Western Asset Mortgage Capital Corporation
Q2 2015 Earnings Call Transcript

Published: 31 Jul 2015

[Operator:]

Welcome to the Western Asset Management Capital Corporation’s Second 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. At this time all participants have been placed in a listen-only mode. And the floor will be open for your questions following the presentation. Now first, I’d like to turn the call over to Mr. Larry Clark, Investor Relations for the company. Please go ahead, Mr. Clark.

[Larry Clark:]

Thank you, operator. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months ended June 30, 2015. 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’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 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’ll now turn the call over to Gavin James, Chief Executive Officer.

[Gavin James:]

Thank you, Larry, and thanks 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. 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 second quarter of 2015 turned out to be another challenging period for the U.S. mortgage markets, with an extraordinary level of interest rate volatility brought up by events in Greece and China as well as a boarder geopolitical risk. Despite this continued volatility, we once again generated strong core earnings plus drop income for the quarter, which more than supported our existing dividend. While our portfolio wasn’t immune to the overall volatility in the mortgage markets our diversification and proactive approach to portfolio management enabled us to deliver a break even economic return for the quarter. During the second quarter we recorded a GAAP net loss of $0.05 per share while generating core earnings plus drop income of $0.76 per share. Our economic return on booked value was break even for the quarter which included a $0.64 per share dividend, enabling us to remain one of the highest yielding mortgage REITs in the sector based on yesterday’s closing prices. During the second quarter we continue to implement our strategy of building a more diversified portfolio, with a higher portion of credit sensitive investments. To that end, credit investments represented approximately 32% of our total portfolio as of June 30th, which is up from 28% at the end of the first quarter. In addition we were proactive in both our asset and liability management during the quarter looking to take advantage of relative value opportunities across the entire mortgage sector as well as manage through the increased interest rate volatility. A high level of volatility generally both negatively for mortgage spreads, which prove to be the case in the agency sector, which we reduce - which reduced the value of our agency holdings. However the larger position that we have built in the credit sensitive sector performed well during the quarter. And our liability hedges were well positioned along the yield curve, which resulted in an increase in the value of our hedge positions during the quarter, further offsetting the mark-to-market decline in some of our assets. And finally given our ability to be nimble we were able to continue to adjust our leverage and hedge position throughout the quarter in response to the significant swings in the U.S. treasury market. The combination of these factors helped to produce a solid quarter from a relative performance standpoint, particularly given the lessen ideal conditions is for managing a mortgage REIT. Our view on interest rates remained consistent, we believe that the long end of the curve will be range bound over the remainder of the year and the short-term rates will remain near zero until at least early fall and then only gradually increase from there. This view is based on I believe that economic growth in the U.S. will continue to be modest over the next several quarters and that the federal will proceed gradually and would caution when it finally decides to increase short-term rates. Our portfolio has continued to perform well into the third quarter with a slight increase in book value since the end of the second quarter. Additionally we have significantly increased our whole-loan holdings to over $150 million up from $30 million at June 30th. We have spent the last several quarters building our whole-loan origination platform and performing extensive due diligence on originators and now we are beginning to see a meaningful pipeline of opportunities for our origination partners. Given our increased holdings of residential whole-loans we have initiated a due diligence process of becoming a member of the Federal Home Loan Bank. It is our hope that our membership will be approved by the end of 2015. If we are successful in our application to the FHLB we will have access to a low cost longer-term financing that will reduce our cost of funds and improve the overall economics of our portfolio. In terms of our overall strategy we intend to continue on the same course we have been on for the past several quarters. We plan to continue to diversify our portfolio into the credit sensitive investments and to continue employ an active strategy - management strategy. With the higher volume of whole-loan investment opportunities starting to come through our pipeline, we expect to accelerate the shift towards it more although we can’t guarantee the performance of our portfolio investments, we believe we are well positioned to deliver on our long-term objective in 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 Steven Sherwyn our CFO to discuss our financial results.

[Steven Sherwyn:]

Thanks, Kevin. Good morning everyone. I will discuss our financial results for the second quarter ended June 30, 2015. Except were specifically indicated all metrics are as of that date. On a GAAP basis, we recorded a net loss for the quarter of approximately $1.7 million or $0.05 per basic and diluted share. Included in the net loss was approximately of $42.8 million of net unrealized loss on MBS, of the securities and whole-loans approximately $4.3 million net realized gain on MBS and other securities and whole-loans and approximately $13.2 million of net gain on derivative instruments. For the quarter our core earnings plus drop income was approximately $31.7 million or $0.76 per basic and diluted share. This compares to core earnings plus drop income of approximately $34.4 million or $0.82 per basic and diluted share for the first quarter ended March 31, 2015. Our core earnings were approximately $26.9 million or $0.64 per basic and diluted share, which is the 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 $4.8 million or $0.12 per basic and diluted share, which is consistent with the prior quarter given our use of to be announced or TBA forward contracts on Agency RMBS. Drop income represents non-GAAP financial measure and is defined as the difference between the spot price and the forward settlement price for comparable security on the trade date. For the quarter ended June 30, 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 $4.31 billion relatively unchanged from the first quarter. Our net interest income for the second quarter was approximately $34.5 million. This number is a GAAP financial measure and does not include the interest we receive 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 receive from our IO securities treated as derivatives, and the cost of our interest rate swaps was also approximately $31.8 million. This compares to non-GAAP net interest income of approximately $34.4 million for the first quarter of 2015. A slight increase in our net interest income was primarily due to a moderately smaller portfolio and higher hedge adjusted borrowing cost, resulting from our leverage and duration management during the quarter. Our weighted average net interest spread for the second 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 2.79%, reflecting a 3.98% gross yield on our portfolio and a 1.19% effective cost of funds. This compares to weighted average net interest spread of 3.16% for the first quarter of 2015, reflecting a 3.97% gross yield on our portfolio and a 0.81% effective cost of funds. Our net yield decreased primarily due to higher effective interest costs, as I mentioned earlier. During the second quarter, our constant prepayment rate, or CPR, for our Agency RMBS portfolio was 9.8% on an annualized basis. This compares to 7.6% for the first quarter of 2015. Despite the increase in refinancing activity that occurred during the second quarter, we were 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 second quarter were approximately $5.8 million, which includes approximately $3.1 million for general and administrative expenses and approximately $2.7 million in management fees. Included in the G&A expenses were non-cash stock-based compensation of approximately $781,000. Our book value per share as of June 30, 2015 was $13.89, which takes into account a $0.64 regular cash dividend that we declared on June 18, 2015, and paid on July 28, 2015. As of June 30th, the estimated fair value of our portfolio was approximately $3.9 billion, and we have borrowed a total of approximately $3.4 billion under our existing master repurchase agreement. Our leverage ratio was approximately 5.9 times at quarter end, which is inclusive of a net neutral position in TBA. We continue to be in the attractive position of having repo capacity well in excess of our current needs. At June 30th, we had master repurchase agreements with 25 counterparties and outstanding borrowings with 20 counterparties. We continue to have an excellent relationship 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. Further as Gavin mentioned, we’ve started the due diligence process on becoming a member of the Federal Home Loan Bank. As of June 30, 2015, we had entered into approximately $10.1 billion in notional value of pay-fixed interest rate swaps, excluding forward starting swaps of $2.2 billion and approximately $7.4 billion of pay-variable interest rate swaps, excluding forward starting swaps of $1.2 billion, giving us a net pay-fixed swap position of approximately $2.7 billion. Additionally, we have entered into $105 million notional amount of a pay-fixed interest rate swaps with a swap term of one year and exercise expiration date of June 2016. As a result of our hedge positions, our Agency RMBS portfolio had a slightly negative net duration of 0.1 month 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 ratio 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 turn the call to Anupam 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 second quarter saw a continuation of interest rate volatility. 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 change throughout the quarter. As the quarter progressed and mortgage spreads right now, we reduced our leverage both by closing out our net loan position in TBAs and reducing our holding of 20 year and 30 year fixed rate pools. We also added interest rate tail hedges to the portfolio these tactical moves enabled us to reduce the mark-to-market loses on our Agency portfolio and helped us mitigate the pressure on our book value during a very challenging period. On the credit sensitive portion of the portfolio, we added to our overall positions as the quarter progresses particularly near the end of the quarter, when credit spreads became more attractive in certain sectors of the market. By the end of June we had increased our exposure to CMBS particularly mezzanine and B-Notes as well as GSE credit risk transfer or CRT securities. All of which we believe offer compelling risk adjusted returns relative to our investment universe. Within the CRT securities, we shifted more of our holdings towards the equity slices rather than the unrated classes, which have proven to be a good rate as equity slices have outperformed in the current environment. Finally, we modestly increased our holdings of whole-loans in the quarter, as we have been inventing up our origination platform and putting in place our agreements with our origination partners. In the month of July, we accelerated addition of this asset class to the portfolio, adding more than $120 million in residential whole-loans, as our pipeline has begun to generate a higher volume of deal flow. Based on our current outlook, we expect to continue replacing Agency RMBS in the portfolio with residential and commercial whole-loans through the reminder of the year, as we migrate to a more credit sensitive portfolio. We believe that our credit sensitive investments will continue to perform well in gradually improving U.S. economy, while exhibiting less interest rate sensitivity than agency securities. With respect to leverage it should be noted that as our portfolio becomes more weighted to credit sensitive investments, our asset level of leverage will gradually decline as the required collateral levels are generally higher for credit assets versus Agency RMBS. Given the number of cross currents in global macroeconomic environment and the eventual increase in domestic short-term rates, we expect to maintain a relatively neutral net duration position within our agency portfolio. That being said, we also expect to continue to manage our leverage and duration opportunistically based on our view of U.S. mortgage market at any point in time. As we have said in the past, our goal is to maximize total return for our shareholders, we plan on continuing to implement the strategy by holding a diversified portfolio of security 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 a stable book value. With that we will now entertain you questions. Operator, please open up the call.

[Operator:]

Thank you. We will now begin the question-and-answer session. [Operator Instructions]. And our first question comes from Joel Houck from Wells Fargo. Please go ahead.

[Joel Jerome Houck:]

Good morning, and congratulations on the good job mitigating the book value decline and what was obviously a challenging quarter for the industry. I guess looking out the rest of the year you just mentioned a new bit, you’re going to increase exploiting the credit sensitive assets. Given your CPI level on the Agency on the other hand it seems like you are in a lot of specified pools that aren’t that sensitive to rate I am wondering the fed does in fact increase and we see more volatility. From your perspective how is that play out in terms of increasing allocation into more broadly in the agency space and I guess do you worry that just because there is one fed rating the fear of additional increases and it’s been so long since we’ve actually seen rate increases that it’s perhaps not even worth taking on that risk profile on the agencies base.

[Anupam Agarwal:]

Sure, I mean Joel thank you for - I think the way I am looking and the reason I kind of I am focusing at increasing the credit versus mortgage spreads, although in the short term I am constructive for agency, but over a long-term thinking about not only through the year end, but next year ultimately fed will stop buying agencies. And I am less worried about the rate increase because on average as we kind of mentioned we are running a flat duration gap for our book. I think my worry overall over long-term is kind of increase in mortgage spreads and that’s really where we kind of see that continued improvement in - continued addition of credit, both specially whole-loans book in residential and commercial mortgages we’ll continue to perform well. Because our general view of macro-environment is that we’ll continue be in the slow growth environment for globally, which will cause our U.S. growth to be slow. And yes, we expect that fed with raise rate sometime this year. But it will still be an environment with pretty high rate wall and in the higher rate wall environment it is difficult to see that the mortgage spreads tighten.

[Joel Jerome Houck:]

Okay. That’s very helpful. And on the hedging side, I mean, can you maybe give us a little color on given your type of portfolio, it seems like your agency portfolio held up a lot better than most how you’re viewing the hedge ratio and then where you think the most exposure is in terms of the yield curve?

[Anupam Agarwal:]

Yeah I mean look, I think as you can kind of see that we just - the reason our portfolio hold well is because as we have talked in the past we consistently always look to add sales [ph] hedges in the portfolio. So in addition to keeping the duration flat what we also do at any point in time is try to hedge broader spread widening and at any point in time we have options on 10 years as a last rate wall to hedge any spread widening. And I think you will continue to see significant usage of those options or different other instruments like CDS or interest rate swaps or rate wall, kind of sales [ph] hedges to protect for spread widening. But overall from rate perspective, I think as we’ve mentioned we very opportunistically add or short duration, but generally it doesn’t last for long time it is very, very opportunistic.

[Joel Jerome Houck:]

Alright, thank you very much Anup.

[Operator:]

Our next question comes from Rich Shane from JP Morgan. Please go ahead.

[Rich Shane:]

Thanks guys for taking my questions. So I understand the shift to the not agency credit sensitive assets and I understand strategy of reducing duration on the agency book, but what I want to make sure we fully reconcile it, book value is down presumably reducing the duration on the agency book diminishes the ROE on that portion of the investments. Should we anticipate some compression of core earnings from here?

[Anupam Agarwal:]

No. Not really look I mean, I think from my perspective which is I think the answer I would divide the answer in couple of steps. One is keeping the duration t gap as closed to flat as possible is really more for the perspective that we want to - we are not looking to add any interest rate volatility in our portfolio. What we are clearly trying to do is capture the carry from our mortgage book. The reason we continue to shift more towards credit is that carry is pretty effective and we kind of think that it will continue to work very well. Now in terms of over long-term because I think in a short-term I am constructive on mortgage spreads and the return is very attractive on credit-sensitive assets.

[Rich Shane:]

Okay. But again by reducing the duration - I mean, I understand the strategy of hedging and why you would want to do that in this current environment. But presumably that comes at a cost in terms of near-term earnings. So is the idea that you are going to be able to shift quickly enough to non-agency that that’s going to offset the - I mean at least theoretical compression related to taking down your interest rate risk on the agency side.

[Anupam Agarwal:]

That’s actually exactly right Rich. I mean I think our returns what we in the credit spread products is very attractive and we are very confident that we can shift the portfolio pretty quickly to kind of add more whole-loan products in both residential and commercial to be able to replace the core earnings, which from that versus - we still earn some carry on agency. But overall with kind of we will be able to boost it pretty significantly from our whole-loans and commercial real estate assets.

[Rich Shane:]

And then last question related to that. Does it make sense to actually instead of netting out the portfolio through swaps take down the exposure, would that create realized losses and you don’t want to do that in this environment?

[Anupam Agarwal:]

No I mean, I think Rich you have kind of seen in the past that generally what we do is every on a regular basis we do some compression trades and you kind of see the swap book overall come down between fixed paying versus floating, but it doesn’t have any right now the way it stands, it doesn’t have any economic impact for it. But on the regular basis we do compression trades. And you would kind of see it, I mean if you look at it in our past quarters, every regular basis we have done the compression trades to kind of reduce our overall swap book without making any impact on our economic - economic impact and we will keep doing it. I think we’ve shown it in the past and I fully intend to kind of do that in the future as well.

[Rich Shane:]

Got it. And just one last clarification, I’m always honest being with myself to acknowledge when I don’t fully understand something. When you say compression trade what you are basically saying is giving up spread in order to mitigate book value risk?

[Anupam Agarwal:]

No, I think when I say compression trades you asked me the question about swap book and the compression trade that I just simply means that if you look at the paid for swaps and you have fixed paying swaps versus floating, I’m just saying that instead of each category you can just see compressed. For example, if you pick the category of greater than five years notional amount, you have $6 billion in notional amount of fixed based swaps and you have $4.6 billion of variable pay. You can see some that netting out against each other and we may close out that swap positions. That’s all.

[Rich Shane:]

Got it. Okay, that make sense. Thank you very much.

[Operator:]

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

[Jason Stewart:]

Hey, good morning it’s Jason. Thanks for taking the question. Wanted to ask you how you thought through the IO inverse IO portfolio and whether you look at that today what’s your view on rates and spread there is more of an asset hedge and how that’s going to play out going forward over the next couple of quarters in your mind?

[Anupam Agarwal:]

Sure. I mean I think one within that IO inverse IO book we have been... we still expect our broad macro views that even though fed will raise rates sometime this year, but the pace of raise will be pretty slow and ultimately that terminal fed funds rate will be low. And relative to that we still find IO inverse IO market pretty attractive. But having said that, we have shifted our portfolio more from inverse IO to into more of IO book and even within IO kind more arm IOs which have been with the collateral type which has been very stable prepay and that has provided as attractive carry. And we can’t simply look at fully risk adjusted with our view where we see a better value and we continue to shift our portfolio between the two based and where we see the best value given our rate view and forecast.

[Jason Stewart:]

That’s helpful and thank you. And if you took a step back there and you thought about that asset class versus swaps is a hedge or an asset. I’m just wondering how much you think it can contribute to earnings or is it really more something you view as a complement to your hedge portfolio?

[Anupam Agarwal:]

Look I kind of see that as a complement to our overall portfolio both from kind of purely hedge adjusted carry for our mortgages versus what we can - where we can generate spreads. So it’s just one of the categories among many for how we can add spread to our portfolio.

[Jason Stewart:]

Got it and clearly it’s been a good one for you, appreciate you answering the question. Thank you.

[Operator:]

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

[Gavin James:]

Okay, thank you very much. Thanks for joining us on the call. Appreciate your time this morning. And we look forward to seeing many of you in the months ahead. Thank you, operator.

[Operator:]

Thank you. The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.