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Western Asset Mortgage Capital Corporation (NYSE:WMC)

Q1 2013 Earnings Call

May 15, 2013, 11:00 am ET

Executives

Larry Clark - Investor Relations

Gavin James - President, Chief Executive Officer, Director

Steven Sherwyn - Chief Financial Officer, Treasurer

Travis Carr - Chief Operating Officer

Stephen Fulton - Chief Investment Officer

Analysts

Richard Shane - JPMorgan

Michael Widner - Keefe, Bruyette & Woods

Daniel Furtado - Jefferies & Company

Jim Fowler - Harvest Capital Strategies

Operator

Good day, ladies and gentlemen. Welcome to the Western Asset Mortgage Capital Corporation's first quarter 2013 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 first, I would 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 ended March 31, 2013.

By now, you should have received a copy to today's press release. If not, it is available on the company's website at www.westernassetmcc.com. In addition, we are including an accompanying slide presentation that you can refer to during the call. You can access these slides in the Investor Relations section of the website.

With us today from management are 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 would 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 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 James

Thank you, Larry, and thank you everyone for joining us today for our first quarter 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 COO, 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, our liability profile and future outlook. After our prepared remarks, we will conduct a brief Q&A session.

During the first quarter, we incurred a GAAP net loss of $1.18 per share but generated core earnings of $0.93 per share and declared a dividend of $0.95 per share. Due to the volatility that was seen in the mortgage market during the first quarter, our net book value declined approximately $0.10 to $19.42 per share, inclusive of our Q1 divided as of March 31, 2013.

Quite simply, we saw the equivalent of a perfect storm in the mortgage market during the first quarter, given this past few weeks, we have put in place on our portfolio. In our view, this was the result of the market incorrectly servicing remarks from Chairman Bernanke and believing the QE3 will be coming to an end sooner than expected. It is believed this is only for a short period of time but it was enough to put downward pressure on asset prices and resulted in a declining net book value given the marks on the book value as of March 31, 2013.

Since the end of the first quarter, the market has recognized that it was premature, this assessment of an early end to QE3. As a result, asset prices have partially recovered and we have seen some rebound in our book value during the second quarter.

Our experience in the first quarter provide some good insight into our investment philosophy. We position our portfolio for optimal performance over an entire interest rate cycle. (inaudible) on the direction of interest rates and mortgage market, we generally do not make significant adjustments to our portfolio in response to short-term fluctuations in interest rates or market pricing. Despite the market's premature belief in an early end to QE3, we maintained our view that the Fed will remain accommodative in to the foreseeable future. However the experience in the first quarter illustrates the volatility that can occur in any one particular quarter during an interest rate cycle.

It is important to note that our primary focus is to generate a consistent dividend for our shareholders while we are making short-term trades in the portfolio in an attempt to increase book value on a quarter-to-quarter basis. We believe in the philosophy of putting the cash in the hands of our shareholders and allowing them to make their own decisions on how to deploy that capital.

Even with our performance in the first quarter, when taking the longer-term perspective, which takes into account the interest rate cycle we have experienced since our IPO in May 2012, we have delivered an economic return of 15.5% on an annualized basis calculated by reference to the change in book value plus dividends since the IPO. This performance placed the WMC at the high end of our peer group over that time period.

While there may certainly be other quarters in which the market amply moved against our positions and of course we cannot guarantee any results, we are confident that over the entire interest rate cycle we will be able to generate a consistently strong dividend for our shareholders while maintaining a stable book value.

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

Steven Sherwyn

Thanks, Gavin. Good morning, everyone. I will discuss our financial results for the first quarter ended March 31, 2013. Except where specifically indicated, all metrics are as of that date. On a GAAP basis, we incurred a net loss for the quarter of approximately $28.5 million, or $1.18 per basic and diluted share. Included in the net loss was approximately $55 million of net unrealized loss on RMBS and other securities approximately $14 million of net realized loss and other loss on RMBS and other securities and approximately $15 million of net gain on derivative instruments and so-called linked transactions.

As a point of clarification, under GAAP linked transactions occur when the initial purchase of a financial asset and repurchase financing are entered into contemporaneously with or in contemplation of one another. The company records the initial transfer and repurchase financing of a linked transactions on a net basis although in fact as an economic matters these arrangements are identical to transactions accounted for as repurchase transactions for similar transaction to more assets.

As of March 31, 2013 we owned approximately $57 million of non-Agency RMBS and had approximately $44 million of repo borrowings that were considered linked transactions resulting in an approximately $23 million line item on our balance sheet. For the quarter, our core earning would be a non GAAP number defined as net income or loss 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, one-time events pursuant to changes in GAAP and other non-cash charges was approximately $22.6 million, or $0.93 per diluted share.

Our net interest income for the period was approximately $28.6 million. This number is a GAAP number and does not include the interest we received from our IO securities that are treated as derivatives nor does it take into account the cost of our interest rate swap both of which are included in the gain on derivative 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, interest we received from linked transactions and taking into account the cost of our hedging was approximately $26.1 million. Included in this calculation was approximately $57.1 million of coupon interest offset by approximately $21.1 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 non-Agency RMBS and IO securities as well as the fully hedged cost of financing was 2.17%, reflecting 3.04% gross yield on our portfolio and 0.87% effective cost of funds. Our operating expenses for the period were approximately $3.9 million which includes approximately $1.7 million for general and administrative expenses and approximately $2.1 million in management fees. Including these expenses were incremental costs pertaining to the discovery and resulting corrective actions we took regarding the net royalty that was used to accrete interest income and to amortize the cost basis of certain of the company's residential mortgage-backed securities. Our net book value decreased by approximately 10% during the period from $21.57 on December 31 to $19.42 on March 31, after adjusting for the $0.95 dividend that we declared on April 1.

As Gavin mentioned earlier, this decline in net book value was primarily due to a combination of mortgage spread widening and pay-ups declining during the quarter which is then partially reversed during the second quarter. Our economic return which as previously noted, represents the change in book value plus dividend, for the quarter was -negative 6%, which includes the aforementioned $0.95 dividend. From the approximately 10.5 months since our IPO we have generated an economic return of approximately 15.5% on an annualized basis.

During the first quarter, our constant prepayment rate or CPR for our Agency RMBS portfolio was 3.4% on an annualized basis. This compares to 3.6% for the fourth quarter of 2012. The CPR for our Agency RMBS portfolio for the month of April 2013 was also 3.4%. Our CPR continues to remain low as a result of our focus on buying securities that exhibit low prepayment characteristics.

As of March 31, the estimated fair value of our portfolio was approximately $4.4 billion and we borrowed a total proxy $4.1 billion under our existing master repurchase agreements. Our leverage ratio was approximately 8.7 times at quarter end inclusive of linked transactions and adjusted for the $0.95 dividend. We continue to be in the attractive position of having repo capacity well in excess of our needs.

At March 31, we had master repurchase agreements with 17 counterparties. We continue to receive offers to expand our repo lines from these and other institutions. At the present time, we feel 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 would like to provide a few general remarks on the state of the Agency RMBS market. The outlook for Agency RMBS continues to be favorable. The premature market concern in the first quarter that the Fed would begin tapering its RMBS purchases caused the sector to reprice and even though mortgage spreads have partially recovered from the (inaudible) values remain attractive. It is our belief that the Fed is not moving away from a zero short-term interest rate environment any time soon and they are not done buying mortgages.

We think QE3 will continue at least through 2013. We believe the near zero interest rate environment will continue, even beyond QE3. As the Fed has repeatedly reiterated, the monetary policy will remain accommodative so long as U.S. unemployment exceeds 6.5% and inflation remains below 2.5%.

It is our opinion that the Fed's foremost priority is keeping primary mortgage rates low in order to support economic growth by enabling homeowners to strengthen their finances and lower their monthly expenses. Accordingly when the Fed does start to taper its purchases, we believe that the first area it will pull back from will the treasuries rather than mortgages. Our conviction that QE3 will continue for a prolonged period of time is based on a number of observations.

First, we think that the US economy is still in a fairly tepid shaped at least as it relates to the job market. We believe that the economy will need to create more than 200,000 nonfarm jobs per month in order to demonstrate sustainable growth.

Second, the European economy is still weak and likely to remain so in the near to intermediate term.

Finally, with the Bank of Japan embarking on its own QE program, global interest rates should remain at historic low.

Given this factor of our view on interest rates over the next six to 12 months is that we see a yield curve with near to zero interest rates at the short end of the curve with a higher probability at the long end of the curve declines moderately from its present level. That being said, we recognize that eventually all of the stimulative monetary policy being embarked upon throughout the world will produce its intended results and the global economy will strengthen.

As signs of this become apparent, we would expect the long end of the curve would steepen and if this would occur well before the Fed adjusts short-term rates, we will begin to see tapering out of QE3. Our hedge positions in the portfolio reflects this view and Steve Fulton will provide more detail on our hedging strategy later in the call.

Given the ongoing historically low mortgage rates, we believe that organic refinancing will remain active. However, we don’t expect that the pace of mortgage refinancings will significantly increase from the current level. Industry wide loan processing capacity is still somewhat constrained. Originators remain unwilling to increase capacity due to the heavy investment and the eventual slowdown in activity that will occur when rates finally increase from their historic lows. That being said, there are a few originators that are being aggressive in the market place but we view this as more of a grab for market share rather than an expansion of overall production and capacity.

Our view on policy risk for the mortgage market is that it remains elevated. New leadership at the FHFA will likely lead to more borrower friendly policies, including the expansion of the HARP program. We think that there is a good chance that HARP eligibility will be extended to mortgages that were originated after 2009 thereby creating a whole new cohort of borrowers that will eventually refinance.

Our outlook on QE3, interest rates and the refinancing environment has essentially remained consistent for the last several quarters and we still view prepayments as a primary risk and deterrent towards higher net interest spreads. Given the lower prices of Agency bonds, we continue to view their hedge adjusted carry as attractive, particularly with the type of collateral that we target which are prepayment protected mortgage pools.

Now I will turn the call over to Steve Fulton for further discussion of our portfolio and investment outlook. Steve?

Stephen Fulton

Thanks, Travis. Good morning, and thanks for joining us this morning today. While we are disappointed with the decrease in net book value for the quarter, we are pleased to continue to generate strong core earnings that support our dividend. The level of decrease we had to net book value was magnified by some extraordinary timing for the marks on the portfolio from quarter-end to quarter-end

Putting in perspective, at December 31, 2012 the market was at the 12 month tight in mortgage spreads and a 12 month high in specified pool pay-ups. For March 31, 2013, the market has completely reversed itself. T was at the 12 month high in mortgage spreads and the 12 month low in spec pool pay-ups. In other words, we pretty much saw the worst top to bottom mark-to-market you will likely to have in any one quarter.

The market moved against our strategy during the first quarter but the recovery we have seen so far in the second quarter has given us increased confidence that we are well positioned to generate attractive risk-adjusted returns over the entire interest rate cycle. Our investment strategy remains unchanged, that is to buy call protected securities but opt for the best risk-adjusted carry and hedge them over an interest rate cycle. Since our IPO, we have seen a 10-year treasury rate go from 1.6% to 1.4% to 2.1% back to 1.6% and then to 1.85% at the end of March.

As we have mentioned, during that period, we have delivered a positive economic return primarily for the generation of strong core earnings which has enabled us to pay an attractive dividend. Our hedging strategy remains intact as (inaudible) protect asset value over an interest rate cycle and not meant to produce trading gains on a quarter-to-quarter basis or even the necessarily mitigating small of changes in mortgage spreads and interest rates. We are managing the assets and liabilities of the portfolio to generate attractive risk-adjusted net interest income which enables us to pay high dividends while targeting a stable book value over time.

On the asset side, we continue to make select trades around both, WALA and call protection attributes among various originators where our general theme remains the same, that is the focus on securities with low prepayment characteristics as you can see from our industry-leading low prepayment strategy that continue to work for the quarter. During the quarter we increased our relative exposure to 20-year securities as we believe that they have less extension risk so they exhibit very slow prepayment fees and they tend to be much less responsive to small moves in interest rates. One reason is that the primary to secondary split for these securities is stickier than on -year mortgages.

We have also bolstered our exposure to non-Agencies during the quarter. We continue to believe that over interest rate cycle, it makes sense to own these securities through their effective hedging characteristics and positive securities. We have laid on some TBA securities at the end of the quarter but that more of a placeholder until we located the specified pools that we had targeted.

Now I will turn to some of the specifics of the portfolio. On March 31, 2013, the total estimated market value of our portfolio was approximately $4.4 billion and consisted primarily of Agency mortgages. Our portfolio with weighted towards 30 year fixed rate mortgage pools which represent approximately 68% of the value of total portfolio. As I mentioned earlier, we modestly increased our exposure to 20-year fixed rate mortgage pools during the quarter as it became more attractive on a relative value basis. At quarter-end they represented approximately 20% of our total portfolio. Non-Agency RMBS increased to approximately 5% of the total portfolio, that’s up from less than 1% at year-end. The remainder of our RMBS portfolio consists of Agency interest-only strips, inverse interest-only strips and that sector represents 6% percent of total.

We break down our Agency specified pools by sector. 24% of the total was invested in mortgage pools with MHA loans with high LTVs which is consistent with our investment strategy of minimizing our prepayment risks. The next largest sector was pools with low loan balances at 43% of the portfolio representing new issuance and low WALA represent 10% of the portfolio of the total and the remaining 3% consists of High SATO or Spread at Origination and investor loans.

Our weighted average loan age or WALA of the portfolio was 9.4 months. We continue to believe that managing a WALA ramp is a key component towards keeping our prepayments low. As Steve Sherwyn noted, our CPR was 3.4% for the quarter which compares to an average of 18% for our Agency peers and is reflective of the effectiveness of our securities selection and portfolio management strategy.

For April, we were also at 3.4% CPR. Interestingly the most recent market CPR data shows an increased prepayments at specified pools that were previously thought to be, by some, to be prepayment protected such as GNMA 4.5 originated after 2009 and some of the below 90% LTV MHA originated loans. We don't own any of these stories and expect pools that we have chosen to investment in and continue to experience very low prepayments.

Now turning to the liability side of the balance sheet. As Steve mentioned, we funded our portfolio through the use of short-term repurchase agreements or repos. As of March 31, we have borrowed approximately $4.1 billion under these agreements resulting in a leverage of approximately 8.7 times inclusive of linked transactions. We took leverage down early in the quarter from where it was at the end of December given the pressure on asset price that we experienced but when spreads hit their wides near the end of the quarter which entered the market had become oversold and we added a bit of leverage that increased size of our portfolio.

As of March 31, we had entered into approximately $3.5 billion in notional value of interest rate swaps and swaptions. Our swap and swaption positions represented approximately 85% of our outstanding funding. The swap contracts was an approximate notional value of $2.6 billion ranging in maturities between 18 months and 21 years with a weighted average remaining maturity of 7.9 years and with weighted average fixed rate of 1.4%. Approximately 29% of our notional value of these swap positions are held in forward starting swaps to start approximately 7.5 months forward. Our swaption contract with an approximately notional value of $910 million allow us to enter into swaps that have an average fixed pay rate of 2.5% and an average swap term of 14.9 years. As a result, our portfolio had a net duration of approximately 8/10 of a year at quarter-end.

While the net duration of our portfolio remains modestly positive, the majority of that positive duration has been at the shorter end of the yield curve and we have maintained a slight negative duration at the longer end, albeit somewhat smaller than at the end of December. If we think of the next move and in long-term rates, there is likely to be a modest decline before the begin their eventual path higher.

We have kept the duration of our repos fairly low as we believe repo rates will come down moderately in the near future by which time we will likely extend the duration of our repo book. We have also rolled out the duration some of our swaps as their duration hedge increased as a result of the time that had passed since we first put them in place. We have increased their maturities in order to obtain the higher durations that we originally targeted.

For the second quarter of 2013, we expect incremental net spreads to be in the 185 basis points to 205 basis point range. A lower than average prepayments have helped us generate higher than average gross yields and as we said, we expect slightly lower repo rates going forward. As Steve and Gavin have mentioned, since the end of the quarter, we seen a modest rebound in mortgage spreads and pay-ups for specified pools that have positively affected and impacted the valuations of many of the securities in our portfolio, the increase over the past 45 days is still to reverse some the decrease in net book value that we experienced in the first quarter.

Going forward, our overall goal remains the same. We seek to generate an optimal risk adjusted net economic return on the portfolio over an interest rate cycle for active management of our assets and liabilities. We believe this will translate into strong core earnings which will enable us to pay an attractive dividend while at the same time maintaining a stable book value per share. We have delivered on that goal for the 10.5 months that we have been in operation and are optimistic that we can achieve it again for the full year 2013.

With that, we will now entertain your questions. Operator, can you open up the call?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from the line of Rick Shane with JPMorgan. Please go ahead.

Richard Shane - JPMorgan

Steve, you talked a little bit about how spreads have tightened and pay-ups have rebounded. But one of the things that we have observed that since May that trend has started to soften off a little bit. Where do you think we are versus March 31 and maybe the quarterly peak and where we stand today?

Steven Sherwyn

Nicely spread in the end. They are bouncing around a little bit today. The spreads tightening up a little bit today on the yields of the some of the economic numbers that we just released, PBI and industrial productions and other things. But I would say, in general, we probably retraced about 30%, 35% maybe 40% of the market as we trace about 30% to 40% of its widening that occurred during the first quarter. Spec pool pay-ups have probably rebounded, let's say 25% to 20%. It depends upon which spec pool you are talking about. But as a general number the spec pool pay-ups have bounced about 25% to 30%.

Operator

Our next question is from the line of Mike Widner with KBW. Please go ahead.

Michael Widner - Keefe, Bruyette & Woods

I got a bunch. So I guess I will start with one, jump back in the queue but, I guess on the portfolio, the net size is down about 15%, 12% I guess if we include the payment out there. But I was just wondering if you could comment on that? It’s a pretty sizable reduction in the size of the portfolio which would imply probably some reduction in net interest income available next quarter if we are going to stay there. So just what your outlook is on that and then why the size reduction?

Steven Sherwyn

We reduced the size. We had a couple of different points throughout the first quarter just reflecting and our fact that there was some pressure on spreads. As we got towards the very end of the first quarter, we thought spreads had really overshot, financially we thought spreads have gotten to, never expected that at that time had reacted as much they reacted to the actual end of QE1.

So when you have just a rumor of a potential tapering versus the actual end of QE1 and spreads react the same, we thought that they pretty much overshot a reasonable bound. So we add back a pretty good chunk of our portfolio shrinkage that you saw from the end of fourth quarter to the end of quarter one. So if I give you exact numbers, most of size is probably pretty much replaced but it was towards the end of the year, end of the quarter and the first month in April.

Michael Widner - Keefe, Bruyette & Woods

So that’s interesting but if I tied this back to Rick's question, as we look at MBS prices really across the spectrum pay-ups included, April was a very strong month, MBS prices were up pretty much across the board but since late April and especially over the past two weeks, by our marks almost everything is down and even pay-ups are flattish at best versus where they were at the end of Q1. So I am just curious how to reconcile your comments with what I can see out there in pricing sheets and what I can pull up for Bloomberg pricing anyway. With that, if you were adding MBS back over the past month and that it tanked again, I am not sure how much comfort I should take from that.

Stephen Fulton

Well, basically we added it in early April. For us the month of April was pretty strong month, as you mentioned. It may have given a little bit of that back but actually pay-ups, over the last few days in certain pools, they are different from pool to pool, we have original CR3s versus CQ 3.5 versus 90% LTV 4s and 90% LTV 4.5s. All those pay-ups are bouncing around all over the place.

But for the real call protected securities, the pay-ups continue to, Bonnie [ph] just reminded me of that, if you look at it on a hedged performance basis, mortgages have continued to perform okay in May. Some parts of the mortgage market have given back some of the strong gains in April but net net versus first few months of the quarter, we are still up.

Operator

(Operator Instructions) Our next question is from the line of Daniel Furtado with Jefferies & Company. Please go ahead.

Daniel Furtado - Jefferies & Company

My first question I guess is more of a just looking for confirmation that you are basically at or near zero TBAs in the portfolio today. Then my second question would be, is the longer term play here, based on the commentary I am hearing on the call this morning, feels like to me, we would expect as you anticipate QE3 tapering or before that were to occur, we should see a rotation out of these protected securities into more of TBA type portfolio or is that an incorrect takeaway from what I am hearing?

Stephen Fulton

Well, there is a whole bunch of things that we think portfolio moves we would make in anticipation of the Fed tapering of mortgage purchases. Once again, we still think that’s a long way off. Certainly towards the end of 2013, if not the beginning of 2014. We believe that there is a much greater likelihood that the Fed lowers its purchases of treasuries before it lowers the purchases of mortgages. It is important to keep the overall supply demand characteristics of the mortgage market in perspective. Just look at Fannie and Freddie, there is about $3.8 trillion of Fannie and Freddie securities outstanding. That $3.8 trillion generates annual coupon payments of about $172 billion versus monthly net issuance of about $17 billion, meaning that the existing stock of mortgages both are almost 10 times as in coupon payments as the net issuance is on a monthly basis.

That’s without the Fed. So even without the Fed, its not as though there is some from that supply demand imbalance. If anything, the supply demand imbalance, there is not enough supply of mortgages. The other thing that I think put this in a slightly different position than a lot of our peers is the idea we are global money managers. So we get to talk to a lot of other potential investors and one of the investor groups that we spent a lot of time talking and we manage money for are global central banks.

The 25 largest global central banks have $11 trillion in dollar reserves. Virtually every central bank we talked to throughout the world, throughout Europe, Asia Central America, South America and North America and the Middle East is either making an investment in mortgages or considering an investment mortgages or adding to their already existing investment in mortgages. So there are other pools of money that, quite honestly, over the next one to three years, could easily dwarf what the Fed is doing right now.

Like I said, the net issuance, ex the Fed, is a Fannie and Freddie securities is very close to zero. So it is not as though that without the Fed there is some gigantic supply demand imbalance. With regards to the Fed, the Fed has basically said, the rate they are worried about the most is the primary mortgage rate. Probably the rate they worry about the least is swap spread rates and the 10-year rate is somewhere in the middle. If you just think about the data, the Fed has said, of course Janet Yellen has said, and she is likely to be the successor to Bernanke, as he has decided to leave in January that the Fed is likely to overly accommodate us. But if just think what the data looks like now, nonfarm payrolls last release was 165,000. But compare that to new jobless claims of 325,000. So we are actually adding new jobless claims at twice the level that we are creating jobs.

We have mortgage foreclosure rate of 3.5% versus the historical of 1% but mortgage delinquencies of 7.25 versus the historical of 4%. All of the numbers that we just released were down 4% CPI down 7/10 of a percent. Empire State manufacturing index down 1.4%. Industrial production down, capacity utilization down. One of the most numbers that gets a little press every now and then but I think is really important to look at, it is certainly on Janet Yellen's mind, is underemployment. Under underemployment currently stands at 13.9%. That compares with the recession years of 2003 of under 7%. As we currently have underemployment that is twice of what we had in the early 2000 recession.

These are not numbers that smell or like a sustainable economic recovery. So while the market remains jittery, and the market is always jittery, we think that the odds of the Fed pitching in the towel on the sector, which is the housing sector that is worried about more than any other sector by cutting back its purchases of mortgages is very unlikely. Not impossible but very unlikely. That doesn’t mean that the market is not going to over react. As somebody just reminded me, Europe is of course in trouble again. As you have, sort of an explosion of non performing loans throughout the entire Euro zone.

So our view is that the global economy remains extremely fragile. The U.S. economy, as one person described, it is the least dirty shirt in the laundry but globally, growth is extremely weak, inflation is below the Fed's target. If it is not below the Fed's worry zone, it is well below the Fed's actual target. So once again the thought, and the Fed worries more about the housing sector than any other sector of the economy.

I just think the thought that it is going to pitch in the towel is probably not well founded, and even if they do, there is a limit to how much mortgage spreads can widen. Mortgage spreads are not corporate bonds that can default. They do pay you back at par. When you start looking at mortgage yields versus other benchmark global sovereign securities, you can se why they are still attracted to central banks.

So we don’t think there is going to much of a supply demand issue even if the Fed exited tomorrow, which we don’t actually think is going to happen. So our outlook, it really hasn’t changed all that much. It doesn’t mean that the market is not going to be skittish, the mortgage is not going to reprice. Its zero risk here and there. But our view of how to hedge that for the Spanish market for a price that fits but in our view of how you hedge that is, once we have a consistently growing global and U.S. economy, the first thing that’s going to move is the long-term interest rates.

That’s why we are hedging our mortgages with short duration on the long end of the curve. If we think ultimately that those hedges will work, they didn’t work in the first quarter, but they worked over a cycle. So I apologize for the long winded answer. I expect a lot of information in there but I think all of those things are pretty important to think about.

Operator

Thank you. Our next question is from the line of Jim Fowler with Harvest Capital. Please go ahead.

Jim Fowler - Harvest Capital Strategies

I just wanted to ask you about one of the point. So you commented that you think that the Fed would quit buying treasuries before mortgages. So what I take from that the treasury rates would rise if mortgage treasury spreads don’t change then mortgage rates will rise eliminating some of the need and some of the premium in the prepaid protected securities without any change in the duration. So I wonder if the hedges that you comment about will actually be effective if we just lose the incremental premium on the prepaid protected securities given the current level of rates. I wonder if you could benchmark how much do you think those premiums are relative to where they would normally be?

Steven Sherwyn

Once again, we look at premiums as duration. We don’t really, in other words, one security has a point dollar price higher than other security with the same coupon, that’s just duration that you have hedge. In other words, that point can go zero but they don’t generally won't go below zero. There is actually some call protected securities and some low balanced securities which are maintaining their premium to TBAs even at a discount.

Now, obviously they turnover faster. They default faster. The turnover faster as people move up from $100,000 to $125,000 or $150,000 homes as the economy strengthens. So there will be certain pay-ups that will get hurt. There will be other pay-ups that will actually do reasonably well.

The key is how do you hedge their duration and when rates rise durations extend based in along a steeper curve. So the way to do that, that would hedge that spread duration over interest rate cycle. Once again, not from the one 90 day period to another 90 day period, is negative duration at the long end of the curve and it is also to start to layer in some swaption volatility. In other words, buy swaptions and probably some longer dated swaptions which is (inaudible) three by seven swaption volatility of five by ten swaption volatility. But the point that we think that makes sense to increase our expense is to buy more protection, we will.

It is just that we don’t really foresee that for the next six to 12 months. So having said that, we remain, maybe the duration of the long end of the curve because that’s ultimately where the problems is going to be and we continue to own swaption volatility, even though quite honestly all that’s done is cost us money. But in terms that you have got to pay for it.

Operator

Thank you. Our next question is from a follow up from the line of Mike Widner. Please go ahead.

Michael Widner - Keefe, Bruyette & Woods

So let me ask if you could talk a little bit more about the accounting restatement in the quarter and exactly what, I guess a couple questions related to that. What exactly was the change? Did it change the way you do premium amortization?

Then second. Was there any impact? Because the impact on earnings this quarter? Is there a one-time charge or one-time benefit? Anything like that?

Gavin James

Hi, Sherwyn. Can you get that?

Steven Sherwyn

Let me start with your second question first. The impact was strictly to Q4 and the prior quarters. We discovered the inconsistency towards the end of the first quarter. We made the adjustments for the prior orders. The current quarter, there was no impact on. Basically the methodology that was being used was using the retrospective method of accounting which is appropriate on the Agency portfolio but instead of using actual cash flow, it was effectively taking actual cash flows and spreading out the difference between actual and projected cash flows over the life of the security. That was then impacted and that’s why those changes were made primarily in Q4.

Michael Widner - Keefe, Bruyette & Woods

Okay. So I am a little confused around then what the accounting treatment you guys are using for premium amortization as right now? Is it still forward-looking or is it lifetime or is it backward?

Steven Sherwyn

It is forward-looking. We are using a one-year CPR expectation, comparing that to actual cash flows but it is being modeled with one one-year CPR. The CPRs are updated every quarter and retrospectively adjusted for those updated CPRs.

Michael Widner - Keefe, Bruyette & Woods

So that sounds very similar to what you were doing in the past. The difference being that you are now making more updates based on what was happening in the past but my understanding is you are using a 12 months forward-looking treatment anyway?

Steven Sherwyn

It is the same model as before. Unfortunately the methodology that was being applied with being applied incorrectly. Instead of looking at actual cash flows during the quarter, it was taking the difference between actual cash flows and expected cash flows and spreading them out over the life of the security. If you look at the GAAP literature, you are supposed to actually pickup the full difference in the quarter when it occurs and that’s why the adjustment was required.

Operator

Thank you. I show no further questions. I would now like to turn the call back over to Mr. James for closing remarks.

Gavin James

Well, thanks everybody for listening to the call today. Thanks everybody for their questions. We look forward to seeing you all in person, hopefully in the foreseeable near future and with that we would like to end the call. Thanks very much.

Operator

Thank you. Ladies and gentlemen, this concludes Western Asset Management's conference call. Thank you for your participation. You may now disconnect.

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