Western Asset Mortgage Capital Corporation
Q2 2019 Earnings Call Transcript

Published: 7 Aug 2019

[Operator:]

Welcome to the Western Asset Mortgage Capital Corporation’s Second Quarter 2019 Earnings Conference Call. Today's call is being recorded and will available for replay beginning at 5

[Larry Clark:]

Thank you, Chad. 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, 2019. 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; Harris Trifon, 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. Our strategy to position Western Asset Mortgage Capital in sectors of the mortgage market where we see attractive risk-adjusted returns by drawing on the power of our global manager Western Asset continued to show in our second quarter results.Through Western's robust origination and banking relationship, we added $1.2 billion in target assets including both residential and commercial MBS for our Agency portfolio and Non-Agency CMBS commercial loans and GSE Risk Transfer Securities for our credit sensitive porfolio.Our investment team was very active this quarter as the significant interest rate volatility in the fixed income market created what we believe to be compelling investment opportunities in the mortgage sector.Despite the backdrop of a market characterized by heightened rate volatility, we have continued to deliver solid financial performance generating $0.21 in earnings per share on a GAAP basis for the second quarter, core earnings of $0.31 per share for the quarter and $0.63 per share for the first six months, and closing an economic return on book value of 1.1% for the quarter and 6.5% year-to-date, an annualized rate of 13%.We continued to demonstrate our commitment to paying an attractive dividend that is sustained by strong core earnings. Our second quarter dividend of $0.31 per share represents an annualized yield on average book value of 11.7%, and we remained consistent for 13th consecutive quarters. Over that same time period, our core earnings have exceeded our total dividend paid by just over 8%.We believe this is a direct result of our differentiated investment strategy, which has enabled us to assemble a diversified portfolio, mortgage-related assets, which itself is a direct result of our ability to draw on the breadth and depth of Western Asset's global investment, risk and operating platforms. As we've stated before, we view our association with Western Asset as an important strategic advantage for WMC and its shareholders.We also pleased to have completed two significant capital market transactions during the quarter. In May, we completed a $49 million equity offering which allowed us to take advantage of what we saw a compelling investment opportunity afforded by the volatile rate environment. This trade enabled us to further invest in our target assets. We believe this offering enhances the overall earnings power of our portfolio, while also supporting our long-term goals of growing the company to achieve better scale and increasing liquidity.While we already enjoy many of the benefits of the global scale of Western Asset, we continue to see specific benefits of increased scale for WMC, including allowing us to spread our fixed cost over a larger equity base, increasing our ability to sustain origination relationships on favorable terms and enhancing the liquidity of our share, all of which accrue to the benefit of our shareholders.In June, we completed the securitization of a portion of our Residential Whole Loan, resulting in the issuance of $919 million in mortgage-backed notes. This transaction represents the company's first securitization and enables us to finance our assets with longer term fixed rate financing at attractive levels. Our successful execution of this financing also reflects the company's ability to leverage the platform of Western Asset as Western has established relationships in this sector of the financing market having completed prior securitizations on similar pools of mortgage loans.We are pleased with our solid financial results in the second quarter and year-to-date. We remain focused on our primary objective of generating consistent and sustainable core earnings that will support an attractive dividend while maintaining a relatively stable book value for our shareholders.With that, I'll turn the call over to our CFO, Lisa Meyer. Lisa?

[Lisa Meyer:]

Thank you, Jennifer. The second quarter was another strong quarter for WMC, driven by our 9th consecutive quarter of solid core earnings. During the quarter, we generated net income of $10.6 million or $0.21 per share and core earnings of $15.8 million or $0.31 per share. Our portfolio continues to consistently generate income that covers our $0.31 dividend, which has remained constant for 13 consecutive quarters.A key contributor to our ongoing strong performance is our diversified investment portfolio. As Jennifer mentioned, and Harris will provide in more detail, we continued to assemble a portfolio of our targeted assets including both credit sensitive investments and Agency MBS. We were particularly active during the second quarter putting to work the capital that we raised from our equity offering. We increased the size of our total portfolio by over $900 million net of payoffs and exits primarily by a acquiring approximately $1.1 billion of Agency MBS and a $137 million in credit sensitive investment.In the quarter, our portfolio generated net interest income of $20.4 million inclusive of hedging costs. Our credit sensitive investments contributed $14.5 million or 72% of the total compared to 62% in the second quarter of 2018. Our annualized net interest margin in the second quarter was 2.14%, down from 2.36% in the first quarter. The decline was a result of lower weighted average yield on our portfolio due to higher proportion of Agency securities which was partially offset by a decrease in effective cost of funds.Turning to expenses, our total expenses for the quarter were $5.1 million, down $200,000 from the first quarter of 2019. The decline was mainly due to lower professional fees and lower loan servicing fees on our residential bridge loans as a result of $67 million of payoffs and no new reinvestment in the asset class. These reductions were partially offset by increased compensation expense and other G&A expenses.Our leverage ratio was 5.6 times at the end of the quarter which excludes the $1.6 billion of non-recourse securitized debt and was down from 5.9 times at the end of the first quarter. As Jennifer mentioned, we completed our first securitization during the quarter backed by a portfolio of Residential Whole Loan. This longer term non-recourse financing was beneficial to us for a number of reasons including been able to lock in at attractive loan-term interest rates as well as be able to provide less collateral than we would on the alternative sources of financing.Over time, we expect our adjusted leverage ratio will vary depending upon the mix at our Agency and credit sensitive assets in the portfolio. At June 30, we had $2.9 billion of repo borrowings under 18 of our 33 master repurchase agreements and $69 million outstanding under our longer-term financing facility. We continue to operate with a significant degree of interest rate protection on our repurchase agreement financing from our integrated swap position. At quarter end we held interest rate swaps to the net notional amount of $3.4 billion excluding forward starting swap covering over 80% of our outstanding repo exposure. The net duration gap on our Agency portfolio was 0.09 years.With that, I will now turn the call over to Harris Trifon. Harris?

[Harris Trifon:]

Thanks, Lisa. My first quarter as CIO of WMC certainly proves to be an eventful one. To quickly recap, we saw a significant rally in the rates market and nearly a 10% decline in the equity market only to see the selloff completely retrace by the end of the quarter. We also completed an equity raise, issued our first securitization and added a sizable exposure to the Agency RMBS market for the first time in eight quarters.Our view of the macro environment has not changed materially nor could we anticipate any near-term changes to our broad market views. Interest rates have remained low with sporadic episodes of increased rate volatility. Inflation remains well below target levels. The U.S. economy continues to grow at a subdued yet steady phase and has modestly outperformed the slower global economy.Central banks around the world continue to be accommodative in light of the slower global growth outlook. Domestic real estate market, both residential and commercial, remain relatively healthy against the backdrop of ongoing job growth, positive household formation and limited new supply.Looking ahead, we believe that the credit spread sectors will continue to perform well in this environment and we continue to find compelling investment opportunities in residential and commercial home loans. We also believe that our Agency MBS holdings, both commercial and residential, providing an important balance to our credit sensitive assets and will remain a core component of our portfolio.Now turning to our activity during the quarter, where we added over $1.2 billion of investments in the portfolio, consisting of both credit sensitive assets and Agency MBS. For the first time in several quarters, we invested back into Agency RMBS taking it from essentially no exposure to just under $600 million or nearly 12% of our total portfolio at quarter end.For quite some time, we have been cautious about Agency RMBS due to its high sensitivity to interest rate volatility and its convexity profile. Previously, we saw more attractive investment opportunities in other areas of the mortgage market. However, in the second quarter, the Agency mortgage market provided a better entry point. With the more attractive opportunities to invest in Agency RMBS and in combination with our equity raise, we were able to leverage-off the larger Western Asset platform and quickly re-establish a meaningful position in this sector of the market.We also added $500 million of Agency CMBS to the portfolio as we continue to see attractive risk-adjusted returns in this sector. We invested $137 million on the credit side of our portfolio, primarily in the structured markets, through investments in both Non-Agency CMBS and GSR Risk Transfer Securities on the residential side. And while we invested in a $50 million Commercial Whole Loans, we continue to be active in the Residential Whole Loan, mainly non-QM mortgages originated by our growing base of partners.Although we did not close any Residential Whole Loan transactions in the second quarter, we do expect to close some transactions in Q3. It should be noted that our ability to invest in such a large amount of capital in a very short period of time is reflective of our access to Western Asset's global platform, providing WMC the scale to not only identify attractive opportunities, but also to source, structure, underwrite and manage these investments. This is something that we cannot do as a standalone mortgage REIT.In summary, 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 value. Our differentiated investment strategy is based on holding a diversified portfolio of loans and securities that offer what we view to be the best risk-adjusted returns over our investment horizon. We believe this approach is the best way to pursue our objective, while continuing to enhance shareholder value.With that, we will open the call up to your questions. Operator, please go ahead.

[Operator:]

Thank you. [Operator Instructions]. The first question comes from Trevor Cranston with JMP Securities. Please go ahead.

[Trevor Cranston:]

Hi. Thanks. Good morning. Congratulations on a nice quarter. First question on the capital deployment during the quarter. I guess looking back over the last few -- you guys have been pretty consistently able to acquire good volumes of resi whole-loans. Just curious if you could elaborate on why that didn't happen this quarter? If it was primarily due to your views on relative value or if there were other factors within the market such as lack of supplier, increased competition, just generally interested in your comments around why that fell off this quarter?

[Harris Trifon:]

Sure, thanks for the question, Trevor. The reason for the drop-off, it was a combination of a few different factors. One was, we were actively working on completing our inaugural securitization which we talked about during the comments. That was an enormous endeavor that spent not just efforts from the investment team but also Lisa’s team as well which took a lot of time in effort. The second thing was, to your point, we have observed over the last couple of months an enormous amount of competition and new capital coming into that sector which has compressed margins, and therefore, made the relative value proposition a little less attractive on the margins. Does that help answer your question?

[Trevor Cranston:]

Yes, that does. I guess -- so related to that I guess when you guys are looking at your opportunity set today, I mean can you talk about how that opportunity stacks up versus the Agency market in particular or the CMBS market as well?

[Harris Trifon:]

Sure. Trevor, as you recall throughout many of these conference calls and follow up conversations, we have an active relative value approach to how we manage the portfolio of WMC. And non-QM while we’re constructive on the sector and we think it has enormous benefits to our portfolio and we continue to be actively engaged and involved in the sector, clearly over the last couple of weeks and months, markets have been extraordinarily fluid and dynamic. And relative value proposition in all of these sectors, whether it’s Agency CMBS or Agency RMBS or traditional structured products or the Whole Loan that we’re looking at in the non-QM space on the residential side and some of the commercial real estate related opportunities, it changes day-by-day particularly in an environment like this.So as we discussed during the call, we’ve been a little bit -- we favored a little bit more heavily the Agency side of our portfolio over the last couple of months. So we continue to find very interesting investments on the credit sensitive side of the ledger. We executed on a number of those in the second quarter and we continue to find pretty interesting opportunities this quarter as well.

[Trevor Cranston:]

Markets have obviously been pretty volatile recently. I was curious if you guys could share any color you have with what you’re seeing particularly within the credit market, if you’ve witnessed any spread widening within either the resi or the CMBS sectors? And if you could also maybe comment on how that might have impacted book value particularly so far in August?

[Harris Trifon:]

Sure. We’ve seen a very limited amount of spread widening for CMBS and RMBS sectors over the last couple of months. Obviously the last few days have been pretty extraordinary in terms of the magnitude of the market movements that we’ve seen both in treasuries as well as the equity market.So we have seen a very modest amount of spread widening. However, that spread widening has been very well contained and actually has been much less than what we’ve seen in the corporate credit markets for example. So we continue to think that there’s some interesting opportunities on the credit side, both in securities form as well as in Whole Loan form, both on the commercial and residential side. We don’t anticipate at this time to see a very meaningful amount of spread widening in the traditional structured product market. We've been encouraged by some of the new deals that have priced over the last week or so both in CMBS as well as RMBS and just the overwhelming amount of demand for securities, particularly the most subordinate securities and those capital structures. So, we continue to be broadly constructive on the markets while recognizing that we’re in a period of heightened volatility and we're managing the portfolio accordingly.

[Lisa Meyer:]

And Trevor, I just wanted to on our book value. Our book value since quarter end has been relatively flat to slightly down. And in September when we do our dividend release, we will announce our August book value.

[Trevor Cranston:]

Okay. That's helpful. And then last question from me related to the securitization that you guys were able to complete. Were there any deal expenses associated with that in the income statement and can you also say if those were part of the core EPS calculation this quarter as well?

[Lisa Meyer:]

So, yes. There were expenses related to that. They were approximately about $5.6 million in expenses and those expenses are actually capitalized and they're amortized as deferred financing costs over a five year period.

[Operator:]

Our next question will be from Eric Hagen with KBW. Please go ahead.

[Eric Hagen:]

Hey. Thanks. Good morning guys and congrats on getting that securitization completed. That was really nice to see. On that securitization, is there return of leverage on the retained tranches of the deal? And it’s just a little hard to tease apart if that might be levered or if there’s repo just supporting new assets that have been acquired since you did that deal?

[Lisa Meyer:]

There is no turn of leverage on the retained portion. The way that structure is set up is set up as a CMO structure, not a REMIC. So based upon that structure, we cannot encumber those positions.

[Eric Hagen:]

Interesting. Okay. And …

[Harris Trifon:]

I would just add to that too. The amount of structural leverage that are embedded in those securities, not only there’s a restriction that Lisa just mentioned from the investment team’s perspective, it is not our view that it’s appropriate to put additional leverage on those securities.

[Eric Hagen:]

Got it. Okay. And since you're not levering the retained tranche on whereas I think some other mortgages RIETs that are active in the market are, what is the levered return that you expect on that deal?

[Harris Trifon:]

We expect mid-teen IRR on the package of securities that we retained on that deal.

[Eric Hagen:]

Got it. And then sticking with the deal, you guys are obviously holding a fairly concentrated piece of credit risk. And so, the mark-to-market at least appears somewhat high. But if you guys intend to hold that bond for the life of the security then the mark-to-market is really effectively noise, and your total return will be the book yield that you -- that kind of mid-teens return you just talked about. I just want to make sure I'm thinking about that correctly and if I’m thinking about it incorrectly, can you just guide us to what the biggest inputs are that are going to drive the mark-to-market on that?

[Lisa Meyer:]

No, I believe, you are thinking about that correctly.

[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:]

Thanks everyone 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.