Western Asset Mortgage Capital Corporation
Q1 2017 Earnings Call Transcript

Published: 6 May 2017

[Operator:]

Welcome to Western Asset Mortgage Capital Corporation's First Quarter 2017 Earnings Conference Call. Today's call is being recorded and will be available for replay begin at 5

[Larry Clark:]

Thank you, operator. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months ended March 31, 2017. We issued our earnings press release yesterday afternoon, and it's available on the company's website at www.westernassetmcc.com. In addition, we have 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, 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:]

Thanks, Larry. Welcome everyone, and we appreciate you joining us for the first quarter earnings conference call. I think we have some good color to add to our earnings release for you, so I appreciate you being here. I'm going to begin with some opening comments, then Lisa Meyer, our Chief Financial Officer is going to discuss our financial results, and then Anup Agarwal, our Chief Investment Officer will provide an overview of our investment portfolio and our outlook and then we will open it up to your questions. As we've said in previous calls, WMC's goal as a hybrid mortgage REIT is to provide our shareholders with an attractive dividend that is supported by sustainable core earnings, as well as to provide the potential for higher returns, while maintaining a relatively stable book value. We also have some important corporate goals which include a focus on operational excellence and the highest standards of financial reporting and disclosure. In the first quarter, we've largely completed the repositioning of the portfolio that we began in the fourth quarter of 2016 and discussed with you in our March conference call. As Anup will discuss, we've changed the asset composition of our portfolio significantly over the past six months to reduce our exposure to Agency RMBS and increase our exposure to other assets that we anticipate will offer better risk-adjusted returns, including Agency CMBS, Whole-loans and other investments. Also, consistent with our overall goals, and subsequent to quarter end, we have significantly reconfigured and simplified our hedge book in order to improve our efficiency and our effectiveness. We expect these changes will reduce our hedging costs, as well as our management fees, which will positively impact the core earnings potential of WMC, while maintaining a similar hedge profile. This will also create a more transparent balance sheet. We've included an updated swap table in our presentation and Lisa will discuss this in greater detail. Returning to our first quarter results, we're pleased with the performance that our investment team delivered during the first quarter. Our team achieved an economic return on book value of 4.8%, which compares favorably among our peers who have reported so far. We delivered these results while simultaneously repositioning our portfolio to improve risk adjusted returns. The process of repositioning the portfolio resulted in slightly lower core earnings of $0.25 in the first quarter, as we chose to forego near term interest income, in order to better position the portfolio for higher interest income going forward. We do not expect this to recur in the second quarter. While we cannot guarantee future results, we do anticipate that the combined benefits of the portfolio repositioning and the restructuring of our hedge book will both meaningfully contribute to improved core earnings potential through higher net interest income, lower hedging cost and lower fees and expenses. Our first quarter dividend remained stable at $0.31 per share for the fourth quarter in a row. This dividend stability reflects our commitment to the long term goal of generating a strong total return for our shareholders through attractive dividends, derived from sustainable core earnings, combined with the potential for appreciation in the value of our portfolio. Every dividend decision that we make reflects our view on the long term earnings power of the portfolio and our first quarter dividend declaration was no different. We continue to make progress on our corporate goals, focusing on best in class, risk and portfolio management practices, while increasing overall efficiencies throughout our operations. Our general and administrative expenses for the quarter decreased both on year over year basis, as well as sequentially, as we have been successful in achieving some cost savings. In addition, some of the portfolio changes we've made, and are continuing to make, are in part, the result of our ongoing focus on risk management and use of best in class tools and practices to determine the optimal level of risk we deploy in the portfolio, given our views of the macro environment and the various scenarios that may play out. We're pleased with our continued progress toward our overall goals in the first quarter and anticipate the impact of our portfolio and corporate initiative will contribute positively to our results in 2017. With that, I'll turn the call over to Lisa Meyer to discuss the first quarter results. Lisa?

[Lisa Meyer:]

Thank you, Jennifer. As Jennifer mentioned, we delivered strong performance in the first quarter of 2017, generating an economic return on book value of 4.8%. On a GAAP basis, we recorded net income of $20.2 million, or $0.48 per share. The GAAP income was driven by our net interest income for the quarter, combined with net realized gains in our portfolio, most notably, from our Non Agency RMBS. Partially offsetting these gains were unrealized losses on our investments and losses on our hedge positions. We generated core earnings plus drop income of $10.3 million or $0.25 per share, which is down sequentially and below our dividend of $0.31. We believe the lower core earnings, at least in part, were specific to certain actions we took in the first quarter. First, we repositioned our portfolio and sold a large portion of our Agency RMBS and non Agency RMBS holdings and redeployed our capital into Agency CMBS and Residential Whole and Bridge loans. To obtain higher yields, we chose to take a later settlement date on the Agency CMBS, which reduced our core earnings, but we believe will benefit us in the long-term. Second, we had lower drop income in the quarter than in past quarters. Drop income for the first quarter was approximately $1 million or $0.03 per share reflecting our view that the environment for holding Agency TBAs was not ideal in the first quarter. As Anup has said in the past, our drop income will vary from quarter-to-quarter, depending on our near-term view of Agency mortgage spreads. Finally, our higher hedging costs negatively impacted our net interest margins. As Jennifer mentioned, we have taken significant steps to simplify our hedge positions in the second quarter. Essentially, we reduced the gross size of our hedge book by approximately $5.2 billion, by terminating approximately $3.2 billion in notional value fixed pay swaps and $2 billion in notional value variable pay swaps and replacing the terminated swaps with $1.9 billion in notional value fixed pay swaps, including forward starting swaps of $0.9 billion, at market rates. We have a detailed table of these positions on Page 11 on our investor presentation. The importance of the restructuring is that it will considerably lower our hedge costs as well as reduce our management fee. As a result, we believe the current portfolio will generate sequentially higher core earnings. Of course the actual level of core earnings will depend on future market conditions. While the restructuring will have a minimal impact on our book value or economic return, it will result in a significant tax loss. Therefore, it is very likely that we will generate an overall tax loss in 2017, resulting in a major portion, if not all of our dividends being classified as a return of capital. We will have more visibility on the tax classification of our 2017 dividends at the end of the year and will provide an update at that time. We increased our book value by 1.8% during the quarter to $10.45, up from $10.27 at December 31, 2016. A detail of the change in book value has been provided on Page 5 of our investor presentation. Our net interest income for the quarter, including the cost of our hedges, was $13.7 million, down from $22.6 million in the fourth quarter of 2016. Looking at net interest income by source, approximately 53% of it was derived from our Non-Agency RMBS and CMBS holdings, 20% from our Agency RMBS and CMBS holdings, which includes the impact of our hedge positions, and the remaining 27% from our Whole-loans and other securities. Our total expenses for the quarter were $4.9 million, declining 4% from $5.1 million in the fourth quarter of 2016, and down 23% from $6.4 million in the first quarter of 2016. The year-over-year improvement was primarily due to lower professional fees and general and administrative expenses as we continue to review our expenses to identify opportunities to operate more efficiently. As of March 31, the estimated fair value of our portfolio was $3.0 billion, and we had borrowed a total of $2.2 billion. We continue to have repo capacity in excess of our current needs. We have master repurchase agreements with 27 counterparties and outstanding borrowings with 16. Our leverage ratio was 5.3 times at quarter end and 5.5 times when adjusted for our net TBA positions. With that I will now turn the call over to Anup Agarwal. Anup?

[Anupam Agarwal:]

Thanks Lisa. Let me spend a few minutes discussing our portfolio management during the quarter and our outlook going forward. As we entered 2017, we expected interest rates to be range bound given slow growth and low inflation, both in the U.S. and abroad. The first quarter, essentially unfolded as we expected. Legislation from the new Administration regarding fiscal and tax stimulus is taking longer than anticipated, U.S. economic growth was subpar for the first quarter and there remains a good deal of geopolitical uncertainty around the world. The Fed raised rates by 25 basis points in March, and we expect it will likely increase rates once or twice more in 2017. In addition, it has indicated that it will eventually reduce its balance sheet, particularly related to its reinvestment in Agency RMBS. As both, Jennifer and Lisa have already discussed, our portfolio benefited from the macro scenario that we had envisioned, and that has in fact played out year to date. Spread sectors, particularly in the mortgage space, have continued to perform well under an ongoing favorable environment for both residential and commercial real estate. The Agency RMBS markets were relatively stable during the first quarter but did experience some modest spread widening on concerns over the Fed's future reinvestment plans. Agency CMBS, however, slightly outperformed the Agency RMBS sector, as these bonds tend to be less influenced by what the Fed does with its RMBS holdings. During the quarter, we made some significant portfolio changes, a few of which we started in fourth quarter of 2016. One of the changes was that we continued to rotate out of Agency RMBS, into Agency CMBS. We talked about our reason for this move on our yearend conference call, which was twofold. First, the Agency CMBS that we purchased have slightly higher gross yields than the RMBS and is more cost efficient to hedge. Second, given the uncertainties surrounding the Fed's plans with its RMBS holdings, we believe that Agency RMBS spreads are likely to widen in long term. Consistent with our cautious view on Agency RMBS spreads we also held fewer TBA positions relative to past quarters, which led to lower drop income for the quarter. Our ongoing use of TBAs will vary from quarter to quarter, depending on our near term view of Agency mortgage spreads. In the credit sensitive portion of the portfolio, we sold a vast majority of our non Agency RMBS holdings as they had reached full value in our view. We also sold our entire position of non Agency IO's and inverse IO's as they had rebounded in value during the quarter. We remain constructive on the commercial real estate credit sector, favoring both lower rated CMBS, as well as commercial mezzanine loans, which we believe provide attractive carries. Our exposure to Residential Whole loans increased moderately during the first quarter. We have also added a number of Residential Bridge loans to our portfolio, which we find particularly attractive. While these loans are short term in nature, they offer compelling yields, while still conforming to our underwriting standards. So as we see opportunities going forward, our exposure to this asset class will increase. We are excited about our portfolio repositioning, as we believe that it positions us well for increased core earnings and a more stable book value. As always, we will continue to monitor the relative value of opportunities across the broad mortgage universe in an effort to generate attractive risk-adjusted returns for our shareholders. With that, we will open up the call to questions.

[Operator:]

[Operator Instructions] Your first question comes from the line of Max Maier of Wells Fargo. Please go ahead.

[Max Maier:]

First just a quick question on the swaps, on Slide 11, I only see that the pay swaps, is that net of free fee swaps? And if not, where does that fit at April 28?

[Sean Johnson:]

This is Sean. We compressed all of our swaps, so the only swaps we have now are pay fixed.

[Max Maier:]

Okay, that's helpful. And then, just more thematically, I cover mortgage servicers, mortgage insurers, single-family rental companies, and it seems like all of them have a slightly different view of what's going to happen if anything to the GSEs, and I've been on a few mortgage recalls now, but nobody has really touched on that. So I'd be curious to hear your thoughts on potential GSE reform and how that could affect your business?

[Anupam Agarwal:]

True. Max, we think that GSE reform is not, in our view, the current priority for the Administration. We think there are lots of other things which they have to focus on. GSEs have been doing very, very well and they are very profitable. I think it's something which they will deal with sometime in 2018, and Secretary Mnuchin has indicated the same.

[Max Maier:]

I would say that's somewhat similar to our views. But given the reliance in the space on Agency MBS as this government guarantees securities is highly liquid. How do you think it would change the mortgage REIT model, if that government guarantees suddenly went away and you have kind of this most drastic scenario where there's no longer an implicit government subsidy in the housing system?

[Anupam Agarwal:]

I think that's a great question Max. I think given the size of U.S. housing market, I don't think it's feasible for the government guarantee to just completely go away. We think the framework that we would expect to happen under the most likely scenario is that existing portfolios stay with some type of government guarantee and any future issuance would be, even in most plans that are being floated by whether it's Congress, Senate, or even in the past from Treasury, all being around what's the appropriate capitalization of Fannie and Freddie, but still continuing to provide that guarantee which requires to keep a healthy housing market. I think the Administration knows that the housing market is incredibly important for the economy. We think the housing market is incredibly healthy right now. So I just don't think that they will do something which will impact the broad availability of this tail insurance from government.

[Max Maier:]

Yes, I would generally agree, given the Trump administration's voter base and alliance housing system on that subsidy. Just trying to kind of get a sense of under that extreme scenario, you have to plan for everything. But anyway that's it, I appreciate your feedback and thank you on the good quarter?

[Operator:]

The next question comes from the line of Rick Shane of JPMorgan. Please go ahead.

[Richard Shane:]

If you could just sort of help us understand how you see the opportunity over the next 12 to 18 months, related to the Feds wind down of reinvestment, because for the first time in a longtime, look, I know your strategy is a hybrid strategy, but for the first time that pure agency strategy, which you guys have history in, is potentially delivering higher risk adjusted returns than the other strategies, we haven't seen that in the long time, love to hear how you're approaching that?

[Anupam Agarwal:]

Sure. It's a really great question. I think that you've seen us differentiate ourselves in the marketplaces relative to others in terms of RMBS Agency and that our views are that over the longer term, we think as the Fed starts the process of stop reinvesting its capital from its Agency RMBS, we think that, longer term, Agency spreads will widen. And this is why you have seen us actively shift actively our portfolio. You've seen two things, one is you've seen our portfolio shift away from Agency RMBS into Agency CMBS and that is greatly driven by our views that, longer term, you will see Agency RMBS spreads widen. That's one part. The second is that you've also seen us reposition our portfolio into more Whole loan opportunities, which are in three broad sectors. In Whole loans we have actively shifted to continue to grow our non QM, but also our bridge residential, bridge commercial, as well as our commercial mezz loans, very which are more carry opportunities and offer attractive risk adjusted returns. I think with a view that when broadly we think of the macro environment, it will be very much range bound with respect to rates, very benign. Looking forward, it should be very attractive for spread sectors but you could have the more idiosyncratic risk relative to Agency RMBS. And so you have seen us, relative to our peers, running with lower leverage than a lot of our peers. So that's how I'm thinking about it. In the longer run, we think that Agency RMBS will have some risk of spread widening.

[Richard Shane:]

Okay, that's all. Thank you guys and again apologize for any redundancy as you know it's been a day.