Western Asset Mortgage Capital Lost Big, But Hedged Well In Q2

Aug.13.13 | About: Western Asset (WMC)

Western Asset Mortgage Capital Corp. (NYSE:WMC) is a mortgage REIT. It IPO'd May 15, 2012, so it has very little history. However, after the recent "June from hell" and a tough Q1 2013, WMC was able to claim it had delivered an economic return on book value of 8% since its IPO. This is a good statement to be able to make.

WMC's investment strategy focuses on Agency RMBS but it also invests in non-Agency RMBS, CMBS and other asset backed securities. WMC is externally managed by Western Asset Management Company, a global leader in diversified fixed-income management since 1971. This firm has approximately $459B in assets under management. This includes $58B in total mortgage exposure. $39B of this is in Agency RMBS. $8.8B is invested in non-Agency RMBS. $1.3B is invested in CMBS, and $8.8B is invested in ABS.

In Q2 2013 WMC had big losses. It lost $156.3 million in unrealized losses on RMBS and other securities and about $9.6 million in realized losses on RMBS and other securities. However, it had approximately $113.4 million in net gains on derivative instruments and linked transactions. The company generated core earnings of $22.8 million (or $0.94 per basic and diluted share). All told WMC had a net loss of $27.7 million (or -$1.14 per basic and diluted share).

Compared to other mortgage REITs with primarily Agency fixed rate securities, this was a good performance for the "quarter from hell" - Q2 2013. The annualized net interest rate spread on its portfolio was 2.18%. This included Agency RMBS, interest from Agency IO securities accounted for as derivatives, Non-Agency RMBS (including linked transactions); and it took into account the cost of interest rate swaps. Again this beat many of WMC's competitors.

WMC's book value fell about -10.5% from $19.42 as of March 31, 2013, to $17.39 as of June 30, 2013. The economic return for Q2 2013 was -5.8%, which includes the $0.90 per common share dividend. This was ugly, but it was not nearly as bad as it could have been. WMC's hedges worked much better than in Q1 2013. This was a good thing, since WMC has a relative high leverage ratio of 9.4x as of June 30, 2013. This is only 8.2x when you adjust TBA positions out of the calculation.

The table below describes WMC's current portfolio holdings as of June 30, 2013.

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As you can see the non-agency holdings are still a small part of the portfolio. However, WMC does intend for this part of the portfolio to grow in the future.

How did WMC's Q2 2013 performance compare to other primarily Agency fixed rate RMBS mortgage REITs? American Capital Agency Corp. (NASDAQ:AGNC), a leader in the industry, had an other comprehensive income loss of -$6.89 per common share. Ultimately this led to a book value loss of -$3.42 per common share. Its book value fell to $25.51 as of June 30, 2013, from $28.93 as of March 31, 2013. This was an -11.8% loss in book value. This was worse than WMC's percentage loss of about -10.5%.

If you compare AGNC's dividend to WMC's dividend using the August 12, 2013, closing stock prices of $16.45 for WMC and $23.33 for AGNC, then WMC paid a 21.88% dividend ($0.90 per common share annualized) and AGNC paid an 18.00% dividend ($1.05 per common share annualized). In other words WMC outperformed AGNC on this metric. Further, AGNC had a net interest spread for its portfolio of 1.86% (including dollar roll income) compared to WMC's 2.18%. In other words, WMC's dividend is likely to remain higher than AGNC's for the near term.

WMC did even better against a lesser competitor, CYS Investments (NYSE:CYS). CYS lost -$2.67 per common share as its book value fell from $12.87 per common share on March 31, 2013, to $10.20 per common share on June 30, 2013. This was a -$2.67 per common share loss (or -20.7%). This is almost double WMC's book value loss percentage. Plus CYS paid a Q2 2013 dividend of only $0.34 per common share. Annualized this is only 16.64% at CYS's closing price of $8.17 on August 12, 2013. Plus CYS had a net interest rate spread (including drop income) of only 1.36%. This was below both AGNC's and WMC's percentages. In sum WMC outperformed its peers.

It is great that WMC outperformed its peers. However, does that mean it is a good investment going forward? It did lose -10.5% of its book value in Q2 2013. There is no easy or certain answer to this. However, the company has pointed out that interest rates seem to have stabilized for the moment. The 10-year US Treasury note yield chart below substantiates this.

The three month chart of the Fannie Mae 30-year 3.5% RMBS below confirms the stabilization.

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It is easy to see how the mortgage rate increase of about 1% in Q2 2013 led to big declines in the book value of Agency RMBS. However, at the same time the mortgage rate increase should lead to increased net interest rate spreads as the volatility in the market decreases. This likely means at least a maintenance of the current dividend. Plus the company thinks the market should be conducive to book value appreciation in 2H 2013.

The economic fundamentals tend to substantiate management's claims. The IMF cut its world economic growth estimate from 3.3% (April 2013) to 3.1% as of July 9, 2013. The World Bank lowered its world economic growth estimate from 2.4% (January 2013) to 2.2% as of June 12, 2013. This does not sound like a backdrop for rampant global inflation in spite of the Fed. Refinancing activity has continued to decrease and the newly higher mortgage rates should only continue this trend in the months to come. There will be fewer new RMBS available in the near term. This too will tend to stabilize the RMBS markets.

There is talk of the Fed tapering in the fall, but much of this is built into current prices (and interest rates). Plus the Fed almost has to taper to keep its participation percentage in both the US Treasuries markets and the US MBS markets approximately the same. The US Treasury is expected to borrow less in 2H 2013. Don't forget we had the 2.9% payroll tax hike this year and the sequester cuts, so the US Treasury should have more income, and it should spend less than last year.

With lower refinancings and still relatively low housing sales, the Fed will have to buy fewer RMBS just to keep its percentage participation in that market the same. Remember there is the highest amount of interest in the "good credit" new Agency home loans. With lower refinancings due to higher mortgage rates, the number of those available will decrease in 2H 2013. Even with a bit of Fed tapering in 2H 2013, the rates of these securities should remain about the same. The expectation of a fall disaster in the RMBS markets is likely overblown.

In the short term (and perhaps the much longer term) WMC looks like a buy. There are any number of problems coming up such as the eventual Fed funds rate raises. However, the Fed has promised this particular item will not occur until mid 2015 at least. When you can collect a near 22% dividend in what appears to be a relatively safe environment, a lot of investors will be inclined to do that. WMC is proving that it is a leader. It deserves strong consideration as an investment.

The two-year chart of WMC provides some technical direction to this trade.

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The slow stochastic sub chart shows that WMC is near oversold levels. The main chart shows that it has been in a downtrend since April 2013. However, it does appear to be bottoming. Plus the fundamentals mentioned above substantiate a bottoming scenario, at least for the near term.

WMC is trading 5.4% below its book value as of the close August 12, 2013. With a nearly 22% dividend and a stabilizing RMBS environment, it is a buy. Further its move into non-Agency securities should help it be more stable in the future. These securities, which are currently trading at huge discounts to face value, should appreciate in value as the housing market slowly recovers. Further the lower availability of new Agency RMBS due to lower refinancing activity (due to higher mortgage rates) should increase the attractiveness of the non-Agency securities. This will likely cause book value increases in the non-Agency securities. Increasing activity in this area should help WMC be more profitable in the future. It should specifically help WMC garner book value as the huge discounts of these securities slowly lessen.

WMC is a buy. It has an average analysts' recommendation of 2.9 (a hold). It has a CAPS rating of four stars (a buy). I think the CAPS rating is more accurate. I'm wary after the huge Q2 losses, but I'm also aware of the adage, "buy where there's blood in the streets". I think everyone saw the blood in Q2 2013. As a result fewer may be inclined to buy in Q3 2013. However, this may be a good time to do so. You will have to monitor your investment every quarter. If you notice interest rates starting to shoot up again, you may want to sell. However, with a near 22% dividend, WMC looks like a buy. Plus the company did remind you that you have not lost money since the IPO price in May 2012.

NOTE: Some of the fundamental financial data above is from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in WMC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.