Western Asset Mortgage Capital Corporation
Q4 2014 Earnings Call Transcript

Published: 27 Feb 2015

[Operator:]

Welcome to Western Asset Mortgage Capital Corporation’s Fourth Quarter and Yearend 2014 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 on 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, Robert. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation’s financial results for the three months ended December 31, 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 and thank you everyone for joining us today for our fourth quarter and year-end conference call. 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 are pleased with fourth quarter results as we delivered a strong finish in what was another volatile and often challenging year for the U.S. mortgage markets. During the fourth quarter, we recorded net income of $0.37 per share while generating core earnings plus drop income of $0.87 per share. We delivered an economic return on book value of 2.5% for the quarter and 15.8% for the full year, which included a dividend of $0.70 per share in the fourth quarter and $2.74 for the full year making us the highest yielding mortgage REITs in the sector. Our strong performance reflects the continued the implementation of our strategy to build a more diversified portfolio with a higher proportion of credit sensitive investments as well as our ability to take advantage of the growth and value opportunities across the entire mortgage sector through our proactive approach to portfolio management. Our success reflects the significant competitive advantages provided from leveraging Western Asset's world-class investment platform, which was recently recognized as Morningstar 2014 fixed income manager of the year. 2014 was also an important year for us with respect to the capital market. In the second quarter we faced a successful follow on offering shares raising a total approximately $215 million included in this amount with an additional investment in the Company by our external manager Western Asset of approximately $10 million. The offering was accretive on a book value basis to existing shareholders and increased the market capitalization of the Company by approximately 50%. The new capital enabled us to accelerate our portfolio diversification strategy to the benefit of both our new shareholders as well as our longer term holders. In addition it has lowered our administrative expenses on a relative basis as we are able to leverage our fixed costs over a larger capital base. Our strong performance in the fourth quarter was due to a number of factors. First, our core positions in the agency RMBS, non-agency RMBS, and CMBS performed well during the quarter. Second we were proactive during the quarter and took advantage of mortgage spread widening that occurred early in the quarter by increasing our TBA exposure thus benefiting from the subsequent finance spreads that occurred through year end, posted performance of our assets was more than offset by the decrease in the value of our hedge position as the yield curve flattened and long-term rates declined over the course of the quarter. Including both our fourth quarter and full year results, we have generated a meaningful level of outperformance relative to our February [indiscernible] traded high grade mortgage REITs. The outperformance on economic return basis was 140 basis points for the quarter and approximately 180 basis points for the year. That continued to be on the interest rate because at the long end of the curve we will remain range bound over the course of the year and short term rates will remain near zero until at least late summer and then only gradually increase from there. This view is based on our belief the economic growth in the U.S. will remain modest over the next several quarters and that the Fed will continue to be supportive of the economy, erring on the side of caution when it finally decides to increase short term rates. Our portfolio has been positioned to perform well in this environment with increases in the value of our agency and non-agency holdings during the month of January more than offsetting a decline in the value of our hedge positions. As a result our estimated book value has improved since the end of 2014. Anup Agarwal will go into more detail on our outlook investment strategy for 2015. Our investment strategy for 2015 will be more of the same. We plan to continue diversify our portfolio into credit sensitive investments and continue to employ an active management strategy. The comprehensive investments platform of Western Asset is clearly an advantage in helping us implement this strategy. We believe that 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 in time. Although we can't guarantee the performance of our portfolio investments we believe we are 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. At this time I'm 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 fourth quarter and year ended December 31, 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 $15.4 million or $0.37 per basic and diluted share. Included in the net income was approximately $48.3 million of net unrealized gains on mortgage backed securities, other securities and whole-loans and approximately $9 million of net realized and other loss on MBS and other securities and approximately 53.3 million of net loss on derivative instruments and linked transactions. For the quarter our core earnings plus drop income was approximately $36.4 million or $0.87 per basic and diluted share. This compares to core earnings plus drop income of approximately $27.8 million or $0.67 per basic and diluted share for the third quarter ended September 30, 2014. Our core earnings were approximately $27.3 million or $0.65 per basic and 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 $9.2 million or $0.22 per diluted share. As we have began utilizing more to be announced or TBA forward contracts on agency RMBS in the form of dollar roll transactions, it has resulted in an incremental drop income. Drop income represents a non-GAAP financial measure and 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 December 31, 2014, our average amortized cost of MBS and other securities held including agency and non-agency interest-only strips accounted for as derivates and linked transactions was approximately 4.44 billion as compared to 4.57 billion for the third quarter ended September 30, 2014. Our net interest income for the fourth quarter was approximately $33.9 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 our IO securities treated as derivatives, the interest we received from linked transactions and the cost of interest rate swaps was approximately $31.8 million. This compares to non-GAAP net interest income of approximately $24.9 million for the third quarter of 2014. The sequential increase in our net interest income was primarily due to lower hedge adjusted borrowing costs due to our duration management during the quarter. For the full year 2014, we reported net income of $100.7 million on a GAAP basis or $2.67 per basic and diluted share including a net income with approximately 189 million of net unrealized gains on mortgage backed securities, other securities and whole loans approximately $19.2 million of net realized and other loss on mortgage backed securities and other securities and approximately 178.6 million of net loss on derivative instruments and linked transactions. For the year our core earnings plus drop income was approximately $119.3 million or $3.17 per basic and diluted share. Our core earnings were approximately $89.9 million or $2.39 per basic and diluted share and our drop income was approximately 29.4 million or $0.78 per basic and diluted share. Our net interest income for the year was approximately 126.8 million on a GAAP basis, on a non-GAAP basis our net interest income including the interest we received from IO securities treated as derivatives, interest we receive from linked transactions and the cost of our interest rate swaps was approximately $106.8 million. Our weighted average net interest spread for the fourth quarter of 2014, which takes into account the interest that we received from non-agency RMBS, CMBS, IO and other securities as well as the fully hedged cost of our financing was 2.71% reflecting a 3.79% gross yields on our portfolio at a 1.08% effective cost of funds. This compares to a weighted average net interest spread of 1.95% for the third quarter reflecting a 3.75% gross yields on our portfolio and 1.80% effective cost of funds. Our net yields increased primarily due to lower interest cost as I mentioned earlier. During the fourth quarter our constant prepayment rate or CPR for our agency RMBS portfolio was 6.8% on an annualized basis. This compares to 6.5% for the third quarter of 2014. Despite the increase in refinancing activity we have been able to maintain a low CPR due to our focus on buying agency RMBS that we believe exhibit well prepayment characteristics. Our operating expenses for the fourth quarter were approximately $4.9 million which includes approximately $2.4 million for general and administrative expenses and approximately 2.5 million in management fees. Included in the G&A expense were non-cash stock based compensation of approximately $549,000. Our G&A expenses annualized percentage of our average stockholder's equity were approximately 1.5%. On a book value per share as of December 31, 2014 was $14.94, which takes into account the $0.70 regular cash dividend that we declared on December 18, and paid on January 27, 2015. At December 31, the estimated share value of our portfolio was approximately 4.4 billion and we borrowed a total of approximately 3.39 billion under our existing master repurchase agreements. Our leverage ratio was approximately 6.3 times at year end, our adjusted leverage ratio was approximately 6.8 times at year end, adjusted for $325 million notional value of net long positions [technical difficulty] a mortgage pass-through certificates we held at the end of the year. We continue to be in the very attractive position of having refill capacity well in excess of our current needs. At December 31, 2014 we had massive repurchase agreement with 24 counterparties and outstanding borrowings with 21 counterparties. We continue to have excellent relationships with our bank counterparties and feel comfortable with our existing group. We've a highly diversified repo vendor book and we believe that we have more than ample liquidity to meet our present and expected funding requirements. At December 31, we've entered into approximately 3.4 billion in notional value of pay fixed interest rate swaps excluding forward starting swaps of 2.4 billion and 2.1 billion of pay variable interest rate swaps excluding forward starting swaps of 110 million, giving us a net pay fixed swap position of approximately $1.3 billion. Additionally we've entered into approximately 105 million notional amount of pay fixed interest rate swaptions with a one year swap term and an exercised exploration date of June 2016. As a result of our hedge positions, our agency RMBS portfolio had a net duration of negative one month at year end. We are comfortable with our current leverage, we can adjust our [implied] leverage fairly quickly through the use of TBAs and we determine our leverage based on what we believe will 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 Agarwal. Anup?

[Anup Agarwal:]

Thanks, Steve. Good morning and thank you for joining us today. Let me spend a few minutes discussing our investment results for the quarter and update you on our portfolio strategy. As Gavin mentioned, the fourth quarter saw an increase in interest rate volatility particularly in early October when the tenure treasury rate drop by roughly 30 basis points and mortgage spreads by now. Given our ability to be active managers and our view at the time that mortgage market was oversold, we increased our exposure to TBAs and subsequently benefited from a tightening of spreads that occurred through the end of the year. For the first two months of fourth quarter, we kept our adjusted leverage in the mid to high 7 range as we increased our TBA exposure. As the spread narrowed later in the quarter, we steadily took off this straight and reduced our adjusted leverage down to 6.8 by end of the year. This trade worked very well for us and generated a significant amount of drop income in the fourth quarter. The portfolio diversification strategy that we began in the fall of 2013 remains on course as we continue to shift our portfolio towards credit sensitive investments and tactically reallocated our positions within non-agency space to sectors where we believe we could achieve better hedge adjusted returns such as U.S. and European CMBS [mass] tranches and GSE credit risk transfer securities. In addition, during the quarter, we made progress towards implementing our residential whole loan strategy, making our first investments in residential mortgage whole loans. We also kept the duration of our agency portfolio during the quarter slightly negative based on our views of 10 years treasury yield. As a result as Gavin mentioned, our hedge positions experienced a loss for the quarter although we held a significant amount of out of the money swap options which helped to mitigate the decline in the value of our hedge book during the precipitous rate drop in October. The appreciation of our assets combined with our strong core plus drop income enabled us to generate a positive economic return on book value of 2.5% for the quarter. 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 maintained our primary exposure to 3.5%, 4% and 4.5% coupons in 30-year fixed rate pools and 3%, 3.5% and 4% coupons in 20-year 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. As we entered 2015, we believe that prepayment risk would increase and the specified pools would outperform TBA. In January, we moved to a net negative position in TBAs thus lowering our implied or adjusted leverage. This statistical shift worked well as specified pools are performed TBAs in January; however, the continued flattening of yield curve has put pressure on our hedge positions although they have recovered somewhat in February with the modest retracement in the 10-year yield to around 2% rate after hitting a low of 1.64% at the end of January. In addition, our non-agency portfolio has performed well year-to-date particularly our holdings in GSE credit risk transfer securities, so as Gavin mentioned earlier we estimate that overall our book value has increased modestly since the beginning of the year. We remain extremely nimble in our portfolio management and given their mortgage spreads have trended recently it is possible and even likely that we will increase our exposure to TBAs at some point during the remainder of the first quarter. We are making progress towards implementing our residential whole loan strategy. We have built the program that enables us to invest in structures that provide exposure to residential mortgage loans and we made our first whole loan investment whole loan investment during the quarter. We will be focusing on high credit quality; non-QM mortgage where we believe we can earn higher net interest spreads without taking on much incremental credit risk. We are expanding our sourcing capabilities in this area and have also started to invest in commercial real estate whole loan. As we mentioned last quarter, our plan is to gradually replace a portion of our agency RMBS holdings with assets purchased through our whole loan programs, it is worth noting that our portfolio diversification strategy could not be implemented as effectively without the access we have to Western Assets comprehensive platform where we’re able to draw upon the experience of a full team of experts across a number of sectors in the mortgage market and the broader fixed income in credit markets. Implementing this strategy is when we really see the benefit of broad expertise of Western for managing the REIT. Our primary investment strategy remains unchanged and that is to maximize total 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 their best risk adjusted returns 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, please open up the call.

[Operator:]

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Joel Houck of Wells Fargo. Go ahead.

[Joel Houck:]

I guess to start off with respect to kind of reposition in the portfolio, talk about where we are in the process of minimizing the agency exposure it seems like the risk reward trade off we put on this a number of your peers calls, risk reward trade-off is not all that great right now in agency. Where we are in the process and how you see kind of 2015 playing out? If in fact the fed has raised rates this year and the yield curve flattens and with that the mortgage basis widens a bit.

[Anup Agarwal:]

Yes, thanks Joel, I appreciate the question. Look I think we plan to continue our diversification process for more credit spread products and what you would kind of see is we continue to grow both our European CRE and U.S. CRE opportunities as well as a whole loan opportunities both in residential and commercial real estate space as well as opportunistically looking at spreads in non-agency residential mortgage market so what you'd expect is as we see the opportunities we will continue to grow our credit book and continue to reduce our agency book still one of the benefits you've as you do whole loans that you get the benefit of whole loan treatment versus agency book. So we continue to increase I expect to use TBAs more as opportunistic penetrate where we see mortgage basis right now and if we have a view that mortgage basis will tighten we will use TBAs opportunistically, but otherwise we will continue on the path of larger credit spread products.

[Gavin James:]

This is Gavin, just to add to that I think no one advantage we have given our size currently is that we can be incredibly nimble and to Anup's point we can move between sectors in the mortgage market and also it allows us to be very flexible when it comes adding to the duration of portfolio given the way yields are at certain point in time if we believe that towards the top end of our range you'd see us increase our duration profile and subsequently if they book down to bottom end of that trading range with reduced duration. So being nimble in these markets is we feel is a very clear advantage.

[Joel Houck:]

I definitely agree with that, maybe when you kind of look at the tradeoff between current period return to minimizing book value volatility, as you transition out into more diversified strategy, how will that if it all changed going forward versus what we've seen maybe historically at Western?

[Anup Agarwal:]

Look, I think because we are pretty active managers, we've kept the volatility to our book value reasonably kind of restrained and I think it's because even with the kind of volatility you saw in the last quarter and this quarter we always have tail hedges in the portfolio but to answering your question, I think as we shift more to credit spread products given our view that U.S. economy will continue to move along at a slow and steady pace, that the volatility of on the margin will go down as we shift more to credit sensitive products but look, I mean I think we managed to look at both fundamentals and technical of the portfolio. One of the things which I'd highlight even the most [REIT to] work in credit risk transfer, securities last year, saw massive amount of volatility even though overall non-ageing market moved along but you kind of saw the credit risk transfer deals go from 450 to 265 and back out to 500 with 10 year spread duration. Now, this is their value effective management comps but when it was at 265 we reduced our book of credit transfer deals pretty dramatically and then as the spreads right now we put it -- we added this right back. I think in my mind diversification of the portfolio without active management I think it just gives you a sense of lower volatility but I think the value really comes from both combination of diversifying to credit risk products and at the same time active management.

[Operator:]

The next question comes from Mike Widner of KBW.

[Mike Widner:]

Hey, good morning guys. Wonder if you could talk a little more about the residential whole loan program and I guess the first question there is I see it got $7 million of residential whole loans roughly, I take it that's through that program and those are the sort of loans you were talking about?

[Anup Agarwal:]

That's a [indiscernible] Mike.

[Mike Widner:]

And so I mean maybe just a little more I mean seems like you guys have been talking about these for a while and just now that we're seeing just want to go back make sure that we're still talking same general idea, these are going to be non-QM loans mostly?

[Anup Agarwal:]

That's correct Mike, I think we still kind of think that the value across the whole loan sector is really in non-QM and our program as we have discussed with you has really not changed. I think as you know and as we have talked about it with you, I mean just bells and whistles you have to put together to be successful in the program, it just takes longer, always takes longer than what you anticipate it to be and we had the same part we had to deal with but we are seeing the production continue to move up and I think you would -- we are just about in a process of adding some more you will see kind of added in the quarter the profile still continues to be the same, non-QM low LTB, pretty attractive risk award and you would kind of see whole year we have continued to diversify more originators who provide us this not you alone, but our approach still continues to be the same.

[Mike Widner:]

And just out of curious, so these loans are they mostly hybrid arm types 5/1, 10/1, 7/1 or they fixed?

[Anup Agarwal:]

No, none of them fixed, I think at this point in time our focus is primarily on odd products. Our primary focus is 5/1, 7/1 at this point in time.

[Mike Widner:]

And any thoughts on levering and financing, how should we think about that as well securitization at some point or what are the different options and how are you guys looking at it?

[Anup Agarwal:]

Right now we have a pretty attractive financing available and ultimately as we’ve discussed with you, we will securitize these loans and we’re being taking pretty active approach with rating agencies to help them understand what we have originating, what we have originated, how we originate, what due diligence we do so that they are comfortable with the high quality of the assets we’re originating but even currently there is a pretty good leverage available from the repo counterparties we currently have.

[Mike Widner:]

So basically its repo funding as opposed to term loan facilities or conduits or anything like that right now?

[Anup Agarwal:]

I mean since 2015, we have added significant amount of non-QM loans and right now it’s from repo counterparties because that’ really where we see the best execution we have. All the different financing available, but at this in time we just don’t see using anything other than just a repo counterparty financing.

[Mike Widner:]

That makes sense and what kind of proximate rate you’re looking at and then I mean 2% is the ballpark we’re seeing in kind of most non-agency stuff elsewhere is that consistent with you guys?

[Anup Agarwal:]

Yes, I think 2% or lesser I mean I think generally what we kind of see non-agency really ranges from about 1.5% to 2%. I think we tend to be the beneficiary of it at the lower end but that’s kind of the range. The range we’re going to see is 150 to 2. More of our financing tend to be on the lower end of that spectrum and again as we have talked about given the value of the western assets platform and given our levered book of all investment is pretty miniscule relative to our overall trading book. We tend to get more favorable treatment from our counterparties relative to rest of the REIT sector.

[Mike Widner:]

I guess just a pretty different question. You guys were quite active in the fourth quarter in terms of managing your swap book, and I guess if I think back to I guess 2013 you guys had sort of -- there is these tax issues that arise for what you can write off and derivatives versus -- my recollection was a large part of this sort of special dividend paid in stock that whole sort of thing arose out of kinds of rebalancing that led to a weird sort of tax situation, I mean with the active swap -- very active swap management now do we have to worry about, not worry about -- look forward to I suppose only that stuff again?

[Anup Agarwal:]

I would say Mike that’s a difficult question to answer on this call. We can get into a little bit more details maybe later on in the quarter, but right now so by some getting here as we can’t really comment.

[Operator:]

[Operator Instructions] We have no further question Mr. James.

[Gavin James:]

Thank you, operator. With that then we would like to conclude the call. Again thanks to everybody’s support, we feel we had a great year and we look forward to seeing you all in person.