Western Asset Mortgage Capital Corporation
Q2 2018 Earnings Call Transcript

Published: 7 Aug 2018

[Operator:]

Welcome to the Western Asset Mortgage Capital Corporation's Second Quarter 2018 Earnings Conference Call. Today's call is being recorded and will be available for replay beginning at 5

[Larry Clark:]

Thank you, Operator. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months ended June 30, 2018. The company issued its earnings press release yesterday afternoon and is 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 also 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:]

Thank you, Larry. Welcome, everyone. We delivered strong second quarter financial results as we continue to realize the benefits of our diversified portfolio and our differentiated investment strategy. On a broader level, our results continue to reflect our ability to draw on the breadth and depth of Western Asset, our managers, global investments, risk and operating platforms, which we view as a strategic advantage for WMC and its shareholders. In the second quarter, our core earnings plus drop income was $0.36 per share, an increase of 7% from the first quarter of 2018 and 17% higher than the fourth quarter of 2017. This quarter's core earnings increase was primarily driven by our continued shift towards owning more credit-sensitive assets, which Lisa and Anup will talk more about; improved hedging costs; and lower G&A expenses. We delivered an economic return on book value of 0.4% for the second quarter, which includes our shareholder dividend of $0.31, partially offset by a decline in our book value of $0.27. For the first 6 months of 2018, our economic return on book value was 5.1% and it was 21% for the full year 2017, both at the high end of our peer group for those periods. Our shareholder dividend has remained consistent now for 9 consecutive quarters, and our core earnings plus drop income has exceeded the dividend by approximately 10% in the aggregate over that time period. The decline in our book value in the second quarter was primarily the result of spread widening in our Agency CMBS portfolio, which occurred late in the quarter and was driven by what we believe were temporary market conditions as those spreads have rebounded in the -- here in third quarter. Our second quarter performance was driven by contributions across our holdings and reflect our diversified and differentiated investment approach. This differentiated approach is the direct benefit of our ability to draw on Western Asset's size, scale and deep relationships to source opportunities in virtually any subsectors of the fixed income market. The investment team was once again quite active this quarter, acquiring over $300 million in target assets, the vast majority in credit-sensitive investments. These assets continue to be sourced from a broad spectrum of the mortgage market and includes many investments where we have developed strategic relationships with mortgage loan originators, originators who understand what we are looking for and are -- who are able to provide us with attractive opportunities that meet our disciplined criteria. Similarly, in our commercial loan investments, we're also able to get involved early in the transaction and collaborate on key aspects of the deal structure. Essentially, WMC is able to leverage the Western Asset investment platform to gain access to opportunities that we simply would not have as a stand-alone mortgage REIT. In the second quarter, we repurchased about 63,000 shares of our stock at an average price of $9.88 per share or about a 12% discount to book value. We have repurchased shares in each of the past 3 quarters, each time at a significant discount to book, which has been accretive to our book value and has represented a compelling investment opportunity, in our view. We still have over 1.7 million shares left under our existing share repurchase authorization, and we'll continue to evaluate opportunities to repurchase shares in the future. We're pleased with our strong financial results in the second quarter and year-to-date. We remain focused on our objective on behalf of our shareholders of generating consistent and sustainable core earnings that will support an attractive shareholder dividend while improving the stability of the company's book value. With that, I'll turn the call over to our CFO, Lisa Meyer. Lisa?

[Lisa Meyer:]

Thank you, Jennifer. We delivered another strong performance in the second quarter of 2018, our fifth consecutive quarter of solid core earnings. We generated net income of $1.5 million or $0.03 per share. Our core earnings plus drop income was $15.2 million or $0.36 per share, an increase of $0.02 per share over the prior quarter. There were 5 key contributors to our performance. First, we had a slightly larger average investment portfolio and an ongoing shift in the credit-sensitive investment. During the quarter, we sold approximately $405 million of mainly Agency securities and redeployed the capital by acquiring $275 million in credit-sensitive investments, consisting of $240 million in residential whole and bridge loans and the remaining in the commercial loan and non-Agency CMBS. Second, the portfolio generated a higher net interest margin as a result of our shift towards credit-sensitive investment. Our net interest margin increased by 11 basis points from 1.94% at March 31 to 2.05% at June 30. The third contributor to our performance was a reduction of our net interest rate swap expense of $2.1 million from the first quarter of 2018; fourth, a decrease in professional fees of approximately $480,000 mostly related to the completion of our first internal control audit in the first quarter; and lastly, the increase in core earnings was partially offset by slightly higher management fee and an increase of approximately $590,000 in third-party asset management and loan servicing fee on our growing residential bridge and commercial loan portfolio. Our leverage ratio at June 30 was 7.3x when excluding $1.3 billion of nonrecourse securitized debt from a CMBS securitization. We are required under GAAP to consolidate the CMBS securitization because the $68 million subordinate charge we acquired contains certain control rights. Our adjusted leverage ratio declined from 7.7x at March 31. As we continue to add more credit sensitive to our portfolio, we expect this trend to continue. With our view that interest rates will continue to rise, we decided to settle our $1.5 billion forward-starting swaps into a current paid swap in April. At quarter end, we had effectively hedged approximately 96% of our interest rate exposure on our repo debt. We believe that this interest rate protection will minimize the impact of future rate increases on our portfolio. At June 30, we had master repurchase agreements with 28 counterparties and outstanding borrowings with 17 of those counterparties. Our financing options continued to be ample as a result of WMC's ability to draw upon the resources and relationships of Western Asset. With that, I will now turn the call over to Anup Agarwal. Anup?

[Anupam Agarwal:]

Thanks, Lisa. Our overall performance in the second quarter was driven by contributions across our holdings and a number of subsectors of the mortgage market but mainly from our Agency CMBS portfolio and our credit-sensitive loans and securities. Let me spend a few minutes discussing each. As we have mentioned in the past, one of our portfolio repositioning initiatives over the last 18 months has been to rotate our Agency RMBS into Agency CMBS. As of June 30, Agency CMBS represented 83% of our total Agency holdings and 55% of our total adjusted portfolio. As a reminder, Agency CMBS consists of securities that are issued by Fannie Mae, Freddie Mac and Ginnie Mae to finance multi-family residential properties. We find these securities attractive for a number of reasons. First, the underlying loans have built in prepayment protection and, therefore, are less sensitive to interest rate risks than single-family mortgages. Second, Agency CMBS offers a more attractive price than RMBS because it is more cost efficient to hedge. And third, given the [indiscernible] its RMBS holdings, we believe that Agency RMBS credits are likely to remain under pressure until the spreads influence market assets. Agency CMBS has been a meaningful contributor to our portfolio performance growth in the second quarter and over the last 18 months. These holdings generated over 30% of our net interest income during the quarter. However, as Jennifer mentioned, spreads on Agency CMBS widened out late in the quarter, which negatively impacted our book value. We believe the widening was due to temporary market conditions as spreads have tightened our gain here in the third quarter. In the credit-sensitive portion of the portfolio, we remain invested across several sectors of the market, primarily in Non-Agency CMBS and RMBS residential whole and bridge loans, commercial loans and GSE Credit Risk Transfer securities. During the quarter, we increased our exposure to a number of these sectors with the largest increases taking place in residential bridge loans and non-QM residential whole loans, which we find particularly attractive. Our residential whole loans, including both bridge and non-QM, now make up about 34% of our credit-sensitive holdings and are meaningful contributors to our overall profitability. We find residential non-QM loans attractive because they offer a moderately higher yield than performing mortgages and, in our opinion, have a very similar risk profile. Our view of residential growth rate remains favorable as healthy market continues to exhibit ongoing strength and resilience. Residential bridge loans are attractive to us because they are short term in nature and offer compelling deals while still performing to our underwriting standards. Another area of residential sector that we are looking at is in prime jumbo mortgage securitizations. They offer higher yields than Agency RMBS yet have a similar risk profile, in our view. However, we are being opportunistic when investing in this space. On commercial credit side, we own good deal of non-Agency CMBS, which includes securitizations that are backed by variety of property types. These mortgage pools are also tend to be geographically diverse across the U.S. Given our favorable outlook for the economy, we remain optimistic about commercial real estate fundamentals going forward. On last quarter's call, I spent time discussing our approach to commercial mezz loans, which we continue to find attractive and are heading to our portfolio. As a reminder, we are focused on short-term loans that are secured by properties with solid credit fundamentals and strong covenants that protect the lenders. We like these loans because we are able to get involved in the deals early and often collaborate on key aspects of the structure. This is a good example of WMC being able to leverage Western Asset's investment platform and having access to opportunities that we would not have as a stand-alone mortgage REIT. In conclusion, we plan on continuing to increase our holdings, our credit-sensitive investments as part of our differentiated investment strategy. We remain focused on our overall goal of delivering solid core earnings and preserving book value. With that, we will open up the call to questions.

[Operator:]

[Operator Instructions]. The first question comes from Trevor Cranston with JMP Securities.

[Trevor Cranston:]

I guess, first, a couple of questions about the residential loan strategy. Can you just give us an update on kind of what you guys are seeing in that market, both for the bridge loans and the whole loans, in terms of the progress that you've -- you see originators make in if the people you've partnered with have been able to see any increase in volumes sort of as the conventional conforming origination space has struggled some? And also, if you're seeing more originators coming into the space and the potential for an increased supply of loans?

[Anupam Agarwal:]

Sure, Trevor, thank you. Relating to -- let's talk about the non-QM first. On the non-QM side, if you are seeing -- we are seeing continued growth relative as a conventional volume comes down. But look, keep in mind, we have a very differentiated strategy kind of on non-QM [indiscernible] for. As you've heard from us before, kind of our non-QM is really focused at this high-quality borrower who's not really looking to maximize the leverage, focused on primarily adjustable rate mortgages, low loan to value. So there, we tend to -- kind of our process is to be very deliberate and focused at finding these borrowers from kind of small to medium bank, kind of in the credit sensitive and kind of like the high-quality loan, loan-to-value attractive relative to conventional. So yes, we are seeing more low volume because those are the loans, which were originated by banks. [Indiscernible] so we continue to add more partners to our program. But broadly, we're kind of seeing the issuance of non-QM securitizations continue to grow. So the volumes are increasing, but just kind of keep in mind that our strategy for non-QM is quite different relative to all other market participants, and that volume for that borrower who is not looking for additional leverage is just different. Most of the participants are quite different, so we do see corresponding channels growing, but just kind of keep in mind, our strategy is different. The second, in terms of residential bridge. Yes, kind of I mean, again, our focus is on high-quality, very experienced borrower who has been doing their cosmetics, rehab for a long period of time. Again, we tend to be very deliberate in terms of finding the high-quality borrower there. And we have seen growth, but we have been very disciplined in how many we add just simply because the quality and our discipline is very important to us.

[Trevor Cranston:]

Got it. That’s helpful. And can you also maybe touch on the financing side for those strategies and if there's been any sort of changes there in terms of the number of counterparties who are willing to lend against those loans or any of the terms you're seeing in financing them?

[Anupam Agarwal:]

Yes. I mean, look, I think we continue to see strong interest from additional counterparties who are looking to finance it. Again, I think one of the things you have -- as you have kind of seen and -- as you've seen, not only lots of non-QM securitizations have been done, but also, we did, first, for our -- one of our funds we did are non-QM securitizations. So there are a couple of things you can see. One is because you have lots of securitizations, which are being done. Second is now our -- this is the strategy that we have been doing for 2, 3 years, so most counterparties we have had, they can see the performance in terms of the prepaid fees, in terms of the delinquencies. And they kind of see that, one, our standards have not changed; and second is our performance has continued to, knock on wood, but our performance [indiscernible] foresee. So because of that and because of fixed rate, we continue to have growth in counterparties who are going to finance those.

[Trevor Cranston:]

Got it. Okay. Now on the commercial side, can you maybe remind us -- I know you guys said you sort of have a positive fundamental view. But can you remind us sort of if you have any particular focus on the type of property types you guys are most willing to lend against? Or if there's anything in particular you guys are avoiding in terms of geography or different property types?

[Anupam Agarwal:]

I mean, look, I think all the things, whether it's geography, property type, all of those come into our -- come into consideration as an added evaluation of any given opportunity. But what about -- in addition to those, what is most important for us really is, in addition to the big, big fundamentals is one of the covenants we are able to kind of [indiscernible] to negotiate as a part of the structure and -- just to kind of make sure that we have a loan, which -- but we have confidence that all the things in the restructuring that it gets paid off. So that -- having the right covenants, in my mind, in that current economic cycle is really important. And that's why, as Jennifer had mentioned in her comments and I've mentioned, that we play early on to be able to collaborate on the structure. And that's what the view is that we are able to have -- to get a very strong transaction. Look, without coverage, you can have all the property types and geography, but it would help you a lot when the current economy comes. So kind of it's a combination of both, but it is -- it's -- and this is really the benefit of Western Asset as a platform comes that when you ask the same question from some of the other entities, they would give you an answer that they are either focused on just multi-family or any given property type. And it's more of, for us, we have the expertise to be able to look across all of it. Sorry, long answer.

[Trevor Cranston:]

No, that's very helpful. Then last question, are you guys able to quantify how much the second quarter earnings benefited from the widening spread between three month LIBOR and Agency repo rates? And also, it'd be helpful if you guys could share your view on sort of where you expect that relationship to stabilize since it's come in a lot since the peak in the second quarter?

[Lisa Meyer:]

As far as our swaps -- so as I mentioned, we are effectively hedged 96% of our repo exposure, so I think, during the quarter, we benefit from that by approximately $2 million. So that was also very helpful related to our core earnings. What was -- I'm sorry, what was the second part of your question?

[Trevor Cranston:]

Second part of the question was just sort of your guys thoughts on where you'd expect the relationship between three month LIBOR and Agency repo rates to stabilize.

[Anupam Agarwal:]

Yes. I mean, I think -- look, I think Agency repo rates are kind of have -- are going to stabilize at both of our -- look, I mean, I think there is just continues to be a blurry around what markets use for how many ranges that we'll have. Overall, natural conditions are quite constructive, kind of inflation is not going anywhere. So overall, kind of as you kind of see a consensus built around how many ranges are there, which continues to be the case, I think that relationship [indiscernible].

[Jennifer Murphy:]

I also just wanted to add that both our hedges and our repo are indexed to LIBOR, so.

[Operator:]

[Operator Instructions]. This concludes our question and answer session. I would like to turn the conference back over to Jennifer Murphy for any closing remarks.

[Jennifer Murphy:]

Great. Thanks very much for joining us, and have a great day.

[Operator:]

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