Western Asset Mortgage Capital Corporation
Q1 2015 Earnings Call Transcript

Published: 6 May 2015

[Operator:]

Welcome to the Western Asset Management Capital Corporation's (sic) [Western Asset Mortgage Capital Corporation's] First Quarter 2015 Earnings Conference Call. Today's call is being recorded and will be available for replay beginning at 5 p.m. Eastern Standard Time. [Operator Instructions] Now first, I'd like to turn the call over to Mr. Larry Clark, Investor Relations for the company. Please go ahead, sir.

[Larry Clark:]

Thank you, operator. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the 3 months ended March 31, 2015. 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; Steven Sherwyn, 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 Factor section of the company's reports filed with the SEC. Copies are available on the SEC's website. We disclaim any obligation to update our forward-looking statements unless required by law. With that, I'll now turn the call over to Gavin James, Chief Executive Officer.

[Gavin Lewis James:]

Thanks, Larry, and thanks, everybody, for joining us today for our first quarter conference call. I will begin the call by providing some opening comments. Steve 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. The first quarter of 2015 proved to be another challenging period for the U.S. mortgage markets, given the ongoing interest rate volatility that occurred during the quarter. Despite this continued volatility we generated strong core earnings for the quarter which more than supported our existing dividend. We delivered a positive economic return for the period, despite the impact of unrealized losses on our interest rate hedges, on our book value. During the first quarter, we recorded net income of $0.34 per share or generating core earnings plus drop income of $0.82 per share. Our economic return on book value was 1.9% for the quarter, which included a $0.67 per share dividend, enabling us to remain the highest-yielding mortgage REIT in the sector and that's based on yesterday's closing prices. Our results continue to reflect the ongoing implementation of our strategy to build a more diversified portfolio with a higher portion of credit-sensitive investments as well as our ability to take advantage of relative value opportunities across the entire mortgage sector through our proactive approach to portfolio management. Our performance in the first quarter was due to a number of factors. First, our core positions in Agency RMBS, Non-Agency RMBS and CMBS performed well. We were also proactive during the quarter in continually adjusting our leverage and hedge positions in response to the significant swings in the U.S. Treasury market. In addition, we harvested some gains in our Non-Agency RMBS portfolio, as we sold some high dollar priced securities based on our belief that they'd become fully valued. Our view on interest rates remains consistent. We believe that the long end of the curve will remain range-bound over the course of the year and short-term rates will remain near 0 until at least late summer, and then only gradually increase from there. This view is based on our belief that the economic growth in the U.S. will remain modest over the next several quarters and that the federal will continue to be patient and then proceed gradually with caution when it finally decides to increase short-term rates. Our portfolios continue to perform well in the second quarter with the recent move up in rates, the value of our Agency and Non-Agency holdings during the month of April have declined slightly but this has been more than offset by the increase in the value of our hedge positions. As a result, our estimated book value has improved since the end of the first quarter. Anup Agarwal will go into more detail on our outlook going forward. Our investment strategy remains the same. We plan to continue to diversify our portfolio into credit-sensitive investments and to continue to employ an active management strategy. 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 M. Sherwyn:]

Thanks, Gavin. Good morning, everyone. I will discuss our financial results for the first quarter ended March 31, 2015. Except where specifically indicated, all metrics are as of that date. On a GAAP basis, we recorded net income for the quarter of approximately $14.1 million or $0.34 per basic and diluted share. Included in the net income was approximately $28.4 million of net unrealized gains on MBS, other securities and whole-loans, approximately $7.5 million of net realized gain on MBS and other securities and approximately $48.3 million of net loss on derivative instruments. For the quarter, our core earnings plus drop income was approximately $34.4 million or $0.82 per basic and diluted share. This compares to core earnings plus drop income of approximately $36.4 million or $0.87 per basic and diluted share for the fourth quarter ended December 31, 2014. Our core earnings were approximately $29.5 million or $0.71 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, noncash stock-based compensation expense and other noncash charges. For the quarter, we generated drop income of approximately $5 million or $0.11 per diluted share, which is within our expected quarterly range given our use of to be announced or TBA forward contracts on Agency RMBS. Drop income represents a non-GAAP financial measure and is defined as the difference between the spot price and the forward settlement price for a comparable security on the trade date. For the quarter ended March 31, 2015, our average amortized cost of MBS and other securities held, including Agency and Non-Agency Interest-Only Strips, accounted for as derivatives, was approximately $4.32 billion as compared to approximately $4.45 billion for the fourth quarter ended December 31, 2014. Our net interest income for the first quarter was approximately $34.4 million. This is a GAAP financial measure 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 swaps. The latter 2 are included in the loss on derivative instruments line in our income statement. On a non-GAAP basis, our net interest income, including interest we receive from our IO securities treated as derivatives, and the cost of interest rate swaps was also approximately $34.4 million. This compares to non-GAAP net interest income of approximately $31.8 million for the fourth quarter of 2014. The increase in our net interest income was primarily due to lower hedge adjusted borrowing cost resulting from our duration management during the quarter. Our weighted average net interest spread for the first quarter of 2015, which takes into account the interest that we received from Non-Agency RMBS, CMBS and IO, whole-loans and other securities as well as the fully hedged cost of our financing was 3.16%, reflecting a 3.97% gross yield on our portfolio and a 0.81% effective cost of funds. This compares to weighted average net interest spread of 2.71% for the fourth quarter of 2014, reflecting a 3.79% gross yield on our portfolio and a 1.08% effective cost of funds. Our net yield increased primarily due to lower effective interest costs, as I mentioned earlier. During the first quarter, our constant prepayment rate, or CPR, for our Agency RMBS portfolio was 7.6% on an annualized basis. This compares to 6.8% for the fourth quarter of 2014. Despite the increase in refinancing activity that occurred during the first quarter, we are able to maintain a low CPR due to our focus on buying Agency RMBS that we believe exhibit low prepayment characteristics. Our operating expenses for the first quarter were approximately $5.6 million, which includes approximately $2.9 million for general and administrative expenses and approximately $2.7 million in management fees. Included in G&A expenses were noncash stock-based compensation of approximately $679,000. Our G&A expenses expressed as an annualized percentage of our average stockholders' equity were approximately 1.9% and were higher in the first quarter mainly due to higher professional cost and noncash stock-based compensation. Our book value per share as of March 31, 2015 was $14.55, which takes into account the $0.67 regular cash dividend that we declared on March 26, 2015, and paid on April 28, 2015. As of March 31, the estimated fair value of our portfolio was approximately $4.2 billion, and we have borrowed a total of approximately $3.6 billion under our existing master repurchase agreements. Our leverage ratio was approximately 6x at quarter end. Our adjusted leverage ratio was approximately 7.2x at quarter end, adjusted for $737 million notional value of net loan positions in TBA mortgage pass-through certificates that we held at quarter end. We continue to be in the attractive position of having repo capacity well in excess of our current needs. At March 31, we had master repurchase agreements with 25 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 lender book and believe that we have more than ample liquidity to meet our present and expected funding requirements. As of March 31, we had entered into approximately $4.5 billion in notional value of pay-fixed interest rate swaps, excluding forward starting swaps of $2.4 billion and approximately $3.1 billion of pay-variable interest rate swaps excluding forward starting swaps of $265 million, giving us a net pay-fixed swap position of approximately $1.4 billion. Additionally, we have entered into approximately $655 million notional amount of pay-fixed interest rate swaptions, with swap terms ranging from 1 to 10 years and exercise expiration dates between June 2015 and June 2016. As a result of our hedge positions, our Agency RMBS portfolio had a net duration of negative 1.7 months at quarter 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 will now turn the call over to Anup Agarwal. Anup?

[Anupam 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 first quarter saw a continuation of extreme interest rate volatility where the 10-year U.S. Treasury rate dropped by roughly 50 basis points in January and then increased by approximately 60 basis points by early March, only to drift lower from there, ending the quarter down just over 20 basis points. Given our ability to add value through active management, we made a number of adjustments to our portfolio and our interest rate hedges as market conditions changed throughout the quarter. As we enter 2015, we believe that prepayment risk will increase, putting pressure on TBAs to drop the [indiscernible] specified pools. In January we moved to a net negative position in TBAs, thus lowering our implied or adjusted leverage. This tactical shift worked well as specified pools outperformed TBAs in January. However, the flattening of the yield curve put pressure on hedge positions during January. We subsequently improved during the remainder of the quarter with partial replacement of 10-year U.S. Treasury yield. In early February, shortly after interest rates bottomed, when we increased leverage again by returning to net positive TBA position and adjusted our hedges, moving closer to a net neutral duration on our Agency RMBS portfolio. With respect to our Agency portfolio, we also sold down some of our exposure to 30-year pools and increase that exposure to 20-year pools as we believe that these pools offered a better hedge-adjusted [ph] carry and increased prepayment protection. We have 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. The majority of our Agency investments continue to be in mortgage pools with low loan balance with the remainder in high LTV or investor pools, which is consistent with our investment strategy of minimizing our prepayment risk. Our activity in credit sensitive portion of portfolio during the quarter consisted primarily of shifting our holdings within the sector, as we sold some of our high dollar price Non-Agency RMBS position and increased our holdings of residential whole-loans and GSE risk -- credit risk transfer securities. In addition, we made our first investment in commercial real estate whole-loans, although the overall mix of assets between Agency and Non-Agency securities was relatively unchanged in the quarter. We continue to target a study increase in the mix of Non-Agency securities over a longer term horizon and as we mentioned last quarter, our plan is to gradually replace a portion of our Agency RMBS holdings with the assets purchased through our whole-loan programs. 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. We have entered the second quarter with interest rates increasing closer to high-end of our expected range. As Gavin mentioned, the value of our Agency and Non-Agency holdings during the month of April have declined slightly, while the value of our interest rate hedges have continued to recover. We have slightly reduced our adjusted leverage and maintained an approximate net neutral duration on our Agency portfolio, given our belief that the number of cross-currents in global macroeconomic environment, it is best to maintain such a duration positions. That being said, we expect to continue to manage our leverage and duration opportunistically, based on our view of U.S. mortgage market at any point in time. We are making steady progress on our home loan strategy, we have increased our investment in non-QM residential mortgages and are also ramping up our commercial mortgage program, with a focus on short-term transitional, commercial first mortgages with maturities inside 2 years, loan amounts in the $5 million to $20 million range and LTVs in 65% to 70% range. 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 the 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 our stable book value. With that, we will now entertain your questions.

[Operator:]

[Operator Instructions] Our first question comes from Joel Houck from Wells Fargo.

[Joel Jerome Houck:]

You guys talked about the inter-quarter net duration band that you're comfortable with. Of all the mortgage REITs you covered, I think you guys are probably one of the more active managers out there, and I guess it would be helpful from a kind of risk-reward trade-off to understand what you're comfortable with inter-quarter, we obviously see the end of quarter net duration, but as you know it changed dramatically inter-quarter.

[Anupam Agarwal:]

Yes, thanks, Joel. Again, I think as we have discussed before with you, I think at any point in time, I think you -- the most you kind of see from us in terms of a duration gap has been plus minus. Plus 1 to minus 1 in duration, at any point in time, on Agency portfolio.

[Joel Jerome Houck:]

And how about the overall, taking into account the credit book which has some offsetting characteristics to the Agency book?

[Steven M. Sherwyn:]

Yes, no, I think look, we -- I always look at both just the combination of Agency portfolio as well as just a broader credit book. But some of the -- some of the credit instruments even when they show that they have a duration, there's -- they don't -- they are more credit instruments than a interest rate sensitive instrument. If it's a legacy RMBS security, yes, they have -- they're all floaters and they have 0 duration. And you get some benefits of it, but ultimately kind of where we see the bigger impact of duration is really on the Agency book. I think, I look at both combination of Agency, as well as the combination of Agency and credit-sensitive book and overall, you would not see from us going too within the band of plus 1 year to minus 1 year. Generally, even when it's plus 1 to minus 1, kind of on the wider end of those ranges, it's more when we have a very, very strong conviction that it's going one way or the other. Generally, it sticks within about plus minus half-year is where we would see our book.

[Operator:]

And our next question comes from Lucy Webster from Compass Point.

[Lucy C. Webster:]

I was hoping you could just generally talk about what you're seeing in the CRE market these days, and maybe where you see that strategy ramping over the course of the year.

[Anupam Agarwal:]

Sure, no, I mean, look, I think in CRE -- so there are effectively 3 segments in CRE where we see opportunity. The first one, which happens to be in our Legacy CMBS market where kind of we have been -- the Junior AAAs or what is called as AJs, we still see some value in some of those legacy books, but that legacy AJ book is slowly starting to come down because the bet played out, still have a strong carry, still have a very attractive leverage yield, but it's the strategy played out and I think we are slowly starting to reduce that exposure. The place where we do see value right now is on second -- on the new issue CMBS, especially lower in the classes in the BB, B, classes because those yields look very attractive as well as in U.S. and Europe CRE mezz, especially buying kind of the net positions, anywhere from 55 to 75 kind of LTV, kind of positions ranging anywhere from 650 over to 800 over. And actually the part of the -- the third part of the bucket which is the U.S. mezz and European mezz as well as the whole-loan program in CRE, which is kind of the transitional loans where borrowers used to go to community bank. These are again low LTV loans which are 60, 65 loan-to-value loans, 2 year maturity, 1- to 2-year maturity, have some coupon anywhere from 6% to 9%. That's really where we see -- those are the 2 buckets where we see value and that's really what you will see us grow while the other buckets kind of come down.

[Operator:]

[Operator Instructions] We have no further questions, Mr. James.

[Gavin Lewis James:]

Okay, with that, I'd like to thank everybody for joining the call today, and I look forward to meeting many of you in person over the course of the next couple of months. Thank you, operator.

[Operator:]

Thank you, again for joining us for the call. We look forward to seeing many of you in the months ahead. Thank you. You may now disconnect the line.