Western Asset Mortgage Capital Corp (WMC) 2013 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to Western Asset Mortgage Capital Corporation's first-quarter 2013 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.

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 March 31, 2013. 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 are including an accompanying a 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; Stephen Fulton, Chief Investment Officer; and Travis Carr, Chief Operating 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 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 everyone for joining us today for our first-quarter conference call. I will begin the call by providing some opening comments. Steven Sherwyn, our CFO, will then discuss our financial results. Travis Carr, our COO, 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 Q&A session.

During the first quarter we incurred a GAAP net loss of $1.18 per share. We generated quarter earnings of $0.93 per share and declared a dividend of $0.95 per share. Due to the volatility we are seeing in the mortgage market during the first quarter, our net book value declined approximately $0.10 to $19.42 a share, inclusive of our Q1 dividend as of March 31, 2013.

Quite simply we saw the equivalent of a perfect storm in the mortgage market during the first quarter given the (inaudible) we put in place on our portfolio. In our view this was the result of the market incorrectly interpreting remarks from Chairman Bernanke and believing that QE3 would be coming to an end sooner than expected. This belief persisted for only a short period of time, but it was enough to put downward pressure on asset prices and result in declining our book value given the marks on the portfolio of March 31, 2013.

Since the end of the first quarter the market has recognized that it was premature in its assessment of the end to QE3. As a result, asset prices have partially recovered, and we have seen some rebound in our book value during the second quarter. Our experience in the first quarter provides some good insight into our investment philosophy. We position our portfolio for optimal performance over an entire interest rate cycle. Unless our view of the direction of interest rates and mortgage markets changes, we generally do not make significant adjustments to our portfolio in response to short-term fluctuations in interest rates for market pricing.

Despite the market's premature belief in an early end to QE3, we maintained our view that the Fed will remain highly accommodated into the foreseeable future. However, the experience in the first quarter illustrates the volatility that can occur in any one particular quarter during an interest rate cycle.

It is important to note that our primary focus is to generate a consistent dividend for our shareholders rather than making short-term trades in the portfolio in an attempt to increase book value on a quarter-to-quarter basis. We believe in the philosophy of putting the cash in the hands of our shareholders and allowing them to make their own decisions on how to deploy that capital.

Even with our performance in the first quarter, when taking the longer-term perspective which takes into account the interest rate cycle we have experienced since our IPO in May of 2012 we have delivered an economic return of 15.5% on an annualized basis calculated by reference to change in book value plus dividends since the IPO. This performance places WMC at the high end of our peer group over that time period. While there may certainly be other quarters in which the market temporarily moves against our positions, and, of course, we cannot guarantee any results, we are confident that over the entire interest rate cycle will be able to generate a consistently strong dividend for our shareholders while maintaining a stable book value.

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

Thanks, Gavin. Good morning, everyone.

I will discuss our financial results for the first quarter ended March 31, 2013. Except where specifically indicated, all metrics are as of that day. On a GAAP basis we incurred a net loss for the quarter of approximately $28.5 million or $1.18 per basic and diluted share. Included in the net loss is approximately $55 million of net unrealized loss in RMBS and other securities, approximately $14 million of net realized loss and other loss on RMBS and other securities, and approximately $15 million of net gain on derivative instruments and so-called linked transactions. As a point of clarification, under GAAP linked transactions occur when the initial purchase of a financial asset and repurchase financing are entered into contemporaneously with, or in contemplation of one another.

The Company records the initial transfer and repurchase financing of a linked transition on a net basis, although in fact, as an economic matter, these arrangements are identical to transactions accounted for as repurchase transactions or similar transactions -- similar assets. As of March 31, 2013 we owned approximately $67 million of non-Agency RMBS and had approximately $44 million of repo borrowings that were considered linked transactions resulting in an approximately $23 million line item on our balance sheet. For the quarter our core earnings which is the non-GAAP number defined as net income or loss excluding net realizing and unrealized gains and losses on investments, net unrealized gains and losses on derivative contracts and non-cash stock-based compensation expense, one-time events purusant to changes in GAAP and other non-cash charges was approximately $22.6 million or $0.93 per diluted share.

Our net interest income for the period was approximately $28.6 million. This number is a GAAP number and does not include the interest we received from our I/O securities that are treated as derivatives, nor does it take into account the cost of our interest rate swap, both of which are included in the gain on derivative instruments line in our income statement.

On a non-GAAP basis our net interest income, including the interest we received from I/O securities treated as derivatives, interest we received from linked transactions and taking into account the cost of our hedging was approximately $26.1 million. Included in this calculation was a approximately $57.1 million of coupon interest offset by approximately $21.1 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 non-agency RMBS and I/O securities, as well as the fully hedged cost of our financing was 2.17%, reflecting 3.04% gross yield on our portfolio and 0.87% effective cost of funds.

Our operating expenses for the period were approximately $3.9 million which includes approximately $1.7 million for general and administrative expenses and approximately $2.1 million in management fees. Included in these expenses were incremental costs pertaining to the discovery and resulting corrective actions we took regarding the methodology that was used to accrue interest income and to amortize the cost basis of certain of the Company's residential mortgage-backed securities.

Our net book value decreased by approximately 10% during the period from $21.67 on December 31 to $19.42 on March 31 after adjusting for the $0.95 dividend that we declared on April 1. As Gavin mentioned earlier, the decline in net book value was primarily due to a combination of mortgage spread widening and payoffs declining during the quarter, which has been partially reversed during the second quarter. Our economic return, which as previously noted, represents the change in book value plus dividends for the quarter was negative 6% which includes the aforementioned $0.95 dividend.

For the approximately 10.5 months since our RPO we have generated an economic return of approximately 15.5% on an annualized basis. During the first quarter our constant prepayment rate or CPR for our agency RMBS portfolio was 3.4% on an annualized basis. This compares to 3.6% for the fourth quarter of 2012. The CPR for our agency RMBS portfolio for the month of April 2013 was also 3.4%. Our CPR continues to remain low as a result of our focus on buying securities that exhibit low prepayment characteristics.

As of March 31, the estimated fair value of our portfolio was approximately $4.4 billion, and we borrowed a total of approximately $4.1 billion under our existing master repurchase agreements. Our leverage ratio was approximately 8.7 times at quarter end inclusive of linked transactions and adjusted for the $0.95 dividend.

We continue to be in the attractive position of having repo capacity well in excess of our needs. At March 31 we had master repurchase agreements with 17 counter-parties. We continue to receive offers to expand our repo lines from these and other institutions. At the present time we feel comfortable with our existing counter-parties 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'd like to provide a few general remarks on the state of the agency RMBS market. The outlook for agency RMBS continues to be favorable. The premature market concern in the first quarter that the Fed would begin tapering its RMBS purchases caused the sector to re-price, and, even though mortgage spreads have partially recovered from their wides, values remain attractive. It is our belief that the Fed is not moving away from a zero short-term interest rate environment any time soon, and they are not done buying mortgages. We think QE3 will continue at least through 2013.

We believe the near zero interest rate environment will continue even beyond QE3 as the Fed has repeatedly reiterated that monetary policy will remain accommodative so long as US unemployment exceeds 6.5% and inflation remains below 2.5%. It is our opinion that the fed's foremost priority is keeping primary mortgage rates low in order to support economic growth by enabling homeowners to strengthen their finances and lower their monthly expenses. Accordingly, when the Fed does to start to taper its purchases, we believe that the first area it will pull back from will be treasuries rather than mortgages.

Our conviction that QE3 will continue for a prolonged period of time is based on a number of observations. First, we think that the US economy is still in a fairly tepid shape at least as it relates to the job market. We believe that the economy will need to create more than 200,000 non-farm jobs per month in order to demonstrate sustainable growth. Second, the European economy is still weak and likely to remain so in the near to intermediate term. Finally, with the Bank of Japan embarking on its own QE program, global interest rates should remain at historic lows.

Given this backdrop, our view on interest rates over 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 a higher probability that the long end of the curve declines moderately from its present levels. That being said, we recognize that eventually all of these stimulative monetary policies being embarked upon throughout the world will produce its intended result, and the global economy will strengthen.

As signs of this become apparent, we would expect the long end of the curve would steepen and that this would occur well before it the Fed adjusts short-term rates or begins tapering out of QE3. Our hedged positions in the portfolio reflect this view, and Stephen Fulton will provide more detail on our hedging strategy later in the call. Given the ongoing historically low mortgage rates, we believe that organic refinancing will remain active. However, we don't expect that the pace of mortgage refinancings will significantly increase from the current level.

Industry-wide loan production capacity is still somewhat constrained. Originators remain unwilling to increase capacity due to the heavy investment involved and the eventual slowdown in activity that will occur when rates finally increase from their historic lows. That being said, there are a few originators that are being aggressive in the marketplace. But we view this as more of a grab for market share would than rather than an extension of overall production capacity.

Our view on policy risk for the mortgage market is that it remains elevated. New leadership at the FHFA will likely lead to more borrower friendly policies including the expansion of the HARP program. We think that there's a good chance that HARP eligibility will be extended to mortgages that were originated after 2009 thereby creating a whole new cohort of borrowers that will eventually refinance. Our outlook on QE3, interest rates and the refinancing environment have essentially remained consistent for the last several quarters, and we still view prepayments as a primary risk and deterrent for its higher net interest spreads. Given the lower prices of agency bonds, we continue to view their hedge adjusted carry as attractive, particularly with the type of collateral that we target which are prepayment protected mortgage pools.

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

Thanks, John.

Good morning. Thanks for joining us this morning -- today. While we are disappointed with the decrease in net book value for the quarter, we are pleased to continue to generate strong core earnings that support our dividends. The level of decrease we had in net book value is magnified by some extraordinary timing for the marks on the portfolio from quarter ended to quarter end. To put it in perspective, at December 31, 2012 the market was at the 12 month height in mortgage spreads and the 12 month high in specified pool payouts.

By March 31, 2013 the market had completely reversed itself and was at the12 month high in spread -- spreads -- mortgage spreads and the 12 month low in spec pool payouts. In other words we pretty much saw the worst top to bottom, mark to market you are likely to have in any one quarter. The market moved against our strategy during the first quarter, but the recovery we have seen so far in the second quarter has given us increased confidence that we are well-positioned to generate attractive risk adjusted returns over the entire interest rate cycle.

Our investment strategy remains unchanged. That is to buy call protected securities that offer the best risk-adjusted carry and hedge them over an interest rate cycle. Since our IPO, we've seen ten-year treasury rates go from 1.6% to 1.4% to 2.1% back to 1.6% and then the 1.85% at the end of March. As we have mentioned, during that period we have delivered a positive economic return primarily through the generation of strong core earnings which has enabled us to pay an attractive dividend.

Our hedging strategy remains intact as meant to protect asset values over an interest rate cycle, and not meant to produce trading gains on a quarter-to-quarter basis, or even to necessarily mitigate against small changes in mortgage spreads and interest rates. We are managing the assets and liabilities of the portfolio to generate attractive risk-adjusted net interest income which enables us to pay high dividends while targeting a stable book value over time.

On the asset side we continue to make select trades around both WALA and call protection attributes among various originators, but our general theme remains the same that it's a focus on securities with low prepayment characteristics. As you can see from our industry-leading low prerepayments, that strategy has continued to work for a -- for the quarter. During the quarter we increased our relative exposure to 20-year securities as we believe that they have less extension risk and will exhibit very slow prepayment speeds, that they tend to be much less responsive to small moves in interest rates. One reason is that the primary to secondary spread for these securities is stickier than on 30-year mortgages.

We also bolstered our exposure to non-agency during the quarter. We continue to believe that over an interest rate cycle it makes sense to own these securities because of their effective hedging characteristics and positive carry. We had owned some TBA securities at the end of the quarter, but that was more as a placeholder until we located the specified pools that we would target. Now I will turn to some of the specifics of the portfolio.

On March 31, 2013 the total estimated market value of our portfolio was approximately $4.4 billion and consisted primarily of agency mortgages. Our portfolio was weighted towards 30-year fixed rate mortgage pools which represent approximately 68% of the value of the total portfolio. As I mentioned earlier, we modestly increased our exposure to 20-year fixed rate mortgage pools during the quarter as they became more attractive on a relative value basis.

At quarter end they represented approximately 20% of our total portfolio. Non-agency RMBS increased to approximately 5% of the total portfolio. That's up from less than 1% at year-end. And the remainder of our RMBS portfolio consists of agency interest only strips, inverse interest only strips, and that sector represents 6% of the total.

If you break down our agency specified pools by sector, 44% percent of the total was invested in mortgage pools with MHA loans with high LTVs which is consistent with our investment strategy at minimizing our prepayment risk. The next largest sector was pools with low loan balances at 43% pf the portfolio. Pools representing new issuance and low WALA represent 10% of the portfolio -- of the total. And the remaining 3% consist of high [SPATO] or spread origination and investor loans.

The weighted average loan age, or WALA, for the portfolio was 9.4 months. We continue to believe that managing our WALA amp is a key component for keeping our prepayments low. As Steve Sherwyn noted, our CPR was 3.4% for the quarter which compares with an average of 18% for our agency peers and is reflective of the effectiveness of our security selection and portfolio management strategy. For April we were also at 3.4% CPR. Interestingly the most recent market CPR data shows an increase prepayments at specified pools that were previously thought to be by some to be prepayment protected. Such as Ginnie Mae 4.5%s originated after 2009 and some of the below 90% LTV MHA originated loans.

We don't own any of these stories, and the spec pools we have chosen to invest in continue to experience very low prepayments. Now turning to the liability side of our balance sheet. As Steve mentioned we funded our portfolio through the use of short-term repurchase agreements, or repos. As of March 31 we had borrowed approximately $4.1 billion under these agreements resulting in a leverage of approximately 8.7 times inclusive of late transactions.

We took leverage down early in the quarter from where it was at the end of December given the pressure curve on asset prices that we experienced, but when spreads hit their wides near the end of the quarter we felt that the market had become oversold, and we added a bit of leverage and increased the value of our portfolio. As of March 31 we had entered into approximately $3.5 billion in notional value of interest rate swaps and swaptions. Our swap and swaption positions represented approximately 85% of our outstanding funding.

The swap contracts with an approximate notional value of $2.6 billion range in maturities between 18 months and 21 years with a weighted average remaining maturity of 7.9 years and weighted average expire rate of 1.4%. Approximately 29% of the notional value of these swap positions are held in forward starting swaps that start approximately 7.5 months forward. Our swaption contracts with an approximate notional value of $910 million allow us to enter into swaps that have an average fixed pay rate of 2.5% and an average swap term of 14.9 years.

As a result, our portfolio had a net duration of approximately 0.08 of a year at quarter end. While the net duration of our portfolio remains modestly positive, the majority of that positive duration has been at end of the shorter end of the curve, and we have maintained a slight negative duration at the longer end, albeit somewhat smaller than at the end of December. We think that the next move in long-term rates is likely to be a modest decline before they begin their eventual path higher.

We have kept the duration of our repos fairly low as we believe repo rates will come down moderately in the near future, at which time we will likely extend the duration of our repo book. We've also ruled out the duration of some of our swaps, as their duration has decreased as a result of the time that had passed since we first put them in place. We have increased their maturity in order to obtained the higher durations that we originally targeted.

For the second quarter 2013 we expect incremental net spreads to be in the 185 basis points to 205 basis point range. Our lower than average prepayments have helped us generate higher than average gross yields. And, as we have said, we would expect slightly lower repo rates going forward.

As Steve and Gavin had mentioned, since the end of the quarter we've seen a modest rebound in mortgage spreads and payouts for specified pools, and this has positively impacted the valuations of many of the securities in our portfolio. The increase over the past 45 days has served to reverse some of the decrease in net book value that we experienced in the first quarter.

Going forward, our overall goal remains the same. We seek to generate an optimal risk adjusted net economic return on the portfolio over an interest rate cycle through active management of our assets and our liabilities. We believe this will translate into strong core earnings which will enable us to pay an attractive dividend, while at the same time maintaining a stable book value per share. We have delivered on that goal or the 10.5 months we been in operations and are optimistic that we can achieve it again foo the full-year 2013.

With that we will now entertain your questions. Operator could you open up the call?

Thank you, sir.

(Operator Instructions)

Rick Shane, JPMorgan.

Steve, you talked a little bit about how spreads have tightened and payouts have gone -- have rebounded. But one of the things that we've observed is that since May that trend has started to soften up a little bit. Where do you think we are versus March 31 and maybe the quarterly peak and where we stand today?

United States' spreads -- they're bouncing around a little bit today. A little bit -- spreads -- tightening up a little bit today on the heels of some of the economic numbers that were just released, dpi, industrial production and some other things, but I'd say in general we've probably retraced about 30%, 35% 40% of -- the market as retraced about 30 to 40% of its widening that occurred during the first quarter. And spec pool payouts have probably rebounded let's say 25% to 30%. It depends on which spec pool you are talking about, but as a general number that spec pool payouts have bounced back about 25 to 30%.

Okay, great. Thank you very much.

Mike Widner, KBW.

I've got a bunch, so I guess I'll start with one and jump back in the queue. On the portfolio the net size is down about 15%, 12%, if we include the payment out there. But just wondering if you could comment on that. It's a pretty sizable reduction in the size of the portfolio, which would imply probably some reduction in net interest income available next quarter if we're going to stay there. So, just what your outlook is on that and why the size reduction.

We reduced the size at a couple different points throughout the first quarter, reflecting the fact that there was some pressure on spreads. As we got towards the end -- the very end of the first quarter we thought spreads had really sort of overshot -- quite honestly we thought spreads had gotten to --in other words spreads at that time had reacted as much as they reacted to the actual end of QE1.

So when you have just a rumor of the potential tapering versus the actual end of QE1 and spreads react the same, we thought they pretty much overshot a reasonable bound, and so we added back a pretty good chunk of our -- of the portfolio shrinkage that you saw from the end of Q4 to the end of Q1, without giving you exact numbers. Most of that size is probably pretty much replaced that is towards the end of the year end the quarter, and the first month into April.

Sir, that's interesting, but I guess if I tie this back to Rick's question, as we look at MBS prices really across the spectrum, payups included, April was a very strong month. MBS prices were up pretty much across the board, but late April and especially over the past two weeks by our marks almost everything is down, and even payups are flattish at best versus where they were at the end of Q1. So I'm just curious how to reconcile your comments with what I can see out there, and pricing sheets, and what I can pull-up for Bloomberg pricing anyway. And with that if you are adding in MBS back over the past month, and then it's kind of tanked again, I'm not sure how much comfort I should take from that.

Well, basically we added in early April. And throughout the month of April was a pretty strong month as you mentioned. May has given us a little bit of that back, but actually payouts over the last few days certain -- in certain pools. They are different from pool to pool. In another words CR3%s versus CP3.5%s versus 90 LTV 4%s and 4.5%s and all those payouts are bouncing around all over the place.

But for the real call-protected securities the payouts continue to -- Yes, Bonnie just reminded me that if you look at it on a hedge performance basis, mortgages continue to perform okay in may. Some parts of the mortgage market have given back some of the strong gains in April, but net net versus end of the quarter, we're still up.

(Operator Instructions)

Daniel Furtado, Jefferies and Company.

My first question is more of a looking for conformation that you're at or near zero TBAs in the portfolio today. And then, my second question would be, is the longer-term play here, based on the commentary I'm hearing on the call this morning, feels like to me we would expect, as you anticipate QE3 tapering or before that were to occur we should see a rotation out of these prepay protected securities into more of a TBA type portfolio, or is that an incorrect take away from what I'm hearing?

Well there's a whole bunch of things that we think portfolio moves we would make in anticipation of the Fed tapering its mortgage purchases. Once again, we still think that's a long way off, certainly towards the end of 2013, if not the beginning of 2014. We still believe that there's a much greater likelihood that the Fed lowers its purchases of treasuries before it lowers its purchases of mortgages.

It's important to keep the overall sort of supply demand characteristics of the mortgage market in perspective. If you just look at Fannie and Freddie, there is about $3.8 trillion of Fannie and Freddie securities outstanding. Those -- that $3.8 trillion generates monthly coupon payments -- excuse me annual coupon payments of about $172 billion versus monthly net interest and monthly net issuance of about $17 billion. Meaning that there's significantly -- the existing stock of mortgages throws off almost 10 times as much in coupon payments as the net issuance is on a monthly basis. So even with that, that's without the Fed.

So, even without the Fed, it is not as though there's some dramatic supply demand imbalance. If anything the supply demand imbalance is that there's not enough supply of mortgages. The other thing that I think we put this in a slightly different position than a lot of our peers is that we are a global money manager. So, we get to talk to a lot of other potential investors, and one of the investor groups that we spend a lot of time talking with and we manage money for are Global Central Banks.

Global said the 25 largest Global Central Banks have $11 trillion in dollar reserves. And virtually every central bank we talked to throughout the world Europe, Asia, Central America, South America, North America and the Middle East is considering as you know making an investment in mortgages, considering an investment in mortgages or adding to their already existing investment in mortgages. There are other pools of money that could quite honestly could easily -- over the next one to three years could easily dwarf what the Fed is doing right now.

And like I said the net issuance ex the Fed is -- of Fannie and Freddie securities is very close to zero. So, it's not as though that without the Fed there is some gigantic supply demand imbalance. With regards to the Fed -- the Fed has basically said the rate they are worried about the most is the primary mortgage rate. Probably the rate they are worried about the least is swap spread rates. And the 10-year rate is somewhere in the middle.

If you just kind of think about the data, the Fed has said -- and of course Janet Yellen has said, and she is likely to be the successor to Bernanke if he decides to leave in January. They are likely -- the Fed is likely to have been overly accommodative. But if you just kind of think of what the data looks like now, [nontuan] payrolls last released was 165,000. But compare that to new jobless claims of 325,000. So we're actually adding new jobless claims at twice the level that we're creating jobs. And we have mortgage foreclosure rates of 3.5% versus the historical of 1% and mortgage delinquencies of 7.25% versus the historical of 4%. All of the numbers that we just released, factory orders down 4%, dpi down 0.7%, Empire State manufacturing index down 1.4%, industrial production down, capacity utilization down.

And one of the most, I think -- numbers that gets a little press every now and then, but I think it's really important to look at -- it's certainly on Janet Yellen's mind -- is underemployment. Underemployment currently stands at 13.9%. That compares with the recession years of 2000 to 2003 of under 7%. We currently have underemployment that's twice what we had in the early 2000 recession. These are not numbers that smell or look like a sustainable economic recovery. So, while the market remains jittery -- the market's always jittery -- we think the odds of the Feds pitching in the towel on the sector, which -- the housing sector, is worried about more than any other sector by cutting back its purchases of mortgages is very unlikely. Not impossible, but very unlikely.

That doesn't mean the market is not going to over react -- oh, yes, as somebody just reminded me Europe is, of course in trouble again. It seems sort of an explosion of nonperforming loans throughout the entire Euro zone. Our view is that the global economy remains extremely fragile. The US economy as one person described it is the least dirty shirt in the laundry. But, globally growth is extremely weak. Inflation is well below -- inflation is well below the Fed's target. It's not below the fed's worry zone, its well below the Fed's actual target. So once again the thought that -- and the Fed worries more about the housing sector than any other sector in the economy.

I just think the thought that it is going to pitch in the towel is probably not well-founded, and even if they do, it's -- there is a limit to how much mortgage spread can widen. Mortgage spreads are not corporate bonds that can default. They do pay you back at par. And when you start looking at mortgage yields versus other benchmark global sovereign securities you can see why they're so attractive to central banks.

So, we don't think there is going to be much of the supply demand issue even if the Fed exited tomorrow, which we don't actually think is going to happen. So, our outlook really hasn't changed all that much. Doesn't mean that market is not going to be skittish, and the market's not going to reprice its view of risk here and there, but our view of how to hedge that is that once we have a consistently growing global and US economy, the first thing that is going to move is long-term interest rates.

That is why we're hedging our mortgages with short duration at the long end of the curve. We think ultimately that -- those hedges will work. They didn't work in the first quarter. But they've worked over a cycle. I apologize for the long-winded answer. I stuck a lot of information in there. But I think all of those things are important to think about.

Jim Fowler, Harvest Capital.

I just wanted to ask your thoughts on one other point. So, you commented that you think the fed would quit buying treasuries before mortgages. So, would I take from that is that treasury rates would rise? If mortgage treasury spreads don't change then mortgage rates will rise, eliminating some of the need and some of the premium in the prepay protected securities without any change in the duration side? I wonder if the hedges that you comment about will actually be affected if we just lose the incremental premium on the prepay protected securities, given the current level of rates. I wonder if you could benchmark how much you think those premiums are relative to where they would normally be.

Once again, we look at premiums as duration. We don't really in other words one security has a point dollar price higher than another security with the same coupon, that's just duration that you have to hedge. In other words that point can go to zero, but it generally won't go below zero.

And there are some actually some call-protected securities and some low balance securities, which will actually maintain the premium to TBAs even as a discount. In other words they turn over faster. They default faster. The turn over faster. People move up from $100,000 homes to $125,000 homes to $150,000 homes as the economy strengthens. So, there will be certain payouts that will get hurt. There will be other payouts that will do reasonably well.

The key is, how do you hedge their duration? And when rates rise, durations extend, they extend along the steeper curve. The way to do that, the way to hedge that spread duration over interest rate cycle. Once again not from one 90-day period to another 90-day period, is negative duration at the long end of the curve. It's also to start to layer in some swaption volatility. In other words, buy swaps, and probably some longer data swaps, which is vegas as opposed to gammas, so the 3x7 swaption volatility of 5x10 swaption volatility.

So at the point we think that it makes sense to increase our expenses to buy more protection, we will. It's just that we don't really perceive that for the next 6 months to 12 months. But having said, that we remain negative duration at the long end of the curve, because that is ultimately where the problem is going to be. And we continue to own swaption volatility, even though quite honestly all that's done is cost us money. But it's insurance you have to pay for.

Mike Widner.

Let me ask you if you could talk a little bit more about the accountings restatement in the quarter, and exactly what -- I guess a couple questions related to that. What exactly was the change? Did it change the way you do premium amortization? And then second, was there any specific impacts on earnings this quarter? Was there a one-time charge one-time benefit? Anything like that?

Steve Sherwyn, can you get that one?

Sure. Let me start with your second question first. The impact was strictly to Q4 in the prior quarters. We discovered the inconsistency toward the end of the first quarter. We made the adjustments for the prior quarters. The current quarter there was no impact on.

Basically the methodology that was being used was using the retrospective method of accounting, which is appropriate on the agency portfolio, but instead of using actual cash flows, it was effectively taking actual cash flows and spreading out the difference between actual and projected cash flows over the life of the security. And that was what impacted, and that's why the changes were made primarily in Q4.

Okay, so I'm a little confused on what the accounting treatment you guys are using for premium amortization is right now. Is it still a forward-looking, or is it lifetime or is it backward act (multiple speakers)?

It is a forward-looking. We're using a one-year CPR expectation comparing that to actual cash flows, but it is being modeled to one-year CPR. The CPRs are updated every quarter and retrospectively adjusted for those updated CPR's.

So that sounds very similar to what you were doing in the past. The difference I guess being you're now making more updates based on what was happening in the past, but my understanding is you were using a 12-month forward-looking estimate anyway.

It's the same model as before. Unfortunately, the methodology that was being applied was being applied incorrectly. The -- instead of looking at actual cash flows during the quarter, it was taking the difference between actual cash flows and expected cash flows and spreading them out over the life of the security. If you look at the GAAP literature, you are supposed to actually pick up the full difference in the quarter when it occurs. And that's why the adjustment was required.

Thank you. I show no further questions and now I'd like to turn the call back over to Mr. James for closing remarks.

Thanks, everybody, for listening to the call today, and thanks, everybody, for their questions. We look forward to seeing you all in person, hopefully, in the foreseeable future. And with that we would like to end the call. Thanks very much.

Thank you. Ladies and gentlemen, this concludes Western Asset Management's conference call. Thank you for your participation. You may now disconnect.