Western Asset Mortgage Capital Corporation
Q4 2019 Earnings Call Transcript

Published: 5 Mar 2020

[Operator:]

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

[Larry Clark:]

Thank you, Jason. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months and year ended December 31, 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 a 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 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'll now turn the call over to Jennifer Murphy. Jennifer?

[Jennifer Murphy:]

Thank you, Larry. Welcome, everyone. We generated strong results for our shareholders in 2019 as we continued to deliver on our strategic goals, benefiting from the scale and scope of Western Asset's global platform. Total shareholder return for the year was 38.7% driven by strong investment portfolio performance and consistent dividends, which we have maintained for 15 consecutive quarters. We generated an economic return on book value of 2.5% for the fourth quarter and 12.8% for the full year, reflecting our focus on active portfolio positioning and risk management.We continue to be committed to our primary objective of generating attractive total return for our shareholders while also providing for greater book value stability. Our success in 2019 is attributable to our differentiated investment strategy designed to balance our residential and commercial credit holdings with our interest rate investments. We continue to benefit from our focus in this area and made increased volatility in fixed income markets in early 2020, and our portfolio has performed in line with our expectations.We'll provide an updated estimate of our book value when we announce our first quarter dividend in a few weeks. We generated GAAP net income of $0.23 per share for the fourth quarter, core earnings of $0.30 per share for the quarter and $1.21 for the full year. Our quarterly core earnings have been very consistent over the last three years. They've averaged $0.32 per share, higher than our average quarterly dividend of $0.31 per share over that same time period.We also were quite active in the capital markets in 2019, issuing both equity and debt. We did this to enhance the overall earnings potential of the portfolio and support our long-term goal of growing the company and gaining greater scale, which we believe will benefit shareholders long-term.In May, we completed a $49 million equity offering. And in August and December, we issued an additional $90 million in total of our 6.75% convertible senior unsecured notes due in 2020. These important steps enable us to further invest in our target assets. During the fourth quarter, we also used our at-the-market program to issue $3 million of equity. This program allows us to efficiently raise capital from time to time as market conditions permit.Also in May, we completed a securitization of Residential Whole-Loans by issuing $919 million in mortgage-backed notes. This transaction represented the company's first securitization and enabled us to finance our target assets with longer-term fixed rate financing at attractive levels.I'd like to provide an update on our recent corporate development. As you may know, two weeks ago, Western Asset's parent company, Legg Mason, entered into a merger agreement with Franklin Resources. The transaction is structured so that Franklin will preserve the autonomy of our manager, Western Asset. Therefore, we don't expect any changes to WMC's relationship with Western or its investment approach.In fact, we believe that over time, Western's affiliation with its new parent may open up additional growth opportunities. The transaction is expected to close in the third quarter of this year. In conclusion, our shareholders benefited from WMC's strong financial results in 2019. Western Asset's hallmark is its team-based investment approach.And WMC's performance is a testament to the work of our investment team led by Chief Investment Officer, Harris Trifon, and Deputy Chief Investment Officer, Sean Johnson. We expect our differentiated investment strategy and our focus on risk management will continue to serve our shareholders well in 2020.With that, I'll turn the call over to Lisa Meyer. Lisa?

[Lisa Meyer:]

Thank you, Jennifer. We are pleased with our strong financial results for the year and the fourth quarter. A key contributor to our performance is our diversified investment portfolio, which balances high-quality credit investments in both Residential and Commercial loans with agency mortgages. As Harris will discuss shortly, we were very active during the quarter.We acquired $479 million of credit investments by rotating out of security that we believe were fully valued and by deploying the proceeds raised in the capital markets. During the quarter, we generated net income of $12.5 million or $0.23 per share, and our core earnings plus drop income was $15.8 million or $0.30 per share. Core earnings may fluctuate from quarter-to-quarter. However, the long-term earnings power of our portfolio has enabled us to pay a constant dividend for 15 consecutive quarters.Our portfolio generated net interest income of $18.7 million, inclusive of hedging costs, which is an increase from $18.4 million in the third quarter of 2019. Our annualized net interest margin in the fourth quarter increased slightly to 1.72% from 1.69% in the third quarter. The increase was a result of higher yield on our portfolio and only a modest increase in our effective cost of funds.At year-end, we had $2.3 billion of repurchase agreement borrowings under 21 of our 34 master repurchase agreement and $536 million outstanding under our longer-term financing facility. While there has been some recent disruption in the overnight repo market, we are not affected by this. Our repo financing is done at longer maturity. We continue to have adequate access to this market, and we are actively managing our counterparty and repo maturity.In 2019, we added five financing counterparties and still have a number of new potential lenders that are interested in financing our investment. That being said, we are closely monitoring the situation. As of December 31, our recourse leverage was 5.4x, consistent with the third quarter. Our objective is to remain relatively stable book value while generating core earnings sufficient to support our dividend.We continue to manage our leverage to balance these two objectives. In addition, over time, we expect our adjusted leverage ratio will vary upon the mix of our agency and credit assets in the portfolio. We continue to operate with interest rate protection on our repurchase agreement from our interest rate swap position. At year-end, our net duration gap on our agency portfolio was slightly positive at a little under one month.With that, I will now turn the call over to Harris Trifon. Harris?

[Harris Trifon:]

Thanks, Lisa. Before discussing our investment activity, I would like to spend some time talking about the recent market volatility and its impact on interest rates and spread sectors. Increasing concerns surrounding the coronavirus has resulted in significant equity market volatility. And during the first two months of 2020, we have seen outsized moves in both U.S. treasury yields and U.S. credit spreads. However, spreads on our investments have performed in line with our expectations.In January, deposit market environment benefited our book value, but the latter part of February was challenging and has largely offset the earlier gains. Our current macro outlook remains generally the same with the exception that our global GDP views have been notched down somewhat given concerns about the impact of the coronavirus. However, we believe that the U.S. will continue to be a bright spot relative to the global economy as it has consistently shown an incredible amount of resiliency even in light of weaker growth around the world.The Fed remained very accommodative and ready to support the economy as evidenced by the 50 basis point cut in rates this week with additional cuts priced in, and central banks around the world adhere to be following suit. While we can't predict when the markets will become highly volatile or when the economic cycle will turn, our focus on higher-quality collateral that backs our credit investments, coupled with our interest rate investment strategy, is designed to perform under a variety of economic scenarios.We have assembled a balanced portfolio of high-quality mortgage assets on the credit side and combine them with interest rate-driven securities that have structural protection against prepayments. By employing this approach, we believe that we're able to mitigate the two primary risks faced by mortgage REITs

[Operator:]

[Operator Instructions] The first question comes from Eric Hagen from KBW. Please go ahead.

[Eric Hagen:]

Hi. Good morning, guys. Thank you very much. I’m sure you guys can probably predict that I want to ask a little bit more about the market recently. Can you just share how pricing and spreads have behaved for your two anchor assets, right, the agency DUS and the non-QM? I know that you mentioned some – there’s been some spread widening in the market. But has the spread widening been on a credit-related basis? Has the credit assumptions weakened in the market? Or is that really just a function of the fact that benchmark rates have decreased rapidly? Thanks.

[Harris Trifon:]

Hi, Eric. Good morning. Thanks for the question. As I said during my prepared remarks, spreads have moved in line with our expectations. I think your latter point was spot on in that the market has not yet changed nor have we, our expectations for the underlying credit performance of assets. So the spread widening that we’ve seen in the market thus far has largely been a function of the sharp move lower in benchmark rate levels as well as the increased volatility and risk aversion that’s associated with that.

[Eric Hagen:]

Okay. Any way you can get kind of specific with spread levels on DUS and agent – excuse me, non-QM?

[Harris Trifon:]

Sure. Starting first with non-QM, and I would actually extend it to commercial loans as well, we have not observed up unto this point any material shift in pricing. If anything, what we’ve seen is pricing continuing to hold firm and some limited number of cases actually moving up. On the Agency DUS side and Agency mortgages more generally, we certainly have seen pressure on the market as rates have moved sharply lower to all-time lows.So on the Agency RMBS side, of course, prices have been impacted largely as a reflection of increased concerns about much higher prepay rates going forward. And on the Agency DUS side, it’s largely been a function of the high dollar prices given the move lower in rates. So we certainly have seen some pressure, I would say, so far, anywhere from 10 to 20, 25 basis points on the Agency DUS is what we’ve seen.

[Eric Hagen:]

Okay. Got it. So any – so the retracement in your book value during February appears to be mostly a function of the widening in DUS because that’s where you’re hedged. Whereas the credit, while it’s widened hasn’t necessarily – the price hasn’t changed, that hasn’t necessarily driven a retracement in your book value. Am I sort of correct in assuming that?

[Harris Trifon:]

Yes, that’s correct.

[Eric Hagen:]

Okay. Got it. On the hedging side, it seems like the reduction to your hedge ratio last quarter should allow you guys to benefit relatively quickly from the Fed’s cut earlier this week. The question is whether you guys have made any further changes on the hedging side and what’s your best estimate for how your cost of funds will change with respect to the fact that the Fed did cut this past week.

[Harris Trifon:]

Sure. Well, as you know, Eric, as we’ve discussed on this call over the last few quarters, we do actively manage our duration profile and, by extension, our swap portfolio. That is something that’s ongoing, particularly in environments like this, where there’s an enormous amount of volatility and markets are extraordinarily fluid. So I think the changes that you observed in the fourth quarter are largely a reflection of our active management of the portfolio.In terms of your question on cost of financing, certainly with the surprise 50-basis-point cut by the Fed earlier this week and our expectation of continued Fed cuts going forward, we expect to see the cost of our financing continue to go down, which is largely what we’ve seen over the last few months. But obviously, we expect an accelerated pace of those declines.

[Eric Hagen:]

Okay. Got it. Thank you. And then the long and short TBA positions, I realize it’s a net neutral. But what coupons are those in? And can you discuss how dollar roll profitability has changed so far this year, especially in light of the fact that – just given all the volatility over the last two weeks? Thank you.

[Harris Trifon:]

Most of our positions were in 3s and 3.5. But again, we’re obviously actively trading in the market, and so there are a number of coupons that we’re using to take positions, both long and short in the marketplace. In terms of the dollar roll, obviously, given the fluidity in markets, it’s moved around quite a bit. Most of our exposure continues, however, to be sort of in the belly of the coupon stacking, 3s and 3.5, 3.5.

[Eric Hagen:]

Okay. Has the roll improved, though, over the last two weeks? Or has – just any color there would be good.

[Sean Johnson:]

It’s Sean. Yes, it’s improved on a nominal basis. Obviously, everybody has to recalibrate their expected speeds going into future months given where rates are right now. But from a nominal basis, roll pricing has improved.

[Eric Hagen:]

Got it. Thank you very much for the comments, guys. Appreciate it.

[Harris Trifon:]

Thanks, Eric. Have a good day.

[Operator:]

[Operator Instructions] The next question comes from Trevor Cranston from JMP Securities. Please go ahead.

[Trevor Cranston:]

Thanks. Good morning. Follow-up on the question or the comments you made about the spread widening you’ve seen so far in February. Can you comment on sort of how you guys are thinking about prioritizing sort of marginal investments today if it’s the most attractive opportunities to you? Might be in the agency CMBS market or non-agency CMBS. Or curious sort of how you’re – where you’re deploying capital and how you’re thinking about that right now? Thanks.

[Harris Trifon:]

Good morning, Trevor. Yes, certainly, the opportunity set is pretty varied at this point just given, as I said before, the fluidity in market. We continue to like the relative value propositions that our targeted asset classes, particularly on the credit side offer, namely non-QM residential loans as well as certain types of commercial loans. So we continue to be very actively engaged with the marketplace there and have a significant pipeline of investments.On the rate-sensitive side, as I said a moment ago, Agency DUS spreads have certainly been under pressure. That sector looks much more interesting from a relative value perspective. At the same time, Agency RMBS has certainly cheapened up, continue to cheapen up, and we’ve been more actively we’ve been more actively engaged in that market as it relates to WMC than we have been historically.

[Trevor Cranston:]

Okay. That makes sense. Then you also commented that you haven’t seen a material change in spreads on the non-QM loans or commercial whole loans. Can you provide any commentary on sort of what you’ve seen? Or any color you’ve heard on the securitization markets, particularly as it relates to the non-QM side? And if you’d expect the spread widening we’ve seen in other markets to maybe impact the profitability or viability of securitizing loans in the near term anyways?

[Harris Trifon:]

Sure. We of course have seen some very modest spread widening in non-QM and just structured products in general. However, the vast majority of that, we would attribute to just general risk aversion as a function of the increased volatility that we’ve seen in macro risk market. Our expectation right now, however, is that the ultimate execution on a non-QM securitization has not changed materially. And so it’s still an outlet that we think offers an incredible amount of value and one that we expect to utilize going forward.

[Trevor Cranston:]

Okay. Appreciate the comments. Thank you.

[Operator:]

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:]

Thank you, everyone, for joining us today, and we look forward to updating you again soon.

[Operator:]

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