Western Asset Mortgage Capital Corporation
Q1 2018 Earnings Call Transcript

Published: 8 May 2018

[Operator:]

Good morning and welcome to the Western Asset Mortgage Capital Corporation First Quarter 2018 Conference Call. All participants will be in listen-only mode [Operator Instructions]. After today's presentation there will be an opportunity to ask questions. [Operator Instructions] Please note that this event is being recorded. I would now like to turn the conference over to Tony Rossi, Investor Relations. Please go ahead.

[Tony Rossi:]

Thank you, Danielle. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months March 31, 2018. The company issued its earnings press release yesterday afternoon, and it's available on the company's website at www.westernassetmcc.com. In addition, the company has included an accompanying slide presentation that you can refer to during the call. You can access these slides in the Investor Relations section of the website. With us today from management are Jennifer Murphy, Chief Executive Officer; Lisa Meyer, Chief Financial Officer; and Anup Agarwal, 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 forecast 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 Securities and Exchange Commission. Copies are available on the SEC's website at www.sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law. With that, I will now turn the call over to Jennifer Murphy. Jennifer?

[Jennifer Murphy:]

Thanks, Tony. As we've said many times our primary goal is to generate consistent and sustainable core earnings that support an attractive dividend well improving the stability of our company book value. So I'm pleased to report that we delivered another quarter of solid performance, generating GAAP net income of $0.51 per share and core earnings plus drop income of $0.34 per share an increase of core earnings per share of 9.7% over the fourth quarter of 2017. We also delivered an increase in book value of 2%, the fifth consecutive quarterly increase. The book value increase to get together with a $0.31per share dividend provided our shareholders with an economic return on book value of 4.8% for the quarter, once again at the high-end of our peer group. Our dividend has remained stable for eight consecutive quarters and our core earnings plus drop income has exceeded the dividend by approximately 9% in the aggregate over that same time period. Our first quarter performance was driven by contributions across our holdings and reflects the benefits of this significant asset repositioning we began in December 2016, the restructuring of our hedge portfolio last year and our long term strategy of investing in a diversified portfolio across a number of sub sectors of the mortgage market. We produced a strong result despite the backdrop of a fixed income market characterized by rising interest rates and increased volatility during the quarter. A major reason we've been repositioning the portfolio over the last several quarters was to be prepared for the challenging market environment that we experienced in the first quarter. Our portfolio outperformed our hybrid peer group this quarter primarily because of our strategic and significant move into Agency CMBS and credit sensitive investments, a reduction in holdings of agency RMBS and because we reconfigured our hedge positions to better match those assets. Anup Agarwal, Sean Johnson and the rest of the investment team were quite active during the quarter acquiring nearly $500 million in target assets, which included over $400 million of credit sensitive investments. These assets were sourced from a broad spectrum of the mortgage market and included a number of investments where we worked with our strategic partners in the capital markets getting involved early in the transaction and collaborating on the deal structure, covenants and pricing. Essentially WMC is able to leverage the Western Asset platform to gain access to proprietary opportunities that we simply would not have as a standalone mortgage REIT. It's Western Asset scale that makes it an important trading partner for many of the world's largest broker, dealers and banks providing our investment team access to real estate related opportunities, origination and financing. And it's the breadth and depth of Western's Global investment, risk and operational platform that enables us to evaluate respond quickly and ultimately invest in these opportunities. In our view, having a manager of Western Asset size and deep investment capability is our primary competitive advantage. In the first quarter, we repurchased approximately 115,000 shares of our stock at about a 14% discount to book value. As you may recall, we also repurchase shares in the fourth quarter for the first time for the company also at a discount. Both of these purchases were accretive to our book value and represented a compelling investment opportunity in our view. We still have nearly 1.8 million shares left on our existing share repurchase authorization and we will continue to evaluate opportunities to repurchase shares in the future particularly at times when our stock trades at a meaningful discount to book value. So in conclusion, we are pleased with our ongoing strong financial results, we dissembled a diversified portfolio of residential and commercial assets and it put considerable effort into fine tuning our investment and operational prophecies and execution to better enable us to deliver strong and consistent returns to shareholders. Our solid performance of a testament to the efforts of our entire investment team headed by Anup Agarwal and demonstrates the effectiveness of the strategic initiatives that we've been implementing over the last several quarters. As you can see from our results, this quarter as well as over the course of 2017, we think these efforts are paying-off. With that, I'll turn the call over to our CFO Lisa Meyer. Lisa?

[Lisa Meyer:]

Thank you, Jennifer. We believe in another strong performance in the first quarter of 2018. This is the fourth consecutive quarter of solid earnings. Our book value per share for the first quarter of 2018 increased 2% from $11.37, resulting in an economic return on book value of 4.1%. We also maintain a consistent $0.31 per share quarterly dividend. We generated net income of $21.7 million or $0.62 per share and core earnings plus drop income of $14.1 million or $0.34 per share. The key consecutives to outperformance were a result at the following. In larger investment portfolio, we continue to shift our portfolio for credit sensitive investments. During the quarter, we acquired $404 million in credit sensitive investments and $18 million in Agency CMBS while disposing of $11.8 million at the Agency and non-Agency security. The restructured hedge portfolio generated lowest swap related interest expense resulting in a decrease of $742,000 or 41% compared with the fourth quarter of 2017. In addition, the net gains on an interest rate swap were in excess of the unrealized losses on our investment, resulting in a net gain of $10.6 million. These benefits were partially offset by an increase in our operating and general and administrative expenses of approximately $450,000 or 9%, which I will discuss shortly. Included in the $404 million of credit sensitive investments we acquired during the first quarter was $68 million subordinate tranche from $1.4 billion CMBS securitization. Since with the subordinate tranche had seven control right and because the company together with other account managed by Western Asset hold more than 50% of the transit with the control right. For GAAP purposes we required to consolidate the CMBS securitization. The consolidation resulted in a growth of our financial statement recording a secured commercial loan of $1.4 billion and corresponding non [indiscernible] of $1.3 billion. The consolidation of the $1.3 billion of non-incurred [ph] securitized debt increased our leverage ratio to 10.5 times as well our leverage ratio was only 7.7 times at quarter end when excluding the non-incurred securitized debt. Overtime, we expect our adjusted leverage ratio to decline as we continue to add more credit sensitive investment to our portfolio. Looking at our net interest income for the quarter of $18.3 million by source, approximately 46% of it was derived from our Agency CMBS and RMBS holdings, and 54% come from our credit sensitive investment. The portfolio had a net interest margin of 1.9% during the quarter. The underlying average deal on asset was 4.16% and we had an effective cost of funds at 2.5%. The net interest margin increased by11 basis points from the previous quarter as a result of an increase in the average deals on our investments driven primarily by asset mix and partially offset by an increase in our effective cost of funds. Our total expenses increased to $5.3 million for the quarter, 2018 compared with $4.9 million to the first quarter of 2017. The year-over-year increase of approximately $450,000 was mainly the result of following three factors. One, increase in professional fees of approximately $400,000 related to the fees associated with the completion of our first internal control audit. Two, an increase in operating expenses of approximately $550,000 mainly related to loan servicing fees, as we increase our residential and commercial loan investments the cost associated with servicing these loans will increase. And three, the increases were partially offset by lower management fee. The decline in our management fee was due in part to the restriction that occurred in April of 2017 of average portfolio. As of March 31, 2018, we had master repurchase agreement with 28 counterparties and outstanding borrowings with 17 of those counterparties. Our financing options continue to be clinical as a result of WMCs ability to grow up [ph] on the resources and the relationship with Western Asset. With that, I will now turn the call over to Anup Agarwal. Anup?

[Anup Agarwal:]

Thanks Lisa. The significant changes we made to our portfolios holdings during 2017 and continue into the this year because rotating out of Agency RMBS and into Agency CMBS and credit sensitive mortgages were the primary drivers of our solid performance for the first quarter. We are realizing the benefits of our strategy of investing in a diversified portfolio. As we have discussed on previous calls, we have believed for some time that we are about to enter a period in which volatility will increase and the rates will rise. And that most Agency RMBS do not adequately compensate for that risk. Therefore, we have been proactively positioning the portfolio in order to improve its interest rate risk profile by both lowing the duration and decreasing the convexity risk. We continuous to believe that Agency CMBS offer a more attractive risk-adjusted returns, agency CMBS have a better prepayment protection and convexity are less than expensive to hedge and we believe our less expose to spread widening that may occur when Fed significantly reduces its holdings of Agency RMBS. Our major shift into Agency CMBS and other credit sensitive investments is an example of the benefit that WMC derived from being affiliated with Western Asset. Western's size and deep investment capabilities enabled WMC to source investment opportunities and implement significant changes in the portfolio both quickly and effectively, which we believe is a competitive advantage. To give you an example of our ability to leverage Western's investment platform, I would like to highlight a transaction that invested in during the quarter. As Lisa mentioned, we invested in a subordinate interest in $1.4 billion securitized commercial loan, the underlying collateral for this securitized loan consists of a multi asset single borrower loan to a publically traded equity REIT and as it's part of planned spinoff of an approximate $3 billion portfolio consisting of 50 properties, containing over 16 million square feet. The loan is basically an intermediate term bridge loan to [indiscernible] the disposition of the portfolio over next couple of years. The underlying loan has relatively low loan to value and WMC loans at 68 million subordinate terms in the securitized loan, which yields LIBOR plus 950. Because of Western's long established capital markets relationships, the team was able to partner with three originating investment banks, in the early stages of the transaction, collaborating on the deal structure, covenants and pricing. We are excited about this and other similar opportunities that we are seeing as a result of our affiliation with Western Asset. We continue to pursue the overall goal of increasing our holdings of credit sensitive investments and further diversifying our portfolio. Within this sector, we are finding number of attractive opportunities in residential home loans, commercial real estate loans and prime jumbo loans that are part of securitization. We are particularly focused on the residential bridge loans and non-QM residential loans. We find the bridge loans are attractive because they are short term in nature, and they offer compelling yields, while still conforming to our underwriting standards. The non-QM loans also offer a moderately higher yield when comparing mortgages and in our opinion have a very similar risk profile. Our view of residential growth rate remains favorable as the housing market continues to exhibit ongoing strength under volumes. Within the commercial growth space sector we have continuous to focus on adding select commercial mezzanine loans, and junior franchise of non-Agency CMBS. As I highlighted, we continue to find co-investment opportunities with Western Asset in commercial real estate loans, where Western has the ability to influence the transaction structure and covenants. We remain focused on short-term loans that are secured by properties with solid credit fundamentals and strong covenants that protect the lenders. In conclusion, we are very pleased with the performance of our portfolio during the quarter and we continue to focus on our goal of delivering solid core earnings and preserving book values. With that, we will open up the call to questions.

[Operator:]

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Richard Shane of JP Morgan. Please go ahead.

[Richard Shane:]

Hey, guys. Thanks for taking my questions. Look from a tactical perspective you guys have really executed over the last several quarters. But there is a strategic issue here which is that you have a huge platform but this is a relatively small vehicle and frankly the point probably lacks a little bit of scale. We're starting to see consolidation in the industry, and it strikes me that you guys can go sort of one or two directions, I'm curious how you look at the opportunity whether it makes sense to continue to operate at the size or whether it makes sense to try to scale up or to actually add this platforms to something that already has scale?

[Jennifer Murphy:]

Hey, Rick. It's Jennifer. Thanks for your question. We're not surprised to see consolidation because like you we definitely see the benefit of scale. Our association with Western Asset at that our manager is really gives us many of the benefits of scale. We have a broad investment team in structured products in particular and then we have a broader investment team in global fixed income all of which we can draw on. We have a very deep risk effort at the operational team et cetera. So many of the benefits that other companies, other return looking for from scale we get those through Western Asset. Where we see benefit for WMC in particular is in the direct expenses related to the reed so an increased capital base for WMC would help amortize those expenses over a broader capital base. Also this is an incredibly important business to Western Asset. So WMC in particular regardless of its size, it's a major focus for the company. I think you know our CEO Jim Hirschmann is the chairman of the board of this company; I'm the Chief Operating Officer of Western Asset, Anup, a very significant structured products team at Western. All of that indicates I think to you are the important that we place on WMC as a business. So even though I guess its size may not look very large to you in relation to Western Asset as a whole, its profile within our company is very high. So I think we're interested in continuing to grow this business and continuing to increase the capital base of WMC in a way that benefits its shareholders and its existing convertible note holders, so we're that's what we're working towards. So did that answer your question?

[Richard Shane:]

It does. And look at, I think it is very fair for observation I think that the commitment from a high level management perspective is very real. I also think that you're right the general benefit in terms of scale from the resources and intellectual horsepower of Western. But the place where there is a gap frankly is in terms of financial efficiency in that and that's ultimately going to be especially with the stock trading below NAV or below book, excuse me going to be the challenge?

[Jennifer Murphy:]

Yes, agreed. So as I think you've seen we've put a strong focus and reducing expenses where we can and we've made pretty significant progress on that score and I think we can do a bit more. So we're focused on that but I hear you, it's a fair point. We're aware of it and we're working towards addressing that direct issue.

[Richard Shane:]

Got it, yeah I would describe it is probably at the point not even much of a numerator issue it's more of a denominator issue?

[Jennifer Murphy:]

Yeah. I think that's a fair appraisal. I think that's right.

[Richard Shane:]

Okay. Thanks, guys.

[Operator:]

[Operator Instructions] The next question comes from Trevor Cranston of JMP Securities. Please go ahead.

[Trevor Cranston:]

Hi, thanks and congratulations on a good quarter. First question, your leverage picked up a little bit this quarter as you grew the portfolio a bit and some share buybacks. It sounds like you guys are still finding some interesting opportunities for investment. So can you talk about how you guys are thinking about leverage and continued capacity to continue to grow the portfolio from here and how are you balancing that with the desire buyback shares at this point? Thanks.

[Jennifer Murphy:]

Anup, you want to take the investment issue then I can talk about share buyback after that if you like?

[Anup Agarwal:]

Yeah, sure, so as we look at the investor opportunity perspective that we continue to see significant amount of opportunities ranging from all the effective - all the credit sensitive things we've outlined. So from - ranging from prime jumbo to non-QM to bridge loans as well as commercial mezz - commercial mezz opportunities, we've been working on whole the significant amount of opportunities on each one of those sub sectors and we can continue to see kind of opportunities around that. And I think what we can have seen as we have outlined before that as we continue to add those opportunities you will see leverage slowly kind of - leverage will slowly tick down and I think that been our plan that's really what I expect over the next three quarters or next four months. And we will look our approach is very methodically at a find the opportunities if you like and then implementing them in our portfolio. There is a pretty cost of course in terms of the quality of the underlying credit being one of the quality and act where we implement those you will see the leverage come down.

[Jennifer Murphy:]

And Trevor, on share buybacks as you saw, we continue to be evaluating those as our stock trades at a significant discount to book value. So far we've not found our cash needs to be a constraint to buying back shares I think the main constraint we face is we have lots of blackout periods and limitations on daily training volume that we can buyback. So I think we will continue to evaluate that going forward but today are that the cash required for us to do that has not been a constraint for us.

[Trevor Cranston:]

Got it, okay, that makes sense. And then I saw yesterday, I think that there is a pricing of WAMCO non-QM, RMBS deal that's fairly significant in size. So I was wondering if you guys could comment on what WMC's participation in that deal might be and how we should think about that? Thanks.

[Jennifer Murphy:]

I would just say, WMC did not participate in that deal. But those types of things we are, we do and we'll evaluate transactions like that for WMC to the extent they make sense and we think they're accretive for shareholders and right for the portfolio and we have got did you want to comment further on that?

[Anup Agarwal:]

No. I think that's perfect.

[Jennifer Murphy:]

Did that answer your question, Trevor?

[Trevor Cranston:]

Yeah, so that - so just to be clear I guess those are non-QM loans that other vehicles that WAMCO had accumulated and securitized and just sort of separate from what WMC has been doing?

[Jennifer Murphy:]

Exactly, it's a similar portfolio but a different, yes, different vehicle.

[Trevor Cranston:]

Okay, got you. And then one question on the swap portfolio, I noticed that the forward starting book looked like it had - for the forward start period expired at the end of April, can you just say what you did with those if you let any unsettle or if those were replaced with new forward starting swaps? Thanks

[Lisa Meyer:]

Hi, this is Lisa. To the entire one from $1.6 billion, we actually let it kick in. So what we effectively did is fully hedge our debt.

[Trevor Cranston:]

Okay, got you. That's perfect. Thank you.

[Operator:]

There are no further questions at this time. I would now like to turn the conference back to Jennifer Murphy for any closing remarks.

[Jennifer Murphy:]

Great, thank you everybody for joining us today and Rick and Trevor for questions. Have a great day.

[Operator:]

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