Western Asset Mortgage Capital Corp (WMC) 2014 Q2 法說會逐字稿

Welcome to Western Asset Mortgage Capital Corporation's second-quarter 2014 earnings conference call. Today's call is being recorded and will be available for replay beginning at 5 PM Eastern Time. (Operator Instructions). Now first 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 ended June 30, 2014. 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 accompany slide presentation that you can refer to during the call. You can also 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; and Anup Agarwal, Chief Investment Officer.

before I 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 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 will now turn the call over to Gavin James, Chief Executive Officer.

Thanks, Larry, and thank you, everyone, for joining us today for our second-quarter conference call. I will begin the call by providing some opening comments, Steve Sherwyn, our CFO, will then discuss our financial results, and then Anup Agarwal, our Chief Investment Officer, will provide an overview of our investment portfolio and our future investment outlook. After our prepared remarks we will conduct a brief question-and-answer session.

We delivered a strong performance in the second quarter which reflects the positive impact of our strategy to move to a hybrid REIT model. During the quarter we recorded GAAP net income of $1.68 per share while generating core earnings and drop income of $1 per share. We generated an economic return of 12.6%, which is the highest quarterly economic return since our inception, and reflective of the strong performance of our hybrid portfolio.

During the course of the second quarter the percentage of Agency RMBS in our portfolio went from approximately 77% and at the end of the first quarter to 71% at June 30 as we added a significant amount of Non-Agency RMBS and commercial mortgage-backed securities to the portfolio, which we believe provides more attractive relative value opportunities in the current environment.

Our continuing shift to a hybrid model was accelerated by our common stock offering and private placement during the second quarter that generated net proceeds of approximately $215 million. As a result of the capital raise we were able to increase the size of our investment portfolio to $4.7 billion from $3.3 billion at the end of the prior quarter.

The advantages provided by the broad resources and expertise of the Western Asset investment platform were critical to our strong performance in the second quarter -- notably, in immediately investing the net proceeds from the capital raise, thereby avoiding any drag on earnings. We also continue to rely on Western Assets' well developed relationships with counterparties to access the repo markets and ensure adequate financing for both our newly raised capital and our existing portfolio.

Western Assets' deeply experienced and deeply resourced structured products team has allowed us to quickly add to our Non-Agency RMBS exposure and to develop a CMBS position. The world-class capabilities of the Western Asset platform continue to be a key driver of value for shareholders in the REIT.

Our existing portfolio, as well as the new capital that was deployed, were well-positioned for the relatively stable interest rate environment that we saw during the second quarter. As a result our book value per share increased to $15.31 at June 30, up from $14.19 at the end of the prior quarter.

As a result of these shifts in the portfolio and the changes we have made in our hedging strategy we are seeing improved yields and lower hedge adjusted financing costs, which contributed to an 89 basis point increase in our weighted average net interest spread over the prior quarter. We believe the stronger earnings power of the portfolio positions us well to continue paying an attractive dividend to our shareholders.

Our outlook for interest rates, the economy and market conditions has not materially changed since our last conference call. We have positioned the portfolio given the following assumptions. If you look at the 10-year points on the yield curve we think that will remain range bound between [2.5%] and 3% over the remainder of the year with the overall trend pointing towards a gradual increase in rates, with short-term rates remaining close to zero.

Economic growth in the US will remain modest over the next several quarters and the Fed will continue to be supportive of the economy. The demand for Agency MBS will continue to be strong as the Fed reinvests the cash flows from its existing portfolio and money market funds, sovereign wealth funds, private investors all remain in the market.

The supply from both Agency and Non-Agency assets will continue to be somewhat constrained given the low level of expected new protection. We are very pleased that we saw immediate results from our shift in strategy. We continue to believe that our competitive advantage is our ability to be nimble and adjust the portfolio to gain exposure to the asset classes and specific securities that provide the most attractive risk-adjusted returns at any given point.

Comprehensive investment platform at Western Asset was clearly an advantage in helping us to quickly deploy the proceeds from our capital raise and diversify our assets during the second quarter. Although we can't guarantee the performance of our portfolio of investments, we believe the new composition of our portfolio has us well-positioned to deliver on our long-term objective of generating strong core earnings to support an attractive dividend while also maintaining a stable book value.

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

Thanks, Gavin. Good morning, everyone. I will discuss our financial results for the second quarter ended June 30, 2014. Except where specifically indicated, all metrics are as of that date. On a GAAP basis we reported net income for the quarter of approximately $67.6 million or $1.68 per basic and diluted share.

Included in the net income was approximately $114.1 million of net unrealized gains on mortgage-backed securities, approximately $14.3 million of net realized loss on mortgage-backed securities, and approximately $66 million of net loss on derivative instruments and linked transactions.

For the quarter our quarter earnings were approximately $30 million or $0.75 per diluted share which is a non-GAAP financial measure which we define as net income or loss excluding net realized and unrealized gains and losses on investments, net unrealized gains and losses on derivative contracts, non-cash stock-based compensation expense and other non-cash charges.

In addition to our core earnings for the quarter we generated drop income of approximately $10 million or $0.25 per diluted share. As we have been transitioning our portfolio to more of a hybrid REIT model, we've also been utilizing more to be announced, or TBA, forward contracts on Agency RMBS in the form of dollar roll transactions which has resulted in incremental drop income.

Drop income represents a non-GAAP financial measure and is defined as the difference between the spot price and the forward settlement price for comparable security on the trade date.

For the quarter our quarter earnings plus drop income was approximately $40 million or $1 per basic and diluted share. This compares to core earnings plus drop income of approximately $15.2 million or $0.56 per basic and diluted share for the first quarter ended March 31, 2014.

For the quarter ended June 30, 2014 our average amortized cost of mortgage-backed securities held, including Agency and Non-Agency interest-only strips accounted for as derivatives and linked transactions was approximately $4.83 billion as compared to approximately $3.09 billion for the first quarter ended March 31, 2014.

Our net interest income for the second quarter was approximately $38.6 million, this number is a GAAP financial measure and does not include the interest we receive and pay on our link transactions, interest we receive from our IO securities that are treated as derivatives, nor does it take into account the cost of our interest rate swaps. The latter two are included in the gain on derivative instruments line in our income statement.

On a non-GAAP basis our net interest income, including the interest we receive from IO securities treated as derivatives and interest we receive from linked transactions, was approximately $34.4 million. This compares to non-GAAP net interest income of approximately $15.7 million for the first quarter of 2014.

Sequential increase in our net interest income was due to our larger than average portfolio during the June quarter and hedge adjusted net spend on our investments and a move to a more diversified portfolio consisting of a larger portion of Non-Agency mortgage assets.

Our weighted average net interest spread for the second quarter of 2014, which takes into account the interest that we receive from Non-Agency RMBS, CMBS, and IO securities, as well as the fully hedged cost of our financing was 2.69%, reflecting a 3.86% growth yield on our portfolio and a 1.17% effective cost of funds.

This compares to a weighted average net interest spread of 1.8% reflecting a 3.57% gross yield on our portfolio and a 1.77% effective cost of funds for the first quarter. Our net yield increased due to a higher mix of Non-Agency RMBS and CMBS and a lower cost of funds.

During the quarter our constant prepayment rate, or CPR, for our Agency RMBS portfolio was 4.9% on an annualized basis. This compares to 3.8% for the first quarter. We believe our CPR continues to remain low due to our focus on buying Agency RMBS that we believe exhibit low prepayment characteristics.

Our operating expenses for the quarter were approximately $4.9 million which includes approximately $2.4 million for general and administrative expenses and approximately $2.5 million in management fees. Included in the G&A expenses were non-cash-based stock compensation of approximately $480,000.

Our G&A expenses expressed as an annualized percentage of our average stockholders' equity were approximately 1.5%, an improvement of just over 50 basis points from the first quarter and was the result of additional capital that we raised which enabled us to spread our fixed cost over a larger capital base.

Our book value per share as of June 30, 2014 was $15.31 which takes into account the $0.67 regular cash dividend that we declared on June 19, 2014 and paid on July 29, 2014. For purposes of comparison our March 31, 2014 book value per share was $14.19, an increase of nearly 8%.

As Gavin previously mentioned, we believe our book value per share increased primarily as a result of a more diversified portfolio, which benefited from the mortgage spread tightening during the quarter and was supplemented by dollar roll income from our net long TBA position.

As of June 30 the estimated fair value of our portfolio was approximately $4.7 billion and we had borrowed a total of approximately $4.1 billion under our existing master repurchase agreements. Our leverage ratio was approximately 6.5 times at quarter end. Our adjusted leverage ratio was approximately 7.5 times at quarter end adjusted for $680 million notional value of net long positions in TBA mortgage pass-through certificates that we held at the end of the quarter.

We continue to be in the attractive position of having [repo] capacity well in excess of our current needs. At June 30 we had massive repurchase agreements with 23 counterparties and outstanding borrowings with 19 counterparties. We continue to have excellent relationships with our bank counterparties and we feel comfortable with our existing group.

We have a highly diversified repo lender book and believe that we have more than ample liquidity to meet our present and expected funding requirements.

As of June 30 we had entered into approximately $5.4 billion in notional value of pay fixed interest rate swaps excluding forward starting swaps of $1.4 billion and $2.5 billion of pay variable interest rate swaps excluding forward starting swaps of approximately $110 million giving us a net pay fixed swap position of approximately $2.9 billion.

Additionally, we have entered into approximately $305 million notional amount of net pay fixed interest rate swaptions with swap terms that range between 1 and 10 years and have exercised expiration dates that range from July 2014 to October 2014.

As a result of our hedge positions our overall portfolio had a net duration of approximately 3 months at quarter end. Excluding our Non-Agency RMBS holdings our net duration was approximately negative one half year.

We are comfortable with our current leverage. We can adjust our economic leverage fairly quickly through the use of TBAs and we determine our leverage based on what we believe will enable us to optimize our core earnings on a risk-adjusted basis and maintain a relatively stable book value. With that I will now turn the call over to Anup.

Things, Steve. Good morning and thank you for joining us today. Let me spend a few minutes discussing our investment results for the quarter and update you on our portfolio strategy. As Gavin mentioned, we generated a very strong economic return on book value of 12.6% during the second quarter driven by our positions in both fixed rate agency securities and Non-Agency RMBS and CMBS.

On our call last quarter we talked about our belief that interest-rate volatility will remain low and that our outlook for [Moby] spreads was positive. Given that view we felt comfortable operating with adjusted leverage in the 8 times range and, as we said, we utilized the TBA market to adjust our leverage.

As a result we generated both gains on our TBA positions as well as meaningful drop income to supplement our core earnings. We also discussed how we saw opportunities to generate attractive ROEs in the credit sector such as GSE credit risk transfer securities. Our allocation to this sector early in the quarter helped contribute to our outperformance.

As spreads tightened for these securities over the course of the quarter, by the end of the quarter the GSE credit risk transfer market had appreciated to the point where we believed that there were better relative value opportunities in other sectors and we reduced our positions and swapped into those other sectors.

We continue to see opportunities in CMBS sector particularly in legacy CMBS and in the mezzanine traunches of the CMBS market both in the US and in Europe. During the quarter we significantly increased our exposure to this sector and we invested in our first euro denominated CMBS transaction leveraging off Western's deep expertise across international fixed income markets.

In addition, we hedged the currency of this transaction. We also increased our exposure to Non-Agency RMBS, which performed well during the quarter, and we believe will continue to do so in gradually improving economy, while also exhibiting less interest rate sensitivity than agency securities. Our Non-Agency pools consist of approximately 14% of prime loans, 65% of Alt-A loans and the remaining 21% being subprime loans.

With regard to our Agency portfolio, as Gavin mentioned, we reduced our percentage allocation to Agency RMBS during the quarter as we increased our exposure to other sectors of mortgage market. However, within our agency portfolio we continue to increase our exposure to 4% and 4.5% coupon fixed-rate pools as we believe that these securities offer a more attractive net interest spread on a hedge adjusted basis than the lower coupon pools.

Notwithstanding these securities continue to be invested in mortgage pools with lower loan balance or high LTVs which is consistent with our investment strategy of minimizing our prepayment risk.

Regarding our macro view, we continue to believe that interest rates will remain range bound given the slow growth environment of the economy. While we continue to believe that this will be the case, we believe that we are presently at the low end of that range and that there is a decent probability that rates will gradually head back up towards the mid- or high-end of the range over the remainder of the year.

And therefore at June 30 we positioned our overall portfolio with a net duration close to positive three months. Given our ability to be nimble, our general approach has been when the 10 year is at the low end of our expected range to be shorter in duration and when the 10 year is up at the high end of the range to be slightly longer in duration.

Interest rate volatility remains low and under current conditions we feel comfortable maintaining our exposure through TBA securities as a way to supplement our core earnings with incremental drop income which, as Steve mentioned, contributed approximately $0.25 per share to our earnings in the quarter.

We want to emphasize that we intend to continue to be proactive portfolio managers, always monitoring the relative value opportunities we have across the broad mortgage universe. We have access to and benefit from Western Asset's comprehensive platform where we are able to draw upon the experience of a full team of experts across a number of sectors in mortgage market and the broader fixed income and credit markets.

In that respect we are making progress towards implementing our full [loan] strategy. We are well along in building a program to start investing in structures that provide exposure to residential mortgage market whole loans and expect to begin purchases in current quarter.

Although the timing is not definitive initially we will be focusing on high credit quality non-QM mortgages where we believe that we can earn higher net interest spreads without taking on much incremental credit risk. Our plan is to gradually replace a portion of Agency RMBS holdings with assets purchased through this residential mortgage whole loan program.

Our primary investment strategy remains unchanged, that is to assemble a diversified portfolio with securities that offer what we believe are the best risk and hedge adjusted carry over our investment horizon, which is consistent with our long-term objective of generating sufficient core earnings through supporting attractive dividend while also maintaining a stable book value. With that we will now entertain your questions.

(Operator Instructions). Mike Widner, KBW.

I guess my first question is just the $680 million of TBAs that you mentioned, just wondering is that included in the table that breaks out the Agency MBS, the 2. -- I'm looking at page 5 of the presentation $2.98 billion. Does that include -- is that inclusive of the $680 million of TBAs or is that in addition?

Mike, the TBAs are treated as derivatives so it is all built into the derivatives line. So the amount that is included in that line would be the fair market value as of June 30 of that position, not the notional amount.

Okay. So I am looking at the principal balance column and what you're telling me is the $680 million is not included in there. So as we think about modeling it I need to include sort of an additional $680 million, is that right?

Well, right, but it is treated as a derivative. So all that the GAAP financial statements pick up is the fair market value of that asset.

Well, I certainly understand the balance sheet treatment, I'm talking about the table on page 5 of the presentation where you list coupons and principal balance and amortized cost and fair value. So this is not a balance sheet presentation, this is a portfolio composition presentation. I am just trying to make sure I understand whether that is included in this table or not?

Portfolio composition is consistent with the GAAP presentation.

Mike, I think you are right that that $680 million is not included in this and I think that, for your calculation, I think you should include that in it.

Yes, okay. Fair enough that is what I was trying to figure out there. And then I guess this is maybe a little more of a subtle point, but you guys talked about in both the presentation, the press release and your verbal comments -- you sort of talk about drop income and dollar roll income as if they are sort of the same thing.

In the parlance of most of the mortgage REITs there is the subtle difference in the drop income is just the difference between this month's settlement price versus if you entered a [buy] MBS two, three months out. The drop income is not dollar roll, it is just the difference in spot purchase price versus a forward purchase price where as dollar roll you're actually flipping the contract month to month.

And I'm just trying to understand how you guys are doing it and the mechanics of it. And so, is it more of the latter true dollar roll that you are talking about when you talk about drop income? Or does that question make sense?

It is dollar roll.

It is actual trades.

Yes, it is actual trades, Mike, what you are talking about.

Okay, so it is true dollar roll. And then I guess one final one. This is a little more conceptual. If I go to your hedge summary slide on I guess page 9 of the presentation. I am just wondering how I should think about the -- if I look at the five-year line for the fixed pay and variable pay, how should I think about that, right?

I mean because, again, I know there's multiple contracts in here, at least there probably is. But you have got $3.2 billion where you are a fixed pay or a 10.3 years average maturity. And then on the variable pay it is about a 10.4 year average maturity.

So roughly it's -- and just on the surface it looks like you are sort of on opposite sides of $1 billion or $1.1 billion of very similar swaps. And I guess I'm just trying to think about how that works and what is going on there. If there is actually more sub components underneath it I'm not seeing that explain the strategy better?

Yes, I think, Mike, I think it is just simply I think we could have easily -- as a summarized table we could have easily just collapsed the two. I mean if I go in a market and collapse the two I think it should -- ideally you can easily just assume that in the fixed (inaudible) instead of on a 3.2 versus 1.1 and the variable you can just as easily kind of see it as a 2.1 adjusted fixed [rate] a swap and that is pretty much it.

And so why do the multiple? I mean is it just because you don't want to liquidate some of the ones in the fixed pay piece? Or I mean is there -- I am just trying to figure out what the strategy there is.

Yes, and I think, literally there is no special strategy there. Like I think this will probably -- just looking at hedging or kind of unwinding some of the swaps and we ended up just taking another variable pay. But we could easily just ultimately at some point in time they will get collapsed.

It is just a matter of what we saw at that time and who we can unwind the hedge. But there is no particular strategy in it. I think we could easily just unwind one of those variable pay swaps and collapse the 2 and make it more like 2.1, there is no special strategy in it.

Okay, great.

There are some tax issues in that regard.

Yes. No, of course so, that makes sense. I was just trying to figure out if maybe one of them you had a mix of 20-year and 7-year and there was some weird sort of play on yield curve distortions. But it sounds like it's not really that.

And then I guess just maybe one final big picture one as long as I am still here. I mean the book value increase was obviously nice this quarter. And just wondering if you have any thoughts on how much of that might have been agencies tightening up versus treasuries versus just being in the right products and making the right choices. It was a little bit of both obviously. But how important was the spread tightening in terms of that book value gain?

I mean I think, Mike, it was a combination of all three. I mean I think it was definitely the mortgage spreads tightening, it was also significant rotation into CMBS portfolio because you kind of saw that from the last quarter to this quarter one of the biggest increases where we put capital to work was really in the CMBS strategy where we added nominally legacy CMBS as well as some of the mezz notes.

And I think, and as you know, that that part of the credit book in the marketplace improved quite a bit because remember kind of when we talked our bet really was that a lot of the recovery, which is being assumed by marketplace for those commercial mortgage-backed securities on an underlying loan is by market is significantly lesser than what our expectation is and it will results in rallying prices of those securities or the offer of better risk adjusted carry.

So that made a pretty big difference. As well as our choice of active trading in the book kind of helped pretty significantly as well. As I kind of mentioned in my comments, the perfect example would be risk transfer securities, that was part of our book. And what you kind of saw that did look attractive at one point in time in the quarter, when the spreads tightened out quite a bit we reduced that position as well.

And we kind of -- that is just kind of doing an active management of the portfolio and looking at where are the best opportunities to kind of help overall maintain the book value and kind of play the game. Again, this is an advantage of the Western Assets platform where I have the benefit of a pretty large team where we can find those best relative value trades and kind of put significant amount of capital to work.

Well, great. Well -- and then it seemed to work while this quarter, so nice job and thanks for all the clarity.

Merrill Ross, Wunderlich Securities.

Do you expect TBAs to remain special after October when the Fed finishes tapering theoretically? And if they are not special, how would you think about replacing that carry income or allocating capital to maintain your earnings levels?

Sure, look I think that is a great question. I mean I think they are not -- look, our views are that when they are not special I think that will also impact the mortgage spreads. And I think as we replace it is that's why you're kind of seeing us replace some of that into more credit [bets] as well as growing the whole loan part of the portfolio where we can see the better net spread margins.

And the TBA positions, really we use it more opportunistically to kind of see when we do see that spread attractive level that is the time we increase our TBA position. But we're also very disciplined about reducing those TBA positions based on where we see the -- when we see the value. And when we see our value going away we reduce that position. But ultimately I expect to replace it with other credit products or whole loan portfolios.

Thank you, that makes sense.

(Operator Instructions). And we are showing no further questions, Mr. James.

Okay, operator. Thank you very much. And I thank you, everybody, for joining the call today. We look forward to visiting with you -- many of you in person over the coming months ahead. And once again thanks a lot.

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