Western Asset Mortgage Capital Corp (WMC) 2018 Q2 法說會逐字稿

Welcome to the Western Asset Mortgage Capital Corporation's Second Quarter 2018 Earnings Conference Call. Today's call is being recorded and will be available for replay beginning at 5:00 p.m. Eastern Standard Time. (Operator Instructions)

Now first, I'd like to turn the call over to Mr. Larry Clark, Investor Relations. 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 3 months ended June 30, 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 also 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 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. Welcome, everyone. We delivered strong second quarter financial results as we continue to realize the benefits of our diversified portfolio and our differentiated investment strategy. On a broader level, our results continue to reflect our ability to draw on the breadth and depth of Western Asset, our manager's, global investment, risk and operating platform, which we view as a strategic advantage for WMC and its shareholders.

In the second quarter, our core earnings plus drop income was $0.36 per share, an increase of 7% from the first quarter of 2018 and 17% higher than the fourth quarter of 2017. This quarter's core earnings increase was primarily driven by our continued shift towards owning more credit sensitive assets, which Lisa and Anup will talk more about, improved hedging costs, and lower G&A expenses.

We delivered an economic return on book value of 0.4% for the second quarter, which includes our shareholder dividend of $0.31, partially offset by a decline in our book value of $0.27. For the first 6 months of 2018, our economic return on book value was 5.1%, and it was 21% for the full year 2017, both at the high end of our peer group for those periods. Our shareholder dividend has remained consistent now for nine consecutive quarters, and our core earnings plus drop income has exceeded the dividend by approximately 10%, in the aggregate, over that time period.

The decline in our book value in the second quarter was primarily the result of spread widening in our Agency CMBS portfolio, which occurred late in the quarter and was driven by what we believe were temporary market conditions, as those spreads have rebounded here in the third quarter.

Our second quarter performance was driven by contributions across our holdings and reflects our diversified and differentiated investment approach. This differentiated approach is the direct benefit of our ability to draw on Western Asset's size, scale and deep relationships to source opportunities in virtually any subsector of the fixed income market.

The investment team was, once again, quite active this quarter, acquiring over $300 million in target assets, the vast majority in credit sensitive investments. These assets continue to be sourced from a broad spectrum of the mortgage market and include many investments where we have developed strategic relationships with mortgage loan originators -- originators who understand what we are looking for and are able to provide us with attractive opportunities that meet our disciplined criteria. Similarly, in our commercial loan investments, we're also able to get involved early in the transaction and collaborate on key aspects of the deal structure. Essentially, WMC is able to leverage the Western Asset investment platform to gain access to opportunities that we simply would not have as a standalone mortgage REIT.

In the second quarter, we repurchased about 63,000 shares of our stock at an average price of $9.88 per share, or about a 12% discount to book value. We have repurchased shares in each of the past three quarters, each time at a significant discount to book, which has been accretive to our book value and has represented a compelling investment opportunity in our view. We still have over 1.7 million shares left under our existing share repurchase authorization and we'll continue to evaluate opportunities to repurchase shares in the future.

We're pleased with our strong financial results in the second quarter and year-to-date. We remain focused on our objective on behalf of our shareholders of generating consistent and sustainable core earnings that will support an attractive shareholder dividend, while improving the stability of the company's book value.

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

Thank you, Jennifer. We delivered another strong performance in the second quarter of 2018, our fifth consecutive quarter of solid core earnings.

We generated net income of $1.5 million, or $0.03 per share. Our core earnings plus drop income was $15.2 million, or $0.36 per share, an increase of $0.02 per share over the prior quarter. There were 5 key contributors to our performance.

First, we had a slightly larger average investment portfolio and an ongoing shift into credit sensitive investments. During the quarter, we sold approximately $405 million of mainly Agency securities and redeployed the capital by acquiring $275 million in credit sensitive investments, consisting of $240 million in Residential Whole and Bridge Loans and the remaining in a commercial loan and Non-Agency CMBS;

Second, the portfolio generated a higher net interest margin as a result of our shift towards credit sensitive investments. Our net interest margin increased by 11 basis points from 1.94% at March 31 to 2.05% at June 30;

The third contributor to our performance was a reduction of our net interest rate swap expense of $2.1 million from the first quarter of 2018;

Fourth, a decrease in professional fees of approximately $480,000, mostly related to the completion of our first internal controls audit in the first quarter;

And lastly, the increase in core earnings was partially offset by slightly higher management fees and an increase of approximately $590,000 in third-party asset management and loan servicing fees on our growing residential bridge and commercial loan portfolio.

Our leverage ratio at June 30 was 7.3x when excluding $1.3 billion of non-recourse securitized debt from a CMBS securitization. We are required under GAAP to consolidate the CMBS securitization because the $68 million subordinate tranche we acquired contains certain control rights. Our adjusted leverage ratio declined from 7.7x at March 31. As we continue to add more credit sensitive to our portfolio, we expect this trend to continue.

With our view that interest rates will continue to rise, we decided to settle our $1.5 billion forward-starting swap into a current paid swap in April. At quarter end, we had effectively hedged approximately 96% of our interest rate exposure on our repo debt. We believe that this interest rate protection will minimize the impact of future rate increases on our portfolio.

At June 30, we had master repurchase agreements with 28 counterparties and outstanding borrowings with 17 of those counterparties. Our financing options continue to be ample 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. Our overall performance in the second quarter was driven by contributions across our holdings in a number of subsectors of the mortgage market, but mainly from our Agency CMBS portfolio and our credit sensitive loans and securities.

Let me spend a few minutes discussing each.

As we have mentioned in the past, one of our portfolio repositioning initiatives over the last 18 months has been to rotate out of Agency RMBS into Agency CMBS. As of June 30, Agency CMBS represented 83% of our total Agency holdings and 55% of our total adjusted portfolio.

As a reminder, Agency CMBS consists of securities that are issued by Fannie Mae, Freddie Mac and Ginnie Mae, to finance multi-family residential properties.

We find these securities attractive for a number of reasons.

First, the underlying loans have built in prepayment protection and therefore are less sensitive to interest rate risk than single-family mortgages.

Second, Agency CMBS offers a more attractive price than RMBS because it is more cost efficient to hedge.

And third, given the Fed's plans to shed its RMBS holdings, we believe that Agency RMBS spreads are likely to remain under pressure until the Fed's influence in that market ends.

Agency CMBS has been a meaningful contributor to our portfolio's performance, both in the second quarter and over the last 18 months. These holdings generated over 30% of our net interest income during the quarter. However, as Jennifer mentioned, spreads on Agency CMBS widened out late in the quarter, which negatively impacted our book value. We believe the widening was due to temporary market conditions, as spreads have tightened again here in the third quarter.

In the credit sensitive portion of the portfolio, we remain invested across several sectors of the market, primarily in Non-Agency CMBS and RMBS, Residential Whole and Bridge Loans, Commercial Loans and GSE Credit Risk Transfer securities. During the quarter, we increased our exposure to a number of these sectors, with the largest increases taking place in Residential Bridge Loans and Non-QM Residential Whole Loans, which we find particularly attractive.

Our Residential Whole Loans, including both Bridge and Non-QM, now make up about 34% of our credit sensitive holdings and are meaningful contributors to our overall profitability.

We find Residential Non-QM loans attractive because they 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.

Residential Bridge Loans are attractive to us because they are short term in nature and offer compelling yields, while still conforming to our underwriting standards.

Another area of the residential sector that we are looking at is in prime jumbo mortgage securitizations. They offer higher yields than Agency RMBS, yet have a similar risk profile, in our view. However, we are being opportunistic when investing in this space.

On the commercial credit side, we own good deal of non-Agency CMBS, which includes securitizations that are backed by a variety of property types. These mortgage pools also tend to be geographically diverse across the U.S. Given our favorable outlook for the economy, we remain optimistic about commercial real estate fundamentals going forward.

On last quarter's call, I spent time discussing our approach to commercial mezz loans, which we continue to find attractive and are adding to our portfolio. As a reminder, we are focused on short-term loans that are secured by properties with solid credit fundamentals and strong covenants that protect the lenders. We like these loans because we are able to get involved in the deals early, and often collaborate on key aspects of the structure. This is a good example of WMC being able to leverage Western Asset's investment platform and having access to opportunities that we would not have as a standalone mortgage REIT.

In conclusion, we plan on continuing to increase our holdings of credit sensitive investments as part of our differentiated investment strategy. We remain focused on our overall 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 Trevor Cranston with JMP Securities.

I guess, first, a couple of questions about the residential loan strategy. Can you just give us an update on what you guys are seeing in that market, both for the Bridge Loans and the Whole Loans, in terms of the progress that you see originators make or if the people you've partnered with have been able to see any increase in volumes as the conventional conforming origination space has struggled some? And also, if you're seeing more originators coming into the space and the potential for an increased supply of loans?

Sure, Trevor, thank you. Let's talk about the Non-QM first. On the Non-QM side, we are seeing continued growth relative as the conventional volume comes down. But look, keep in mind, we have a very differentiated strategy on Non-QM, for what we look for. As you've heard from us before, our Non-QM is really focused at the high-quality borrower, who's not really looking to maximize the leverage, focused on primarily adjustable rate mortgages, low loan to value. So there, our process is to be very deliberate and focused at finding these borrowers from small community banks, in the credit sensitive and the high-quality, low loan-to-value, attractive relative to conventional. So yes, we are seeing more volume, because those are the loans, which are originated by banks anyway, so we continue to add more partners to our program. But broadly, we're seeing the issuance of Non-QM securitizations continue to grow. So the volumes are increasing, but just keep in mind that our strategy for Non-QM is quite different relative to all other market participants, and that volume for that borrower who is not looking for additional leverage is just different. Most of the participants are quite different, so we do see correspondent channels growing, but just keep in mind, our strategy is different.

The second, in terms of Residential Bridge. Yes, our focus is on the high-quality, very experienced borrower, who has been doing the cosmetic rehabs for a long period of time. Again, we tend to be very deliberate in terms of finding the high-quality borrower out there. And we have seen growth, but we have been very disciplined in how many we add, just simply because the quality and our discipline are very important to us.

Got it. That's helpful. And can you also maybe touch on the financing side for those strategies and if there's been any sort of changes there in terms of the number of counterparties who are willing to lend against those loans or any of the terms you're seeing in financing them?

Yes. We continue to see strong interest from additional counterparties who are looking to finance it. Again, I think one of the things you have seen, not only lots of Non-QM securitizations have been done, but also, first, for one of our funds we did a Non-QM securitization. So there are a couple of things you can see. One is because you have lots of securitizations, which are being done. Second is now that this is the strategy that we have been doing for two to three years, so most counterparties we have had, they can see the performance, in terms of the prepaid fees and in terms of the delinquencies. And they kind of see that, one, our standards have not changed; and second is our performance has continued to, knock on wood, but our performance continues to be pristine. So because of that and because of our history, we continue to have growth in counterparties who are going to finance those.

Got it. Okay. Now on the commercial side, can you maybe remind us -- I know you guys said you sort of have a positive fundamental view. But can you remind us sort of if you have any particular focus on the type of property types you guys are most willing to lend against? Or if there's anything in particular you guys are avoiding in terms of geography or different property types?

I think all the things, whether it's geography, property type, all of those come into consideration as an added evaluation of any given opportunity. But in addition to those, what is most important for us really is, in addition to the big fundamentals, is what are the covenants we are able to negotiate as a part of the structure and just to make sure that we have a loan which we have confidence in all the things in the structuring, that it gets paid off. So having the right covenants, in my mind, in the current economic cycle is really important. And that's why, as Jennifer had mentioned in her comments and I've mentioned, that we play early on to be able to collaborate on the structure. And that's with the view that we are able to get a very strong transaction. Look, without coverage, you can have all the property types and geography, but it wouldn't help you a lot when the turn in the economy comes. So it's a combination of both, but this is really where the benefit of Western Asset as a platform comes that when you ask the same question from some of the other entities, they would give you an answer that they are either focused on just multi-family or any given property type. And it's more of, for us, we have the expertise to be able to look across all of it. Sorry, long answer.

No, that's very helpful. Then last question, are you guys able to quantify how much the second quarter earnings benefited from the widening spread between 3-month LIBOR and Agency repo rates? And also, it'd be helpful if you guys could share your view on sort of where you expect that relationship to stabilize since it's come in a lot since the peak in the second quarter?

As far as our swaps, as I mentioned, we are effectively hedged 96% of our repo exposure, so I think, during the quarter, we benefited from that by approximately $2 million. So that was also very helpful relating to our core earnings. I'm sorry, what was the second part of your question?

Second part of the question was just sort of your guys thoughts on where you'd expect the relationship between 3-month LIBOR and Agency repo rates to stabilize.

Yes. I think Agency repo rates are going to stabilize at both -- look, I think there just continues to be stability around what markets view for how many raises that the Fed will have. Overall, macro conditions are quite constructive, inflation is not going anywhere. So overall, as you see a consensus built around how many raises from the Fed, which continues to be the case, I think that relationship will settle down.

I also just wanted to add that both our hedges and our repo are indexed to LIBOR.

(Operator Instructions) This concludes our question-and-answer session. I would like to turn the conference back over to Jennifer Murphy for any closing remarks.

Great. Thanks very much for joining us, and have a great day.

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