Western Asset Mortgage Capital Corp (WMC) 2014 Q3 法說會逐字稿

Welcome to the Western Asset Mortgage Capital Corporation's third-quarter 2014 earnings conference call. Today's call is being recorded and will be available for replay beginning at 2 PM Eastern time. (Operator Instructions). 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 September 30, 2014. By now, you should have received a copy of yesterday'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, Chief Executive Officer; Steven Sherwyn, Chief Financial Officer; and Anup Agarwal, Chief Investment Officer.

Before we begin, I'd like to review the Safe Harbor statement. This conference call will contain statements that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecasts 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.

Thanks, Larry and thank you, everyone, for joining us on the third-quarter conference call today. We're conducting this quarter's call earlier in the day than we normally do. That's because the WMC team is here in New York.

I'll 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 another quarter of strong performance despite a relatively challenging and volatile fixed income market. During the period, we recorded GAAP net income of $0.63 per share while generating core earnings and drop income of $0.67 per share. We generated an economic return of 4.2% for the quarter and 13.3% year-to-date, which is reflective of our emphasis on total return and shareholder value and the strong performance of our diversified portfolio. We increased our quarterly cash dividend by 4.5% to $0.70 per share while our net book value remained stable. This is consistent with our goal of delivering an attractive dividend while also maintaining a stable book value.

During the course of the third quarter, we slightly increased the credit-sensitive portion of our portfolio to approximately 27% of the total as we added GSC risk-sharing securities and other asset-backed securities to our portfolio. Our continuing shift to a hybrid model has, subject to REIT requirements, broadened our investable universe and has enabled us to generate attractive risk-adjusted returns.

During the quarter, long-term interest rates continue to remain at the low end of our expected range and therefore we decreased our agency portfolio net duration by adjusting our interest rate hedges. As a result of those adjustments, our hedge adjusted cost of funds increased, impacting our net interest spread. But this also enabled us to maintain a stable book value, which decreased by less than 0.4% from the end of the June quarter.

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. We now expect the yield on the 10-year treasury to be range-bound between 2.25% and 2.755% over the next 12 months. But we expect that range will be data-dependent based on conditions in the global economy and we believe that short-term rates will remain close to zero until the end of 2015.

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 and private investors all remain active in the market. The supply for both agency and non-agency assets will be somewhat constrained given the low level of expected new production.

We are very pleased with our financial performance for the quarter and year-to-date, which we believe is the result of our shift in strategy to diversify our portfolio away from a pure agency REIT into a hybrid REIT and our active management strategy. The comprehensive investment platform of Western Asset is clearly an advantage in helping us make this shift. We continue to believe that among our competitive advantages 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 in time.

Although we can't guarantee the performance of our portfolio investments, we believe that 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.

Additionally, our Board of Directors recently approved two changes to the Board structure and composition. First, the Board has created the position of lead independent director and appointed its current audit committee chair, Mr. Cristian Mitchell, to the position. Mr. Mitchell's role will be to lead and represent the independent directors in discussions with the Company's management and its manager, Western Asset. We are pleased that Chris has agreed to serve as the lead independent director. The Company has already benefited from Chris' experience and dedication as our audit committee chair and we expect to benefit from his contributions in his expanded role.

Second, the Board has appointed a new independent member, Ran Kripalani, to the Board effective November 10, 2014, increasing the total number of independent directors to four and the total number of directors to six. We welcome Ran to our Board of Directors. He brings significant knowledge and expertise in mortgages and mortgage-backed securities and we look forward to his contribution to our Board and the Company.

In connection with these changes, the Board amended our corporate governance principles to establish the lead independent director role and to require that two-thirds of our directors be independent. We believe these changes, which we made as part of a regular review of our corporate governance practices, are important to our growing Company and place us within industry best practices. 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 third quarter ended September 30, 2014. Except where specifically indicated, all metrics are as of that date. On a GAAP basis, we recorded net income for the quarter of approximately $26.1 million, or $0.63 per basic and diluted share. Included in the net income number was approximately $4.5 million of net unrealized loss on mortgage-backed securities, approximately $4.9 million of net realized gain on mortgage-backed securities and approximately $1.6 million of net loss on derivative instruments and linked transactions.

For the quarter, our core earnings plus drop income was approximately $27.8 million or $0.67 per basic and diluted share. This compares to core earnings plus drop income of approximately $40 million, or $1 per basic and diluted share for the second quarter ended June 30, 2014. Our core earnings were approximately $20.3 million or $0.49 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, noncash stock-based compensation expense and other noncash charges.

For the quarter, we generated drop income of approximately $7.5 million or $0.18 per diluted share. As we have transitioned our portfolio to a hybrid REIT model, we have 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 as it is defined as the difference between the spot price and the forward settlement price for a comparable security on the trade date.

For the quarter ended September 30, 2014, our average amortized cost of mortgage-backed securities held, including agency and nonagency interest-only strips accounted for as derivatives and linked transactions, was approximately $4.57 billion as compared to approximately $4.83 billion for the second quarter ended June 30, 2014.

Our net interest income for the third quarter was approximately $34.3 million. This number is a GAAP financial measure and does not include the interest we receive and pay on our linked transaction, 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 received from IO securities treated as derivatives, interest we receive from linked transactions and the cost of our interest rate swaps, was approximately $24.9 million. This compares to non-GAAP net interest income of approximately $34.4 million for the second quarter of 2014. The sequential decline in our net interest income was due to our modestly smaller average portfolio during the September quarter and higher hedge-adjusted borrowing costs due to our duration management during the quarter.

Our weighted average net interest spread for the third quarter of 2014, which takes into account the interest that we receive from our non-agency RMBS, CMBS and IO securities, as well as the fully hedged cost of our financing, was 1.95% reflecting a 3.75% gross yield on our portfolio and a 1.80% effective cost of funds. This compares to a weighted average net interest spread of 2.69% for the second quarter reflecting a 3.86% gross yield on our portfolio and a 1.17% effective cost of funds. Our net interest yield decreased primarily due to higher interest costs related to our duration management as I mentioned earlier.

During the quarter, our constant prepayment rate or CPR for our agency RMBS portfolio was 6.5% on an annualized basis. This compares to 4.9% for the second 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 $5 million, which includes approximately $2.3 million for general and administrative expenses and approximately $2.8 million in management fees. Included in G&A expenses were noncash stock-based compensation of approximately $587,000. Our G&A expenses expressed as an annualized percentage of our stockholders' equity were approximately 1.4%, an improvement of approximately 40 basis points in the first half of 2014 and was the result of the additional capital that we raised earlier this year, which has enabled us to spread our fixed costs over a larger capital base.

Our book value per share as of September 30, 2014 was $15.26 per share, which takes into account the $0.70 of regular cash dividend that we declared on September 23 and paid on October 28, 2014. For purposes of comparison, our book value per share declined by 0.3% from its June 30, 2014 level of $15.31. We believe that our stable book value per share was primarily the result of our more diversified portfolio and negative duration hedge-adjusted agency portfolio and was supplemented by dollar roll income from our net long TBA position.

As of September 30, the estimated fair value of our portfolio was approximately $4.4 billion and we had borrowed a total of approximately $3.9 billion under our existing master repurchase agreements. Our leverage ratio was approximately 6.1 times at quarter-end. Our adjusted leverage ratio was approximately 7.9 times at quarter-end adjusted for $1.1 billion of notional value of net long positions and TBA mortgage pass-through certificates that we held at the end of the quarter.

We continue to be in the attractive position of having rebuilt capacity well in excess of our current needs. At September 30, 2014, we had master repurchase agreements with 23 counterparties and outstanding borrowings with 20 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 September 30, 2014, we had entered into approximately $5.9 billion in notional value (inaudible) interest rate swaps, excluding forward starting swaps of approximately $1.9 billion and $3.3 billion of paid variable interest rate swaps, excluding forward starting swaps of $110 million, giving us a net paid fixed swap position of approximately $2.6 billion.

Additionally, we have entered into approximately $805 million notional amount of net paid fixed interest rate swaptions with swap terms that range between 1 and 10 years and have exercise expiration dates that range from October 2014 to June 2016 and a $540 million notional amount of paid variable interest rate swaption with a swap term of 10 years and an exercise expiration date of December 2014.

As a result of our hedge positions, our overall portfolio had a net duration of approximately 9 months at quarter-end. Excluding non-agency RMBS, CMBS and ABS holdings, our net duration was approximately negative 1.4 months. 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 stable book value. With that, I will now turn the call over to Anup Agarwal. Anup?

Thanks, 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. On our call last quarter, we talked about our belief that interest rate volatility will remain low and that our outlook for mortgage spreads was positive. We also said that given our ability to be nimble, our general approach would be that when the 10 years is at the low end of our expected range, we would be shorter in duration. 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.

We also adjusted the duration of our agency portfolio during the quarter between negative duration of one-half to three-quarters of a year based on our views of the 10-year yield and while mortgage spreads widened modestly in the quarter, we generated a positive economic return of over 4% as a result of our portfolio positioning. We also discussed how we intend to continue to be proactive portfolio managers always monitoring the relative value opportunities we have subject to the REIT requirements across the fixed income universe.

During the quarter, we modestly increased our exposure to credit-sensitive investments, particularly GSC credit risk-sharing securities and other asset-backed securities. We maintained our overall allocation to CMBS and nonagency RMBS, but we shifted out of some of our legacy CMBS positions and into CRE, mezzanine securities both in US and Europe where we saw a better relative value. We also slightly reduced our exposure to specified pools of fixed rate agency RMBS. As a result, 27% of our total investment portfolio consists of credit-sensitive investments as of the end of September. We continue to believe that our credit-sensitive investments will continue to perform well in a gradually improving US economy while also exhibiting less interest rate sensitivity than agency securities.

With regard to our agency portfolio, we continue to increase our exposure to 4% coupon 30-year fixed rate pulls as we believe that these securities offer a more attractive net interest spread on a hedge-adjusted basis than the lower coupon 15 and 20-year fixed pools. Our agency investments continue to be invested in mortgage pools with low 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 US economy and weak global economic conditions, particularly in Europe. While we continue to believe that this will be the case, we believe that we are presently at the low end of the range and there is a decent probability that rates will gradually head back up towards the mid or high end of the range over the next 12 months. And therefore, at September 30, we have positioned our hedge-adjusted agency portfolio with slight negative duration.

Interest rate volatility has recently increased modestly, but we expect that it will continue to remain low by historic standards and under current conditions, we feel comfortable maintaining our exposure to TBA securities as a way to supplement our core earnings with incremental drop income, which, as Steve mentioned, contributed approximately $0.18 per share to our earnings in the quarter.

We are making progress towards implementing our residential home loan strategy. We have built a program that enables us to invest in structures that provide exposure to residential mortgage home loans and to that end, we made our first whole loan investment in October. Initially, we'll 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 current plan is to gradually replace a portion of our agency RMBS holdings with the assets purchased through this residential mortgage whole loan program. We want to again emphasize that we continue to benefit from our access to Western Asset's comprehensive platform where we are able to draw upon experience of a full team of experts across a number of sectors in mortgage market and the broader fixed income and credit markets.

Our primary investment strategy remains unchanged to maximize total return for our shareholders. This 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 to support an attractive dividend while also maintaining our stable book value. With that, we will now entertain your questions.

(Operator Instructions). Ken Bruce, Bank of America.

Good morning, guys. This is (inaudible) for Ken Bruce. Thanks for taking the question. Just looking at the TBA position, you almost doubled that during the quarter and it seems like the TBA market improved for you all. Can you just talk about how you see that evolving going forward, if we should assume that type of run rate or are you thinking that that comes back down now that you think that rates are at the lower end of the range? Thanks.

Sure, I mean I think TBA position -- our view on the TBA position has always been that if we are constructive on mortgage spreads and the specialness of the pool, then we will increase our TBA positioning. We do expect that we will continue to have a reasonable run rate for drop income, but it will be -- our TBA positioning is always opportunistic based on where we see spreads.

Okay. So just if I hear what you are saying, you say (inaudible) at the low end, you are buying prepaid protected specified pool. Should I kind of see that that comes down from $1 billion from here?

Yes, I mean I think that's exactly right.

Okay, great. Thank you.

Joel Houck, Wells Fargo.

Thanks, good morning, guys. Good quarter. I'm wondering, subsequent to the quarter, mid-October obviously had a huge rally in treasury that was short-lived, but given that it was substantially outside of your range expectations, certainly probably anybody's, can you maybe talk about or maybe give us some color, if you will, in terms of how -- what you're doing in terms of portfolio and the hedging on days like that? It was a very volatile week (multiple speakers). Also if there were any hedging changes.

That's a great question, Joel. A couple of things in that framework. One, as you kind of saw that we adjusted our range for 10 years, that given the economic data which has come out, we have adjusted our range for 10 years to be more like 225 to 275. But more importantly directly on days like October 15, we also have tail hedges in the portfolio so that at any point in time when we see our expectation of the rate wall just before October 15, as you know, was pretty low and we had added some tail hedges in the portfolio with the expectation that if 10 years falls below 2.2, then it will effectively add some duration. And then as the 10 years fell below 2%, that covers -- that effectively hedges our broad mortgage spread widening. Once it fell to kind of lower end to 1.8, 1.9, then we [went] short duration back again. But generally our views for days like that is to have tail hedges in the portfolio, which can protect us from mortgage spread widening.

Okay. And on the converse side, I mean I think your views on rates have generally been pretty good to give you guys credit for being public about it. In a rising rate environment, a lot of your peers have said they think the mortgage basis would tighten if that's a normal type of environment unlike what we saw in 2013. So I guess the question is do you concur with the notion that if we saw rates start to rise at the long end that the mortgage basis would indeed tighten?

There are two parts. One, that we remain short, which is kind of the view that long-end rates will rise. But in that environment, mortgage base, we continue to be constructive on mortgage spreads as well. Look, I think the part which we continue to be also very cautious about that global economic data could cause broader spread widening. You can have instances like October 15 over the next three months, which can cause mortgage spreads to widen and we will just be opportunistic in those scenarios.

Okay, great. Thank you very much.

Lucy Webster, Compass Point.

Hi, good morning. Thanks for taking my question. I was hoping you could talk about the risk-sharing transactions and maybe the leverage capacity or availability of those transactions and how you might think about that sector with supply growing in 2015.

Look, as we have shared with investors before that when the risk-sharing deal spreads tighten to 2.65, 2.75, we had reduced our exposure to that sector and as the spreads have widened out, we have added exposure back in for those securities, but I continue to be pretty cautious for risk-sharing deals and I think it's more driven by not only significantly increased supply on risk-sharing deals, as well as a just broad credit spread environment given the global economic conditions.

In addition, I think different dealers have started bringing their risk-sharing or similar to risk-sharing deals in the marketplace. We find them attractive from purely as a leveraged carry product, but I don't expect in short term those spreads to tighten meaningfully.

Great. And then could you give us some more color on the CMBS book and how you're thinking about the sector with the new QRM requirements?

Yes, absolutely. I think with the upcoming QRM requirements, it adds -- if anything, it continues to be attractive for us. If anything, we think that that increases attractiveness of CMBS portfolio even more given we happen to be a REIT. We have the capability of owning a certain percent of the collateral. So we still continue to be very constructive on the bottom part of the capital structure on the spread for BBBs, both single borrower deals, as well as conduit deals and what we have done though is we have started shifting our portfolio from legacy CMBS to more CRE, mezz opportunities, both US and Europe.

Great, thanks for taking my questions.

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

Okay. With that, I'd like to thank you all for joining us on the call today and we look forward to seeing many of you in person in the months ahead. So once again thank you.

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