Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2010

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number 001-34569

 

 

Ellington Financial LLC

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

Delaware   26-0489289

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

53 Forest Avenue, Old Greenwich, Connecticut 06870

(Address of Principal Executive Office) (Zip Code)

(203) 698-1200

(Registrant’s Telephone Number, Including Area Code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ¨    No  x

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filers” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one.):

 

Large Accelerated Filer   ¨    Accelerated Filer   ¨
Non-Accelerated Filer   x    Smaller Reporting Company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class

 

Outstanding at November 18, 2010

Common Shares Representing Limited Liability Company Interests, no par value

  16,497,092

 

 

 


Table of Contents

ELLINGTON FINANCIAL LLC

FORM 10-Q

 

PART I. Financial Information

     2   

Item 1. Consolidated Financial Statements (unaudited)

     2   

Item  2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     45   

Item 3. Quantitative and Qualitative Disclosures about Market Risk

     69   

Item 4T. Controls and Procedures

     72   

PART II. OTHER INFORMATION

  

Item 1. Legal Proceedings

     72   

Item 1A. Risk Factors

     72   

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

     72   

Item 6. Exhibits

     73   

SIGNATURES

     74   


Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Consolidated Financial Statements (unaudited)

ELLINGTON FINANCIAL LLC

CONSOLIDATED STATEMENT OF ASSETS, LIABILITIES AND SHAREHOLDERS’ EQUITY

(UNAUDITED)

 

     September 30,
2010
     December 31,
2009
 
     Expressed in U.S. Dollars  

ASSETS

     

Cash and cash equivalents

   $ 117,712,224       $ 102,863,164   
                 

Investments and financial derivatives:

     

Investments at value (Cost - $1,190,037,209 and $753,892,552)

     1,214,179,036         755,440,869   

Financial derivatives - assets (Cost - $156,135,281 and $113,567,635)

     147,153,313         123,638,023   
                 

Total investments and financial derivatives

     1,361,332,349         879,078,892   
                 

Deposits with dealers held as collateral

     18,083,499         23,071,006   

Receivable for securities sold

     1,026,530,501         513,821,219   

Interest and principal receivable

     5,243,224         9,297,899   

Deferred offering costs

     3,139,102         2,533,272   

Prepaid insurance

     249,005         —     
                 

Total Assets

   $ 2,532,289,904       $ 1,530,665,452   
                 

LIABILITIES

     

Investments and financial derivatives:

     

Investments sold short at value (Proceeds - $894,958,301 and $509,587,384)

   $ 893,250,608       $ 502,543,554   

Financial derivatives - liabilities (Proceeds - $26,948,187 and $8,043,963)

     33,054,923         14,045,886   
                 

Total investments and financial derivatives

     926,305,531         516,589,440   
                 

Reverse repurchase agreements

     476,723,000         559,978,100   

Due to brokers - margin accounts

     105,805,269         106,483,358   

Payable for securities purchased

     707,793,904         41,645,394   

Accounts payable and accrued expenses

     2,520,190         2,015,547   

Accrued base management fee

     1,172,513         1,137,018   

Accrued incentive fees

     2,524,272         2,274,530   

Interest and dividends payable

     471,850         748,052   
                 

Total Liabilities

     2,223,316,529         1,230,871,439   
                 

SHAREHOLDERS’ EQUITY

     308,973,375         299,794,013   
                 

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

   $ 2,532,289,904       $ 1,530,665,452   
                 

ANALYSIS OF SHAREHOLDERS’ EQUITY:

     

Common shares, no par value, 100,000,000 shares authorized;

     

(11,985,670 and 11,972,113 shares issued and outstanding)

   $ 300,215,321       $ 292,946,604   

Additional paid-in capital - LTIP units

     8,758,054         6,847,409   
                 

Total Shareholders’ Equity

   $ 308,973,375       $ 299,794,013   
                 

PER SHARE INFORMATION:

     

Common shares, no par value

   $ 25.78       $ 25.04   
                 

See Notes to Consolidated Financial Statements

 

2


Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT SEPTEMBER 30, 2010

(UNAUDITED)

 

Current Principal/
Notional Amount

    

Description

   Rate     Maturity      Value  
                         Expressed in U.S.
Dollars
 

 

Long Investments (392.97%) (a) (b) (l)

       

 

Mortgage-Backed Securities (392.97%)

       

 

Agency Securities (305.62%)

       

 

Fixed Rate Agency Securities (283.48%)

       

 

Principal and Interest - Fixed Rate Agency Securities (112.00%)

       
$ 75,851,728      

Government National Mortgage Association 733597 Pool

     5.00     4/40       $ 81,244,312   
  25,328,802      

Government National Mortgage Association 733660 Pool

     4.50     5/40         26,757,504   
  24,425,280      

Federal Home Loan Mortgage Corporation A93579 Pool

     5.00     8/40         25,719,057   
  18,587,762      

Federal National Mortgage Association 969626 Pool

     6.00     1/38         20,067,522   
  17,606,359      

Federal Home Loan Mortgage Corporation A94009 Pool

     5.00     9/40         18,552,701   
  13,212,576      

Federal Home Loan Mortgage Corporation A94030 Pool

     4.50     9/40         13,775,143   
  12,409,247      

Federal National Mortgage Association AD2376 Pool

     5.00     3/40         13,161,558   
  12,123,319      

Federal National Mortgage Association AD8541 Pool

     5.50     8/40         12,962,480   
  11,966,028      

Federal National Mortgage Association AE5208 Pool

     4.50     9/40         12,478,324   
  11,188,198      

Government National Mortgage Association 697753 Pool

     5.00     6/40         11,983,609   
  11,158,401      

Federal National Mortgage Association AC1210 Pool

     5.50     7/39         11,930,771   
  9,931,045      

Government National Mortgage Association 721342 Pool

     5.00     7/40         10,584,322   
  9,566,831      

Federal National Mortgage Association AC3691 Pool

     5.50     10/39         10,205,118   
  9,287,545      

Government National Mortgage Association 737198 Pool

     5.00     4/40         9,947,831   
  8,828,798      

Federal Home Loan Mortgage Corporation A93613 Pool

     5.00     8/40         9,296,449   
  8,473,256      

Federal Home Loan Mortgage Corporation A85728 Pool

     6.00     4/39         9,135,229   

See Notes to Consolidated Financial Statements

 

3


Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT SEPTEMBER 30, 2010 (CONTINUED)

(UNAUDITED)

 

Current Principal/
Notional Amount

    

Description

   Rate     Maturity      Value  
                         Expressed in U.S.
Dollars
 

 

Principal and Interest - Fixed Rate Agency Securities (112.00%) (continued)

       
$ 7,216,775      

Government National Mortgage Association 741038 Pool

     5.00     8/40       $ 7,729,842   
  6,215,459      

Government National Mortgage Association 740961 Pool

     5.00     7/40         6,624,319   
  5,965,655      

Federal National Mortgage Association 970853 Pool

     6.00     12/38         6,407,021   
  5,318,521      

Government National Mortgage Association 737176 Pool

     4.50     4/40         5,608,547   
  4,552,435      

Government National Mortgage Association 747137 Pool

     4.50     8/40         4,810,643   
  4,019,302      

Government National Mortgage Association 721317 Pool

     5.00     7/40         4,289,977   
  3,497,436      

Federal National Mortgage Association 934966 Pool

     6.00     1/39         3,756,192   
  3,232,398      

Federal Home Loan Mortgage Corporation A94013 Pool

     5.00     9/40         3,406,139   
  1,744,056      

Federal National Mortgage Association AD1524 Pool

     6.00     1/40         1,873,089   
  3,482,325      

Other Federal National Mortgage Association Pools

     6.00     9/39 - 2/40         3,741,240   
                
             346,048,939   
                

 

TBA - Fixed Rate Agency Securities (171.48%) (c)

       
  140,750,000      

Federal National Mortgage Association (30 Year)

     4.50     10/10         146,610,918   
  91,000,000      

Government National Mortgage Association (30 Year)

     5.00     10/10         96,900,781   
  87,500,000      

Federal National Mortgage Association (30 Year)

     4.50     10/10         92,025,391   
  67,500,000      

Federal National Mortgage Association (15 Year)

     4.50     11/10         70,943,555   
  36,000,000      

Federal Home Loan Mortgage Corporation (30 Year)

     5.00     10/10         37,822,500   
  28,000,000      

Federal National Mortgage Association (30 Year)

     5.00     10/10         29,478,750   
  20,000,000      

Federal National Mortgage Association (30 Year)

     6.00     10/10         21,479,688   
  20,000,000      

Government National Mortgage Association (30 Year)

     4.50     10/10         21,053,125   
  13,000,000      

Federal Home Loan Mortgage Corporation (30 Year)

     4.50     10/10         13,521,016   
                
             529,835,724   
                

 

Total Fixed Rate Agency Securities (Cost $875,722,120)

          875,884,663   
                

See Notes to Consolidated Financial Statements

 

4


Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT SEPTEMBER 30, 2010 (CONTINUED)

(UNAUDITED)

 

Current Principal/
Notional Amount

    

Description

   Rate     Maturity      Value  
                         Expressed in U.S.
Dollars
 

 

Floating Rate Agency Securities (22.14%)

       

 

Principal and Interest - Floating Rate Agency Securities (22.14%)

       
$ 12,124,566      

Federal National Mortgage Association 968454 Pool

     5.12     5/38       $ 12,728,636   
  9,714,389      

Federal National Mortgage Association 879659 Pool

     5.77     10/36         10,215,213   
  9,188,508      

Federal National Mortgage Association 879705 Pool

     5.21     2/38         9,678,572   
  7,426,930      

Federal National Mortgage Association 902181 Pool

     5.99     10/36         7,845,295   
  7,385,144      

Federal National Mortgage Association 840238 Pool

     3.85     7/35         7,749,047   
  5,870,557      

Federal Home Loan Mortgage Corporation 1G1675 Pool

     3.23     4/37         6,109,792   
  4,525,531      

Federal National Mortgage Association 880442 Pool

     5.69     4/36         4,812,268   
  3,476,133      

Federal National Mortgage Association 952440 Pool

     5.51     9/37         3,679,276   
  3,384,158      

Federal Home Loan Mortgage Corporation 1J0297 Pool

     5.69     2/37         3,570,846   
  1,903,810      

Federal National Mortgage Association 961359 Pool

     6.08     1/38         2,017,892   
                

 

Total Floating Rate Agency Securities (Cost $67,211,611)

          68,406,837   
                

 

Total Agency Securities (Cost $942,933,731)

          944,291,500   
                

 

Private Label Securities (87.35%)

       

 

Principal and Interest - Private Label Securities (83.88%)

       
  375,270,725      

Various

     0.32% - 111.45     5/19 - 5/47         259,160,679   
                

 

Total Principal and Interest - Private Label Securities (Cost $242,534,079)

  

       259,160,679   
                

 

Interest Only - Private Label Securities (3.47%)

       
  160,942,457      

Various

     0.50% - 6.49     4/35 - 9/47         10,726,857   
                

 

Total Interest Only - Private Label Securities (Cost $3,940,309)

          10,726,857   
                

 

Residual Certificates - Private Label Securities (0.00%)

       
  232,175,009      

Various

     —          6/37         —     
                

 

Total Residual Certificates - Private Label Securities (Cost $629,090)

          —     
                

 

Total Private Label Securities (Cost $247,103,478)

          269,887,536   
                

 

Total Mortgage-Backed Securities (Cost $1,190,037,209)

          1,214,179,036   
                

 

Total Long Investments (Cost $1,190,037,209)

        $ 1,214,179,036   
                

See Notes to Consolidated Financial Statements

 

5


Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT SEPTEMBER 30, 2010 (CONTINUED)

(UNAUDITED)

 

Current Principal/
Notional Amount

    

Description

   Rate     Maturity      Value  
                         Expressed in U.S.
Dollars
 

 

Investments Sold Short (-289.10%) (d)

       

 

TBA - Fixed Rate Agency Securities Sold Short (-289.10%) (c)

       
$   (143,000,000)      

Government National Mortgage Association (30 Year)

     5.00     11/10       $ (152,105,078
  (128,750,000)      

Federal National Mortgage Association (30 Year)

     4.50     10/10         (134,111,230
  (91,000,000)      

Government National Mortgage Association (30 Year)

     5.00     10/10         (96,900,781
  (91,000,000)      

Federal National Mortgage Association (30 Year)

     4.00     10/10         (93,559,375
  (87,500,000)      

Federal National Mortgage Association (30 Year)

     4.50     10/10         (92,025,391
  (87,500,000)      

Federal National Mortgage Association (15 Year)

     4.50     11/10         (91,963,867
  (36,000,000)      

Federal Home Loan Mortgage Corporation (30 Year)

     5.00     10/10         (37,822,500
  (34,500,000)      

Government National Mortgage Association (30 Year)

     4.50     10/10         (36,316,641
  (33,000,000)      

Federal Home Loan Mortgage Corporation (30 Year)

     5.00     11/10         (34,634,531
  (30,500,000)      

Federal National Mortgage Association (30 Year)

     6.00     10/10         (32,756,523
  (27,000,000)      

Federal National Mortgage Association (30 Year)

     5.00     10/10         (28,425,938
  (18,500,000)      

Federal National Mortgage Association (30 Year)

     5.50     10/10         (19,664,924
  (16,000,000)      

Federal Home Loan Mortgage Corporation (30 Year)

     5.50     10/10         (16,967,500
  (13,000,000)      

Federal Home Loan Mortgage Corporation (30 Year)

     4.50     10/10         (13,521,016
  (12,000,000)      

Federal National Mortgage Association (30 Year)

     4.50     11/10         (12,475,313
                

 

Total TBA - Fixed Rate Agency Securities Sold Short (Proceeds -$894,958,301)

  

       (893,250,608
                

 

Total Investments Sold Short (Proceeds -$894,958,301)

  

     $ (893,250,608
                

See Notes to Consolidated Financial Statements

 

6


Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT SEPTEMBER 30, 2010 (CONTINUED)

(UNAUDITED)

 

     Primary Risk
Exposure
     Notional or
Number of
Contracts
    Range of
Expiration
Dates
     Value  
                         Expressed in U.S.
Dollars
 

Financial Derivatives - Assets (47.63%)

          

Swaps (47.63%) (e)

          

Long Swaps:

          

Credit Default Swaps on Asset Backed Indices (Cost $3,875,496) (f)

     Credit         80,784,430        6/36 - 9/37       $ 4,054,303   

Short Swaps:

          

Credit Default Swaps on Asset Backed Securities (g)

     Credit         (125,959,213     6/34 - 12/36         102,574,132   

Credit Default Swaps on Asset Backed Indices (h)

     Credit         (125,328,252     8/37 - 10/52         40,519,381   

Credit Default Swaps on Corporate Bond Indices (i)

     Credit         (19,700,000     6/15         5,497   
                

Total Swaps (Cost $156,135,281)

             147,153,313   
                

Total Financial Derivatives - Assets (Cost $156,135,281)

           $ 147,153,313   
                

Financial Derivatives - Liabilities (-10.70%)

          

Swaps (-9.73%)

          

Long Swaps:

          

Credit Default Swaps on Asset Backed Indices (Proceeds -$26,812,788) (f)

     Credit         60,188,716        8/37 - 10/52       $ (26,831,423

Short Swaps:

          

Interest Rate Swaps (j)

     Interest Rates         (70,000,000     10/14 - 9/20         (3,064,503

Credit Default Swaps on Asset Backed Indices (h)

     Credit         (6,544,229     9/37         (158,820
                

Total Swaps (Proceeds -$26,948,187)

             (30,054,746
                

Futures (-0.97%)

          

Short Futures:

          

Euro-Dollar contracts (k)

     Interest Rates         (990     12/10 - 9/12         (3,000,177
                

Total Futures

             (3,000,177
                

Total Financial Derivatives - Liabilities (Proceeds -$26,948,187)

           $ (33,054,923
                

See Notes to Consolidated Financial Statements

 

7


Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT SEPTEMBER 30, 2010 (CONCLUDED)

(UNAUDITED)

 

 

(a) See Note 2 and Note 8 in Notes to Consolidated Financial Statements.
(b) At September 30, 2010, the Company’s long investments guaranteed by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, and the Government National Mortgage Association represented 166.95%, 45.61%, and 93.06% of shareholders’ equity, respectively.
(c) To Be Announced (“TBA”) securities settle on a forward basis. At settlement the purchaser generally receives agency pass-through mortgage certificates with original maturity dates typically between 15 and 30 years.
(d) At September 30, 2010, the Company’s short investments guaranteed by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, and the Government National Mortgage Association represented 163.43%, 33.32%, and 92.35% of shareholders’ equity, respectively.
(e) The following table shows the Company’s swap assets by dealer as a percentage of shareholders’ equity:

 

Dealer/Parent Company

   Percent of
Shareholders’
Equity
 

Affiliates of Morgan Stanley

     21.27

Affiliates of Credit Suisse

     8.97

Affiliates of Deutsche Bank

     6.51

 

(f) For long credit default swaps on asset backed indices, the Company sold protection.
(g) For short credit default swaps on asset backed securities, the Company purchased protection.
(h) For short credit default swaps on asset backed indices, the Company purchased protection.
(i) For short credit default swaps on corporate bond indices, the Company purchased protection.
(j) For short interest rate swap contracts, a fixed rate is being paid and a floating rate is being received.
(k) Each contract represents a notional amount of $1,000,000.
(l) The table below shows the Company’s long investment ratings from Moody’s, Standard and Poor’s, or Fitch, as well as the Company’s long investments that were unrated but affiliated with Fannie Mae, Freddie Mac, or Ginnie Mae. Ratings tend to be a lagging credit indicator; as a result, the credit quality of the Company’s long investment holdings may be lower than the credit quality implied based on the ratings listed below. In situations where an investment has a split rating, the lowest provided rating is used. The ratings descriptions include ratings qualified with a “+”, “-”, “1”, “2”, or “3”.

 

Rating Description

   Percentage of
Shareholders’
Equity
 

Unrated but Agency-Guaranteed

     305.62

Aaa/AAA/AAA

     8.55

Aa/AA/AA

     15.33

A/A/A

     6.15

Baa/BBB/BBB

     5.35

Ba/BB/BB or below

     51.97

Unrated

     0.00

See Notes to Consolidated Financial Statements

 

8


Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT DECEMBER 31, 2009

(UNAUDITED)

 

Current Principal/
Notional Amount/
Number of Contracts

    

Description

   Rate     Maturity      Value  
                         Expressed in U.S.
Dollars
 

 

Long Investments (251.99%) (a) (b) (p)

       

 

U.S. Treasury Securities (2.25%)

       
$ 7,000,000       U.S. Treasury Note      3.38     11/19       $ 6,734,635   
                

 

Total U.S. Treasury Securities (Cost $6,981,860)

          6,734,635   
                

 

Mortgage-Backed Securities (249.73%)

       

 

Agency Securities (179.56%)

       

 

Fixed Rate Agency Securities (111.59%)

       

 

Principal and Interest - Fixed Rate Agency Securities (98.13%)

       
  34,714,432       Federal Home Loan Mortgage Corporation A89303 Pool      5.00     10/39         35,609,414   
  31,281,944       Federal National Mortgage Association 931563 Pool      5.00     7/39         32,137,310   
  24,810,869       Federal National Mortgage Association AA7010 Pool      5.00     6/39         25,539,688   
  24,297,795       Federal National Mortgage Association 931555 Pool      4.50     7/39         24,267,423   
  21,126,037       Federal National Mortgage Association 969626 Pool      6.00     1/38         22,429,909   
  16,084,407       Federal National Mortgage Association AA7781 Pool      4.50     6/39         16,071,841   
  14,512,976       Federal Home Loan Mortgage Corporation A88479 Pool      6.00     9/39         15,444,982   
  14,457,231       Federal National Mortgage Association 992296 Pool      5.50     1/39         15,160,892   
  12,216,156       Federal Home Loan Mortgage Corporation A81799 Pool      6.50     9/38         13,167,680   
  11,596,693       Federal National Mortgage Association AC1210 Pool      5.50     7/39         12,214,564   
  10,829,097       Federal National Mortgage Association 991126 Pool      6.00     1/39         11,475,459   
  10,472,183       Federal National Mortgage Association AA8720 Pool      5.00     6/39         10,779,804   
  10,443,398       Federal National Mortgage Association 931603 Pool      4.50     7/39         10,430,344   
  9,874,131       Federal National Mortgage Association 931511 Pool      5.50     7/39         10,355,495   
  8,824,543       Federal Home Loan Mortgage Corporation A85728 Pool      6.00     4/39         9,391,255   

See Notes to Consolidated Financial Statements

 

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Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT DECEMBER 31, 2009 (CONTINUED)

(UNAUDITED)

 

Current Principal/
Notional Amount/
Number of Contracts

    

Description

   Rate     Maturity      Value  
                         Expressed in U.S.
Dollars
 

 

Principal and Interest - Fixed Rate Agency Securities (98.13%) (continued)

       
$ 8,107,716      

Federal National Mortgage Association AA9129 Pool

     5.50     8/39       $ 8,496,633   
  7,409,648      

Federal National Mortgage Association 970853 Pool

     6.00     12/38         7,862,331   
  5,118,273      

Federal Home Loan Mortgage Corporation A87956 Pool

     5.00     8/39         5,253,427   
  4,396,960      

Federal National Mortgage Association 934966 Pool

     6.00     1/39         4,663,525   
  1,690,818      

Federal National Mortgage Association AC0766 Pool

     6.00     9/39         1,793,324   
  1,558,710      

Federal National Mortgage Association 902880 Pool

     6.00     11/36         1,652,719   
                
             294,198,019   
                

 

TBA - Fixed Rate Agency Securities (13.46%) (c)

       
  20,000,000      

Federal National Mortgage Association (30 Year)

     4.00     1/10         19,331,250   
  10,000,000      

Federal National Mortgage Association (30 Year)

     4.00     2/10         9,633,594   
  8,250,000      

Federal National Mortgage Association (30 Year)

     4.50     1/10         8,235,820   
  3,000,000      

Government National Mortgage Association (30 Year)

     5.50     1/10         3,144,375   
                
             40,345,039   
                

 

Total Fixed Rate Agency Securities (Cost $334,451,930)

          334,543,058   
                

See Notes to Consolidated Financial Statements

 

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Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT DECEMBER 31, 2009 (CONTINUED)

(UNAUDITED)

 

Current Principal/
Notional Amount/
Number of
Contracts

    

Description

   Rate     Maturity      Value  
                         Expressed in U.S.
Dollars
 

 

Floating Rate Agency Securities (67.97%)

       

 

Principal and Interest - Floating Rate Agency Securities (67.97%)

       
$ 24,670,643      

Federal Home Loan Mortgage Corporation 1J1558 Pool

     6.20     1/37       $ 26,074,250   
  22,267,072      

Federal Home Loan Mortgage Corporation 1N1428 Pool

     5.74     2/37         23,399,863   
  19,431,122      

Federal National Mortgage Association 946842 Pool

     5.71     9/37         20,419,774   
  19,341,420      

Federal National Mortgage Association 840243 Pool

     4.45     8/35         20,135,281   
  17,394,041      

Federal National Mortgage Association 968454 Pool

     5.12     5/38         18,274,575   
  16,328,189      

Federal National Mortgage Association 918119 Pool

     5.55     5/37         16,999,537   
  15,426,363      

Federal National Mortgage Association 909945 Pool

     5.84     2/37         16,240,263   
  10,819,119      

Federal Home Loan Mortgage Corporation 1N1460 Pool

     5.94     1/37         11,397,635   
  9,936,519      

Federal National Mortgage Association 840238 Pool

     4.73     7/35         10,406,531   
  8,858,659      

Federal National Mortgage Association 914820 Pool

     6.01     4/37         9,389,551   
  8,834,947      

Federal Home Loan Mortgage Corporation 1G1675 Pool

     5.27     4/37         9,124,360   
  7,633,178      

Federal National Mortgage Association 886455 Pool

     6.12     8/36         8,007,600   
  7,539,919      

Federal Home Loan Mortgage Corporation 1J1652 Pool

     5.79     5/37         7,841,399   
  5,813,015      

Federal National Mortgage Association 952440 Pool

     5.77     9/37         6,049,634   
                

 

Total Floating Rate Agency Securities (Cost $197,937,966)

          203,760,253   
                

 

Total Agency Securities (Cost $532,389,896)

          538,303,311   
                

See Notes to Consolidated Financial Statements

 

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Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT DECEMBER 31, 2009 (CONTINUED)

(UNAUDITED)

 

Current Principal/
Notional Amount/
Number of
Contracts

    

Description

   Rate      Maturity      Value  
                          Expressed in U.S.
Dollars
 

 

Private Label Securities (70.17%)

        

 

Principal and Interest - Private Label Securities (66.17%)

        
$ 345,186,599      

Various

     0.30% - 111.94%         3/25 - 5/47       $ 198,361,316   
                 

 

Total Principal and Interest - Private Label Securities (Cost $205,747,380)

           198,361,316   
                 

 

Interest Only - Private Label Securities (4.00%)

        
  265,467,157      

Various

     0.50% - 6.51%         4/35 - 9/47         12,002,080   
                 

 

Total Interest Only - Private Label Securities (Cost $7,494,892)

           12,002,080   
                 

 

Residual Certificates - Private Label Securities (0.00%)

        
  257,483,379      

Various

     -         6/37         335   
                 

 

Total Residual Certificates - Private Label Securities (Cost $697,664)

           335   
                 

 

Total Private Label Securities (Cost $213,939,936)

           210,363,731   
                 

 

Total Mortgage-Backed Securities (Cost $746,329,832)

           748,667,042   
                 

 

Options (0.01%) (d)

        
  284      

S&P 500 Index Put Options Purchased

     -         3/10         39,192   
                 

 

Total Options (Cost $580,860)

           39,192   
                 

 

Total Long Investments (Cost $753,892,552)

         $ 755,440,869   
                 

See Notes to Consolidated Financial Statements

 

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Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT DECEMBER 31, 2009 (CONTINUED)

(UNAUDITED)

 

Current Principal/
Notional Amount/
Number of
Contracts

   

Description

  

Rate

   Maturity      Value  
                       Expressed in U.S.
Dollars
 

 

Investments Sold Short (-167.63%) (e)

        

 

TBA - Fixed Rate Agency Securities Sold Short (-167.63%) (c)

        
$ (178,750,000  

Federal National Mortgage Association (30 Year)

   4.50%      1/10       $ (178,442,773
  (124,000,000  

Federal National Mortgage Association (30 Year)

   5.00%      1/10         (127,293,750
  (60,000,000  

Federal National Mortgage Association (30 Year)

   5.50%      1/10         (62,831,250
  (40,000,000  

Federal Home Loan Mortgage Corporation (30 Year)

   5.00%      1/10         (41,018,749
  (36,500,000  

Federal National Mortgage Association (30 Year)

   6.00%      1/10         (38,655,782
  (20,000,000  

Federal National Mortgage Association (30 Year)

   4.00%      1/10         (19,331,250
  (15,000,000  

Federal Home Loan Mortgage Corporation (30 Year)

   6.00%      1/10         (15,907,031
  (10,000,000  

Federal National Mortgage Association (30 Year)

   4.00%      2/10         (9,633,594
  (6,000,000  

Federal Home Loan Mortgage Corporation (30 Year)

   5.50%      1/10         (6,285,000
  (3,000,000  

Government National Mortgage Association (30 Year)

   5.50%      1/10         (3,144,375
                

 

Total TBA - Fixed Rate Agency Securities Sold Short (Proceeds -$509,587,384)

           (502,543,554
                

 

Total Investments Sold Short (Proceeds -$509,587,384)

         $ (502,543,554
                

See Notes to Consolidated Financial Statements

 

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Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT DECEMBER 31, 2009 (CONTINUED)

(UNAUDITED)

 

    

Primary Risk

Exposure

   Notional or
Number  of
Contracts
   

Range of

Expiration

Dates

   Value  
                    

Expressed in U.S.

Dollars

 

Financial Derivatives - Assets (41.24%)

          

Swaps (41.24%) (f)

          

Long Swaps:

          

Other Swaps

   Credit      8,700,000      9/13 - 6/14    $ 257,212   

Short Swaps:

          

Credit Default Swaps on Asset Backed Securities (g)

   Credit      (113,743,916   6/34 - 12/36      95,199,131   

Credit Default Swaps on Asset Backed Indices (h)

   Credit      (43,482,040   8/37 - 10/52      19,596,453   

Credit Default Swaps on Corporate Bonds (i)

   Credit      (36,325,000   3/13 - 12/14      8,475,895   

Interest Rate Swaps (j)

   Interest Rates      (11,000,000   10/14      109,332   
                

Total Swaps (Cost $113,567,635)

          123,638,023   
                

Total Financial Derivatives - Assets (Cost $113,567,635)

  

     $ 123,638,023   
                

Financial Derivatives - Liabilities (-4.69%)

          

Swaps (-4.33%)

          

Long Swaps:

          

Credit Default Swaps on Asset Backed Securities (Proceeds -$6,666,250) (k)

   Credit      15,252,372      5/34 - 9/36    $ (10,547,540

Credit Default Swaps on Asset Backed Indices (Proceeds -$2,063,750) (l)

   Credit      3,250,000      8/37      (1,878,143

Short Swaps:

          

Total Return Swaps (m)

   Equity Market      (11,447,595   4/10 - 5/10      (87,798

Credit Default Swaps on Corporate Bond Indices (n)

   Credit      (19,542,400   12/13      (459,941
                

Total Swaps (Net Proceeds -$8,043,963)

          (12,973,422
                

Futures (-0.36%)

          

Short Futures:

          

Euro-Dollar contracts (o)

   Interest Rates      (1,257   3/10 - 9/11      (1,072,464
                

Total Futures

             (1,072,464
                

Total Financial Derivatives - Liabilities (Net Proceeds -$8,043,963)

   $ (14,045,886
                

See Notes to Consolidated Financial Statements

 

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Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT DECEMBER 31, 2009 (CONTINUED)

(UNAUDITED)

 

 

(a) See Note 2 and Note 8 in Notes to Consolidated Financial Statements.
(b) At December 31, 2009, the Company’s long investments guaranteed by the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association represented 52.27% and 126.24% of shareholders’ equity, respectively.
(c) To Be Announced (“TBA”) securities settle on a forward basis. At settlement the purchaser generally receives agency pass-through mortgage certificates with original maturity dates typically between 15 and 30 years.
(d) Each contract represents the option to sell the S&P 500 index on a specified date at a specified price with each contract point representing $100.
(e) At December 31, 2009, the Company’s short investments guaranteed by the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association represented 21.08% and 145.50% of shareholders’ equity, respectively.
(f) The following table shows the appreciated value of the Company’s swap contracts by dealer as a percentage of shareholders’ equity:

 

Dealer/Parent Company

   Percent  of
Shareholders’
Equity
 

Affiliates of Morgan Stanley

     21.72

Affiliates of Credit Suisse

     15.73

 

(g) For short credit default swaps on asset backed securities, the Company purchased protection.
(h) For short credit default swaps on asset backed indices, the Company purchased protection.
(i) For short credit default swaps on corporate bonds, the Company purchased protection.
(j) For short interest rate swap contracts, a fixed rate is being paid and a floating rate is being received.

See Notes to Consolidated Financial Statements

 

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Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED CONDENSED SCHEDULE OF INVESTMENTS

AT DECEMBER 31, 2009 (CONCLUDED)

(UNAUDITED)

 

(k) For long credit default swaps on asset backed securities, the Company sold protection.
(l) For long credit default swaps on asset backed indices, the Company sold protection.
(m) Notional amount represents number of underlying shares or par value times the closing price of the underlying security.
(n) For short credit default swaps on corporate bond indices, the Company purchased protection.
(o) Each contract represents a notional amount of $1,000,000.
(p) The table below shows the Company’s long investment ratings from Moody’s, Standard and Poor’s, or Fitch, respectively; as well as the Company’s long investments that were unrated but affiliated with Fannie Mae, Freddie Mac, or Ginnie Mae. Ratings tend to be a lagging credit indicator; as a result, the credit quality of the Company’s long investment holdings may be lower than the credit quality implied based on the ratings listed below. In situations where an investment has a split rating, the lowest provided rating is used. The ratings descriptions include ratings qualified with a “+”, “-”, “1”, “2”, or “3”.

 

Rating Description

   Percentage  of
Shareholders’
Equity
 

U.S. Treasury Securities

     2.25

Unrated but Agency-Guaranteed

     179.56

Aaa/AAA/AAA

     10.80

Aa/AA/AA

     12.54

A/A/A

     5.00

Baa/BBB/BBB

     2.66

Ba/BB/BB or below

     39.17

Unrated

     0.01

See Notes to Consolidated Financial Statements

 

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Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED STATEMENT OF OPERATIONS

(UNAUDITED)

 

     Three Month
Period  Ended
September 30,
2010
    Three Month
Period  Ended
September 30,
2009
    Nine Month
Period  Ended
September 30,
2010
    Nine Month
Period  Ended
September 30,
2009
 
     Expressed in U.S. Dollars  

INVESTMENT INCOME

        

Interest income

   $ 10,859,011      $ 14,275,393      $ 33,574,261      $ 37,209,523   
                                

EXPENSES

        

Base management fee

     1,172,513        1,151,178        3,384,765        3,109,724   

Incentive fee

     2,524,273        8,191,751        3,006,988        16,599,124   

Share-based LTIP expense

     459,533        1,012,656        1,959,733        2,835,656   

Interest expense

     921,238        597,184        2,600,642        1,609,205   

Professional fees

     542,807        605,308        1,444,943        1,663,235   

Compensation expense

     210,000        —          710,000        —     

Insurance expense

     285,000        151,638        845,000        369,771   

Agency and administration fees

     184,829        154,210        531,024        435,037   

Custody and other fees

     167,551        110,776        426,474        348,043   

Directors’ fees and expenses

     68,653        60,500        202,039        161,500   
                                

Total expenses

     6,536,397        12,035,201        15,111,608        27,131,295   
                                

NET INVESTMENT INCOME (LOSS)

     4,322,614        2,240,192        18,462,653        10,078,228   
                                

NET REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS AND FINANCIAL DERIVATIVES

        

Net realized gain (loss) on:

        

Investments

     (2,697,230     8,619,569        9,617,853        (12,195,810

Swaps

     (3,867,746     (6,785,374     3,352,106        13,996,499   

Futures

     (581,249     (190,171     (1,607,129     (228,982

Purchased options

     —          (1,678,722     (580,860     (2,326,785
                                
     (7,146,225     (34,698     10,781,970        (755,078
                                

Change in net unrealized gain (loss) on:

        

Investments

     23,769,183        28,895,446        16,715,705        80,595,904   

Swaps

     (4,348,295     283,929        (17,229,456     (6,798,249

Futures

     (579,038     (1,058,513     (1,927,713     (1,508,363

Purchased options

     —          (209,230     541,668        (1,133,400
                                
     18,841,850        27,911,632        (1,899,796     71,155,892   
                                

NET REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS AND FINANCIAL DERIVATIVES

     11,695,625        27,876,934        8,882,174        70,400,814   
                                

NET INCREASE (DECREASE) IN SHAREHOLDERS’ EQUITY RESULTING FROM OPERATIONS

   $ 16,018,239      $ 30,117,126      $ 27,344,827      $ 80,479,042   
                                

NET INCREASE (DECREASE) IN SHAREHOLDERS’ EQUITY RESULTING FROM OPERATIONS PER SHARE:

        

Basic and Diluted

   $ 1.30      $ 2.45      $ 2.21      $ 6.47   

See Notes to Consolidated Financial Statements

 

17


Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

(UNAUDITED)

 

     Three Month
Period  Ended
September 30,
2010
    Three Month
Period  Ended
September 30,
2009
    Nine Month
Period  Ended
September 30,
2010
    Nine Month
Period  Ended
September 30,
2009
 
     Expressed in U.S. Dollars  

CHANGE IN SHAREHOLDERS’ EQUITY RESULTING FROM OPERATIONS

        

Net investment income (loss)

   $ 4,322,614      $ 2,240,192      $ 18,462,653      $ 10,078,228   

Net realized gain (loss) on investments and financial derivatives

     (7,146,225     (34,698     10,781,970        (755,078

Change in net unrealized gain (loss) on investments and financial derivatives

     18,841,850        27,911,632        (1,899,796     71,155,892   
                                

Net increase (decrease) in shareholders’ equity resulting from operations

     16,018,239        30,117,126        27,344,827        80,479,042   
                                

CHANGE IN SHAREHOLDERS’ EQUITY RESULTING FROM SHAREHOLDER TRANSACTIONS

        

Shares issued in connection with incentive fee payment

     —          840,737        275,689        840,737   

Dividends paid

     (1,854,851     (18,477,003     (20,400,887     (18,477,003

Shares repurchased

     —          —          —          (7,331,000

Share-based LTIP awards

     459,533        1,012,656        1,959,733        2,835,656   

Special distribution to Ellington Financial Management LLC

     —          —          —          (1,787,027
                                

Net increase (decrease) in shareholders’ equity from shareholder transactions

     (1,395,318     (16,623,610     (18,165,465     (23,918,637
                                

Net increase (decrease) in shareholders’ equity

     14,622,921        13,493,516        9,179,362        56,560,405   

SHAREHOLDERS’ EQUITY, BEGINNING OF PERIOD

     294,350,454        284,144,533        299,794,013        241,077,644   
                                

SHAREHOLDERS’ EQUITY, END OF PERIOD

   $ 308,973,375      $ 297,638,049      $ 308,973,375      $ 297,638,049   
                                

See Notes to Consolidated Financial Statements

 

18


Table of Contents

ELLINGTON FINANCIAL LLC

CONSOLIDATED STATEMENT OF CASH FLOWS

(UNAUDITED)

 

     Nine Month Period
Ended  September 30,
2010
    Nine Month Period
Ended  September 30,
2009
 
      Expressed in U.S. Dollars  

INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS:

    

NET INCREASE (DECREASE) IN SHAREHOLDERS’ EQUITY RESULTING FROM OPERATIONS

   $ 27,344,827      $ 80,479,042   

Cash flows provided by (used in) operating activities:

    

Reconciliation of the net increase (decrease) in shareholders’ equity resulting from operations to net cash provided by (used in) operating activities:

    

Change in net unrealized (gain) loss on investments and financial derivatives

     1,899,796        (71,155,892

Net realized (gain) loss on investments and financial derivatives

     (10,781,970     755,078   

Amortization of premiums and accretion of discounts (net)

     (5,748,761     (7,889,321

Purchase of investments

     (2,298,598,968     (1,315,520,455

Proceeds from disposition of investments

     1,808,693,771        810,152,262   

Proceeds from principal payments of investments

     88,706,643        74,902,068   

Proceeds from investments sold short

     894,958,301        586,898,945   

Repurchase of investments sold short

     (529,747,733     (39,937,401

Payments made to open financial derivatives

     (219,775,962     (105,898,375

Proceeds received to close financial derivatives

     177,147,934        137,266,254   

Proceeds received to open financial derivatives

     73,351,913        389,999   

Payments made to close financial derivatives

     (52,642,330     (18,017,877

Shares issued in connection with incentive fee payment

     275,689        840,737   

Share-based LTIP expense

     1,959,733        2,835,656   

(Increase) decrease in assets:

    

(Increase) decrease in repurchase agreements

     —          4,528,875   

(Increase) decrease in receivable for securities sold

     (512,709,282     (684,003,624

(Increase) decrease in deposits with dealers held as collateral

     4,987,507        605,907   

(Increase) decrease in interest and principal receivable

     4,054,675        (217,267

(Increase) decrease in prepaid insurance

     (249,005     309,022   

Increase (decrease) in liabilities:

    

Increase (decrease) in due to brokers - margin accounts

     (678,089     (10,417,750

Increase (decrease) in payable for securities purchased

     666,148,510        272,055,537   

Increase (decrease) in accounts payable and accrued expenses

     504,643        1,303,603   

Increase (decrease) in incentive fee payable

     249,742        8,191,751   

Increase (decrease) in interest and dividends payable

     (276,202     (178,929

Increase (decrease) in base management fee payable

     35,495        843,625   
                

Net cash provided by (used in) operating activities

     119,110,877        (270,878,530
                

Cash flows provided by (used in) financing activities:

    

Shares repurchased

     —          (7,331,000

Deferred offering costs paid

     (605,830     (1,565,600

Special distribution to Ellington Financial Management LLC

     —          (1,837,310

Dividends paid

     (20,400,887     (18,477,003

Reverse repurchase agreements, net of repayments

     (83,255,100     324,037,856   
                

Net cash provided by (used in) financing activities

     (104,261,817     294,826,943   
                

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

     14,849,060        23,948,413   

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

     102,863,164        61,400,254   
                

CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 117,712,224      $ 85,348,667   
                

Supplemental disclosure of cash flow information:

    

Interest paid

   $ 2,795,653      $ 1,715,250   
                

Shares issued in connection with incentive fee payment (non-cash)

   $ 275,689      $ 840,737   
                

Share-based LTIP awards (non-cash)

   $ 1,959,733      $ 2,835,656   
                

Aggregate TBA trade activity (buys + sells) (non-cash)

   $ 10,645,380,011      $ 2,168,704,767   
                

See Notes to Consolidated Financial Statements

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. Organization and Investment Objective

Ellington Financial LLC was formed as a Delaware limited liability company on July 9, 2007 and commenced operations on August 17, 2007. EF Securities LLC, a wholly owned consolidated subsidiary of Ellington Financial LLC, was formed as a Delaware limited liability company on October 12, 2007 and commenced operations on November 30, 2007. EF Mortgage LLC, a wholly owned consolidated subsidiary of Ellington Financial LLC, was formed as a Delaware limited liability company on June 3, 2008 and commenced operations on July 8, 2008. EF CMO LLC, a wholly owned consolidated subsidiary of EF Mortgage LLC, was formed as a Delaware limited liability company on June 3, 2008 and commenced operations on July 8, 2008. Ellington Financial LLC, EF Securities LLC, EF Mortgage LLC and EF CMO LLC are hereafter collectively referred to as the “Company”. All inter-company accounts are eliminated in consolidation.

On October 14, 2010, the Company closed its initial public offering of its common shares representing limited liability company interests, or common shares, pursuant to which it sold 4,500,000 common shares to the public at a public offering price of $22.50. The Company raised approximately $101.3 million in gross proceeds, resulting in net proceeds of approximately $95.0 million, after deducting approximately $2.9 million in underwriting discounts and approximately $3.4 million in other expenses related to the initial public offering. The Company’s common shares trade on the New York Stock Exchange under the symbol “EFC”.

The Company specializes in various fixed income investment strategies, with a current focus on non-agency residential mortgage-backed securities, or RMBS, and asset-backed securities, or ABS.

The Company’s primary objective is to generate attractive risk-adjusted returns by constructing a portfolio of investments (that may also include direct investments in mortgage-related business platforms) and by implementing a strategy that can generate high risk-adjusted returns on these investments.

Ellington Financial Management, LLC (“EFM” or the “Manager”) is a registered investment advisor that serves as the Manager to the Company pursuant to the terms of the Amended and Restated Management Agreement dated July 1, 2009 (the “Management Agreement”). EFM is an affiliate of Ellington Management Group, LLC, an investment management firm and also a registered investment advisor. In accordance with the terms of the Management Agreement, the Manager implements the investment strategy and manages the business and operations on a day-to-day basis for the Company and performs certain services for the Company, subject to oversight by the board of directors.

2. Significant Accounting Policies

The accompanying unaudited interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America for interim financial information. In the opinion of management, all adjustments, consisting of normal recurring accruals considered necessary for fair presentation, have been included. Interim results are not necessarily indicative of the results that may be expected for the entire fiscal year.

In June 2007, the AICPA issued Amendments to ASC 946-10 (ASC 946), Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies (“ASC 946”). ASC 946 was effective for fiscal years beginning on or after December 15, 2007 with earlier application encouraged. After the Company’s adoption of ASC 946, the FASB issued guidance which effectively delayed indefinitely the effective date of ASC 946. However, this additional guidance explicitly permitted entities that had early adopted ASC 946 before December 31, 2007 to continue to apply the provisions of ASC 946. The Company has elected to continue to apply the provisions of ASC 946. ASC 946 provides guidance for determining whether an entity is within the scope of the AICPA Audit and Accounting Guide for Investment Companies (the “Guide”). The Guide provides guidance for determining whether the specialized industry accounting principles of the Guide should be retained in the financial statements of a parent company of an investment company or an equity method investor in an investment company. Effective August 17, 2007, the Company adopted ASC 946 and follows its provisions, which, among other things, requires that investments be reported at fair value in the financial statements. The following is a summary of significant accounting policies followed by the Company.

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

(A) Valuation: The Company applies ASC 820-10, Fair Value Measurement and Disclosures (“ASC 820-10”), to its holdings of financial instruments. ASC 820-10 establishes a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:

 

   

Level 1—inputs to the valuation methodology are observable and reflect quoted prices (unadjusted) for identical assets or liabilities in active markets,

 

   

Level 2—inputs to the valuation methodology other than quoted prices included in Level 1 are observable for the asset or liability, either directly or indirectly, and

 

   

Level 3—inputs to the valuation methodology are unobservable and significant to the fair value measurement.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The inputs or methodology used for valuing securities are not necessarily an indication of the risk associated with investing in these securities.

(B) Securities Transactions and Investment Income: Securities transactions are recorded on trade date. Realized and unrealized gains and losses are calculated based on identified cost. Principal write-offs are generally treated as realized losses. Interest income is recorded as earned. Generally, the Company accretes market discounts and amortizes market premiums on debt securities using the effective yield method and classifies paydown gains or losses as interest income. Accretion of market discounts and amortization of market premiums require the use of a significant amount of judgment and the application of several assumptions including, but not limited to, prepayment and default rate assumptions.

(C) Cash and Cash Equivalents: During the current period the Company added classifications to the Consolidated Statement of Cash Flows and accordingly has conformed the prior period presentation. Cash and cash equivalents include amounts held in an interest bearing overnight account and money market funds. As of September 30, 2010, 30%, 34% and 36% of cash and cash equivalents were held in the BlackRock Liquidity Temp Fund, the JP Morgan Prime Money Market Premier Fund and an interest bearing account at the Bank of New York Mellon Corporation, respectively. As of December 31, 2009, 34%, 39%, 19% and 8% of cash and cash equivalents were held in the BlackRock Liquidity Temp Fund, the JP Morgan Prime Money Market Premier Fund, the JP Morgan US Treasury Plus Premier Fund and an interest bearing account at the Bank of New York Mellon Corporation, respectively.

(D) Financial Derivatives: The Company enters into various types of financial derivatives. The two major types utilized are swaps and futures.

Swaps: The Company may enter into various types of swaps, including interest rate swaps, total return swaps, and credit default swaps. The primary risk associated with the Company’s interest rate swap activity is interest rate risk. The primary risk associated with the Company’s total return swap activity currently is equity market risk. The primary risk associated with the Company’s credit default swaps is credit risk.

The Company is subject to interest rate risk exposure in the normal course of pursuing its investment objectives. To help mitigate interest rate risk, the Company enters into interest rate swaps. Interest rate swaps are contractual agreements whereby one party pays a floating rate of interest on a notional principal amount and receives a fixed rate on the same notional principal, or vice versa, for a fixed period of time. Interest rate swaps change in value with movements in interest rates.

The Company enters into total return swaps in order take a “long” or “short” position with respect to an underlying referenced asset. The Company is subject to market price volatility of the underlying referenced asset. A total return swap involves commitments to pay interest in exchange for a market-linked return based on a notional amount. To the extent that the total return of the security, group of securities or index underlying the transaction exceeds or falls short of the offsetting interest obligation, the Company will receive a payment from or make a payment to the counterparty.

The Company enters into credit default swaps. A credit default swap is a contract under which one party agrees to compensate another party for the financial loss associated with the occurrence of a “credit event” in relation to a

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

“reference amount” or notional amount of a credit obligation (usually a bond or loan). The definition of a credit event often varies from contract to contract. A credit event may occur (i) when the underlying reference asset(s) fails to make scheduled principal or interest payments to its holders, (ii) with respect to credit default swaps referencing mortgage/asset backed securities and indices, when the underlying reference obligation is downgraded below a certain rating level or (iii) with respect to credit default swaps referencing corporate entities and indices, upon the bankruptcy of the underlying reference obligor. The Company typically writes (sells) protection to take a “long” position or purchases (buys) protection to take a “short” position with respect to underlying reference assets or to hedge exposure to other investment holdings.

As of September 30, 2010, the Company is party to credit derivatives contracts in the form of credit default swaps on mortgage/asset backed securities and indices (ABSCDS). As a seller of credit protection via ABSCDS, the Company receives periodic payments from protection buyers, and is obligated to make payments to the protection buyer upon the occurrence of a “credit event” with respect to underlying reference assets. Written credit derivatives held by the Company at September 30, 2010 and December 31, 2009, respectively, are summarized below:

 

Single Name and Index Credit Default Swaps

(Asset Backed Securities)

   Amount at
September 30, 2010
    Amount at
December 31, 2009
 

Fair Value of Written Credit Derivatives, Net

   $ (22,777,120   $ (12,425,683

Fair Value of Purchased Credit Derivatives Offsetting Written Credit Derivatives with Third Parties(1)

   $ 30,399,155      $ 2,528,269   

Notional Amount of Written Credit Derivatives(2)

   $ (140,973,146   $ (18,502,372

Notional Amount of Purchased Credit Derivatives Offsetting Written Credit Derivatives with Third Parties(1)

   $ 74,126,146      $ 4,375,000   

 

(1) Offsetting transactions with third parties include purchased credit derivatives to the extent they offset written credit derivatives which have the same reference obligation.
(2) The notional amount is the maximum amount that a seller of ABSCDS would be obligated to pay, and a buyer of credit protection would receive upon occurrence of a “credit event.” Movements in the value of credit default swap transactions may require the Company or the counterparty to post or receive collateral. Amounts due or owed under an ABSCDS contract may be offset against amounts due or owed on other ABSCDS contracts with the same ISDA counterparty.

Unless terminated by mutual agreement by both the buyer and seller, ABSCDS contracts typically terminate at the earlier of the (i) date the buyer of protection delivers the reference asset to the seller in exchange for payment of the notional balance following the occurrence of a credit event or (ii) date the reference asset is paid off in full, retired, or otherwise ceases to exist. Implied credit spreads may be used to determine the market value of swap contracts and are reflective of the cost of buying/selling protection. Higher spreads would indicate a greater likelihood that a seller will be obligated to perform (i.e., make payment) under the swap contract. In situations where the credit quality of an underlying reference asset has deteriorated, credit spreads combined with a percentage of notional amounts paid up front (points up front) are frequently used as an indication of ABSCDS risk. ABSCDS credit protection sellers entering the market would expect to be paid a percentage of the current notional balance up front (points up front) approximately equal to the fair value of the contract in order to write protection on the reference assets underlying the Company’s ABSCDS contracts. Stated spreads at September 30, 2010 on ABSCDS contracts where the Company wrote protection range between 9 and 458 basis points on contracts that were outstanding at this date. Stated spreads at December 31, 2009 on ABSCDS contracts where the Company wrote protection range between 9 and 85 basis points on contracts that were outstanding at this date. However, participants entering the market at September 30, 2010 and December 31, 2009, would likely transact on similar contracts with material points upfront given these spreads. Total net up-front payments received relating to ABSCDS contracts outstanding at September 30, 2010 and December 31, 2009 were $22.9 million and $8.7 million, respectively.

Swaps change in value with movements in interest rates or total return of the referenced securities. During the term of swap contracts, changes in value are recognized as unrealized gains or losses. When the contracts are terminated, the Company will realize a gain or loss equal to the difference between the proceeds from (or cost of) the

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

closing transaction and the Company’s basis in the contract, if any. Periodic payments or receipts required by swap agreements are recorded as unrealized gains or losses when accrued and realized gains or losses when received or paid. Upfront payments paid/received by the Company to open swap contracts are recorded as an asset and/or liability on the Consolidated Statement of Assets, Liabilities and Shareholders’ Equity and are recorded as a realized gain or loss on the termination date. The Company may be required to deliver or receive cash or securities as collateral upon entering into swap transactions.

The Company’s swap contracts are generally governed by ISDA trading agreements, which are separately negotiated agreements with dealer counterparties. Changes in the relative value of the swap transactions may require the Company or the counterparty to post or receive additional collateral. Typically, a collateral payment or receipt is triggered based on the net change in the value of all contracts governed by a particular ISDA trading agreement. Collateral received from counterparties is included in Due to brokers—margin accounts on the Consolidated Statement of Assets, Liabilities and Shareholders’ Equity. Collateral paid to counterparties is included in Deposits with dealers held as collateral on the Consolidated Statement of Assets, Liabilities and Shareholders’ Equity. Entering into swap contracts involves market risk in excess of amounts recorded on the Consolidated Statement of Assets, Liabilities and Shareholders’ Equity.

Futures Contracts: A futures contract is an agreement between two parties to buy and sell a financial instrument for a set price on a future date. The Company enters into Euro-dollar futures contracts to hedge its interest rate risk. Initial margin deposits are made upon entering into futures contracts and can be either cash or securities. During the period the futures contract is open, changes in the value of the contract are recognized as unrealized gains or losses by marking to market on a daily basis to reflect the market value of the contract at the end of each day’s trading. Variation margin payments are made or received periodically, depending upon whether unrealized gains or losses are incurred. When the contract is closed, the Company records a realized gain or loss equal to the difference between the proceeds of the closing transaction and the Company’s basis in the contract.

Written Options: The Company may write options. When the Company writes an option, an amount equal to the premium received is recorded as a liability and is subsequently marked-to-market. Premiums received for writing options that expire unexercised are recognized on the expiration date as realized gains. If an option is exercised, the premium received is subtracted from the cost of purchase or added to the proceeds of the sale to determine whether the Company has realized a gain or loss on the related investment transaction. When the Company enters into a closing transaction, the Company will realize a gain or loss depending upon whether the amount from the closing transaction is greater or less than the premiums received. The Company may be required to deliver or receive cash or securities as collateral upon entering into certain option transactions. Movements in the value of the option transactions may require the Company or the counterparty to post additional collateral. Since its inception, the Company has not written any options.

Derivative instruments disclosed on the Consolidated Condensed Schedule of Investments include: credit default swaps on asset backed securities, credit default swaps on asset backed indices, credit default swaps on corporate bonds, interest rate swaps, total return swaps, euro dollar futures contracts, and other swaps.

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

Gains and losses on the Company’s derivative contracts for the three and nine month period ended September 30, 2010 and 2009 are summarized in the tables below:

2010:

 

Derivative Type

  

Primary Risk
Exposure

   Net Realized
Gain/(Loss) for
the Three
Month Period
Ended
September 30,
2010
    Change in Net
Unrealized
Gain/(Loss) for
the Three
Month Period
Ended
September 30,
2010
    Net Realized
Gain/(Loss) for
the Nine Month
Period Ended
September 30,
2010
    Change in Net
Unrealized
Gain/(Loss) for
the Nine Month
Period Ended
September 30,
2010
 

Financial derivatives -assets

           

Credit Default Swaps on Asset Backed Securities

   Credit    $ (2,683,184   $ (1,646,712   $ 8,787,335      $ (16,802,409

Credit Default Swaps on Asset Backed Indices

   Credit      (891,664     (722,952     (5,184,323     934,231   

Credit Default Swaps on Corporate Bond Indices

   Credit      (49,797     (166,100     (47,608     (167,495

Credit Default Swaps on Corporate Bonds

   Credit      —          —          (2,281,392     (2,650,145

Other Swaps

   Credit      —          —          335,312        (257,212

Interest Rate Swaps

   Interest Rates      125,261        —          —          (109,332
                                   
        (3,499,384     (2,535,764     1,609,324        (19,052,362
                                   

Financial derivatives - liabilities

           

Credit Default Swaps on Asset Backed Securities

   Credit      —          —          (1,657,578     3,881,292   

Credit Default Swaps on Asset Backed Indices

   Credit      (243,101     37,436        6,280,681        (227,659

Credit Default Swaps on Corporate Bond Indices

   Credit      —          —          (1,003,740     1,145,978   

Total Return Swaps

   Equity Market      —          —          (853,876     87,798   

Interest Rate Swaps

   Interest Rates      (125,261     (1,849,967     (1,022,705     (3,064,503
                                   
        (368,362     (1,812,531     1,742,782        1,822,906   
                                   

Futures contracts

           

Short Euro-Dollar contracts

   Interest Rates      (581,249     (579,038     (1,607,129     (1,927,713
                                   

Total

      $ (4,448,995   $ (4,927,333   $ 1,744,977      $ (19,157,169
                                   

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

2009:

 

Derivative Type

  

Primary Risk
Exposure

   Net Realized
Gain/(Loss) for
the Three
Month Period
Ended
September 30,
2009
    Change in Net
Unrealized
Gain/(Loss) for
the Three
Month Period
Ended
September 30,
2009
    Net Realized
Gain/(Loss) for
the Nine Month
Period Ended
September 30,
2009
    Change in Net
Unrealized
Gain/(Loss) for
the Nine Month
Period Ended
September 30,
2009
 

Financial derivatives - assets

           

Credit Default Swaps on Asset Backed Securities

   Credit    $ (2,133,967   $ 4,100,082      $ 6,876,076      $ (2,193,563

Credit Default Swaps on Asset Backed Indices

   Credit      328,928        (4,974,904     14,581,233        (4,442,963

Credit Default Swaps on Corporate Bond Indices

   Credit      (74,696     (132,057     (224,088     (385,171

Credit Default Swaps on Corporate Bonds

   Credit      (404,234     1,035,092        (913,444     (967,600

Total Return Swaps

   Equity Market      (1,889,354     353,195        (801,721     96,337   

Other Swaps

   Credit      —          95,405        —          95,405   
                                   
        (4,173,323     476,813        19,518,056        (7,797,555
                                   

Financial derivatives - liabilities

           

Credit Default Swaps on Asset Backed Securities

   Credit      22,392        (180,550     (342,005     (1,455,489

Credit Default Swaps on Corporate Bond Indices

   Credit      —          (150,500     —          (150,500

Credit Default Swaps on Corporate Bonds

   Credit      —          —          625        —     

Total Return Swaps

   Equity Market      (1,231,873     45,748        (1,242,807     166,226   

Interest Rate Swaps

   Interest Rates      (1,402,570     92,418        (3,937,370     2,439,069   
                                   
        (2,612,051     (192,884     (5,521,557     999,306   
                                   

Futures contracts

           

Short Euro-Dollar contracts

   Interest Rates      (190,171     (1,058,513     (228,982     (1,508,363
                                   

Total

      $ (6,975,545   $ (774,584   $ 13,767,517      $ (8,306,612
                                   

Swap assets are included in Financial Derivatives—Assets on the Consolidated Statement of Assets, Liabilities and Shareholders’ Equity. Swap liabilities are included in Financial Derivatives—Liabilities on the Consolidated Statement of Assets, Liabilities and Shareholders’ Equity. In addition, swap contracts are summarized by type on the Consolidated Condensed Schedule of Investments. Unrealized depreciation on futures contracts is included in Financial Derivatives—Liabilities on the Consolidated Statement of Assets, Liabilities and Shareholders’ Equity. For interest rate swaps, credit default swaps and futures, notional amounts reflected on the Consolidated Condensed Schedule of

 

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Table of Contents

ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

Investments represent approximately 221%, 132%, and 85%, respectively, of average monthly notional amounts of each such category outstanding during the nine month period ended September 30, 2010. For interest rate swaps, credit default swaps, total return swaps, other swaps and futures, notional amounts reflected on the Consolidated Condensed Schedule of Investments represent approximately 11%, 96%, 111%, 130% and 216%, respectively, of average monthly notional amounts of each such category outstanding during the year ended December 31, 2009. The Company uses average monthly notional amount outstanding to indicate the volume of activity with respect to these instruments.

(E) Short Sales: When the Company sells securities short, it typically satisfies its security delivery settlement obligation by obtaining the security sold from the same or a different counterparty via repurchase agreement. The Company generally is required to deliver cash or securities as collateral to the repurchase agreement counterparty. A gain, limited to the price at which the Company sold the security short, or a loss, unlimited as to dollar amount, will be recognized upon the termination of a short sale if the market price is less than or greater than the proceeds originally received.

(F) Reverse Repurchase Agreements and Repurchase Agreements: The Company enters into reverse repurchase agreements with third-party broker-dealers whereby it sells securities under agreements to repurchase at an agreed-upon price and date. Interest on the value of repurchase and reverse repurchase agreements issued and outstanding is based upon competitive market rates at the time of issuance. The Company accounts for reverse repurchase agreements as collateralized borrowings. When the Company enters into a reverse repurchase agreement, the lender establishes and maintains an account containing cash and securities having a value not less than the repurchase price, including accrued interest, of the reverse repurchase agreement. The Company enters into repurchase agreement transactions with third-party broker-dealers whereby it purchases securities under agreements to resell at an agreed-upon price and date. In general, securities received pursuant to repurchase agreements are delivered to counterparties of short sale transactions. Assets held pursuant to repurchase agreements are reflected as assets on the Consolidated Statement of Assets, Liabilities and Shareholders’ Equity. Repurchase and reverse repurchase agreements that are conducted with the same counterparty may be reported on a net basis if they meet the requirements of ASC 210-20, Balance Sheet, Offsetting. There are no repurchase and reverse repurchase agreements netted in the consolidated financial statements.

Reverse repurchase agreements are carried at their contractual amounts, which the Company believes is the best estimate of fair value. At September 30, 2010, the Company’s open reverse repurchase agreements had remaining terms that ranged from 1 to 270 days and they had interest rates ranging from 0.27% to 2.46% as of that date. At September 30, 2010, approximately 82% of open reverse repurchase agreements were with four counterparties. At December 31, 2009, the Company’s open reverse repurchase agreements had remaining terms that ranged from 4 to 236 days and had interest rates ranging from (0.01)% to 2.75% as of that date. The negative borrowing rate relates to a single reverse repurchase agreement involving a Treasury holding. At December 31, 2009, market demand for this Treasury security was such that the lender was willing to pay interest to the Company in order to access the security as collateral under the reverse repurchase arrangement. At December 31, 2009, approximately 79% of open reverse repurchase agreements were with three counterparties.

The Company follows the provisions of ASC 860-20, Sales of Financial Assets, which requires an initial transfer of a financial asset and a repurchase financing that was entered into contemporaneously or in contemplation of the initial transfer to be evaluated as a linked transaction unless certain criteria are met, including that the transferred asset must be readily obtainable in the marketplace. As of September 30, 2010 and December 31, 2009, the Company did not have any material seller financing. No transactions are accounted for as linked transactions at September 30, 2010 and December 31, 2009.

(G) Purchased Options: The Company has entered into options primarily to help mitigate overall market risk. When the Company purchases an option, an amount equal to the premium paid is recorded as an asset and is subsequently marked-to-market. Premiums paid for purchasing options that expire unexercised are recognized on the expiration date as realized losses. If an option is exercised, the premium paid is subtracted from the proceeds of the sale or added to the cost of the purchase to determine whether the Company has realized a gain or loss on the related investment transaction. When the Company enters into a closing transaction, the Company will realize a gain or loss depending upon whether the amount from the closing transaction is greater or less than the premiums paid.

(H) When-Issued/Delayed Delivery Securities: The Company may purchase or sell securities on a when-issued or delayed delivery basis. Securities purchased or sold on a when-issued basis are traded for delivery beyond the normal settlement date at a stated price or yield, and no income accrues to the purchaser prior to settlement. Purchasing or selling securities on a when-issued or delayed delivery basis involves the risk that the market price or yield at the time of settlement may be lower or higher than the agreed-upon price or yield, in which case a realized loss may be incurred.

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

The Company transacts in the forward settling To Be Announced MBS (“TBA”) market. The Company typically does not take delivery of TBAs, but rather settles with its trading counterparties on a net basis. The market value of the securities that the Company is required to purchase pursuant to a TBA transaction may decline below the agreed-upon purchase price. Conversely, the market value of the securities that the Company is required to sell pursuant to a TBA transaction may increase above the agreed upon sale price. As part of its TBA activities, the Company may “roll” its TBA positions, whereby the Company may sell (buy) securities for delivery (receipt) in an earlier month and simultaneously contract to repurchase (sell) similar, but not identical, securities at an agreed-upon price on a fixed date in a later month (with the later-month price typically lower than the earlier- month price). The Company accounts for its TBA transactions (including those related to TBA rolls) as purchases and sales. As of September 30, 2010, total assets included $529.8 million of TBAs as well as $895.1 million of receivable for securities sold relating to unsettled TBA sales. As of December 31, 2009, total assets included $40.3 million of TBAs as well as $510.5 million of receivable for securities sold relating to unsettled TBA sales.

As of September 30, 2010, total liabilities included $893.3 million of TBAs sold short as well as $529.8 million of payable for securities purchased relating to unsettled TBA purchases. As of December 31, 2009, total liabilities included $502.5 million of TBAs sold short as well as $41.6 million of payable for securities purchased relating to unsettled TBA purchases. On a net basis, as of September 30, 2010, the Company held a net short position in TBAs of $363.5 million while at December 31, 2009, the Company held a net short position in TBAs of $462.2 million.

(I) Offering Costs/Placement Fees/Deferred Offering Costs: Offering costs and placement fees are charged against shareholders’ equity. Costs associated with the Company’s public offering of common shares, which closed on October 14, 2010, have been capitalized as of September 30, 2010.

(J) LTIP Units: Long term incentive plan units (“LTIP units”), have been issued to independent directors as well as the Manager. Costs associated with LTIP units issued to independent directors are amortized over the vesting period in accordance with ASC 718-10, Compensation—Stock Compensation. Costs associated with LTIP units issued to the Manager are amortized over the vesting period in accordance with ASC 505-50, Equity-Based Payments to Non-Employees. The vesting period for units issued to independent directors under the Ellington Incentive Plan for Individuals (the “Director LTIP”) is one year for the grants awarded on August 17, 2007 and October 1, 2009, and nine months for the grant awarded on December 31, 2008. Vesting period for units issued to the Manager under the Ellington Incentive Plan for Entities (the “Manager LTIP”) occurs over a three year period with one-third of the units vesting at the end of each year. The cost of the Manager LTIP units fluctuates with the price per share until the vesting date, whereas the cost of the Director LTIP units is based on the price per share at the initial grant date. As of September 30, 2010, all LTIPs granted to the Manager were fully vested.

(K) Dividends: Dividends payable are recorded in the consolidated financial statements on the ex-dividend date.

(L) Shares Repurchased: Common shares that are repurchased by the Company subsequent to issuance decrease total number of shares outstanding and issued.

(M) Earnings Per Share (“EPS”): Basic EPS is computed using the two class method by dividing net increase (decrease) in shareholders’ equity resulting from operations after adjusting for the impact of long term incentive plan units deemed to be participating securities, by the weighted average number of common shares outstanding calculated excluding long term incentive units. Because the Company’s long term incentive plan units are deemed to be participating securities, and the Company has no other equity securities outstanding, basic and diluted EPS are the same. See Note 7 for EPS computations.

(N) Income Taxes: The Company intends to be treated as a partnership for U.S. federal income tax purposes. In general, partnerships are not subject to entity-level tax on their income, but the income of a partnership is taxable to its owners on a flow-through basis.

The Company follows the provisions of ASC 740-10, Income Taxes (“ASC 740-10”), which requires management to determine whether a tax position of the Company is more likely than not to be sustained upon examination by the applicable taxing authority, including resolution of any related appeals of litigation process, based on the technical merits of the position. The tax benefit to be recognized is measured as the largest amount of benefit

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

that is greater than fifty percent likely of being realized upon ultimate settlement which could result in the Company recording a tax liability that would reduce shareholders’ equity. The Company did not have any additions to its unrecognized tax benefits resulting from tax positions related either to the current period or to 2009, 2008 or 2007 (its open tax years), and no reductions resulting from tax positions of prior years or due to settlements, and thus had no unrecognized tax benefits since inception. The Company does not expect any change in unrecognized tax benefits within the next fiscal year.

The Company may take positions with respect to certain tax issues which depend on legal interpretation of facts or applicable tax regulations. Should the relevant tax regulators successfully challenge any such positions, the Company might be found to have a tax liability that has not been recorded in the accompanying consolidated financial statements. Also, management’s conclusions regarding ASC 740-10 may be subject to review and adjustment at a later date based on factors including, but not limited to, further implementation guidance from the FASB, and on-going analyses of tax laws, regulations and interpretations thereof.

(O) Principles of Consolidation: These consolidated financial statements include the accounts of the Company and its controlled subsidiaries. All significant inter-company accounts and transactions have been eliminated.

(P) Subsequent Events: The Company applies the provisions of ASC 855-10, Subsequent Events, in the preparation of its consolidated financial statements. This standard establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued.

(Q) Recent Accounting Pronouncements: In January 2010, the FASB issued ASU No. 2010-6 Fair Value Measurements and Disclosures—(Topic 820), Improving Disclosures about Fair Value Measurements. This amends Subtopic 820-10 to require new disclosures for transfers in and out of Levels 1 and 2, and reporting gross activity in Level 3 fair value measurements, and clarifies the level of detail of existing disclosures. The new disclosures and clarifications are effective for interim and annual reporting periods beginning after December 15, 2009, with the exception of reporting certain gross activity in Level 3 fair value measurements which is effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. Adoption of ASU 2010-6 did not have a material impact on the Company’s consolidated financial statements.

3. Valuation

The following is a description of the valuation methodologies used for the Company’s financial instruments.

Level 1 valuation methodologies include the observation of quoted prices (unadjusted) for identical assets or liabilities in active markets, often received from widely recognized data providers.

Level 2 valuation methodologies include the observation of (i) quoted prices for similar assets or liabilities in active markets, (ii) inputs other than quoted prices that are observable for the asset or liability (for example, interest rates and yield curves) in active markets and (iii) quoted prices for identical or similar assets or liabilities in markets that are not active.

Level 3 fair value methodologies include (i) the use of proprietary models that require the use of a significant amount of judgment and the application of various assumptions including, but not limited to, prepayment and default rate assumptions, and (ii) the solicitation of valuations from third-parties (typically, broker-dealers). Third-party valuation providers often utilize proprietary models that are highly subjective and also require the use of a significant amount of judgment and the application of various assumptions including, but not limited to, prepayment and default rate assumptions. The Manager utilizes such information to assign a good faith valuation (the estimated price that would be received to sell an asset or paid to transfer a liability in an orderly transaction at the valuation date) to such financial instruments. The Manager has been able to obtain third-party valuations on the vast majority of the Company’s financial instruments and expects to continue to solicit third-party valuations on substantially all of the Company’s financial instruments in the future to the extent practical.

The Manager uses its judgment based on its own models, the assessments of its portfolio managers, and third-party valuations it obtains, to determine and assign fair values to the Company’s Level 3 financial instruments. Because of the inherent uncertainty of valuation, estimated values may differ significantly from the values that would have been used had a ready market for the financial instruments existed, and the differences could be material to the consolidated financial statements.

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

The table below reflects the value of the Company’s Level 1, Level 2, and Level 3 financial instruments at September 30, 2010:

 

Description

   Level 1     Level 2     Level 3      Total  

Assets:

         

Investments at value-

         

U.S. Treasury and agency residential mortgage-backed securities

   $ —        $ 944,291,500      $ —         $ 944,291,500   

Private label residential mortgage-backed securities

     —          —          269,887,536         269,887,536   
                                 

Total investments at value

     —          944,291,500        269,887,536         1,214,179,036   
                                 

Financial derivatives-assets-

         

Credit default swaps on corporate indices

     —          5,497        —           5,497   

Credit default swaps on asset backed securities

     —          —          102,574,132         102,574,132   

Credit default swaps on asset backed indices

     —          44,573,684        —           44,573,684   
                                 

Total financial derivatives-assets

     —          44,579,181        102,574,132         147,153,313   
                                 

Total investments and financial derivatives- assets

   $ —        $ 988,870,681      $ 372,461,668       $ 1,361,332,349   
                                 

Liabilities:

         

Investments sold short-

         

U.S. Treasury and agency residential mortgage-backed securities

   $ —        $ (893,250,608   $ —         $ (893,250,608
                                 

Financial derivatives-liabilities-

         

Credit default swaps on asset backed indices

     —          (26,990,243     —           (26,990,243

Interest rate swaps

     —          (3,064,503     —           (3,064,503

Unrealized depreciation on futures contracts

     (3,000,177     —          —           (3,000,177
                                 

Total financial derivatives-liabilities

     (3,000,177     (30,054,746     —           (33,054,923
                                 

Total investments sold short and financial derivatives-liabilities

   $ (3,000,177   $ (923,305,354   $ —         $ (926,305,531
                                 

There were no transfers between Level 1, Level 2, or Level 3 financial instruments during the nine month period ended September 30, 2010.

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

The table below reflects the value of the Company’s Level 1, Level 2, and Level 3 financial instruments at December 31, 2009:

 

Description

   Level 1     Level 2     Level 3     Total  

Assets:

        

Investments at value-

        

U.S. Treasury and agency residential mortgage-backed securities

   $ —        $ 545,037,946      $ —        $ 545,037,946   

Private label residential mortgage-backed securities

     —          —          210,363,731        210,363,731   

Purchased options

     39,192        —          —          39,192   
                                

Total investments at value

     39,192        545,037,946        210,363,731        755,440,869   
                                

Financial derivatives-assets-

        

Credit default swaps on corporate bonds

     —          —          8,475,895        8,475,895   

Credit default swaps on asset backed securities

     —          —          95,199,131        95,199,131   

Credit default swaps on asset backed indices

     —          19,596,453        —          19,596,453   

Interest rate swaps

     —          109,332        —          109,332   

Other swaps

     —          —          257,212        257,212   
                                

Total financial derivatives-assets

     —          19,705,785        103,932,238        123,638,023   
                                

Total investments and financial derivatives-assets

   $ 39,192      $ 564,743,731      $ 314,295,969      $ 879,078,892   
                                

Liabilities:

        

Investments sold short-

        

U.S. Treasury and agency residential mortgage-backed securities

   $ —        $ (502,543,554   $ —        $ (502,543,554
                                

Financial derivatives-liabilities-

        

Credit default swaps on corporate indices

     —          (459,941     —          (459,941

Credit default swaps on asset backed securities

     —          —          (10,547,540     (10,547,540

Credit default swaps on asset backed indices

     —          (1,878,143     —          (1,878,143

Total return swaps

     —          (87,798     —          (87,798

Unrealized depreciation on futures contracts

     (1,072,464     —          —          (1,072,464
                                

Total financial derivatives-liabilities

     (1,072,464     (2,425,882     (10,547,540     (14,045,886
                                

Total investments sold short and financial derivatives-liabilities

   $ (1,072,464   $ (504,969,436   $ (10,547,540   $ (516,589,440
                                

In January 2010, the Company revised its Level classification for credit default swaps on asset backed indices and credit default swaps on corporate indices from Level 3 to Level 2. These transactions are valued based on widely used pricing sources, which is more consistent with a Level 2 valuation approach. Accordingly, certain classifications in the December 31, 2009 table above have also been conformed to the September 30, 2010 presentation.

At September 30, 2010 and December 31, 2009, the Company held money market investments that are included in cash and cash equivalents on the Consolidated Statement of Assets, Liabilities and Shareholders’ Equity and are considered Level 1 financial instruments.

 

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Table of Contents

ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

The tables below include a roll-forward of the Company’s financial instruments for the three month periods ended September 30, 2010 and 2009, respectively (including the change in fair value), for financial instruments classified by the Company within Level 3 of the valuation hierarchy.

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Three Month Period Ended September 30, 2010

 

     Beginning
Balance as of
June 30, 2010
     Accreted
Discounts /
Amortized
Premiums
     Realized
Gain/(Loss)
    Change in Net
Unrealized
Gain (Loss)
    Net
Purchases
(Sales)
    Transfers
In and/or
Out of
Level 3
     Ending
Balance as of
September 30,
2010
 

Assets:

                 

Investments at value-

                 

Private label residential mortgage-backed securities

   $ 245,518,617       $ 2,783,145       $ 2,511,118      $ 22,015,715      $ (2,941,059   $ —         $ 269,887,536   
                                                           

Total investments at value

     245,518,617         2,783,145         2,511,118        22,015,715        (2,941,059     —           269,887,536   
                                                           

Financial derivatives-assets-

                 

Credit default swaps on asset backed securities

     113,425,291         —           (2,683,184     (1,646,712     (6,521,263     —           102,574,132   
                                                           

Total financial derivatives-assets

     113,425,291         —           (2,683,184     (1,646,712     (6,521,263     —           102,574,132   
                                                           

Total investments and financial derivatives-assets

   $ 358,943,908       $ 2,783,145       $ (172,066   $ 20,369,003      $ (9,462,322   $ —         $ 372,461,668   
                                                           

Liabilities:

                 

Total investments sold short and financial derivatives- liabilities

   $ —         $ —         $ —        $ —        $ —        $ —         $ —     
                                                           

All amounts of net realized and change in net unrealized gain (loss) in the table above are reflected in the accompanying Consolidated Statement of Operations. Change in net unrealized gain (loss) of $18.9 million, $(1.6) million and $0 for the three month period ended September 30, 2010 relate to investments, financial derivative-assets and financial derivative-liabilities, respectively, held by the Company at September 30, 2010.

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Three Month Period Ended September 30, 2009

 

     Beginning
Balance as of
June 30, 2009
    Accreted
Discounts /
Amortized
Premiums
     Realized
Gain/(Loss)
    Change in Net
Unrealized
Gain (Loss)
    Net
Purchases
(Sales)
    Transfers
In and/or
Out of
Level 3
     Ending
Balance as of
September 30,
2009
 

Assets:

                

Investments at value-

                

Private label residential mortgage-backed securities

   $ 188,002,122      $ 3,788,924       $ 2,514,151      $ 34,357,266      $ (21,312,553   $ —         $ 207,349,910   

Trade claims

     4,640,832        —           5,315,552        (4,640,832     (5,315,552     —           —     
                                                          

Total investments at value

     192,642,954        3,788,924         7,829,703        29,716,434        (26,628,105     —           207,349,910   
                                                          

Financial derivatives-appreciated value-

                

Credit default swaps on corporate bonds

     5,308,817        —           (404,234     1,035,092        1,129,238        —           7,068,913   

Credit default swaps on asset backed securities

     109,243,278        —           (2,133,967     4,100,082        (6,759,487     —           104,449,906   

Other swaps

     22,000        —           —          95,405        —          —           117,405   
                                                          

Total financial derivatives-assets

     114,574,095        —           (2,538,201     5,230,579        (5,630,249     —           111,636,224   
                                                          

Total investments and financial derivatives-assets

   $ 307,217,049      $ 3,788,924       $ 5,291,502      $ 34,947,013      $ (32,258,354   $ —         $ 318,986,134   
                                                          

Liabilities:

                

Financial derivatives-liabilities-

                

Credit default swaps on asset backed securities

   $ (10,911,356   $ —         $ 22,392      $ (180,550   $ (22,391   $ —         $ (11,091,905
                                                          

Total financial derivatives-liabilities

     (10,911,356     —           22,392        (180,550     (22,391     —           (11,091,905
                                                          

Total investments sold short and financial derivatives-liabilities

   $ (10,911,356   $ —         $ 22,392      $ (180,550   $ (22,391   $ —         $ (11,091,905
                                                          

During 2010, the Company revised its Level classification for credit default swaps on asset backed indices and credit default swaps on corporate indices from Level 3 to Level 2. These transactions are valued based on widely used pricing sources, which is more consistent with a Level 2 valuation approach. Accordingly, credit default swaps on asset backed indices and credit default swaps on corporate indices, with a net value of $18.4 million and $0.1 million, respectively, as of June 30, 2009, no longer are shown in the above table.

All amounts of net realized and change in net unrealized gain (loss) in the table above are reflected in the accompanying Consolidated Statement of Operations. Change in net unrealized gain (loss) of $21.6 million, $(2.7) million and $(0.2) million for the three month period ended September 30, 2009 relate to investments, financial derivative-assets and financial derivative-liabilities, respectively, held by the Company at September 30, 2009.

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Nine Month Period Ended September 30, 2010

 

     Beginning
Balance as of
December 31, 2009
    Accreted
Discounts /
Amortized
Premiums
     Realized
Gain/(Loss)
    Change in Net
Unrealized
Gain (Loss)
    Net
Purchases
(Sales)
    Transfers In
and/or Out of
Level 3
     Ending
Balance as of
September 30,
2010
 

Assets:

                

Investments at value-

                

Private label residential mortgage-backed securities

   $ 210,363,731      $ 8,721,948       $ 14,411,100      $ 26,360,262      $ 10,030,495      $ —         $ 269,887,536   
                                                          

Total investments at value

     210,363,731        8,721,948         14,411,100        26,360,262        10,030,495        —           269,887,536   
                                                          

Financial derivatives- assets-

                

Credit default swaps on corporate bonds

     8,475,895        —           (2,281,392     (2,650,145     (3,544,358     —           —     

Credit default swaps on asset backed securities

     95,199,131        —           8,787,335        (16,802,409     15,390,075        —           102,574,132   

Other swaps

     257,212        —           335,312        (257,212     (335,312     —           —     
                                                          

Total financial derivatives- assets

     103,932,238        —           6,841,255        (19,709,766     11,510,405        —           102,574,132   
                                                          

Total investments and financial derivatives-assets

   $ 314,295,969      $ 8,721,948       $ 21,252,355      $ 6,650,496      $ 21,540,900        —         $ 372,461,668   
                                                          

Liabilities:

                

Financial derivatives- liabilities-

                

Credit default swaps on asset backed securities

   $ (10,547,540   $ —         $ (1,657,578   $ 3,881,292      $ 8,323,826      $ —         $ —     
                                                          

Total financial derivatives- liabilities

     (10,547,540     —           (1,657,578     3,881,292        8,323,826        —           —     
                                                          

Total investments sold short and financial derivatives- liabilities

   $ (10,547,540   $ —         $ (1,657,578   $ 3,881,292      $ 8,323,826      $ —         $ —     
                                                          

During 2010, the Company revised its Level classification for credit default swaps on asset backed indices and credit default swaps on corporate indices from Level 3 to Level 2. These transactions are valued based on widely used pricing sources, which is more consistent with a Level 2 valuation approach. Accordingly, credit default swaps on asset backed indices and credit default swaps on corporate indices, with a net value of $17.7 million and $(0.5) million, respectively, as of December 31, 2009, no longer are shown in the above table.

All amounts of net realized and change in net unrealized gain (loss) in the table above are reflected in the accompanying Consolidated Statement of Operations. Change in net unrealized gain (loss) of $22.1 million, $(18.1) million and $0 for the nine month period ended September 30, 2010 relate to investments, financial derivative-assets and financial derivative-liabilities, respectively, held by the Company at September 30, 2010.

 

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ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Nine Month Period Ended September 30, 2009

 

     Beginning
Balance as of
December 31, 2008
    Accreted
Discounts /
Amortized
Premiums
     Realized
Gain/(Loss)
    Change in Net
Unrealized
Gain (Loss)
    Net
Purchases
(Sales)
    Transfers In
and/or  Out
of Level 3
     Ending
Balance as of
September 30,
2009
 

Assets:

                

Investments at value-

                

Private label residential mortgage-backed securities

   $ 142,773,539      $ 11,054,965       $ (20,417,507   $ 78,447,732      $ (4,508,819   $ —         $ 207,349,910   

Trade claims

     —          —           5,315,552        —          (5,315,552     —           —     
                                                          

Total investments at value

   $ 142,773,539      $ 11,054,965       $ (15,101,955   $ 78,447,732      $ (9,824,371   $ —         $ 207,349,910   
                                                          

Financial derivatives-assets

                

Credit default swaps on corporate bonds

     10,085,262        —           (913,444     (967,600     (1,135,305     —           7,068,913   

Credit default swaps on asset backed securities

     108,126,227        —           6,876,076        (2,193,563     (8,358,834     —           104,449,906   

Other swaps

     22,000        —           —          95,405        —          —           117,405   
                                                          

Total financial derivatives-assets

     118,233,489        —           5,962,632        (3,065,758     (9,494,139     —           111,636,224   
                                                          

Total investments and financial derivatives-assets

   $ 261,007,028      $ 11,054,965       $ (9,139,323   $ 75,381,974      $ (19,318,510   $ —         $ 318,986,134   
                                                          

Liabilities:

                

Financial derivatives-liabilities-

                

Credit default swaps on corporate bonds

   $ —        $ —         $ 625      $ —        $ (625   $ —         $ —     

Credit default swaps on asset backed securities

     (10,651,424     —           (342,005     (1,455,489     1,357,013        —           (11,091,905
                                                          

Total financial derivatives-liabilities

     (10,651,424     —           (341,380     (1,455,489     1,356,388        —           (11,091,905
                                                          

Total investments sold short and financial derivatives-liabilities

   $ (10,651,424   $ —         $ (341,380   $ (1,455,489   $ 1,356,388      $ —         $ (11,091,905
                                                          

During 2010, the Company revised its Level classification for credit default swaps on asset backed indices and credit default swaps on corporate indices from Level 3 to Level 2. These transactions are valued based on widely used pricing sources, which is more consistent with a Level 2 valuation approach. Accordingly, credit default swaps on asset backed indices and credit default swaps on corporate indices, with a net value of $22.8 million and $0.4 million, respectively, as of December 31, 2008, no longer are shown in the above table.

All amounts of net realized and change in net unrealized gain (loss) in the table above are reflected in the accompanying Consolidated Statement of Operations. Change in net unrealized gain (loss) of $34.8 million, $(1.8) million and $(1.8) million for the nine month period ended September 30, 2009 relate to investments, financial derivative-assets and financial derivative-liabilities, respectively, held by the Company at September 30, 2009.

4. Base Management Fee, Incentive Fee, and Special Distribution to the Manager

The Company has engaged the Manager to manage the assets, operations and affairs of the Company and pays various management fees associated with that arrangement. Effective July 1, 2009, the Board of Directors approved an Amended and Restated Management Agreement between the Company and the Manager, which, among other things, reduced the annual base management fee to 1.50% from 1.75% of shareholders’ equity, changed the incentive fee from a quarter-by-quarter calculation to a rolling four quarter calculation, removed the reduction to the management fees related to shares held by the Manager, and removed the corresponding provisions relating to special distributions to the Manager. The Base Management Fees and Incentive Fees are detailed below for periods (i) prior to July 1, 2009 and (ii) after July 1, 2009.

 

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Table of Contents

ELLINGTON FINANCIAL LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

 

Base Management Fees

Periods after July 1, 2009—The Manager receives an annual base management fee in an amount equal to 1.50% per annum of the Company’s shareholders’ equity as of the end of each fiscal quarter (before deductions for base management fees and incentive fees payable with respect to such fiscal quarter). The base management fee is payable quarterly in arrears.

Periods prior to July 1, 2009—The Manager received an annual base management fee equal to 1.75% of the Company’s shareholders’ equity, defined as the aggregate net proceeds from sales of its equity securities, plus retained earnings for the measurement period, less amounts paid for repurchases and/or redemption of the Company’s capital stock. However, the base management fee calculation described in the preceding sentence excluded from the calculation equity securities held by the Manager. The base management fee was payable monthly in arrears.

Summary information—For the three month periods ended September 30, 2010 and 2009, the total base management fee incurred by the Company was $1.2 million and $1.2 million, respectively. For the nine month periods ended September 30, 2010 and 2009, the total base management fee incurred by the Company was $3.4 million and $3.1 million, respectively.

Incentive Fees

Periods after July 1, 2009—The Manager is entitled to receive a quarterly incentive fee equal to the positive excess of (i) the product of (A) 25% and (B) the excess of (1) Adjusted Net Income (described below) for the Incentive Calculation Period (which means such fiscal quarter and the immediately preceding three fiscal quarters (but excluding any fiscal quarters prior to July 1, 2009)) over (2) the sum of the Hurdle Amounts (described below) for the Incentive Calculation Period, over (ii) the sum of the incentive fees already paid or payable for each fiscal quarter in the Incentive Calculation Period preceding such fiscal quarter.

For purposes of calculating the incentive fee, “Adjusted Net Income” for the Incentive Calculation Period means the net increase in shareholders’ equity from operations, after all base management fees but before any incentive fees for such period, and excluding non-cash equity compensation expenses for such period as reduced by any Loss Carryforward (as described below) as of the end of the fiscal quarter preceding the Incentive Calculation Period.

For purposes of calculating the incentive fee, the “Loss Carryforward” as of the end of any fiscal quarter is calculated by determining the excess, if any, of (1) the Loss Carryforward as of the end of the immediately preceding fiscal quarter over (2) the net increase in shareholders’ equity from operations (expressed as a positive number) or net decrease in shareholders’ equity from operations (expressed as a negative number) for such fiscal quarter. There were no Loss Carryforwards as of the end of any fiscal quarter in 2009 or at September 30,