Western Asset Mortgage Capital Corp (WMC) 2018 Q1 法說會逐字稿

Good morning, and welcome to the Western Asset Mortgage Capital Corporation's First Quarter 2018 Conference Call. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Tony Rossi, Investor Relations. Please go ahead.

Thank you, Danielle. 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, 2018. The Company issued its earnings press release yesterday afternoon, and it is available on the Company's website at www.westernassetmcc.com.

In addition, the Company has 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 report 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?

Thanks, Tony. As we've said many times, our primary goal is to generate consistent and sustainable core earnings that support an attractive dividend, while improving the stability of our company's book value.

So, I'm pleased to report that we delivered another quarter of solid performance, generating GAAP net income of [$0.52] per share (corrected by company after the call) and core earnings plus drop income of $0.34 per share, an increase of core earnings per share of 9.7% over the fourth quarter of 2017. We also delivered an increase in book value of 2%, the fifth consecutive quarterly increase. The book value increase, together with our $0.31 per share dividend, provided our shareholders with an economic return on book value of 4.8% for the quarter, once again at the high end of our peer group.

Our dividend has remained stable for eight consecutive quarters, and our core earnings plus drop income has exceeded the dividend by approximately 9%, in the aggregate, over that same time period.

Our first quarter performance was driven by contributions across our holdings and reflects the benefits of the significant asset repositioning we began in December 2016, the restructuring of our hedge portfolio last year, and our long-term strategy of investing in a diversified portfolio across a number of subsectors of the mortgage market.

We produced these strong results despite the backdrop of a fixed income market characterized by rising interest rates and increased volatility during the quarter. A major reason we've been repositioning the portfolio over the last several quarters was to be prepared for the challenging market environment that we experienced in the first quarter. Our portfolio outperformed our hybrid peer group this quarter primarily because of our strategic and significant moves into Agency CMBS and credit-sensitive investments, a reduction in holdings of Agency RMBS, and because we reconfigured our hedge positions to better match those assets.

Anup Agarwal, Sean Johnson and the rest of the investment team were quite active during the quarter, acquiring nearly $500 million in target assets, which included over $400 million of credit-sensitive investments. These assets were sourced from a broad spectrum of the mortgage market and included a number of investments where we worked with our strategic partners in the capital markets, getting involved early in the transaction and collaborating on the deal structure, covenants and pricing. Essentially, WMC is able to leverage the Western Asset platform to gain access to proprietary opportunities that we simply would not have as a standalone mortgage REIT.

It's Western Asset's scale that makes it an important trading partner for many of the world's largest broker-dealers and banks, providing our investment team access to real estate-related opportunities, originations and financing. And it's the breadth and depth of Western's global investment, risk and operational platform, that enables us to evaluate, respond quickly and ultimately invest in these opportunities. In our view, having a manager of Western Asset's size and deep investment capabilities is our primary competitive advantage.

In the first quarter, we repurchased approximately 115,000 shares of our stock at about a 14% discount to book value. As you may recall, we also repurchased shares in the fourth quarter for the first time for the Company, also at a discount. Both of these purchases were accretive to our book value and represented a compelling investment opportunity in our view. We still have nearly 1.8 million shares left on our existing share repurchase authorization, and we will continue to evaluate opportunities to repurchase shares in the future, particularly at times when our stock trades at a meaningful discount to book value.

So in conclusion, we're very pleased with our ongoing strong financial results. We've assembled a diversified portfolio of residential and commercial assets and have put considerable effort into fine-tuning our investment and operational processes and execution, to better enable us to deliver strong and consistent returns to shareholders. Our solid performance is a testament to the efforts of our entire investment team, headed by Anup Agarwal, and demonstrates the effectiveness of the strategic initiatives that we've been implementing over the last several quarters. As you can see from our results this quarter, as well as over the course of 2017, we think these efforts are paying off.

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

Thank you, Jennifer. We delivered another strong performance in the first quarter of 2018. This is the fourth consecutive quarter of solid earnings. Our book value per share for the first quarter of 2018 increased 2% to $11.37, resulting in an economic return on book value of 4.8%. We also maintained a consistent $0.31 per share quarterly dividend.

We generated net income of $21.7 million, or $0.52 per share and core earnings plus drop income of $14.1 million or $0.34 per share.

The key contributors to our performance were a result of the following:

A larger investment portfolio. We continue to shift our portfolio toward credit-sensitive investments. During the quarter, we acquired $404 million in credit-sensitive investments and $80 million in Agency CMBS, while disposing of $11.8 million of Agency and Non-Agency securities.

The restructured hedge portfolio generated lower swap-related interest expense, resulting in a decrease of $742,000, or 41% compared with the fourth quarter of 2017. In addition, the net gains on our interest rate swaps were in excess of the unrealized losses on our investments, resulting in a net gain of $10.6 million.

These benefits were partially offset by an increase in our operating and general and administrative expenses of approximately $450,000 or 9%, which I will discuss shortly.

Included in the $404 million of credit-sensitive investments we acquired during the first quarter, was a $68 million subordinate tranche from a $1.4 billion CMBS securitization. Since the subordinate tranche had certain control rights and because the Company, together with other accounts managed by Western Asset, holds more than 50% of the tranches with the control rights, for GAAP purposes we were required to consolidate the CMBS securitization. The consolidation resulted in a gross up of our financial statements, recording a securitized commercial loan of $1.4 billion and the corresponding non-recourse securitized debt of $1.3 billion. The consolidation of the $1.3 billion of non-recourse securitized debt increased our leverage ratio to 10.5x, although our leverage ratio was only 7.7x at quarter-end when excluding the non-recourse securitized debt. Over time, we expect our adjusted leverage ratio to decline as we continue to add more credit-sensitive investments to our portfolio.

Looking at our net interest income for the quarter of $18.3 million by source, approximately 46% of it was derived from our Agency CMBS and RMBS holdings, and 54% from our credit-sensitive investments.

The portfolio had a net interest margin of 1.9% during the quarter. The underlying average yield on our assets was 4.16% and we had an effective cost of funds of 2.5%. The net interest margin increased by 11 basis points from the previous quarter as a result of an increase in the average yield on our investments, driven primarily by asset mix and partially offset by an increase in our effective cost of funds.

Our total expenses increased to $5.3 million for the quarter of 2018 compared with $4.9 million for the first quarter of 2017. The year-over-year increase of approximately $450,000 was mainly the result of the following three factors:

One, an increase in professional fees of approximately $400,000, related to the fees associated with the completion of our first internal control audit.

Two, an increase in operating expenses of approximately $560,000, mainly related to loan servicing fees. As we increase our residential and commercial loan investments, the cost associated with servicing these loans will increase.

And three, the increases were partially offset by lower management fees. The decline in our management fees was due in part to the restructuring that occurred in April of 2017 on our hedge portfolio.

As of March 31, 2018, we had master repurchase agreements with 28 counterparties and outstanding borrowings with 17 of those counterparties. Our financing options continue to be plentiful as a result of WMC's ability to draw upon the resources and relationships of Western Asset.

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

Thanks, Lisa. The significant changes we made to our portfolio holdings during 2017 and continuing into this year, which was rotating out of Agency RMBS and into Agency CMBS and credit-sensitive mortgages, were the primary drivers of our solid performance for the first quarter. We are realizing the benefits of our strategy of investing in a diversified portfolio.

As we have discussed on previous calls, we have believed for some time that we're about to enter a period in which volatility will increase and rates will rise, and that most Agency RMBS do not adequately compensate for that risk. Therefore, we have been proactively positioning the portfolio in order to improve its interest rate risk profile by both lowering the duration and decreasing the convexity risk.

We continue to believe that Agency CMBS offer a more attractive risk-adjusted return. Agency CMBS have better prepayment protection and convexity, are less expensive to hedge and we believe are less exposed to spread widening that may occur when the Fed significantly reduces its holdings of Agency RMBS.

Our major shift into Agency CMBS and other credit-sensitive investments is an example of the benefit that WMC derives from being affiliated with Western Asset.

Western's size and deep investment capabilities enable WMC to source investment opportunities and implement significant changes in the portfolio, both quickly and effectively, which we believe is a competitive advantage.

To give you an example of our ability to leverage Western's investment platform, I would like to highlight a transaction that we invested in during the quarter.

As Lisa mentioned, we invested in a subordinate interest in a $1.4 billion securitized commercial loan. The underlying collateral for this securitized loan consists of a multi-asset single borrower loan to a publicly traded equity REIT and is part of the planned spinoff of an approximate $3 billion portfolio consisting of 50 properties containing over 16 million square feet. The loan is basically an intermediate term bridge loan to facilitate the disposition of the portfolio over the next couple of years.

The underlying loan has a relatively low loan-to-value and WMC owns a $68 million subordinate tranche in the securitized loan, which yields LIBOR plus 950. Because of Western's long established capital markets relationships, the team was able to partner with three originating investment banks in the early stages of the transaction, collaborating on the deal structure, covenants and pricing. We are excited about this and other similar opportunities that we are seeing as a result of our affiliation with Western Asset.

We continue to pursue the overall goal of increasing our holdings of credit-sensitive investments and further diversifying our portfolio. Within this sector, we are finding a number of attractive opportunities in Residential Whole-Loans, commercial real estate loans and prime jumbo loans that are part of securitizations.

We are particularly focused on residential bridge loans and non-QM residential loans. We find the bridge loans attractive because they are short-term in nature and they offer compelling yields, while still conforming to our underwriting standards.

The non-QM loans also offer a moderately higher yield than conforming mortgages, and in our opinion, have a very similar risk profile. Our view of residential real estate remains favorable as the housing market continues to exhibit ongoing strength and resilience.

Within the commercial real estate sector, we have continued to focus on adding select commercial mezzanine loans and junior tranches of Non-Agency CMBS. As I highlighted, we continue to find co-investment opportunities with Western Asset in commercial real estate loans, where Western has the ability to influence the transaction, the structure and covenants. We remain focused on short-term loans that are secured by properties with solid credit fundamentals and strong covenants that protect the lenders.

In conclusion, we are very pleased with the performance of our portfolio during the quarter, and we continue to focus on our goal of delivering solid core earnings and preserving book value.

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

(Operator Instructions) The first question comes from Rick Shane of JPMorgan.

From a tactical perspective, you guys have really executed over the last several quarters. But there is a strategic issue here, which is that you are part of a huge platform, but this is a relatively small vehicle and, frankly, at this point probably lacks a little bit of scale. We are starting to see consolidation in the industry, and it strikes me that you guys can go one of two directions. I'm curious how you look at the opportunity, whether it makes sense to continue to operate at this size and whether it makes sense to try to scale up or to actually add this platform to something that already has scale.

Rick, it's Jennifer. Thanks for your question. We're not surprised to see consolidation, because like you, we definitely see the benefits of scale. Our association with Western Asset as our manager really gives us many of the benefits of scale. We have a broad investment team in structured products in particular. And then we have a broader investment team in global fixed income, all of which we can draw on. We have a very deep risk group, a deep operational team, et cetera. So many of the benefits that other companies, other REITs are looking for from scale, we get those through Western Asset. Where we see benefits for WMC in particular is in the direct expenses related to the REIT. An increased capital base for WMC would help amortize those expenses over a broader capital base. Also, this is an incredibly important business to Western Asset. WMC in particular, regardless of its size, is a major focus for the Company. I think you know our CEO, Jim Hirschmann, is the Chairman of the Board of this company. I'm the Chief Operating Officer of Western Asset. Anup leads a very significant structured products team at Western. All of that indicates, I think, to you the importance that we place on WMC as a business. So even though I guess its size may not look very large to you in relation to Western Asset as a whole, its profile within our company is very high. I think we're interested in continuing to grow this business and continuing to increase the capital base of WMC in a way that benefits its shareholders and its existing convertible noteholders. So that's what we're working towards. Does that answer your question?

It does. And look, I think it's a very fair observation. I think the commitment from a high-level management perspective is very real. I also think that you're right that you benefit in terms of scale from the resources and intellectual horsepower of Western. But the place where there is a gap, frankly, is in terms of financial efficiency. And that's ultimately going to be, especially with the stock trading below book, going to be the challenge.

Yes, agreed. As I think you've seen, we've put a strong focus in reducing expenses where we can. We've made significant progress on that score. I think we can do a bit more. So we're focused on that. But I hear you. It's a fair point. We're aware of it, and we're working towards addressing that direct issue.

Got it. Yes, I would describe it as probably, at this point, not even much of a numerator issue. It's more of a denominator issue.

Yes, I think that's a fair appraisal. I think that's right.

(Operator Instructions) The next question comes from Trevor Cranston of JMP Securities.

First question. Your leverage ticked up a little bit this quarter as you grew the portfolio a bit and did some share buybacks. It sounds like you guys are still finding some interesting opportunities for investment. So can you talk about how you guys are thinking about leverage and continued capacity to continue to grow the portfolio from here? And how you're balancing that with the desired buyback of shares at this point?

Anup, you want to take the investment issue? And I can talk about share buybacks after that if you like.

Yes, sure. I think from an investment opportunity perspective, we continue to see a significant amount of opportunities ranging from all the credit-sensitive things we have outlined. So ranging from prime jumbos to non-QM to bridge loans, as well as commercial-mezz opportunities. We've been working on a significant amount of opportunities on each one of those sub-sectors. And we continue to see a ton of opportunities around that. And I think what you will see, and as we've outlined before, that as we continue to add those opportunities, you will see leverage slowly tick down. And I think that's been our plan. That's what we expect over the next three quarters or next 12 months. And our approach is very methodically find the opportunities which we like and then implement them into our portfolio. We take a pretty cautious approach in terms of the quality of the underlying credit we want to see. And as slowly we implement those, you will see the leverage come down.

And Trevor, on share buybacks. As you saw, we continue to be evaluating those as our stock trades at a significant discount to book value. So far, we've not found our cash needs to be a constraint to buying back shares. I think the main constraint we face is, we have lots of blackout periods and limitations on daily trading volumes that we can buy back. So I think we'll continue to evaluate that going forward. But to date, the cash required for us to do that has not been a constraint for us.

Got it. Okay, that makes sense. And then, I saw yesterday, I think, that there was pricing of a WAMCO non-QM RMBS deal that was fairly significant in size. So I was wondering if you guys could comment on what WMC's participation in that deal might be and how we should think about that.

Sure, go ahead. Sorry.

I will just say, WMC did not participate in that deal. But those types of things, we are, we do and will evaluate transactions like that for WMC to the extent that they make sense and we think they're accretive for shareholders and right for the portfolio. Anup, did you want to comment further on that?

No, I think that's perfect.

Does that answer your question, Trevor?

Yes. So just to be clear, I guess, those are non-QM loans that other vehicles that WAMCO had accumulated and securitized and just sort of separate from what WMC has been doing?

Exactly. It's a similar portfolio, but a different vehicle.

Okay. Got you. And then one question on the swap portfolio. I noticed that the forward starting book looked like it had -- or the forward start period expired at the end of April. Can you just say what you did with those, if you let any un-settle or if those were replaced with new forward starting swaps?

This is Lisa. So the entire $1.6 billion, we actually let it kick in. So what we effectively did is fully hedge our debt.

There are no further questions at this time. I would now like to turn the conference back to Jennifer Murphy for closing remarks.

Great. Thank you, everybody, for joining us today and, Rick and Trevor, for your questions. Have a great day.

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