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Ellington Shifts Subprime Bond Bets to Riskier Debt After Slump

Ellington Financial LLC has been offloading higher-quality subprime-mortgage bonds so it can buy riskier securities after declines of as much as 30 percent.

The investment firm has been “aggressively” selling subprime debt issued before 2005, which typically trades for about 80 cents on the dollar, Chief Executive Officer Larry Penn said today on a conference call. It’s replacing those notes, which are its largest holdings among home-loan bonds without government backing, with newer subprime securities that can be bought for between 30 cents and 50 cents on the dollar, he said.

Subprime debt created prior to 2005 trades at higher prices and has lost less value since March than more recent securities because the underlying loans were better underwritten and made before accelerating gains in U.S. home prices inflated collateral values. Ellington Financial is changing tactics as “extreme volatility” in markets and pending regulations cause investors and Wall Street banks to retreat from risk, Penn said.

“With the large dealers reluctant to add risk, it became much easier for us,” said Penn, whose Old Greenwich, Connecticut-based firm has $2.4 billion of assets and is run by hedge-fund manager Michael Vranos’ Ellington Financial Management LLC.

While the shift to newer securities leaves the firm more exposed to the size of recoveries on defaulted loans, the bonds have projected yields of more than 10 percent, assuming a 15 percent decline in home prices, said Mark Tecotzky, Ellington Financial’s co-chief investment officer.

Vranos Joins

Vranos, the former head of Kidder Peabody & Co.’s top-ranked mortgage-bond business in the early 1990s, started Ellington Financial Management LLC in 1994 and is co-chief investment officer of publicly-traded Ellington Financial LLC.

Two Harbors Investment Corp., a real estate investment trust run by hedge fund Pine River Capital Management LP, also targeted so-called non-agency mortgage securities without government backing tied to riskier loans last quarter. Two Harbors’ co-CIO Bill Roth said in a Nov. 2 interview that subprime-bond prices meant “we don’t have to count on these guys paying us back.”

Invesco Mortgage Capital Inc., a REIT overseen by Invesco Ltd., reduced its capital devoted to non-agency home-loan bonds last quarter, and focused more on the safest, senior classes of so-called re-remic mortgage-bond repackagings in the $1.2 trillion market, Chief Investment Officer John Anzalone said Nov. 3 conference call.

Ellington Financial’s “long” positions in non-agency mortgage securities climbed $34 million last quarter to $420 million, as newer subprime and so-called Alt-B bonds rose to 23 percent of the portfolio from 5 percent, according to a slide posted on the company’s website. About 43 percent of its holdings have been added since March 31, the company said.

The firm reduced how much it uses so-called ABX credit-default swaps tied to subprime debt as hedges, Penn said. It’s instead using credit swaps tied to corporate debt, which have more room to fall if markets deteriorate, Penn said.

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