Western Asset Mortgage Capital Corporation
Q3 2017 Earnings Call Transcript

Published: 8 Nov 2017

[Operator:]

Good day and welcome to the Western Asset Mortgage Capital Corporation Investor Call and Webcast for the Third Quarter 2017. All participants will be in listen only mode. [Operator Instructions] Now first, I'd like to turn the call over to Mr. Larry Clark, Investor Relations for the company. Mr. Clark, the floor is yours sir.

[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 September 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 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. And welcome everyone. We appreciate you joining us. I'm going begin with some opening comments. Lisa Meyer, our Chief Financial Officer will then discuss our financial results and then Anup Agarwal, our Chief Investment Officer is going to provide an overview of our investment portfolio and outlook. After our remarks we will open it up open it up for a brief Q&A. I am pleased to report we delivered another quarter of solid performance generating an economic return on book value of 5.2% and bringing our economic return for the first nine months of the year of 2017 to 15%. As we have noted during previous calls, our primary goal is to provide our shareholders with an attractive dividend that is supported by sustainable core earnings plus drop income as well as provide potential for higher total returns while maintaining a relatively stable book value. During the third quarter, we again achieved that goal, generating solid and what we believe to be sustainable core earnings declaring attractive dividend which has been stable for the last six quarters and posting an increase in our book value. Our third quarter performance reflects the benefits of the portfolio repositioning that we began in December 2016.The restructuring of our hedge portfolio in the second quarter of 2017 and our long-term strategy of investing in a diversified portfolio across a number of sub sectors of the mortgage market. As many of you know, WMC's manager is Western Asset Management Company which manages over 435 billion in assets. Western Asset's scale makes it an important trading partner for many of the world's largest broker dealers and banks, which gives our investment team access to real estate related opportunities, originations and financing. In our view, our manager Western Asset's scale and scope is our competitive advantage. Our WMC team is deeply connected to Western Asset and Western Asset is deeply committed to WMC's success. As a result, WMC can draw on the breadth and the depth of Western Asset's relationships, team and global platform. Our corporate goals focus on providing WMC the benefits of best in class investment and risk management capabilities, the operational excellence and efficiencies of a scaled firm and access to the investment, financing and other strengths of a large global fixed income manager. I am also pleased to report that in early October we completed $115 million offering of 6.75% convertible senior notes due in 2022. We believe that this financing is an attractive source of longer term capital which should enable us to increase the earnings power of our portfolio in the coming quarters. In addition, we expanded our institutional investor base with the addition of several new investors to our company and we welcome them as long-term partners. As we have discussed each quarter our dividend decisions in consultation with our board reflect our long term due of the earnings power of our portfolio. This approach has allowed us to pay a consistent dividend for six quarters and stability in our dividend continues to be an important corporate goal for us. So, in conclusion we have built a diversified portfolio of residential and commercial assets and we put considerable effort into fine tuning our investment and operational processes and execution to better enable us to deliver strong and consistent results to our shareholders. As you can see from our results this quarter and year-to-date, we believe these efforts are paying off. So, with that I am going to turn the call over to Lisa Meyer, to discuss our third quarter results. Lisa?

[Lisa Meyer:]

Thank you, Jennifer. We are pleased with our continued strong performance for the third quarter. We generated net income of 22.8 million or $0.54 per share. Book value increased 2.3% to $10.88 per share. This is a third consecutive quarter of book value appreciation, generating a strong economic return of 15% for the first nine months of 2017 and 5.2% for the quarter. A detailed book value schedule has been provided on page 18 of our investor presentation. Core earnings plus drop income for the first quarter $13.5 million or $0.32 per share. We generated solid and what we believe is sustainable core earnings that has enabled us to declare an attractive dividend of $0.31. Our dividend has been stable now for six consecutive quarters. We did not record any drop income for the third quarter. The lack of drop income for the quarter reflected our view that the environment for holding Agency TBAs was not ideal during the period. As Anup has said in the past, our drop income will vary from quarter-to-quarter depending upon our near-term view of Agency mortgage spreads. Our net interest income for the quarter including the cost of our hedges was 17.5 million, up from 16.8 million in the second quarter of 2017. Looking at net interest income by source, approximately 46% of it was derived from our Agency CMBS and RMBS holdings, 31% from our Non-Agency CMBS and RMBS holdings and the remaining 23% from our residential whole and bridge loans and other securities. Our investment portfolio of net interest margin declined slightly to 2.21% from 2.25% in the second quarter. The decline in our net interest margin was a result of a low average deal on our investments partially offset by a lower average cost of fund mainly due to the restructuring of hedge book in the second quarter. Our total expenses for the third quarter was $4.2 million, declined 5% from $4.5 million in the second quarter and down 12% from $4.8 million in the third quarter of 2016. The decline in our expenses in the third quarter was primarily due to lower general and administrative expenses. The year-over-year decline in our expenses was a combination of lower management fee as well as lower general and administrative expenses, particularly professional fees. The reduction in the management fee was result of the restructuring of our interest rate swap in the second quarter which significantly reduced the equity base used to calculate the fee. Our leverage ratio was 7.3 times at quarter end, which decreased from 6.3 times at the end of the second quarter. We increased our leverage to the end of the third quarter in anticipation of the convertible notes offering which closed in early October. We do this financing as equity right capital which is more efficient and issuing straight equity. It is important to mention that we view leverage on the portfolio as the whole and not necessarily by asset class. We may put higher leverage on our Agency security because they are the easiest and cheapest to finance while keeping lower leverage on our credit sensitive investment which are more costly to finance. Overtime, we expect a leverage ratio to decline as we our transition of portfolio to high of the portion of credit sensitive investments. We continue to have repo capacity in excess of our current needs, as a result of WMC's ability to tag into the resources of Western Asset. We continue to have master purchase agreements with 27 counterparties and outstanding borrowings with only 17. With that, I will now turn the call over to Anup Agarwal. Anup?

[Anup Agarwal:]

Thanks, Lisa. Our overall performance in the third quarter was driven by contributions across our holdings and reflects the benefits of our strategy of investing in diversified portfolio in number of sub sectors of mortgage market. Our Agency CMBS and RMBS holdings performed as expected during the quarter, as spreads were slightly tighter in both sectors. The credit sectors in mortgage market have also continued to perform well under an ongoing favorable environment for both residential and commercial growth space. In the credit sensitive portion of our portfolio, we remain invested across several sectors of the market primarily in residential pool and bridge loans, non-Agency CMBS, GSC, credit risk transfer securities and non-Agency RMBS. I would like to spend a few minutes discussing where we see the best relative value opportunities now and how we expect to allocate our capital over the next six to nine months. We believe that the most favorable risk adjusted return opportunities in our investible universe are into four primary sectors. Residential home loans particularly bridge loans, re-performing mortgage loans that are packaged in well-structured securitizations, commercial mezzanine loans, including junior franchise of non-Agency CMBS and Agency CMBS. Let me elaborate on a couple of these sectors where we intend to continue deploying the bulk of our capital. As you know, over last nine months we have reallocated a significant amount of our holdings into Agency CMBS which as of quarter end made up 54% of our portfolio. We find the sector attractive for a number of reasons. First the pools are issued by Fannie Mae and Freddie Mac to finance multi-family residential properties. The other line loans have built a predominant protection and therefore are less considered to interest rate risk then single-family mortgages which make up the collateral in Agency RMBS. Agency CMBS also offers a more attractive more attractive spread than RMBS due to high yields and lower effective cost of funding resulting from lower relative hedging costs. We believe that we have competitive advantage in this sector due to the advice and skills of Western Asset, not only are we able to ramp up our holdings fairly quickly, but we have the capability to directly source the securities from originators while others may have to buy this paper from investment banks which can be more expensive and could take longer to build a position. Another area of focus for us continues to be the residential bridge loans. These loans are short term in nature, generally one to three years and are used for renovating homes to be sold or held for rent. We have building a network of originators and working with them to develop underwriting guide lines that we believe give result in a pipeline of loans that will provide us with attractive risk adjusted returns. We believe these relationships are mutually beneficial to both parties, we established long term partnerships with the quality originators and they benefit from their relationship with a premier global fixed income manager, the institutional processes that we introduced to their origination capabilities results in an increased likelihood of execution. In addition, we believe we can achieve higher total returns on residential bridge loans from the use of repo financing. As Lisa noted earlier, we have relationships with numerous repo third parties, which is another benefit of having Western Asset as our manager. As our relationships with originators of residential bridge loans expand, and we see our opportunities going forward, our exposure to this asset class will steadily increase. In addition, we are looking at adding exposure to residential the performing loans primarily through junior franchise as well as junior franchise of well-structured securitizations as we believe this sector of mortgage market is also attractive. We are very 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 a relatively 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:]

Thank you, sir. We will now begin the question and answer session. [Operator Instructions] The first question we have will come from Trevor Cranston of JMP. Please go ahead.

[Trevor Cranston:]

Hi, thanks, good morning. First question on the re-performing loan opportunities that you guys are looking at. From the prepared comments it sounded like you guys are mostly looking at buying franchise from a securitization that's done by presently somebody else I guess. But can you talk about that opportunity in the sense of - is it possible that you guys would have go out there in by whole loan packages yourself and do securitization and is there any opportunity to pick up additional returns by maybe focusing on part of the market that has less like a shorter queen pay history. Or you guys more focused on in a long that have a 12 month plus queen pay history in this or good for securitization currently, thanks.

[Anup Agarwal:]

Yeah, sure that's a great question. And I think so it's - let me divide your question into two different parts. The first one kind on in terms of we generally look for paying the pools before it securitizes and then kind of buying the junior franchise. As you know there is no availability of junior franchise from somebody else's securitization generally whenever people are doing securitization for re-performing loans, they tend to keep all the junior securities. So, our approach has been that we see the pools perfectly and we look for WMC, we look to see the pools before it is securitized and that ultimately utilize the benefit of securitization our point because the way we are explaining credit in our presentation is more driven by it - it may not be under our shelf or - it may not it - we could utilize somebody else's shelf, but ultimately, we see those securitization on those loan pools to securitize when we are investing in junior classes. Because for all quality controlled and the kind of long we want to have is very much fair amount. The second question in terms of less clear pay I think could we look at those yeah, but looking at the harder part our bank tends to be obviously more cleaner pay history. And that's very much driven by two things, one our views are that variability in ultimate expectation of losses or defaults is much better for cleaner pay history versus little bit dirtier pay history. And second is overall the pricing of loans for dirtier pay versus cleaner pay had just kind of compressed quite a bit. And relatively you just don't see as most of it pick up in yield even while evaluating this portion in broader loss expectation to want us to evaluate lose dirtier paper. Did I answer to your question?

[Trevor Cranston:]

Yeah, that was very helpful. Thank you for that. Second question, I was curious on the bridge loan strategy if you could may be talk a little bit about sort of what the average loans size you guys are doing as in what the ultimate value of the property is when the loan is paid off and I am partially curious because I was wondering if you guys think that at change to the mortgage interest deduction could have any impact on the performance of that portfolio. Thanks.

[Anup Agarwal:]

Yeah, I mean - lot of these changes be including mortgage interest rate deductions, I think will have impact on a broader mortgage market by the - that our interest in bridge loans is very much driven by a very fundamental shift in mortgage market and the fundamental shift in mortgage market is, if you buy a house availability of leverage to do construction from traditional bank loans is just doesn't exist. On average - having said that, our focus for bridge loans really is in higher quality borrowers. So, you may even think about most bridge loan lenders, our focus is really care A, care B kind of borrowers so this is very seasoned borrowers. On average loan size is about $270,000 and again that is focused at slightly on the update on the better end of this spectrum interest of the loan size, much better on the incomes of the borrower kind of capabilities and again also in loan to values in terms of what people are willing to finance. Generally, there is a pretty large this portion, what people are willing to finance our focus been to be more on 50% or lesser and that is also significantly lot on the back end in terms of what the value of the property occur after on reverse could be. So, our bend tends to be on just the higher quality borrower and we are happy - we are more comfortable taking up bit lesser yield but just kind of the focusing on higher quality borrowers.

[Trevor Cranston:]

Got it. Last question, can you guys share how you are thinking about internally the outlook for interest rates and particularly the number for short term flood funds rate increase you guys are expecting over the next through the end of next years I guess. And also, how that impacts how you guys are constructing to hedge portfolio going to the end of the year. Thanks.

[Anup Agarwal:]

Sure, I mean, our views have been pretty - very much consistent. Our views are that you will be in the slower environment for a while and with likes of John Powell, we still continue to be very constructive about who will be in the slower at the moment [ph] and there will be upper grades in December and then to kind of next year, but will be in its very slow growth, kind of environment and that's very much driven by how we are positioned in the portfolio. If you look at our overall duration, we are pretty close to flat, kind of our focus for overall towards standing just safer versus Agency RMBS, there still is kind of a view that, it will be - that environment will be normally constructive for the paper which tends to, which tends to - which still has a virus spread in alternative to Agency RBS. That's only why we continue to grow home loans and to some of the credit risk paper because with the constructive broadly for risk characters especially related to housing.

[Trevor Cranston:]

Okay, I appreciate the comments, thank you.

[Operator:]

Next, we have Richard Shane of J.P. Morgan.

[Richard Shane:]

Hi guys thanks for taking my question this morning. So, when we look at the financials, I think two things stand out, one is that you enable to establish stability around the dividend and second that you've established stability in the last three quarters around book value? I like to talk about the book value trend a little bit. On one end, we can take here and say hey, this is a great trend, on the other it's been during a period of militantly low volatility. So, it's hard to sort out what's the cause here? Is it a strategic and statical shift or is it just the market is giving you that opportunity? And what I'd love to discuss is, what are the strategies, what has been put in place so that if we eventually enter another period of volatility that we can expect that book value to remain stable.

[Jennifer Murphy:]

I guess I'll just talk about a couple of common trick, thank you for your question. You're right that book based stability is a corporate goal for us. It's so focused for us, and I would say, I think Anup can talk about some of the things he's doing in the portfolio that are meaningful to your question and then I think give us components that we have really made a change here in the way we are approaching the portfolio. But, the main thing I would mention to you is, we have much more active engagement between our investment and risk team to help manage not only the returns of the portfolio, but the risk profile of the portfolio, so that we are balancing those things well. And, one of the power of the expense reductions we've made and the restructuring of the H portfolio, is it's given Anup and his team Sean Johnson and other senior people on our team, the ability to think about the portfolio in ways that really balance risk and return better going forward. Anup do you want to add to that.

[Anup Agarwal:]

Yeah, actually, thanks Jennifer. I think thanks for the question though. But there are a couple of things I would kind of highlight forth by, you're right the market sentiment has been very constructive, but I think you've also seen our portfolio, which is different than lot of other market participants. You've kind of seen a pretty sizeable growth in Agency CMBS. And that was very well designed that our user, even with rate volatility around we just believe that Agency CMBS will be significantly less volatile because of the pre-payment help these feature and second is the growth of home loans, kind of tend to be significantly less volatile. As well as when you try to look at even our home loan for example, again that tend to very low, less volatile even in very straight forward environment. And we are keeping kind of the curate duration pretty flat but, it will be started between growing other segments a lot. And I think that will be our continued approach, that we will look for opportunities where we are able to find segments which will have significantly less volatility. So, whether you think of an environment where the current slams more. And, in that environment you can currently have prepaid senior per Agency RMBS but in that same world you have less oriented Agency RMBS, just simple because you have a prepaid therapy associated with it. Second if you talk to different market person, then you can take it out of the way, you can construct, if what happened to the rates, kind of the company is doing lot better and the rates is deeper. Even in that environment, again you can see the Agency RMBS market to widen little bit, but if the nature hired, but, Agency CMBS actually was hiding just simply because you cannot have the people therapy, these are all borrowed for investing in properties to rent it out, so, this is multifamily. Similarly, on our bridge loan opportunity or our non-care or some of the other home loan endowers we continue to add to our growth. Again, those tend to be very stable from book value and stability and at the same time our commitment to have a table dividend yield. So, those are the things which I will highlight in the package talk, forever about kind of all those things they're doing, but kind of in summary those are the things we're doing.

[Richard Shane:]

No, that's a great way to answer. And ultimately, I think establishing that stability in a more bolder environment, you can demonstrate that stability in a more bolder environment will lead to, hope investors evaluate more stuff like that, I mean, we continue to trade into discounted block. I think that's a reflection at this point over that history in proving yourself overtime, that's ultimately the opportunity. You know, in my mind the low volatility environment that we've been through in the last year has provided it lowered the cost of, were you positioning that portfolio, lower the cost of reducing that volatility. And it sounds like you guys could embrace those changes.

[Jennifer Murphy:]

Rick absolutely, I think I would add to, I think you know our goal is to give our investors both the equity shareholders and also the convertible note holders, an excellent investment experience with us overtime. So, all things considered, so we are focused on all aspects of that, of value, dividend, how we manage the portfolio etcetera. So, that's overall our goal is to give investors a really strong experience.

[Richard Shane:]

Got it, appreciate that. Thanks guys.

[Operator:]

[Operator Instructions] At this time it appears that we have no further questions. We are going to conclude our question-and-answer Session. I will now like to turn the conference call back over to Ms. Jennifer Murphy, Chief Executive Officer for any closing remarks. Ma-am?

[Jennifer Murphy:]

Thank you, Mike. And thank you everyone for joining us today. Have a terrific day.

[Operator:]

And we thank you Ma-am and to the rest of the management team also for your time today. The conference is now concluded, at this time you may disconnect your lines. Thank you, again. Everyone take care and have a great day.