Western Asset Mortgage Capital Corp (WMC) 2014 Q4 法說會逐字稿

Welcome to the Western Asset Mortgage Capital Corporation fourth quarter and year end 2014 -- 2014 earnings conference call. Today's call is being recorded and will be available for replay 5PM Eastern Standard 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, Robert. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months and year ended December 31st, 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 accompanying slide presentation that you can refer to during the call. You can access these slides in the Investor Relation 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 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 of 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 factor 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 fourth quarter and year-end 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 are pleased with our fourth quarter results as we delivered a strong finish in what was another volatile and often challenging year for the U.S. mortgage markets. During the fourth quarter we recorded net income of $0.37 cents per share, or generating core earnings plus drop income of $0.87 cents per share. We delivered an economic return on book value of 2.5% for the quarter and 15.8% for the full year which included a dividend of $0.70 cents per share for the fourth quarter, and $2.74 for the full year making us the highest yielding mortgage REIT in the sector.

Our strong performance reflects the continued implementation of our strategy to build a more diversified portfolio with a high proportion of credit-sensitive investments, as well as our ability to take advantage of the relative value opportunities across the entire mortgage sector through our proactive approach to book value management. Our success reflects a significant competitive advantages provided by leveraging Western Assets world class investment platform which was recently recognized as Morningstar's 2014 fixed income manager of the year.

2014 was also an important year for us with respect to the capital markets. In the second quarter we completed a successful follow-on offering of shares raising a total of approximately $215 million. Included in this amount was an additional investment in the Company by our external manager, Western Asset of approximately $10 million. The offering was accretive on a book value basis to existing shareholders and increased the market capitalization of the Company by approximately 50%. The new capital enabled us to accelerate our portfolio diversification strategy to the benefit both our new shareholders as well as our longer term holders.

In addition it has lowered our administrative expenses on a relative basis as we are able to leverage our fixed costs over a larger capital base. Our strong performance in the fourth quarter was due to a number of factors. First our core position in agency RMBS, non-agency RMBS, and CMBS performed well during the quarter. Second, we were proactive during the quarter and took advantage of mortgage spread widening that occurred early in the quarter by increasing our TBA exposure thus benefiting from the subsequent timing of the spreads that occurred through the year-end.

Positive performance of our assets was more than offset by the decrease in the value of our hedge position as the yield curve flattened and long-term rates declined over the course of the quarter. Including both our fourth quarter and full year results we have generated a meaningful level of our performance relative to our pair group of other publicly trade hybrid mortgage REITs. The out-performance on an economic return basis point -- basis was 140 basis points for the quarter and approximately 180 basis points for the year.

Our continued view on interest rates is that the long end of the curve will remain range-bound over the course of the year, and short-term rates will remain near zero until at least late summer, and then only gradually increase from there. This view is based on our belief that the economic growth in the U.S. will remain modest over the next several quarters and that the Fed will continues to be supportive of the economy erring on the side of caution when it finally decides to increase short-term rates.

Our portfolio has been positioned to perform well in this environment with increases in the valley of our agency and non-agency holdings during the month of January more than offsetting a decline in the value of our hedge positions. As a result our estimated book value has improved since the end of 2014. Anup Agarwal will go into more detail for 2015.

Our investment strategy for 2015 will be more of the same. We plan to continue to diversify our portfolio into credit-sensitive investments and continue to employ an active management strategy. A comprehensive investment platform at Western Asset is clearly an advantage in helping us implement this strategy. We believe that among our competitive advantages our ability to be nimble and adjust the portfolio to gain exposure to the asset classes and specific securities that provide the more attractive risk-adjusted returns at any given point in time.

Although we can't guarantee the performance of our portfolio investments, we believe we are 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 will 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 fourth quarter and year-ended December 31st, 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 $15.4 million or $0.37 cents per basic and diluted share. Included in net income was approximately $48.3 million of net unrealized gains on mortgage backed securities, other securities, and home loans, and approximately $9 million of net realized and other loss on MBS and other securities and approximately $53.3 million of net loss on derivative instruments and link transactions.

For the quarter our core earnings plus drop income was approximately $36.4 million or $0.87 cents per basic and diluted share. This compares to core earnings plus drop income of approximately $27.8 million, or $0.67 for basic and diluted share for the third quarter ended September 30th 2014. Our core earnings were approximately $27.3 million or $0.65 cents per basic and diluted share which is a non-GAAP financial measure which we divided 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.

For the quarter we generated drop income of approximately $9.2 million or $0.22 cents per diluted share. As we begin utilizing more to be announced, or TBA, forward contracts on agency RMBS in the form of dollar (inaudible) transactions has resulted in an 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 a comparable security on the trade date.

For the quarter ended December 31st, 2014, our average amortized cost of MBS and other securities held, including agency and non-agency interest only strips, accounted for as derivatives and linked transactions was approximately 4.4 -- was approximately $4.44 billion as compared to $4.57 billion for the third quarter ended September 30th 2014. Our net interest income for the fourth quarter was approximately $33.9 million. This number is a GAAP financial measure and does not include the entries we receive and pay on our linked transactions.

Interest we receive from our IO securities are treated as derivatives. Nor does it take into account the cost of our interest rate swaps. The (inaudible - background noise) the gain of derivative instruments in our line in our income statement. Our a non-GAAP basis our net interest income including the interest we receive from our IO securities treated as derivatives. Interest we received from linked transactions and the cost of interest rate swaps was approximately $31.8 million.

This compares to non-GAAP net interest income of approximately $24.9 million for the third quarter of 2014. The sequential increase in our net interest income was primarily due to lower hedge (inaudible) to borrowing costs due to our duration management during the quarter. For the full year 2014 we reported net income of $100.7 million on a GAAP basis or $2.67 for basic and diluted shares including net income, was approximately $189 million of net unrealized gains on mortgage backed securities, other securities, and home loans, approximately $19.2 million of net realized and other loss on other mortgage backed securities and other securities, and approximately $178.6 million of net loss on derivative instruments and linked transactions.

For the year our core earnings plus drop income was approximately $119.3 million or $3.17 per basic and diluted share. Our core earnings were approximately $89.9 million or $2.39 for basic and diluted share, and our drop income was approximately $29.4 million or $0.78 for basic and diluted share. Our net interest income for the year was approximately $126.8 million on a GAAP basis. On a non-GAAP basis our net interest income, including the interest we received from IO securities treated as derivatives, interest we received from linked transactions, and the cost of our interest rate swaps was approximately $106.8 million.

Our weighted average net interest spread for the fourth quarter of 2014 which takes into account the interest we received from non-agency RMBS, MBS, IO and other securities as well as the fully hedged cost of our financing was 2.71% reflecting a 3.79% gross yield on our portfolio and a 1.08% effective costive funds. This compares to a weighted average net interest spread of 1.95% for the third quarter, reflecting a 3.75% gross yield on our portfolio and a $1.80 effective cost of funds. Our net yield increased primarily due to lower interest costs as I mentioned earlier.

During the fourth quarter our constant pre-payment rate, or CPR, for our agency RMBS portfolio was 6.8% on an annualised basis. This compares to 6.5% for the third quarter of 2014. Despite the increase in refinancing activity we have been able to maintain a low CPR due to our focus on buying agency RMBS that we believe exhibit low pre-payment characteristics. Our operating expenses for the fourth 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 expense were non cash stock-based compensation of approximately $549,000. Our G&A expenses expressed as an annualized percentage of our average stockholder's equity were approximately 1.5%. On a book value per share as of December 31st, 2014 with $14.94 which takes into account the $0.70 cents regular cash dividend that we declared on December 18th and paid on January 27th, 2015. At December 31st, the estimated fair value of our portfolio was approximately $4.4 billion and we had borrowed a total of approximately $3.39 billion under our existing massive repurchase agreements.

Our leverage ratio was 6.3 times at year-end. Our adjusted leverage ratio was approximately 6.8 times at year-end adjusted for $325 million notional value of net loan position, a mortgage pass through certificate to be held at the end of the year. We continue to be in the very attractive position of having [repo] capacity well in excess of our current needs. At December 31st, 2014 we had master repurchase agreements with 24 counter parties and outstanding borrowings with 21 counter parties.

We continue to have excellent relationships with our bank counter parties and feel comfortable with our existing group. We have a highly diversified repo lender book and we believe we have more than ample liquidity to meet our present and expected funding requirements. At December 31st we had entered into approximately $3.4 billion in notional value of pay fixed interest rate swaps, excluding forward starting swaps of $2.4 billion and $2.1 billion of pay variable interest rate swaps, excluding forward-starting swaps of $110 million giving us a net pay fixed swap position of approximately $1.3 billion.

Additionally we have entered into approximately $105 million notional amount of pay fix interest rate swaptions with a one-year swap term and an exercise expiration date of June 2016. As a result of our hedge positions our agency RMBS portfolio has a net to ratio of negative one month at year-end. We are comfortable with our current leverage. We can adjust our implied 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. As Gavin mentioned the fourth quarter saw an increase in interest rate volatility, particularly in early October when the10-year treasury rate dropped by roughly 30 basis points and mortgage spreads by [now]. Given our ability to be active managers and our view at the time that mortgage market was over sold, we increased our exposure to TBAs and subsequently benefited from a tightening in spreads that occurred throughout -- through the end of the year.

For the first two months of fourth quarter we kept our adjusted leverage in the mid to high 7s range as we increased our TBA exposure. As the spread narrowed later in the quarter we [suddenly] took off this trade and reduced our adjusted leverage down to 6.8 by end of the year. This trade worked very well for us and generated a significant amount of drop income in the fourth quarter. The portfolio diversification strategy that we began in the fall of 2013 remained on course as we continue to shift our portfolio toward credit sensitive investments and tactically reallocated our positions within non-agency space to sectors where we believe we could achieve better hedge adjusted returns such as US and European TMBS [mess] traunches and GFC credit risk strength for securities.

In addition during the quarter we made progress toward implementing our residential home loan strategy making our first investments in residential mortgages whole loans. We also kept the direction of our agency portfolio during the quarter slightly negative based on our views of 10-year treasury yield. As a result as Gavin mentioned our hedge positions experienced a loss for the quarter although we held a significant amount of out-of-the-money swaptions which helped to mitigate the decline in the value of our hedge book during the precipitous rate drop in October. The depreciation of our assets combined with our strong core plus drop income enabled us to generate a positive economic return on book value of 2.5% for the quarter.

We continue to believe that our credit sensitive investments well continue to perform well in a gradually improving U.S. economy while also exhibiting less interest rate sensitivity than agency securities. With regard to our agency portfolio we maintain our primary exposure to 3.5%, 4% and 4.5% coupons in 30-year fixed rate pools, and 3%, 3.5% and 4% coupons in 20-year pools. Our agency investments continue to be invested in mortgage pools with low loan balances or high LVPs which is consistent with our investment strategy of minimizing our pre-payment risk.

As we enter 2015 we believe that pre-payment risk would increase and that specified pools would out perform TBAs. In January we moved to a net negative position in TBAs thus lowering our implied or adjusted leverage. This tactical shift worked well as specified pools out performed TBAs in January. However, the continuing flattening of yield curve has put pressure on our head positions. Although they have recovered somewhat in February with a modest retracement in the 10-year yield to around 2% today. After hitting a low of 1.64% at the end of January.

In addition our non-agency portfolio has performed well to date particularly holdings in GFC credit-risk transfer securities. So as Gavin mentioned earlier we estimate that overall our book value has increased modestly since the beginning of the year. We remain extremely nimble in our portfolio management and given the mortgage spread have trended recently it is possible and even likely that we will increase our exposure to TBAs at some point during the remainder of the first quarter.

We are making progress toward implementing our residential home loan strategy. We have built a program that enables us to invest in structures that provide exposure to residential mortgage loans and we made our first whole loan investment during the quarter. We will be focusing on high credit quality, non QM mortgages where we believe we can earn higher net interest spreads without taking on much incremental credit risk. We are expanding our sourcing capabilities in this area and have also started to invest in commercial real estate home loans.

As we mentioned last quarter our plan is to gradually replace a portion of our agency RMBS holdings with assets purchased through our whole loan programs. It is worth noting that our portfolio diversification strategy could not be implemented as effectively without access we have to Western Asset's comprehensive platform where we are able to draw upon the experience of the full team of experts across a number of sectors in the mortgage market and the broader fixed income and credit markets.

Implementing this strategy is when we really see the benefit of broad expertise of Western for managing the REIT. Our primary investment strategy remains unchanged and that is to maximize full return for our shareholders. We plan on continuing to implement the strategy by holding a diversified portfolio of securities that offer what we believe are the best risk adjusted returns over our investment horizon. Which is consistent with our long-term objective of generating sufficient quarter earnings to support an attractive dividend while also maintaining a stable book value. With that we will now entertain your questions. Operator, please open up the call

(Operator Instructions) The first question comes from Joel Houk of Wells Fargo. Go ahead.

Thanks and good morning, and congratulations on a solid 2014. I guess start off with respect to kind of repositioning the portfolio, talk about where we are in the process of minimizing the agency exposure. It seems like the risk-reward tradeoff, we have heard this on a number of your peers' calls, the risk-reward tradeoff is not all that great right now in agency. Where we are in the process and how you see kind of 2015 playing out, if in fact the Fed does raise rates the middle of the year and the yield curve flattens and with that the mortgage basis widens a bit.

Thanks, Joel. I appreciate the question. I think we plan to continue our diversification process for more credit spread products. What you would kind of see is we continue to grow both our European CRE and U.S. CRE opportunities as well as our whole loan opportunities both in residential and in commercial growth [tip] space as well as opportunistically looking at spreads in non-agency residential mortgage market.

What you would expect is, as we see opportunities we will continue to grow our credit book and continue to reduce our agency book. Still one of the benefits we -- you have as you do whole loans, that you get the benefit of whole loan treatment versus agency book We continue to increase. I expect to use TBAs more as an opportunistic kind of trades where we see mortgage basis widen out, and if we have a view that mortgage basis will tighten we will use the TBAs opportunistically. But otherwise we will continue the path of larger credit spread product.

Joel, just -- it's Gavin -- just to add to that, you know one of the advantages we have given our size currently is that we can be incredibly nimble, and to Anup's point we can move between sectors in the mortgage market, and also it allows us to be very flexible when it comes to adding to the duration of the portfolio given where yields are at a certain point in time if we believe they're toward the top end of our range. It's increased our duration profile. And subsequently if they put down at the bottom end of our trading range would reduce our duration. Being nimble in these markets is, we feel, is a very, very clear advantage.

I definitely agree with that. Maybe when you kind of look at the tradeoff between current period of returns and minimizing book value volatility, as you transition out into more diversified strategy how will that, if at all, change versus what we have seen maybe historically at Western?

Joel, I think because we are pretty active managers we have kept volatility to our book value reasonably restrained. I think it is because even with the kind of volatility you saw last quarter and this quarter we have always have tail hedges in the portfolio. But answering your questions (inaudible) as we shift more to credit spread products given our view that US economy will continue to move along at a slow and steady pace that the volatility of unmargined will go down as we shift more to credit-sensitive products. But look, you may think -- we managed to look at both fundamentals and tacticals of our portfolio. One of the things which I would highlight is even the most REIT-filled work in credit-risk transfer securities last year saw massive amount of volatility, even the overall non-agent market moved along, but you saw the credit risk transfer deals go from 450 to 265 and back up to 500 with 10-year spread duration.

This is where a value effective management counts, that when it was at 255 we reduced our book of credit transfer deals pretty dramatically and then as the spread widen out, we put it -- we added it right back. In my mind diversification of the portfolio without active management, I think it just gives you a sense of lower volatility, but I think the value really comes from both combination of diversifying to credit risk products and at the same time active management.

Thanks for the response, guys.

The next question comes from Mike Widner from KBW.

Good morning, guys. Wonder if you can talk a little more about the residential whole loan program. I guess the first question there is I see you have $7 million of residential whole loans roughly. I take it that's through that program and those are the sort of loans you were talking about?

That's exactly right, Mike.

So maybe just a little more -- I mean it seems like you guys have been talking about these for a while and just now that we are seeing them, just want to go back and make sure we are still talking the same general idea. These are going to be non QM loans mostly?

That's correct, Mike. We still think the value across the whole loan sector is really in non QM. And our program, as we discussed with you, it has really not changed. I think as you know and as we talked about it with you, it is just bells and whistles you have to put together to be successful in the program. It just takes longer. It always takes longer than what you anticipate it to be, and we had the same part we have to deal with, but we are seeing the production continue to move up and I think you would -- we are just about in the process of adding some more. You will see kind of added in the quarter the profile still continues to be the same. Non QM, low LTV, pretty attractive risk-reward and you will see whole year we have continued to diversify more originators who provide us with those [traunches] of loans. Our approach still continues to be the same.

And just out of -- are these loans mostly hybrid arm types, 5/1s, 7/1s, 7/1s or are they fixed?

None of them are fixed. I think it's just -- at this point in time our focus is primarily on our products. Our primary focus is 5/1, 7/1 at this point in time.

Any thought on levering and financing? How should we think about that? Securitization at some point or what are the different options and how are you guys looking at it?

Right now we have a pretty attractive financing available and we ultimately, as we have discussed with you, we will securitize these loans and we have been taking a pretty active approach with trading agencies to help them understand what we have originated, how we originated and what due diligence we do, so they are comfortable with the high quality of the assets we are originating. Even currently there is a pretty good leverage available from the repo counter parties we currently have.

So basically it is repo funding as opposed to term loan facilities or conduits or anything like that right now?

I mean, since 2015 we have added significant amount of non-[term] loans. Right now it is from repo counter parties because that's where we see the best execution. We have all the different financing available, but at this point in time we just don't see using anything other than the repo counter party financing.

That makes sense. What kind of approximate rate are we looking at? 2% is the ballpark we're seeing in most non agency stuff. Is that consistent with you guys?

I think 2% or less. I think generally what we kind of see non-agency really ranges from about 1.5% to 2%. I think we tend to be the beneficiary at the lower end but that is kind of the range. The range we kind of see is 150 (sic) to 2%. More of our financing tends to be on the lower end of the spectrum. Again, as we have talked about, given the value of the Western Asset platform, and given our levered book of all investment is pretty miniscule relative to our overall trading book. We tend to get more favorable treatment from our counter parties relative to the rest of the REIT sector.

Gotcha. Yes it makes sense. I guess a pretty different question, you guys were quite active in the fourth quarter in terms of managing your swap book. If I think back to 2013 you guys had sort of the -- you know, there's these tax issues that arise for what you can write off and derivatives versus -- and my recollection was a large part of that sort of special dividend paid in stock, that whole sort of thing arose out of kinds of rebalancing that led to a weird sort of tax situation. Would the active swap -- very active swap management now do we have to worry about -- not worry about, but look forward to any of that stuff again?

Steve?

I would say Mike that is a difficult question to answer on this call. We can get into a little more details maybe later in the quarter, but right now [by some getting here] we can't really comment.

Yes, that makes some sense. All right, well thank you, guys. I appreciate it. And again, congrats on a solid year.

Thank you.

Thank you.

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

Thank you, operator. With that then we would like to conclude the call. Again thanks for everybody's support. We feel we had a great year and we look forward to seeing you all in person over the course of the next month or two. Thank you, operator.

This call has been concluded.