Western Asset Mortgage Capital Corp (WMC) 2022 Q1 法說會逐字稿

Welcome to Western Asset Mortgage Capital Corporation's First Quarter 2022 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 of Investor Relations. Please go ahead, Mr. Clark.

Thank you, Jason.

I want to thank, everyone, for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the first quarter of 2022. The company issued its earnings press release yesterday afternoon, and it's available in the Investor Relations section of the company's website.

In addition, the company has included a slide presentation on the website that you can refer to during the call. With us today from management are Bonnie Wongtrakool, Chief Executive Officer; Lisa Meyer, President and Chief Financial Officer; Greg Handler, Chief Investment Officer; and Sean Johnson, Deputy 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 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. We disclaim any obligation to update our forward-looking statements unless required by law.

With that, I'll now turn the call over to Bonnie Wongtrakool. Bonnie?

Thank you, Larry, and welcome, everyone.

As you may recall, we announced last December, our plan to focus on residential real estate-related investments and to transition out of the commercial investments in our portfolio. We will be making this transition over the course of the coming quarters by seeking to maximize the value of our commercial assets and strategically focusing our resources on the residential market. We believe that this strategic shift will allow us to address attractive market opportunities and will ultimately result in a more stable and improved earnings profile.

During the first quarter, we continued to implement the strategic portfolio shift, while working proactively to strengthen our balance sheet. As we discussed on last quarter's call, we sold the unencumbered hotel property that we foreclosed on in 2021 and received $36 million in net proceeds, while reporting an $8.7 million gain on the sale of the property. We used the proceeds from the sale, along with cash on hand, to reinvest into approximately $160 million of our target assets and to repurchase an additional $3.4 million of our 2022 convertible notes.

We also reduced our recourse leverage and increased our interest rate hedge positions during the quarter to protect the portfolio in light of the ongoing interest rate and spread volatility. We are confident that we have sufficient liquidity in this market environment to continue executing on our investment strategy.

In February, we completed our third securitization of approximately $400 million, backed by $432 million of residential whole loans. This securitization enabled us to secure a long-term fixed rate financing at a weighted average interest rate of 3.1%, which we view as a favorable level given the rising interest rate environment. We were able to lock in an attractive net interest spread on this pool of residential mortgages through this financing.

However, the quarter was not without its challenges. In particular, the rapid rise in interest rates and concurrent spread widening across all fixed income sectors. Our portfolio was not immune to these pressures, and our GAAP book value per share declined 14.7% from the prior quarter, while economic book value per share declined 7.3%.

We had previously expected that transitioning and repositioning our portfolio could create timing issues that would impact our near-term earnings power, and this was the case again in the first quarter. Our financial results were negatively impacted by the combination of lower net interest income and elevated prepayments on our residential whole loan portfolio.

Consequently, our distributable earnings were $379,000, or $0.01 per share in the first quarter, down $529,000 from the fourth quarter. While the first quarter was no doubt a difficult one, we are confident that we are taking the right steps to resolve our challenged investments, strengthen our balance sheet and improve the earnings power of the portfolio. We believe our progress on these steps will be reflected in our stock price over time and remain committed to building value for shareholders.

Before turning the call to Sean and Greg, I want to highlight that we recently published our 2021 Annual Report to Shareholders, and we encourage you to visit our Investor Relations website to read through it. In addition, we recently filed our Proxy Statement and are in the process of mailing out the materials to shareholders. And finally, we will be holding our Virtual Annual Meeting on Friday, June 24, and welcome your participation.

Now, I'll hand it over to Sean and Greg to go into more detail about the investment portfolio. Sean?

Thanks, Bonnie.

As Bonnie noted, we were active again this quarter and repositioned the portfolio, adding both non-qualified residential mortgages and securities to our holdings as spreads widened. In February, we successfully executed our third residential whole loan securitization, considering our strategy of securing permanent financing on our non-QM holdings. We plan to continue our strategy of purchasing non-QM loans and financing via securitizations and this should allow us to lock in favorable long-term funding rates and reduce mark-to-market volatility.

During the first quarter, we acquired $117 million worth of newly originated non-QM loans. We were able to purchase these assets at attractive levels, as the spread on non-QM loans widened to between 275 and 295 basis points during the quarter. Securitizations widened during the quarter as well, with AAA pricing in the 170 to 180 basis point range.

To speed the transition of our portfolio, in addition to purchasing loans, we added $40 million of non-QM RMBS securities. We had the opportunity to make these purchases at attractive spreads as well. Especially at these wider spreads, our residential investments continue to present attractive fundamental value, benefiting from the strong housing market, low unemployment levels and solid consumer balance sheet.

While we expect home price appreciation to moderate from this very strong recent performance, we believe the housing market will remain well supported given the favorable supply and demand dynamics, as well as disciplined lender underwriting standards.

Our non-QM portfolio continues to perform well with less than 1% of our total loans by dollar value being more than 30 days delinquent at quarter-end. This underscores the effectiveness of our credit underwriting standards, focusing on high-quality borrowers that have meaningful equity in their homes.

Our portfolio weighted average loan-to-value is 59%, and the average FICO score for our borrowers at origination is 747.

During much of the quarter, rates on non-QM mortgage loans lagged the rise in conventional mortgage rates and many non-QM borrowers were able to refinance at relatively attractive rates. As a result, our portfolio continued to experience an elevated level of prepayments.

First quarter non-QM prepayments were 30.7 CPR, compared to 28.2 CPR in the previous quarter. We anticipate that the substantial rise in mortgage rates of the last quarter will cause refinancing activity in our portfolio to moderate.

More than half of our non-QM loan portfolio consists of adjustable rate mortgages, with approximately 15% of them scheduled to have rate resets in the next 12 months. This reduces portfolio duration and leads to higher interest income as interest rates rise.

Going forward, we remain positive on overall residential credit fundamentals. While securitizations are trading currently at wider levels than they were pre-COVID, new loan pricing already reflects this.

With that, I'll turn the call over to Greg Handler to discuss our commercial holdings. Greg?

Thank you, Sean.

During the first quarter, spreads generally widened across the commercial mortgage credit sector, but our commercial holdings in aggregate were only modestly impacted by the market move.

At quarter-end, we held seven commercial whole loans at a fair value of $128 million. All but one of these loans have performed in line with expectations.

The six performing loans represent $102 million of principal balance and are currently marked at $101 million, a negligible discount to cost. We expect these loans to pay off over the next several quarters as properties are either sold or refinanced. However, the ultimate timing and realization of loan payoffs depend on the specific factors pertaining to each property, and there could be no assurance as to whether or when the payoffs will occur.

With respect to the junior mezzanine loan backed by a retail and entertainment complex located in the Northeast, we continue to engage in discussions with the borrower and certain other lenders regarding potential alternatives to a judicial process. We believe the property has significant upside and are seeing encouraging growth in sales and attendance, as well as positive momentum in leasing activities. As we have noted previously, there remains a risk of further impairment under certain scenarios. Given the ongoing uncertainty regarding possible outcomes, our loan is currently marked with a value of $27 million, down slightly from the fourth quarter, primarily due to changes in the assumptions around the estimated timing of resolution to the situation.

Within non-agency commercial mortgage-backed securities, our single asset, single borrower credit portfolio is valued at $83.4 million, down slightly from the prior quarter. This portfolio consists mainly of Class A retail and hotel properties that cater to leisure travelers, and we are continuing to see positive operating momentum at a number of these properties. This portion of our portfolio had an approximate 65% original loan-to-value, and all but one of these loans, representing less than $1 million of the $83 million portfolio, remain current. These properties are generally high-quality assets with strong equity sponsors. So, we believe that their collateral values have not been materially or permanently impaired.

Our CMBS conduit exposure is valued at $22 million, up slightly from the prior quarter. And while credit trends are improving on some loans, others remain challenged. As a result, we placed two investments on non-accrual status during the first quarter as the operating performance of the underlying properties is taking longer than anticipated to recover. We remain focused on optimizing our recovery value in our CMBS position and continue to believe our positions will benefit as more COVID restrictions are lifted and the economy moves towards a full reopening.

We did not exit any CMBS positions during the first quarter, but will continue to evaluate potential sales of our investment in this space with a view to redeploying proceeds from the sales and payoffs and into new target assets that offer attractive risk-adjusted returns.

I'll now turn the call over to Lisa Meyer, our President and CFO. Lisa?

Thank you, Greg.

Before reviewing our first quarter results, I want to highlight some of the measures we have recently taken to further improve our balance sheet. WMC continues to benefit from the support of the broader Western Asset platform, facilitating our ability to work with our strategic financing partners to improve liquidity and secure attractive longer-term financing.

Earlier this month, we executed a one-year extension on our non-agency CMBS and non-agency RMBS financing facility. In February, as previously noted, we completed our third securitization of non-QM loans, which provided long-term fixed rate financing for $432 million of loans, previously financed under our residential whole loan facility. We also repurchased an additional $3.4 million of our existing 6.75% convertible senior notes due October 1st of 2022 at a weighted average premium to par of approximately 0.8%.

At quarter-end, we had a remaining outstanding balance of $34.3 million on the 2022 notes. We believe we have ample liquidity to continue repurchasing and retiring the 2022 notes prior to their maturity, provided accretive repurchase opportunity to exist over the next six months and then address remaining bonds at maturity.

Now turning to our financial results. We have provided great detail regarding our portfolio and our first quarter results in our press release and our earnings presentation. So, I am going to focus here only on items that warrant additional discussion. We reported distributable earnings of $379,000, or $0.01 per share for the first quarter, down from fourth quarter's level of $908,000.

Three primary factors drove the decline. First, we recorded approximately $350,000 lower net interest income on our non-agency CMBS portfolio, primarily due to an accounting change of two distressed conduit bonds that were put on non-accrual during the quarter.

Second, we experienced an elevated level of prepayments in our residential whole loan portfolio in the first quarter. There were $95.6 million of loan paydowns during the quarter, which led to lower net interest income of approximately $268,000. In addition, the paydowns resulted in $2.5 million of premium amortization, which was similar to last quarter's amortization on roughly the same level of prepayments.

Third, we experienced high professional fees of $230,000 as a result of higher accounting, internal audit and external audit fees related to our year-end reporting. These items were partially offset by $368,000 in lower management fees, as the 25% reduction in fees paid to our manager went into effect in January. We also recorded an $88,000 reduction in compensation expense.

While our distributable earnings for the first quarter were lower than our dividend of $0.04 per share, it is important to note that we evaluate the level of the dividend every quarter based on several factors. These factors include our outlook for the long-term sustainable earnings power of the portfolio and our taxable income. While it did not impact distributable earnings, we did incur a one-time expense that impacted our GAAP earnings and our book value.

We incurred transaction costs of approximately $2.9 million related to our residential whole loan securitization that was completed in February of 2022. We were required to expense these costs because of our decision to elect the fair value option for the securitized debt. We elected the fair value option for the debt in order to reduce the accounting mismatch caused by fair value in the assets and not the debt.

GAAP book value for the quarter was $2.73 per share, a decrease of $0.47 per share from the fourth quarter. The decline was driven mainly by spread widening across our holdings, mainly from our residential whole loans due to their relative size in the overall portfolio. The wider spreads led to a net unrealized losses of $38.9 million, or $0.64 per share. This was partially offset by consolidated realized gains of $12.1 million, or $0.20 per share from the sale of the hotel, as well as $6.9 million, or $0.11 per share of gains on our derivatives due to interest rate hedging activity during the quarter.

Economic book value, which reflects the value of the retained interest in the consolidated securitization trust, rather than the associated gross assets and liabilities decreased by 7.3% for the quarter to $2.81 per share.

Turning to leverage. Our recourse leverage ratio at quarter end was 2.8x, down from 3.8x at December 31st of 2021. As we completed the securitization in February, which is non-recourse, our recourse leverage ratio declined as expected. Our recourse leverage ratio will fluctuate as we continue to grow the portfolio with the goal of executing additional securitizations.

In summary, we remain focused on actions that will solidify our capital structure and maintain our liquidity, while positioning WMC to benefit from improving economic conditions and the ongoing recovery of certain commercial real estate sectors that were most impacted by the pandemic. With a significant portion of the assets now financed by attractive longer-term financing, we feel that we are well positioned to continue to grow our portfolio through select investment opportunities with the objective of improved financial results in the quarters ahead.

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

(Operator Instructions) Our first question comes from Jason Stewart from JonesTrading.

I want to start with margin on the residential side. Obviously, there was a little bit of dislocation in the securitization markets in 1Q. I guess, one, could you address that? And if there was any impact that we should expect to see in terms of a drag on margin going forward? And then if you could sort of bifurcate that and say, on a go-forward basis, based on new loan yields, what you expect margin on the residential side to be? That would be helpful.

Yes. Sure. It's Sean. I can answer that question. I think towards the end of March and early April was sort of the wide in the securitization market. We've seen a little bit of improvement since then, but whole loan pricing has widened out, as I've mentioned. And so the NIM is still pretty good. There's a couple of deals that printed in the last week. Cost of funds were in the 4.60% to 4.75% range with yield on non-QM around 6%. So, we're still seeing all-in NIM of over 100 basis points. So the securitization market is still pretty accretive given those numbers.

Okay. That's helpful. And then switching gears to CRE 3. Under what scenario -- I mean, thank you for the disclosure, first of all, this is much appreciated. Under what scenario do you envision having to advance additional funds in a restructuring?

Yes. This is Greg Handler. For that investment to proceed, obviously, we would need to expect significant recovery in any such investment. So it would either require additional collateral or something we felt very strongly about in isolation. But I think it's something that, given our already outsized exposure, we would obviously need very significant support from the investment committee to make any additional investment. I would say it's not something that we're planning on doing at this point.

Okay. Any chance you could update us on what your -- as you've gone through this process, a current LTV looks like?

I think a lot of it will depend on sort of the final stage of modification for this property. In terms of the capital performance, obviously, they continue -- as we mentioned, there's continued increase. But in terms of what the final long-term run rate for the property will look like, it's still highly variable at this point. So, we haven't restruck the LTV at this point. But obviously, we're looking for a finalized structure that gives the property enough time to fully recover, as well as giving it the ability to refinance. We definitely feel the time has been beneficial for this project, and we did see some progress with the negotiations towards a resolution. We do feel that the lenders are working together in this instance. And so we do see some progress there. We're hoping that we'll have a more stabilized final capital structure to present in the coming quarter or two.

The next question comes from Trevor Cranston from JMP Securities.

Another question on the non-QM strategy. Can you talk about what you guys are seeing in terms of supply of loans coming out from originators, given how much rates have moved back to? And then in terms of the prepayment speed on the existing portfolio, you mentioned that you expect that to decline. Can you maybe give us a sense as to kind of where you think speeds on that portfolio will stabilize over the next couple of quarters?

Sure. I think supply, having talked to the originations we've been buying from sort of ground to a halt for a couple of weeks as rates jumped. And then recently, we've seen originations pick back up again. I think we were expecting a record year of non-QM production. I think right now, originations are down probably by a third from where they were before rates began to rise. So early first quarter pace is a third lower right now. But I do expect quite a bit of supply. I think it's going to be a shift in the market where we'll see more originators focusing in non-QM as the agency refinance opportunity declines.

So, I'm not expecting supply to increase by that much over the next few quarters. We're already seeing a strong recovery in originations.

As far as prepays, we saw outstanding 30-year prepay declined by 20% in the last prepay report and the refi index. The mortgage bankers refi index is at an extremely low level right now. So, we do expect prepays to decline. I'm not sure exactly to what extent, but it should slow pretty well. I think the non-QM sort of borrower has a little bit more turnover and incentive to prepay than the average borrower, but we do expect prepayments to decline. Like I said, if agency is down 20% and given the time to originate the non-QM loan is maybe 30 days to 45 days versus a couple of weeks for an agency, we should see declines happen pretty soon.

Okay. Got you. And then you guys mentioned that you also made about $40 million of investments in non-QM MBS. Can you say where in the capital stack those investments were and sort of how you view the returns available in secondary market MBS purchases versus acquiring loans and doing your own securitization?

Sure. Yes, Trevor. We've definitely seen the spreads in that new issue and secondary markets widening in concert. So, we did take advantage of that. Targeting, I'd say, similar credit risk profile to the ones that we've originated historically. And it is attractive. I think the majority of the purchases we made were investment-grade rated, very short duration with less extension risk maybe than some of the lower rated subordinated tranches.

So obviously, my goal is staying liquid, staying higher in the capital structure and we do see attractive levered returns on those assets. But I still think our goal is still to have long-term financing via securitizations. So, we view the securities investment as more of an opportunistic rotation as we see opportunities in real time, but still committed to the acquisition and securitization of the whole loans.

The next question comes from Dan Holzclaw from DIA Management Services.

Yes. I do have a question about the recent proposal of a reverse split. I just wonder if you could please explain your rationales, goals and what the plan is if investors fail to approve a reverse split?

Sure, Dan. This is Bonnie. Thanks for the question. Yes, one of the factors that we've considered in recommending this to the Board and they're approving it is diversifying the investor base. So, there are some constraints that institutional investors have based upon the level of stock price. And we felt that a reverse stock split, if implemented, could expand the potential base of investors that could buy WMC. So, that is part of it. If it does not pass, we are obviously operating in a situation at our current levels. And so we'll just continue to focus on our strategy of focusing on a transition and building shareholder value. That's our status quo plans, and we look forward to the results of the vote.

Now, with the current price of the stock, if the plans continue, it's getting to the area of delistment. what would be -- do you see Western Asset stepping in as the manager in supporting the company if the company continues trending towards this level if reverse split doesn't happen?

So Western Asset as the external manager fully does support WMC. They do believe in the fundamental value of WMC. And as you know, we did grant a management waiver for 2022, and we fully expect that they will continue to lend their full managerial support to the entity.

(Operator Instructions) There are no more questions in the queue. This concludes our question-and-answer session. I'd like to turn the conference back over to Bonnie Wongtrakool for any closing remarks.

Thank you, operator. And thank you all again for joining us for today's call. We appreciate your continued interest in WMC, and we look forward to personally connecting with you in the weeks ahead. We hope that everyone has a good rest of the day and remains healthy and safe. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.