Western Asset Mortgage Capital Corp (WMC) 2017 Q3 法說會逐字稿

Good day, and welcome to the Western Asset Mortgage Capital Corporation Investor Call and Webcast for the Third Quarter 2017. (Operator Instructions) Please note, this event is being recorded.

Now I'd like to turn the conference call over to Mr. Larry Clark, Investor Relations for the company. Mr. Clark, the floor is yours, sir.

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, 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've 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 forecasts due to the impact of many factors beyond the control of the company.

All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk 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 our forward-looking statements, unless required by law.

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

Thank you, Larry, and welcome, everyone. We appreciate you joining us. I'm going to begin with some opening comments. Lisa Meyer, our Chief Financial Officer, will then discuss our financial results. And then, Anup Agarwal, our Chief Investment Officer, is going to provide an overview of our investment portfolio and outlook. After our remarks, we'll open it up for a brief Q&A.

I'm pleased to report we delivered another quarter of solid performance, generating an economic return on book value of 5.2%, and bringing our economic return for the first 9 months of the year of 2017 to 15%. As we've noted during previous calls, our primary goal is to provide our shareholders with an attractive dividend that is supported by sustainable core earnings plus drop income, as well as provide the potential for higher total returns, while maintaining a relatively stable book value. During the third quarter, we again achieved that goal, generating solid, and what we believe to be sustainable core earnings, declaring an attractive dividend, which has been stable for the last six quarters, and posting an increase in our book value.

Our third quarter performance reflects the benefits of the portfolio repositioning that we began in December 2016, the restructuring of our hedge portfolio in the second quarter of 2017, and our long-term strategy of investing in a diversified portfolio across a number of subsectors of the mortgage market.

As many of you know, WMC's manager is Western Asset Management Company, which manages over $435 billion in assets. Western Asset's scale makes it an important trading partner for many of the world's largest broker-dealers and banks, which gives our investment team access to real estate-related opportunities, originations and financing. In our view, our manager Western Asset's scale and scope is our competitive advantage.

Our WMC team is deeply connected to Western Asset, and Western Asset is deeply committed to WMC's success.

As a result, WMC can draw on the breadth and the depth of Western Asset's relationships, team and global platform. Our corporate goals focus on providing WMC the benefits of best-in-class investment and risk management capabilities, the operational excellence and efficiencies of a scaled firm, and access to the investment, financing and other strengths of a large global fixed income manager.

I'm also pleased to report that in early October, we completed a $115 million offering of 6 3/4% convertible senior notes due in 2022. We believe that this financing is an attractive source of longer-term capital, which should enable us to increase the earnings power of our portfolio in the coming quarters. In addition, we expanded our institutional investor base with the addition of several new investors to our company, and we welcome them as long-term partners.

As we have discussed each quarter, our dividend decisions, in consultation with our board, reflect our long-term view of the earnings power of our portfolio. This approach has allowed us to pay a consistent dividend for 6 quarters and stability in our dividend continues to be an important corporate goal for us.

In conclusion, we've built a diversified portfolio of residential and commercial assets and we have put considerable effort into fine-tuning our investment and operational processes and execution to better enable us to deliver strong and consistent results to our shareholders. As you can see from our results this quarter and year-to-date, we believe these efforts are paying off.

So with that, I'm going to turn the call over to Lisa Meyer to discuss our third quarter results. Lisa?

Thank you, Jennifer. We are pleased with our continued strong performance for the third quarter. We generated net income of $22.8 million or $0.54 per share. Book value increased 2.3% to $10.88 per share. This is the third consecutive quarter of book value appreciation, generating a strong economic return of 15% for the first 9 months of 2017 and 5.2% for the quarter. A detailed book value schedule has been provided on Page 18 of our investor presentation.

Core earnings plus drop income for the quarter was $13.5 million or $0.32 per share. We generated solid and what we believe is sustainable core earnings that has enabled us to declare an attractive dividend of $0.31. Our dividend has been stable now for six consecutive quarters. We did not record any drop income for the third quarter. The lack of drop income for the quarter reflected our view that the environment for holding Agency TBAs was not ideal during the period. As Anup has said in the past, our drop income will vary from quarter-to-quarter, depending upon our near-term view of Agency mortgage spreads.

Our net interest income for the quarter, including the cost of our hedges, was $17.5 million, up from $16.8 million in the second quarter of 2017. Looking at net interest income by source, approximately 46% of it was derived from our Agency CMBS and RMBS holdings; 31% from our Non-Agency CMBS and RMBS holdings; and the remaining 23% from our Residential Whole and Bridge Loans and other securities.

Our investment portfolio's net interest margin declined slightly to 2.21% from 2.25% in the second quarter. The decline in our net interest margin was a result of a lower average yield on our investment, partially offset by a lower average cost of funds, mainly due to the restructuring of our hedge book in the second quarter.

Our total expenses for the third quarter were $4.2 million, declining 5% from $4.5 million in the second quarter and down 12% from $4.8 million in the third quarter of 2016. The decline in our expenses in the third quarter was primarily due to 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. The reduction in the management fee was a result of the restructuring of our interest rate swaps in the second quarter, which significantly reduced the equity base used to calculate the fee.

Our leverage ratio was 7.3x at quarter end, which increased from 6.3x at the end of the second quarter. We increased our leverage toward the end of the third quarter in anticipation of the convertible notes offering, which closed in early October. We view this financing as equity-like capital, which is more efficient than issuing straight equity. It is important to mention that we view leverage on the portfolio as a whole and not necessarily by asset class. We may put higher leverage on our Agency securities because they are the easiest and cheapest to finance, while keeping lower leverage on our credit-sensitive investments, which are more costly to finance. Over time, we expect our leverage ratio to decline as we transition our portfolio to a higher proportion of credit-sensitive investments.

We continue to have Repo capacity in excess of our current needs, as a result of WMC's ability to tap into the resources of Western Asset. We continue to have master repurchase agreements with 27 counterparties and outstanding borrowings with only 17.

With that, I will now turn the call over to Anup Agarwal. Anup?

Thanks, Lisa. Our overall performance in the third quarter was driven by contributions across our holdings and reflects the benefit of our strategy of investing in diversified portfolio in a number of subsectors of mortgage market.

Our Agency CMBS and RMBS holdings performed as expected during the quarter, as spreads were slightly tighter in both sectors. The credit sectors in mortgage market have also continued to perform well under an ongoing favorable environment for both residential and commercial real estate.

In the credit-sensitive portion of our portfolio, we remain invested across several sectors of the market, primarily in Residential Whole- and Bridge Loans, Non-Agency CMBS, GSE Credit Risk Transfer securities and Non-Agency RMBS.

I would like to spend a few minutes discussing where we see the best relative value opportunities now and how we expect to allocate our capital over the next six to nine months.

We believe that the most favorable risk-adjusted return opportunities in our investable universe are in four primary sectors: Residential Whole-Loans, particularly Bridge Loans; Re-performing mortgage loans that are packaged in well-structured securitizations; commercial mezzanine loans, including junior tranches of Non-Agency CMBS; and Agency CMBS.

Let me elaborate on a couple of these sectors where we intend to continue deploying the bulk of our capital.

As you know, over last nine months, we have re-allocated a significant amount of our holdings into Agency CMBS, which as of quarter end, made up 54% of our portfolio. We find this sector attractive for a number of reasons. First, the pools are issued by Fannie Mae and Freddie Mac to finance multifamily residential properties. The underlying loans have built-in prepayment protection and therefore are less sensitive to interest rate risk than single-family mortgages, which make up the collateral in Agency RMBS. Agency CMBS also offers a more attractive spread than RMBS, due to higher yields and lower effective cost of funding resulting from lower relative hedging costs.

We believe that we have competitive advantage in this sector due to the size and scale of Western Asset. Not only are we able to ramp up our holdings fairly quickly, but we have the capability to directly source these securities from originators, while others may have to buy this paper from investment banks, which can be more expensive and could take longer to build a position.

Another area of focus for us continues to be Residential Bridge Loans. These loans are short-term in nature, generally, one to three years, and are used for renovating homes to be sold or held for rent. We have been building a network of originators and working with them to develop underwriting guidelines that we believe will result in a pipeline of loans that will provide us with attractive risk-adjusted returns.

We believe these relationships are mutually beneficial to both parties. We establish long-term partnerships with quality originators and they benefit from their relationship with a premier global fixed income manager. The institutional processes that we introduce to their origination capabilities results in an increased likelihood of execution.

In addition, we believe we can achieve higher total returns on our Residential Bridge Loans through the use of Repo financing. As Lisa noted earlier, we have relationships with numerous Repo counterparties, which is another benefit of having Western Asset as our manager.

As our relationships with originators of Residential Bridge Loans expand and we see opportunities going forward, our exposure to this asset class will steadily increase. In addition, we are looking at adding exposure to Residential Re-performing Loans, primarily through junior tranches, as well as junior tranches of well-structured securitizations, as we believe this sector of the mortgage market is also attractive.

We are very pleased with the performance of our portfolio during the quarter and year-to-date, and we believe that it continues to position us both 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 returns for our shareholders.

With that, we will open the call to questions.

(Operator Instructions) The first question we have will come from Trevor Cranston of JMP.

First question on the reperforming loan opportunity that you guys are looking at. From the prepared comments, it sounded like you guys were mostly looking at buying tranches on a -- from securitizations that's done by potentially somebody else, I guess. But can you talk about that opportunity in the sense of, is it possible that you guys will go out there and buy whole-loan packages yourself and do a securitization? And is there any opportunity to pick up additional returns by maybe focusing on the part of the market that has the less, like a shorter clean pay history? Or are you guys more focused on loans that have a 12-month-plus clean pay history and is -- are good for securitization currently?

Yes, Trevor. That's a great question. Let me divide your question in two different parts. The first one- we generally look for seeing the pool before it's securitized, and then buying the junior tranches. As you know, there is no availability of junior tranches from somebody else's securitization. Generally, whenever people are doing securitization for Re-performing loans, they tend to keep all the junior securities. So our approach is that we see the pools, especially when we look for WMC. We look to see the pool before it is securitized, and then ultimately, utilize the benefit of securitization. Our point, that is the way we have explained it in our presentation, is more driven by it may not be under our shelf but we could utilize somebody else's shelf. But ultimately, we see those securitization or those loan pools before it is securitized, when we are investing in junior classes. Because for us, quality control and the kind of collateral we want to have is very much paramount. The second question, in terms of less cleaner pay. Could we look at those? Yes, but the hard part, our bent tends to be always more cleaner pay history, and that's very much driven by two things. One, our views are that the variability in ultimate expectation of losses, or default, is much better for cleaner pay history versus those with a little bit dirtier pay history. And second is, overall, the pricing of the loans for dirtier pay versus cleaner pay has compressed quite a bit. On a relative basis, you just don't see as much of a tick-up in yield, even while evaluating the dispersion in the broader loss expectation, to warrant us to evaluate kind of a little dirtier paper. Did I answer your question?

Yes, that was very helpful. Second question, I was curious on the bridge loan strategy. If you could maybe talk a little bit about sort of what the average loan size you guys are doing is in? What the ultimate value of the property is when the loan is paid off? And I'm partially curious, because I was wondering if you guys think that any change to the mortgage interest deduction could have any impact on the performance of that portfolio?

Yes, a lot of these changes, including mortgage, the interest rate deductions, I think will have impact on broader mortgage market. But our interest in Bridge Loans is very much driven by a very fundamental shift in mortgage market. And the fundamental shift in mortgage market is, if you wanted to buy a house, availability of leverage to do construction from traditional bank loans just doesn't exist. Our average, having said that, our focus for Bridge Loans really is in the higher-quality borrowers. Usually, you might think about most Bridge Loan lenders, our focus is really Tier A, Tier B kind of borrowers, so this is very seasoned borrowers. Our average loan size is about $270,000. And again, that is focus is slightly on the better end of the spectrum in terms of loan size, much better in terms of the borrower capabilities, and again, also in lower loan-to-values in terms of what people are willing to finance. Generally, there is a very large dispersion of what people are willing to finance. Our focus tends to be more on 50% or lesser, and that is also significantly lower on the back end in terms of what the value of the property after repairs would be. So our bent tends to be on just the higher-quality borrower. And we are more comfortable taking a bit lesser yield, but just focusing on higher-quality borrowers.

Got it. Last question. Can you guys share how you're thinking about internally, the outlook for interest rates, and particularly, the number of short-term Fed funds rate increases you guys are expecting over the next -- or through the end of next year, I guess? And also, how that impacts how you guys are constructing the hedge portfolio going into the end of the year?

Sure. I mean, I think our views have been very much consistent. Our views are that we'll be in this slow growth environment for a while, and with Fed Chairman designate Jerome Powell, we still continue to be very constructive, but we'll be in a slow growth environment. Our views are that there'll be a Fed raise in December and then two next year. But we'll be in this very slow growth kind of environment. That's very much driven by how we are positioned in the portfolio. We look at our overall key rate duration. We are pretty close to flat, our focus overall is towards the Fannie DUS paper versus Agency RMBS. It still is with a view that it's going to be an environment that is constructive for that DUS paper, which still has a wider spread relative to Agency RMBS. That's really why we continue to grow Whole-Loans and some of the credit risk paper, because it will be constructive broadly, for risk capture, especially related to housing.

Next, we have Rick Shane of JPMorgan.

So when we look at the financials, I think two things stand out. One is that you've been able to establish stability around the dividend. And second, that you've become -- established some stability in the last 2 quarters around book value. I'd like to talk about the book value trend a little bit. On one hand, we can sit here and say, "Hey, this is a great trend." On the other, it has been during a period of relatively low volatility. So it's hard to sort out what's the cause here, is it a strategic and tactical shift? Or is it just the market has given you that opportunity? And what I'd love to discuss is, what are the strategies? What has been put in place so that as we eventually enter another period of volatility, that we can expect that book value to remain stable?

I guess, I'll just start with a couple of comments, Rick. Thank you for your question. You're right. That book value stability is a corporate goal for us. It's a focus for us. And I would say -- I think, Anup can talk about some of the things he's doing in the portfolio that are meaningful to your question, and then, I think, give us confidence that we have really made a change there in the way we're approaching the portfolio. But the main thing I would mention to you is we have much more active engagement between our investment and risk teams to help manage, not only the returns of the portfolio, but the risk profile of the portfolio, so that we're balancing those things well. And the power of the expense reductions we've made, and the restructuring of the hedge portfolio, is that it's given Anup and his team, Sean Johnson, and others, senior people on our team, the ability to think about the portfolio in ways that really balance risk and return better, going forward. Anup, do you want to add to that?

Yes, yes, absolutely. Thanks, Jennifer. Rick, thanks for the question. There are a couple of things I will highlight towards why the market sentiment has been very constructive. But I think what you've also seen in our portfolio, which is different than large other market participants, is you've seen a pretty sizable growth in Agency CMBS. And that was very much by design. Our views are that even with rate volatility around, we just believe that Agency CMBS will be significantly less volatile because of the prepayment penalty feature in it. Second is the growth of Whole-Loans tend to be significantly less volatile. As well as, when you look at even our Whole-Loan non-QM book, again, they tend to be very low, less volatile, even in very straight volatile environment. And we are keeping the key rate duration pretty flat, but at the same time, we've been growing other segments of the market. And I think that will be our continued approach, that we will actively look for, opportunities where we are able to find segments which will have significantly less volatility. So whether you think of an environment where the curve flattens more. And in that environment, you could have prepay protection for Agency RMBS. But in that same world, you have less volatility for Agency CMBS, just simply because you have a prepay penalty associated with it. Second is, if you talk to different market participants and you can take it the other way, you can say, "Hey, what happens if the rates, the economy is doing a lot better and the rates, the curve is steeper?" Even in that environment, again, you can see the Agency RMBS market widen a little bit, but if the rates are higher, Agency CMBS actually will tighten, just simply because you have the prepayment penalty, these borrowers are investing in properties to rent out. So this is multifamily. Similarly, on our Bridge Loan opportunity or our non-QM, or some of the other whole-loan endeavors we continue to add to our book. Again, those tend to be very stable from book value stability. And at the same time, our commitment to have a stable dividend yield. So those are the things which I will highlight. Look, I can talk forever about all the things that we are doing. But in summary, those are the things we are doing.

No, look, that's a great answer. And ultimately, I think establishing that stability in a more volatile environment will -- you've been demonstrating that stability in a more volatile environment, will lead to -- will help investors evaluate multiple and stuff like that. I mean, I think that, look, you continue to trade at a discount to book. I think that's a reflection, at this point, of that history, and proving yourself over time, that's ultimately, the opportunity. In my mind, the low volatility environment that we've been through in the last year has provided -- has lowered the cost of repositioning that portfolio, lowered the cost reducing that volatility. And it sounds like you guys have embraced those changes.

Rick, absolutely. I would just add, too, I think our goal is to give our investors, both the equity shareholders and also the convertible note holders, an excellent investment experience with us over time, so all things considered. So we're focused on all aspects of that, book value, dividend, how we manage the portfolio, et cetera. So that's our goal, to give investors a really strong experience.

(Operator Instructions) At this time, it appears that we have no further questions. We will then conclude our question-and-answer session.

I would now like to turn the conference call back over to Ms. Jennifer Murphy, Chief Executive Officer, for any closing remarks. Ma'am?

Thank you, Mike. And thanks -- thank you, everyone, for joining us today. Have a terrific day.

And we thank you, ma'am, and to the rest of the management team also, for your time today. The conference call has now concluded. At this time, you may disconnect your lines. Thank you, again, everyone. Take care, and have a great day.