Western Asset Mortgage Capital Corp (WMC) 2015 Q3 法說會逐字稿

Welcome to the Western Asset Mortgage Capital Corporation's third quarter 2015 earnings conference call. Today's call is being recorded, and will be available for replay beginning at 5.00 PM Eastern Standard Time. At this time, all participants have been placed in a listen-only mode, and the floor will be open for your questions following the presentation. 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 September 30, 2015. 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'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, Steve Sherwyn, Chief Financial Officer, Anup Agarwal, Chief Investment Officer, and George Yeboah, Controller. Before we begin, I would like to review the Safe Harbor statement. This conference call will contain statements that constitute include 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 Securities and Exchange Commission. Copies are available on the SEC's website. We disclaim any obligations 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. Thank you everyone for joining us today for our third quarter conference call. Steve Sherwyn, our CFO is ill at the moment, so George Yeboah, our Controller, who works closely with Steve will be handling the discussion of our financial results on Steve's behalf. However Steve will be available to assist with the question-and-answer session in any post call follow-up that may be required. Steve is expected to undergo medical treatment later this month, and we will monitor his condition. One of the benefits of management by a firm like Western Asset, is that we have access to significant external and internal resources to address the needs of the CFO role, if we need to adjust Steve's role.

Now turning to our results. During the third quarter, the fixed income markets continued to experience a high level of volatility, driven by concerns over slower global economic growth, and ongoing uncertainty over the timing of when the Federal Reserve would begin to increase interest rates. While our portfolio wasn't immune to the overall volatility in the fixed income markets, and in particular, the US mortgage markets, our diversification and proactive approach to portfolio management, enabled us to deliver an approximately breakeven economic return for the quarter. During the quarter we recorded a GAAP loss of $0.05 per share, while generating core earnings plus drop income of $0.54 per share. We declared a $0.60 per share dividend for the quarter, enabling us to remain one of the highest yielding mortgage REITs in the sector, based on yesterday's closing prices.

We continue to implement our strategy of building a more diversified portfolio with a higher proportion of credit sensitive investments, and to that end credit investments represented approximately 38% of our total portfolio as of September 30, which is up from 28% at the beginning of the year. In addition, we were proactive in both our asset and liability management during the quarter, looking to take advantage of our 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 once again proved to be the case for the Agency sector in the third quarter, placing pressure on our book value. In addition, in a very atypical fashion, swap spreads tightened relative to US treasuries, forcing our liability hedges to be less effective and creating a drag on the mark-to-market value of our portfolio at quarter end. Although the tail hedges we had in place served to offset some of this drag. Credit spreads also widened during the quarter, but the impact to our portfolio was minimal, due to the positive interest carried that we generated, and the relative outperformance of our specific short duration holdings.

Finally, given our ability to be nimble, we were able to continually adjust our leverage and hedge positions throughout the quarter, in response to the significant swings in the US Treasury market. The combination of these factors help us to produce a respectable 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 that the long end of the curve will be range bound over the near term, and the short-term rates will remain near zero until the end of the year, and then gradually increase from there. This view is based on our belief that economic growth in the US will continue to be modest over the next several quarters, and that the Fed will proceed very slowly in raising the short term rates back to a more normalized level.

In terms of our overall investment strategy, we intend to accelerate our efforts to continue diversifying our portfolio into credit sensitive investments, while continuing to actively manage the portfolio in response to changes in market conditions. We have spent the last several quarters building our whole-loan origination platform, and we are now seeing a steady volume of investment opportunities coming through our pipeline, and in the fourth quarter we would expect to add significantly to our whole-loan positions in the portfolio. Anup Agarwal will go into more detail with the outlook going forward. At this time I'm now going to turn the calling over to George Yeboah, our Controller, to discuss our financial results. George.

Thanks Gavin. Good morning everyone. I will discuss our financial results for the third quarter ended September 30, 2015. Except where specifically indicated, all metrics are as of that date. On a GAAP basis we recorded a net loss of the quarter of approximately $1.9 million, or $0.05 per share. Our core earnings plus drop income was approximately $22.6 million, or $0.54 per share. This compares to core earnings plus drop income of approximately $31.7 million, or $0.76 per share, for the second quarter of 2015. Our core earnings for the quarter were approximately $20 million, or $0.48 per share, which is a non-GAAP financial measure, and our drop income was approximately $2.6 million, or $0.06 per share. Our average amortized cost of MBS and other securities held included Agency and non-Agency interest only strips, accounted for as derivatives was approximately $3.7 billion, down 15% from the second quarter, as we reduce our average portfolio leverage during the quarter.

Our net interest income for the third quarter was approximately $28.8 million. This number 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. On a non-GAAP basis our net interest income was approximately $25.1 million. This compared to non-GAAP net interest income of approximately $31.8 million for the second quarter of 2015. The decrease in our net interest income was primarily due to a smaller [portfolio] (corrected by company after the call) and higher hedge adjusted borrowing cost during the quarter.

Our weighted average net interest spread for the third quarter of 2015 which takes into account the interest that we received from our non-Agency RMBS, CMBS, IOs, whole-loans, and other securities, as well as the fully hedged cost of our financings was 2.45%, reflecting 4.03% gross yield on our portfolio, and a 1.58% effective cost of funds. This compares to a weighted average net interest spread of 2.79% for the second quarter of 2015, reflecting a 3.98% gross yield on our portfolio, and a 1.19% effective cost of funds. Our net yield decreased primarily due to higher effective interest costs as I mentioned earlier.

Our operating expenses for the third quarter were approximately $5.6 million, which includes approximately $2.9 million for general and administrative expenses, and approximately $2.8 million in management fees. Included in our G&A expenses were non-cash stock-based compensation of approximately $509,000. Our book value per share as of September 30, 2015 was $13.26, which takes into account the $0.60 per share regular cash dividend that we declared on September 24, 2015, and paid on October 27, 2015. As of September 30th, the estimated fair value of our portfolio was approximately $3.5 billion, and we had borrowed a total of approximately $3 billion under our existing master repurchase agreements.

Our leverage ratio was approximately 5.4 times at quarter end, and 6.5 times when adjusted for our net positions in TBAs. We continue to have repo capacity in excess of our current needs. At September 30th, we had master repurchase agreements with 27 counterparties, and outstanding borrowings with 19 counterparties. We continue to have excellent relationships with our bank counterparties, and feel comfortable with our existing group.

As of September 30, we had entered into approximately $4.6 billion in notional value of pay-fixed interest rate swaps, which exclude forward starting swaps of $1 billion, and approximately $2.4 billion of pay-variable interest rate swaps, excluding forward starting swaps of $500 million, giving us a net pay-fixed swap position of approximately $2.2 billion. Additionally, we have entered into a net $105 million notional of pay-fixed rate interest rate swaptions.

As a result of our hedge position, our Agency portfolio had a slightly positive duration of [0.2] (corrected by company after the call) months at quarter end. We are comfortable with our current leverage. We have and we will continue to adjust our implied leverage fairly quickly through our use of TBAs, which we believe enables us to optimize our drop income on a risk adjusted basis. With that said, I will now turn the call over to Anup Agarwal. Anup.

Thanks George. Good morning, and thank you for joining us today. Let me spend a few minutes discussing our portfolio management during the quarter, and our strategy going forward. When the third quarter began, we were operating with a view that a slow growth global economic environment would persist for a period of time. As the quarter progressed, we downgraded our outlook to an even lower growth scenario. Therefore given our ability to add value through active management, we made a number of adjustments to our portfolio and interest rate hedges, to reflect the changing market conditions. As mortgage spreads widened out during the quarter, we reduced our leverage by selling off some of our holdings of Agency RMBS, primarily 20-year fixed rate pools. We also added additional interest rate and equity tail hedges to the portfolio. These tactical moves enabled us to reduce the mark-to-market losses on our portfolio, and helped us mitigate the pressure on our book value during another very challenging period.

As a consequence of operating with lower average leverage, we generated lower core earnings than the prior quarter. In addition with mortgage spreads widening, we didn't find the TBA market to be particularly attractive in the quarter, and we had lower drop income.

In the credit sensitive portion of our portfolio, we increased our exposure to CMBS, particularly mezzanine and B notes, which we believe offer compelling risk adjusted returns relative to our investment universe. Finally, we significantly increased our holdings of whole-loans, as our pipeline is generating a higher volume of deal flow, and we continue to find this asset class particularly attractive relative to our Agency holdings.

Based on our current outlook, we expect to continue to replacing Agency RMBS in the portfolio with whole-loans through the remainder of the year, as we transition to a more credit-sensitive portfolio. We believe that our credit-sensitive investments will perform relatively well in a slow growth US economy, while also exhibiting less interest rate sensitivity than Agency securities. For instance, our residential whole-loan portfolio consists solely of hybrid ARMs, and our CMBS mezz securities are primarily floating rate 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 our required collateral levels are generally higher for credit assets versus agency RMBS. At the end of third quarter, we took leverage up a bit, but this was a temporary move based on our view of the US mortgage market at that point in time. As always, we manage our leverage opportunistically, based on changing conditions in the mortgage market. As a general statement, we believe that there presently is more room for mortgage spreads to widen, which will affect the amount of leverage we carry throughout the fourth quarter. To date in the fourth quarter mortgage spreads have essentially moved within a narrow range, and our portfolio has been relatively stable. We continue to use both interest rate and equity tail hedges to protect the portfolio against a broad "risk-off" market.

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.

We will now begin the question-and-answer session.

(Operator Instructions).

At this time we will pause momentarily to assemble our roster. The first question comes from Rick Shane of JPMorgan. Please go ahead.

Hey guys. First of all I just want to give Steve my best wishes. We're thinking of him, and miss him on the call today.

We will relay that. Thanks very much, Shane.

Thank you. Second, I think that this will probably persist for the near term. You made the comments in your slides and in your press release that interest rates fell to sort of the low end of your expectations. And what we saw consequently, strategically or tactically was consistent with that, which is you reduced the duration. Is your expectation, and you talked about adding some swaps towards the end of the quarter, is your expectation that you'll continue to drive that lower, or is this where you would continue to operate for the next six months, if your interest rate outlook doesn't change?

Yes, Rick, I think it's in part driven by our outlook for interest rates, and in part by our outlook for mortgage spreads. And as you saw from our statement that we think mortgage spreads still have some more room to widen, and we think that interest rates, in our view, will be range bound between the 2% to 2.5% range on the long end. And I think it will continue to be a pretty challenging environment for the Agency side. Having said that, the credit spreads actually look very attractive at this point in time, and you will kind of see us running lower leverage, kind of taking more opportunistic views on mortgage Agency side, and continue to grow our credit book during this quarter.

Got it. And I just want to follow up on a comment that you just made, which is at least a bias towards Agency spreads widening from here. What are the factors that drive that thought process? So just uncertainty around rates?

I think uncertainty about the rates, uncertainty about the US economic growth outlook, and it's as much as there is a higher probability that Fed will raise rates in December, at least all of the comments from Janet Yellen have been more towards a direction, that there is a higher likelihood that the Fed will hike in December. But it's after that, how many hikes and the timing of that. There continues to be the broader, as much as interest rate volatility has come down, but it was pretty elevated last quarter. And I think it's going to be elevated. We expect that interest rate volatility to pick up the remaining part of this year, as well as first quarter next year.

Got it. And if I can ask one last question that will somewhat we like an equity investor talking to a MBS investor. Are you surprised given the environment that we've been in, which is in many ways a flight-to-quality trade, that Agency spreads which again as an equity guy, I would think of as being a flight-to-quality trade, widened as quickly as they did. And I understand they were tight going in. But if they were tight going in, now they're pretty wide. Doesn't that seem odd in a flight-to-quality environment?

No, not really. I think you have heard this from me for the last about two or three quarters that I've been worried about. I mean a big part of our driver when we started to shift ourselves to hybrid, was with a view that not only do we see better opportunities in credits, but it was also with a view that the last six months or so, that Agency spreads just don't look that attractive, and we expect that they will widen out in this "risk-off" environment. Look, your point for flight to quality, yes the Agency spreads don't widen out as much relative to credit spread products. Think about if the credit spread products widen out by 50 basis points, you could have a much, much significantly smaller widening in Agency spreads. But you have to keep in mind that in that environment still you are looking at a leveraged position for Agencies, so you still get hurt more, and when we think about Agency spreads, I always think about not only just the holdings, we have a levered Agency book. Even if on a relative basis you might not have as much widening, but the impact on that is quite significant given the leverage for the Agency book.

Great, that's actually very helpful context. Thank you.

(Operator Instructions). As there are no further questions at this time, I would like to turn the call back over to management.

Thanks Operator. And thank you everybody for joining the call today. We look forward to seeing many of you in person in the months ahead. So once again, thanks for joining.

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