Western Asset Mortgage Capital Corp (WMC) 2012 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Western Asset Mortgage Capital Corporation's fourth-quarter and year-end 2012 earnings conference call. Today's call is being recorded and will be available for replay beginning at 5.00 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 I would like to turn the call over to Mr. Larry Clark, Investor Relations for the Company. Please go ahead, Mr. 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 and year ended December 31, 2012. By now, you should have received a copy of today's press release. In addition, we are 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 at www.westernassetmcc.com.

With us today from Management are Gavin James, Chief Executive Officer; Steven Sherwyn, Chief Financial Officer; Stephen Fulton, Chief Investment Officer; Travis Carr, Chief Operating 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.

Thank you, Larry. And thank you all for joining us today for our fourth-quarter and year-end earnings conference call. I will begin the call by providing some opening comments. Steve Sherwyn, our CFO, will then discuss our financial results. Travis Carr, our Chief Operating Officer, will discuss the current trends we are seeing in the Agency RMBS market. And then Steve Fulton, our Chief Investment Officer, will provide an overview of our investment portfolio, our liability profile, and future outlook. After our prepared remarks, we will conduct a brief question-and-answer session.

We are very pleased with the results that we achieved to date as a publicly traded mortgage REIT. From the IPO, which was completed on May 15, 2012 through December 31, 2012, we have delivered an annualized economic return on book value in excess of $0.32, from a price of $2.35 per share in dividends and $1.67 per share increase in book value. The $2.35 in dividends that we declared represented an annualized yield of 18.8% on the IPO price of $20. And the increase in book value represented a 13.3% annualized return. We are proud that we were successful in achieving our goal of generating a very attractive dividend, which was supported by strong core earnings from the portfolio, while at the same time delivering an increase in book value.

We also completed a follow-on offering in October, raising over $300 million in new equity -- bringing our total capital raised in 2012 to over $500 million. Our strong performance in 2012 was delivered against the backdrop of continued historical low interest rates, massive intervention in the mortgage market by the Fed, and ongoing implementation of the government-sponsored HARP program, all of which resulted in the elevated mortgage refinancing and prepayments. Our results are due to the hard work and dedication of the entire Western Asset Agency RMBS team, as we believe that our years of experience in the mortgage sector and our deep bench are key competitive advantages.

Let me now turn to a few fourth-quarter highlights. We generated strong core earnings of $1.05 per share, and increased our regular quarterly dividend by 6% to $0.90 a share, and paid an additional dividend of $0.22 a share. Our annualized economic return on book value for the quarter was $0.189, which we define as change in book value during the quarter plus the fourth-quarter dividend, expressed as an annualized percentage in beginning book value. In addition, during the quarter we made some initial investments in non-Agency RMBS, for purposes of seeking to assist in hedging against higher interest rates. Steve Fulton, our CFO -- our CIO, will go into more detail regarding our approach to this sector of the RMBS market and the role that these securities have in our portfolio.

Looking forward to 2013, we see a number of factors that will influence the RMBS market, such as the Fed's continued purchase of Agency securities, a gradually improving economy, a housing recovery that is well underway, continued low short-term interest rates but moderately higher long-term interest rates, and ongoing HARP refinancing activity. Our goal at Western Asset Mortgage Capital Corporation will be to maximize the risk-adjusted net economic returns delivered to shareholders, primarily through strong core earnings, resulting in an attractive dividend while maintaining or increasing book value per share.

At this time, I am going to turn the call over to Steve Sherwyn, our CFO, to discuss our financial results.

Thanks, Gavin. Good morning, everyone. I will discuss our financial results for the fourth quarter ended December 31, 2012. Except where specifically indicated, all metrics are as of that date. Our net income for the quarter was approximately $24.8 million, or $1.04 per weighted average diluted share. Our core earnings, which is a non-GAAP number defined as net income excluding net realized and unrealized gains and losses on investments, net unrealized gains and losses on derivative contracts, and non-cash stock-based compensation expense, was approximately $25.1 million or $1.05 per diluted share.

Our net interest income for the period was approximately $30.6 million. This number is a GAAP number and does not include the interest we received from our IO securities or our treated as derivatives. Nor does it take into account the cost of our interest rate swaps, both of which are included in the gain/loss on derivative instruments line in our income statement. On a non-GAAP basis, our net interest income, including the interest we receive from IO securities treated as derivatives, and taking into account the cost of hedging, was approximately $28.2 million. Included in this calculation was approximately $55.6 million of coupon interest, offset by approximately $18.1 million of net premium amortization and discount accretion.

Our weighted average net interest spread for the quarter, which takes into account the interest that we receive from IO securities as well as the fully hedged cost of financing, was 2.05%, reflecting a 2.86% gross yield on our portfolio and a 0.81 effective cost of funds. Our operating expenses for the period were approximately $3.2 million, which includes approximately $1.3 million of general and administrative expenses and approximately $1.9 million in Management fees.

In addition to core earnings, we also had approximately $12.6 million of net realized gains as a result of modest repositioning of our portfolio, which were offset by $10.9 million of realized losses on interest rate swaps, as we terminated some agreements early and entered into longer-dated swaps, in a move to extend the duration of our liabilities. Our net book value decreased by less than 0.5% in the period, $21.76 on September 30 to $21.67 on December 31. Our relatively stable book value performance was better than the agency REIT peer group average decline of 4%, and was primarily attributable to our negative duration at the long end of the curve, which helped us in a quarter that saw moderate widening of spreads.

During the fourth quarter, our constant prepayment rate, or CPR, for our Agency RMBS portfolio was 3.6% on an annualized basis. This compares to 4.1% for the third quarter. The CPR for our Agency RMBS portfolio for the month of January 2013 was 3.1%. Our CPR continues to remain low as a result of our focus on buying securities that exhibit low prepayment characteristics. As of December 31, the estimated fair value of our portfolio was approximately $5.2 billion, and we had borrowed a total of approximately $4.8 billion under our existing master repurchase agreement. Our leverage ratio was approximately 9.2 times at year end.

We continue to be in the attractive position of having [repo] capacity well in excess of our needs. At year end, we had 14 master repurchase agreements, and currently we have agreements with 16 counterparties. We continue to receive offers to expand our repo lines in these and other institutions. At present we feel comfortable with our existing counterparties, and believe that we have more than ample liquidity to meet our present and expected funding requirements.

With that, I will now turn the call over to Travis Carr. Travis?

Thanks, Steve. I would like to provide a few general remarks on the state of the Agency RMBS market. The outlook for Agency RMBS continues to be favorable from a technical standpoint, as net supply is expected to remain moderately negative and demand is strong. The Fed is buying approximately $70 billion of Agency RMBS per month, and is targeting generic, low-coupon, newly originated mortgages. QE3 has helped keep mortgage rates low, has reduced volatility in the Agency sector of the RMBS market, and has caused spreads to compress. There has been some recent concern in the market that the Fed may end its purchase program earlier than previously anticipated. However, in Chairman Bernanke's recent semiannual address to Congress, he indicated that the program would continue and that short-term interest rates would remain low until there was a substantial improvement in the outlook for the labor market, which has been defined as an unemployment rate that approaches 6.5%.

As a result of the historically low interest rates and the ongoing HARP program, industrywide mortgage refinancing increased in the fourth quarter, and consequently prepayment speeds picked up. However, since the beginning of the year, there has been more data pointing to a gradually improving economy, and the bond market has reacted by pushing the 10-year Treasury rate up 40 basis points, to 2% from its levels in mid-December. While the 10-year rate has backed down to around 1.9%, the run-up did cause early indicators of refinancing activity to subside.

Our view on interest rates for the next 6 to 12 months is that we see a yield curve with near zero interest rates at the short end of the curve, with moderate steepening at the long end of the curve as the economic recovery proceeds. Our hedge positions in the portfolio reflect this view, and Steve Fulton will provide more detail on our hedging strategy later in the call. Lastly, the housing market continues to show signs of recovery, with both higher sales volume and higher home prices in many markets across the country. As a result of these factors, the Agency RMBS market has sold off moderately and spreads have widened since the first of the year, giving back some of the gains that were achieved in the fourth quarter of 2012.

Given the lower prices of Agency bonds, we view their hedge-adjusted [carry] as attractive, particularly with the type of collateral that we target, which are prepayment-protected mortgage pools. While there is the potential for lower mortgage refinancing activity if long-term rates increase, we still view prepayments as a primary risk and deterrent towards higher net spreads.

Now I will turn the call over to Steve Fulton for further discussion of our portfolio and investment outlook. Steve?

Thanks, Travis. Good morning, and I thank everybody for joining us on our call today. We are pleased to report that our portfolio performed within expectations for the fourth quarter. And we generated strong core earnings, enabling us to increase our regular dividend, while maintaining a stable book value in an environment of modest spread widening in the RMBS sector. These results were due to a combination of our active asset and liability management. On the asset side, we continued to make select trades around both WALA and call protection attributes. But our general theme remained the same, and that was to focus on securities with low prepayment characteristics.

As you can see from our industry-leading low prepayments, that strategy worked well for the quarter. On the liability side of the balance sheet, we have been concerned about higher long-term interest rates, and therefore assembled a longer-dated swap position than most of our peers. While the net duration of our portfolio has been modestly positive, the majority of that duration has been at the shorter end of the yield curve. We maintained a negative duration at the longer end. The strategy served us well in the fourth quarter, as it helped manage the impact of widening spreads on our portfolio.

Additionally, we took an initial position in non-Agency RMBS in the quarter, as we view securities as a hedge against higher interest rates resulting from a improving economy, and we believe they will perform well in a recovering housing market. Lastly, in the fourth quarter we took advantage of what we view as an attractive opportunity in the TBA or dollar role market. We have since exited that segment of the market, as the opportunities have become less compelling to us. But we continue to monitor the TBA market, and we will opportunistically participate in it when we see the economics being attractive.

We understand the TBA market through our over 25 years of experience with it. TBAs can be more difficult to hedge than specialized pools, so they pose some incremental [convexity] risks that we presently prefer not to take on. We would consider dedicating a portion of our portfolio to them when we believe they represent a medium- to long-term opportunity that at the same time can be hedged effectively. So, now I will talk a little bit -- specifics of the portfolio.

So, as of December 31, 2012, the total estimated market value of our portfolio was approximately $5.2 billion and consisted almost exclusively of Agency mortgages. Our portfolio is heavily weighted towards 30-year fixed-rate mortgage pools, which represent approximately 87% of the value of the total portfolio. We modestly reduced our exposure to 20-year fixed-rate mortgage pools during the quarter. That yield curve steepened and they became less attractive on a relative value basis. At year end, they represent approximately 6% of our total portfolio.

The remainder of our RMBS portfolio consists of Agency interest-only strips, inverse interest-only strips, and fixed-rate CMOs, in the aggregate amount of 6% of the total. Non-Agency RMBS was less than 1% of the total portfolio as of year end. Our heavy emphasis on 30-year mortgages is based on our continued view that they produce the highest hedge-adjusted carry in the current yield curve and interest-rate environment. If you break down our Agency specified pools by sector, 50% of the total was invested in mortgage pools with lower loan balances, which is consistent with our investment strategy of minimizing our prepayment risk. The next largest sector was pools with MHA loans with high LTVs at 35%. Pools with a low WALA and a low percentage of third-party-originated loans, or TPO, represent 13% of the total. And the remaining 2% consists of investor and low FICO loans. Our weighted average loan age, or WALA, for the portfolio was 7.1 months. We believe that managing our WALA [ramp] is a key component towards keeping our prepayments low. As Steve Sherwyn noticed -- noted, excuse me, our CPR was 3.6% for the quarter, which compares to an average of 18% for our Agency peers, and is reflective of the effectiveness of our security selection and portfolio management strategy.

Now, turning to the liability side of the balance sheet. As Steve mentioned, we funded our portfolio for the use of short-term repurchase agreements, or repos. As of December 31, we had borrowed $4.8 billion under these agreements, resulting in leverage of approximately 9.2 times. We were comfortable taking leverage up to this level at year end, due to low volatility and the fact that two of the risk factors that impact the RMBS market, prepayments and supply, tend to be fairly muted during the last two months of the year. In addition, our hedges allowed us to effectively manage that value at risk. Subsequent to year end, we have taken leverage back down to the low eight times range, which is where we believe that the appropriate level is, given the current market conditions.

As of December 31, we had entered into approximately $3.3 billion, the notional value of interest-rate swaps and swaptions. Our swap and swaption positions represented approximately 69% of our outstanding funding. The swap contracts, with an approximate notional value of $2.8 billion, range in maturity of between about 22 months and 21 years, with a weighted average remaining maturity of 7.2 years and bear a weighted average fixed rate of 1.2%. Approximately 25% of the notional value of these swap positions are held in forward-starting swaps that start approximately nine months forward.

Our swaption contracts, with an approximate notional value of $520 million, allow us to enter into swaps that have an average fixed pay rate of 3% and an average swap term of 18.6 years. As a result, our portfolio had a net duration of approximately 0.7 of the year at year end. We have maintained our emphasis on longer-dated swaps and swaptions, as we believe that over the next nine months there will be a gradual increase in long-term rates as the economy continues to improve. And we currently maintain a slightly positive duration for the entire portfolio, we have negative duration at the long end of our portfolio, as we expect that when rates increase, the long end of the curve will be disproportionately affected.

For the first quarter of 2013, we expect incremental net spreads to be in the 175 basis points to 2% range. Our lower than average prepayments have helped us generate higher than average gross yields, and we expect slightly lower repo rates going forward. For nearly all of the first two months of 2013, we generally saw the same trend in the RMBS market that we saw in the fourth quarter, which contributed to a modest decline in the prices of all RMBS securities since the start of the year. However, over the last several days, there have been a number of developments that have served to create a meaningful increase in demand for specified pools. And these developments include Chairman Bernanke's Humphrey Hawkins testimony last week; Vice Chair Janet Yellen's speech to the National Association for Business Economics earlier this week; the Treasury Market Practices' group decision to keep the MBS fails to the Agency MBS fails charge rate impacted 2%, which was announced on March 1; and of course, the recent capital raises that have taken place in the mortgage REIT sector that have increased the overall level of demand. Collectively, these developments have resulted in higher payoffs for specified pools and have positively impacted the valuations of many of the securities in our portfolio. The increase over the past several days has served to reverse some of the decrease we have seen in our book value since the beginning of the year.

On a final note, I want to discuss in more detail our approach towards non-Agency MBS. We are constantly evaluating the entire RMBS market for attractive risk-adjusted opportunities, and as such, non-Agency securities are considered part of our target assets. As I mentioned earlier, we purchased our first batch of non-Agencies primarily as a cost-effective hedging vehicle against higher interest rates. Subsequent to year end, we increased our exposure to this sector of the market, as we saw good relative value opportunities. And if I were to put it in perspective, non-Agency RMBS presently represent less than 5% of the fair value of our total portfolio.

We rely on upon Western Asset's non-Agency RMBS team to determine the specific securities that we purchase. Western Asset has been investing in this non-Agency RMBS sector for over 25 years, and has a proven track record over that time. They were also one of the 19 chosen by the US Government to participate in Public Private Investment Program, or PPIP, for non-Agency securities. So, depending upon market conditions and our view of the relative value, non-Agency RMBS will from time to time be included in our portfolio.

Going forward, our overall goal will not change. And it will be to generate an optimal risk-adjusted net economic return on the portfolio, within the universe of the entire RMBS market and through active management of our assets and our liabilities. We believe that this will translate into strong core earnings, which will enable us to pay an attractive dividend, while at the same time maintaining our increasing book value per share. We delivered on this goal for 2012, and we are optimistic that we can achieve it again in 2013.

With that, we will entertain any and all questions.

(Operator Instructions)

Rick Shane, JPMorgan.

One housekeeping question -- what was the actual of cash payment on the hedge -- on the swaps this quarter?

You mean like in dollars?

In dollars, yes.

We have to get back to you on that. I don't have the exact number in front of us. Steve, do you --

I don't have it in front of me either. Rick, we will get back to you on that.

Okay, great. We will circle with you guys on that. And then, I would just like to make sure I fully understand the swaption transaction. It all makes sense to me, it's very consistent with what you guys are describing in terms of your expectations on rates. And I am thinking that probably average fixed pay for that -- for 18- to 20-year paper now is probably a little bit below -- 20 or 30 basis points below the 3% you are showing here. I guess what surprises me is the short duration of the expiration date on that. Should we see this as more [kill] risk management, or is this a swap -- a swaption that you actually ultimately plan to exercise?

No, the swap -- swaptions basically affect -- they do two things. They hedge duration and they hedge convexity. If you look at swaption volatility, it's at multi-year lows. Although it's not as low as it got in the late -- 2003 to 2007 period. So, it's just one of the many tools you can use to hedge your risk factors. So, there are three risk factors in a REIT, and those risk factors are duration, convexity, and spread duration. And swaptions are just simply that -- they are a method to hedge some of your convexity risk and to add some type of duration protection.

In terms of whether or not we would exercise it, we wouldn't exercise it unless it was in the money. So -- and we might not at that point either; we might just sell it. So, these are just hedges. A swaption is the right to pay a fixed rate, not an obligation to pay a fixed rate. And it's an asset that is mark-to-market on book value on a daily basis. But it's just one of the tools we use in hedging.

Got it. And just to maybe bring it to a slightly finer point. Why the relatively -- and I may not know enough about that market in terms of what is available. But it strikes me that if you are hedging long-term higher rates, that the expiration date on this seems relatively short.

Well, there are essentially two types of volatility -- there is gamma and vega. Gamma being short-term volatility, three months to a year, and beta being longer-term volatility. So, the length of time of the option is not necessarily correlated to the part of the curve that it hedges. So, the length of time being a year when we entered into these contracts, and now are roughly nine months or something like that, just reflects our desire to hedge gamma, which is short-term volatility, as opposed to vega, which is longer-term volatility.

Okay. Steve, I will circle back with you on this a little bit. I think there are some details I need to understand better.

Okay.

Thank you.

Daniel Furtado, Jefferies & Company.

The first question, I think, is relatively straightforward. And that is, is it safe to assume -- and I apologize if I missed this. But is it safe to assume that your forward-starting swaps are all 10-year in tenor?

No, they are everything from 3 years to 20 years.

Okay. And then, the second thing is --

On average, they are 18.6 years.

On average -- the average starting swaps are 18.6 years.

Now keep in mind -- [I just want to say] -- forward starting swaps. One thing -- and those just represent duration hedges and spread duration hedges. In other words, you don't have to -- when they -- in other words, if you enter into a swaption, a one-year swaption, you are always going to be struck at the forward swap curve. And it's going to be a 10-year swap, one year forward. So, this really isn't that different from a swaption. In other words, you don't necessarily have to actually pay when these come around; they are -- they just serve as duration hedges, similar to being short of Treasury or being short TBAs. So, again, it's one thing that is important for people to realize, that these are duration and spread duration hedges. They are not necessarily something you actually have to pay on at the time we -- at the time they come due.

Got you. Thank you for that. And then, speaking on the liability side, when we look out across the space, we have seen greater use of term debt, whether it's preferred, convert, even a private placement recently. How do you think about your capital needs for '13, and the allocation between some type of term debt or more equity? Or just how you are breaking that down, from Management's view?

I would say, basically, we are looking at everything. The straight preferred debt, the callable, if something was callable in five years -- when it was trading in the 8% type area, didn't seem that attractive to us. I think that the recent private deal is a very interesting deal. It's much longer term, it's a pretty long duration liability. It's a pretty interesting trade, and so we are definitely doing some work on that.

And we don't have, what I would say, capital needs. We will solicit capital to the extent we think it can be deployed in an appropriate risk-adjusted return that increases the value of the overall company for the existing shareholders. So, I don't know if that answers your question. But we are looking across all potential capital, seeing which one we think is most appropriate and which one we think is priced most recently -- once again, providing value to the existing shareholders.

Great, thank you. And congratulations on a nice quarter.

Thank you.

(Operator Instructions)

Mike Widner, KBW.

Just wondering if you could talk a little bit more about how you view the non-Agency role going forward, and particularly in light of some of DeMarco's recent comments and the asset sales we might see out of Fannie and Freddie. And just wondering if you could talk about that fairly generally?

Sure. I would say DeMarco didn't say anything that we found particularly surprising or unexpected. The way we -- once again, the way we view the non-Agencies that we assembled is really as cost-effective hedges to higher longer-term interest rates that would be accompanied by a generally improving housing market. So, we really view them on a portfolio basis; we don't view them, really, on a standalone basis. What does the risk-adjusted return of our portfolio look like after adding these? That is really the way we look at this.

We consider these basically to be securities that have negative duration, at least the sectors that we are buying, and to exhibit price movements that move inversely to positive duration period. It doesn't really happen on a day-to-day basis, but we think they hedge tail risk, if you will, of a slightly more rapidly improving economy. So, we just continue -- it's a sector we continue to monitor. We talk daily -- well, more than daily, we talk five times a day with our non-Agency team. We look at the types of ROEs that that sector can generate; where we see forward housing prices; what we think the likely scenario is, given our view of forward housing prices for prices; how they correlate with interest rates. So, there is a lot of things that go into it. But once again, I guess we view it -- I would say we view it on a portfolio -- from a portfolio standpoint. What does the portfolio look like after we add these things? Does it have a higher risk-adjusted return? If so, we will continue -- we will possibly add it. If not, we won't; we might sell.

So, I guess the real question I have is that -- I know DeMarco didn't really say much new. But it certainly, with Fannie and Freddie both selling off $30 billion issues of assets and multiple types of transactions as they say, going forward -- I am just wondering how much you think about that as -- or how much you think your view may change or could change, based on the assets that come out?

And then, could you see becoming more of a hybrid mortgage REIT from the standpoint of -- you like -- you potentially like the spread opportunity there. And particularly if there is not going to be -- I mean, we will see how active the buyers are. But spreads on Agencies continue to generally get tighter, and with the Fed mucking around in there, it's not the most predictable of asset classes. So, just wondering -- again, just color on whether you are open to thinking about that as a more meaningful part of the portfolio, from a net interest spread standpoint as opposed to just a hedging standpoint?

It's really driven by relative value. And I will say this -- I think we are one of the few asset managers that can say with a straight face that we have world-class teams in both sectors. We have been managing non-Agencies for a very long time. It's a sector that we are heavily involved in. As I said, we manage for the PPIP, and it's public information where our performance ranks. So, you can look it up. But it really is purely relative value.

We will see what they sell, we will see where it's priced, and we will see, more importantly, what it does to the value at risk of the portfolio if it's added. And that is really the way we look at it. We try not to get too -- and maybe we should -- we are trying not to get too hung up on are we are hybrid? Are we an agency? We try to just gravitate towards the highest risk-adjusted return, with a consistent trying our best to hedge all various risks to maintain or increase book value. And I wish I could be more specific than that, but it just depends of what trades and what the relative value is when it trades.

Yes, well, I think that is a good answer and an appropriate answer. And the reason I ask is just -- all the rage these days is, at least from an investor standpoint, in large part, is people are looking for more non-Agency concentration, because of market perceptions of where relative spreads are. And really just wanted you guys to give a clear articulation of your view and the fact that -- what it sounds like is you just like the risk-adjusted returns on the Agency side better today, and you are always open to reevaluating that. But --

Actually, I [should] say, right now today -- like today or yesterday, I think the risk-adjusted returns on the Agency side are actually better. Towards the end of the year and towards -- and at the very first part of the first quarter, we definitely saw some -- select -- because, once again, these sectors are very different from one other. There is securities price from dollar prices of $40 all the way up to a dollar price of $105 in the non-Agency sector. And they all reflect very different risk-reward and duration and effective hedging position. So, they are all very different from one other.

So, we don't view it as just one big market. But once again, what we try to do is say -- okay, if we put these -- this group of securities into the portfolio, what does it look like when we are done? Are we better off on an ROE and effective convexity and duration, or are we worse off? And if we are worse off, we are certainly not going to do it, and we would probably look to sell. So, right now, today, I think the value is actually in Agencies. And really -- and I will tell you what I really think the Fed is up to, is -- I think people are missing it a little bit. The Fed is trying to crush volatility. That is really what they are up, and they want to continue to do that.

It's -- of course they want to keep mortgage rates low. But that is really not their primary goal, in my view. Their primary goal is to continue to pull volatility out of the market. Because when you have -- as you lower volatility on asset classes, you tend to push people further out. And people look for -- essentially look for risk, where they can get a return. So, that really to me is what the Fed is up to. And that is why we continue to find this such an attractive business opportunity.

That is certainly an interesting perspective. And if that is what the Fed is doing, trying to crush vol, so to speak, I am not sure how successful it has been in the Agency MBS market, just because of the run-up in prices ahead of the QE -- most recent QE announcement, whether you call it 3 or 4, or 10 or whatever.

Infinity.

Yes. But there has been a lot of vol since then, both in Q4 and then [quarter to date] and even in the last couple of days, as you have indicated. So, if the strategy is to crush vol by sucking up all the assets, I am not sure about the relative success. But in any case, I definitely appreciate all the comments and the clarity on the strategy. And congrats on a solid quarter and year.

Thanks.

Boris Pialloux, National Securities.

Just a quick question regarding your leverage. Your leverage went up from 8.5 to 9.2, while almost all your peers actually reduced their leverage at the end of the year. So, what was the thought process? And second is, are you targeting 9 times for 2013?

Well, first of all, I would say a couple of things. The basic concept is, we increased leverage over the last two months of the year, as we thought there was -- typically in the last couple months of the year has lower volatility, due to low refinancing and lower production. And so, we temporarily took leverage up as a result, and we reduced it back into the low 8 rate. It's also important to recognize that leverage is not really the primary risk measurement for a mortgage REIT; it's more of a second order approximation of risk. So, the real risk is duration, convexity, and spread duration. And so, we target value at risk, hedge-adjusted carry, and risk-adjusted return. So, the real answer is that if you have yourself hedged right, you can actually have lower risk in a 9 times leverage portfolio than an 8 times leverage portfolio. It really depends on what is on your liability side. And I think that shows up in how our book value performed in the fourth quarter.

So, I am not trying to get everybody to not ask the question about leverage. It's absolutely an appropriate question. But it -- really the way we think about things is value at risk. And value at risk depends upon -- a lot on what you have on the liability side in terms of hedges, especially spread duration hedges, and basically how you have hedged both your convexity and duration and where your partial durations are. So, I am not -- like I said, I am not trying to -- I think it's similar to the comments I have made on duration. I think most of our peers report a duration number -- and that, I have to be really honest with you, that is not a helpful number. It doesn't tell you that much. If you don't know where that duration is, it's really not reflective of risk.

So, a portfolio with a 0.4 duration, in our view, could very easily have more risk, depending on where that duration is, than a portfolio with a 0.7 duration. And I would say the same thing with regard to leverage. It really depends on what your -- what is on your liability side of your balance sheet and how you have hedged the risk characteristics of that extra leverage. And so, we took it up, reflecting our view of what was on our liability side. In other words, we thought that what we had -- and it turns out we were correct -- that what we had on the liability side effectively hedged that extra leverage. And it did. But that doesn't mean we are going to run that leverage all the time. And subsequently, we have taken it back down because we think that is what the current market environment -- what makes sense in the current market environment.

So, I don't know if I answered your question or not. But -- and I will tell you, we don't really look at what our peers are doing and we don't really target a dividend. What we target is value at risk, and that is what we are looking at, and hedge-adjusted return, trying to maximize hedge-adjusted return, minimize value at risk, and protect book value.

All right, thank you for the color.

(Operator Instructions)

Daniel Furtado, Jefferies & Company.

I have a hypothetical for you, and I don't know if you care to answer this or not. But if you did have perfect knowledge of the timing of the Fed's exit from QE3, what would your target leverage and asset composition be the day before that announcement was made?

(Laughter) Well, boy. I mean -- we would [logging] a tremendous amount of gamma. Our leverage would -- I don't know that our leverage would necessarily be that low, what we would try to do is have really effective leverage -- we would probably take it down to 4 or 5 or something like that. It would depend upon how much we thought we could hedge the resultant widening in mortgages with spread duration hedges. And I think you can. And like I said, I think the fourth quarter proves that, that you can have things on your liability side that actually hedge spread widening.

But the answer to your question is, we would have -- [we would bring along] a lot of swaption vol, we would be very short at the long of the curve. We would be short TBAs, as a spread duration hedge, probably in the very low coupons, 2.5% or something like that. I think we would probably target a low to negative spread duration, once we had completely taken account. So, short to long end, long vol, and probably either 1 by 10 or one by 20 swaption vol. In other words, long gamma, not vega. And probably net, would probably be short spread duration.

Great. Thanks, Steve, I appreciate the insight there. Very helpful.

And at this time, we have no further questions. Mr. James?

Okay. Well, thanks, everybody, for joining us on the call. And again, my thanks to the Western Asset investment team for a great quarter, great year today. So, I will look forward to seeing many of you in the next couple of months, as we get out to visit many of our investment analysts. So, once again, thanks very much.

Thank you very much. Ladies and gentlemen, that will conclude the conference for today. We do thank you for your participation. You may now disconnect your lines at this time.