Western Asset Mortgage Capital Corporation
Q2 2017 Earnings Call Transcript

Published: 9 Aug 2017

[Operator:]

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

[Larry Clark:]

Thank you, Brian. 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, 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 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. 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. Thanks to everyone for joining us today. I'm going to start with some comments, then Lisa Meyer, our Chief Financial Officer is going to talk about our financial results, and then Anup Agarwal, our Chief Investment Officer is going to talk about our portfolio and markets and after our prepared presentation, we will open it up for Q&A. As we've said to you 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, plus drop income as well as to provide the potential for higher total returns, while maintaining a relatively stable book value. I am pleased to report that for the second quarter, we delivered on all aspects of this goal, generating solid and what we believe to be sustainable core earnings plus drop income to clearing attractive dividends which has been stable for the last five quarters and posting an increase in our book value. All of this translated into a strong economic return on book value of 4.8% which brings our economic return from the first half of the year to 9.6%. Simply put, we are reaping the benefits of our repositioned portfolio, our simplified hedge book and our focus on operational efficiencies, all of which consisted of prior commitment to best in class risk and portfolio management practices. Our second quarter performance was driven by contributions across our holdings and reflect the benefit of the portfolio of repositioning that we began in December 2016, the restructuring of our hedge portfolio in the second quarter and our long term strategy in investing in our diversified portfolio across a number of subsectors over the mortgage markets. It also speaks to our ability to draw on the team of Western Asset, our managers as well as the breadth of Western Assets global investment risk and operational platform which we view as a strategic advantage. We continue to search for types of opportunity in credit sensitive loans and securities that offer compelling risk adjusted returns and want to increase our portfolio’s exposure to these assets overtime. As we discussed in each quarter, our dividend positions us in competition with our board reflects our long term view of the earnings power of the portfolio. In consistent with this approach, in June we declared a quarterly dividend of $0.31 which is inline with the previous four quarters. As I mentioned at the outset, we believe greater stability in our dividends benefits our shareholders which is why it’s an important corporate goal for us. Over the past year we’ve put considerable focus in the tightening of our investment and operational processes and execution that better enable us to bring the full benefits of Western Assets and its team to our fellow WMC shareholders. And as I think you can see from our results this quarter, these efforts are getting traction. With that, I’ll turn the call over to Lisa Meyer. Lisa?

[Lisa Meyer:]

Thank you, Jennifer. We are pleased with the results of the second quarter. The repositioning of our portfolio and restructuring of our hedge books resulted in strong performance, generating GAAP net income of $20.7 million or $0.49 per share core earnings plus drop income of $13.3 million or $0.32 per share, a 1.8% increase in book value to $10.64 and an economic return on book value of 4.8%. Our GAAP income was driven by our net interest income for the quarter, combined with net unrealized gains in our portfolio, from appreciation across all our asset classes. Partially offsetting these gains were realized losses on the sale of certain investments and losses on our hedge positions due to a decrease in swap rates. Core earnings plus drop income was up sequentially from the first quarter and slightly higher than our dividend of $0.31. The higher core earnings was a result of a higher net interest margin and lower operating expenses, driven in part by the construction of a hedge position which occurred early in the quarter. Our drop income for the quarter was $0.7 million or $0.02 per share, down slightly from $0.03 per share in the first quarter. The lower drop income for the quarter and for the first half of the year reflected our view that the environment for holding Agency TBA was not ideal during the period. As Anup has said in the past, our drop income will vary from quarter to quarter depending on how near term view of Agency mortgage spreads. We increased our book value by 1.8% during the quarter to $10.64, up from $10.45 at March 31, 2017. The detailed book value schedule has been provided on page five of our earnings presentation. Our net interest income for the quarter including the cost of our hedges was $16.8 million, up from $13.7 million in the first quarter of 2017. Looking at net interest income by source, approximately 41% of it was derived from our agency RMBS and CMBS holding, 35% from our Non Agency RMBS and CMBS Holding and the remaining 24% from our residential whole and bridge loans and other securities. Our weighted average net interest margin increased to 2.25% from 2.01% in the first quarter as a result of a lower effective cost of funds from the restructuring of a hedge book in April. We’ve reduced our hedging cost by approximately 60% from the first quarter while maintaining our desired hedge profile. Our total expenses for the second quarter were $4.5 million, declined 8% from $4.9 million in the first quarter and down 12% from $5.1 million in the second quarter of 2016. The decline in our expenses in the second quarter was finally due to significantly lower management fees as a result of our hedge book restructuring and lower general and administrative expenses. The year-over-year decline in our expenses was a combination of lower management fees as well as lower general and administrative expenses, particularly professional fees. We continued to review our expenses to identify opportunities to operate more efficiently. Our leverage ratio was 6.3 times at quarter end and 5.8 times when adjusted for the June 27 sale of approximately 209 million of Agency RMBS that settled shortly after quarter end. We continued to have repo capacity in excess of our needs. We have master repurchase agreements with 27 counterparties and outstanding borrowings with only 17 counter parties. As the result of our hedge book restructuring in April, at quarter end we held $2.3 billion in basis swap including forward starting swap of $832 million. We provided detailed table of this positions on page 11 of our earnings presentation. 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 have mentioned on several of our previous calls, we have expected interest rates to be range bound given slow but steady growth and low inflation, both in the U.S. and abroad. The second quarter unfolded as we expected, legislation from the new administration regarding fiscal and tax stimulus continues to take longer than anticipated, U.S. economic growth is continuing at a moderate pace and despite ongoing geopolitical uncertainty around the world central banks are signalling a path towards normalization. We continue to believe that most major goal economies will experience improved growth but that remains low by historical standards. The Fed raised rates by 25 basis points in June, and we expect it will likely increase rates once more in 2017. In addition, it has essentially laid out its’ plans for reducing its balance sheet, particularly related to its holding of Agency RMBS. As both, Jennifer and Lisa have already discussed, our portfolio has benefited from the macro scenario that we had envisioned, and that has unfolded year-to-date. Spread sectors, in the mortgage space, have continued to perform well under an ongoing favorable environment for both residential and commercial real estate. Agency RMBS markets were relatively stable during the second quarter. Agency CMBS, slightly outperformed the Agency RMBS sector, during the quarter as these bonds tend to offer a slightly better carry and are less influenced by what the Fed does with its RMBS holdings. During the quarter, we continued with some of the portfolio changes that we implemented in the first quarter, specifically we continued to rotate out of Agency RMBS, into Agency CMBS. We are always evaluating our holdings within the sector and are willing to shift between Agency RMBS and Agency CMBS depending on our view of relative value between the two. Longer term, we view our Agency portfolio as a source of funds for further investing in credit side of the portfolio as opportunities arise. That being said, Agency Securities remain a large part of our overall portfolio and are like to continue to be in the near term. As Lisa mentioned, we also held fewer TBA positions relative to past quarters, which led to lower drop income, 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 remain invested across several sectors of the market particularly in Non Agency CMBS, Non Agency RMBS, GSE Credit Risk Transfer securities and whole-loans. During the quarter, we increased our exposure to residential bridge loans which we find particularly attractive. These loans are short term in nature and they offer compelling yields, while still confirming to our underwriting standards. So as we see opportunities going forward our exposure to this asset class will likely increase. In addition, we are looking at adding exposure to residential bridge performing loans or RPLs as we believe that this sector of the mortgage market is also attractive. We also remain constructive on the commercial real estate credit sector favouring both lower rated CMBS as well as commercial mezzanine loans, where we believe that spreads have room to tighten over the remainder of the year. With respect to lower graded commercial mezzanine loans, we prefer loans where we have been able to negotiate governments. We are pleased with the performance of our portfolio during the quarter and year to-date and we believe that it continues to position us well for solid core earnings and relatively stable book value. As always we will continue to monitor the relative value of opportunities across broad mortgage universe in an effort to generate attractive risk adjusted total economic returns for our shareholders. With that, we will open up the call to questions.

[Operator:]

We will now begin the question and answer session. [Operator Instructions] First question comes from Trevor Cranston with JMP Securities. Please go ahead.

[Trevor Cranston:]

Hi. Thanks and congratulations on a good quarter. First question I think last quarter when you talked about undertaking the portfolio repositioning, you talk about concerns about the Feds tapering impact on the Agency RMBS market? How that could impact spreads in that sector? What are the – I think things we’ve heard from lot of peers this quarter is that they find the Agency RMBS sector today relatively attractive just because spreads have been tighten to the extent that a lot of other structured products have over the last couple of quarters. So, can you give us an update on your view on the agency RBS sector in light of all the comments the Fed has made and what they've telegraphed about how they plan to handle the taper and a spread winding something you guys are still concern about? Thanks.

[Anupam Agarwal:]

Yes. Trevor, thank you for – look, I think great question. Our views on Agency RMBS, so that we find Agency RMBS to be attractive and I think they’re exactly right that spreads have not tighten as much as some of other sectors, but kind of as you see from our positioning my belief is that Agency CMBS relative basis, like the DUS bonds relative basis look more attractive relative to Agency RMBS. Having said that, Fed has made pretty clear about how they want to go about unwinding their balance sheet, so I’m not as concerned about Agency RMBS at this point in time. But if you think about it relative basis, relative to the cost of convexity and cost of hedging for Agency RMBS, Agency CMBS just at the current level still looks more attractive, which is why you us positioned more favorable to Agency CMBS.

[Trevor Cranston:]

Got it. Okay. That’s helpful. And then on the whole-loan side obviously there is some growth in the bridge loan portfolio again this quarter and the other whole-loans are been sort of kind of consistently around the $200 million level. Can you give us an update on sort of how the sourcing of those products is going and if you’re seeing any additional opportunities to bring in loan flow if it’s sort of expected to be consistent in the near-term?

[Anupam Agarwal:]

Yes. Look, I think on our whole-loan efforts, I mean, as we pointed out that our focus is on not only in non-QM but also bridge residential and bridge commercial. And I think you saw some growth in bridge residential. And I expect that we continue find more opportunities on bridge residential as well as bridge commercial. So I think you will continue to see growth on – I expect that we will see growth on both of those buckets.

[Trevor Cranston:]

Okay. Appreciate the color. Thank you.

[Operator:]

Next question comes from Rick Shane with JPMorgan. Please go ahead.

[Rick Shane:]

Thanks guys for taking my questions. Look, I’d like sort of delve in a little bit on the non- Agency CMC -- the non-agency CMBS, obviously a small portion of a balance sheet but a very contributor to the P&L and I’m calculating it's about a 9 plus percent yield. Could you provide some sort of background or some sort of parameters about what portfolio looks like? Because I’m assuming these are subordinated pieces.

[Anupam Agarwal:]

Yes. I mean I think look, that’s exactly right, and I think – look, it’s a combination. The non-Agency CMBS portfolio is a mix of opportunities in commercial mezz loans or commercial mezz securities, as well as some of the BB, B securities from older vintage, so more like 2012, 2013, 2014 timeframe, as well as some of the legacy securities from kind of things like CMBS AJs [ph], again opportunities we – CMBS AJs which were originated in 2006 and 2007. But I think what we continued as a property types spread across -- look our buyers has been away from retail, but overall kind of it say -- each one of these transactions where we have on written all the underlying portfolio types. What we expect kind of is the mezz part of the portfolio continues to get refinance then you will see that mezz loans continue to shrink. And we are looking at new opportunities that we can continue to invest in mezz loans. But AJ opportunity which is kind of that similar yield it just an opportunity which is continues to pay off just because as a loan gets refi from the legacy portfolio those AJs continue to factor down based on a pay offs. And the BB, B opportunities from 2014, 2015 portfolio, I mean, I think that’s a sector which is lag, so think about it that overall we kind of see the BBB market for 2013, 2014 BBB have continues to shrink from they use to be at 500, 600 over, now they are about close to 400 versus new ratio BBB are at 325. So I expect the bases -- as you have seen the basis shrink for the BBBs in legacy kind of the 2013, 2014 or call it CMBS 2.0. Similar I expect the basis for CMBS 2.0 BBs will shrink – has shrunk, but will continue to shrink. But right now where the spreads are [Indiscernible] to look pretty attractive, – because those BBs is still right now are trading in 700, high 700 to 800 kind of yield, so kind of that’s the kind of mix of the portfolio. We still continue to see -- there are still lot more room for it to tighten relative to current markets.

[Rick Shane:]

Got it. And it looks like your financing them with about -- those non-Agency CMBS securities was around 30% haircut. Do you think that over the long terms I mean look, we’re in a good period from a credit perspective, but do you think over the long term that’s the way we should think about leverage on that portfolio?

[Anupam Agarwal:]

Yes. I mean, look, I think you kind of see the non-Agency RMBS, I mean, that portfolio has – I think non-agency market continues to be very, very velvet market. If anything, look, I think given how well bid it is and how much demand it is and how much of that – and that market is shifted all to stable long-term. And that I think haircut for those will continue to – I expect that to continue to be stable and financing costs continue to go down just simply become the whole market has become very comfortable with where they should.

[Rick Shane:]

Got it. And last question, I realized that there are other folks who want to jump in here, but on that non-agency book you took a pretty significant OTTI mark. And the first footnote to explain it. And the footnote says, other than temporary impairment on IOs and IIOs coming for is derivative. Help me understand that. I mean, I try to ask question here, but I just don’t get it.

[Jennifer Murphy:]

You don’t get the IOs that are accounted for as derivatives or the OTTI, sorry, just to clarify.

[Rick Shane:]

No, I get the OTTI, I just won’t understand is that – I’m not sure I understand why – what the derivatives book is associated with that portfolio and why it move so dramatic in the context of -- why you have such a big IO or IIO position against that particular portfolio?

[Jennifer Murphy:]

I think, well, let’s flip back, so the IOs that are accounted for as derivatives, the accounted for as derivatives because the underlying cash flows are so different from the actual security, so GAAP requires us to account for those as derivatives. We don’t have a significant portion of IOs and reverse IOs in our portfolio. I think what the footnote is indicating is that included in that calculation are those securities which are normally flow to our line items on our financial statement which is your gain and loss on derivative instrument. So we’re just saying that any income or loss associated whether is it in that line item.

[Rick Shane:]

Okay. So what you’re seeing is that – in that OTTI number of 5.9 million the IO and IIO derivatives marks might be a rounding error. What is the 5.9 million mark this quarter then and that’s what I want to try to get there?

[Jennifer Murphy:]

5.9 million relates to the entire non-Agency CMBS portfolio. So as in this space sometimes if the cash flows are extended, so say, a loan is refinance and is extended, what happens is it causes an extension of that cash flow which results in an OTTI calculation or an OTTI that we have take OTTI on it. Because these flow under what we called 99/20, so there is no judgment in there, so if there is decrease in the cash flows then we are required by math just to take OTTI, so that 5.9 million is the OTTI across all of the non-Agency CMBS which include IOs, which is a small portion.

[Rick Shane:]

Okay. I won’t need to follow-up on this. Thank you, guys.

[Operator:]

[Operator Instructions] At this time there doesn’t appear to be any more questions in the queue. I’d like to turn the conference back over to Ms. Murphy for any closing remarks.

[Jennifer Murphy:]

Okay. Thank you. Thank you all for joining us today. And please feel free to call us directly if you have any questions.

[Operator:]

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