Western Asset Mortgage Capital Corporation
Q4 2015 Earnings Call Transcript

Published: 1 Mar 2016

[Operator:]

Welcome to Western Asset Mortgage Capital Corporation’s Fourth Quarter and Year End 2015 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 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 and 12 months ended December 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; Lisa Meyer, Interim 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 Factors section of the company’s reports filed with the Securities and Exchange Commission. Copies are available on the SEC’s website, www.sec.gov. We disclaim any obligations to update our forward-looking statements unless required by law. With that, I will now turn the call over to Anup Agarwal, for some opening remarks. Anup?

[Anup Agarwal:]

Thank you, Larry, and thank you everyone for joining us today for our fourth quarter conference call. We’re going to deviate slightly from our usual format today. Before we begin with our usual review of the quarter’s results, I want to say a few words about the change in CEO that we announced yesterday afternoon. As you saw, Gavin James has announced his retirement from Western Asset Management, and will be stepping down from his position as CEO of the REIT on June 1. Gavin, has been the CEO of the REIT since its IPO, and has provided exceptional leadership during a very challenging time in the mortgage markets. We are all very grateful for his service, and I speak for entire Western Asset team when I say that he is a great colleague that we have all enjoyed working with. We wish him well, as he begins a new chapter in his life. The Board of Directors has named Jennifer Murphy as the new CEO upon Gavin’s retirement. Jennifer currently servesas the Chief Operating Officer for Western Asset Management Company. She has spent nearly 30 years with Western Asset and our parent company Legg Mason. Including serving as Chief Administrative Officer of Legg Mason, and President and CEO of Legg Mason Capital Management. The equity investment affiliate of Legg Mason. Given the experience and success Jennifer has had at both Legg Mason, and Western Asset, we believe she is well qualified to lead the REIT in our continuing efforts to generate an attractive return for our shareholders. With that, I’ll turn the call over to Gavin to begin our usual discussion. Gavin?

[Gavin James:]

Thank you, Anup and thank you for those kind words. I have greatly enjoyed my time at Western Asset and I will miss working with such a talented group of dedicated people. I’m going to start off our review of the fourth quarter with some opening comments. Lisa Meyer, our interim Chief Financial Officer will then discuss our financial results. And then Anup Agarwal, 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. During the fourth quarter, we continue to see a high level of volatility in the fixed income markets driven by global macroeconomic concerns and uncertainty related to interest rate policy changes in the United States. That is generally the case, heightened volatility leads to spread widening in the mortgage sector and higher hedging costs, and the fourth quarter was no exception. As a result of these factors, we had an economic return on book value of negative 3.6% in the quarter, which was disappointing for us, related to our expectations, and our past performance. From an earnings perspective, we’ve recorded a GAAP net loss of $0.49 per share, while generating core earnings plus drop income of $0.39 per share. We declared a $0.58 per share dividend for the quarter, enabling us to remain one of the highest yielding mortgage REITs in the sector based on yesterday’s closing prices. Over the course of 2015, we remain consistent with our strategy to transition our portfolio towards more credit sensitive investments, subject to the regulatory limitations regarding our portfolio composition, and which we believe present more attractive risk adjusted returns. We’ve done a lot of work to increase our ability to source the type of assets that we want for the portfolio and as we move through the year, we’re able to accelerate the shift away from agency mortgages. At the end of 2015, credit sensitive investments comprised 43% of our portfolio, up from 28% at the end of the prior year. The transition in our portfolio is clearly an ongoing process, and part of a longer-term strategy. We have to accept the credit sensitive investments are not going to continuously outperform agency mortgages, and it will be shorter periods of time in which market conditions are less favorable for the strategy, as we saw in the fourth quarter. However, over the long-term, given our expectations for ongoing yet gradual economic growth in the U.S. including a continued positive outlook for both residential and commercial real estate markets. We believe the credit sensitive investments represent the most attractive relative value opportunities within the mortgage sector, and a portfolio more heavily weighted towards these assets will generate the best economic return for our shareholders. We continue to believe that we are in a lower for longer interest rate environment. Given uncertain global economic conditions and continued modest growth in the U.S. economy. We believe that economic growth in the U.S. will be in the 1.5% to 2% range for the next several quarters. And the Fed will only raise rates one or two times through 2016. In addition to our fourth quarter earnings today, we also announced that our Board of Directors has reauthorized our share repurchase plan which expired at the end of 2015 for up to 2.05 million shares of our common stock. In our assets, the best use of capital continues to be weighted toward investing in our target assets. However the buyback authorization gives us the flexibility to be opportunistic, in considering other options for capital deployment that may be attractive on a relative basis at any given point in time. On a final note, as you know, our friend and colleague Steve Sherwyn, passed away in December, and our thoughts and prayers continue to be with Steve’s family. I also want to thank Lisa Meyer, who stepped in as our interim Chief Financial Officer during this transition period. Lisa has done an excellent job providing oversight to our finance and accounting team, supporting the investment team, and reporting to our executive team and the Board of Directors. At this time, I’m going to turn the call over to Lisa to discuss our financial results.

[Lisa Meyer:]

Thank you, Gavin. Good morning, everyone. I will discuss our financial results for the fourth quarter ended December 31, 2015. Except where specifically indicated, all metrics are as of that date. On a GAAP basis, we recorded a net loss for the quarter of approximately $20.1 million or $0.49 per share. Our core earnings plus drop income was approximately $16.6 million or $0.39 per share. This compares to core earnings plus drop income of approximately $22.6 million or $0.54 per share for the third quarter of 2015. Our core earnings for the quarter were approximately $15 million or $0.36 per share, which is a non-GAAP financial measure and our drop income was approximately $1.5 million or $0.03 per share. Our average amortized cost on our investments including Agency and Non-Agency Interest-Only Strips, accounted for as derivatives was approximately $3.1 billion, down 10% for the third quarter, as we reduced our average portfolio leverage during the fourth quarter. Our net interest income for the fourth quarter was approximately $27.4 million. This number is a GAAP financial measure and does not include the interest received from our Interest-Only Strips that are accounted for as derivatives, nor does it take into account the cost of our interest rate swaps. On a non-GAAP basis, our net interest income was approximately $20.1 million. This compares to non-GAAP net interest income of approximately $25.1 million for the third quarter of 2015. The decrease in our net interest income was approximately due to a smaller portfolio and higher hedge adjusted borrowing cost during the quarter. Our weighted average net interest spread for the fourth quarter of 2015, which takes into account, the interest received from our investments including our Agency and Non-Agency Interest-Only Strips, accounted for as derivatives as well as the fully hedged cost of our financing was 2.18%, reflecting a 4.42% gross yield on our portfolio and a 2.24% effective cost of funds. This compares to a weighted average net interest spread of 2.45% for the third quarter of 2015, reflecting a 4.03% gross yield on our portfolio and 1.58% effective cost of funds. Our net yield decreased primarily due to higher effective interest costs, as I mentioned earlier. Our operating expenses for the fourth quarter were approximately $5.5 million, which includes approximately $2.8 million for general and administrative expenses, and approximately $2.7 million in management fees. Included in general and administrative expenses, is approximately $332,000 of non-cash stock based compensation. Our book value per share as of December 31, 2015 was $12.21, which takes into account, the $0.58 regular cash dividend that we declared on December 17, 2015 and paid on January 26, 2016. As of December 31, the estimated fair value of our portfolio was approximately $3.1 billion, and we borrowed a total of approximately $2.6 billion under our existing master repurchase agreement. Our leverage ratio was approximately 5.1 times at year-end and 6.7 times when adjusted for our net TBA position. We continue to have repo capacity in excess of our current needs. At December 31, we had master repurchase agreements with 26 counterparties and outstanding borrowers with 21 counterparties. We continue to have excellent relationships with our bank counterparties and we feel comfortable with our existing group. As of December 31, we entered into approximately $5.5 billion in notional value pay-fixed interest rate swaps, excluded forward starting swaps of $710 million and approximately $2.3 billion of pay-variable interest rate swaps, giving as a net pay-fixed swap position of approximately $3.2 billion. Additionally, we enter into a net $105 million notional value pay-fixed interest rate swaptions. We are comfortable with our current leverage. We have and will continue to adjust our implied leverage fairly quickly through the use of TBAs, which we believe enables us to optimize our core earnings on a risk-adjusted basis. With that, I will now turn the call over to Anup Agarwal. Anup?

[Anup Agarwal:]

Thanks, Lisa. Let me spend a few minutes discussing our portfolio management during the quarter and our strategy going forward. When the fourth quarter begin, we were operating with a view that is slow growth, global economic environment, would persist for a period of time and that while the Fed will increase rates in December, they would be slow to implement, further increases, until it was clear that the economic data justified the moves. As the quarter progressed in the mortgage spreads, continue to show a very high level of volatility. So we reduce our leverage by selling off some of our holdings of Agency RMBS, as well as, some of our Agency IOs and Inverse IOs. We also added additional interest rate in equity tail hedges to the portfolio, given our concern for potential future interest rate mortgage and credit spread volatility. In addition, we didn’t find TBA market to be, particularly attractive in the quarter, and therefore we had lower drop income, as we have mentioned in the past, when we expect a high level of rate and spread volatility, we generally will have lower exposure TBAs. During the fourth quarter, we saw a high level of rate volatility where the rate on 10 years begin the quarter at 2.1%, increased to nearly 2.4% by mid quarter and then swung back and forth within 25 basis point range, until ending the year at 2.27%. That being said, we tactically increased our TBA position in the last two weeks of the year. As the opportunistic trades based on our expectations for short-term agency spreads, we subsequently reversed this position in early weeks of 2016 booking again on the transaction. As a consequence of operating with lower leverage, on average, and experiencing higher hedging costs, we generated lower core earnings than the prior quarter. In the credit sensitive portion of the portfolio, our overall exposure to CMBS remained relatively constant for the quarter. However, we reduced our exposure to a new issued CMBS rotated into mezz and B-notes as well as legacy AAA junior classes. In addition, we will do the exposure to Non-Agency RMBS and GSE credit risk transfer securities. We implemented these moves based on where we saw the best relative value opportunities within the Non-Agency CMBS and RMBS sectors. Finally, we continue to increase our holdings of Whole-Loans, as we continue to find this asset class particularly attractive relative to our agency holdings, as well as other credit sensitive securities. Based on our current outlook, we expect to continue replacing Agency RMBS in the portfolio with Whole-Loans, as we move forward into 2016 and of course subject to the regulatory limitations regarding our portfolio composition. While we believe that these portfolio moves should enable us to generate attractive risk adjusted returns over the course of the next 12 to 18 months, in the short run it has put pressure on our book value as the credit spreads widened in the fourth quarter and have continued to widen in the first few months of 2016. As a result, we generated a negative economic return, up 3.6% in the fourth quarter, primarily driven by mark-to-market unrealized losses on our portfolio due to this credit spread widening. Given the challenging equity and credit markets that we have seen during early part of 2016, our book value has come under additional pressure and had declined between 4% and 6% since the beginning of the year. As Gavin mentioned, our performance in any given quarter, maybe challenging but we are positioning the portfolio to perform well over a longer investment horizon. We believe that our credit sensitive investments will perform relatively well in a slow growth U.S. economy, while also exhibiting less interest rate sensitivity than agency securities. As I mentioned on the past calls, our residential Whole-Loan portfolio consists solely of hybrid ARMs and some of our CMBS securities are backed by variable rate loans. The underlying collateral on the bulk of our investments is U.S. residential and commercial real estate. We continue to see positive fundamentals for both of these markets, given healthy consumer and end market demand, limited new supply and a moderately growing jobs market. We believe that the credit spread widening in the mortgage market is more technically driven and happening in correlation with the spread widening in corporate credit market and is not being driven by any deterioration in the fundamentals of U.S. real estate markets. With respect to leverage, it should be noted that as our portfolio becomes more rated to credit sensitive investments on an absolute level of leverage will gradually decline, as required collateral levels are generally higher for credit assets versus agency RMBS. As always we manage our leverage opportunistically based on changing conditions in the mortgage market. As a general statement, we believe that when there is a high likelihood from mortgage spreads to widen, it will affect the amount of leverage we get carried throughout any given quarter As we have consistently said in the past, our goal is to maximize full 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 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. Please go ahead.

[Joel Houck:]

Thank you, and again, condolences for Western's loss with the passing of Steve. We're really going to miss him going forward especially on these calls.

[Gavin James:]

Thanks, Joel.

[Anup Agarwal:]

Thanks, Joel.

[Joel Houck:]

So obviously, there is no big secret that the book value has been under pressure for the entire sector for some time. This is really the first quarter in quite a while where Western was an outlier in the fourth quarter. And given your commentary on first-quarter developments, I guess it would be helpful if perhaps you guys could maybe today talk about the geography between how much agency, non-agency and the hedges contributed to the book value decline in Q4. And then perhaps if you could disclose that or consider disclosing that going forward, I think that would help investors. So I guess the first question is, can you talk about how much each one of the broader categories contributed to the book value decline in the fourth quarter? And then the second question is related to that, in that, given your commentary about lower for longer, where does the tolerance for Non-agency MBS allocation kind of wane, if you will? In other words, if we start to see kind of persistence weakness in the economy and even lower rates, would you guys contemplate turning back the credit exposure at some point this year? Thank you.

[Anup Agarwal:]

No absolutely, Joel. Thank you for – look when I think in the fourth quarter, I would probably say, in terms of book value decline was pretty balanced between credit, and agency spread. Because kind of keep in mind in the first quarter – I mean in the fourth quarter, you had – and especially the first half of the quarter, you had agency spreads widened a reasonable amount before coming in. And the credit spreads to a great degree saw bigger impact in late part of November and December. So I think the book value decline contributions came pretty balanced between the two books. Versus as well as the soft spreads, tightened quite a bit. So I think the combination of all of these contributed to the book value decline. Versus in is looking forward, I think as we commented for up to this time and the first quarter, a big part has – those comes more from credit spreads. Because credit spreads if you look at broader structured product markets whether it's a CMBS or credit risk transfer securities, the January/February saw pretty much one of the largest widening of kind of that segment especially in the credit segment of the market. Looking – our views are, continue to be to – will be in this slow growth environment, and what we're seeing is that spreads have stabilized. We are not seeing the widening, and our view is that we will be in this slow growth environment for the U.S. consumer and U.S. economy. But, as per your questions, look, I think – and we continue to run a reasonable amount of rate hedges to protect for downshift in economy. But if we see pretty significant weakness if we kind of see that the world is – that U.S. economy is turning more towards recession, then we will reduce our credit further, and you would see little more tail hedges in the portfolio. And kind of effectively shift a little more towards the agency exposure.

[Joel Houck:]

Okay. Thanks, Anup. And just to clarify, given that the book value so far is not down as much in the first quarter and the fourth quarter, can we necessarily infer that the agency and the hedges have held in better in the first quarter than they did in Q4?

[Anup Agarwal:]

For sure. For sure…

[Joel Houck:]

All right. Thank you very much.

[Operator:]

[Operator Instructions] And we have no additional questions at this time. I would like to turn the conference back over to Mr. James for closing remarks.

[Gavin James:]

Okay. Thanks, everybody. Thanks for joining the call. And if you have any follow-up questions, please feel free to contact us. Thanks very much.

[Operator:]

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