Western Asset Mortgage Capital Corporation
Q2 2013 Earnings Call Transcript

Published: 6 Aug 2013

[Operator:]

Welcome to the Western Asset Mortgage Capital Corporation's Second Quarter 2013 earnings conference call. Today's call is being recorded and will be available for replay beginning at 6.00 P.M. Eastern Standard Time. At this time, all participants have been placed in listen-only mode, and the floor will be open for you questions following the presentation. Now first, I would 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 June 30, 2013. By now, you should have received a copy of today's press release. If not, it is available on the company's website at www.westernassetmcc.com. In addition, we are 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, Steven Sherwyn, Chief Financial Officer, Stephen Fulton, Chief Investment Officer and Travis Carr, Chief Operating Officer. Before we begin, I would 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 risks factors section of the company's reports filed with the Securities 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 Gavin James, Chief Executive Officer. Gavin?

[Gavin James:]

Thank you, Larry, and thank you everyone for joining us today for our second quarter conference call. I will begin the call by providing some opening comments. Steve Sherwyn, our CFO, will then discuss our financial results, Travis Carr, our Chief Operating Officer will discuss the current trends we are seeing in the Agency RMBS market, and then Steve Fulton, our Chief Investment Officer, will provide an overview of our investment portfolio, our liability profile and future outlook. After our prepared remarks, we will conduct a brief Q&A session. During the second quarter, we incurred a GAAP net loss of $1.14 per share but generated core earnings of $0.94 per share and declared a $0.90 per share regular dividend. Due to the volatility that was seen in the mortgage market during the second quarter, our net book value declined approximately 10% to $17.39 per share, as of June 30, 2013. While the increase level of interest rate and mortgage volatility put pressure on the asset side of our balance sheet we were pleased with the performance of our hedges which reduced the negative impact to our book value during the quarter. Interim issue public offering in May 2012 through June 30, 2013 we have delivered an economic return on book value of 8%, calculated by the changing book value, first dividend which is significantly better than the average of our Agency RMBS peers over that same timeframe. It is particularly notable that during this period the mortgage market has experienced increased volatility, widening spread and higher interest rate; not ideal condition for managing a portfolio of RMBS. Here we have managed to generate relatively strong return which we believe is a testament to the strength of our security selection and hedging strategy. Our results are due to the hard work and dedication of the entire Western Asset RMBS team that’s we believe with three years of experience in the mortgage sector and a deep bench or key competitors advantages. Following the swift moves in interest rate and mortgage spread occurred in the second quarter, the market since become relatively more stable, over the last few weeks 10-year treasury note has been 2.5% and 2.7%. The interest rate volatility has leveled off. Given the economy and out outlook for interest rates, we believe that it is unlikely that we will continue experience the same degree of volatility that we saw during the first half of 2013. We think that we will likely see conditions in the mortgage market that are more conducive for maintaining or increasing book value over the remainder year. We remained committed to our investment philosophy. We position our portfolio for optimal performance over an entire interest rate cycle while there may certainly be other quarters in which the market temporary moves against that positions and of course we cannot guarantee any results. We are confident that over the entire interest rate cycle we will be able to generate a consistently strong dividend for our shareholders while maintaining a stable book value. At this time, I am going to turn the call over to Steve Sherwyn, our CFO, to discuss our financial results. Steve?

[Steven Sherwyn:]

Thanks, Gavin. Good morning, everyone. I will discuss our financial results for the second quarter ended June 30th, 2013. Except where specifically indicated, all metrics are as of that date. On a GAAP basis, we incurred a net loss for the quarter of approximately $27.7 million, or $1.14 per basic and diluted share. Included in the net loss was approximately $156 million of net unrealized loss on RMBS and other securities approximately $10 million of net realized loss and other loss on RMBS and other securities and approximately $113 million of net gain on derivative instruments and linked transactions. For the quarter, our core earnings which the non GAAP number defined as net income or loss excluding net realized and unrealized gains and losses on investments, net unrealized gains and losses on derivative contracts and non-cash stock-based compensation expense, one-time events pursuant to changes in GAAP and other non-cash charges was approximately $22.8 million, or $0.94 per diluted share. Our net interest income for the period was approximately $28.2 million. This number is a GAAP number and does not include the interest we received from our IO securities that are treated as derivatives nor does it take into account the cost of our interest rate swap both of which are included in the gain on derivative instruments line in our income statement. On a non-GAAP basis, our net interest income including the interest we received from IO securities treated as derivatives, interest we received from linked transactions and taking into account the cost of our hedging was approximately $25.9 million. Included in this calculation was approximately $53.6 million of coupon interest offset by approximately $17.9 million of net premium amortization and discount accretion. Our weighted average net interest spread for the quarter which takes into account the interest that we received from non-Agency RMBS and IO securities as well as the fully hedged cost of financing was 2.18%, reflecting a 3.14% gross yield on our portfolio and 0.96% effective cost of funds. Our cost to funds increased 9 basis points compared to the first quarter which is primarily attributable to the increase hedging we didn’t respond the higher volatility we saw in the second quarter. Our operating expenses for the period were approximately $3.4 million which includes approximately $1.5 million for general and administrative expenses and approximately $1.8 million in management fees. After adjusting for the $0.95 dividend that we declared April 1, our net book value decreased by approximately 10% during the period from $19.42 on March 31st to $17.39 on June 30, 2013. The decline in net book value was primarily due to the combination of mortgage spread widening and AFs declining during the quarter offset by the positive performance of our hedges. Our economic return for the quarter was a negative 5.8% which as previously noted represents the change in book value plus dividend and which includes the second quarter dividend $0.90. As Gavin mentioned earlier for the approximately 13.5 months since our IPO through June 30, 2013 we have generated an economic return of approximately 8%. During the second quarter our constant prepayment rate or CPR for our Agency RMBS portfolio was 4.4% on an annualized basis. This compares to 3.4% for the first quarter of 2013. Our CPR continues to remain while as a result of our focus on buying securities that exhibit low prepayment characteristics. As of June 30, the estimated fair value of our portfolio was approximately $4.2 billion and we have borrowed a total of approximately $4 billion under our existing Master Repurchase Agreements. Our leverage ratio was 9.4 times at quarter end inclusive of linked transactions our adjusted leverage ratio was approximately 8.2 times at quarter end adjusted for 500 million notional value of net short positions in TBA mortgage pass through certificate that we held at the end of the quarter. We continue to be in a attractive position of having repo capacity in excess of our needs. At June 30th, we had master repurchase agreements with 17 counterparties. We continue to receive offers to expand our repo lines from these and other institutions. At the present time, we feel comfortable with our existing counterparties and believe that we have ample liquidity to meet our present and expected funding requirements. With that, I will now turn the call over to Travis Carr. Travis?

[Travis Carr:]

Thanks, Steve. I would like to provide a few general remarks on the state of the Agency RMBS market. The long term outlook for Agency RMBS remains favorable both from a technical and fundamental perspective. From a technical point of view, net supply of new issuance is expected to decline going forward and demand is expected to be at least equal to if not greater than supply even with Fed tapering factored in. Fundamentally the asset class remains attractive for investments the yield curve has steepened, spreads have become more attractive, prepayment activity is expected to decline, the repo market is functioning well and the economy is improving at a gradual pace. Despite the recent volatility that the market has experienced the asset class remains highly liquid and has attracted demand from a wide cross section of global investors. We believe that the risk of higher interest rates and wider mortgage spreads has larger than priced into the market given current valuation level. With respect to our view on the direction of interest rates we continue to believe that the Fed is not moving away from a zero short term interest rate environment anytime soon and they are not done buying mortgages. They have repeatedly reiterated that monetary policy will remain accommodated for as long as the economy needs it. Our view on the U.S. economy is that while it is on path towards a gradual recovery don’t expect to see a meaningful acceleration of growth anytime soon. We still believe that the economy needs to create more than 200,000 non-farm jobs per month in order to demonstrate sustainable growth. Additionally global interest rate should remain low as the European economy is still weak, Japan continues to support its economic recovery and China appears to be slowing down. That being said we continue to recognize that the global economy will ultimately strengthen and interest rates will eventually rise even further they come after historically low level as this begins to happen we would expect that long term rates would increase first and then short term rates would eventually follow. Our hedges positions in the portfolio reflect view and we will likely further adjust them as this scenario plays out over time. The mortgage refinancing market is expected to decline going forward and has already shown signs of slowing down. The mortgage bankers association expects refinancing activity to decline by around 20% in 2013 and another 60% in 2014. Major lenders are already responding by adjusting their staffing levels. We continue to believe that issuers will focus on hard eligible collateral, particularly with the potential for the hard eligibility date to be extended to June 2010. Our overall view to mortgage market is that longer term risk that faces are the potential for spread widening and higher interest rate and more prepayments are expected to decline going forward, they also remain a risk and deterrent towards growth yields in any agency RMBS portfolio. We have start to position our portfolio to address these risk and continue to view the market as offering an attractive head adjusted carry particularly with the type of collateral that we target. Now, I’ll turn the call over to Steve Fulton for further discussion of our portfolio and investment outlook, Steve?

[Steve Fulton:]

Thanks Travis. Good morning, and thanks everybody for joining us today. While we were disappointed with the decrease in net book value for the quarter on a relative basis, we are actually pleased with our performance giving the extraordinary volatility we saw in the second quarter to a combination of strong security selection and a effective hedging strategy; we were still able to generate strong core earnings that supported our dividend. A decline in book value is moderated by liability hedges particularly, our large position in long dated swaptions which increased value as market volatility increased. We started the second quarter with a $900 million position in swaptions and added to that position is volatility increase at one point having our exposures high as 1.4 billion before settling back to the quarter ending position of 1.2 billion. Subsequent to the end of the quarter, we started to wind down our position in swaptions and begin to replace them with interest rate swaps that accomplish the same goal of reducing portfolio duration but are more cost effective in the current market environment. This is an example of our active management style where we response tactically to changing market conditions, we believe that our broad operating net pipeline which include expertise and mortgages, liquidity and derivatives, enables us to be number one times of market dislocation and is a clear competitive advantage. When most of our portfolio activity during the quarter took place on the liability side of our balance sheet, we did make some modest changes on the asset side. Specifically we sold some our lower coupon on 3rd year pools and traded into slightly higher coupon pools. And this is done in order to reduce our exposure to spread duration. We maintained our exposure to 20-year pools and non-agency securities during the quarter as we believe they also remain attractive from the spread duration valuation perspective. We intend to increase our exposure to both these two categories as we believe they represent good relative value and offer better production against mortgage spreads. That being said, we’ve just been through period of increased interest rate and spread volatility that led to a very large sell off in the mortgage market. Swaption volatility have come down since early July and the think that in near term the mortgage market will experience more stability and we are positioning our portfolio accordingly. In aggregate the action we are taking on both sides of the balance sheet subsequent to the second quarter have been us a little bit longer in duration and little bit more negatively convex that we exited the quarter. Spec pool pay-ups had decline significantly in the recent sell-off and presently we estimated that our average pay-up in the portfolio is about 25 basis points over a quarter of a point. However our portfolio similar to other portfolios in the agency space still remains at a premium dollar price, so slow prepayments are good for the portfolio as they increase their gross yield but we still favor a prepayment protected securities, we are focusing on securities with lower pay ups at present. Our investment strategy remains relatively unchanged that is to buy call protected securities that offered a best risk-adjusted carry and hedge them over an interest rate cycle. With that let me turn to some other portfolio details as of the end of second quarter. As of June 30th, 2013, the total estimated market value of our portfolio was approximately $4.2 billion and consisted primarily of Agency mortgages. Our portfolio with weighted towards 30 year fixed rate mortgage pools which represent approximately 70% of the value of total portfolio, (exposure) to 20 year fixed rate mortgage pools at quarter end was approximately 19%. Non-Agency RMBS represented approximately 4% of our portfolio and the remainder consisted of Agency interest-only strips and inverse interest-only strips which represented approximately 7% of the total. If you break down our Agency specified pools by sector, 50% of the total was invested in mortgage pools with MHA loans with high LTVs which is consistent with our investment strategy of minimizing our prepayment risks. The next largest sector was pools with low loan balances at 42%. Pools representing new issuance and low WALA was 6% of the total and the remaining 3% consists of High SATO or Spread at Origination and investor loans. Our weighted average loan age or WALA for the portfolio was 14.4 months which includes our non-agency holdings, we to believe that managing a WALA ramp is another component towards keeping our prepayments low. As Steve Sherwyn noted, our CPR was 4.4% for the quarter which compares to an average of approximately 17% for our Agency peers and is reflective of the effectiveness of our securities selection and portfolio management strategy. Now let me turn for a moment to the liability side of the balance sheet. As Steve mentioned, we funded our portfolio through the use of short-term repurchase agreements or repos. As of June 30th, we have borrowed $4 billion under these agreements resulting in a leverage of approximately 8.2 times after adjusting for the 500 million short TBA positions that are settled in mid-July. We are presently targeting leverage to be in the 7.5 to 9 times range in the near term given our outlook for volatility. As of June 30th, we had entered into approximately $3.5 billion in notional value of interest rate swaps and swaptions. Our swap and swaption positions represented approximately 89% of our outstanding funding. The swap contracts was an approximate notional value of $2.3 billion ranging in maturities between 15 months and 21 years with a weighted average remaining maturity of 7 years and their weighted average fixed rate of 1.4%. Approximately 24% of our notional value of these swap positions are held in forward starting swaps that start approximately 6.5 months forward. Our swaption contract with an approximately notional value of $1.2 billion allow us to enter into swaps that have an average fixed pay rate of 3% and an average swap term of 11.4 years. As a result, our portfolio had a net duration of approximately 7/10 of a year at quarter-end. While the net duration of our portfolio remains modestly positive, the majority of that positive duration has been at the shorter end of the yield curve and we have maintained a slight negative duration at the longer end. For the third quarter of 2013, we expect incremental net spreads to be in the 2.2% to 2.4% range. This is a result of generally wider spread in the market since last quarter, additionally our lower than average prepayments have helped us generate higher than average gross yields. As we wrap up our prepared remarks and think about the current environment, I think it’s important to note that we have been through an extraordinary first half of the year in the RMBS market. From where we currently sit, mortgages are very close to being fully extended. So extension risk is greatly diminished and pay ups have been greatly reduced. We’ve taken a hit but given the market views that we have expressed on the call today. We don’t think there is a whole lot of an additional damage that can be inflected on the portfolio. As a result, we feel comfortable that we will continue to generate strong core earnings in the second half of the year while experiencing more stability in book value. With that we will entertain your questions. Operator please open up the call.

[Operator:]

(Operator Instructions) Our first question is from the line of Mike Widner with KBW. Please go ahead.

[Mike Widner:]

Good morning, guys. I guess for us just a simple question of forward starting swaps. You got 550 million of those. Any indication of what buckets those are in are they adding the 10 year range or they kind of shorter than that?

[Gavin James:]

They are spread across the curve. So they are we have forward starting swaps in each set and part of our current bucket.

[Mike Widner:]

Okay, I mean, sort of a different topic. You have some pretty, you guys actively start stuff in the TBA place. So wondering if you can just talk about the relative economics of kind of using sure positions there versus the obvious opportunity as dollar roll income just because of the big month to month drops on the pricing?

[Gavin James:]

I mean, when you sort mortgages forward, you don’t necessarily have to pay the dollar roll unless you hold them over a settlement period. So, and once again dollar rolls are not kept and stoned I mean they can change pretty dramatically from sort of month to month and from coupon to coupon. So it’s just, I mean it depends on what particular risk which (wind) the shorten and what month were shorting in. In general it’s been a pretty effective strategy, it doesn’t work all the time for everything but by in large if you pick the right coupon and pick the right month there are pretty effective spread duration hedges. And there is certainly, they much more closely match spread duration hedging than the necessary swap does.

[Mike Widner:]

I mean, that certainly make sense, and I guess just from the ad side there is one other things we sort of wrestle with is, trying to, I mean, your disclosure obviously gives us, I think, some pretty good transparency but there is those elements where we sometimes wonder about the tension of sort of you guys have very attractive net interest spreads reported at 2.18 relative to the group. And so obviously just trying to tease apart, how do you there while at the same time having using TBAs and such for hedging purposes, I guess?

[Gavin James:]

Just remember, TBA short it’s just duration short. It doesn’t cost you any money and so you actually roll it over a settlement cycle; whereas if you short a little side swap you are paying fixed the moment it settles, the moment you enter into it. So like I said it really depends on what coupon you choose, the month you sorted on and whether or not you hold the short over the settlement cycle.

[Mike Widner:]

So I guess I sort of get that but the notion if you sell it two days before the settlement it would seem to me that you are still underpaying the cost because of the change in price, but.

[Gavin James:]

The assumption the people are making in the dollar roll market is that today's price and today's price for this month and there is a forward price for next month and that next month's price will become today's price. Sometimes that happens, sometimes that doesn't happen. So it's not necessarily cast in stone that it works like that. And you can see multiple tick movements in dollar rolls as you approach 48 hour day which is basically a call out day. That's when you really find out who is short and who is not? So you can have a dollar roll sitting at 930 seconds or through LIBOR for three weeks out of the month. And then on the two days prior and during the 48 hour call out trade 30 seconds cheaper than that. So once again it's all a matter of timing.

[Mike Widner:]

Got you.

[Gavin James:]

I will tell you that we don't look at them, there’s times they look like expensive short stuff, there is times they don't. There were some people in the first quarter, there was some of our competitors who tried to take advantage of the dollar roll market in (inaudible) which was the 930 seconds, which was Feb’s coupon of choice; that worked out pretty poorly. So there is times when the dollar roll market can work out well for you and there is times when it doesn't work out so well for you. You just have to pick the right security in the right time.

[Mike Widner:]

Right, which is why I was trying to get a little more granularity on what exactly you guys are picking, so as we try and mark things and model things. We know where you are, but I try to understand that you don't want to give out positions by coupon and what not.

[Gavin James:]

That was a relatively short term spread duration trade, so we just thought it would be more effective than further swaps or further interest rate swaps.

[Mike Widner:]

Makes sense, I guess one final from me, again you guys talked about net interest spread right now is 218. Where do you see incremental spreads for putting money to work now is assets paid down or wherever you are putting money to work.

[Gavin James:]

I think we have been looking on sort of 220 or 240 type range, just where we would get money, but we're considering the total range of everything we buy which includes some (IOs, federation) exposure, collateral and then collateral and then also some agencies.

[Operator:]

Next question is from the line of Daniel Furtado with Jefferies & Company. Please go ahead.

[Daniel Furtado:]

I just had kind of a bigger picture question, the bank demand for agency it seems to have veined a little bit here. Why do you think that is and do you have any concerns of thoughts around proposals to increase risk waiting at the banks for agency MBS.

[Gavin James:]

Yes, I am a little, Bonnie whose been doing a lot of work, Bonnie von Trickle who's one of the senior portfolio managers, doing a lot of work on what the banks have been up to. Bonnie, if you don't mind filling in on that one?

[Bonnie von Trickle:]

Yes, the demand has been lower recently and I think it's a function of two things, one is you know the banks have been waiting for a selloff for quite some time and we did get so often and now you see them coming a bit, that they're not going to put all their cards in because of the second factor which is there are going to be some changes on the regulatory front. So the way that gains and losses on their mortgage holdings are accreted they now have to flow through their income statement, unless they put them into a different category. So the effect of those two things is that bank demand right now or as of late and probably (the best) the mean year term is going to be a little bit less than what you would have expected before. Having said that we knew in fact that will come in, you know, even if we stay here in this range or if we have a further selloff and (obviously) we will stay on this range, but the mix of what they'll buy will be a little bit different. Traditionally they would have bought one of the current coupon, production coupon third year mortgages. They'll probably shift to something that is a little bit lower end spread duration so 15 year, 20 year mortgages that will fluctuate less with movements in rates.

[Daniel Furtado:]

Understood, thank you for that, it's very helpful.

[Operator:]

(Operator Instructions), the next question is from the line of Jackie Earl, with Compass Point, please go ahead.

[Jackie Earl:]

Just one quick one, I know in your press release you mentioned the intention to slightly increase your holdings in non agency RMBS, what would you need to see in the market, or what would change your outlook to having a more material investment in that agency?

[Gavin James:]

Well we actually think it represent pretty good value right now so we are currently increasing our position. I don't know if that exactly answers your question, in other words you know they cheapened up based on some selling and some bid list and also some selling under the GSEs, they're not at their recent wides but they're still the type of securities we like which we believe hedge house price depreciation and actually hedge higher interest rates, are trading in the low six and a quarter, six and three eights type yields which you know once you leverage them we consider them to be pretty attractive right at the moment.

[Jackie Earl:]

You have how many like target capital allocation to non agency?

[Gavin James:]

Yes, I'd say that right now we're sort of shooting for probably 10% but to somewhere in the 10% to 15% range, it’ll all depend on pricing, and pricing changes dramatically then our targets will change.

[Operator:]

(Operator Instructions) And we have no further questions Mr. James.

[Gavin James:]

Okay, well thanks again for joining us on the call and we look forward to seeing many of you in the future months ahead, and with that we'll close, many thanks.

[Operator:]

Thank you ladies and gentlemen, that does conclude our conference for the day, we'd like to thank you for your participation and you may now disconnect.