Western Asset Mortgage Capital Corporation
Q3 2021 Earnings Call Transcript

Published: 5 Nov 2021

[Operator:]

Welcome to Western Asset Mortgage Capital Corporation's Third Quarter of 2021 Earnings Conference Call. Today's call is being recorded and will be available for replay beginning at 5

[Larry Clark:]

Thank you, Matt. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the third quarter of 2021. The company issued its earnings press release yesterday afternoon, and it's available in the Investor Relations section of the company's website at www.westernassetmcc.com. In addition, the company has included a slide presentation on the website that you can refer to during the call. With us today from our management team are Bonnie Wongtrakool, Chief Executive Officer; Lisa Meyer, President and Chief Financial Officer; Greg Handler, Chief Investment Officer; and Sean Johnson, Deputy Chief Investment Officer. Before we begin, I'd like to review the safe harbor statement. This conference call will contain statements that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the safe harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecasts due to the impact of many factors beyond the control of the company. All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of the company's reports filed with the SEC. We disclaim any obligation to update our forward-looking statements unless required by law. With that, I'll now turn the call over to Bonnie Wongtrakool. Bonnie?

[Bonnie Wongtrakool:]

Thank you, Larry, and welcome, everyone. I'm pleased to be joining WMC at its recently appointed CEO and look forward to meeting you in the weeks and months ahead. I'm no stranger to the company, as I was part of the portfolio management team during its early years as a public company. However, many of you may not know me, so I thought it appropriate to provide you some background on my tenure at Western Asset. I joined Western Asset in 2003 and have more than 18 years of fixed income investment management experience. I was a member of Western Asset's mortgage and consumer credit team for 14 years, first, as an analyst, then as a portfolio manager managing the firm's dedicated mortgage funds. My more recent roles at Western Asset includes being a member of the firm's U.S. Broad Strategy committee as well as chairing the ESG Strategic Steering Committee. With respect to WMC, I have enjoyed partnering with both Greg Handler and John Johnson over the years and look forward to working with them more closely again as part of the senior management team. I also want to congratulate Lisa Meyer in her expanded role as both President and CFO of WMC. Lisa has served as CFO and Treasurer since 2016 and brings more than 23 years of financial experience to the role. She has been a principal contributor to the company's financial and operating strategy, particularly as we continue to strengthen our balance sheet. At this time, I want to take a step back and review the proactive steps we have taken over the last 18 months to address the impact of the pandemic on our portfolio. Following the onset of the pandemic in the spring of last year, the resulting volatility in the equity and fixed income markets adversely impacted portions of our portfolio, which led us to take swift action to protect the portfolio, strengthen our balance sheet and reduce overall risk. Our early actions involved significantly reducing our leverage, securing longer-term fixed rate financing at attractive levels, reducing our reliance on short-term repurchase agreements, increasing our liquidity and bolstering our common equity by selling new shares at a premium to book value. Over the course of 2020 and throughout this year, we have focused on strengthening our balance sheet, lowering resource leverage, refinancing and extending our funding agreements, and improving the earnings power of the portfolio. To be specific, we have #1, secured longer-term financing for our commercial and residential whole loan holdings at reduced rates, including a $356 million securitization of a large portion of our residential non-QM book. #2, recalibrated our dividend to better reflect the earnings profile of our portfolio; #3, we repurchased or retired approximately $159 million of our 2022 every quarter convertible senior notes at an average discount of 3.5%. And #4, issued $86 million of new convertible notes that mature in 2024. The combination of our new note issuance and the repurchase of our existing notes during the quarter enabled us to reduce our convertible debt by $36 million, which includes our ability to further execute on our investment strategy. These actions were driven by our commitment to protecting shareholder value and improving our earnings power. Turning to our investment activity. This year, we have focused on residential non-QM originations, an area where we have deep experience and a solid track record. Western Asset has been investing in this sector since 2014, and WMC has not experienced any cumulative losses over the whole time frame. We continue to view non-QM as an attractive value proposition. And as of September 30, 2021, have acquired more than $240 million of residential non-QM loans. Our residential portfolio has performed well this year as the housing market and consumer balance sheet remains strong. While we expect housing price appreciation to moderate, we believe that housing market will remain well supported given favorable supply and demand dynamics and disciplined lender underwriting standards. Our commercial portfolio is also benefiting from the economic recovery and a more vibrant sales and refinance market. Aside from the 2 special situations that we have discussed in the past and have been diligently working through, most of our commercial investments continued to perform in line with our expectations for continued economic recovery. This year, we've received approximately $162 million in proceeds from payoffs in our commercial portfolio, including both whole loans and non-Agency CMBS investments. In the third quarter alone, we had 5 of these investments fully pay off, amounting to nearly $150 million in proceeds. We have used those proceeds to make new investments in non-QM loans and to pay down debt. Both Greg and Sean will discuss our portfolio strategy in more detail. But I will say that under current market conditions, going forward, we expect that our core investments will focus on high-quality residential non-QM investments, complemented by select commercial investments that are backed by solid properties and seasoned sponsors. We believe that this portfolio mix will enable us to maintain our current relatively low leverage and enhance our ability to return to generating sustainable earnings that support an attractive dividend with the overall goal of protecting and improving value for the benefit of our shareholders. Now, I'll hand it over to Sean and Greg to go into more detail about the investment portfolio. Sean?

[Sean Johnson:]

Thanks, Bonnie. Our residential investments continue to perform well in the third quarter, benefiting from the strong housing market fueled by historically low mortgage rates, tight supply, favorable consumer sentiment and rising income. Third quarter national home price indices again rose at double-digit annual rates. We remain constructive on U.S. mortgage credit. Mortgage underwriting today has performed much more responsibly than it was in prior periods. And when combined with the fundamental strength in today's housing market, consumers are generally less burdened with mortgage payments and have more equity in their homes. This provides a cushion to withstand hold price fluctuations and swings in economic conditions when they occur. The percentage of loans that were part of a forbearance plan declined, dropping to 0.6% at quarter end from 6% at the beginning of the year. All but one of the loans in forbearance are now in their repayment period. We see this as a confirmation of the effectiveness of our credit underwriting, where we focus on high-quality borrowers that have meaningful equity in their home, as we believe it creates a strong incentive for them to prioritize their mortgage payment and remain current on that obligation. Prepayments in our non-QM portfolio remains somewhat elevated, but slowed from the second quarter's 44.7 CPR to 34 CPR in the third quarter. Non-QM origination volumes continue to grow as originators focus on non-QM production. We continue to engage with existing and new non-QM originators and acquired $233 million of residential whole loans during the third quarter. As Bonnie mentioned, we expect that for now, this will remain a core focus for us, given our solid track record in the space and its favorable risk return profile. As we have discussed in the past, we have developed strategic relationships with residential mortgage loan originators who understand our specifications well and are able to provide us with attractive opportunities to meet our disciplined criteria. Our approach to residential whole loans has always been to focus on high-quality borrowers with lower LCVs who are able to demonstrate a strong desire and ability to repay. We plan to continue to grow this portion of our portfolio in the near-term with the goal of financing these investments through another securitization. With that, I'll turn the call over to Greg Handler to discuss our commercial holdings. Greg?

[Greg Handler:]

Thank you, Sean. In regards to our commercial loan portfolio, this quarter, we received full payoffs on 3 of our commercial loans, representing $101 million. We are encouraged by the improving trends in commercial loan activity, and we believe this more favorable financing environment will benefit our fixed remaining loans, representing $100 million, particularly for properties with post-COVID stabilized cash flows. However, there can be no assurances, this will be the case. Similarly, the commercial securities portfolio also saw a significant paydown. During the quarter, we received a full payoff of $11 million on a non-Agency CMBS investment that was valued on our books at an approximate 5% discount to par, reversing an unrealized loss on that investment. We also received $45.3 million from the repayment of our subordinated interest in our REEL 2019 securitization, which was fully paid off during the quarter. You may recall that this securitization originally consisted of over $900 million in combined bond tranches and was backed by a diverse portfolio of primarily retail power centers located across North America, most of which were sold over the last 2 years by the redeposit. Let me now provide a brief update on our 2 special situations. As to the $30 million hotel loan that we have previously discussed, after dismissal of the borrower's bankruptcy proceedings, we and the other holders of the loan were closed on the property for the purpose of selling it. Marketing of property had begun, but continuing litigation has delayed a resolution. We believe that based on preliminary indication, there is a reasonable likelihood that the outstanding principal balance of $30 million and interest payments will be recovered. We hope to have final resolution in the near future, although there is no guarantee that we will realize a full recovery on the asset. With respect to the junior mezzanine loan backed by a retail and entertainment complex located in the Northeast, we continue to be in discussions with the borrower and certain other lenders regarding potential alternatives to address the situation. Given the ongoing uncertainty regarding possible outcome, we recorded an additional $5.2 million write-down on this loan during the quarter. The loan is currently marked at a value of $27.5 million and a risk of further impairment under certain outcomes. We continue to work diligently on reaching positive resolutions for these 2 challenged investments as well as positioning the remainder of our commercial portfolio for potential future appreciation. Outside of nonqualified mortgages, we may reinvest some of the proceeds from our commercial payoffs into our other core strategies. Within CMBS and CRE, we are looking to supplement our residential holdings with select high-quality commercial investments, particularly in the new issue non-Agency CMBS market, where we are seeing attractive opportunities in new lender in post-COVID stabilized properties. We are targeting transactions that have solid credit fundamentals and strong covenants that protect us as lenders. We like these loans because we are able to get involved in the deals early and can often collaborate on key aspects of the structure. We are encouraged by the continued momentum in the U.S. economy and the signs of improvement in many of the commercial real estate markets. The resurgence of consumer spending has led to higher retail sales, which has been strong at the beginning of the year. As a result, retail occupancy rates and rental productions are improving in many markets. We have also seen a healthy rebound in leisure travel, which has led to improved hotel operating metrics across the country, particularly in the resort and limited service segments in the market. In summary, we remain focused on positioning our existing portfolio with potential future appreciation and growing in a disciplined manner with new investments that offer attractive risk-adjusted returns. I'll now turn the call over to Lisa Meyer, our President and CFO. Lisa?

[Lisa Meyer:]

Thank you, Greg. Before I review our third quarter results, I want to discuss further improvements we have proactively made to our financing arrangements to improve our balance sheet. As Bonnie mentioned, in August, we repurchased $22.3 million aggregate principal amount of our 6.75% convertible senior notes due October 1, 2022, at a weighted average discount to par value of 2.8%. In September, we issued $86 million of new 6.75 convertible senior notes due in September of 2024 and used the net proceeds together with approximately $20 million of cash on hand to repurchase an additional $100 million of our 2022 notes. This resulted in a remaining balance of only $46 million in our existing 2022 notes at quarter end. These transactions have enabled us to not only extend the maturity for 2 years on 2/3 of our remaining convertible debt, but also lowered the overall convertible debt by $36 million. We have ample liquidity to address both our 2022 note maturities and to execute on our investment strategy. We continue to focus on improving and diversifying our other sources of recourse financing. Now, turning to our financial results. During the quarter, our residential portfolio continued to perform well, as did a number of our commercial investments. Our distributable earnings for the quarter were $3.8 million or $0.06 per share, an improvement of $1 million from the second quarter. At the same time, our financial results during the quarter were negatively impacted by the further decline in fair value of a nonperforming commercial loan, as well as spread widening on certain non-Agency CMBS holdings. This resulted in a GAAP net loss of $4.2 million or $0.07 per share and a decrease in our GAAP book value to $3.45 per share, down 2.8% from the second quarter. In addition, we've experienced elevated levels of prepayment in our non-QM portfolio during the quarter that led to $2.1 million in loan premium amortization. Economic book value, which reflects the value of our retained interest in the consolidated securitization trust, rather than the gross assets and liabilities, decreased by 2.4% for the quarter to $3.20 per share. Economic return on GAAP book value was a negative 1.1% for the quarter and included a $0.06 per share dividend. A dividend of $0.06 per share has been consistent for the last 4 quarters. We evaluate the level of our dividend every quarter based on a number of factors, including our outlook for the sustainable earnings power of the portfolio and our taxable income. Our recourse leverage was 2.9x at September 30, up from 2.5x at June 30. The modest increase was primarily due to the additions we made to our non-QM Holdings, which occurred later in the quarter. In summary, we continue to focus on actions that will solidify our capital structure and maintain our liquidity while positioning WMC to benefit from the growing economy and any ongoing recovery of certain commercial real estate sectors that were most impacted by the pandemic. With a significant portion of our assets now financed by attractive longer term financing, we feel we are well positioned to grow our portfolio through select investment opportunities with the objective of improved financial results in the quarters ahead. With that, we will open up the call to your questions. Operator, please go ahead.

[Operator:]

. Our first question will come from Trevor Cranston with JMP Securities.

[Trevor Cranston:]

A question on capital available for new investments. Obviously, in the third quarter, you had a significant amount of payoffs from the commercial portfolio, and were able to acquire some new residential loans. Looking at the remaining commercial loan portfolio, it looks like the payoffs are kind of skewed towards the back half of 2022. I guess as you look over the next couple of quarters, do you feel like you have enough capital available to continue acquiring new loans sort of roughly at the pace you were going in 3Q? Or is going forward, that' going to be somewhat dependent on continued payoffs from the commercial loan portfolio, in particular?

[Greg Handler:]

Thanks for the question. And we feel very strongly about our capital position right now. We've continued to acquire new assets, but also pay down existing debt. We feel that we're in a position to continue to grow the balance sheet. And we'll look to potentially create additional capital through turning out additional financing and the securitization as well. So I think we're in a good position both to redeploy capital as well as to pay down debt. In terms of the payoff schedule, you're right, the commercial portfolio, that has a little bit into 2022, although we may see paydowns ahead of that as well. Sean, anything you have for a comment?

[Sean Johnson:]

Yes. I think that's pretty accurate. We've got improved advance rates, small haircuts on our warehouse financing and then our projected securitization will also generate some free cash to do some interesting things with. So we don't really feel like we're capital constrained any time in the near term here.

[Trevor Cranston:]

And on the non-Agency MBS portfolio in particular, you mentioned a couple of payoffs this quarter. Is there any sort of way you can help us think about your projection for continued payoffs within that portfolio? And whether it's through refinancings or maturity of those loans.

[Greg Handler:]

Sure. Yes. The market has been pretty much the last bastion to recover. We've seen tremendous amount of activity in the second half, starting in the second half of this year. New issue non-agency, commercial mortgage origination volume has been nothing sort of spectacular in the last couple of months. I think October was the strongest issuance month on record post GST. So that trend, we do think is very positive, and the confidence of lenders and just the ability to obviously keep through COVID and even to re-underwrite loans to COVID levels of cash flows. So clearly, the parts of the market, the best during COVID, things like apartments and industrial and distribution logistics, properties, have been the first to recover. But we've been encouraged seeing things. They still have COVID related questions, things like offices and hotels and even high quality retail, getting financed and refinancing and then just overall transaction volume. We've been pointing to the amount of money raised by distressed investors looking to capitalize on the opportunities. And we do think there's a lot of dry powder. So CRE transaction volumes also have picked up significantly in the third quarter, well on pace to being the highest levels of CRE transaction volume post GSE as well. So we do think that, that should help shore up liquidity in some of the legacy non-agency positions. And we do feel like the resolutions on some of these questionable assets with our outlook dressed under COVID, it does feel like the trend is that they're breaking towards more positive resolutions generally. So we think that that should benefit our holdings as well.

[Trevor Cranston:]

That's helpful. And then on the non-QM side, can you give us a sense roughly kind of where you're projecting returns on doing a new securitization today given where loan prices are? And so where the execution is on new securitizations?

[Greg Handler:]

Sure. New securitizations, the ones that have printed in the last week or 2 have been wider than they were, say, in September. So it makes handicapping the returns a little bit tough. But I'd say if it was mid-teens yield before, it might be low teens now.

[Trevor Cranston:]

And then last question. On the mezz loan, which there was a small write-down on this quarter. Can you just help me understand, is that -- was there any sort of change in the status alone, which led to that write down? Or is it sort of a situation where the more time that progresses without a positive resolution, the sort of the value of the loan just deteriorates over time?

[Greg Handler:]

So yes, the mark down in the quarter, I wouldn't say there was any material event that led to that. The ongoing negotiations, obviously, we're getting somewhat of a sense of what the potential outcomes may be. And we are communicating those ongoing discussions with the third-party pricing service who's evaluating the -- coming up with the final valuation. So I would say, in some ways, I think time is actually our friend in this. The longer it takes, the longer the property has the ability to stabilize and value. We see tremendous value in the assets over the long-term, and we're working to position to capitalize and recover as much of that over time. So I think we're still working diligently to protect the position there. And I think just the -- clearly, the range of outcomes is still very broad, and we're factoring in several different potentials there. And also just a very high discount rate given the high level of uncertainty. So that's really the main drivers.

[Operator:]

Our next question will come from Jason Stewart with Jones Trading.

[Jason Stewart:]

Just a follow-up on the mezz loan in the Northeast. In the event of an adverse outcome, does it look more like an equity participation instead of a loan? How do you think about that sort of tail of distribution?

[Greg Handler:]

That's certainly part of the analysis. I think there's a potential to be equitized, to be converted to preferred equity, to have some sort of a split between loan and preferred as well. So again, I think we want to see a stabilized cash -- capital structure that allows the property, the REIT, to fully open and give everyone in the capital stack time to recognize the full value. So that's really our end goal. But obviously, there's adverse -- there's even more adverse scenarios, which we're also factoring beyond that. Okay.

[Jason Stewart:]

And then let's just take the assumption that it's worth less than you have it marked at now, though assume you're comfortable with the fair value of it. How do you look at repurchasing stock and your comfort level with the way you allocate capital for new investments versus something like a stock repurchase today?

[Lisa Meyer:]

It's Lisa. So we have to balance the 2, whether we want to repurchase stock or whether we want to allocate that to investments, and we review both scenarios. We're small. And so actually buying back stock will actually make us smaller. And one of our goals is to really try to grow the company. And we think in order to grow the company, our capital will be better allocated to new investments.

[Jason Stewart:]

And you think those investments generate a higher ROE than repurchasing the stock at some discount to book value?

[Lisa Meyer:]

Yes.

[Jason Stewart:]

And how do you think about the cost structure of the company as you factor that into the equation?

[Lisa Meyer:]

I think we are comfortable with the cost structure of the company. I think with the refinancing of our convertible notes and also overall reducing our convertible note debt. And we're going to look to continue to further do that.

[Bonnie Wongtrakool:]

I would just add that certainly, on the cost structure, we do recognize that scale is very important in this business. So we are looking to, as Lisa said, organically grow. That's our first priority to grow the portfolio through our investment strategy. We believe we can do that. We see good opportunities, and we'll do it in a very disciplined manner that we think is going to be accretive to shareholders.

[Operator:]

. As there are no more questions, this concludes our question-and-answer session. I would like to turn the conference back over to Bonnie Wongtrakool, Chief Executive Officer, for any closing remarks.

[Bonnie Wongtrakool:]

Thank you, operator, and thank you all again for joining us for today's call. We appreciate your continued interest in WMC and hope everyone remains healthy and safe. Have a great day, and I look forward to personally connecting with you in the weeks ahead.

[Operator:]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.