Western Asset Mortgage Capital Corp (WMC) 2016 Q1 法說會逐字稿

Good morning, good afternoon. Welcome to the Western Asset Mortgage Capital Corporation's first-quarter 2016 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 conference 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 March 31, 2016. 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 Relations section of the website. With us today from management are Gavin James, Chief Executive Officer; Lisa Meyer, Interim 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 to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecasted, 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 any of our forward-looking statements, unless required by law. With that, I will now turn the call over to Gavin James. Gavin?

Thank you, Larry, and thank you, everyone, for joining us today for our first-quarter conference call. I will begin the call by providing some opening comments. Lisa Meyer, our Interim Chief Financial Officer, 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 first quarter was a particularly challenging period for the US mortgage markets, as we saw general widening in agency mortgage spreads, credit spreads and swap spreads. As a result of the wider spreads on our investments, combined with higher hedging costs, we generated a negative economic return on book value for the quarter of 7%. And lower sequential quarter core earnings, plus drop income of $9.5 million or $0.23 per share.

The credit-sensitive sectors of the fixed income markets experienced a downturn in January, as concerns surrounding around global economic conditions and commodity exerted pressure on risk assets. However, whereas many asset classes, such as equities and corporate high-yield, rebounded as investor-sensitive improved in March, credit-sensitive mortgage markets lagged before the market rally. This lag negatively impacted our performance on a relative basis during the first quarter. In particular, CMBS, which comprises more than 15% of our portfolio, significantly lagged the recovery in other asset classes. However, this appears to have been more technical in nature, and not driven by any deterioration in the fundamentals of the US commercial real estate markets.

We saw several highly levered players without permanent capital who were large investors in CMBS, forced into liquidating their positions during the first quarter, as the value of their holdings declined. This led to a temporary price dislocation in the CMBS market as the sudden pressure played out. As longer-term institutional investments stepped in to capitalize on the relative value opportunity created by the fore-selling, CMBS has started to catch up with a rally in the other markets since the second quarter began.

Other asset classes that comprise a meaningful portion of portfolio, such as Non-Agency RMBS and CMBS, have staged a recovery in the second quarter as well. As a result, we've seen a positive impact of our book value of between 3% to 5% since the beginning in the second quarter. With the conditions that cause certain credit-sensitive assets to lag, the go-to-market rally now subsiding, we believe there is still substantial runway for further spread-tightening in our securities that will position us for a stronger performance going forward.

With respect to our macro view, we continue to believe that we are in a lower-for-longer interest rate environment, given modest growth in the US GDP and uncertain global economic conditions. We believe that economic growth in the US will be in the 1.5% to 2% range for the next several quarters, and the federal [earning rate] interest rates one or two times through 2016.

Given these expectations, combined with our continued positive outlook for both the US residential and commercial real estate markets, we continue to believe that the credit-sensitive investments represent the most attractive relative value opportunity in the mortgage sector. We also believe that over our longer-term investment horizon, a portfolio more heavily-weighted towards these assets will generate the best economic return for our shareholders.

Before turning the call over to Lisa to discuss our financial results, I would like to mention that last week our Board of Directors appointed Lisa to serve as our Chief Financial Officer effective as of June 6 of this year. Since assuming the Interim CFO position in November 2015, Lisa has demonstrated the knowledge, skills and capabilities to effectively lead our finance team. Lisa's extensive experience in the real estate and real estate finance industries will be particularly valuable as a permanent member of WMC. Congratulations, Lisa. And now I'll turn the call over to you.

Thank you, Gavin, for those kind words. I'm excited to be a part of the Western team, and also look forward to meeting our investors and our analysts in the coming months. I will discuss our financial results for the first quarter ending March 31, 2016. Except where specifically indicated, all metrics are as of that date.

On a GAAP basis, we recorded a net loss for the quarter of $36.3 million or $0.88 per share. Our core earnings plus drop income was $9.5 million or $0.23 per share. This compares to our core earnings plus drop income of $16.6 million or $0.39 per share for the fourth quarter of 2015. Our core earnings for the quarter were $8.8 million or $0.21 per share, which is a non-GAAP financial measure. And our drop income was $0.7 million or $0.02 per share.

Our low core earnings for the quarter of 2016 were primarily the result of a smaller investment portfolio, coupled with a slightly lower growth yield on our access, and higher hedge-adjusted borrowing costs when compared to the fourth quarter of 2015. Our average amortized costs on our investment, including agency and non-agency interest-only strips accounted for as derivatives, was $2.8 billion -- down 9% from the fourth quarter, as we reduced our average portfolio leverage during the first quarter.

Our net interest income for the quarter was $21.6 million. This is a GAAP financial measure and does not include the interest we received from our interest-only strips that are accounted for 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 $4.3 million. This compares to non-GAAP net interest income of $20.1 million for the fourth quarter of 2015.

Our weighted average net interest spread for the quarter of 2016 -- which takes into account the interest received from our investments, including our agency and non-agency interest-only strips, accounted-for derivatives, as well as our fully hedged cost of our financing -- was 1.53%. Reflecting a 4.26% gross yield on our portfolio and a 2.73% effective cost of funds. This compared to a weighted average net interest spread of 2.18 % for the fourth quarter of 2015, reflecting a 4.42% gross yield on our portfolio, and a 2.24% effective cost of funds.

Our net yield decreased between modestly lower gross yield on our portfolio and higher effective interest costs, as I mentioned earlier. Our operating expenses for the first quarter were $6.4 million, which includes $3.6 million for general administrative expenses and $2.8 million in management fees. Included in G&A expenses is $572,000 of non-cash stock-based compensation.

Our book value per share as of March 31, 2016, was $10.90, which takes into account the $0.45 regular dividend that we declared on March 24, 2016, and paid on April 26, 2016. As of March 31, the estimated fair value of our portfolio was $2.8 billion, and we had borrowed a total of $2.4 billion under our existing master repurchase agreement. Our leverage ratio was 5.3 times at quarter-end, and 6.2 times when adjusted for our net TBA position.

We continued to have refill capacity in excess of our needs. At March 31 we had master repurchase agreements with 27 counter-parties and outstanding borrowings with 20 counter-parties. We continue to have excellent relationships with our bank counter-parties and feel comfortable with our existing group.

As of March 31, we had $4.0 billion in notional pay-fixed interest rate swaps, excluding forward starting swaps of $1.7 billion, and $3.7 billion of pay-variable interest rate swaps, giving us a net pay fix swap position of $2.0 billion. Additionally, we entered into $105 million notional value of pay-fixed interest rate swap [options], with the swap term of one year.

We are comfortable with our current leverage, and will continue to adjust our implied leverage fairly quickly through the use of TBAs. Which we believe enables us to optimize our core earnings on a risk-adjusted basis. With that, I will now turn the call over to Anup Agarwal. Anup?

Thanks, Lisa. Let me spend a few minutes discussing our portfolio management during the quarter and our strategy going forward. As we entered 2016, we were operating with a view that a slow-growth US economy will persist, and an uncertain global economic environment will cause the Fed to be hesitant about implementing additional rate increases.

During the first half of the quarter, the market appetite for risk on assets decreased dramatically, as concerns surrounding global markets were heightened, and lower commodity prices added fuel to the fire. This led to a rally in attrition market, but put pressure on credit-sensitive sectors, as Gavin mentioned earlier.

Early in the quarter, we reduced our overall portfolio leverage by selling some of our holdings across most sectors, and reducing our net long TBA position. We also reduced our exposure to agency IO and inverse IO derivatives, and readjusted many of our hedge positions. The net result of these volatile market conditions led to a lower book value, and our defensive portfolio actions led to lower core earnings and drop income.

With respect to our agency holdings, we ended the quarter with a slightly smaller position than at the beginning of the quarter. In addition, we have rotated our holdings to include a higher portion of longer-duration, lower-coupon securities, given our current view for lower-for-longer interest rate and our belief that they offer an attractive hedge-adjusted carry, relative to other parts of the agency market.

In addition, we didn't find the TBA market to be particularly attractive during the quarter, and therefore, we had lower drop income. As we have mentioned in the past, when we expect a high level of rate and spread volatility, we generally will have more exposure to TBAs. We continued to see a high level of rate and spread volatility during the quarter, which led to our tactical decision to reduce our net long TBA position.

In credit-sensitive portion of the portfolio, we reduced our overall exposure to non-agency RMBS, GSE credit risk transfer securities, and to a lesser degree, non-agency CMBS and ABS. However, during the quarter, we also shifted our exposure in our CMBS holdings to include a higher portion of double-B and legacy Junior AAA securities, as we've found these securities to be very attractive relative to entire credit-sensitive fixed income universe.

Since that time, all of our credit-sensitive sectors of mortgage markets have improved, and we believe that going forward, credit spreads will continue to tighten. This is a pattern that we have seen occur consistently in the past, and given that underlying fundamentals of US real estate markets remain favorable, we believe it will be no different this time around.

With respect to our holdings in residential whole-loans, we kept our exposure to this asset class relatively stable during the first quarter. And while asset values have held up much better than in our credit-sensitive sectors of mortgage market, we chose not to increase our exposure to whole-loans, because of our defensive posture and tactical decision to reduce leverage during the quarter. However, that being said, we would expect that over time, we will continue placing agency RMBS in the portfolio with whole-loans, as we continue to find them an attractive asset class.

While we are not satisfied with our financial results for the quarter, we remain optimistic going forward. And as we have mentioned in the past, our performance in any given quarter may be challenging, but we are positioning the portfolio to perform well over a longer investment horizon. The underlying collateral on the vast majority of our investments is US residential and commercial real estate. Both of these markets continue to exhibit positive fundamentals, and we do not expect that to change any time soon.

With respect to leverage, I will remind you that as our portfolio becomes more rated to credit-sensitive investments, our absolute level of leverage will gradually decline, as the required collaterals are generally higher for credit assets versus agency RMBS. As always, we manage our leverage opportunistically, based on changing conditions in the mortgage market.

And as we have consistently said in the past, our goal is to maximize full 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. This 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 instructions)

Our first question today comes from Rick Shane from JPMorgan. Please go ahead with your question.

Hey, guys, thanks for taking my question. I'm curious if some of the transition in the portfolio that you have made quarter-to-date is translating into realized losses? And if that is going to lower the management fee going forward?

Look -- and I'll be perfectly honest, and perhaps a little blunt here. Book value has gone down pretty substantially over the last year. The management fee is essentially -- has actually crept higher. I am wondering at some point, if there is going to be a reconciliation between that? Because on a per-share basis, what investors are paying has gone up pretty substantially.

Rick, the way I think about it in terms of answer to your realized losses, I mean look, I think that at this point in time, all the portfolio we have held, the realized losses really come from that if we are forced to reduce or sell some of our credit-sensitive securities. But again, what you see is that we have held onto the highest-yielding credit-sensitive. And I am very confident that the spreads will continue to tighten for us.

And you have seen that, as Gavin mentioned in his prepared remarks, that book value is up in the range of 3% to 5%. Second is, keep in mind, management fee is based on the book value than anything else. The impact is commensurate with as you see the book value improve. I think you've just got to keep in mind, we as management are very much aligned to performance of our mortgage rate.

And I think for mortgage rate, I think of last year and this quarter as being tough. It's not just for us. I think that last year was probably one of the toughest years for agency market. We expected that agency spread will widen out. They did widen out quite a bit. I think this start of this quarter has been tough.

But at the same time, we are seeing opportunities which are just phenomenal on the credit side. We saw some of the CMBS during the quarter. You saw the CMBS double-Ds at 1,200 over some of the other credit-sensitive products at 10%, 11% unlevered yields. So that is something we think that they are very accretive for [moj reta] in the macro-environment we see outlined, which is low-rate environment for a long period of time. We think that we will be able to generate pretty attractive [dividend] yields for people.

I hear what you're saying. And we recognize that asset values have rebounded quarter-to-date, and some of this is temporal. But the long-term trend on book value has been pretty pronounced. It was down roughly 25% year over year. And you're right, a couple percent, even a 5% rebound this quarter will certainly help. But it does feel like there has been a fair amount of degradation of book value. And I understand that there are opportunities out there in the market right now, but I'm just wondering, ultimately, if there are ways to reconcile that for the investors?

Look, I think it has a tough environment on hedging for agencies. It has been a tough environment for agencies, and it's a tough environment for credit in this quarter. But overall, personally, I think that this is, by far, a great environment for all mortgage rates. I think our shift to whole-loan environment will help stabilize the book value. I think we continue to see pretty substantial opportunities on the whole-loans and credit segment.

So I think what you see is -- is the volatility over, and there's not going to be any volatility? You will see some volatility. But this low rate environment is phenomenal for any mortgage rate, including ourselves. And I think that, given our capabilities, I feel pretty confident that slowly it will recover yet, the fact 3% to 5%, is pretty attractive.

But I don't think that, that is it. I think that opportunities still -- even with the spread tightening, I think, there -- is still very substantial. I just think that the spreads widen out so quickly, so fast, in very short period of time, that it shows a pretty large impact. And the same is true for even agencies. Yes, it's kind of -- agencies took a lot of beating last year. But in this low-rate environment, this is a great environment for carry.

Is a going to be some volatility along the way? Yes, there are a whole bunch of global issues still out there. But slowly, all the central banks are reasonably -- have the same talks that it will be low-rate and very accommodative policy for a very long period of time. And I think that, on a long term -- look, we don't -- we are not in the business of predicting for any quarter to quarter. But over a long period of time, this should be a very accretive environment for REITs, including ourselves.

Got it. Okay, great. Thank you for taking the questions.

Thanks, Rick.

Our next question comes from Joel Houck from Wells Fargo. Please go ahead with your question.

Thanks for taking my question. Obviously the overall environment was -- or spread environment -- was the weakest in early to mid-February. I'm wondering if you can give us a sense for how much book value is down versus year-end at that period of time? So we can get a sense for how much tolerance or book value swings inter-quarter that you guys are comfortable with?

Look, it's a tougher question, Joel, but I will give you more in the framework for what we saw for credit. How about I try to answer your question by giving you some idea for what the credit spreads did at year-end to January, February, and how it has come back, and what has come back and what has not come back? Is that reasonable to start with?

Well, yes, any color you can provide is helpful. But any time -- I appreciate it's been a tough environment. But just about everybody has reported, and you guys are the biggest outlier, I think. I think investors are looking -- what we're trying to understand is -- the value proposition obviously stacks below book value. And there is inherent value in what you own. As you pointed out, the price appreciated. But if the quarter would have ended at the bottom and you would have had a 20%, 25% book value to client, I don't think that type of volatility, I don't think investors are signing up for.

So walk me through what you want. But if you have a number, or at least if it would say it was down 20 and say: look, we're changing the overall risk metrics that we are comfortable with, so that, that doesn't happen again. Because I don't think the investors we [tail] in institutional sign up for investing in mortgage REITs when book value can be down 11% in the quarter, to be honest with you.

Look, I think all those are fair points. I think there a couple of things when you think about the book value being down 10%. I think keep in mind that, if you look from the total return perspective, there was a dividend of 3%. So overall, the book value, really, if you include the dividend, was really down 7%.

The second part, I think, more important part here for what you highlighted, and I will point to you is, look, I think the quarter we'll be facing -- January, February is not a normal part, and I do not expect that to occur on a consistent basis. I think the quarter was more one of those framework where, as in March, a lot of the credit assets reverted back. But the credit-sensitive part for, whether it's in CMBS or in -- CMBS especially there, we had a larger part of our book. That just did not revert back as quickly.

So things like -- whether it's a legacy CMBS, Junior AAAs or the double-Bs -- which will be part huge value -- they just did not come back as quickly. But at the same time, in April, that's really what we've seen that's great timing. That ultimately, those are the lagging positions which have reverted back. Now, how much more to go? We still think there's a pretty significant room from that point on. And I think that, that's really what will cause us to continue to perform.

Yes, I think part of the tough part for February was just simply that our longer-term hedges did not really work as well. So at around February 29 or so, book value was down. We gave that framework in our last conference call. That book value was down about close to 6%. And we attribute that.

So the hard part for us, for what we face, is into March, as the other credit products started to work back, our products just lagged. And in January, February timeframe, our hedges for the portfolio for credit also did not revert back. But I fully expect there is always going to be, over period of time, there will be periods where your portfolio versus the hedges, the correlation kind of breaks down. Do I think that, that will be norm? No.

Okay. Maybe one more if I could. One of your peers this morning disclosed that their duration gap was, at the end of March, close to two, and it went higher into April. And the genesis of that was that, having a larger duration gap does offset some of the spread-widening in the credit book. Because presumably, rates go down and you gain money on the agency book. Can you talk to us about your overall positioning, what the duration gap was at the end of March, where it's at now? And how you think about the agency book perhaps hedging or offsetting more volatile environments on the credit book?

Look, I think one thing I was going to highlight is that since the beginning of the second quarter, as we highlighted, that our book value is up by 3% to 5%. The second part, intensive duration gap -- look, I think we had some duration added, and that helped over all. We had some hedges for book, both the credit and agencies, in terms of additional duration.

But broadly, the way we are looking at it right now, broadly the way I'm looking at right now, I just think that rates will be in range-bound kind of environment. In that range-bound environment, we kind of expect to be pretty [fast], you know. Generally, if you look at it in our past, whenever we believe in the range-bound environment, we generally tend to be pretty tight from duration gap. We don't run ton of duration gap, and that is really what you've seen in the past, and that's how you would expect to be. Now, if we have a duration, of course, that will mean kind of higher hedging cost, but we have adjusted our hedges.

So what you would expect from us would be -- going to be pretty damn close to zero, as to the duration gap. And I think it's more the running based on that, we think that very accommodative policy, so you would see the credit spreads to continue to grind tighter. And the agency -- and you would expect that it's a reasonable environment for agencies. It is not by expecting agency spreads tighten dramatically. I think it's just a reasonable environment, and in this reasonable, range-bound environment, we would expect to have a pretty zero duration gap.

Okay, thanks, Anup.

(Operator Instructions)

And our next question comes from Merrill Ross from Wunderlich. Please go ahead with your question.

Thank you, and good afternoon. I want you to address dividend policy, in light of the fact of the shortfall of the core earnings that are directionally correct with the dividend? And it just seems like you're paying out more than you're earning by a wide margin. So could you address that?

Yes, well, our dividend policy is determined by a lot of factors, including our taxable income. So when we determine what the dividend is for a particular period, we not only look at our core earnings, but we also take into account what our taxable income is for the period.

Anything you can share with us about that gap? The gap between GAAP earnings and tax? No, we expect core earnings also to increase, but a lot of the differences between our core earnings earned and taxable income factor into book-to-tax differences on how income is recognize, as well as realized gains on particular investments. Okay, thank you.

Ladies and gentlemen, at this time, we have reached the end of the allotted time for the question-and-answer session. I would like to turn the conference call back over to Mr. Gavin James for closing remarks.

Thank you, operator. As we previously announced, I will be retiring on June 1 of this year, and Jennifer Murphy will be assuming the position of CEO of WMC. Under Jennifer's leadership, I am truly confident in the team's ability to continue to create value in the future. I've enjoyed the opportunity to get to know many of our shareholders and analysts that follow the Company, over the past few years. I wish you all the best going forward. And once again, thank you for joining us today on the call. And have a good day.

Ladies and gentlemen, with that, we will conclude today's conference call. We thank you for attending. You may now disconnect your lines.