Western Asset Mortgage Capital Corp (WMC) 2013 Q2 法說會逐字稿

Welcome to Western Asset Mortgage Capital Corporation's second quarter 2013 earnings conference call. Today's call is being recorded and will be available for replay beginning at 6PM EST. 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. I would like to turn the call over to Mr. Larry Clark, IR for the Company. Please go ahead Mr. Clark.

Thank you, operator. I want to thank everyone for joining us today to discuss WesternAsset Mortgage Capital Corporation's financial results for the three months ended June 30, 2013. By now, you should have relieved 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 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, CEO, Steve Sherwyn, CFO, Stephen Fulton, CIO, and Travis Carr, COO.

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 factor section of the Company's reports filed with the SEC. Copies are available on the SEC's website at www.sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law. With that, I'll now turn over to Gavin James, CEO. Gavin?

Thanks, Larry and thank you for joining us today for our second quarter conference call. I'll begin by providing opening comments. Steve Sherwyn, our CFO, will then discuss our financial results, Travis Carr, our COO, will discuss the current trends we're in the agency RMBS market, and then Steve Fulton, our CIO, will provide an overview of our investment portfolio, our liability profile, and future outlook.

After our prepared remarks, we'll conduct a brief Q&A session. During the second quarter, we incurred a GAAP net loss of $1.14 a share with generated core earnings of $0.94 per share, and declared a $0.90 per share regular dividend. Due to the volatility of what was seen in the mortgage market during the second quarter, our net book value declined approximately 10% to $17.39 per share as of June 30, 2013.

While the increased level of interest rate and mortgage volatility put pressure on our asset side of our balance sheet, we were pleased with the performance of our hedges which reduced the negative impact to our book value during the quarter. Since our initial public offering in May 2012, through June 30, 2013, we have delivered an economic return on book value of 8% calculated by the change in book value, cost dividends, which are significantly better than the average of our agency RMBS peers over that same timeframe.

It is particularly notable that during this period, the mortgage market experienced increase volatility, widening spreads and higher interest rates. Not ideal conditions for managing a portfolio of RMBS. We have managed to generate a relatively strong return, which we believe is a testament to the strength of our security selection and hedging strategy. Our results are due to the hard work and dedication of the entire Western Asset RMBS team and we believe that our years of experience in the mortgage sector and deep bench are key competitive advantages.

Following the swift moves in interest rates and mortgage spreads that occurred in the second quarter, the market has since become relatively more stable. Over the last few weeks, the ten year treasury note has been trading between 2.5% and 2.7%. The interest rate volatility has leveled off. Given our view on the economy and our outlook for interest rates, we believe that it's unlikely that we will continue to experience the same degree of volatility that we saw in the first half of 2013.

We think that we will likely see conditions in the mortgage market that are more conducive to maintaining or increasing book value over the remainder of the year. We remain committed to our investment philosophy. We position our portfolio for optimal performance in the entire interest rate cycle.

While there may certainly be other quarters in which the market temporarily moves against our position, and of course we can't guarantee results, we are confident that over the entire cycle we'll be able to generate a consistently strong dividends for our shareholders while maintaining a stable book value. At this time, I'm going to turn over to Steve Sherwyn, our CFO to discuss results.

Thanks, Gavin. Good morning, everyone. I will discuss our financial results for the second quarter ended June 30, 2013. Except where specifically indicated, all metrics are as of that date. On a GAAP basis we incurred a net loss for the quarter of approximately $27.7 million, or $1.14 per basic and diluted share. Included in the net loss was approximately $156 million of net unrealized loss on RMBS and other securities, approximately $10 million of net realized loss and other loss on RMBS and other securities and approximately $113 million of net gain on derivative instruments and link transactions.

But non-GAAP number to find net income loss, net realized and unrealized gains. Net unrealized gains on derivative contracts, and non-cash stock compensation expense. Non-cash charges, approximately $2.8 million. Our net interest in company was $28.2 million. This number is a GAAP number, did not include interest we received from Iowa securities treated as derivatives. or interest rate swap, both of which included in our income statement.

For the quarter, our core earnings which is a non-GAAP number defined as net income or loss 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, one time events pursuant to changes in GAAP and other non-cash charges, was approximately $22.8 million, or $0.94 per diluted share. Our interest income for the period was approximately $28.2 million. This number is a GAAP and does not include the interest we received from our Iowa 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 that line in our income statement. On a non-GAAP basis, our net interest income, including the interest we received from Iowa securities treated as derivatives, interest we receive from link transactions, and taking into account the cost of our hedging, was approximately $25.9 million. Included in this calculation was approximately $53.6 million coupon interest, offset by approximately $17.9 million of net premium amortization and discount accretion. Our weighted average net interest spread for the quarter, which takes into account the interest we received from non-agency RMBS and Iowa securities, as well as financing was 2.18%.

Reflecting a 3.14% growth yield on our portfolio and .96% effective cost of funds. Our cost of funds increased 9 basis points compared to first quarter, which is primarily attributable to the increase hedging we did in response to the higher volatility we saw in the second quarter. Our operating expenses for the period were approximately $3.4 million, which includes approximately $1.5 million for G&A expenses and approximately $1.8 million in management fees.

After adjusting for the $0.95 dividend that we declared April first, our net book value decreased by approximately 10% during the period from $19.42 on March 31, 2013 to $17.39 on June 30, 2013. The decline in net book value is primarily due to the combination of mortgage spread widening and pay ups declining during the quarter, offset by the positive performance of our hedges.

Our economic return for the quarter was negative 5.8%, which, as previously noted, represents the change in book value, plus dividends, and which includes the second quarter dividends of $0.90. As Gavin mentioned earlier, for the approximately 13.5 months since our IPO through June 30, 2013, we have generated economic return of approximately 8%. During the second quarter our constant prepayment rate, or CPOR, for our agency RMBS portfolio, was 4.4% on an annualized basis. This compares to 3.4% for the first quarter of 2013.

Our CPOR continues to remain low as a result of our focus on buying securities that exhibit low prepayment characteristics. As of June 30, 2013, the estimated value of our portfolio was approximately $4.2 billion, and we had borrowed approximately $4 billion under our existing master repurchase agreement. Our leverage ratio was 9.4 times at quarter end inclusive of link transactions.

Our adjusted leveraged ratio was approximately 8.2 times at quarter end, adjusted for $500 million (inaudible) value of net short positions in TBA mortgage pass through certificates that we held at the end of the quarter. We continue being in the attractive position of having rebuild capacity in excess of our needs. At June 30, 2013 we had master repurchase agreements with 17 counter parties. We continue to receive offers to expand our (inaudible) lines from these and other institutions. At the present time, we feel comfortable with our existing counter parties and believe that we have ample liquidity to meet our present and expected funding requirements. With that, I will turn the call over to Travis Carr. Travis?

Thank you, Steve. I would like to provide a few general remarks on the state of the agency RMBS market. The long term outlook for agency RMBS remains favorable, both from a technical and fundamental perspective. From a technical point of view, net supplies of new issuance is expected to decline going forward and demand is expected to be at least equal to, if not greater than supply, even with (inaudible) factored in.

Fundamentally, the asset class remains attractive for new investments. Yield curve has steepened, spreads have become more attractive, prepayment activity is expected to decline. the repo market is functioning well, and the economy is improving at a gradual pace. Despite the recent volatility that the market has experienced, the asset class remains high to liquid, and has attracted demand from a wide cross-section of global investors.

We believe that the risk of higher interest rates and wider mortgage spreads has largely been priced into the market, given current valuation levels. With respect to our view on the direction of interest rates, we continue to believe that the Fed is not moving away from a zero short interest term environment any time soon, and they're not done buying mortgages. They have repeatedly reiterated a monetary policy will remain accommodated for as long as the economy needs it. Our view on the US economy is that while it was on a path towards

gradual recovery, we don't expect to see a meaningful acceleration of growth any time soon. We still believe that the economy needs to create more than 200,000 non-farm jobs per month in order to demonstrate sustainable growth. Additionally, global interest rates should remain low if the European economy is still weak, Japan continued to support it's economic recovery, and China appears to be slowing down.

That being said, we continue to recognize that the global economy will ultimately strengthen, and interest rates will eventually rise even further as they come off of their historically low levels. As this begins to happen, we expect long-term rates would increase first, and then short-term rates would eventually follow. Our hedge positions in the portfolio reflect a few, and we will likely further adjust them as the scenario plays out overtime.

The mortgage refinancing market is expected to decline going forward and has already shown signs of slowing down. Mortgage bankers association expects refinancing activity to decline by around 20% in 2013, and another 60% in 2014. Major lenders are already responding by adjusting their staffing levels.

We continue to believe that issuers will focus on HARP eligible collateral, particularly with the potential for the HARP eligibility date to be extended to June 2010. Our overall view of the mortgage market is that the longer-term risk that faces are the potential for spread widening and higher interest rates and while prepayments are expected to decline going forward, they also remain a risk and deterrent towards growth yields in any agency RMBS portfolio.

We have sought to position our portfolio to address this risks, and continue to view the market as offering an attractive hedge adjusted carry, particularly with the type of collateral that we target. Now, we'll turn over to Steve Fulton for further discussion of our portfolio and investment outlook. Steve?

Thanks, Travis. Good morning and thank you everybody for joining us today. While we were disappointed with the decrease in net book value for the quarter, relatively, we're pleased with our performance, given the extraordinary volatility we saw in the second quarter to accommodation of strong security selections and effective hedging strategy, we were still able to generate strong core earnings that supported our dividend.

Our decline in book value was moderated by our liability hedges, particularly our large position in (inaudible) which increased in value as market volatility increased. We started the second quarter with a $900 million position in (inaudible) options, and added to that position as volatility increased, at one point having our exposure as high as $1.4 billion before settling back to the quarter ending position with $1.2 billion. Subsequent to the end of the quarter, we have started to wind down our position with (inaudible) and have begun to replace them with interest rate swaps that accomplish the same goal of reducing portfolio duration but are more cost effective in the current market environment.

This is an example of our active management style, where we respond tactically to changing market conditions. We believe a broad operating platform, which includes expertise in mortgages, liquidity and derivatives, enabled us to be nimble at times of market dislocation and as a clear competitive advantage. While most of our portfolio activity during the quarter took place on the liability side of our balance sheet, we did make modest changes on the asset side. Specifically, we sold some of our lower coupon 30 year pools and traded into slightly higher coupon pools.

This was done in order to reduce our exposure to spread duration. We maintained our exposure to 20-year pools and non-agency securities during the quarter as we believe they also remain attractive from a spread duration and valuation perspective. We intend to increase our exposure to both these two categories as we believe they represent good relative value and offer better protection against wider mortgage spreads. That being said, we have just been through a period of increased interest rate and spread volatility that led to a very large sellout on the mortgage market.

(inaudible) volatility has come down since early July, and we think in the near term, the mortgage market will experience more stability and we are positioning our portfolio accordingly. In aggregate, the action we're taking on both sides of the balance sheet, subsequent to the second quarter, have been longer in duration and more negatively con vexed than when we exited the quarter. Spec pool pay ups have declined significantly in the recent sell off, and presently, we estimate that our average pay up is 25 basis points, or one quarter of a point. However, our portfolio, similar to other portfolios in the agency space, still remains at a premium dollar price.

So slow prepayments are good for the portfolio as we increase our gross yield. We still favor prepayment protected securities, we are focusing on securities with lower pay ups at present. Our investment strategy remains relatively unchanged. Call protected securities, which offer the best risk adjusted carry, and hedge over an interest rate cycle. With that, let me turn to some of the portfolio details as of the end of the second quarter.

As of June 30, 2013, the total estimated market value of our portfolio was approximately $4.2 billion, and consisted primarily of agency mortgages. Our portfolio was weighted towards 30 year fixed rate mortgage pools which represented 70% of the value of the total portfolio. Our exposure to 20-year fixed rate mortgage pools was approximately 19%. Non-agency RMBS represented approximately 4% and the remainder consisted of agent interest only strips and inverse inters only strips which represented approximately 7% of the total.

If you break down our agency specified pools by sector, 50% of the total was invested in mortgage pools with NHA loans with high LTVs. This is consistent with our investment strategy of minimizing our prepayment risk. The next largest sector was pools with low loan balances of 42%. Pools representing new issuance and low (inaudible) was 6% of the total, and the remaining 3% consisted of high SATO, or Spread At Origination and investor loans. Weighted average loan age, or WALA, for the portfolio was 14.4 months which includes our non-agency holdings.

We believe that managing our WALA is another component to keeping our prepayments low. As Steve Sherwyn noted, our CPR was 4.4 for the quarter which compares to an average of 17% for our agency peers and is reflective of the effectiveness of our security selection and portfolio management strategy. Now, let me turn to the liability side of our balance sheet. As Steve mentioned, we have funded our portfolio to be used short-term, repo agreement.

As of June 30, 2013 we have borrowed $4 billion resulting in leverage of approximately 8.2 times after adjusting for the $500 million short TBA position that settled in mid July. We're present targeting leverage to be in the 7.5 to 9 times range in the near term, given our outlook for volatility. As of June 30, 2013 we have entered into $3.5 billion in notion of value of interest rate swaps and swaptions.

Our swap and swaption positions represented 89% of our outstanding funding. Swap contracts, approximately notional value of $2.3 billion range in maturities of between 15 months and 21 years with weighted average remaining maturity of 7 years, and bear a weighted average fixed rate of 1.4%. Approximately 24% of the value of these swap position are held in forward starting swaps that start 6 and a half months forward. Our swaps and contracts with approximate notional value of $1.2 billion, allow us to enter into swaps with an average fixed pay rate of 3% and average swap term of 11.4 years.

As a result, the portfolio had net duration of .07 of a year at quarter end. While net duration of our portfolio remains modestly positive duration, it has been at the short of end that we have maintained a slight negative duration at the longer end. For the third quarter of 2013, we expect incremental net spreads to be in the 2.2% to 2.4% range. This is a result of generally wider spreads in the market since last quarter. Additionally our lower than average prepayments have helped us generate higher than average gross yields.

As we wrap up our prepared remarks, I think it's important to note that we have been through an extraordinary first half of the year in the IBS market. From where we sit, mortgages are close to being fully extended, so extension risk is greatly diminished and pay ups have been greatly reduced.

We have taken a hit but given the market views that we have expressed on the call today we don't think there's a lot of additional damage that can be reflected on the portfolio. As a result, we feel comfortable that we will continue to generate strong core earnings in the second half of the year and more stability in book value. With that, we will entertain your questions. Operator, please open up the call.

Thank you, sir. (Operator Instructions). The first question is from Michael Widner from KBW.

Good morning, guys. First, a simple question on the forward starting swaps. You have 550 million of those. Any indication of what bucket those are in? The ten year range or are they shorter than that?

They're spread across the curve. We have forwarded swaps in each part of our curve bucket.

Okay. So different topic. Could you talk about the relative economics of using short positions in TBA, versus the obvious opportunity of dollar roll-income, because of big month to month drops on the pricing.

When you sort mortgages forward, you don't necessarily have to pay the dollar roll unless you hold them over a settlement period. So once again dollar rolls are not cast in stone. They can change pretty dramatically from month to month and coupon to coupon. So it depends on what particular risk we're trying to short and what month we're shorting it. In general, it has been a pretty effective strategy. It doesn't work all the time for everything, but by and large, if you pick the right coupon and you pick the right month, they're pretty effective hedges. and they're certainly much more closely matched, hedging than (inaudible) swap does.

Yeah, that makes sense, and I guess from the add side, one of the things that we wrestle with, the disclosure makes pretty good transparency, but there are elements that we sometimes wonder about. You guys have very attractive net interest spreads that are reported, 218 relative to the group, so obviously trying to tease it apart. How do you get there while at the same time using TBAs for hedging purposes.

Just remember, a TBA short is just a duration short. It doesn't cost you any money until you roll it over a settlement cycle. Whereas if you short an interest rate swap, you're paying fixed the moment it settles. the moment you enter into it. So it depends on the coupon you choose, the month you short it in, and whether or not you hold the short over the settlement cycle.

I guess I sort of get that, but the notion that you sell it two days before the settlement, it would seem to me you still end up paying the cost because of the change in price.

The assumption that people are making in the dollar roll market is today's price, and there's a today price for this month, and there's a forward price for next month, in that next month's price will become today's price. Sometimes that happens, sometimes that doesn't happen. So it's not necessarily cast in stone, but it works like that. And you can see multiple tick movements in dollar rolls as you approach 48-hour day. Which is when you really find out who is short and who is not. So you can have a dollar roll starting at 9-30 seconds or through IBOR for three weeks out of the month. and then, on the other two days prior, during the 48 hour call-out day can trade two to 3-30 seconds cheaper than that. So once again, it's all a matter of timing.

Gotcha.

There are times they look like expensive short stuff, and there are times they don't. There were people in the first quarter, some of our competitors that tried to take advantage of the dollar roll market, (inaudible) 9-30 seconds, which were the Feds coupon of choice, and that worked out pretty poorly. So there are times when the dollar roll market can work out well for you, and times that it doesn't work out so well for you. You just have to pick the right security and the right time.

Right, which is I guess why I was trying to get a little more granularity on what you are picking. I can understand that you don't want to give out positions by coupon and what not.

And quite honestly, that was a relatively short-term spread duration trade. We just thought it would be more effective than further swaps, or further interest rate swaps.

Yes, one final one for me. Again, you guys talk about net interest spread right now, that's 218. Where do you see incremental spreads for putting money to work now, as that's paid down or wherever you are putting money to work?

I think we have been looking at the 220 to 240 type range. Which is where we would get money put to work considering the total range of everything we buy, which includes exposure, collateral, and then also non-agencies.

Great, thank you guys. Appreciate the comments and color.

Sure.

Next question is from the line of Daniel Furtado, from Jefferies.

Thanks, Steve, and thanks everybody for the opportunity. I just have a bigger picture question. The bank demand for agency MBS seems to have waned a little bit here. Why do you think that is, and do you have any concerns or thoughts around proposals to increase risk waiting at the banks for agency MBS?

I'm going to let Bonnie Wongtrakool, who has been doing a lot of work, she's one of our senior portfolio managers, has been doing a lot of work on what the banks have been up to. Bonnie, if you don't mind filling in on that one?

Bank demand has been lower recently, I think it's a function of two things. One is, the banks have been waiting for a sell off for some time, and we did get a sell off, and you see them coming in, but they're not going to put all their cards in, because of the second factor which is changes on the regulatory front. So the way that gains and losses on their mortgage holds are treated, they now have to flow through their income statements unless they put them in a different category.

So the effect of those two things is that bank demand right now, and probably for the near term is probably going to be a little bit less than what you would have expected before. Having said that, we do expect that they will come in, if we stay in this range or have a further sell off, our view is we'll be able to stay in this range. But the mix of what they will buy will be a little bit different. Whereas traditionally they would have bought from the current coupon, production coupon 30-year mortgages, they will probably shift to something that's a little bit lower in spread duration, 15-20 year mortgages that will fluctuate less with movement in rates.

Thank you for that, it's very helpful.

(Operator Instructions). Our next question is from Jackie Earl, with Compass Point.

Good morning, and thank you for taking the question. In your press release you mention the intention to slightly increase your holding in non-agency RMBS. What would you need to see in the market or what would change your outlook to having a more material investment in non-agency?

Well, we actually think they represent pretty good value right now, so we are currently increasing our position. I don't know if that exactly answers your question. In other words, they cheapened up based on some selling and some bid lists and also some selling under the GSEs. They're not at their recent wides but still the types of securities we like, because we believe hedge house price appreciation, and actually hedge higher interest rates are trading in the low 6 and 1/4 or 6 and 3/8 type yields which once you leverage them, we consider them to be pretty attractive at the moment.

You have any target capital allocation to non-agency?

Yeah, I would say right now, we're shooting for probably 10%, but somewhere in the 10% to 15% range. It all depends on pricing/ If pricing changes dramatically, then our targets will change.

Okay, thank you. I appreciate it.

Sure.

(Operator Instructions). We have no further questions. Mr. James?

Okay, well thanks again for joining us on the call. We look forward to seeing many of you in the future months ahead. With that, we'll close. Many thanks.

Thank you, ladies and gentlemen, and that does conclude our conference for today. Thank you for your participation and you may now disconnect.