Western Asset Mortgage Capital Corp (WMC) 2015 Q2 法說會逐字稿

Welcome to Western Asset Mortgage Capital Corporation's second quarter 2015 earnings conference call. Today's call is being recorded and will be available for replay beginning at 5 PM 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, 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, 2015.

By now, you should have received a copy of today's press release. If not, it's available on the Company's website at www.westernassetmcc.com. In addition, we're 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; 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 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 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 thanks, 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.

The second quarter 2015 turned out to be another challenging period for the U.S. mortgage markets with an extraordinary level of interest rate volatility brought about by events in Greece and China as well as broader geopolitical risk. Despite this continued volatility we once again generated strong core earnings plus drop income for the quarter which more than supported our existing dividend. While our portfolio wasn't immune to the overall volatility in the mortgage markets, our diversification and proactive approach to portfolio management enabled us to deliver a breakeven economic return for the quarter.

During the second quarter we recorded a GAAP net loss of $0.05 per share while generating core earnings plus drop income of $0.76 per share. Our economic return on book value was breakeven for the quarter which included a $0.64 per share dividend enabling us to remain one of the highest yielding mortgage REITs in the sector based on yesterday's closing prices.

During the second quarter we continued to implement our strategy of building a more diversified portfolio with a higher portion of credit sensitive investments. And to that end, credit investments represented approximately 32% of our total portfolio as of June 30th which is up from 28% at the end of the first quarter. In addition, we were proactive in both our asset and liability management during the quarter looking to take advantage of relative value opportunities across the entire mortgage sector as well as manage through the increased interest rate volatility. A high level of volatility generally bodes negatively for mortgage spreads which proved to be the case in the Agency sector, which reduced the value of our Agency holdings. However the larger position we have built in the credit sensitive sector performed well during the quarter. And our liability hedges were well positioned along the yield curve, which resulted in an increase in the value of our hedge positions during the quarter, further offsetting the mark-to-market decline in some of our assets.

And finally, given our ability to be nimble we were able to continue to adjust our leverage and hedge positions throughout the quarter in response to the significant swings in the U.S. Treasury market. The combination of these factors helped produce a solid quarter from a relative performance standpoint particularly given the less than ideal conditions for managing a mortgage REIT.

Our view on interest rates remains consistent. We believe the long end of the curve will be range bound over the remainder of the year and that short-term rates will remain near zero until at least early fall and then only gradually increase from there. This view is based on our belief that economic growth in the U.S. will continue to be modest over the next several quarters and that the Fed will proceed gradually and with caution when it finally decides to increase short-term rates.

Our portfolio continues to perform well into the third quarter with a slight increase in book value since the end of the second quarter. Additionally, we have significantly increased our whole loan holdings to over $150 million up from $30 million at June 30. We have spent the last several quarters building our whole loan origination platform and performing extensive due diligence on originators and now we are beginning to see a meaningful pipeline of opportunities from our origination partners.

Given our increased holdings of residential whole loans we have initiated the due diligence process of becoming a member of the Federal Home Loan Bank. It is our hope that our membership will be approved by the end of 2015. If we are successful in our application to the FHLB, we will have access to lower cost long-term financing that will reduce our cost of funds and improve the overall economics of our portfolio.

In terms of our overall strategy, we intend to continue on the same course we have been on for the past several quarters. We plan to continue to diversify our portfolio into credit sensitive investments and to continue to employ an active management strategy. With a higher volume of whole loan investment opportunities starting to come through our pipeline we expect to accelerate the shift towards a more diversified credit sensitive portfolio. 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'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, 2015. Except where specifically indicated all metrics are as of that date.

On a GAAP basis we recorded a net loss for the quarter of approximately $1.7 million or $0.05 per basic and diluted share. Included in the net loss was approximately $42.8 million of net unrealized loss on MBS, other securities and whole loans. Approximately $4.3 million of net realized gain on MBS, other securities and whole loans and approximately $13.2 million dollars of net gain on derivative instruments.

For the quarter our core earnings plus drop income was approximately $31.7 million or $0.76 per basic and diluted share. This compares to core earnings plus drop income of approximately $34.4 million or $0.82 per basic and diluted share for the first quarter ended March 31, 2015. Our core earnings were approximately $26.9 million or $0.64 per basic and 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 $4.8 million or $0.12 per basic and diluted share which is consistent with the prior quarters given our use of "to be announced" or TBA forward contracts on Agency RMBS. 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 June 30, 2015, our average amortized cost of MBS and other securities held, including Agency and Non-Agency Interest-Only Strips, accounted for as derivatives, was approximately $4.31 billion, relatively unchanged from the first quarter.

Our net interest income for the second quarter was approximately $34.5 million. This is a GAAP financial measure and does not include the interest we received 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 the cost of our interest rates swaps was approximately $31.8 million. This compares to a non-GAAP net interest income of approximately $34.4 million the first quarter of 2015. The slight decrease in our net interest income was primarily due to a moderately smaller portfolio and higher hedge adjusted borrowing costs resulting from our leverage and duration management during the quarter.

Our weighted average net interest spread for the second quarter of 2015, which takes in to account the interest that we receive from Non-Agency RMBS, CMBS and IO, whole-loans and other securities as well as the fully hedged cost of our financing, was 2.79% reflecting a 3.98% gross yield on our portfolio and a 1.19% effective cost of funds. This compares to a weighted average net interest spread of 3.16% for the first quarter of 2015 reflecting a 3.97% gross yield on our portfolio and a 0.81% effective cost of funds. Our net yield decreased primarily due to higher effective interest cost as I mentioned earlier.

During the second quarter our constant prepayment rate, or CPR, for our Agency RMBS portfolio was 9.8% on an annualized basis. This compares to 7.6% for the first quarter of 2015. Despite the increase in refinancing activity that occurred during the second quarter, we were able to maintain a low CPR due to our focus on buying Agency RMBS that we believe exhibit low prepayment characteristics.

Our operating expenses for the second quarter were approximately $5.8 million which includes approximately $3.1 million for general and administrative expenses and approximately $2.7 million in management fees. Included in the G&A expenses were non-cash stock based compensation of approximately $781,000.

Our book value per share as of June 30, 2015, was $13.89 which takes in to account the $0.64 regular cash dividend that we declared on June 18, 2015, and paid on July 28, 2015. As of June 30th the estimated fair value of our portfolio was approximately $3.9 billion and we had borrowed a total of approximately $3.4 billion under our existing master repurchase agreements.

Our leverage ratio was approximately 5.9 times at quarter end, which is inclusive of a net neutral position in TBAs. We continue to be in the attractive position of having repo capacity well in excess of our current needs.

At June 30th we had master repurchase agreements with 25 counterparties and outstanding borrowings with 20 counterparties. We continue to have an excellent relationship 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. Further, as Gavin mentioned, we have started the due diligence process on becoming a member of the Federal Home Loan Bank.

As of June 30, 2015, we had entered in to approximately $10.1 billion in notional value of pay-fixed interest rate swaps, excluding forward starting swaps of $2.2 billion and approximately $7.4 billion of pay-variable interest rate swaps excluding forward starting swaps of $1.2 billion, giving us a net pay-fixed swap position of approximately $2.7 billion.

Additionally, we have entered into a $105 million notional amount of a pay-fixed interest rate swaption, with a swap term of 1 year and an exercise expiration date of June 2016. As a result of our hedge positions, our Agency RMBS portfolio had a slightly negative net duration of 0.1 month at quarter 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 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 second quarter saw a continuation of interest rate volatility. Given our ability to add value through active management, we made a number of adjustments to our portfolio and our interest rate hedges as market conditions changed throughout the quarter. As the quarter progressed and mortgage spreads widened out we reduced our leverage both by closing our net long position in TBAs and reducing our holdings of 20 year and 30 year fix rate pools. We also added interest rate tail hedges to the portfolio. These tactical moves enabled us to reduce the mark-to-market losses on our Agency portfolio and helped us mitigate the pressure on our book value during a very challenging period.

On the credit sensitive portion of the portfolio, we added to our overall positions as the quarter progressed, particularly near the end of the quarter, when credit spreads became more attractive in certain sectors of the market. By the end of June we had increased our exposure to CMBS, particularly mezzanine and "B" notes, as well as GSE credit risk transfer or CRT securities, all of which we believe offer compelling risk-adjusted returns relative to our investment universe.

Within the CRT securities we shifted more of our holdings toward the equity slices rather than the unrated classes, which has proven to be a good trade as equity slices have outperformed in the current environment.

Finally, we modestly increased our holdings of whole loans in the quarter as we have been ramping up our origination platform and putting in place our agreements with our origination partners. In the month of July we accelerated the addition of this asset class to the portfolio, adding more than $120 million in residential whole loans as our pipeline has begun to generate a higher volume of deal flow.

Based on our current outlook we expect to continue replacing Agency RMBS in the portfolio with residential and commercial whole loans through the remainder of the year as we migrate to a more credit sensitive portfolio. We believe that our credit sensitive investments will continue to perform well in a gradually improving U.S. economy while also exhibiting less interest rate sensitivity than Agency securities.

With respect to leverage it should be noted that as our portfolio becomes more weighted to credit sensitive investments our absolute level of leverage will gradually decline as the required collateral levels are generally higher for credit assets versus Agency RMBS. Given the number of cross currents in the global macroeconomic environment and the eventual increase in domestic short-term rates, we expect to maintain a relatively neutral net duration position within our Agency portfolio. That being said, we also expect to continue to manage our leverage and duration opportunistically based on our view of U.S. mortgage market at any point in time.

As we have said in the past, our goal is to maximize total return for our shareholders. We plan on continuing to implement this 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 core 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.

Thank you. (Operator Instructions). And our first question comes from Joel Houck from Wells Fargo. Please go ahead.

Good morning and congratulations on the good job mitigating the book value decline in what was obviously a challenging quarter for the industry. I guess looking out the rest of the year you just mentioned, Anup, that you are going to increase exposure in credit sensitive assets. Given your CPR level on Agency on the other hand it seems like you are in a lot of specified pools that are not that sensitive to rates. I'm wondering if the Fed does in fact in more volatility from your perspective how does that play out in terms of increasing allocation to more broadly in the Agency space? And I guess do you worry just before because there is one Fed rating the fear of additional increases and it has been so long since we have actually seen rate increases that it perhaps is not even worth taking on that risk profile in the Agency space.

Sure. Joel thank you. The way I'm looking at it the reason I am focusing on increasing the credit versus mortgage spreads, although in the short-term I am constructive on Agency but over the long-term, thinking about not only through the year end but next year, ultimately, the Fed will stop buying Agency securities. And I'm less worried about the rate increase because, on average, as we mentioned, we are running a flat duration gap for our book. I think my worry over the long-term is the increase in mortgage spreads, and that is really the concern. We believe that the continued addition of credit, especially our whole loan book in residential and commercial mortgages will continue to perform well. Our general view of the macro environment is that we will continue to be in this slow growth environment globally, which will cause U.S. growth also to be slow. And yes, we expect the Fed to raise rates sometime this year, but it will still be an environment with pretty high rate volatility. And in a high rate volatility environment it is difficult to see mortgage spreads tighten.

Okay. That is very helpful. On the hedging side can you maybe give us a little color on given your type of portfolio it seems like your Agency portfolio held up a lot better than most. How are you viewing the hedge ratio and where you think the most exposure is in terms of the (Inaudible)?

As you can plainly see, the reason our portfolio held up well is because, as we have talked in the past, we consistently look to add tail hedges in the portfolio. So in addition to keeping the duration flat what we also try to hedge broader spread widening. At any point in time we have options on ten year treasury rate volatility to hedge any spread widening. And I think you will continue to see significant usage of those options or different instruments like CDS or interest rates swaps or other types of tail hedges to protect for spread widening. But overall, from rate perspective I think as we have mentioned it will be very opportunistically to add or shorten duration, but generally it doesn't last for a long time. It is very, very opportunistic.

All right. Thank you very much, Anup.

Our next question comes from Rick Shane from JPMorgan. Please go ahead.

Thanks, guys, for taking my question. I understand the shift to the Non-Agency credit sensitive assets and I understand the strategy of reducing duration on the Agency book. But what I want to make sure we fully reconcile is book value is down presumably reducing the duration on the Agency book diminishes the ROE on that portion of the investments. Should we anticipate some compression of core earnings from here?

No, not really. I think from our perspective which I think I will divide the answer in a couple of parts. One is keeping the duration gap as close to flat as possible is really more from the perspective that we are not looking to add any interest rate volatility to our portfolio. What we are trying to do is capture the carry from our mortgage book. The reason we continue to shift more towards credit is that the carry is pretty attractive and we think it will continue to work out very well. Now in terms of over the long-term, because I think in the short-term I am constructive on mortgage spreads and the return. Over the long-term, the return is very attractive on credit sensitive assets.

Okay. But again by reducing the duration -- I mean, I understand the strategy of hedging and why you would want to do that in this current environment. But presumably that comes at a cost in terms of near-term earnings. So is the idea that you are going to be able to shift quickly enough to Non-Agency that that is going to offset at least theoretical compression related to taking down your interest rates risk on the Agency side.?

That is actually exactly right, Rick. I think our returns on what we see in the credit spread product is very attractive and we are very confident that we can shift the portfolio pretty quickly to add more whole loan products in both residential and commercial to be able to replace the core earnings from Agency. We still earn some carry on the Agency, but overall we will be able to boost it pretty significantly from our whole loan and commercial real estate assets.

Rick, it is Gavin.

And then last question related to that, does it make sense to actually, instead of netting out the portfolio through swaps, take down the exposure, or would that create realized losses and you don't want to do that in this environment?

Rick, you have seen in the past, and generally what we do on a regular basis, is we do some compression trades and you see the overall swap book come down between fixed pay versus floating. But right now it doesn't have any economic impact. But on a regular basis we do compression trades. And you would see it, if you would look at it in the past quarters on a regular basis we have done the compression trades to reduce our overall swap book without creating any economic impact and we will keep doing that. I think we have shown that in the past and I fully intend to do that in the future as well.

Got it. One last clarification. I'm always honest enough with myself and acknowledge when I don't fully understand something. When you say compression trade what you basically are saying is given up spread in order to mitigate book value risk?

No, no. When I say compression trade, you asked me the question about the swap book and the compression trade simply means that if you look at the page for swaps and you have a fixed paying swap versus floating, I'm just saying that in each category you can see them compressed. For example if you pick the category of greater than 5 year notional amount you have $6 billion in notional amount of fix pay swaps and you have $4.6 billion of variable pay, so can see some of that netting out against each other when we close out that swap position, that's all.

Got it. That makes sense. Thank you very much.

Our next question comes from Jason Stewart from Compass Point. Please go ahead.

Good morning. It is Jason. Thanks for taking the question. I wanted to ask you how you thought through the IO inverse IO portfolio and whether you look at that today what is your view on rates and spreads as more of an asset hedge and how that is going to play out going forward over the next couple of quarters in your mind.

Sure. I think within the IO and inverse IO book we still expect our broad macro view, is that even though the Fed will raise rates sometime this year, the pace of rates will be pretty slow, and ultimately the Fed funds rate will be low. And relative to that we still find IOs and inverse IOs pretty attractive. But having said that, we have shifted our portfolio more from inverse IOs into more of an IO book and even within IO, more IOs which have been the type which have exhibited very stable prepays and that has provided an attractive carry. And we constantly look at the fully risk-adjusted return with our view of where we see a better value. And we continue to shift our portfolio between the two, based on where we see the best value given our rate view and rate forecast.

That is helpful. Thank you. If you took a step back though and you thought about that asset class versus swaps as a hedge or an asset I'm just wondering how much you think it can contribute to earnings or is it really more of something you view as a complement to your hedge portfolio?

I see that as a complement to our overall portfolio, both from a purely hedge adjusted carry for our mortgages versus where we can generate spreads. It is just one of the categories among many for how we can add spread to our portfolio.

Got it. And clearly it has been a good one for you. Appreciate you answering the question. Thank you.

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

Okay. Thank you very much. Thanks for joining us on the call. Appreciate your time this morning. We look forward to seeing many of you in the months ahead. Thank you, operator.

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