Western Asset Mortgage Capital Corporation
Q3 2019 Earnings Call Transcript

Published: 6 Nov 2019

[Operator:]

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

[Larry Clark:]

Thank you, Eely. 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, 2019. The company issued its earnings press release yesterday, 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 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 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 turn the call over to Jennifer Murphy. Jennifer?

[Jennifer Murphy:]

Thank you, Larry. Welcome everyone. I'm pleased to report that we delivered another quarter of solid performance despite a market that continues to exhibit increased rate volatility.We generated GAAP net income of $0.37 per share for the third quarter and core earnings of $0.28 per share for the quarter and $0.91 for the first nine months of the year. The company's book value increased just under 1% in the quarter, despite the volatility in fixed income markets.Our differentiated strategy of holding a diverse portfolio of credit sensitive residential and commercial real estate assets complemented by our investments in mostly Agency CMBS continued to largely balance our portfolio and mitigate the interest rate risks that impacted a number of other reads this quarter. This was the main driver of our strong book value performance.The book value increased together with our dividend provided our shareholders with an economic return on book value of 3.8% for the quarter, and 10.3% for the first nine months of the year. Our core earnings were down modestly from the second quarter primarily due to heightened volatility in the repo market, it temporarily impacted our costs of funds. That being said, our quarterly core earnings have been relatively consistent over the last three years, where they've averaged just over $0.33 per share, which averages higher than our quarterly dividend of $0.31 per share over that same time period.We're comfortable with the earnings power of our portfolio currently, and continue to find attractive investment opportunities as Harris is going to talk about.As we’ve discussed in the past, our dividend decisions in consultation with our Board reflect our long-term view of the earnings power of our portfolio rather than the level of core earnings in any given quarter. We paid a consistent dividend for 14 quarters and stability in our dividend continues to be an important corporate goal for us.I'm also pleased to report that in August, we issued an additional $40 million of our six and three quarter percent convertible senior notes due in 2022, allowing us to further invest in attractive assets. We believe this financing is an attractive source of longer term capital, and we expect the assets are adding to contribute to the earnings power of our portfolio in coming quarters.In addition, this financing supports our long-term goal of growing the company to achieve increased scale, which we believe will also benefit our shareholders over time. Our investment team was quite active again during the quarter, selling over $560 million in Agency MBS and redeploying the capital with the majority going into credit sensitive investments.This investment activity similar to our past quarters is reflective of our active management approach. During the quarter, we made a number of investments where we were able to leverage the western asset investment platform to gain access to opportunities that we would not have as a standalone mortgage rate. This included investments where we've developed strategic relationships with residential and commercial mortgage loan originators, to understand what we're looking for and are able to provide us with attractive opportunities that meet our disciplined investment criteria.So in conclusion, we're very pleased with our ongoing strong financial results. We've assembled a diversified portfolio of residential and commercial assets. And we've remained focused on our investment and operational execution. That better enables us to deliver strong and consistent returns to shareholders.Our performance is a testament really to the efforts of the entire investment team, headed by Harris Trifon, our Chief Investment Officer and Sean Johnson, our Deputy Chief Investment Officer and demonstrates the effectiveness of the strategic initiatives that we've been implementing over the last two years.With that, I'm going to turn the call over to Lisa Meyer. Lisa?

[Lisa Meyer:]

Thank you, Jennifer. This quarter proved to be another challenging quarter with significant interest rate volatility. However, despite the turbulent market environment our book value increased modestly to $10.60 and we generated an economic return on book value of 3.8%. The key contributor to our ongoing strong performance is our diversified investment portfolio, which balances mainly Agency CMBS and credit investments with both residential and commercial loan exposure.As Jennifer mentioned, and Harris will provide more details we were again quite active during those quarters, rotating out of securities that were fully valued into investments that we believe offers better relative value. We continue to shift the mix of our portfolio to more credit investments, selling $562 million of Agency MBS and reinvesting $327 millions of those proceeds into a combination of non-Agency CMBS, commercial loans and residential home loans.In the quarter, our portfolio generated net interest income of $19.3 million inclusive of hedging costs. Our credit sensitive investments contribute 79% to that total, compared to 72% in the second quarter. Our annualized net interest margin in the quarter was 1.69%, down 45 basis points from the last quarter. The decline was a result of a low weighted average yield on our portfolio combined with a higher effective cost of funds, inclusive of our net hedging costs.We generated net income $19.7 million or $0.37 per share and core earnings of $15 million or $0.28 per share. And as Jennifer mentioned, our core earnings was down modestly from the second quarter, mainly due to increased volatility in the repo market. Although short term interest rates declined, in third quarter we did not experience a parallel build decrease in repo rate. Resulting in a higher effective cost of funds.We have to actively stagger our repurchase agreement maturity to mitigate our exposures to the volatility in the market. In the fourth quarter, the repo market has begun to stabilize. So we expect to see less of a negative impact in core earnings. At September 30, we had $2.5 billion in repo borrowings under 20 of our 33 master purchase agreements and $397 million outstanding under our longer term financial facility. We continue to evaluate additional traffic sources of financings.We continue to operate with a significant degree of interest rate protection from our repo refinancing from our interest rate swap position. At quarter end we held interest rate swaps with the net notional value of $2.5 billion, covering over 86% of our outstanding variable rates debt. The next duration gap on our agency portfolio was 0.3 years. Our leverage ratio was 5.4 times at quarter end, excluding $1.5 billion of non-recourse debt, which was down from 5.6 times at June 30, 2019.As Jennifer mentioned, we issued an additional $40 million of 6.75 convertible senior notes, maturing in 2022, allowing us to further invest in attractive assets. Overtime, we expect our adjusted leverage ratio will vary depending on the mix of our agency and credit sensitive assets in the portfolio.With that, I will now turn the call over to Harris Trifon. Harris?

[Harris Trifon:]

Thanks Lisa. The third quarter proved to be another quarter of significant interest rate volatility. To recap, we saw a rally in the rate market earlier in the quarter with a partial retracement in September. Prepayment speeds on agency mortgages picked up due to an increase in refinance activity. And as previously mentioned, there was significant volatility in the repo market due to a variety of technical factors which caused the Federal Reserve to take measures to stabilize the market.Our view of the macro environment has not changed materially nor do we anticipate any near term changes to our broad market views. Interest rates continue to remain low with episodes of increased rate volatility. The U.S. economy continues to grow at a subdued yet steady pace, and it's modestly outperforming the slower global economy. Inflation remains well below target levels and central banks around the world continue to be accommodated in light of the slower global growth outlook.Despite the subdued pace of economic growth in the U.S., consumer balance sheets remain solid, and the robust labor market is supporting the housing sector, which continues to show positive improvement. We believe that this backdrop should continue to provide a supportive environment for credit assets. In general, we have seen an increase in compelling investment opportunities across a number of the credit subsectors throughout the course of the year. And as a result, we continue to rotate the portfolio into more credit sensitive assets during the quarter.Our investments were focused on three main sub sectors; commercial real estate home loans, non-Agency CMBS, and residential home loans. We invested $130 million into two sizable commercial real estate loans where the collateral were new luxury retail malls.These investments are very much consistent with our disciplined and selective approach to the space, where we focused on high quality properties, short duration loans and situations where we generally are able to play a significant role in shaping the credit protections and structural terms of the transaction. We also invested in over $100 million in non-Agency CMBS during the quarter.We continue to hold a favorable view of commercial real estate fundamentals in the U.S. As demand drivers remain positive and new construction continues to be muted. Both factors being supportive of increased rents, as well as improved cash flows at property levels. We continue to find interesting opportunities in the Residential Whole Loan space.The U.S. housing sector continues to exhibit positive fundamentals, a strong household formation, a solid labor market and historically attractive mortgage rates, are all contributing to ongoing demand and continued home price appreciation, albeit at a slower pace than the last few years.Against this backdrop, the supply of new homes remains somewhat constrained due to increased discipline among the public home builders, as well as tighter lending standards. While we invested $80 million of capital into this asset class during the quarter, a number of transactions that we had planned to complete in the quarter were delayed to the fourth quarter. We also believe that our Agency MBS holdings both commercial and residential provide an important balance to our credit sensitive assets and will remain a core component of our portfolio.However, we did sell about a third of our Agency RMBS holdings that we acquired during the second quarter, and these securities performed well and in our view were fully valued. We rotated a small portion of our Agency CMBS holdings during the quarter as well. These were all securities specific relative value trades as we generally continue to favor Agency CMBS over RMBS.As we have stated in the past, Agency CMBS will remain a core component of our portfolio due to with attractive risk adjusted returns, as well as its lower sensitivity to interest rate risk due to its built in prepayment protection. And also because it's more efficient to hedge relative to Agency RMBS.While Agency CMBS spreads widened modestly during the quarter, where we saw significant volatility in interest rates, it did outperform Agency RMBS, which is more strongly impacted by interest rate volatility and prepayments. Our overall performance in the third quarter highlighted why we liked this sector of the market.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 approach is built on a barbell investment strategy that pairs Agency CMBS and to a lesser degree RMBS with credit investments which includes both residential and commercial loan exposures.We maintain an active approach to portfolio management, continually seeking the best relative value opportunities within our target universe. 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:]

We will now begin the question-and-answer session. [Operator Instructions]. Our first question comes from Eric Hagen with KBW.

[Eric Hagen:]

Thanks, guys. Good morning. I noticed that you didn't mention the residential bridge loan opportunity in your prepared remarks and the portfolio has gone down a little bit over the last few quarters. And I'm just curious, why you guys might not view that as an attractive opportunity set right now, it just maybe runs a little bit in contrast with some of the commentary we've heard from other REITs? Thanks.

[Harris Trifon:]

Thanks for the question, Eric. I would say it's not that we don't find the investment opportunity attractive. It's just on a relative basis to be compared to the other favored credit assets and sub sectors that we've been investing in. Namely, non-qualifying mortgages residential loans, some of the large transitional commercial loans, as well as some of the non-agency securities that we've been active in over the course of the last quarter. It's just simply not as attractive.There's also a number of operational risk and volatility that those types of loans important to the portfolio. As a result, we thought that was better opportunities away from this sector.

[Eric Hagen:]

Okay. So it’s not been historically the credit that you dislike, it’s just the pricing in terms of like of the ones themselves that might not be that attractive to you?

[Harris Trifon:]

That’s correct. Particularly relative to say a year ago.

[Eric Hagen:]

Sure, sure, sure. Thanks. And then just on the non-QM side, how selective can you be with respect to the loans that you’re buying from your origination partners? I mean I think it’s no secret that the prepayment speeds on those loans have been relatively fast. So I'm just curious that as you guys redeploy capital into that segment, just how - again just how selective can you be? I guess that’s the question, thanks.

[Sean Johnson:]

Yeah, hey it’s Sean how are you doing?

[Eric Hagen:]

Good Sean. How are you?

[Sean Johnson:]

Good, thanks. We know the originators that we’ve been buying from continue to produce a consistent product. And so we continue to see the higher qualities coming out of them and we’ve been able to purchase more of that. It’s become a bit more competitive from a price standpoint. But we still are able to buy what we need to buy.We’ve also been adding some new originators that are producing loans in the quality sector that we care about. We’ve seen tremendous growth in sectors that are sort of outside of our target for credit and rate. And so, it feels like the whole market is growing pretty rapidly and demand as well is growing, but we still feel like we’re in a good place with our target for the sector.

[Eric Hagen:]

How would you...

[Harris Trifon:]

I would just add more broadly, even away from non-QM, the one thing that’s critically important to myself and Sean and the rest of the investment team is never to sacrifice our discipline on credit. So that simply means that, we step away from the snap here, as we were talking about a few moments ago. Then we’re completely comfortable with that.

[Eric Hagen:]

Got it, yeah that’s helpful, that definitely answers the question. How many origination partners are you guys working with on the non-QM side?

[Sean Johnson:]

We have seven active partners, and we have a couple of more that are coming on board here in the next couple of weeks.

[Eric Hagen:]

Okay, super. And then one housekeeping item, just the transactions that were delayed in the fourth quarter, am I hearing that the yield will improve because of those transactions in the fourth quarter, or will it stay relatively the same?

[Sean Johnson:]

It will stay relatively the same.

[Eric Hagen:]

Okay, thanks guys for the comments, appreciate it.

[Sean Johnson:]

Thanks for the questions Eric.

[Operator:]

Our next question comes from Trevor Cranston with JMP Securities.

[Trevor Cranston:]

Hey, thanks good morning. A follow up question on the non-QM portfolio, it sounds like there are some transactions pending for 4Q. Can you guys talk about how you’re currently thinking about the tax sourcing the securitization market again, total loans that you’re currently holding outside of securitization and how you’re viewing the profitability or financing price securitization given how far rates have come down? Thanks.

[Harris Trifon:]

Yeah, I think we still view the securitization market both within those assets as wide open. So in terms of your question on profitability our view in the attractiveness of securitization hasn’t really changed much over the course of the year, if anything it’s become more attractive as a financing option over the course of the year.And in terms of our plans, as Sean mentioned we are in the process of on-boarding a couple of new originator counterparties and so we certainly expect to be able to access the securitization market at some point in 2020.

[Trevor Cranston:]

Okay, great thank you. And then I understood from the prepared comments you guys made, the core focus of the portfolio continues to be to barbell between Agency CMBS and credit. But you did note that Agency RMBS obviously underperformed during the third quarter quite a bit. Over the short term, are you guys seeing any opportunities to add to that portion of portfolio or would you still say that within the agency sector, even given that widening in the RMBS space you continue to favor Agency CMBS near term?

[Harris Trifon:]

I think, generally speaking, we still do favor Agency CMBS, because as I mentioned earlier during the prepared comments. There are just structural advantages to that market relative to RMBS. That said, the Agency RMBS market to your point has continued to keeping up and is currently trading at multiyear wise relative to any comparable risk and certainly is much more attractive now than it has been in quite some time as a result.

[Trevor Cranston:]

Okay. Got you. And then last question. I think you guys mentioned that repo had improved somewhat in the fourth quarter. Can you provide any additional color sort of on where you're seeing the agency repo, it's currently - particularly after the Fed cut, we had recently?

[Sean Johnson:]

Yes. Hi, it's Sean. We saw pretty craziness in September. Agency repo trading close to LIBOR. And when things got a little weird it widened out to about LIBOR plus 20. Right now we're back to - for three months LIBOR - three months repo we're looking at LIBOR and LIBOR plus 2, something in that area. So it's really normalized back to where it was before the real stress has hit the market.

[Trevor Cranston:]

Okay. Great. Appreciate the color. Thank you.

[Sean Johnson:]

Sure.

[Operator:]

[Operator instructions] As we have no further questions, this will conclude our question-and-answer session. I would like to turn the conference back over to Jennifer Murphy for any closing remarks.

[Jennifer Murphy:]

Thanks, everybody, for joining us and for your questions today and we'll talk to you soon.

[Operator:]

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