Western Asset Mortgage Capital Corporation
Q3 2018 Earnings Call Transcript

Published: 8 Nov 2018

[Operator:]

Hello, everyone, and welcome to the Western Asset Mortgage Capital Corporation’s Third Quarter 2018 Earnings Conference Call. Today’s call is being recorded and will be available for replay beginning at 5

[Larry Clark:]

Thank you, Brian. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation’s financial results for the three months ended September 30, 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 SEC. 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’ll now turn the call over to Jennifer Murphy. Jennifer?

[Jennifer Murphy:]

Thanks, Larry. Our strategy to position Western Asset Mortgage Capital in the most attractive sectors of the mortgage market by drawing on the power of Western Asset really shows in our third quarter results. Through Western’s robust relationships with high-quality originators, we added $580 million in credit-sensitive assets such as Residential Whole-Loans, residential bridge loans and commercial loans this quarter. Through Western’s bank relationships, we continue to source Agency CMBS directly and through brokers, and these assets continue to be a core position in our differentiated investment strategy. Our book value increased 0.3% as our hedging strategy and portfolio positioning in Agency CMBS, rather than Agency RMBS, continued to largely shield our portfolio from the interest rate risk that impacted many other REITs this quarter. Our economic return on book value was up 3.1% for the quarter, once again, at the high end of our peer group. GAAP income of $0.50 per share and core earnings plus drop income of $0.33 per share reflect the earnings power of our underlying portfolio, supporting our $0.31 per share dividend declared in September, which we have sustained for 10 quarters. In late September, we raised $68 million in new equity, which we were able to fully invest in our target assets, including residential whole and bridge loans, commercial loans and Agency CMBS. We have waived management fees on this new equity for six months to mitigate the impact of the time needed to get the proceeds fully invested, but we’ve been able to achieve our target positioning in just over a month, again, drawing on Western Asset’s robust origination and banking relationships. We believe this additional equity will be accretive to the core earnings power of the portfolio, and at the same time, supports our long-term goal to gradually increase our scale. While we already enjoyed many of the benefits of the global scale of Western Asset, we do see specific benefits to increase scale for WMC, including allowing us to spread our fixed costs over a larger equity base, increasing our ability to sustain origination relationships on favorable terms and enhancing the liquidity of our shares. This may potentially improve analyst coverage for the stock, which, we think, is likely to increase information and analysis available to shareholders as well as potentially our valuation. While we did not repurchase any shares during the third quarter, we did repurchase shares at significant discounts to book value during each of the three preceding quarters, and we may consider additional repurchases in the future depending on our stock price relative to book value and other factors. Our senior management team, along with our Board of Directors, are also WMC shareholders, and we remain deeply committed to pursuing long-term strategies that we believe will create additional value for shareholders. With that, I’ll turn the call over to our CFO, Lisa Meyer. Lisa?

[Lisa Meyer:]

Thank you, Jennifer. We delivered another quarter of strong financial results, driven by our sixth consecutive quarter of solid core earnings. Book value per share increased to $11.13, and when combined with our consistent dividend of $0.31 per share, we delivered an economic return on book value of 3.1%. As Jennifer mentioned, we generated net income of $20.9 million or $0.50 per share. And our core earnings plus drop income was $13.8 million or $0.33 per share. Our portfolio continues to generate income in excess of a $0.31 dividend. A key contributor to our ongoing strong performance is the continued repositioning of our portfolio into credit-sensitive investments. As Anup will discuss shortly, we continue to assemble a diversified portfolio of securities, residential loans and commercial loans. We were able to grow the size of our credit-sensitive investments by 25% in the third quarter, adding $375 million in Residential Whole-Loans, $81 million in residential bridge loans, $94 million in commercial loans and $29 million in non-Agency RMBS. In the third quarter, our diversified portfolio generated net interest income of $18.1 million inclusive of hedging costs. Of this amount, $12.2 million or 67% was generated by our credit-sensitive investments and $5.9 million or 33% was generated by our Agency investments. The net interest margin on our portfolio was 2.06%. To minimize the impact of the increase in interest rates on our net interest income, we continue to operate with significant interest rate protection from our interest rate swap position. As of September 30, 2018, we held interest rate swap with a net notional amount of $3.3 billion, and our net duration gap was a negative 0.63 as measured in year. Turning to expenses. We had an increase in general and administrative expenses of approximately $165,000 from the second quarter of 2018, primarily as a result of a non-recurring professional fee. Our objective is to maintain a relatively stable book value, while generating core earnings sufficient to support our dividend. We will manage our leverage to balance these objectives. Our leverage ratio at September 30 was 6.7 times when excluding the $1.1 billion of non-recourse securitized debt from a consolidated CMBS securitization. We expect our adjusted leverage ratio to continue to decline as we rotate the portfolio to add more credit-sensitive investments. As of September 30, we had master purchase agreements with 28 counterparties and outstanding borrowings with 16 of those counterparties. We continue to evaluate other attractive sources of financing, and our options continue to be ample as a result of WMC’s ability to draw upon the resources and global relationship of Western Asset, which is one of the competitive advantages to our company. With that, I will now turn the call over to Anup Agarwal. Anup?

[Anup Agarwal:]

Thanks, Lisa. This quarter continues to highlight our team’s capability to source and position the portfolio across diverse asset classes, given market conditions. Our overall performance in the third quarter was driven by contributions across our holdings in 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 two years have been to rotate out of Agency RMBS into Agency CMBS. As of September 30, Agency CMBS represented 84% of our total Agency holdings and 51% of our total adjusted portfolio. We find these securities attractive because the underlying loans have built-in prepayment protection and are, therefore, less sensitive to interest rate risk than single-family residential mortgages, making them more efficient to hedge. Because of their low interest rate sensitivity, we are able to achieve a minimal duration gap, considerably lower than other mortgage REITs that have high exposure to Agency RMBS. As a reminder, Agency CMBS consists of securities that are issued by Fannie Mae, Freddie Mac and Ginnie Mae to finance multifamily residential properties. These securities have the same guarantee as residential Agency MBS with a more attractive risk profile. Agency CMBS has been a meaningful contributor to our portfolio performance, both in third quarter and over the course of this year. These holdings generated approximately 25% of our net interest income during the quarter. In addition, spreads on Agency CMBS tightened during the quarter, which positively impacted our book value. As Lisa mentioned, we deployed our new equity capital on credit-sensitive portion of our portfolio, where we are investing across several sectors of the market, primarily in residential whole and bridge loans, non-Agency CMBS and MBS and commercial loans. We increased our exposure to a number of these sectors, mostly at the end of the quarter due to the timing of our capital raise. The largest increases were in non-QM Residential Whole-Loans and commercial bridge loans, which we continue to find attractive. Our Residential Whole-Loans, including both bridge and non-QM, now make up nearly 60% of our credit-sensitive holdings and are meaningful contributors to our overall profitability. Our approach to non-QM loans has always been focused on high-quality borrowers with significant equity positions and the demonstrated ability to repay their loans, and then buying these loans at attractive pricing relative to non-QM loans being offered in the traditional secondary market. Our approach is differentiated from others who are likely investing based on ongoing housing recovery and a belief that the credit profile of the typical subprime borrower will continue to improve. That being said, our view of residential real estate remains favorable as the overall housing market is still healthy, despite a recent slowdown in price appreciation and sales activity in certain markets. We source our non-QM loans from a select group of originators, who share our underwriting philosophy. These are generally community banks, who are making loans to their valued customers, but are choosing to sell them to us due to balance sheet constraints. These borrowers have significant net worth but haven’t quite reached the thresholds of becoming a private wealth client at a large bank. We only buy closed loans that have already been fully due diligence by originators and then we conduct our own due diligence before acquiring them. We are generally buying hybrid ARMs, which don’t have the right convexity associated with the traditional fixed-rate loan. As of September 30, our weighted average loan to value for our non-QM loans was 59%, and our borrower had average FICA score of 742, and average net coupon was 5.07. These aren’t the typical non-QM loans that you might see in traditional secondary market. We also continue to like residential bridge loans because they are short term in nature and offer compelling deals, while still conforming to our underwriting standards. Our overall exposure to these loans decreased slightly between quarters as our $81 million in purchases were offset by $89 million in repayments. On the commercial credit side, we own $339 million of non-Agency CMBS, which includes securitizations that are backed by variety of property types. These mortgage pools represent just over 20% of our credit-sensitive assets and tend to be geographically diverse across the U.S. We remain optimistic of our commercial real estate fundamentals given our favorable outlook for the economy. On past calls, I’ve spent time discussing our approach to commercial mezz and bridge loans, which we continue to find attractive and are adding to our portfolio. We target short-term loans that are secured by properties with solid credit fundamental and strong covenant that protects 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 standalone mortgage REIT. In conclusion, we plan to continue increasing our holdings of credit-sensitive investments as a part of our differentiated investment strategy. We remain focused on our primary goal of delivering solid core earnings and preserving book value over time. We believe that capital deployed from our recent equity offering is consistent with this goal and should enhance the earnings potential of our portfolio in the quarters ahead. With that, we will open up the call to questions.

[Operator:]

We will now begin the question-and-answer session. [Operator Instructions] Looks like today’s first question will be from Trevor Cranston with JMP Securities. Please go ahead.

[Trevor Cranston:]

Hi, thanks. Good morning. First question, obviously, you guys were able to successfully deploy a fair amount of capital into credit-sensitive assets this quarter. When you think about your opportunities set going forward and the current makeup of the portfolio, specifically, looking at something like the Residential Whole-Loans, do you think – the pace of acquisitions you made in the quarter, obviously, was partially supported by new capital, but do you think that pace of acquisition is something that is something you could maintain going forward? And if so, could you maybe talk about which portion of the portfolio you might potentially look to decrease or sell down as you continue to add to the whole loan portions of the portfolio? Thanks.

[Anup Agarwal:]

Sure. Thanks, Trevor. Look, I mean, I think as we have kind of said before, I mean, I think we will gradually – our goal is that oftentimes the opportunities continue to exist, which we see it at this point of time for our non-QM loans and some of the bridge commercial. We will continue to grow that. And what you would kind of see is thematically over a period of time, you would see that growth while we continue to bring down our Agency side of the book and as much as we continue to be constructive on Agency CMBS. But it will just be – as we continue to see opportunities, we will continue to grow the pace of our whole loan book.

[Trevor Cranston:]

Okay. Looking at the resi whole loans in particular, that portfolio was up to a decent size now. And it looks like the financing is mostly pretty short term in nature. Can you talk about how you are thinking about the potential for securitizing that? And what that would potentially mean in terms of the advance rate against loans and the funding costs as compared to what the short-term funding looks like?

[Lisa Meyer:]

Yes, we still – we always look at better ways to finance our assets. So we are looking at potentially securitizations. I believe, on our previous yield, the advance rate was 90%.

[Anup Agarwal:]

Yes.

[Lisa Meyer:]

So that was the advance rate. We’re also looking into potentially warehouse lines, which are longer-term financing for these types of assets.

[Trevor Cranston:]

Okay. So is that – is it something that’s more just execution dependent? Or is there anything else that is a reason why you would be waiting to look at some securitization or something like that given that – it seems like the scale is there in the portfolio at this point to have…

[Lisa Meyer:]

Yes, it’s more execution related, because to do a securitization in – within the REIT, you have to have a particular structure. So it just takes a little bit of time to get that in place. So it’s more execution.

[Trevor Cranston:]

Okay, got it. And then switching to the commercial loans. Can you talk a little bit about or give us some more details about the loans you added during the third quarter, whether they are bridge loans or mezz loans? And also maybe talk a little bit more about the opportunities you’re seeing in the commercial loan market? Thanks.

[Anup Agarwal:]

Sure. So look, on the commercial loans, it’s kind of – as you highlighted, like there are two distinct buckets. One is just commercial mezz loans and second is commercial bridge loans. And we continue to see opportunities on both subsegments. But as you have heard from us before, kind of both of those segments are very much dependent or are – on the – we continue to work on the opportunities, but they are all based on underwriting of the loans and the covenants in the loans subject to where we see them. Over a period of time, I expect that on the mezz side, these are three to five-year mezz loans where we are able to drive the covenants as we pointed out versus on the bridge side. It is really focused on financing, which is more bridge to Fannie, Freddie or HUD financing, which is really kind of the short-term loans. They generally tend to be anywhere from six months to 24-month loan, and they are very much underwritten, so that they are very – they will get financed by HUD but it’s just taking – it takes a little bit of time for – from the time you applied to HUD to get the final financing done.

[Trevor Cranston:]

Okay. And so that were the ones that were added during the third quarter sort of a mix of the two buckets? Or was it anything – did it lean one way or the other in terms of bridge loans versus…

[Lisa Meyer:]

They were actually bridge loans.

[Trevor Cranston:]

Okay. Got it. And last thing for me, given the volatility we have seen in rates and some spread markets since the end of the third quarter, could you guys comment on how your book value has performed in the fourth quarter so far?

[Lisa Meyer:]

If you’re going to talk about the CMBS and how it’s planned and how – help with that.

[Anup Agarwal:]

Yes. Yes. Sure. So look, I mean, I think in terms of rate volatility, as you know, kind of, we are not – I think as you know, kind of, as we pointed out in our script as well that we reposition our portfolio, we have repositioned our portfolio to Agency CMBS, which doesn’t have that prepayment – which have that prepayment protections built in, which is really why we are able to carry very minimal duration gap. So from interest rate sensitivity, portfolio has very minimal impact from the rate moves you kind of see. Now on the other side, kind of, yes, there are some spread widening we have seen in some of the spreads that occur especially kind of in DUS. But it has been relatively muted relative to other sectors, which have been – or relative to Agency RMBS, Agency CMBS has performed well.

[Trevor Cranston:]

Got it. Okay, appreciate the comment. Thank you.

[Operator:]

[Operator Instructions] This time, I am not showing any more questions. So I’d like to turn the conference back over to Jennifer Murphy for any closing remarks.

[Jennifer Murphy:]

Thank you, and thanks for joining us, everyone. Have a great day.

[Operator:]

The conference has now concluded. We want to thank everyone for attending today’s presentation. And at this time, you may now disconnect.