Western Asset Mortgage Capital Corporation
Q4 2018 Earnings Call Transcript

Published: 6 Mar 2019

[Operator:]

Welcome to the Western Asset Mortgage Capital Corporation’s Fourth Quarter and Full Year 2018 Earnings Conference Call. Today’s call is being recorded and will be available for replay beginning at 5 o’clock P.M. Eastern Standard Time. At this time, all participants have been placed in a listen-only mode and the floor will be open for your questions following the presentation. Now first, I would like to turn the call over to Mr. Larry Clark, Investor Relations. Please go ahead, Mr. Clark.

[Larry Clark:]

Thank you, Laura. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation’s financial results for the three months and full year ended December 31, 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 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; Sean Johnson, Interim Co-Chief Investment Officer; and Dennis McNamara, Interim Co-Chief Investment Officer. Before we begin I’d like to review the Safe Harbor statement. 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 projection 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. Copies are available on the SEC’s website. 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. Western Asset Mortgage Capital’s ability to draw on the power of Western Asset, our global managers to create a differentiated investment and risk management strategy continues to show in our fourth quarter and full year results. 2018 was another positive year for WMC despite a backdrop of year end market volatility that pressured all spread sectors. WMC’s portfolio generated core earnings plus drop income of $0.34 per share during the fourth quarter of 2018, an increase of 3% from the third quarter and 10% higher than the fourth quarter of 2017. This core earnings increase was primarily driven by our continued shift toward owning credit sensitive assets, which for the first time in our company’s history make up over 50% of our total portfolio. Our solid core earnings in the fourth quarter and the full year were in excess of our dividend levels, allowing us to pay a $0.31 dividend in each quarter of 2018. In fact, we’ve maintained our $0.31 dividend for 11 consecutive quarters now consistent with our objective of providing an attractive dividend for our shareholders. Maintaining a relatively stable book value is also a key objective for us. We have developed a diversified and differentiated investment approach together with robust risk management tool to support this goal. In the fourth quarter, generally wider spreads on our investments resulted in a negative economic return on book value of 3.3% for the quarter. For the full year, we generated a positive economic return on book value of about 4.8%, which put us at the high end of the range of our mortgage REIT peers. We continue to position the portfolio with the objective of achieving relatively little sensitivity to interest rates and virtually no convexity by combining agency commercial mortgage backed securities with high quality residential and commercial loan which Sean Johnson will talk more about. We have also reduced leverage in the quarter, which Lisa Meyer will discuss the ability of book value continues to be an important objective for us. Overall pricing for risk assets has been more positive in the first two months of 2019 and our portfolio has benefited modestly as a result. We will provide a specific estimate of our book value as of February 28, when we announce our first quarter dividend later this month. WMC is able to leverage the Western Asset investment platform to gain access to opportunities that we simply would not have as a standalone mortgage REIT. The investment team acquired over $500 million in credit sensitive assets during the quarter, we would say we are able to source from a broad spectrum of the mortgage market and include many investments where we have developed strategic relationships with residential and commercial mortgage loan originators. Originators who understand us and what we are looking for and are able to provide us with attractive opportunities that meet our disciplined criteria. Late in the third quarter of 2018, we have raised $68 million in new equities which we were able to fully invest in our target assets in the fourth quarter. This additional equity was accretive to the core earnings power of the portfolio and at the same time supported our long-term goals to gradually increase our scale. While we already enjoyed many 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 our larger equity base, increasing our ability to sustain origination relationship on favorable terms, enhancing the liquidity of our shares and expanding analyst coverage for the stock all of which we believe will help to create and sustain an attractive valuation. We maintain our primary focus on our objectives of generating consistent and sustainable core earnings that support on attractive dividends, while improving the stability of the company’s book value. In a few moments Sean will talk more about the specific actions we are taking in the portfolio to achieve these goals on behalf of our shareholders, but first to provide more details of our financial results I will turn the call over to Lisa, our CFO. Lisa?

[Lisa Meyer:]

Thank you, Jennifer. We delivered another quarter of strong financial results driven by our seventh consecutive quarter of solid core earnings. During the quarter, our core earnings plus drop income was $16.2 million or $0.34 per share. As Jennifer mentioned our portfolio continues to generate income in excess about $0.31 dividend. Our dividend has remained consistent now for 11 consecutive quarters and our core earnings plus drop income has exceeded this dividend by approximately 10% in the aggregate over that time period. A key contributor to our ongoing strong performance is the continued repositioning of our portfolio into credit sensitive investments. As Sean will discuss shortly, we continued to assemble a diversified portfolio of residential loans and commercial loans complemented by Agency CMBS and other securities. We were able to grow the size of our credit sensitive investments by 17% in the fourth quarter acquiring $450 million in residential loans and $71 million in commercial loans. In the quarter our portfolio generated net interest income of $21.4 million inclusive of hedging costs, which is an increase of 18% from the third quarter of 2018. Our annualized net interest margin in the fourth quarter increased to 2.25% from 2.06% in the third quarter of 2018. The increase was the result of higher yielding credit sensitive investments and only a modest increase in our effective cost of fund. To minimize the impact of potential increases in interest rates on our $2.8 billion repurchase agreement borrowing, we continued to operate with significant interest rate protection from our interest rate swap position. As of December 31, 2018, we held interest rate swaps with a net notional amount of $2.4 billion and a net duration gap on our agency portfolio of negative three months. Turning to expenses, our total expenses for the fourth quarter of 2018 increased slightly to $5.9 million from $5.8 million in the third quarter of 2018. 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. As of December 31, our recourse leverage ratio was 5.8x, a decline from 6.7x from the third quarter. As of December 31, we had 29 master repurchase agreements with outstanding borrowings under 15 of those agreements. We continued to evaluate other attractive sources of financing and subsequent to year end, we secured 2 new 1-year warehouse facilities, $150 million commercial warehouse facility and a $700 million residential warehouse facility. With that, I will now turn the call over to Sean Johnson. Sean?

[Sean Johnson:]

Thanks, Lisa. In its simplest form, WMC is mostly a portfolio of non-QM residential loans and agency commercial mortgage backed pools. We believe that these two asset classes are quite complementary to each other. The high quality nature of our non-QM loan program with a focus on lower LTVs and higher quality borrowers, offers excellent relative value and an attractive yield profile, against this, our agency CMBS holdings predominantly Fannie Mae pools provide a good balance to our credit sensitive assets and have a convexity profile that is cost efficient to hedge. In addition, the highly liquid nature and abundance of financing available for these securities enables us to adjust the overall size of the portfolio fairly quickly when we believe that market conditions call for it. We also have a growing program to purchase mortgages on commercial properties in whole loan form. This takes our strategy of being involved in the commercial mortgage backed securities market one step further, allowing us to have more control over collateral, borrower profiles, loan terms and covenant. We additionally avoid the cost of certain inflexibilities of the securitization market and can expand our opportunity set without having to compromise our credit profile. Besides experience and resources of Western Asset as a manager further strengthens WMC, layering on skill set that includes a wide reach in the industry to source opportunities, counterparties with whom to transact and risk management that is best in class. Turning to our performance for the year, the significant changes we made to our portfolio’s holdings during 2018 particularly rotating out of agency CMBS and the credit sensitive assets were the primary drivers of our solid performance for the fourth quarter and full year. Over the last 2 years, we have increased our overall exposure to credit sensitive mortgages and securities. As of December 31, credit sensitive assets represent 55% of our total adjusted portfolio, up from 23% at the beginning of the year. As part of this process, we have reduced our overall leverage and book value volatility, all while maintaining the earnings power of the portfolio. As Lisa mentioned, at year end, our adjusted leverage was 5.8x, down from 7.5x the prior year. Our focus on the credit sensitive portion of our portfolio has been to invest across several sectors of the market, but primarily in residential and commercial whole loans. In 2018, we added approximately $1.3 billion of residential whole loans to the portfolio and over 200 million of commercial. Our residential whole loans including bridge and non-QM now make up nearly 70% of our credit sensitive holdings and are meaningful contributors to our overall profitability. Our approach to the non-QM market has always been to focus on high quality borrowers with loans at lower LTVs, which is a demonstration of the borrowers’ desire to repay. The loans are underwritten rigorously to ensure the borrower’s ability to repay. Our view of residential real estate remains favorable as the US housing market is entering a more normalized phase and home price appreciation is expected to remain modest. On the commercial credit side, we own nearly $500 million of a combination of commercial whole loans and non-agency CMBS which includes securitizations backed by a variety of property types. These investments represent approximately 26% of our credit sensitive assets. We expect commercial real estate fundamentals given the ongoing economic expansion and our favorable outlook on the job market to remain solid. In the fourth quarter, we acquired over $70 million of additional commercial whole loans as we saw opportunities to achieve attractive risk-adjusted returns. We continue to target short term loans that are secured by properties with solid credit fundamentals and strong covenants that protect our interests as lender. We like these loans, because we are able to get involved in the deals early, often collaborate on key aspects of the structure. This is a good example of WMC being able to leverage Western assets investment platform and having access to opportunities that we wouldn’t have as a stand-alone mortgage REIT. Another continuing focus for us is increasing the duration of our financing. After year-end, as Lisa mentioned, we opened two one-year warehouse facilities with a long-time partner – financing partner, one each for residential and commercial loan. These offer the security of longer-term committed financing. Our current expectations are for a continued yet moderate U.S. economic growth along with subdued inflation expectations and a more neutral Federal Reserve monetary policy. As such, we believe that our differentiated investment strategy of holding a balanced portfolio with an emphasis on credit-sensitive investments and our focus on risk management positions us well to continue generating strong core earnings while preserving our book value. With that, we’ll open up the call to questions. Operator, please go ahead.

[Operator:]

[Operator Instructions] And our first question will come from Derek Hewett of Bank of America Merrill Lynch. I apologize, it will actually be Steve Delaney of JMP Securities. Mr. Hewett we’ll get to you next.

[Steve Delaney:]

Good morning. Thanks for taking the question. I wanted to ask a little bit about the Whole Loan strategy, clearly, that’s where you’re emphasizing your new investments. When I look at that and I hear your comments on book value stability, I’m curious if the different accounting for Whole Loans relative to MBS is part of your thinking sort of from a strategic standpoint, if you make a bet on a Whole Loan, you just have to be right on the credit, which you don’t have the mark-to-market noise that you get like we saw in December. So a bit just curious if you see that as part of bill – focusing on Whole Loans while they’re more difficult to finance, do you see a big plus in the lack of mark-to-market noise in those assets? Thanks.

[Sean Johnson:]

Hi, thanks, it’s Sean. It’s – that’s not really a focus of ours.

[Steve Delaney:]

Okay.

[Sean Johnson:]

What we’re looking to do in non-QM space is to find basically and help originators originate loans that generally aren’t available in securitized form for us to own the credit tranches. So, generally the – and so it’s really a sourcing thing. We really care about the quality of the loans. We’re accounting for the value at fair value anyway, so it’s not like the accounting thing, it’s some kind of a trick to hide any kind of volatility. Ultimately, for our program, we’re focused on lower LTV and higher quality, our Ammo in the non-QM space is to focus on the higher quality end of the market. We’ve got originators, with a handful of originators that are retaining servicing. We compete on price not on credit, so we generally have a lower coupon than some of our competitors and that actually help to stabilize our effective cash flows as well. So, the focus there is really on the quality of the loans and not really on any kind of accounting funds.

[Steve Delaney:]

Got it. So, would you – you’re in game there Sean as you achieve enough scale in a certain group of assets whether it’s the resi and QMs or whether it’s commercial, do you see the REIT issuing its own securitizations as a source of permanent financing on those Whole Loans?

[Sean Johnson:]

We are focusing on all types of longer-term financing.

[Steve Delaney:]

Okay, great.

[Jennifer Murphy:]

So, you mentioned – you mentioned the warehouse line, we’ve done that and so we clearly will evaluate all opportunities.

[Sean Johnson:]

Yes, we’ve mentioned in the past kind of our focus on trying to extend the options available to us for the longer-term financing.

[Steve Delaney:]

Got it. And just one final one Jennifer for you, if I may, could you just give us an update on your CIO search that’s underway and when that might be completed? And, I guess, the second part of that question is, given the strategy, should we expect that you would – if you may find someone that has a pretty extensive credit background as opposed to maybe just rate risk? Thank you.

[Jennifer Murphy:]

Thanks for your questions, Steve. Yes, the current – our Interim Co-CIO structure is working really well, so, well, we’ve been very happy with that. As you know Western has a strong team-based approach always.

[Steve Delaney:]

Sure.

[Jennifer Murphy:]

And that team-based approach is really benefiting us now. So through Sean and through Dennis, we’re able to both focus on our investment goals for WMC, as well as draw on the full – the broad investment capabilities of Western Asset as a whole. So, we’re in the middle of our search, so, we’re in the search, we’re considering internal and external candidates. I would expect we come to a resolution on that with respect to WMC in the coming quarter. So, I think on or before our next call, I would expect us to resolve that permanently.

[Steve Delaney:]

Right. Well, Sean certainly seems very comfortable talking about the portfolio that’s for sure. So, I think you’re in good hands. Thanks for the comments today.

[Jennifer Murphy:]

Thanks, Steve.

[Sean Johnson:]

Thank you.

[Operator:]

And our next question will come from Derek Hewett of Bank of America Merrill Lynch.

[Derek Hewett:]

Good morning, everyone. As operating expense relative to equity, it looks like that improved a little bit sequentially, but it’s still relatively high versus peers. So besides scaling the portfolio, what are some of the other opportunities to improve operating efficiency going forward?

[Jennifer Murphy:]

Derek, I think I just want to start and Lisa will answer, but – so I think scaling is a significant part of our ability to reduce that operating expense. I also think it’s affected by some of our – the structure of our portfolio, which Lisa can comment on, but I think – I do think scale is a significant issue there, but Lisa, do you want to –

[Lisa Meyer:]

Yes. And part of the operating costs are the servicing fees on our bridge loans, residential bridge loan portfolio. So, as that portfolio starts to roll off, because I don’t think it’s one of our targeted investments going forward, you will see a decline in operating costs related to those bridge loans. Does that make sense, Derek?

[Derek Hewett:]

Okay, great. Yes, it does. And then maybe taking a step back, I mean, the company has made strides repositioning the portfolio towards more credit-sensitive investments and then also CMBS securities over the last, I think 2 years to 3 years to provide at least a stable distribution while defending book value, which has materially improved in terms of volatility relative to peers, especially, highlighted during the fourth quarter, and while valuation has improved somewhat, I think the shares still appear to be trading at a discount to peers. So, what additional steps do you think can be taken to eventually close the pure valuation gap at this point?

[Jennifer Murphy:]

Yes, thanks, Derek. I think as I mentioned in my opening remarks, I do think that we need to continue to address our scale, I think that’s part of the issue of valuation. I think when we analyzed of how other our peers trade on a valuation basis, there are a number of things that seem to drive it, but certainly the scale, liquidity of the shares, analyst coverage, these things all drive valuation along with the actual results of the company. So, as you point out, I think we set up some objective 2.5 years ago when this executive team came into place. We’ve largely delivered on those objectives, that’s an important part of improving our valuation. And now we’re really focused on increasing coverage of our stock and also improving our scale over time as it makes sense. We appreciate you picking up coverage of the stock for example, thank you. So those are I think what we need to do, I think as we get our permanent CIO structure in place that will be an opportunity for us to get out and talk to investors more about our strategy and how we’ve delivered on it.

[Derek Hewett:]

Okay, great. And then my last question has to do with book value, I know you guys are going to announce what book value is as of February 28 when the dividend is announced. But, I guess, given the recovery in or the improvement in the financial markets, and the fact that many if not all peers that provided some guidance in terms of what the book value improved to at least as of I think for most it was as of January 31. I guess, directionally, should we expect a kind of a similar range of outcomes for Western or are there other considerations given the portfolio composition relative to a lot of the other peers?

[Jennifer Murphy:]

I think as I said in my opening remarks, our book values improved modestly, which I think is similar to peers, so I’m not aware of anything that would lead to a different result. I think you know the composition of our portfolio, I think Sean laid it out really nicely, so I think that gives you a good idea, but I think modest improvement is what others have seen and what we have seen as well.

[Derek Hewett:]

Okay, great. That’s all from me. Thank you.

[Jennifer Murphy:]

Thank you.

[Operator:]

Our next question will come from Bose George of KBW.

[Bose George:]

Hey, good morning.

[Jennifer Murphy:]

Hey.

[Bose George:]

Actually, just wanted to start with one on the Agency RMBS, the spreads there have widened obviously quite a bit. Just curious if there is a level at which you guys would be interested in that or do you just see that as not being kind of core to what you’re trying to accomplish?

[Sean Johnson:]

I would say there’s definitely a level where we would care. I don’t think we’re close to that level at this point. But I think the agency commercial mortgage backed investments that we have right now are what make them nice is there – is the convexity profile and that’s hard to replicate in the RMBS space. So, it would – I’m just thinking about OAS levels for the mortgage index around 35 and spreads on DUS [ph] in the 60s. It still feels to me like the Agency CMBS space is – offers better value, especially, hedge adjusted.

[Bose George:]

Okay.

[Dennis McNamara:]

This is Dennis McNamara. I would add that again agencies in an absolute sense clearly have widened, do offer attractive on their own relative to recent history, but the whole sector is widened as Sean has indicated and so on a relative value basis there remained other areas that we are emphasizing.

[Bose George:]

Okay, no that makes sense. And then actually, can you talk about the pipeline for growth in the non-QM business? And also just wanted to tie that into the earlier comments about scaling up the portfolio. So, to the extent that, is the pipeline robust enough to grow that meaningfully, if you do have more capital to put to work?

[Dennis McNamara:]

Yes, I don’t think we’re going to have any problem finding non-QM loans to purchase. We’ve – we’re only dealing with a handful of originators, so, it’s part of our core strategy to be partners with our originators and understand them and have them understand us extremely well. But that said, the program that they’ve been running have grown quite a bit. We did add two new originators in the last few months to help improve our geographic diversity. So, I don’t have any qualms about being able to invest quite a bit more in this space.

[Bose George:]

Okay, great. Thanks.

[Jennifer Murphy:]

Thank you.

[Operator:]

[Operator Instructions] And our next question will come from Mikhail Goberman of JMP Securities.

[Mikhail Goberman:]

Good morning. Thanks for taking the question. Most of my questions have been answered. Just a quick one though on leverage, a big drop-off in the quarter from 6.7 to about 5.8 excluding the securitized debt, is this a level that you guys are comfortable with from sort of general ballpark going forward or is there any appetite to perhaps take it up a little bit?

[Sean Johnson:]

We’re definitely comfortable with the level right now. I think we’ll adjust the level based on opportunity, but the level that we’re at right now is certainly a comfortable one for our asset mix at this point.

[Mikhail Goberman:]

Alright, thank you very much. That’s it for me.

[Sean Johnson:]

Okay, thank you.

[Jennifer Murphy:]

Thanks, Mikhail.

[Operator:]

And 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:]

Thanks, Laura and thank you all again for joining us today. Have a great day.

[Operator:]

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