Western Asset Mortgage Capital Corporation's CEO Discusses Q4 2012 Results - Earnings Call Transcript

Mar. 6.13 | About: Western Asset (WMC)

Western Asset Mortgage Capital Corporation (NYSE:WMC)

Q4 2012 Earnings Conference Call

March 06, 2013, 11:00 AM ET


Gavin L. James - President and CEO

Steven M. Sherwyn - CFO and Treasurer

Travis Carr - COO

Stephen P. Fulton - CIO

Larry Clark - IR


Richard Shane - JPMorgan

Daniel Furtado - Jefferies & Company

Michael Widner - Keefe, Bruyette & Woods

Boris Pialloux - National Securities


Good day, ladies and gentlemen. Welcome to the Western Asset Mortgage Capital Corporation's Fourth Quarter and Year End 2012 Earnings Conference Call. Today's call is being recorded and will be available for replay beginning at 5.00 P.M. Eastern Standard Time. At this time, all participants have been placed in listen-only mode, and the floor will be open for you questions following the presentation.

Now, I'd like to turn the call over to Mr. Larry Clark, Investor Relations for the company. Please go ahead, Mr. Clark.

Larry 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 three months and year-ended December 31, 2012.

By now, you should have received a copy to today's press release. In addition, we're including in the company a slide presentation that you can refer to during the call. You can access these slides in the Investor Relations section of the website at www.westernassetmcc.com.

With us today from management are Gavin James, Chief Executive Officer; Steven Sherwyn, Chief Financial Officer; Stephen Fulton, Chief Investment Officer; and Travis Carr, Chief Operating 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 impended 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 risks factors section of the company's reports filed with the Securities 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 Gavin James, Chief Executive Officer.

Gavin L. James

Thank you, Larry, and thank you all for joining us today for our fourth quarter and year-end earnings conference call. I will begin the call by providing some opening comments. Steve Sherwyn, our CFO, will then discuss our financial results. Travis Carr, our Chief Operating Officer, will discuss the current trends we are seeing in the Agency RMBS market. And then Steve Fulton, our Chief Investment Officer, will provide an overview of our investment portfolio and liability profile and future outlook. After our prepared remarks, we will conduct a brief question-and-answer session.

We are very pleased with the results that we achieved today as a publicly traded mortgage REIT. From the IPO which was completed on May 15, 2012 through December 31, 2012, we have delivered an annualized economic return on book value in excess of 32% comprised of $2.35 a share in dividends and $1.67 per share increase in book value. $2.35 in dividends that we declared represented an annualized yield of 18.8% on the IPO price of $20. And the increase in book value represented a 13.3% annualized return.

We're proud that we were successful in achieving our goal of generating a very attractive dividend which was supported by strong core earnings from the portfolio while at the same time delivering an increase in book value. We also completed a follow-on offering in October raising over 300 million in new equity, bringing our total capital raise in 2012 to over $500 million.

Our strong performance in 2012 was delivered against a backdrop of continued historical low interest rates, massive intervention in the mortgage market by the Fed and ongoing implementation of the government-sponsored HARP program, all of which resulted in the elevated mortgage refinancing and prepayments. Our results are due to the hard work and dedication of the entire Western Asset Agency RMBS team. As we believe that our years of experience in the mortgage sector and our deep bench are key competitive advantages.

Let me now turn to a few fourth quarter highlights. We generated strong core earnings of $1.05 per share and increased our regular quarterly dividend by 6% to $0.90 per share and paid an additional dividend of $0.22 per share. Our annualized economic return on book value for the quarter was 18.9% which we define as change in book value during the quarter plus the fourth quarter dividend expressed as an annualized percentage of beginning book value.

In addition, during the quarter we made some initial investments in non-Agency RMBS with purposes of seeking to assist in hedging against higher interest rates. Steve Fulton, our CIO, will go into more detail regarding our approach to this sector of the RMBS market and the role that these securities have in our portfolio.

Looking forward to 2013, we see a number of factors that would influence the RMBS market such as the Fed's continued purchase of agency securities, a gradually improving economy, a housing recovery that is well underway, continued low short-term interest rates but moderately higher long-term interest rates and ongoing HARP refinancing activities.

Our goal at Western Asset Mortgage Capital Corporation will be to maximize the risk adjusted net economic return delivered to shareholders, primarily the strong core earnings resulting in attractive dividends while maintaining or increasing book value per share.

At this time, I'm going to turn the call over to Steve Sherwyn, our CFO, to discuss our financial results.

Steven M. Sherwyn

Thanks, Gavin. Good morning, everyone. I will discuss our financial results for the fourth quarter ended December 31, 2012. Except where specifically indicated, all metrics are as of that date. Our net income for the quarter was approximately $24.8 million or $1.04 per weighted average diluted share. Our core earnings, which is a non-GAAP number defined as net income excluding net realized and unrealized gains and losses on investments, net unrealized gains and losses on derivative contracts and non-cash stock-based compensation expense, was approximately $25.1 million or $1.05 per diluted share.

Our net interest income for the period was approximately $30.6 million. This number is a GAAP number and does not include the interest we received from our IO securities or treated as derivatives. Nor does it take into account the cost of our interest rate swaps both of which are included in the gain loss on derivatives instruments line in our income statement.

On a non-GAAP basis, our net interest income including the interest we received from IO securities treated as derivatives and taking into account the cost of hedging was approximately $28.2 million. Included in this calculation was approximately $55.6 million coupon interest offset by approximately 18.1 million of net premium amortization and discount accretion.

Our weighted average net interest spread for the quarter which takes into account the interest that we received from IO securities as well as the fully hedged cost of financing was 2.05%, reflecting a 2.86% gross yield on our portfolio and a 0.81% effective cost of funds. Our operating expenses for the period were approximately $3.2 million which include approximately 1.3 million of general and administrative expenses and approximately 1.9 million in management fees.

In addition to core earnings, we also had approximately 12.6 million of net realized gains as a result of modest repositioning of our portfolio which were offset by $10.9 million of realized losses on interest rate swap as we terminated some agreements early and entered into longer-dated swaps in a move to extend the duration of our liabilities.

Our net book value decreased by less than 1.5% or 1% in the period to $21.76 on September 30, to $21.67 on December 31. Our relatively stable book value performance was better than the agency REIT peer group average decline of 4% and was primarily attributable to our negative duration at the long end of the curve, which helped us in a quarter that saw moderate widening of spreads.

During the fourth quarter, our constant prepayment rate or CPR for our Agency RMBS portfolio was 3.6% on an annualized basis. This compares to 4.1% for the third quarter. CPR for our Agency RMBS portfolio for the month of January 2013 was 3.1%. Our CPR continues to remain low as a result of our focus on buying securities that exhibit low prepayment characteristics.

As of December 31, the estimated fair value of our portfolio was approximately $5.2 billion and we had borrowed a total of approximately $4.8 billion under our existing master repurchase agreements. Our leverage ratio was approximately 9.2 times at year end.

We continue to be in the attractive position of having repo capacity well in excess of our needs. At year end we had 14 master repurchase agreements and currently we have agreements with 16 counterparties. We continue to receive offers to expand our repo lines in these and other institutions. At present, we will comfortable with our existing counterparties and believe that we have more than ample liquidity to meet our present and expected funding requirements.

With that, I will now turn the call over to Travis Carr. Travis.

Travis Carr

Thanks, Steve. I'd like to provide a few general remarks on the state of the Agency RMBS market. The outlook for Agency RMBS continues to be favorable from a technical standpoint as net supply is expected to remain moderately negative and demand is strong. The Fed is buying approximately 70 billion of Agency RMBS per month and is targeting generic, low coupon, newly originated mortgages.

QE3 has helped keep mortgage rates low as reduced volatility in the agency sector of the RMBS market and has caused spreads to compress. There has been some recent concern in the market that Fed may end its purchase program earlier than previously anticipated. However, Chairman Bernanke's brief semi-annual address to Congress, he indicated the program would continue and that short-term interest rates would remain low until there was substantial improvement in the outlook for the labor market which has been defined as an unemployment rate that approaches 6.5%.

As a result of these historically low interest rates and the ongoing HARP program, industry-wide mortgage refinancing increased in the fourth quarter and consequently prepayment speed picked up. However, since the beginning of the year, there has been more data pointing to a gradually improving economy and the bond market has reacted by pushing the 10-year treasury rate up 40 basis points to 2% from its levels in mid December.

While the 10-year rate has backed down to around 1.9%, the run up did cause early indicators of refinancing activity to subside. Our view on interest rates for the next six to 12 months is that we see yield curve with near to zero interest rates at the short-end of the curve with moderate steepening at the long-end of the curve as the economic recovery proceeds. Our hedge positions in the portfolio reflect this view and Steve Fulton will provide more detail on our hedging strategy later in the call.

Lastly, the housing market continues to show signs of recovery with both higher sales volume and higher home prices in many markets across the country. As a result of these factors, the Agency RMBS market is sold off moderately and spreads have widened since the first of the year, giving back some of the gains that were achieved in the fourth quarter of 2012. Given the lower prices of agency bond we view their hedge-adjusted carry is attractive particularly with the type of collateral that we target which are prepayment protected mortgage pools.

While there is a potential for lower mortgage refinancing activity as long-term rates increase, we still view prepayment as a primary risk and deterrent towards higher net spreads.

Now, I'll turn the call over to Steve Fulton for further discussion of our portfolio and investment outlook. Steve.

Stephen P. Fulton

Thanks, Travis. Good morning. Thanks everybody for joining us on our call today. We are pleased to report that our portfolio performed within expectations for the fourth quarter and generated strong core earnings, enabling us to increase our regular dividend while maintaining a stable book value in an environment of modest spread widening in the RMBS sector.

These results were due to a combination of our active asset and liability management. On the asset side, we continue to make select trade around both WALA and call protection attributes but our general theme remains the same and that was to focus on securities with low prepayment characteristic. As you can see from our industry-leading low prepayment strategy worked well for the quarter.

On the liability side of the balance sheet, we've been concerned about higher long-term interest rates and therefore assembled a longer-dated swap position than most of our peers. While the net duration of our portfolio has been modestly positive, the majority of that duration has been at the shorter end of the yield curve. We've maintained a negative duration at the longer end. This strategy served us well in the fourth quarter as it helped managed the impact of widening spreads on our portfolio.

Additionally, we took an initial position in non-Agency RMBS in the quarter as we view the securities as a hedge against higher interest rates resulting from an improving economy and we believe it will perform well in a recovering housing market.

Lastly, in the fourth quarter, we took advantage of what we view as an attractive opportunity in the TBA or dollar role market. We have since exited that segment of the market as the opportunities have become less compelling to us and we continue to monitor the TBA market and we'll opportunistically participate in it when we see the economics as being attractive.

We understand the TBA market through our over 25 years of experience with it. TBA can be more difficult to hedge in specified pools, so they pose some incremental convexity risks that we presently prefer not to take on. We will consider dedicating a portion of our portfolio to them when we believe they represent a medium to long-term opportunity but at the same time can be hedged effectively.

Now I'll talk a little bit the specifics of the portfolio. So as of December 31, 2012, the total estimated market value of our portfolio was approximately 5.2 billion and consisted almost exclusively of agency mortgages. Our portfolio was heavily weighted towards 30-year fixed rate mortgage pools which represent approximately 87% of the value of the total portfolio.

We modestly reduced our exposure to 20-year fixed rate mortgage pools during the quarter as the yield curve steepened and it became less attractive on a relative value basis. The new end, they represent approximately 6% of our total portfolio. The remainder of our RMBS portfolio consists of agency interest-only strips, inverse interest-only strips and fixed rate CMOs in the aggregate amount of 6% of the total. Non-Agency RMBS was less than 1% of the total portfolio as of yearend.

Our hedging business on 30-year mortgages is based on a continued view that they produce the highest hedge-adjusted carry and the current yield curve and interest rate environment. If you break down our agency specified pools by sector, 50% of the total was invested in mortgage pools of lower loan balances which is consistent with our investment strategy of minimizing our prepayment risks, the next largest sector was pools with MHA loans with high LTVs at 35%, pools with a low WALA and a low percentage of third-party originated loans or TPO represent 13% of the total and the remaining 2% consisted of an investor and low FICO loans.

Our weighted average loan age or WALA for the portfolio was 7.1 months. We believe that managing our WALA [ramp] is a key component towards keeping our prepayments low. As Steve Sherwyn noted, our CPR was 3.6% for the quarter which compares to an average of 18% for our agency peers and that is reflective of the effectiveness of our securities selection and portfolio management strategy.

Now turning to the liability side of the balance sheet. As Steve mentioned, the fund of our portfolio for the use of short-term purchase agreements or repos, as of December 31, we had borrowed 4.8 billion under these agreements resulting in a leverage of approximately 9.2 times. We are comfortable taking leverage up to this level at year end due to low volatility and the fact that two of the risk factors that impact the RMBS market prepayments and supply can be fairly muted during the last two months of the year.

In addition, our hedge has allowed us to effectively manage that value at risk. Subsequent to year-end, we've taken leverage back down to the low eight times range which is where we believe the appropriate level is given current market conditions. As of December 31, we had entered into approximately 3.3 billion notional value of interest rate swaps and swaptions.

Our swap and swaption positions represented approximately 69% of our outstanding funding. The swap contracts with an approximate notional value of 2.8 billion range in maturities between 22 months and 21 years, with a weighted average remaining maturity of 7.2 years and weighted average fixed rate of 1.2%. Approximately 25% of the notional value of these swap positions are held in forward starting swaps that start approximately nine months forward.

Our swaption contracts with an approximate notional value of 520 million allow us to enter into swaps that have an average fixed pay rate of 3% and an average swap term of 18.6 years. As a result, our portfolio had a net duration of approximately seven-tenths of a year at yearend.

We maintain our emphasis on longer dated swaps and swaptions as we believe that over the next nine months there will be a gradual increase in long-term rates as the economy continues to improve. But we're currently maintaining a slightly positive duration for the entire portfolio. We have negative duration of the long end of our portfolio as we expect that when rates increase, the long end of the curve will be just unfortunately affected.

For the first quarter of 2013, we expect incremental net spreads to be in the 175 basis points to 2% range, our lower-than-average prepayments that helped us generate higher than average gross yields and we expect slightly lower repo rates going forward. In nearly all of the first two months of 2013, we generally saw the same trends in the RMBS market that we saw in the fourth quarter which contributed to a modest decline in the price for all RMBS securities since the start of the year.

However, over the last several days, there have been a number of developments that have served to create a meaningful increase in demand for specified pools. These developments include Chairman Bernanke's Humphrey Hawkins testimony last week, Vice Chair Janet Yellen's speech to the National Association for Business Economics earlier this week, the Treasury Market Practices Group decision to keep MBS sales to the Agency MBS sales charge rate impacted 2% which was announced on March 1. And of course the recent capital raises that have taken place in the mortgage REIT sector that have increased the overall levels on demand.

Selectively, these developments have resulted in higher [payoffs] for specified pools and the positively impact in evaluations of many of the securities in our portfolio. The increase over the past several days has served to revert some of the decrease we've seen in our book value since the beginning of the year.

On a final note, I want to discuss in more detail our approach towards non-Agency RMBS. We are constantly evaluating the entire RMBS market for attractive risk-adjusted opportunities and as such non-Agency securities are considered part of our target assets. As I mentioned earlier, we purchased our first batch of non-Agency, primarily as a cost effective hedging vehicle against higher interest rates. Subsequent to year end, we increased our exposure to this sector of the market as we saw good relative value opportunities and to put it in perspective non-Agency RMBS presently represents less than 5% of the fair value of our total portfolio.

We will rely upon Western Asset's non-Agency RMBS team to determine the specific securities that we purchase. Most of their asset has been investing in this non-Agency RMBS sector for over 25 years, has a proven track record over that time. They were also one of the nine teams chosen by the U.S. Government to participate in Public-Private Investment Program or PPIP for non-Agency securities. So depending upon market conditions and our view of the relative value, non-Agency RMBS will from time to time be included in our portfolio.

Going forward our overall goal will not change and it will be to generate an optimal risk adjusted net economic return on the portfolio within the universe of the entire RMBS market into active management of our assets and our liability. We believe that this will translate into strong core earnings which will enable us to pay attractive dividend while at the same time maintaining our increasing book value per share. We've delivered on this goal for 2012, we are optimistic that we can achieve it again in 2013.

With that, we will entertain any and all questions.

Question-and-Answer Session


Thank you very much. (Operator Instructions). Our first question does come from the line of Rick Shane with JPMorgan.

Richard Shane - JPMorgan

Thanks, guys. Good morning. Can you hear me?

Gavin L. James


Richard Shane - JPMorgan

Excellent. One sort of housekeeping question. What was the actual cash payment on the hedge on swaps this quarter?

Gavin L. James

Like in dollars?

Richard Shane - JPMorgan

In dollars, yes?

Gavin L. James

We have to get back to you on that. I don't have the exact number in front of us. Steve, you…?

Steven M. Sherwyn

I don't have it in front of me either.

Gavin L. James

Rick, we'll get back to you on that.

Richard Shane - JPMorgan

Okay, great. Will circle you guys on that. And then I just like to make sure I fully understand the swaption transaction. It all makes sense to me. It's very consistent with what you guys are describing in terms of your expectations on rate and I'm thinking that probably average fixed pay for that -- for 18 to 20-year paper now is probably a little bit – 20 or 30 basis points below the 3% you're showing here. I guess what surprises me is the short duration of the expiration date on that. Should we see this as more still risk management or is this a swaption that you actually ultimately plan to exercise?

Steven M. Sherwyn

I mean swaption basically affects two things. They hedge duration and they hedge convexity. If you look at swaption volatility, it's at multiyear lows although it's not as low as it got sort of in the late 2003 to 2007 period. So it's just one of the many tools you can use to hedge your risk factors. There's three risk factors in a REIT and those risk factors are duration, convexity and spread duration.

And swaptions are simply that, they are a method to hedge some of your convexity risks and to add some type of duration protection. In terms of whether or not we would exercise it, I mean we wouldn't exercise it unless it was in the money and we might not if – like either just sell it. So these are just hedges. Swaption is the right to pay a fixed rate, not an obligation to pay a fixed rate and it's an asset that's mark-to-market on book value on a daily basis. But it's just one of the tools we use in hedging.

Richard Shane - JPMorgan

Got it. And just to maybe bring it to a slightly finer point, why the relatively – and I may not know enough about that market in terms of what's available, but it strikes me that if you're hedging long-term higher rates that the expiration date on this seems relatively short?

Steven M. Sherwyn

Well, there's essentially two types of volatility; there's gamma and vega, gamma being for the short-term volatility kind of three months to a year and vega being longer term volatility. So the length of time of the option is not necessarily correlated to the part of the curve that it hedges. So the length of time that being a year when we entered into these contracts and now, I don't know, roughly nine months or something like that, this reflects our desire to hedge to gamma which is short-term volatility as opposed to vega which is longer term volatility.

Richard Shane - JPMorgan

Okay. Steve, I'll circle back with you on this little bit. I think there's some details I need to understand better.

Steven M. Sherwyn


Richard Shane - JPMorgan

Thank you.


Our next question does come from the line of Daniel Furtado with Jefferies & Company.

Daniel Furtado - Jefferies & Company

Good morning, everybody. Thank you for the opportunity. The first question I think is relatively straightforward and that's, is it safe to assume and I apologize if I missed this, but is it safe to assume that your forward starting swaps are all tenure and tenor?

Gavin L. James

No. Everything's from three years to 20 years.

Daniel Furtado - Jefferies & Company

Okay. And then the second thing is…

Gavin L. James

On average, they're 18.6 years.

Daniel Furtado - Jefferies & Company

The averaging starting swaps are 18.6 years.

Gavin L. James

Now keep in mind, I was [supposedly] doing the forward starting swaps. Once again, those just represent duration hedges and spread duration hedges. You don't have to -- like in other words if you enter into a swaption, a one-year swaption, you're always going to be struck at the forward swap curve and it's going to be, say, a 10-year swap one year forward. So this really isn't that different than a swaption.

In other words, you don't necessarily have to actually pay when these come around. They just serve as duration hedges somewhat of being short of treasury or being short of TBAs. So again, it's one thing that important for people to realize that these are duration and spread duration hedges. They're not necessarily something we actually have to pay on at the time they come due.

Daniel Furtado - Jefferies & Company

Got you. Thank you for that. And then speaking on the liability side, when we look out cost of space we've seen greater use of term debt whether it's preferred, convert, even a private placement recently. How do you think about your capital needs for '13 and the allocation between some type of term debt or more equity or just kind of how you're breaking that down from management's view?

Gavin L. James

Basically we're looking at everything. The straight preferred debt, sort of callable or something that's callable in five years, when it was trading in the 8% type area, it didn't seem that attractive to us. I think that the recent private deal is a very interesting deal. It's much longer term, it's a pretty long duration liability, so a pretty interesting trade. So we're definitely doing some work on that.

But we don't have what I would say capital needs. We'll solicit capital to the extent we think can be deployed in an appropriate risk-adjusted return that increases the value of the overall company to the existing shareholders. I hope that answers your question, but we're kind of looking across all potential capital and which one we think is most appropriate and which one we think is priced more recently, once again providing value to the existing shareholders.

Daniel Furtado - Jefferies & Company

Great. Thank you. Congratulations on a nice quarter.

Gavin L. James



(Operator Instructions). Our next question does come from the line of Mike Widner with KBW.

Michael Widner - Keefe, Bruyette & Woods

Good morning, guys. Just wondering if you could talk a little bit more about how you view the non-Agency roll going forward, particularly in light of some of DeMarco's recent comments and the asset sales we might see out of Fannie and Freddie and just wondering if we can talk about that fairly generally?

Gavin L. James

Sure. I would say DeMarco didn't say anything that we found particularly surprising or unexpected. Once again, the way we view the non-Agency is that we assemble is really as cost effective hedges to higher longer term interest rates that will be accompanied by a generally improving housing market. So we really view them on a portfolio basis, we don't view them really on a standalone basis. What is the risk-adjusted return of a portfolio look at after adding these? That's really the way we look at this.

We consider basically these securities to have negative duration, at least the sectors that we're buying and to exhibit price movements that move inversely to positive duration securities. And then will happen on a day-to-day basis, but we think hedge tail risk, if you will, of a slightly more rapidly improving economy. It's the sector we continue to monitor. We talk daily -- we talk five times a day with our non-Agency team.

We look at the types of ROEs that that sector can generate, where we see forward housing prices, what we think the likely scenario is given our view of forward housing prices, how they correlate with interest rates. So there's a lot of things that go into it. But once again, I guess we view it. I guess I'd say we view a lot of portfolio – from a portfolio standpoint, what does the portfolio look like after we add these things? Does it have a higher risk-adjusted return? If so, we'll possibly add it. If not, we won't. We might sell.

Michael Widner - Keefe, Bruyette & Woods

I mean I guess the real question I have is that I know DeMarco didn't really say much new, but certainly with Fannie and Freddie both selling of 30 billion issuance of assets and multiple types of transactions as they say going forward. I'm just wondering how much you think about that as -- or how much you think you may change or could change based on the assets that come out?

I mean could you see becoming more of a hybrid mortgage REIT from the standpoint of you potentially like the spread opportunity there and particularly if there's not going to be, and then we'll see – how active the buyers are. But I mean spreads on agencies continue to generally get tighter and with the Fed mucking around in there, it's not the most predictable of asset classes. So just wondering -- again, just color on whether you're open to thinking about that as a more meaningful part of the portfolio from a net interest spreads standpoint as opposed to just a hedging standpoint?

Gavin L. James

It's really driven by relative value and I don't see this. I think we're one of the few asset managers that can say with a straight face that we have world-class teams in both sectors. We've been managing non-Agency for a very long time. It's a sector that we're heavily involved in. As I said, we manage for the PPIP, that's public information, where I performance ranks, so you can look it up. But it really is purely relative value.

We will see what they sell, we'll see what it's priced and we'll see more importantly what it does to serve the value at risk of a portfolio that's added and that's really the way we look at it. I don't get too, and maybe we should, but I don't get too hung up on are we a hybrid, are we an agency? We try just to gravitate towards the highest risk-adjusted return with a consistent -- trying our best to hedge all various risks to maintain or increase book value. And I wish I could be more specific about that. It just depends on what trade and what the relative value is with the trades.

Michael Widner - Keefe, Bruyette & Woods

I mean I think that's a good answer and an appropriate answer and the reason I ask is just all the rage these days is -- at least from an investor standpoint and large part is people are looking for more non-Agency concentration because of market perceptions where relative spreads are and really just wanted you guys to give a clear articulation of your view and the fact that -- what is sounds like is you just like the risk-adjusted returns on the agency side better today and you're always open to reevaluating that, but…

Gavin L. James

I can say right now today or yesterday, I think the risk-adjusted returns on the agency side are actually better. Towards the end of the year and towards the -- at the very first part of the first quarter, we definitely saw some select sectors. These sectors are very different from one another. There's securities price from dollar price to the 40 all the way up to dollar price of 105 in the non-Agency sector and they all reflect very different risk reward and duration and hedging positions, they're all very different from one another.

So we don't use one sort of big market. But once again, what we try to is say, okay, if we put these – this group of securities into the portfolio, what does it look like when we're done? Are we sort of better off on an ROE and effective convexity duration or are we worst off? And if we're worst off, we're certainly not going to do it and we would probably look to sell. So right now today, I think the value is actually in agencies.

And I'll tell you what I really think the Fed is up to as I think people are missing it a little bit. The Fed is trying to crush volatility. That's really what they're up to and they are continuing to do that. Of course they want to keep mortgage rates low, but that's really not their primary goal in my view. Their primary goal is to continue to pull volatility out of the market because as you lower volatility on asset classes, you tend to push people further up and people look for – potentially look for risks where they can get a return. So that really to me is what the Fed is up. And that's why we continue to find this such an attractive business opportunity.

Michael Widner - Keefe, Bruyette & Woods

That's certainly an interesting perspective and if that's what the Fed is doing, trying to crush vol so to speak, I'm not sure how successful it's been in the Agency RMBS market just because of the run up in prices ahead of the QE -- most recent QE announcement where they call is three or four, 10 or whatever…?

Gavin L. James


Michael Widner - Keefe, Bruyette & Woods

Yeah. But I mean there's been a lot of vol since then both in Q4 and then quarter-to-date and even in the last couple of days as you've indicated. But the strategy is to crush vol by sucking up all the assets I'm not sure about the relative success. But in any case, I definitely appreciate all the comments and the clarity on the strategy and congrats on a solid quarter and year.

Gavin L. James



Our next question does come from the line of Boris Pialloux with National Securities.

Boris Pialloux - National Securities

Hi. Thanks for taking my question. Just a quick question regarding your leverage. I mean your leverage went up from 8.5 to 9.2. Almost all your peers actually reduced their leverage at the end of the year. So what was the thought process? Second is, are you targeting nine times for 2013?

Gavin L. James

Well, first of all, I'd say a couple of things. The basic concept is we increase leverage over the last two months of the year as we thought there was typically in the last couple months of the year has low volatility due to lower refinancing and lower production. So we temporarily took leverage off as a result and we've reduced the back end through the low [A grade]. It's also important to recognize that leverage is not really the primary risk measurement for a mortgage REIT. It's more of a second over approximation of risk. So the real risk is duration convexity and spread duration.

So we target value at risk, hedge-adjusted carry and risk-adjusted return. So I mean the real answer is that if you have yourself hedged right, you can actually have lower risks in a nine times leverage portfolio than an eight times leverage portfolio. It really depends on what's on your liability side. And I think that shows up in how our book value performed in the fourth quarter. So I'm not trying to give everybody to not ask the question about leverage, it's absolutely an appropriate question. But really the way we think about things is value at risk.

And value at risk depends upon a lot on what you have on the liability side in terms of hedges, especially spread duration hedges and basically how you've hedged both your convexity and duration and where you're partial durations are. So, like I said, I'm not trying to -- it's similar to the comments I've made on duration. I think most of our peers will quote a duration number and that – I got to be really honest with you, that's not a helpful number. It doesn't tell you that much. If you don't know where that duration is, it's really not reflective of risks. So a portfolio with a 0.4 duration in our view can very easily have more risks where that duration is than a portfolio with 0.7 duration. And I would say the same thing with regard to leverage and it really depends on what's on your liability side of your balance sheet and how you hedge the risk characteristic of that extra leverage. So, we took it up reflecting our view of what was on our liability side.

In other words, we thought that what we had and it turns out we were correct. But what we had on the liability side effectively hedged that extra leverage, and it did. But this doesn't mean we're going to run that leverage all the time and subsequently we've taken aback down because we think that's what the current market environment – it makes sense to current market environment. So, I don't know if I've answered your question or not but – and I will say we don't really look at what our peers are doing and we don't really target a dividend, what we target is value at risks. That's what we're looking at and hedge adjusted return, trying to maximize hedge-adjusted return and minimize value at risk and [textbook] value.

Boris Pialloux - National Securities

Okay. Thank you for the color.


(Operator Instructions). Our next question is a follow-up question from the line of Daniel Furtado with Jefferies & Company.

Daniel Furtado - Jefferies & Company

Thanks again. I have a hypothetical for you and I don't know if you care to answer this or not, but if you did have perfect knowledge of the timing of the Fed's exit from QE3, what would your target leverage in asset composition be the day before that announcement was made?

Steven M. Sherwyn

Well, I would be -- we would be long on a tremendous amount of gamma. I don't know that our leverage would necessarily be that low. What we'd try to do is have really effective – we'll just probably take it down to 4 or 5 or something like that. It will depend upon how much we thought we could hedge the resultant widening in mortgages with spread duration hedges. And I think we can. I mean, like I said I think the fourth quarter proves that that you can have things on your liabilities side that actually hedge spread widening.

But the answer to your question is we do a lot of swaption [involved], we'll be very short in the long end of the curve, we'll be short TBAs as the spread duration hedge probably in the very low coupons, 2.5 to something like that. I think we probably target a low to negative spread duration once we've completely taken account. So short to long end, long vol and probably either 1 by 10 or 1 by 20 swaps involved and with more gamma and not vega. And probably net will try to short spread duration.

Daniel Furtado - Jefferies & Company

Great. Thanks, Steve. I appreciate the insight there, very helpful.


At this time, we have no further questions, Mr. James.

Gavin L. James

Okay. Well, thanks everybody for joining us on the call. And again, my thanks to the Western Asset's investment team for a great quarter, great year. We look forward to seeing many of you in the next couple of months as we get out to visit many of our investors and analysts. So, once again, thanks very much.


Thank you very much. Ladies and gentlemen, that will conclude the conference for today. We do thank you for your participation. You may now disconnect your lines at this time.

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Western Asset Mortgage (WMC): Q4 EPS of $1.05 beats by $0.18. (PR)