Mortgage-Bond ‘Pain’ Not Seen in Results, Ellington Says

A slump in the $1.2 trillion market for U.S. residential mortgage-backed securities without government-backing may not be “fully reflected” in the results of holders of the debt, according to Ellington Financial LLC Chief Executive Officer Larry Penn.

“There’s a lot of pain out there in non-agency RMBS, much of which may not be fully reflected in what’s been publicly reported so far” by other companies, Penn said today on a conference call about the Old Greenwich, Connecticut-based investment firm’s quarterly results. The company, which was formed in 2007, is run by hedge-fund manager Michael Vranos’ Ellington Financial Management LLC, which Penn helped found in 1994.

The comments signal that the valuation of mortgage securities by investment firms and banks often remains inexact. Four years ago today, BNP Paribas SA marked the spread of the financial crisis by freezing withdrawals from three of its funds when it couldn’t value their subprime holdings, and banks including Citigroup Inc. later reported escalating writedowns.

While the Financial Industry Regulatory Authority in May began collecting information on transactions in the market from brokers, the regulator plans to study whether to make the data public. Last month, widely circulated auctions of non-agency securities fell to $9.7 billion, about 50 percent the level of a year earlier, JPMorgan Chase & Co. analysts wrote in an Aug. 5 report.

“With little trading, price activity was unclear, although the few bonds that cleared traded well even during equity market turmoil,” the New York-based analysts led by John Sim wrote.

Penn said on the call that “as we all know, sometimes market paralysis precedes distressed selling.”

Market Declines

One pricing measure, so-called ABX indexes tied to credit-default swaps on subprime debt, often doesn’t correlate with the prices of the actual bonds, according to the JPMorgan analysts.

A Markit ABX index tied to subprime-mortgage bonds rated AAA when issued in 2006 fell yesterday by 2.8 to 47, the sharpest decline since May 2010 and lowest close since June 27, according to London-based administrator Markit Group Ltd. The index, whose levels signal that investors may pay similar amounts in cents on the dollar for comparable bonds, has fallen from a 30-month high of 62.7 in February.

Subprime-mortgage bonds from 2005, 2006 and 2007 on average returned 2.2 percent from June 30 through yesterday, after losing 5.6 percent in the second quarter, according to Barclays Capital index data.

Non-Agency Securities

Last quarter, “certain sectors” of the non-agency mortgage-bond market “had price declines in excess of 20 percent and certain sectors are relatively unscathed,” said Mark Tecotzky, Ellington Financial LLC’s co-chief investment officer with Vranos, the former head of Kidder Peabody & Co.’s top-ranked mortgage-bond business in the early 1990s.

The company’s $370 million of non-agency securities, which are mainly older bonds, fell about 4.7 percent, Chief Financial Officer Lisa Mumford said. The firm’s net loss from operations last quarter totaled $1.3 million, the company said yesterday.

The company’s estimated book value, a measure of the value of its assets minus its liabilities, fell to $22.61 per common share on a diluted basis on July 31 from $22.78 on June 30, according to company statements.

The firm invests in both agency and non-agency mortgage securities and uses credit-default swaps to bet against bonds. Agency mortgage securities are guaranteed by government-supported Fannie Mae and Freddie Mac or federal agency Ginnie Mae, while non-agency debt lacks that backing.

‘Significant Discount’

Ellington Financial LLC rose 39 cents to $18.39 at 4:15 p.m. in New York Stock Exchange composite trading. Investors have lost 8.9 percent, assuming reinvested dividends, since the company’s $101.3 million initial public offering in October, according to data compiled by Bloomberg.

The company yesterday announced plans to repurchase $10 million shares to take advantage of what Penn called the “significant discount” in their value. Tecotzky also said it enjoys a “much more fertile investment landscape” when investing in non-agency mortgage bonds and would focus more on the debt.

Two Harbors Investment Corp., which raised $490 million in equity in July, and MFA Financial Inc. are two of the real estate investment trusts that buy both agency and non-agency mortgage bonds whose executives also said on earnings calls this month they see more relative opportunity in non-agency debt.

Agency mortgage bonds remain a source of strength for the country as signs of a slowing economy roil markets, according to Tecotzky.

“With most of the mortgage origination market still controlled by the government, credit availability is unchanged by recent market events and borrowing costs have come down,” he said. “That’s in sharp contrast to the commercial market, which is mostly dependent on private capital.”

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