Mortgage lenders usually package together mortgages with similar attributes and sell them as securities. These securities are known as mortgage backed securities. Some of the mortgages are issued by government Agencies, which is why they are called Agency MBS, while the issued by private lenders are called non-Agency MBS.
The Agency MBS space is currently surrounded by speculations about a possible exit by the Fed. Given the situation, companies that invest in Agency MBS are concerned about their book values, which are expected to plunge. Ellington Financial LLC (NYSE:EFC) is one such company. However, I believe its book value is safe. Let’s see how.
Business strategy
Ellington Financial LLC (NYSE:EFC) is operating as a specialty finance company since 2007 to acquire and manage mortgage related assets of a hybrid nature. You may think it is a REIT, but it’s not. It is structured as a limited liability company; therefore, it has the ability to opportunistically hedge credit risk without the limitations of the REIT rules.
Ellington targets an equity allocation of 85% to non-Agency MBS and 15% to Agency. Besides, the management is also including the asset backed securities (ABS) sectors, including commercial mortgage backed securities and commercial non-performing loans.
What’s going on in Agency MBS space?
Volatility in the Agency market remains as the timing and method of the Fed’s exit from this market remains a question in investors’ minds. As a result, Agency prices are variable. Therefore, the management at Ellington Financial LLC (NYSE:EFC) continues to focus of securities with high prepayment-protected attributes to maintain low conditional prepayment rates (CPRs). CPR is a measure to calculate the prepayments of a security.
Besides, the rate on 30-year mortgages has been rising since the launch of QE3. In this environment, you can expect the company to generate 2.1% – 2.2% of net interest spread on its Agency purchases, which is 59 basis points (bps) more than the lows in September 2012. However, during the same time frame, the costs of funds have risen just 7 bps, only partially offsetting the increase in asset yields. The prospects for book value growth remain challenging in 2013.
What’s going on in the non-Agency MBS space?
On the other hand, non-Agency MBS are experiencing yield compressions as a result of sustained rally in mortgage credit against the backdrop of improving housing fundamentals and favorable supply/demand dynamics. Another consequence of this is stronger book values.
The rally in the first and the second quarter of the current year have translated into 50 bps lower loss-adjusted yields. You can expect Ellington Financial LLC (NYSE:EFC) to continue its focus on the non-Agency sector, although with a focus on the commercial MBS space in the coming quarters.
How will it help Ellington?
The company has constructed its investment portfolio in a way that you should expect little book value depreciation going forward. First, Agency MBS, which may cause a decline in the book value, account for only 15% of the company’s equity. Second, the non-Agency securities are experiencing a rally, which will lead to a hike in the book value. Therefore, book value compression would be one of the last issues Ellington Financial LLC (NYSE:EFC)’s investors should be worried about.
