Western Asset Mortgage Capital Corporation
Q1 2016 Earnings Call Transcript

Published: 6 May 2016

[Operator:]

Welcome to Western Asset Mortgage Capital Corporation's First Quarter 2016 Earnings Conference Call. Today's call is being recorded and will be available for replay beginning at 5 PM Eastern Standard Time. At this time, all participants have been placed in a listen-only mode and the floor will be open for your questions following the presentation. Now first, I'd like to turn the call over to Mr. Larry Clark, Investor Relations for the company. Please go ahead, Mr. Clark.

[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, 2016. By now, you should have received a copy of today's press release. If not, it's available on the company's website at www.westernassetmcc.com. In addition, we're including 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 Gavin James, Chief Executive Officer; Lisa Meyer, Interim Chief Financial Officer, 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 obligations to update our forward-looking statements unless required by law. With that, I will now turn the call over to Gavin James. Gavin?

[Gavin James:]

Thank you, Larry and thank you everyone for joining us today for our first quarter conference call. I'll begin the call by providing some opening comments. Lisa Meyer, our interim Chief Financial Officer will then discuss some financial results and then Anup Agarwal will provide an overview of our investment portfolio and our future investment outlook. After our prepared remarks, we will conduct a brief question and answer session. The first quarter was a particularly challenging period for the US mortgage markets as we saw general widening in agency mortgage spreads, credit spreads and swap spreads. As a result of the wider spreads on our investments, combined with higher hedging costs, we generated a negative economic return on book value for the quarter of 7% and lower sequential quarter co-running's plus swap income of $9.5 million or $0.23 per share. The credit sensitive section of the income market experienced a downturn in January as concerns surrounding a global economic conditions and commodity prices exerted pressure on risk assets. However, as many asset classes such as equity and corporate high yield rebounded as investor sentiment improved in March credit sensitive mortgage markets lagged the border market rally. This lag negatively impacted our performance on a relative basis during the first quarter. In particular CMBS which comprises of more than 15% of portfolio significantly lagged the recovery in other asset classes. However, this appears to be more technical in nature and not driven by any deterioration of the fundamentals of the U.S. commercial state markets. We saw several highly level players without permanent capital who were large investors in CMBS forcing to liquidating their positions during the first quarter as the value of their holdings declined. This led to a temporary pricing dislocation in the CMBS market as the sudden pressure played out. As longer term institutional investors stepped into capitalized the value opportunity created by the poor selling, CMBS had started to catch up to rally in the other markets when the second quarter began. Other asset classes comprising meaningful portions of our portfolio such as non-agency RMBS and CMBS have staged a recovery in the same quarter as well. As a result we have seen a positive impact on our book value of 3% to 5% since the beginning of the second quarter. With the conditions that caused certain credit sensitive assets to lag the border market, rally is now subsiding, we believe there is still substantial runway for further spread tied to tightening out securities that will position us stronger performance going forward. With respect to our macro feed we continue to believe that we are in a lower longer interest rate environment given modest growth in the US GDP and uncertain global economic conditions. We believe the economic growth in the U.S. will be a 1.5% to 2% range for the next quarters and the federal earnings interest rate is 102 times through 2016. Given these expectations, combined with our continued positive outlook for both the U.S. Residential and commercial real estate markets, we continue to believe that credit sensitive investments represent the most attractive value opportunity within the mortgage sector. We also believe that over our longer term investment arriving, a portfolio more heavily weighted towards these assets will generate the best economic returns for our shareholders. Before turning the call over to Lisa Meyer to discuss our financial results I would like to mention that last week our board of directors appointed Lisa to serve as our Chief Financial Officer effective as of June 6 of this year. In assuming the interim CFO position in November, 2015 Lisa's demonstrated the knowledge, skills, and capabilities to effectively lead our finance team. Lisa's extensive experience in the Riverstake and Riverstake finance industries will be particularly valuable as a permanent member of WMC. Congratulations Lisa and now I will turn the call over to you.

[Lisa Meyer:]

Thank you Gavin for those kind words. I am excited to be a part of Western team and also look forward to meeting our investors and our analysts in the coming months. I will discuss our financial results for the first quarter ending March 31, 2016. Except with specifically indicated all metrics are of that day. On a GAAP basis we recorded a net loss for the quarter of $36.3 million or $0.88 per share. Our core earnings for income was $9.5 million or $0.23 per share. This compares to our core earnings plus drop income of $16.6 million or $0.39 per share with the fourth quarter of 2015. Our core earnings for the quarter were $8.8 million or $0.21 per share which is a non-GAAP financial measure and our drop income was $0.7 million or $0.02 per share. Our low core earnings for the quarter of 2016 was primarily results of a smaller investment portfolio coupled with a slightly lower growth field on our assets and higher hedged adjusted borrowing costs when compared to the fourth quarter of 2015. Our average advertised cost on our investment including agency and non-agency interest only shift accounted for as derivatives was $2.8 billion down 9% from the fourth quarter as we reduced our average portfolio leverage during the first quarter. our next interest incomes with the quarter was $21.6 million. This is a GAAP financial measure and does not include the interest we received from our interest only trip that are accounted for as derivatives nor does it take into account the cost of our interest rate swaps. On a non-GAAP basis our net interest income was approximately $4.3 million. This compares to non-GAAP interest income of $20.1 million for the fourth quarter of 2015. Our Weighted average net interest spread with the quarter of 20165 which takes into account eh interest received from our investments including our agency and non-agency interest only trips accounted for as derivatives as well as our fully hedged cost of our financing was 1.53% reflecting a 4.26% gross yield on our portfolio and 82.73% effective cost of funds. This compared to a weighted average net interest spread of 2.18% for the fourth quarter of 2015 reflecting a 4.42% gross yield on our portfolio and a 2.24% effective cost of funds. Our net yield decreased between a moderately lower gross yield on our portfolio and higher effective interest cost as I mentioned earlier. Our operating expenses for the first quarter was $6.4 million which included a $3.6 million for general & administrative expenses and $2.8 million in management fees. Included in G&A expenses is 572,000 of non-stock based compensation. Our book value per share as of March 31, 2016 was $10.90 which takes into account the $0.45 regular dividend that we declared on March 24, 2016 and paid on April 26, 2016. As of March 31 the estimated share value of our portfolio was $2.8 billion and we had borrowed a total of $2.4 billion under our existing master repurchase agreement. Our leverage ratio was 5.3 times quarter end and 6.2 times when adjusted for our net PDA position. We continue to have repo capacity in excess of our need. At March 31 we had naturally purchased agreements with 27 counterparties and outstanding borrowing with 20 counter parties. We continue to have external relationships with our bank counter parties and feel comfortable with our existing group. As of March 31, we had $4.0 billion in notional, pay fixed, interest rates swaps including forward starting swaps at $1.7 billion and $3.7 billion of paid variable interest rates swaps. Giving us a net pay fix swap position of $2.0 billion. Additionally we entered into $105 million notional value of paid fixed interest rate swaps of one year. We are comfortable with our current leverage. We will continue to adjust on implied leverage fairly quickly through these days which we believed enabled us to optimize our core earnings on our risk adjusted basis. With that I will now turn the call over to Anup Agarwal. Anup?

[Anup Agarwal:]

Thanks Lisa. Let me spend few minutes discussing our portfolio management during the quarter and our strategy going forward. As we enter 2016 we were operating with a view that a slow growth U.S. economy will persist and in uncertain global economic environment will cause the Fed to be uncertain about implementing additional rate increases. During the first half of the quarter the market appetite for risk on assets decreased dramatically as concerns surrounding global markets were heightened and lower commodity prices added fuel to the fire. This led to a rally in a treasury markets but put pressure on credit sensitive sectors as Gavin mentioned earlier. Early in the quarter we reduced our overall portfolio leverage by selling some of our holdings across most sectors and reducing our net long PDA positions. We also reduced our exposure to agency IO and inverse IO derivatives and readjusted many of our hedged positions. The net results of these swaps and market conditions led to a lower book value and our defensive portfolio actions led to lower core earnings and drop in income. With respect to our agency holdings we ended the quarter with a slightly smaller position than at the beginning of the quarter. In addition we have rotated our holdings to include a higher portion of longer duration low coupon securities given our current view for longer interest rates and our belief that they offer an attractive hedge adjusted carry, relative to other parts of agency markets. In addition we didn't find the TBA market to be particularly attractive during the quarter and therefore we have lower drop income. As we have mentioned in the past when we expect a high level of rate and spread volatility, we generally will have lower exposure to TBAs. We continued to see a high level of rate and spread volatility during the quarter which led to our tactical decision to reduce our net long TBA position. In credit sensitive portion of the portfolio, we reduced our overall exposure to non-Agency RMBS, GSE credit risk transfer securities and to lesser degree non-agency CMBS and ABS. However, during the quarter we also shifted exposure in our CMBS holdings to include a higher portion of BB and Legacy junior HHH securities as we found these securities to be very attractive relative to the entire credit sensitive fixed income universe. Since that time all of our credit sensitive sectors of mortgage markets have improved and we believe that going forward credit spreads will continue to tighten. This is a pattern we have seen occur consistently in the past and given that underlying fundamentals of U.S. Real Estate market remain favorable we believe that it will be no different this time around. With respect to our holdings in residential home loans we kept our exposure to this asset class as relatively stable during the first quarter and while asset values have held up much better than in our credit sensitive sectors of mortgage markets, we chose not to increase our exposure to home loans because of our defensive posture and tactical decision to reduce leverage during the quarter. However, that being said we would expect that overtime you would continue placing Agency RMBS in the portfolio with home loans as we continue to find them unattractive as a class. While we are not satisfied with our financial results for the quarter, we remain optimistic going forward and as we have mentioned in the past our portfolio performance in any given quarter maybe challenging but we are positioning the portfolio to perform well over a longer investment horizon. The underlying collateral on the vast majority of our investments s U.S. residential and commercial real estate. Both of these markets continue to exhibit positive fundamentals and we don't expect that to change anytime soon. With this fact to leverage I will remind you that as our portfolio becomes weighted to credit sensitive investments our absolute level of leverage will gradually decline as the required collateral levels are generally higher for credit assets versus Agency RMBS. As always, we manage our leverage opportunistically based on changing conditions in the mortgage market and as we have consistently said in the past our goal is maximize return for our shareholders. We plan on continuing to implement this strategy by holding a diversified portfolio of securities that offer what we believe are the best risk adjusted returns over our investment horizon. This is consistent with our long term objective of generating sufficient core earnings to support an attractive dividend while also maintaining a stable book value. With that, we will now entertain your questions.

[Operator:]

[Operator Instructions] Our first question today comes from Rick Shane from JP Morgan, please go ahead.

[Rick Shane:]

Hey guys, thanks for taking my question. I am curious if some of the transition in the portfolio that you have made quarter-to-date is translated into realized losses and if that is going to lower the management fee going forward? I'll be perfectly honest and perhaps a bit blunt here, book values gone down pretty substantially over the last year, the management fee has actually crept higher, I am wondering at some point if there is going to be a reconciliation because on a per share basis what investors are paying has gone up pretty substantially?

[Anup Agarwal:]

Rick, the way I think is, at this point in time all the portfolio we have held, kind of the realizes losses has really come from that if we are forced to reduce our sell some of our credit sensitive securities but that again, what you see is that we have held on to the highest yielding credit sensitive and I am very confident that the spreads will continue to tighten for it, and you have kind of seen that as Gavin mentioned in his prepared remarks that the book value is up in the range of 3% to 5% Second, let's kind of keep in mind, management fee is based on the book value than anything else. The impact is commensurate with as you see the book value improve, I think just keep in mind as we as management are very much aligned to performance of our mortgage rate, for mortgage rate I think in last year and kind of this quarter has been tough. Not just for us, last year was probably one of the toughest years for Agency market. We kind of expected that Agency spreads will widen out, they did widen out quite a bit. The start of this quarter has been tough but at the same time we are seeing opportunities which are just phenomenal on the credit side, we saw some of the CMBS during the quarter. you saw the CMBS double beat 1200 over some of the other credit sensitive products at 10% to 11% on levered deals so that is something we think they are very accretive for moving rates and in the macro environment which we outline which is low rate environment for long period of time. We think that we will be able to generate pretty attractive yield for people.

[Rick Shane:]

I hear what you are saying, and look we recognized that asset values have rebounded quarter-to-date and some of this is temporal, but the long-term trend on book value has been pretty pronounced, it was down roughly 25% year-over-year and you're right, a couple of percent -- even if 5% rebound, this quarter will certainly help but it does feel like there has been a fair amount of degradation of book value, and I understood there are opportunities out there in the market right now but I'm just wondering ultimately it's -- there are ways to reconcile that for the investors.

[Anup Agarwal:]

Look, I think it is being tough environments on hedging for agencies -- it has been tough environment for agencies and it's a tough environment for credit in this quarter but overall, I -- personally I cannot think that this is by far a great environment for all mortgage REITs. I think our shift to whole loan environment will help stabilize the book value. I think we will -- we continue to see pretty substantial opportunities on the whole loans and credit segments. So I think what you would kind of see is that, our -- is the volatility over and there is not going to be any volatility, you will see some volatility. But this low rate environment is phenomenal for any mortgage REIT including ourselves and I think given our capabilities I feel pretty confident that slowly it will recover yet. Despite 3% to 5% is pretty attractive but I don't think that is it. I think that opportunity is still even with the spread tightening. I think there is still very substantial. I just think that the spreads widen out so quickly, so fast, in very short period of time that it's showed pretty large impact and the same is true for even agencies. Yes, it's kind of -- agencies took a lot of beating last year but in this low rate environment, this is great environment for carry, it is going to be some volatility around the way, then on whole bunch of global issues still kind of out there but slowly all the central banks are reasonably kind of have the same thoughts that it will be low rate and very accommodative policy for very long period of time. And I think that on a long-term plucking of -- we are not in the business of predicting for any quarter-to-quarter but over a long period of time this should be a very accretive environment for REITs, including ourselves.

[Rick Shane:]

Got it. Okay, great. Thank you for taking the questions.

[Operator:]

Our next question comes from Joel Houck from Wells Fargo. Please go ahead with your question.

[Joel Houck:]

Thanks for taking my questions. So obviously the overall environment was -- the spread environment was the weakest in early to mid-February, I'm wondering if you can give us a sense for how much book value is down versus year-end at that period of time? And -- so we can get a kind of sense for how much tower book value swings inter-quarter that you guys are comfortable with?

[Anup Agarwal:]

I mean, this is separate question Joel, but I mean I'll give you kind of more in a framework for what we saw for credit. How about I try to answer your question by kind of giving you some idea for what the credit spreads kind of did during kind of -- at year-end to kind of January/February and how it has come back, and what has come back and what has not come back. Is that kind of reasonable to start with?

[Joel Houck:]

I think -- I mean, yes, any color you can provide is helpful but anytime -- I appreciate it's been a tough environment but just about everybody has reported in you guys are the biggest outliner, I think investors are looking -- what we're trying to understand is, is the value proposition obviously stacks below book value. And there is inherent value in what you own as you pointed out the price appreciated but if the quarter would have ended at the bottom and you would have had 20% to 25% book value to climb I don't think that type of volatility I don't think investors are signing up for. So walk me through what you want but if you have a number or at least if it was -- say it was down 20%, and say look -- we're changing the overall risk metrics that we're comfortable with that doesn't happen again because I don't think investors, retail institutions will sign-up for investing in mortgage REITs when book value can be down 11% in the quarter.

[Anup Agarwal:]

No, I think look, I think -- all those things -- there are a couple of things that you can't think about the book value being down 10% but I think keep in mind that, that is -- if you kind of look from, the total return perspective, there was a dividend of 2%. So overall as a book value, really what came through the dividend was really down 7%. The second part, I think more important of your -- for which you highlighted and I think I was kind of point to -- look I think the quarter what we faced in January/February is not a normal part and I don't expect that to have -- to occur on a consistent basis. I think the quarter was more, one of those framework but lot of assets in March, lot of the credit assets reverted back but the credit sensitive part for whether it's in CMBS, especially where we had a larger part of our book, that just did not revert back as quickly. So it kind of thinks like whether it's a legacy CMBS, junior triple As or the double Bs which we thought of huge value they just did not come back as quickly but at the same time in April, kind of -- that certainly what we have seen that's quite timing and ultimately those of the lagging positions which kind of have reverted back. Now how much more to go -- we still think there is a pretty significant room from that point on. And I kind of think that absolutely work will harvest to continue to perform. Yes, I mean I think the tough part for February was to simply get our longer term hedges did not really work as well too. So kind of at -- around February 29 or so book value was down, we gave that framework in our last conference call, that book value was down about close to 6% and we introduced that. So the harder part for us for what we've faced is in March, there was -- as the other credit products started revert back -- our products just lagged and in January/February timeframe our long-term, our hedges for the portfolio for credit also didn't revert back but I kind of fully expect -- there was always going to be our long period of time. There will be periods where your portfolio versus the hedges, the correlation kind of breaks down. Do I think that there will be none.

[Joel Houck:]

Okay. Maybe one more if I could, so one of your peers this morning disclosed that their duration gap was at the end of March close to two and it went higher into April. And genesis of that was that it kind of having a larger duration gap does offset some of the spread widening in the credit book because presumably rates go down and you gain money on the agency book. Can you talk to us about your overall positioning, what the duration gap was at the end of the March? Where is that now? And how you think about the agency book perhaps hedging or offsetting more volatile environments on a credit book?

[Anup Agarwal:]

Look, I think -- I was going to highlight it that since the beginning of second quarter, as we highlighted that our book value is up by 3% to 5%. The second part, intensive duration gap, look I think -- we had some duration sort of added and that kind of helped. Overall, we had some hedges for booked, both the credit and agencies in terms of additional duration but in a broad way, we are looking at it right now; broadly, the way I'm looking at it right now, I just think that rates will be in range bound kind of environment. In that range bound is the environment, we kind of expect it to be pretty fast. Generally if you look at in our past, whenever we believe in the range bound environment, we generally tend to be pretty tight from duration gap, we don't run ton of duration gap and that's really what you would -- that's what you've seen in the past and that's how you would expect to be. Now if we have a large duration, of course that will mean kind of higher hedging cost but we have adjusted our hedges, so what you would expect from us would be kind of running to be pretty damn close to zero in terms of duration gap, and I think it's more running based on -- we can't think they are very accommodated policy so you would kind of see the credit spreads to continue to growing tighter and the agency -- and you would expect that I think it's a reasonable environment for agencies, it's not kind of I expecting that agency spreads tighten dramatically, I think it's just a reasonable environment and in this reasonable range bound environment we would expect to kind of have a pretty zero duration gap.

[Joel Houck:]

Okay, thanks Anup.

[Operator:]

[Operator Instructions] And our next question comes from Merrill Ross from Wunderlich. Please go ahead with your question.

[Merrill Ross:]

Thank you, and good afternoon. I wanted you to adjust dividend policy, and later effect of the shortfall of the core earnings that are directionally correct with the dividend. And it just seems like you're paying out rather more than earning, making up light margin. So could you adjust that?

[Lisa Meyer:]

Yes, the dividend policy is determined by a lot of factors including our taxable income so when we determine what the dividend is for a particular period we not only look at our core earnings but we also take into account what our taxable income is for the period.

[Merrill Ross:]

Any thing you can share with us about that GAAP? That GAAP earnings and tax?

[Lisa Meyer:]

No, we expect core earnings to also increase but a lot of the differences between our core earnings and taxable income factor into the tax differences on how income is recognized as well as realize gains on particular investments.

[Merrill Ross:]

Okay. Thank you.

[Operator:]

And ladies and gentlemen, at this time we have reached the end of the allotted time for the question-and-answer session. I'd like to turn the conference call back over to Mr. Gavin James for closing remarks.

[Gavin James:]

Thank you, operator. As we previously announced, I will be retiring on June 1st of this year and Jennifer Murphy will be assuming the position of CEO of WMC, under Jennifer's leadership I am pretty confident that the team has the ability to continue to create value in the future. I have enjoyed the opportunity to get to know many of our shareholders and analysts who have followed the company over the past few years. I wish you all the best going forward and once again thank you for joining us today on the call and have good day.

[Operator:]

Ladies and gentlemen, with that we will conclude today's conference call, we thank you for attending. You may now disconnect your lines.