is anyone, besides the short sellers, making money in the mREITs? Are we at that "blood in the streets" buying opportunity in the mortgage real estate investment trust (mREIT) sector yet? I think that time is approaching, despite all of the fear surrounding a Fed tapering, a rising interest rate environment, etc. The market is valuing these stocks as cow pasture, discounting the portfolio holdings of many companies. In this article I will address the fourth largest mREIT, holding Western Asset Mortgage (WMC), which, like its peers, has also seen a large selloff in the last six months. It has been a while since I have opined on it but I still hold the position in the REIT section of my portfolio. I am writing in response to inquires received after I wrote a very controversial piece where I stated I had sold some of my holdings in Annaly Capital (NLY) and American Capital Agency (AGNC) to purchase an mREIT that currently has better fundamentals, Javelin Mortgage Investment (JMI). I hold large positions in each and opine frequently on them given the action in the sector. But just how has WMC responded to the madness? How were its earnings recently? How is the dividend doing? Is WMC really outperforming NLY and AGNC?
Key Headline Statistics From Q3 Earnings - Much Improved From Q2
Overall, third quarter earnings looked pretty good compared to Q2. Recall that in Q2 WMC reported a nasty $1.14 comprehensive loss per common share, comprised of $0.94 in net loss per common share as well as a $156.3 million of net unrealized losses on residential mortgage backed securities. This equated to an overall loss of $27.7 million for the quarter. In contrast, Q3 things turned around a bit. Net income was $7.5 million or $0.31 per common share. Included in the net income was $37.5 million of net unrealized gain on mortgage backed securities (MBS), $48.5 million of net realized loss on MBS (including other loss on mortgage-backed securities of $2.4 million), and $4.4 million of net loss on derivative instruments and linked transactions. Net interest income for the period was $26.4 million and WMC generated core earnings of $20.1 million, or $0.83 per share. Not too bad, but let's dive a bit deeper.
The All Important Spread on Interest Rates
At the end of Q2, WMC reported a net interest rate spread of 2.18%. Basically, it didn't change from the first quarter at all, which was reported to be 2.17%. This spread is still incredibly large. For comparison purposes, AGNC's spread was 1.86% and NLY's 0.98% at the end of Q2, and both remained stagnant in Q3. For WMC in Q3, the interest rate spread increased 10 basis points to 2.28%. It outperformed AGNC and NLY in this regard, both in the increase and total spread.
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 second quarter was 3.14%, compared to 3.04% for the first quarter. In the third quarter the yield on assets increased once again, 38 basis points to 3.42%. Unfortunately, but much like its peers NLY and AGNC as well as JMI, WMC's average cost of funds (derived from the cost of repurchase agreements, other debt and interest rate swaps) increased 18 basis points to 1.14% for the third quarter, from 0.96% for the second 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 at a greater pace. Thus, earnings potential as a result from the interest rate spread alone have increased. In fact, 2.28% 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. Compared to both AGNC and NLY's reported spread, WMC is outperforming both of them markedly.
The Dividend Affordable? WMC Maintains Dividend, Yield Remains Sky High
While we have known about the declared dividend for a while when it was announced in September, 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 a surprise to me. I expected a cut because that is what everyone else was doing. With all of the negativity we have seen a multitude of dividend cuts. WMC seems to be holding up well in this regard, but for the others the cuts have been large. The largest cut was in JMI, which wisely made a 35% cut to its monthly dividend, and now yields 15.3%. The cut was wise because it now has funds to cover its dividends and is instituting a huge buyback. NLY and AGNC have seen dramatic cuts, and now yield 13.8% and 15.7%, respectively. So what about WMC? It has not seen terrible cuts thus far. In the third quarter, the distribution was still $0.90.
That was not a typo, this dividend was maintained. While my other holdings are all busy slashing dividends, WMC has maintained its dividend at $0.90. Based on the current price of the stock of $16.00, there is a huge draw to WMC in that it currently offers an incredible 22.3% dividend yield. In this regard, it's substantially outperforming AGNC, NLY and JMI. It is now my highest yielding mREIT. It now yields what AGNC historically paid me up until the last few quarters. But is the dividend safe. I really expect a cut coming because it's hard to maintain such a high yield in this environment. Earnings just aren't cutting the mustard here. I think the dividend could be safe if they do a share offering, but that would dilute equity and lead to more dividends being paid out. I don't like this approach. I am bracing for a cut because the yield is just too high. We will find out in a few short weeks where the dividend will go. But, the cut, if any, won't be severe so long as management's transitional plans are executed. This is because the company has a diverse asset mix consisting of residential mortgage backed securities, asset backed securities and commercial mortgage backed securities. Additionally, since the company is moving in the direction of being a hybrid mortgage REIT, it also invests in non-agency RMBS. Further, it will likely be moving into the commercial mortgage business, a trend which many of the residential REITs have been following. Therefore, WMC offers strong diversification within the mREIT sector.
Since inception WMC has declared and paid total dividends of $106.6 million or $5.10 a share. Looking under the hood now, it would appear that the dividend was all of WMC's core earnings per share of $0.83 and then some. The dividends paid were definitely up against this core earnings number, and WMC did have sufficient cash to pay it with carry forward earnings. However, in this environment I do not think it will be sustained, but WMC has surprised me more than once. 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.
Book Stabilizing in The Quarter
Book value is ultimately what should drive the share price of the stock price of 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 declined very slightly during the quarter while AGNC and NLY's declined a significantly higher rate.
On September 30, the stock was trading around $15.99. The book value was reported to be $16.81, which was a $0.58 drop from the end of Q2's $17.39 book value. This is only a 3% drop However, it also meant that the stock was trading at about a 5% discount to book value, indicating at the time it was a good time to purchase. The slight book value decline was due to the volatility in the MBS. One factor to consider is the economic return on book value, defined as the change in book value plus dividends paid. When we run the numbers we see that there was a positive economic return on book value of 1.8%. The same cannot be said of AGNC and NLY, which saw negative returns.
The month of October and most of November have seen a lower interest rate environment and more stable moves in the rates compared to July and August. It is likely that the bleeding in book value has ceased and book value could even rise. 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. WMC historically updates the book value of the company when it releases its dividend announcement. Thus, my theory of a stable or increasing book value will be proven right or wrong in just a few short weeks.
WMC Can Handle Rates Rising Slowly
Way back in June I opined on WMC's sensitivity analysis showing that if rates go up 50 basis points, WMC would expect to report a 13.9% increase in the coming quarter's net interest income. If rates go up 100 basis points, then WMC estimates an increase in net interest income of 19.0%. Rates have risen since July, and net interest income actually dipped 5%. The explanation in part is that rates rose sharply and the portfolio was being rebalanced. The analysis at the time only considered current assets held, and not future purchases nor sales. Thus this metric is informational at best, and I do not believe much stock can be put in it any longer. However, these analyses suggest that slowly rising rates can be tolerated, controlling for purchases and sales. Again, much like my concern with AGNC, NLY and JMI, my primary concern would be if short-term interest rates rise too sharply, which WMC notes could reduce income. All things considered, WMC has designed its investment strategy to take advantage of a rising interest rate environment.
WMC seems to have its act together. I am pleased that it is performing well. Share price, unlike that of AGNC and NLY, has not declined since the end of Q2. Instead, it is about even, while the latter two are down double digit percentages. What I am most looking forward to is the dividend announcement. I expect a small cut. My target is $0.80 to $0.85 based on earnings reported in the last two quarters, but management has surprised me before. While AGNC, NLY and JMI can't cut their dividends fast enough, WMC has only made one $0.05 cut to its dividend. The interest rate spread is outperforming that of NLY and AGNC as well. I like the diversification in WMC and am pleased with its performance. Along with JMI, it is my only other mREIT that I am in the green on when counting dividends and average share purchase price.