Let's take a good look at the performance of Western Asset Mortgage (WMC). It is under pressure today (8/19) following another two day rally in the ten year Treasury. Is it time to panic? This stock, along with my two other top mortgage real estate investment trusts (mREITS) holdings, Annaly Capital (NLY) and American Capital (AGNC), has plummeted in 2013, which has primarily been in response to three key concerns. First was the fact that the Federal Reserve may slow or cease its mortgage asset purchases sometime this year. Second was the fear that rising interest rates (as we are seeing today) will crush portfolio holdings of the mortgage real estate investment trusts (mREITS). Third, there have been some true issues with quarterly performances. In recent pieces I have examined the NLY situation, as well as that of AGNC. I recommended them as buys at the time, reiterate the buy rating here, and have opined recently which of the two I think is better right now.
In this article, I will discuss and put into perspective my third largest mREIT holding WMC's most recent quarter and lay out why I believe shares are undervalued and heading higher over the longer term. I most recently opined on the stock in July when it got hammered after a dividend cut that was not nearly as bad as some had expected. Having studied AGNC and NLY closely but having opined on WMC in the past, I have been asked by several readers my overall opinion of WMC. Therefore, I'd like to go over the key takeaways from the most recent quarterly report that investors should focus on to honestly assess if my decision to buy this stock on the way down was wise.
Key Headline Statistics From Earnings - Not Looking To Good
A lot of traders move stocks based on the headline numbers only. While I agree those are important as they give you an indication of the company's performance, they can be misleading at times. However, I would be remiss if I did not provide them. Overall, it looked pretty ugly at first. WMC reported a nasty $1.14 comprehensive loss per common share, comprised of $0.94 in net income per common share as well as a $156.3 million of net unrealized losses on residential mortgage backed securities. This equates to an overall loss of $27.7 million for the quarter. While the news left a lot to be desired, we really need to look under the hood to understand where we are going from here.
The Spread on Interest Rates, A Critical Metric
With interest rates moving wildly during the quarter ending in June, I had honestly expected the interest rate spread to actually improve as I believe that the cost of borrowing would rise at a slower pace compared to the yield being returned from investments. Well, I was wrong. The interest rate spread was essentially stagnant. To my surprise, WMC reported a net interest rate spread of 2.18%. Basically, it didn't change from the first quarter at all, which was reported 2.17%. This spread is still incredibly large. For comparison purposes, AGNC's spread was 1.86% and NLY's 0.98%.
Let's look at this a bit more to see where the assets and yields stand. First, WMC's asset yield on its agency security portfolio for the quarter was 3.14%, compared to 3.04% for the first quarter. Furthermore, WMC's average cost of funds (derived from the cost of repurchase agreements, other debt and interest rate swaps) increased 15 basis points to 0.96% for the second quarter, from 0.87% for the first quarter, due to higher average swap costs associated with entering into longer dated swaps during the quarter.
To put this all into perspective, the cost to borrow rose but the average yields did as well. Thus, earnings potentials as a result from the interest rate spread alone have not changed. In fact, 2.18% for the overall spread is incredibly strong and in this business we want this number to be as high as possible. This statistic is one of the first things I examine when looking over the performance of any mREIT. Overall, it was strong, but I expected the spread to widen.
The Dividend Affordable?
While we have known about the declared dividend for a while when it was announced in June, let's look under the hood of this number a bit. To be honest, I didn't think WMC could afford it. I was worried. The dividend of $0.90 per share was down 5.5% from the last dividend of $0.95 per share. It should be noted that this number was actually better than expected as it was widely believed that the dividend was going to be cut to a $0.85 or less among some of my fellow REIT experts. Some were opining it could drop as low as $0.75.
Since inception WMC has declared and paid total dividends of $84.7 million or $4.20 a share. Looking under the hood now, it would appear that the dividend was nearly all of WMC's core earnings per share of $0.94 Many are focused on the net earnings number, which was a loss. Much of this loss was due to unrealized losses, not actually booked losses. There is some cause for concern as an actual loss may have to be taken, but while the dividend paid was definitely up against this core earnings number, WMC did have sufficient cash to pay it. At a current share price of $14.75, this represents a still sizable yield that WMC has been known for of 23.6%. It is important to note that this dividend can certainly fluctuate moving forward, and with interest rates moving higher in the last few sessions, it is likely that we can expect this dividend to stay at current levels or decline slightly further for the time being.
In The End Book Value Drives The Share Price
Book value is ultimately what should drive the share price of the stock price of the mREITS. Essentially, you want to buy when the stock trades below book value and sell when stock price gets too far ahead of book value. This assumes that book value will remain relatively stable, or in the case of buying below book value, rising. With the extreme volatility over the last few months, book value was anyone's guess. But my readers know that I was adamant that WMC was trading well below book value when I last opined on it. Well, as it turns out, book value dropped as expected, but as of June 30 the stock was actually right at tangible book value.
On June 30, the stock was trading around $17.36. The book value was reported to be $17.39, which was a $2.03 drop from the end of Q1. However, it also meant that the stock was trading about at book value, indicating at the time it was an even money purchase (meaning no discount or premium to book value). Much of the book value decline was due to the volatility in the mortgage-backed securities (MBS), and such many investors and traders we just dumping the stock for fear that it could have been much worse. Barring the last two trading sessions, MBS prices and interest rates were relatively stable over the last few weeks. It is likely that the bleeding in book value has slowed down, though the last two sessions could be an impact. If the rates can remain stable, then we could safely conclude that book value would likely be stabilized as well. One other item is worth mentioning. While others were trading at a discount to book value, WMC was not. This could mean that investors are more hopeful about the mid-term to longer term performance of the stock, and thus did not sell it down to a level that was 10%-15% below book value like we saw with other competitors. Since June 30th however, the stock is down nearly $3.00, or 20%.
Call Me Crazy But The Fed Is No Reason to Worry
As we can see, WMC can stand on its own two feet. We now have two transitional quarters behind us and being a shareholder has been absolutely painful. I began accumulating and completed a position on the way down today with my last purchase at $14.65. During the last few months, a lot of criticisms I received were surrounding the Fed and how devastating its exit will be. Let me be clear: Upon the release of the June FOMC meeting minutes, combined with Ben Bernanke's comments in Boston following their release, it is clear that every member except one had advocated for an extension of the Fed's current economic stimulus program. A few weeks ago the Fed met once again, and their accommodative stance remains in place because the economic data just isn't that strong.
The Fed is not advocating for tapering of asset purchases ahead of stable economic news and/or meeting the economic goals laid out when the program was announced. So the fears of this issue that partially punished the mREITs are simply unfounded right now. Among the most important takeaways is that FOMC was adamant that the low-rate situation, or the zero rate interest policy (ZIRP), will not change until the unemployment rate drops to 6.5%. This is not likely until late 2014 or 2015. Furthermore, Ben Bernanke said that the current unemployment rate of 7.6% might be overstating the "health of the labor market," and as such "highly accommodative monetary policy for the foreseeable future is what's needed."
Conclusion - DON'T Panic
The quarter was tough, no doubt about it. Today's action reminds us of the pain that we have been experiencing. It's natural to want to panic and drive out the last of the weak hands after a day like today. That's how bottoms are formed. I think it would be very fool hearty to sell now after the massive declines. I cannot however say it has not been painful. However, the company has had a lot of time to adjust their strategy, come up with hedging plans and properly rebalance the portfolio. The big headlines from earnings were pretty nasty in terms of the losses. However, two of the most important items to consider with the mREITs were reported to be strong by WMC. First was the interest rate spread. This is the brightest spot for this stock. The company makes a killing from its deals. While the spread did not rise as I thought it would, it didn't decline really either. It remained stagnant, but profitable nonetheless. Second was book value, the measure of which should properly determine the share price of your mREIT and be used as a basis for deciding whether to buy or sell. It declined heavily much like its competitors but was still less than many in the REIT analysis world expected. Given the ongoing profit potential and the overreaction we have seen in the stock in the last two days due to the ten year and MBS prices, WMC is a buy at these levels.