors, we may favor higher-risk assets or we may favor lower-risk assets, or a combination of the two in the interests of portfolio diversification or other considerations. Through December 31, 2013, our non-Agency RMBS strategy has been the primary driver of our risk and return, and we expect that this will continue. However, while we believe opportunities in MBS remain plentiful, we believe other asset classes offer attractive returns as well as asset diversification. These asset classes include residential and commercial mortgage loans, which can be performing or non-performing. We purchased our first pool of non-performing residential loans in December 2013. We also have investments in small balance distressed commercial loans and in collateralized loan obligations, or "CLOs." We believe that Ellington's proprietary research and analytics allows our Manager to identify attractive assets in these classes, value these assets, monitor and forecast the performance of these assets, and opportunistically hedge our risk with respect to these assets.
We continue to maintain a highly leveraged portfolio of Agency RMBS to take advantage of opportunities in that market sector and to maintain our exclusion from regulation as an investment company under the Investment Company Act. Unless we acquire very substantial amounts of whole mortgage loans or there are changes to the rules and regulations applicable to us under the Investment Company Act, we expect that we will always maintain some core amount of Agency RMBS.
We also use leverage in our non-Agency strategies, albeit significantly less leverage than that used in our Agency RMBS strategy. Through December 31, 2013, we financed our asset purchases almost exclusively through reverse repurchase agreements, or "reverse repos," which we account for as collateralized borrowings. In January 2012, we completed a small resecuritization transaction using one of our non-Agency RMBS assets; this transaction is accounted for as a collateralized borrowing and is classified on our Consolidated Statement of Assets, Liabilities, and Equity as "Securitized debt." This securitized debt represents long-term financing for the related asset, in contrast to our reverse repos collateralized by non-Agency assets, which typically have 30 to 180 day terms. However, we expect to continue to obtain the vast majority of our financing through the use of reverse repos.
The strategies that we employ are intended to capitalize on opportunities in the current market environment. We intend to adjust our strategies to changing market conditions by shifting our asset allocations across various asset classes as credit and liquidity trends evolve over time. We believe that this flexibility, combined with Ellington's experience, will help us generate more consistent returns on our capital throughout changing market cycles. In May 2013, we completed a follow-on common share offering which resulted in net proceeds of $125.3 million, after offering costs. Proceeds from the offering were fully deployed during the second quarter into our targeted assets. In the latter part of the second quarter of 2013, we increased our level of cash holdings, both as a buffer against increased market volatility and so as to be able to take advantage of potential investment opportunities. For similar reasons, we maintained a higher level of cash holdings through the remainder of 2013.
As of December 31, 2013, outstanding borrowings under reverse repos and securitized debt were $1.2 billion and our debt-to-equity ratio was 1.98 to 1. Our debt-to-equity ratio does not account for liabilities other than debt financings. Of our total borrowings outstanding as of December 31, 2013, approximately 68.1% or $842.3 million relates to our Agency RMBS holdings. The remaining outstanding borrowings relate to our non-Agency MBS, mortgage loans, and other ABS (which we refer to collectively as our non-Agency portfolio). We opportunistically hedge our credit risk, interest rate risk, and foreign currency risk; however, at any point in time we may choose not to hedge all or a portion of these risks, and we will generally not hedge those risks that we believe are appropriate for us to take at such time, or that we believe would be impractical or prohibitively expensive to hedge.
We believe that we have been organized and have operated so that we have qualified, and will continue to qualify, to be treated for U.S. federal income tax purposes as a partnership and not as an association or a publicly traded partnership taxable as a corporation.
As of December 31, 2013, our diluted book value per share was $23.99 as compared to $24.38 as of December 31, 2012.

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Trends and Recent Market Developments
Key trends and recent market developments for the U.S. mortgage market include the following:
Federal Reserve and Monetary Policy-In December 2013, the U.S. Federal Reserve, or the "Federal Reserve," announced its intention to reduce, beginning in January 2014, the pace of its asset purchases under its accommodative monetary policies; the timing and degree of the Federal Reserve's reduction in asset purchases, or "taper," had been the subject of heightened market speculation since mid-2013;

Housing and Mortgage Market Statistics-Data released by S&P Indices for its S&P/Case-Shiller Home Price Indices for December 2013 showed that, on average, home prices had increased from December 2012 by 13.6% for its 10-City Composite and by 13.4% for its 20-City Composite, resulting in its best calendar year return since 2005; meanwhile, the Freddie Mac survey 30-year mortgage rate ended the year at 4.48%, up 34% from its 3.35% level at the end of 2012;

Non-Performing Residential Loan Market-The U.S. distressed residential market has an estimated $600 billion of supply, representing roughly 3.3 million units, as inventories of seriously delinquent loans, foreclosures, and REO (real estate owned) remain elevated;

Government Sponsored Enterprise, or "GSE," Developments-On December 10, 2013, the U.S. Senate confirmed Mel Watt as the next head of the Federal Housing Finance Agency, or "FHFA,";

Bank Regulatory Capital-Recent proposed changes, if finalized, will increase regulatory capital requirements for the largest, most systemically significant U.S. banks and their holdings companies; this could potentially alter these institutions' appetite for various risk-taking activities, and could ultimately affect the terms and availability of our reverse repo financing; and

Portfolio Overview, Liquidity, and Valuations-Non-Agency MBS rallied for most of 2013 as underlying strength in housing market data continued to provide support to valuations, while Agency RMBS experienced a heightened level of volatility as uncertainty and speculation around future actions of the Federal Reserve dominated the market.

Federal Reserve and Monetary Policy
In December 2013 and then again in January 2014, the Federal Reserve announced reductions in its purchases of Agency RMBS and U.S. Treasury securities under its monthly asset purchase program. Prior to these "taper" announcements, and since September 2012, the Federal Reserve had been purchasing long-dated U.S. Treasury securities and Agency RMBS assets at the pace of $85 billion per month-comprised of $45 billion of U.S. Treasury securities and $40 billion of Agency RMBS. Based on the December and January announcements, the combined monthly reduction in asset purchases amounts to $20 billion, split evenly between Agency RMBS and U.S. Treasury securities. The Federal Reserve continues to reinvest principal payments from these holdings into additional asset purchases. The decision to reduce the pace of monthly purchases to $65 billion was made by the Federal Reserve in light of its view that the broader economy has strengthened considerably. To the extent that labor market conditions continue to improve and inflation remains near desired levels, the Federal Reserve has noted that it will likely continue to reduce the pace of asset purchases in further measured steps at future meetings. Notwithstanding the improvements in the economy, the Federal Reserve continues to express concern that inflation persistently below its 2% objective could pose risks to economic performance.
In addition to announcing its intention to reduce its monthly asset purchases, the Federal Reserve reiterated its intention to maintain the target range for the federal funds rate at 0% to 0.25% as long as the unemployment rate remains above 6.5% and as long as the inflation rate over the next one to two years is projected to be no more than a half a percentage point above the Federal Open Market Committee's, or "FOMC," 2% longer-run goal. However, as the unemployment rate is actually approaching 6.5%, the Federal Reserve has noted that it would soon be appropriate for the FOMC to change its forward guidance in order to provide information about its decisions regarding the federal funds rate after that threshold is crossed. The asset purchase program and the maintenance of a low federal funds rate, among various other measures, were put into place by the Federal Reserve in response to the elevated level of U.S. unemployment and the slow pace of the economic recovery in the aftermath of the 2008 financial crisis. The stated goal of the Federal Reserve's actions, in implementing these policies, was to maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.
During the middle and second half of 2013, as the U.S. unemployment rate declined and the economy continued to show signs of improvement, market speculation about the timing of a decision by the Federal Reserve to taper its monthly asset purchases caused interest rates to rise and prices of long-dated U.S. Treasury securities and Agency RMBS to fall. In fact, all major fixed income sectors experienced substantial price declines during this period, including U.S. Treasury securities, Agency RMBS, and to a lesser extent credit-sensitive sectors such as high-yield corporate bonds and non-Agency MBS. Agency RMBS were especially hard-hit through the end of the year, as heavy selling by mutual bond funds, exchange-traded

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funds, and mortgage REITs exacerbated the price declines and overall volatility. By December 31, 2013, the benchmark 10-year U.S. Treasury yield had risen to 3.03%, up from 1.76% as of December 31, 2012.
Following the December 2013 and January 2014 taper announcements, interest rates declined significantly. By February 28, 2014, the 10-year U.S. Treasury yield had fallen back to 2.65%, and prices of Agency RMBS have rallied as a result. As an example, the price of TBA 30-year Fannie Mae 3.5%s, a widely traded Agency RMBS, rose to 101.41 as of February 28, 2014, up from 99.34 as of December 31, 2013. The decline in interest rates is likely due, at least in part, to a market perception of a lower level of uncertainty around future Federal Reserve actions.
Notwithstanding the recent decline in interest rates and the greater clarity around Federal Reserve asset purchasing activities, we believe that there remains substantial risk that interest rates could begin to rise again. This reinforces the importance of our ability to hedge interest rate risk in both our Agency RMBS and non-Agency MBS portfolios using a variety of tools, including TBAs, interest rate swaps, and various other instruments. Housing and Mortgage Market Statistics
The following table demonstrates the decline in residential mortgage delinquencies and foreclosure inventory on a national level, as reported by CoreLogic in its December 2013 National Foreclosure Report:

                                              As of
Number of Units(1)               December 2013    December 2012
Seriously Delinquent Mortgages           1,978            2,637
Foreclosure Inventory                      837            1,217

(1) Shown in thousands of units. Note: Seriously Delinquent Mortgages are ninety days and over in delinquency and include foreclosures and REO property. As the above table indicates, both the number of seriously delinquent mortgages and the number of homes in foreclosure have declined significantly over the past year. This decline supports the thesis that as homeowners have re-established equity in their homes through recovering real estate prices, they have become less likely to become delinquent and default on their mortgages. Another interesting development can be seen in monthly delinquency roll rate statistics, as shown in the following table:

                                                 As of
Roll Rates (3 Month Moving Average)    October 2013    July 2013
Current to 90+                              0.37 %         0.35 %
90+ to Foreclosure                          5.06 %         4.51 %
Foreclosure to Current                      1.80 %         1.07 %

Note: Current includes loans that are 30 and 60 days delinquent; 90+ excludes foreclosures and REO property.
Roll rates represent the rates at which mortgages move from one category to another toward foreclosure. As can be seen in the table above, between July 2013 and October 2013, the rate at which mortgages have been rolling from current to 90+ days delinquent has grown from 0.35% in July to 0.37% in October. We view these levels as generally indicative of a healthy mortgage environment. The rise in transition speeds from 90+ days delinquent to foreclosure is mainly attributable to the declining supply of delinquent mortgages, rather than the ability of courts and servicers to initiate a greater number of foreclosure proceedings. The large increase in cure rates (foreclosure to current) for mortgages in foreclosure is in large part the result of increased loan modification rates that have accompanied large-scale servicing transfers in recent months from less efficient to more efficient servicers.
Data released by S&P Indices for its S&P/Case-Shiller Home Price Indices for December 2013 showed that, on average, home prices had increased from December 2012 by 13.6% for its 10-City Composite and by 13.4% for its 20-City Composite, resulting in its best calendar year return since 2005. Compared to November 2013, the 10-City Composite remained relatively unchanged, while the 20-City Composite declined 0.1%. According to the report, home prices remain below the peak levels of 2006, but, on average, are back to their late-2004 levels for both the 10- and 20-City Composites. As additional evidence of an improving housing market, single-family housing starts have increased 9.8% as compared to one year ago, up from 620,000 starts in December 2012 to 681,000 starts in December 2013. Finally, as indicated in the table above, as of December 2013 the national inventory of foreclosed homes fell to 837,000 units, a 31% decline when compared to December 2012; this represented the twenty-sixth consecutive month with a year-over-year decline and the lowest level in six years. As a result, there are much fewer unsold foreclosed homes overhanging the housing market than there were a year ago. While the recent

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increase in interest rates and the slow and uneven pace of the recovery of the U.S. economy continue to create potential risks to the recovering housing market, mortgage rates remain near all-time historical lows and, recent trends continue to indicate, on balance, that the recovery in the housing market continues on a strong footing. We believe that near-term home price trends are more likely to be driven by fundamental factors such as economic growth, mortgage rates, and affordability, rather than by technical factors such as shadow inventory.
The Freddie Mac survey 30-year mortgage rate ended 2013 at 4.48% up 34% for the year. Not surprisingly, the Refinance Index published by the Mortgage Bankers Association, or "MBA," declined approximately 63% from the prior year end, and similarly the Market Composite Index, a measure of mortgage application volume, declined approximately 48% from the prior year end.
Higher interest rates reduce housing affordability. Even with the rise in interest rates last year, housing is still inexpensive relative to historical averages based purely on debt-service-to-income ratios; however, after factoring in other metrics such as home-price-to-income ratios, U.S. housing affordability actually appears to be nearing equilibrium levels, implying that the potential for future home price increases may be limited. In fact, if mortgage rates were to unexpectedly rise significantly from current levels, the recent upward trend in housing prices could potentially even reverse.
On March 7, 2014, the U.S. Department of Labor reported that, as of February 2014 the U.S. unemployment rate declined to 6.7%. While the consensus for future job growth is generally mildly positive, the recent declines in the unemployment rate are also partially attributable to a reduction in the labor force participation rate. While it is difficult to quantify the relationship between the unemployment rate and the housing and mortgage markets, we believe that current levels of unemployment do not represent a significant impediment to a continuing housing recovery.
Non-Performing Residential Loan Market
Non-performing loans, or "NPLs," are loans for which the payments are past due for at least 90 days. The U.S. distressed residential market has an estimated $600 billion worth of supply-representing roughly 3.3 million units-as inventories of seriously delinquent loans, foreclosures, and REO remain elevated by historical standards. The judicial foreclosure states (e.g., Florida, New York, and New Jersey), with their longer resolution timelines, continue to comprise an ever-growing percentage of the nationwide NPL inventory. As a result, owners of distressed residential NPLs will likely need to more sell NPLs into the market, as opposed to waiting for foreclosure completion and selling REOs into the market, if they want to maintain their recent disposition pace of distressed inventory. The largest holdings of residential NPLs reside with the Department of Housing and Urban Development, or "HUD," the Federal Housing Authority, or "FHA," U.S. banks, and the GSEs. HUD, which through its Distressed Asset Stabilization Program, or "DASP," sold over six times as many NPLs in 2013 as compared to 2012, is now the market's largest source of NPL supply, and is expected to continue its quarterly auctions for the foreseeable future. Previous U.S. Government programs have generally proven attractive for investors (e.g., FDIC sales, Maiden Lane portfolios, and Term Asset-Backed Securities Loan Facility, or "TALF," financing), and we expect DASP to perform similarly. U.S. banks have also been selling significant amounts of NPLs. Each of the large U.S. money center banks are now active NPL sellers, with some just recently having established a recurring, greatly increased, and significant presence. Strong home price appreciation has moved NPL market pricing closer to internal bank carrying values, leaving banks with better capacity and ability to execute and increase strategic sales of these harder to manage, expensive to carry, non-core assets. Additionally, financing for NPLs is broadly available to investors under increasingly improving terms, as several large banks are competing to lend against distressed residential mortgage loans via repo financing facilities. During the fourth quarter, as part of our non-Agency strategy, we purchased our first pool of non-performing residential loans. The loans were acquired as part of the HUD DASP program. We paid approximately $24.1 million for the pool, which consisted of approximately 200 loans concentrated primarily in the western United States, with an aggregate unpaid principal balance of approximately $36.2 million. We expect that sales volumes of distressed residential mortgage loans will continue to increase and will be a potentially significant ongoing source of investment opportunities for us.
GSE Developments
In late October, both Fannie Mae and Freddie Mac announced a slight relaxation of the May 2009 loan cut-off date for refinancing under the Home Affordability Refinance Program, or "HARP." The new terms now base eligibility on loan origination dates, as opposed to the dates that loans were originally delivered to the GSEs. There have been additional discussions regarding whether to extend the cut-off date even further, or relax other HARP requirements. On December 10, 2013, the U.S. Senate confirmed Mel Watt's nomination as the next head of the FHFA and he took office on January 6, 2014. The first impact of his appointment came in late December, when it was announced that he intended to delay and re-evaluate the implementation of departing FHFA Director Ed DeMarco's initiative to raise guarantee fees, or "g-fees," on new Fannie Mae and Freddie Mac business. G-fees are the fees charged by the GSEs to include mortgage loans in

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Agency pools, and thereby insure the mortgage loan against loss. Since these fees are passed on to borrowers whose loans are originated for inclusion in Agency pools, increased g-fees have the effect of reducing housing affordability for GSE borrowers, but potentially make it more attractive for private lenders to replace the GSEs. The g-fee announcement hurt performance of near-the-money Agency coupons, such as 4.5% and 5.0% pools, as muted expectations of g-fee increases are suggestive of potentially faster prepayment speeds. Director Watt's confirmation has created a number of additional policy concerns in the Agency RMBS market, as he is perceived as likely to pursue policy agendas that will make the expansion of housing affordability a priority, potentially at the expense of Agency RMBS investors. For example, Watt is expected to seriously consider establishing some principal forgiveness programs for GSE-guaranteed loans; his predecessor Ed DeMarco was unwaveringly against principal forgiveness. If implemented, such principal forgiveness programs would likely start out by targeting the most at-risk borrowers, reducing default risk on high loan-to-value pools and pools concentrated in the most distressed geographies. In another departure from his predecessor, Watt is less likely to implement the loan-limit reductions for the GSEs that were proposed for comment by DeMarco in late 2013. Watt is also more likely to reduce loan-level price adjustments, or "LLPAs," and loosen other underwriting standards. Currently the GSEs apply various LLPAs to justify the cost of guaranteeing riskier loans. Lower LLPAs would make it easier for less creditworthy borrowers to obtain loans, whether for home purchases or for refinancings, thus helping promote Watt's likely agenda of assisting less creditworthy borrowers. The combination of the potential for increased prepayment speeds resulting from these potential policy changes, and a lack of clarity on specifically how FHFA policies might change, has cast uncertainty over the Agency RMBS markets. Bank Regulatory Capital Changes
Upcoming changes in banking regulations could impact MBS and ABS pricing, as well as the availability and cost of financing of MBS and ABS assets. The Federal Reserve's current implementation of the Basel III rules on bank Supplementary Leverage Ratios, or "SLRs," will significantly curtail the extent to which banks will be permitted to net certain repo and reverse repo agreements against each other when calculating their capital requirements. As a consequence, in an effort to maximize return on equity, banks may be incentivized to reduce their repo financing operations, especially for lower-cost financings such as those involving U.S. Treasury securities and Agency RMBS. Full implementation of Basel III regulations, in particular the carve-out rules related to accumulated other comprehensive income, or "AOCI," are likely to reduce bank demand for assets with higher duration, and as a result could hurt the liquidity of the tradable MBS market. Under the AOCI carve-out rules, banks with more than $250 billion in assets will be required to include mark-to-market gains and losses on available-for-sale, or "AFS," securities when calculating their Tier 1 capital. This incentivizes banks to hold Agency RMBS in held-to-maturity, or "HTM," and other illiquid assets, effectively locking more bank-held Agency RMBS out of the tradable market, and . . .

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