Western Asset Mortgage Capital Corp (WMC) 2017 Q2 法說會逐字稿

Good day, and welcome to the Western Asset Mortgage Capital Corporation's Second Quarter 2017 Earnings Conference Call. Today's call is being recorded and will be available for replay beginning at 5:00 p.m. Eastern Time. (Operator Instructions) Now first, I'd like to turn the call over to Mr. Larry Clark, Investor Relations for the company. Please go ahead, Mr. Clark.

Thank you, Brian. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the 3 months ended June 30, 2017. We issued our earnings press release yesterday afternoon, and it's available on the Company's website at www.westernassetmcc.com. In addition, we have included 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 Jennifer Murphy, Chief Executive Officer; Lisa Meyer, Chief Financial Officer; and Anup Agarwal, Chief Investment Officer.

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

With that, I will now turn the call over to Jennifer Murphy. Jennifer?

Thanks, Larry. Thanks, everyone, for joining us today. I'm going to start with some comments, then Lisa Meyer, our Chief Financial Officer, is going to talk about our financial results, and then Anup Agarwal, our Chief Investment Officer, is going to talk about our portfolio and markets. And after our prepared presentation we'll open it up for Q&A.

As we've said to you in previous calls, WMC's goal as a hybrid mortgage REIT is to provide our shareholders with an attractive dividend that's supported by sustainable core earnings plus drop income, as well as provide potential for higher total returns, while maintaining a relatively stable book value. I'm pleased to report that for the second quarter we delivered on all aspects of this goal, generating solid, and what we believe to be sustainable core earnings plus drop income, declaring an attractive dividend, which has been stable for the last five quarters, and posting an increase in our book value. All this translated into a strong economic return on book value of 4.8%, which brings our economic return for the first half of the year to 9.6%.

Simply put, we are reaping the benefits of our repositioned portfolio, our simplified hedge book and our focus on operational efficiencies, all of which is consistent with our commitment to best-in-class risk and portfolio management practices.

Our second quarter performance was driven by contributions across our holdings and reflects the benefits of the portfolio repositioning that we began in December 2016, the restructuring of our hedge portfolio in the second quarter, and our long-term strategy of investing in a diversified portfolio across a number of subsectors of the mortgage market. It also speaks to our ability to draw on the team at Western Asset, our manager, as well as the breadth of Western Asset's global investment, risk, and operational platform, which we view as a strategic advantage. We continue to search for attractive opportunities in credit-sensitive loans and securities that offer compelling risk-adjusted returns and want to increase our portfolios exposure to these assets over time.

As we've discussed each quarter, our dividend decisions in consultation with our board reflects our long-term view of the earnings power of the portfolio. And consistent with this approach, in June, we declared a quarterly dividend of $0.31, which is in line with the previous four quarters. As I mentioned at the outset, we believe greater stability in our dividend benefits our shareholders, which is why it's an important corporate goal for us.

Over the past year, we've put considerable focus into fine tuning our investment and operational processes and execution, to better enable us to bring the full benefits of Western Asset and its team to our fellow WMC shareholders, and as I think you can see from our results this quarter, these efforts are getting traction.

With that, I'll turn the call over to Lisa Meyer. Lisa?

Thank you, Jennifer. We are pleased with the results of the second quarter. The repositioning of our portfolio and restructuring of our hedge book resulted in strong performance, generating GAAP net income of $20.7 million or $0.49 per share; core earnings plus drop income of $13.3 million or $0.32 per share; a 1.8% increase in book value to $10.64 and an economic return on book value of 4.8%.

Our GAAP net income was driven by our net interest income for this quarter combined with net unrealized gains in our portfolio from appreciation across all our asset classes. Partially offsetting these gains were realized losses on the sale of certain investments and losses on our hedge positions due to a decrease in swap rates.

Core earnings plus drop income was up sequentially from the first quarter and slightly higher than our dividend of $0.31. The higher core earnings was the result of higher net interest margin and lower operating expenses, driven in part by the restructuring of our hedge positions, which occurred early in the quarter.

Our drop income for the quarter was $0.7 million, or $0.02 per share, down slightly from $0.03 per share in the first quarter. The lower drop income for the quarter and for the first half of the year reflected our view that the environment for holding Agency TBAs was not ideal during the period. As Anup had said in the past, our drop income will vary from quarter-to-quarter depending on our near-term view of Agency mortgage spreads. We increased our book value by 1.8% during the quarter to $10.64, up from $10.45 as March 31, 2017. A detailed book value schedule has been provided on Page 5 of our earnings presentation.

Our net interest income for the quarter, including the cost of our hedges, was $16.8 million, up from $13.7 million in the first quarter of 2017. Looking at net interest income by source, approximately 41% of it was derived from our Agency RMBS and CMBS holdings, 35% from our non-Agency RMBS and CMBS holdings, and the remaining 24% from our residential whole and bridge loans and other securities.

Our weighted average net interest margin increased to 2.25% from 2.01% in the first quarter as a result of a lower effective cost of funds from the restructuring of our hedge book in April. We have reduced our hedging costs by approximately 50% from the first quarter, while maintaining our desired hedge profile.

Our total expenses for the second quarter were $4.5 million, declining 8% from $4.9 million in the first quarter and down 12% from $5.1 million in the second quarter of 2016. The decline in our expenses in the second quarter was primarily due to significantly lower management fees as a result of our hedge book restructuring and lower general and administrative expenses. The year-over-year decline in our expenses was a combination of lower management fees, as well as lower general and administrative expenses, particularly professional fees. We continue to review our expenses to identify opportunity to operate more efficiently.

Our leverage ratio was 6.3x at quarter end and 5.8x when adjusted for the June 27 sale of approximately $209 million of Agency RMBS that settled shortly after quarter-end. We continued to have repo capacity in excess of our needs. We have master repurchase agreements with 27 counterparties and outstanding borrowings with only 17 counterparties. As a result of our hedge book restructuring in April, at quarter end, we held $2.3 billion in pay-fixed swaps, including forward starting swaps of $832 million. We provide a detailed table of these positions on Page 11 of our earnings presentation.

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 outlook going forward. As we have mentioned on several of our previous calls, we have expected interest rates to be range bound, given slow but steady growth and low inflation, both in the U.S. and abroad. The second quarter unfolded as we expected, legislation from the administration regarding fiscal and tax stimulus continues to take longer than anticipated. U.S. economic growth is continuing at a moderate pace, and despite ongoing geopolitical uncertainty around the world, central banks are signaling a path towards normalization. We continue to believe that most major global economies will experience improved growth, but that remains low by historical standards.

The Fed raised rates by 25 basis points in June, and we expect it will likely increase rates once more in 2017. In addition, it has essentially laid out its plans for reducing its balance sheet, particularly related to its holdings of Agency RMBS.

As both Jennifer and Lisa have already discussed, our portfolio has benefited from the macro scenario that we had envisioned and that has unfolded year-to-date. Spread sectors in the mortgage space have continued to perform well under an ongoing favorable environment for both residential and commercial real estate. Agency RMBS markets were relatively stable during the second quarter. Agency CMBS slightly outperformed the Agency RMBS sector during the quarter, as these bonds tend to offer a slightly better carry and are less influenced by what the Fed does with its RMBS holdings.

During the quarter, we've continued with some of the portfolio changes that we implemented in the first quarter. Specifically, we continued to rotate out of Agency RMBS into Agency CMBS. We are always evaluating our holdings within the sector and are willing to shift between Agency RMBS and Agency CMBS, depending on our view of relative value between the two. Longer term, we view our Agency portfolio as a source of funds for further investing in the credit side of the portfolio as opportunities arise. That being said, Agency securities remain a large part of our overall portfolio and are likely to continue to be in the near term.

As Lisa mentioned, we also held fewer TBA positions relative to past quarters, which led to lower drop income. Our ongoing use of TBAs will vary from quarter-to-quarter, depending on our near-term view of Agency mortgage spreads.

In the credit-sensitive portion of the portfolio, we remain invested across several sectors of the market, particularly in Non-Agency CMBS, Non-Agency RMBS, GSE Credit Risk Transfer securities and whole-loans.

During the quarter, we increased our exposure to residential bridge loans, which we find particularly attractive. These loans are short-term in nature and they offer compelling yields, while still conforming to our underwriting standards. So as we see opportunities going forward, our exposure to this asset class will likely increase.

In addition, we are looking at adding exposure to Residential Reperforming Loans, or RPLs, as we believe that this sector of the mortgage market is also attractive. We also remain constructive on the commercial real estate credit sector, favoring both lower rated CMBS, as well as commercial mezzanine loans, where we believe that spreads have room to tighten over the remainder of the year. With respect to lower rated commercial mezzanine loans, we prefer loans where we have been able to negotiate covenants.

We are pleased with the performance of our portfolio during the quarter and year-to-date, and we believe that it continues to position us well for solid core earnings and a relatively stable book value. As always, we will continue to monitor the relative value of opportunities across the broad mortgage universe in an effort to generate attractive risk-adjusted total economic returns for our shareholders.

With that, we will open up the call to questions.

(Operator Instructions) First question comes from Trevor Cranston with JMP Securities.

First question. I think last quarter when you guys talked about undertaking the portfolio repositioning, you had talked about concerns about the Feds' tapering impact on the Agency RMBS market and how that could impact spreads in that sector. I think things we've heard from lot of peers this quarter is that they find the Agency RMBS sector today relatively attractive because spreads haven't tightened to the extent that a lot of other structured products have over the last couple of quarters. So can you give us an update on your view of the Agency RMBS sector in light of all the comments the Fed has made, and what they've telegraphed about how they plan to handle the taper, and if spread widening is something you guys are still concerned about?

Yes. Trevor, thank you. Great question. Our view on Agency RMBS is that we still find Agency RMBS to be attractive. And I think you're exactly right, the Feds have not tightened as much as some of the other sectors. But, as you see from our positioning, my belief is that Agency CMBS on a relative basis, like the DUS bonds, looks more attractive relative to Agency RMBS. Having said that, the Fed has made pretty clear about how they want to go about unwinding their balance sheet. So I'm not as concerned about Agency RMBS at this point in time. But if you think about it on a relative basis, relative to the cost of convexity and cost of hedging for Agency RMBS, Agency CMBS, just at the current level still looks more attractive, which is why you see us positioned more favorable to Agency CMBS.

Got it. Okay. That's helpful. And then on the whole-loan side, obviously, there was some growth in the bridge loan portfolio again this quarter and the other whole-loans have been sort of consistently around the $200 million level. Can you give us an update on how the sourcing of those products is going? And if you're seeing any additional opportunities to bring in loan flow if it's sort of expected to be consistent in the near term?

Yes. I mean, look, I think on our whole-loan efforts, I mean, it's -- as you pointed out that our focus is not only on non-QM, but also bridge residential and bridge commercial. And I think you saw some growth in bridge residential. And I expect that we continue to find more opportunities on bridge residential as well as bridge commercial. So I think you will continue to see growth on both of those buckets.

Next question comes from Rick Shane with JPMorgan.

Look, I'd like to sort of delve in a little bit on the non-Agency CMBS. Obviously, a small portion of the balance sheet was a very significant contributor to the P&L. And I'm calculating it's about a 9-plus percent yield. Could you provide some sort of background or some sort of parameters about what that portfolio looks like, because I'm assuming these are the subordinated pieces.

Yes,that's exactly right. The Non-Agency CMBS portfolio is a mix of opportunities in commercial mezz loans or commercial mezz securities, as well as some of the BBB securities from older vintages, so more like the 2012, 2013, 2014 time frame, as well as some of the legacy securities from things like CMBS AJs, again from opportunities, which were originated in 2006, 2007. We continue to have the property types that are spread across -- look, our bias has been away from retail, but overall you could say, each one of these transactions is where we have underwritten all of the underlying property types. What we expect is the mezz part of the portfolio to continue to get refinanced, then you will see the mezz loans continue to shrink. And we are looking at new opportunities where we can continue to invest in mezz loans. But the AJ opportunity, which is kind of at a similar yield, is just an opportunity which continues to pay off, just because as the loans get refinanced from the legacy portfolio, those AJs continue to factor down, based on the payoffs. And the BBB opportunities from 2014, 2015 portfolio, I mean, I think that's a sector which had lagged. So overall, we kind of see the BBB market for 2013, 2014, BBB have -- continues to tighten from, they used to be at 500, 600 over, now they are more close to 400, versus newer issue BBBs at 325. So I expect the basis for -- as you have seen the basis shrink for the BBBs in legacy in 2013, 2014 or call it CMBS 2.0. Similarly, I expect the basis for CMBS 2.0 BBs will shrink -- has shrunk, but will continue to shrink. But right now, where the spreads are they still look pretty attractive, because those BBs right now are trading in high 700s to 800 yield. So that's the current mix of the portfolio. We still continue to think there is a lot more room for it to tighten relative to the current market.

Got it. And it looks like you're financing them with about -- those non-Agency CMBS securities with around a 30% haircut. Do you think that over the long term -- I mean, look, we're in a pretty good period from a credit perspective, but do you think over the long term that's the way we should think about leverage on that portfolio?

Yes. I think you kind of see the Non-Agency RMBS market continuing to be a very, very well bid market. If anything, I think given how well bid it is and how much demand it has and how much of that market has shifted all to stable long term investors. And that I think haircut for those will continue to -- I expect them to continue to be stable and financing costs continue to go down just simply because the whole market has become very comfortable with where they should be.

Got it. And last question, I realize that there are other folks who want to jump in here. But on that non-Agency book, you took a pretty significant OTTI mark. And it refers to the footnote to explain it, and the footnote says "other than temporary impairment on IOs and IIOs accounted for as derivatives." Help me understand that, I mean, I could try to ask a question here, but I just don't get it?

You don't get the IOs that are accounted for as derivatives or the OTTI? Sorry, if you could clarify.

No. I get the OTTI. I just don't understand, -- I'm not sure I understand why the derivatives book is associated with that portfolio and why it moved so dramatically in the context of -- or why you have such a big IO or IIO position against that particular portfolio?

I think, well, let's step back. So the IOs that are accounted for as derivatives, they are accounted for as derivatives because the underlying cash flows are so different from the actual security. So GAAP requires us to account for those as derivatives. We don't have a significant portion of IOs and reverse IOs in our portfolio. I think what the footnote is indicating is that included in that calculation are those securities, which normally flow through our loan as a line item on our financial statement, which is your gain and loss on derivative instruments. So we're just saying that any income or loss associated with it, is in that line item.

Okay. So what you're saying is that -- in that OTTI number of $5.9 million, the IO and IIO derivatives marks might be a rounding error. What is the $5.9 million mark this quarter then? And that's what I'm really trying to get at. I'm trying...

The $5.9 million relates to the entire non-Agency CMBS portfolio. So as Anup stated, sometimes if the cash flows are extended, so say a loan is refinanced and is extended, what happens is it causes an extension of that cash flow, which results in an OTTI calculation or an OTTI, that we have to take on it. Because these fall under what we call the 9920 securities. So there is no judgment in there. So if there is a decrease in the cash flows, then we are required by math just to take an OTTI. So that $5.9 million is the OTTI across all of the non-Agency CMBS, which includes the IOs, which is a small portion.

(Operator Instructions) At this time, there doesn't appear to be any more questions in the queue. I'd like to turn the conference back over to Ms. Murphy for any closing remarks. .

Okay. Thank you. Thank you all for joining us today. And please feel free to call us directly if you have any questions.

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