Western Asset Mortgage Capital Corporation
Q3 2014 Earnings Call Transcript

Published: 7 Nov 2014

[Operator:]

Welcome to Western Asset Mortgage Capital Corporation’s Third Quarter 2014 Earnings Conference Call. (Operator Instructions). 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 September 30, 2014. By now, you should have received a copy of yesterday's press release. If not, it is 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; Steven Sherwyn, Chief Financial Officer and Anup Agarwal, Chief Investment 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 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 Gavin James, Chief Executive Officer

[Gavin James:]

Thanks Larry. Thank you everyone for joining us on the third quarter conference call today. We’re conducting this quarter's call earlier in the day than we normally do that’s because the WMC team is here in New York, I will begin the call by providing some opening comments. Steven Sherwyn, our CFO, will then discuss our financial results and then Anup Agarwal, our Chief Investment Officer 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. We delivered another quarter of strong performance despite a relatively challenging and volatile fixed income market. During the period we recorded GAAP net income of $0.63 per share while generating core earnings and drop income of $0.67 per share. We generated an economic return of 4.2% for the quarter and 13.3% year-to-date, which is reflective of our emphasis on total return and shareholder value and the strong performance of our diversified portfolio. We increased our quarterly cash dividend by 4.5% to $0.70 per share, while our net book value remained stable. This is consistent with our goal of delivering an attractive dividend while also maintaining a stable book value. During the quarter of the third quarter we slightly increased the credit sensitive portion of our portfolio to approximately 27% of the total as we added GSE risk sharing securities and other asset backed securities to our portfolio. Our continuing shift to a hybrid model has subject to REIT requirements broadened our investable universe and has nailed us to generate attractive risk adjusted returns. During the quarter long term interest rates continue to remain at the low end of our expected range and therefore we decreased our agency portfolio, net duration by adjusting our interest rate hedges. As a result of those adjustments our hedge adjusted cost of funds increased impacting our net interest spread. So this also enabled us to maintain a stable book value which decreased by less 0.4% from the end of the June quarter. Our outlook for interest rates, the economy and market conditions has not materially changed since our last conference call. We have positioned the portfolio given the following assumptions, we now expect the yield on a 10 year treasury to be ranged bound by 2.25% and 2.75% over the next 12 months but we expect that range will be data dependent based on conditions in the global economy and we believe that short term rates will remain close to zero until the end of 2015. Economic growth in the U.S. will remain modest over the next several quarters and the Fed will continue to be supportive of the economy, the demand for agency RMBS will continue to be strong as the Fed reinvests the cash flows from existing portfolio and money market front, sovereign wealth funds and private investors all remain active in the market. And the supply of both agency and non-agency assets will be somewhat constrained given a low level of expected new production. We’re very pleased with our financial performance for the quarter and year-to-date which we believe is the result of our shift in strategy to a diversified portfolio away from a pure agency REIT into a hybrid rate and our active management strategy. The comprehensive investment platform of Western Asset is clearly an advantage in helping us make this shift. We continue to believe that among our competitive advantages is our ability to be nimble and adjust the portfolio to gain exposure to the asset classes and specific securities that provide the most attractive risk adjusted returns at any given point. Although we can't guarantee the performance of our portfolio investments we believe that our portfolio has us well positioned to deliver on our long term objective of generating strong core earnings to support an attractive dividend while also maintaining a stable book value. Additionally our Board of Directors recently approved two changes to the Board structure and composition. First, the Board has created the position of lead Independent Director and appointed its current Audit Committee Chair, Mr. Christian Mitchell to the position. Mr. Mitchell's role will be to lead and represent the independent directors in discussions with the company's management and it's manager Western Assets. We’re pleased that Chris has agreed to serve as the lead Independent Director. The company has already benefited from Chris' experience and dedication as our Audit Committee Chair and we expect to benefit from his contributions in his expanded role. Second, the Board has appointed a new independent member Ron Kirpalani to the Board effective November 10, 2014 increasing the total number of Independent Directors to four and the total number of Directors to six. We welcome Ron to our Board of Directors, he brings significant knowledge and expertise in mortgages and mortgage backed securities and we look forward to his contribution to our Board and the company. In connection with these changes, the Board amended our corporate governance principles to establish the lead independent role and to require that 2/3rds of our directors be independent. We believe these changes which should make us possibly regularly review of our corporate governance practices are important, so our growing company and places within industry best practices. At this time I'm going to turn the call over to Steven Sherwyn, our CFO to discuss our financial results.

[Steven Sherwyn:]

Thanks Gavin. Good morning everyone. I will discuss our financial results for the third quarter ended September 30, 2014. Except for specifically indicated all metrics are as of that date. On a GAAP basis we recorded net income for the quarter of approximately $26.1 million or $0.63 per basic and diluted share. Included in the net income number was approximately $4.5 million of net unrealized loss on mortgage backed securities, approximately $4.9 million of net realized gain on mortgage backed securities and approximately $1.6 million of net loss on derivative instruments and linked transactions. For the quarter our core earnings plus drop income was approximately $27.8 million or $0.67 per basic and diluted share, this compares to core earnings plus drop income of approximately $40 million or $1 per basic and diluted share of the second quarter ended June 30th, 2014. Our core earnings were approximately $20.3 million or $0.49 per diluted share which is a non-GAAP financial measure which we define as net income or loss excluding net realized and unrealized gains and losses on investments, net unrealized gains and losses on derivative contracts, non-cash stock-based compensation expense and other non-cash charges. For the quarter we generated drop income of approximately $7.5 million or $0.18 per diluted share. As we have transitioned our portfolio to a hybrid REIT model we have also been utilizing more to be announced for TBA forward contracts on agency RMBS in the form of dollar roll transactions which has resulted in incremental drop income. Drop income represents a non-GAAP financial measure as it is defined as the difference between the spot price and the forward settlement price for a comparable security on the trade day. For the quarter ended September 30, 2014, our average amortized cost of mortgage backed securities held, including agency and non-agency interest-only strips accounted for its derivates and linked transactions was approximately $4.57 billion as compared to approximately to $4.83 billion for the second quarter ended June 30, 2014. Our net interest income for the third quarter was approximately $34.3 million. This number is a GAAP financial measure and does not include the interest we receive and pay on our linked transactions. Interest we received from our IO securities that are treated as derivatives nor does it take into account the cost of our interest rate swaps. The latter two 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, the interest we received from linked transactions and the cost of our interest rate swaps was approximately $24.9 million. This compares to non-GAAP net interest income of approximately $34.4 million for the second quarter of 2014. The sequential decline in our net interest income was due to our modestly smaller average portfolio during the September quarter and higher hedge adjusted borrowing cost due to our duration management during the quarter. Our weighted average net interest spread for the third quarter of 2014, which takes into account the interest that we received from our non-agency RMBS, CMBS, and IO securities as well as the fully hedge cost of our financing was 1.95%, reflecting a 3.75% gross yield on our portfolio and a 1.80% effective cost of funds. This compares to a weighted average net interest spread of 2.69% for the second quarter, reflecting a 3.86% gross yields on our portfolio and a 1.17% effective cost of funds. Our net yield decreased primarily due to higher interest cost related to our duration management as I mentioned earlier. During the quarter, our constant prepayment rate or CPR for our agency RMBS portfolio was 4.5% on an annualized basis. This compares to 4.9% for the second quarter. We believe our CPR continues to remain low due to our focus on buying agency RMBS that we believe exhibit low prepayment characteristics. Our operating expenses for the quarter were approximately $5 million which includes approximately $2.3 million for general and administrative expenses and approximately $2.8 million in management fees. Included in the G&A expenses were non-cash based stock compensation of approximately $587,000. Our G&A expenses expressed as an annualized percentage of our stockholders’ equity were approximately 1.4%, an improvement of approximately 40 basis points in the first half of 2014 and was a result of the additional capital that we raised earlier this year, which enabled us to spread our fixed cost over a larger capital base. Our book value per share as of September 30, 2014 was $15.26 per share, which takes into account the $0.70 regular cash dividend that we declared on September 23, 2014 and paid on October 28, 2014. For purposes of comparison, our book value per share declined by 0.3% from this June 30, 2014 level of $15.31. We believe that our book value per share was primarily as a result of a more diversified portfolio and negative [ph] duration hedge adjusted agency portfolio and was supplemented by dollar roll income from our net loan TBA positions. As of September 30th, the estimated share value of our portfolio was approximately $4.4 billion and we had borrowed a total of approximately $3.9 billion under our existing master repurchase agreements. Our leverage ratio was approximately 6.1 times at quarter end. Our adjusted leverage ratio was approximately 7.9 times at quarter end, adjusted for $1.1 billion of notional value of net long positions in TBA mortgage pass-through certificates that we held at the end of the quarter. We continue to be in the attractive position and having refill capacity well in excess of our current needs. At September 30, 2014 we had massive repurchase agreements with 23 counterparties and outstanding borrowings with 20 counterparties. We continue to have excellent relationships with our bank counterparties and we feel comfortable with our existing group. We have a highly diversified repo vendor book and believe that we have more than ample liquidity to meet our present and expected funding requirements. As of September 30, 2014 we had entered into approximately $5.9 billion in notional value of pay fixed interest rate swaps, excluding forward starting swaps of approximately $1.9 billion and $3.3 billion of pay variable interest rate swaps, excluding forward starting swaps of $110 million giving us a net pay fixed swap position of approximately $2.9 billion. Additionally, we have entered into approximately $805 million notional amount of net paid fixed interest rate swaptions with swap terms that range between 1 and 10 years and have an exercised exploration dates that range from October 2014 to June 2016. And a $540 million notional amount of pay variable interest rate swaption with a swap term of 10 years and exercised exploration date of December 2014. As a result of our hedge positions, our overall portfolio had a net duration of approximately nine months at quarter end, excluding non-agency RMBS CMBS, ABS holdings our net duration was approximately negative 1.4 months. We are comfortable with our current leverage. We can adjust our economic leverage fairly quickly to these TBAs and we determine our leverage based on what we believe, we’ll enable us to optimize our core earnings on a risk adjusted basis and maintain a stable book value. With that, I’ll now turn the call over to Anup.

[Anup Agarwal:]

Thanks, Steve. Good morning and thank you for joining us today. Let me spent a few minutes discussing our investment results for the quarter and update you on our portfolio strategy. On our call last quarter we talked about our belief that interest rate volatility will remain low and that our outlook for mortgage spreads was positive. We also said that given our ability to be nimble our general approach would be that when the 10 years is at the low end of our expected range we will be shorter in duration. Given that view, we felt comfortable operating with adjusted leverage in the eight times range. And as we said, we utilized the TBA market to adjust our leverage. We also adjusted the duration of our agency portfolio during the quarter between negative duration of 1.5 to three quarter of a year based on our views of the 10 year yield and while mortgage spreads widened modestly in the quarter we generated a positive economic return of over 4% as a result of our portfolio positioning. We also discussed how we intend to continue to be proactive portfolio managers, albeit monitoring the relative value opportunities we have subject to the REIT requirements across the fixed income universe. During the quarter we modestly increased our exposure to credit sensitive investments particularly GSE credit risk sharing securities and other asset backed securities. We maintained our overall allocation to CMBS and non-agency RMBS but we shifted out of some of our legacy CMBS position and into CRE, mezzanine securities both in U.S. and Europe where we saw better relative value. We also slightly reduced our exposure to specified goals of fixed rate agency RMBS as a result 27% of our total investment portfolio consists credit sensitive investments as of end of September. We continue to believe that our credit sensitive investments will continue to perform well in a gradually improving U.S. economy while also exhibiting less interest rate sensitivity than agency securities. With regard to our agency portfolio, we continue to increase our exposure to 4% coupon, 30 year fixed rate pools as we believe that these securities offer a more attractive net interest spread on a hedge adjusted basis than the lower coupon 15 and 20 year fixed pools. Our agency investments continue to be invested in mortgage pools with low loan balance or high LTBs which is consistent with our investment strategy of minimizing our prepayment risk. Regarding our macro view, we continue to believe that interest rates will remain range bound given the slow growth environment of U.S. economy and weak global economic conditions particularly in Europe. While we continue to believe that this will be the case, we believe that we are presently at the low end of the range and there is a decent probability that rates will gradually head back up towards the mid or high end of the range over next 12 months and therefore at September 30, we have positioned our hedge adjusted agency portfolio with slight negative duration. Interest rate volatility has recently increased modestly but we expect that it will continue to remain low by historic standards and under current conditions we feel comfortable maintaining our exposure to TBA securities as a way to supplement our core earnings with incremental drop income which as Steve mentioned contributed approximately $0.18 per share to earnings in the quarter. We’re making progress towards implementing our residential whole loan strategy. We have built a program that enables us to invest in structures that provide exposure to residential mortgage whole loans and to that end we made our first whole loan investment in October. Initially we will be focusing on high credit quality, non-QM mortgages where we believe that we can earn higher net interest spreads without taking on much incremental credit risk. Our plan is to gradually replace a portion of our agency RMBS holdings with the assets purchased through this residential mortgage whole loan program. We want to again emphasize that we continue to benefit from our access to Western Asset comprehensive platform where we’re able to drop on experience of a full team of experts across a number of structures in mortgage and the broader fixed income in credit markets. Our primary investment strategy remains unchanged to maximize total returns for our shareholders. This is to assemble a diversified portfolio with securities that offer what we believe are the best risk and hedge adjusted carry over our investment horizon, which 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 will come from Ken Bruce of Bank of America. Please go ahead.

[Unidentified Analyst:]

This Sean (indiscernible) for Ken Bruce. Just like the TBA position you kind of almost doubled that during the quarter and it seems like the TBA market trying to improve for you all, can you just talk about how you see that evolving going forward if we should kind of assume that type of run-rate or are you saying that kind of comes back down now that you think that rates are at the lower end of the range? Thanks.

[Gavin James:]

Our view on the TBA position has being that if we are constructive on mortgage spreads and the protected specified of the pools then we will increase our TBA positioning. We do expect that we will continue to have a reasonable run-rate for drop income but it will be our TBA positioning is always opportunistic based on where we see spreads.

[Unidentified Analyst:]

Okay so just if I kind of get what you’re saying, you say hit the low end, you’re borrowing prepaid protected specified pool, should I kind of see that as kind of come down a 1 billion from here?

[Gavin James:]

Yes I mean I think that’s exactly right.

[Operator:]

Our next question is from Joel Houck of Wells Fargo. Please go ahead.

[Joel Houck:]

I'm wondering subsequent to the quarter mid-October, there is a huge rally in treasury that was short lived but given that it was substantially outside of your range expectation, certainly probably anybody. Can you maybe talk about or maybe give us some color if you will in terms of how, what you’re doing in terms of portfolio and hedging on days like that, you know it was a very volatile week – hedging changes.

[Gavin James:]

I think couple of things in that framework, one as you kind of saw that we adjusted our range for 10 years that given the economic data which just come out, we have adjusted our ranges for 10 years to more like 225 to 275 but more importantly directly on days like October 15, we also have tail hedges in the portfolio at any point in time when we kind of see – our expectation on the rate fall just before October 15, as you know was pretty low and we added some tail hedges on the portfolio with the expectation that if 10 years falls below 2.2 then it will effectively add some duration and then as the 10 year is going to fall below 2% that kind of covers that effectively hedges are broad kind of mortgage spread widening. Once it's fell to kind of lower end, kind to 1.8 to 1.9 then we will bring short duration back again. But generally our views for days like that is to have tail hedges which can protect us from mortgage spread widening.

[Joel Houck:]

And on the convert [ph] side I mean I think your views on rates have generally pretty good to give you guys credit for being public about it. If we in a rising rate environment lot of your peers have said that they think the mortgage bases would tighten and that’s a normal type environment unlike what we saw in 2013. So I guess the question is do you concur with the notion and if we saw rates start to rise, the long end of the mortgage bases would indeed tighten?

[Gavin James:]

There are two parts, I mean one that we remain short which is kind of view that long end rate will rise but in that environment mortgage based, we will be continue to be constructive mortgage spreads as well. But I think the part which we continue to be also very cautious about the global economic data could cause broader spread widening. You know you can instances like October 15, over next three years which can cause mortgage spread to widen and we will just be opportunistic in those scenarios.

[Operator:]

Our next question is from Lucy Webster of Compass Point. Please go ahead.

[Lucy Webster:]

I was hoping you could talk about the risk sharing transactions and maybe the leverage capacity or availability of those transactions and how you might think about that sector with supply growing in 2015.

[Gavin James:]

Yes, as we had kind of shared with investors before that when the risk sharing deal is going spreads tighten to 65 to 75, we had reduced our exposure to that sector and as the spreads have widened out we had added exposure back in for those securities but I continue to be pretty cautious for risk sharing deals and I think it's more driven by not only significantly increased supply on risk sharing deals as well as just broad credit spread environment given the global economic conditions. In addition, I think different dealers have started bringing their risk sharing or similar to risk sharing deals in the marketplace. We find them attractive from purely as a leveraged carry product but I don’t expect in short term those spreads tighten meaningfully.

[Lucy Webster:]

And then could you give us some more color on the CMBS book and how you’re thinking about the sector with the new QRM requirements?

[Gavin James:]

Yes absolutely. I think with the upcoming QRM requirement adds – if anything it continues to be attractive for us, if anything we think that that increases attractiveness of CMBS portfolio even more given we happen to be REIT. We have the capability of owning certain percent of the collateral. So we still continue to be very constructive on the bottom part of the capital structure, on the spreads for BBB, single borrowed deals as well as conduit deals and what we have done is we have started shifting our portfolio from legacy CMBS to more CRE mez opportunities both U.S. and Europe.

[Operator:]

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

[Gavin James:]

Okay. With that I would like to thank all of you for joining us on the call today and we look forward to seeing many of you in person in the months ahead. So once again thank you.

[Operator:]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.