Western Asset Mortgage Capital Corp (WMC) 2020 Q1 法說會逐字稿

Welcome to the Western Asset Mortgage Capital Corporation's First Quarter 2020 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, Debbie. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the first quarter of 2020. The company issued its earnings press release yesterday and is available in the Investor Relations section of the company's website at www.westernassetmcc.com. In addition, the company has included a slide presentation that you can refer to during the call, and you can also access these slides on the website.

With us today from management are Jennifer Murphy, Chief Executive Officer; Lisa Meyer, Chief Financial Officer; and Harris Trifon, 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 SEC. 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'll now turn the call over to Jennifer Murphy. Jennifer?

Thank you, Larry. Welcome, everyone. The March quarter was an extremely challenging and difficult environment for global markets as the economic impact of the pandemic created unprecedented market conditions, severe illiquidity, volatility and uncertainty.

In the beginning of 2020, we were anticipating continued moderate economic expansion in the United States. At that time, our investment strategy combined primarily Agency CMBS interest rate investments with residential and commercial credit holdings. Our residential credit investments focused on whole loans to non-QM borrowers with strong credit profiles and lower loan-to-values. Our commercial credit investments focused on higher quality, single asset, single-borrower loans where we can play a significant role in shaping covenants and structure.

By mid- to late March, virtually all asset classes, Agency and non-Agency, residential and commercial, suffered an acute lack of liquidity and forced selling in the marketplace, leading to swift and dramatic price declines. Agency CMBS DUS spreads widened from 50 to 60 basis points in January and February to 225 basis points at one point during the week of March 16, closing the week at a 135 basis point spread, a seven standard deviation change.

Spreads widened even more dramatically in non-Agency CMBS, with AAA CMBS widening from approximately 60 basis point spreads to over 300 basis points and BBB CMBS widening from 300 basis points to 1,200 basis points both over 50 standard deviation moves.

These dramatic price declines reflected the uncertainty surrounding the economic impact of unprecedented actions taken by governments, business and individuals to enforce social distancing, including widespread business closures and other lockdown restrictions. The price declines also reflect the anticipated cost of some of the actions taken by federal, state and local authorities to mitigate the impact on individuals and business owners such as prohibitions on eviction and the ability to obtain deferrals of mortgage and rent payments for those affected by the pandemic.

The Fed acted quickly and decisively to stabilize Agency mortgage markets, and this seem to be largely successful as spreads and Agency CMBS DUS bonds, for example, are almost back to pre-crisis levels of about 60 basis points.

In Non-Agency markets, however, spreads have recovered only somewhat in senior AAA CMBS, while Non-Agency RMBS and BBB CMBS spreads have not recovered much at all. You can find this data on Page 5 of our earnings presentation.

As a result of these unprecedented economic and market disruptions, the extreme uncertainty around how long and how negatively mortgage assets would be affected, combined with our portfolio positioning as a hybrid REIT and our exposure to margin calls related to our repo borrowings, we experienced significant declines in the fair value of our assets during the quarter. Book value declined 68%, and we recorded a GAAP net loss of $382 million. As the management team focused on book value stability, we are very disappointed with this result.

However, as the environment normalizes and the real impact on mortgage assets in general and our portfolio in particular become more clear, we are keenly focused on preserving the opportunity for our shareholders to benefit from price recovery in our portfolio.

While we generated core earnings plus drop income of $0.29 per share during the first quarter, relatively consistent with the previous quarter, we made the decision to retain those earnings and suspend the first quarter dividend to maintain additional liquidity to help protect the value of shareholder assets in these distressed and disrupted markets.

We've taken a number of other actions designed to help protect the portfolio during the crisis, including sold assets and repaid the associated repo borrowings to significantly reduce market exposures; entered into an 18-month term facility for our non-QM loan portfolio, removing its exposure to mark-to-market margin calls; entered into a 12-month term facility for Non-Agency CMBS and RMBS securities, significantly mitigating their exposure to mark-to-market margin calls; reduced short-term repo financing to 10% of overall financing and consolidated our financing relationships with collaborative, well-financed counterparties who we believe take a long-term view of our relationship and mortgage REITs generally.

We believe the assets we've retained in the portfolio are supported by the underlying value of the properties that serve as collateral for these investments, as well as the terms and covenants designed to protect their value. While it will likely take time to assess the actual impact of the pandemic on our assets, we believe current prices of Non-Agency residential and commercial assets reflect an overly pessimistic view with little differentiation among securities.

And while the trajectory of the economic downturn and recovery is still very uncertain, we believe that asset prices place too much weight on the most bearish scenarios. As we get more clarity, we expect the underlying values to be more fully reflected in prices. Therefore, we see the potential for significant recovery in our book value as a result.

2020 has been a huge challenge for WMC and the entire mortgage REIT industry. We are committed to taking the necessary steps to protect the portfolio and preserve the opportunity for our shareholders to benefit meaningfully as asset values recover. We believe our focus on high-quality borrowers and assets as well as our diversified approach will provide the opportunity for our assets to recover significantly as the economy recovers.

As fellow shareholders, we are extraordinarily focused on acting to protect shareholder interest. We appreciate your patience as we seek to protect book value, enable shareholders to benefit from recovery and reposition the company to resume delivering on our long-term objectives.

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

Thank you, Jennifer. As Jennifer mentioned, March was a challenging month for many mortgage REITs. The unprecedented market conditions in terms of both magnitude and speed resulted in a significant decline in our asset values. We were severely impacted by this market volatility, resulting in a GAAP net loss of $381.9 million or $7.15 per share. Our core earnings plus drop income was $15.8 million or $0.29 per share.

We have taken certain measures to preserve the long-term value of our equity, including selective asset sales, unwinding interest rate swap positions that were deemed no longer effective and seeking financing arrangements that reduce our exposure to short-term repurchase agreement borrowings with daily margin requirements. More specifically, we took the following actions to achieve these objectives.

During the quarter, primarily in March, we sold just over $1.7 billion in securities. The vast majority consisted of Agency CMBS and RMBS, reducing our purchase agreement borrowings by $1.6 billion. We terminated our entire interest rate swap positions consisting of $3.1 billion in notional value of fixed pay swaps and $1.9 billion of variable pay swaps. The interest rate swaps were no longer effective due to the deep decline in short-term interest rates and were a source of margin calls.

We suspended our first quarter dividend to preserve liquidity and subsequent to quarter end, we entered into two term facilities with counterparties that share our long-term strategic view, which significantly reduced our exposure to margin calls. The combined facilities have an aggregate balance of $485 million and further reduced our repurchase agreement borrowings.

At March 31, our leverage was 9.5x. The higher leverage was a result of unsettled trades over quarter end and a significant decrease in stockholders' equity, which in part was a result of the $296 million of unrealized losses recognized during the quarter.

Since quarter end, we continued to selectively sell assets to reduce leverage, selling approximately $454 million in securities, mainly Agency MBS, and $149 million in whole loans. We expect that by the end of the second quarter, our leverage will be in line with pre-crisis levels.

The current composition of our financing arrangements of approximately $1.5 billion is as follows: Approximately 48% in nonrecourse securitized debt from our Arroyo securitization; approximately 32% in the new term facility; approximately 10% in warehouse lines and approximately 10% in repurchase agreement financing.

We have met our margin requirements to date, and given our significantly reduced exposure to daily mark-to-market financing and a more stable market environment for mortgage credit-related assets, we anticipate continuing to do so.

At March 31, while we were not in compliance with certain covenants with some of our lenders, we have obtained a waiver or modification of those covenants or have paid off the outstanding borrowings with those lenders.

As Jennifer mentioned, we believe the remaining assets we hold in the portfolio have fundamental value in excess of their current prices. While it may take some time for that gap to narrow, we estimate that there is a potential for significant upside to be realized, which would lead to a partial recovery of our book value per share.

With that, I will now turn the call over to Harris Trifon. Harris?

Thanks, Lisa. While the broader market volatility resulting from the COVID-19 pandemic led to extreme price declines on our assets in March, we have experienced some recovery in their prices through the end of April. We believe that current prices in the credit sector of the U.S. residential and commercial real estate mortgage markets envisage severe economic scenarios that were last seen during the Global Financial Crisis.

While assessing the longer-term economic damage of this crisis remains challenging, given its unique nature and unprecedented scale, our view is the extraordinary amount of fiscal and monetary support that the U.S. government is providing our financial system and the broader economy will dampen the economic impact of the quarantine period and support liquidity conditions in fixed income markets.

We believe valuations in mortgage credit assets are particularly favorable relative to fundamentals, even given the increased uncertainty in the near term. We also believe that the current recession will eventually pass and give way to an economic recovery, although the timing and strength of the recovery will be dependent on the spread of the virus and the availability of therapeutics and a potential vaccine.

The magnitude of the price and liquidity dislocation in mortgage markets over the last two months resulted in the most challenging environment in my career. In response to the paradigm shift, we significantly reduced the size of our portfolio in order to lower debt and increase liquidity.

In March, we primarily sold Agency MBS holdings with most of the sales coming after the Federal Reserve announced buy programs for first, the RMBS market and then the CMBS market. During the current quarter, we have also sold some of our residential and commercial credit investments as these markets began to stabilize and prices rose modestly from the late March lows.

Our current portfolio holdings remain diversified across a number of subsectors of the mortgage market, but the majority of our holdings are now in residential whole loans, commercial whole loans and both nongovernment-guaranteed residential and commercial mortgage-backed securities.

Our Residential Whole-Loan portfolio consists of mortgages made to high-quality borrowers who have substantial equity in their homes. The average LTV at origination of this pool of loans was 62%.

These loans are being serviced by our loan origination partners, mainly community banks. And while we expect that some of the borrowers may require some form of loan payment deferrals, we don't believe that there will be any long-term material credit losses from the portfolio nor do we expect a meaningful amount of payment disruption due to forbearance requests.

Our long-term view on residential real estate remains favorable. Right before the crisis, the U.S. housing market was healthy, driven by improved affordability, rising incomes and historically low consumer debt levels. This was overlaid against the backdrop of limited supply and tight credit standards.

The shutdown and economic uncertainty will slow down housing activity significantly in the near term. We are expecting lower prepayments as origination volumes slow and extension of mortgage timelines and home prices to decline by up to 5% in our base case. But we don't believe that there will be significant and permanent declines in residential real estate values in this country.

Our commercial whole-loan portfolio primarily consists of a number of single-asset and single-borrower mortgages where we have focused on short-term loans secured by properties with solid credit fundamentals and strong covenants that protect our interests as lenders. Our $320 million portfolio at quarter end had a weighted average loan-to-value at origination of 65%.

However, we are mindful that some areas of the market will be more exposed to COVID-19 risks, most notably, hotel and retail properties. That being said, we believe that our focus on high-quality properties, with well capitalized sponsors capable of withstanding short-term disruptions, should enable our assets to emerge from the crisis without significant impairment.

Looking ahead, we believe mortgages secured by real estate assets with meaningful equity in the properties and higher quality credit will continue to perform well over the long term. While many sectors of the mortgage market currently offer historically attractive valuations, our primary focus is on maintaining sufficient liquidity and reducing our overall debt while consolidating our financing relationships in order to protect against further book value erosion and position the portfolio for potential future appreciation.

The entire WMC team as well as the broader Western Asset team has worked tirelessly during what has been an extremely difficult environment and was confronted with a variety of challenges over the last two months, and I am proud of our team's effort navigating these unprecedented market conditions. While the decline in book value was large and unexpected, we feel that our current stance is the best way to put us back on course towards our long-term objectives of generating sustainable core earnings that can support an attractive dividend with the overall goal of enhancing stockholder value.

With that, we will open the call up to your questions. Operator, please go ahead.

(Operator Instructions) The first question comes from Eric Hagen with KBW.

And I hope you guys are doing well. A couple of questions on the new funding arrangements. What's the funding cost on those facilities? And are you able to reinvest any paydowns? Or does all the P&I effectively go towards paying down the facilities?

And then what's the paydown seniority on the cash flow from the portfolio? Is the convert rank ahead of the repo in terms of the priority of payments? Or does the collateralized funding rank first?

Okay. I think I'll ask Lisa to comment on that, Eric. Thanks for your question. They are two different facilities. So maybe we should start by commenting on the non-QM loan facility first.

Sure. The non-QM facility, the way it works is that the cash flows from the underlying loan values go to pay out a coupon, which is based upon the WACC, and then any additional proceeds of P&I then actually pay down the facility.

And then the second facility, maybe comment on the...

Sure. The second facility, it works a little differently. What happens is the cash flows go directly to the counterparty. The interest is taken out and then the net proceeds come back to the Company. That is based upon LIBOR plus 500 basis points. And in addition to that, P&I payments -- I mean, principal payments, sorry, go to reduce the facility 50%, and 50% comes to us when it reaches a certain level.

Got it. And how about the -- that was helpful. And the seniority of payments, the conversion from the repo and...

It's a secured financing. So it would be for those assets that are financing it that have first claim on it.

Understood. Great. And then what's your book value and leverage after having completed the sales of the portfolio in April? And then what percentage of your CRE and non-QM portfolio have asked for forbearance so far?

It's a little difficult right now to provide a book value update for April, only because a significant portion of our portfolio now is in whole loan products, and those loan products don't get marked. They get marked on a monthly basis. So we're in the process of just getting in values for those loans. So it's kind of difficult for me to say exactly at this point in time with any clarity what book value is.

But having said that, it's improved. And the parts of the portfolio that are mark-to-market every day, there's improvement. And just to be clear, the loans that Lisa mentioned that are marked monthly are marked by a third party provider, an independent provider.

Got it. Okay. Great. And then can you just maybe guide us a little bit towards the kind of core earnings that we should expect just over the, I guess, kind of near term?

Yes. I think our core earnings, my expectation, given the change in the portfolio is they'll be lower. So maybe, Lisa, you might want to comment. Is there a range we can offer or some sense of that?

Yes. We're estimating the range to be in between $0.06 to $0.07 a month.

The next question comes from Trevor Cranston with JMP Securities.

A couple of follow-up questions. I guess, first, with the portfolio sales you guys have made in April, as you look at what remains in the book, are you continuing to opportunistically look to sell assets?

Or with what remains, is that sort of things you're comfortable with that you'd like to try and capture upside on as markets recover? Or how should we think about the balance of the portfolio going forward from here?

Sure. Trevor, it's Harris. I can take that one. I think, generally speaking, we always try to be as opportunistic as possible, particularly in this environment with our program of derisking and delevering the portfolio. The market conditions, while improved relative to where they were in March, continue to be very fluid. So the opportunity set in terms of selling assets in the portfolio remains fluid as well.

I would say also that the execution of the longer-term facilities for the majority of our securities portfolio as well as our residential loan portfolio certainly goes a long way in giving us more time and flexibility and taking advantage of the liquidity conditions on a day-to-day basis. But our entire team is always focused on evaluating where we think we can move every single line item in the portfolio, and we're constantly weighing the attractiveness of selling versus keeping given the overall goal of trying to preserve as much optionality in the portfolio to recover as much book value as possible.

Okay. Got you. Then a couple of detailed questions on the portfolio. First, on the Non-Agency CMBS, can you give a breakdown of the ratings you own in the remaining portfolio there?

I don't have that in front of me, Trevor, but I would say that most of the ratings are below investment grade. However, I would also note that it's our long-standing view that ratings, particularly for mortgage credit assets, have been overly conservative over the course of the last number of years, and we don't think necessarily reflects the inherent credit quality of the various classes.

Okay. Got you. And then on the commercial loan portfolio, I think you briefly mentioned potential issues with hotel and retail loans in the prepared remarks. Can you provide any additional color on whether or not any of those borrowers have asked for payment deferrals or kind of what the status is of those loans and how you're thinking about the risk there?

Sure. Those conversations are still ongoing. There's one exposure that we have in the portfolio wherein for the April payment, the borrower asked forbearance. That was ultimately not granted in full. And most of the loan exposures we have are structured with various reserves and in many cases, with debt service and interest reserves as well. So those reserves are being drawn down, particularly for assets, which are not operational at this current point in time.

Okay. Got you. And then -- so looking at the details you guys provided on the new financing facilities, it looks like there's a provision for your counterparties to potentially share in some upside price improvement in the assets. When we think about your book value going forward, to the extent prices do recover and spreads tighten, will there be some sort of offset to the improvement in asset values to account for that potential sharing? Or how should we think about how those facilities are going to work in that perspective?

So just to be clear, Trevor, only the residential loan facility has that provision in it. The securities facility, there is no sharing of potential upside. And on the resi loan facility, there is that participation.

You should think about it largely in terms of a monetization event of the underlying assets. In other words, when and if we sell the loans on a portfolio basis or we securitize the loans and achieve financing that way, the delta between the adjusted basis of the loan amount and the facility at that point in time, relative to the proceeds that are generated as a result of one of those two events, would be shared.

The share is heavily in the Company's favor, but that was a concession that we needed to make to achieve some of the structural features that were very important to us, primarily non-mark-to-market as well as the term of the facility itself.

And Trevor, could I just add to that? That opportunity for sharing with that partner is a very small -- would represent a very small part of the potential for a recovery in the portfolio.

Right. Okay. Got it. And then the last question for me. Looking at Slide 12 in the deck, I guess, yes, you showed some positions in TBAs and credit default swaps. I was just wondering if you could provide some color on what those positions are and if those are things you continue to own in the portfolio.

So the TBA is no longer in the portfolio. The credit default swaps were part of a credit hedge that we had in place in the portfolio, and that's what's reflected on the table you're referencing.

Okay. And you -- do you still have that hedge in place? Or has that been taken off?

We still have part of it. We've been adjusting it as market conditions allow, but we still do have a position there, yes.

(Operator Instructions) The next question comes from Derek Hewett with Bank of America.

And I hope everyone is well. Most of my questions were already asked and answered. But in terms of the fee waivers, will that continue until the dividend is turned back on?

Derek, it's Jennifer. We've been making that determination on a month-by-month basis. So it's, in part, to assist the company, WMC, in keeping liquidity and helping to manage our expenses as well. So we'll make that determination again later this month. But we haven't set any particular rule like you just suggested. It's more of a month-to-month determination.

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

Thank you. Thanks, everyone, for joining us today. We appreciate your interest and your questions and hope everyone remains safe and healthy during this challenging time, and we look forward to speaking with you again soon. Thank you.

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