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Western Asset Mortgage Capital Corporation (NYSE:WMC)

Q1 2014 Earnings Conference Call

May 8, 2014 12:00 PM ET

Executives

Larry Clark - IR

Gavin James - President and CEO

Steve Sherwyn - CFO and Treasurer

Anup Agarwal - CIO

Analysts

Dan Furtado - Jefferies

Richard Shane - JPMorgan

Mike Widner - KBW

Jackie Earl - Compass Point

Operator

Welcome to the Western Asset Mortgage Corporation's First Quarter 2014 Earnings Conference Call. Today's call is being recorded and will be available for replay beginning at 5 O’clock PM Eastern Standard Time today. At this time, all participants have been placed in a listen-only mode and the floor will be opened for your questions following the presentation.

Now first 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 you everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months ended March 31, 2014. By now, you should have received a copy of today's press release. If not, it’s available on the Company's Web site 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 Web site.

With us today from management are Gavin James, Chief Executive Officer, Steven Sherwyn, Chief Financial Officer and Anup Agarwal, Chief Investment 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 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 risk factors section of the Company's reports filed with the Securities and Exchange Commission. Copies are available on the SEC's Web site. 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. And then Anup Agarwal, our new Chief Investment Officer will provide an overview of our investment portfolio, our liability profile and our future investment outlook. After our prepared remarks, we will conduct a brief question-and-answer session.

The first quarter of 2014 was a quarter of transition for WMC. We declared a dividend of $0.67 per share and continue to implement our strategic decision to move from our pure agency mortgage REIT to a hybrid model.

During the quarter we recorded a GAAP net loss of $0.32 per share while generating core earnings of $0.46 per share. For the first time since our inception we had a material amount of drop income resulting from our increased use to TBA’s in the portfolio.

Our core earnings and drop income was $0.61 per share in the first quarter. This excludes the catch-up for premium amortization of $0.05 per share. As we indicated on our last conference call, we believe that the hybrid mortgage REIT model can deliver greater value for our stockholders in the current environment. The strategic actions we took as a part for this transition resulted in a smaller overall portfolio as compared to the fourth quarter of 2013, impacting our effective net interest income.

Combined with higher hedge adjusted financing costs that reduced our net interest spread we generated a lower level of core earnings than we have in prior quarters. In addition our book value per share was impacted by unrealized losses on our interest rate hedges as rates moved towards the lower end of our expected trading range. That being said we estimate that our audited book value per share has increased to between $14.92 and $15.02 as of May 5, 2014.

While we are not satisfied with our first quarter results we consider them to a necessary cost of the repositioning of our portfolio over the last six months and believe that we are better positioned to generate improved returns for shareholders going forward. We now have the ability to move, to more fully capitalize on the overall breadth and expertise across the broad mortgage spectrum possessed by managing Western Asset Management Company.

With the hybrid mortgage REIT model we are better able to increase our exposure to the non-agency assets including potential investments in residential and commercial real-estate holdings and other asset backed securities, which we believe currently present more attractive risk adjusted returns than any agency market alone.

Our transition to a hybrid mortgage REIT was further accelerated with the successful follow-on offering we completed in early April. This offering along with a concurrent private offering of 650,000 shares of common stock that was sold to Western Asset Management Company raised net proceeds of approximately $200 million. The offering was accretive on a book value basis to existing shareholders and increased the market capitalization of the Company by approximately 50%.

Last week a portion of the overall allotment option was exercised by our underwriters which resulted in another $14.7 million in proceeds. Using the broad fixed income investment platform available to us at Western both the initial $200 million and the $14.7 million from the overallotment option we’re fully invested on the same day the proceeds were received. We continue to have an overabundance of repo availability which enables us to lever our capital to our targeted levels and fund our portfolio with repo that remains very stable from both a rate and haircut perspective.

It should be noted that since quarter-end, we have increased our leverage to approximately 8 times whereas the availability of repos become a key risk factor for the mortgage REIT industry we believe the overall strength to Western Asset is an organization that have longstanding relationships with repo counterparties both domestically and internationally significantly mitigates funding risk for WMC going forward.

With the adjustments we made in the portfolio and the new capital we have deployed early in the second quarter, we have created a portfolio that we believe will perform well given the following assumptions; interest rate for the long end of the curve will be range bound over the course of the year, with the overall trend pointing towards a very gradual increase in rates and short-term rates will remain near zero; economic growth in the U.S. will remain subdued over the next several quarter and the fed will continues to be supportive of the economies; mortgage spreads on agency RMBS are more likely to narrow rather than widen as the spreads takes repayment continues against a backdrop of lower net new supply; and the supply of non-agency assets will be somewhat constrained given a low level of expected new production.

We are optimistic that the hybrid mortgage model will enhance the returns we can deliver for our shareholders. Given the increased portfolio size and diversification and the lower expense ratio following the capital rates we believe we are all well positioned to generate sufficient core earnings to support an attractive dividend while also reducing the overall volatility of our book value.

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

Steve Sherwyn

Thanks Gavin. Good morning everyone. I will discuss our financial results for the first quarter ended March 31, 2014. Where specifically indicated all metrics are as of that date. On a GAAP basis we incurred a net loss for the quarter of approximately $8.4 million or $0.32 per basic and diluted share. Included in the net loss was approximately $31.1 million of net unrealized gains on MBS, approximately $2 million of net realized gains on MBS and approximately $57.7 million of net loss on derivative instruments and linked transactions.

For the quarter our core earnings were approximately $12.4 million or $0.46 per basic and diluted share which is a non-GAAP financial measure which we define as net income or loss excluding net realized and unrealized gains and losses on investments, net unrealized gains and losses on derivative contracts, non-cash stock-based compensation expense and other non-cash charges. Included in our core earnings is $12.4 million with approximately $1.4 million of estimated catch-up premium amortization resulting from the quarterly adjustments in our projected constant prepayment rate or CPR estimates for our MBS portfolio and the retrospective application of such adjustments to certain of our MBS securities consisting almost entirely of our agency RMBS whole pools.

In addition to our core earnings for the quarter we generated drop income of approximately $2.7 million or $0.10 per basic and diluted share. We should also point out that at year-end we had substantial undistributed taxable income from 2013. As we have been transitioning our portfolio to more of a hybrid REIT model we’ve also been utilizing more to be announced or TBA forward contracts on agency RMBS in the form of dollar roll transaction which has resulted in incremental drop income. Drop income represents a non-GAAP financial measure and is defined as a difference between the spot price and the forward settlement price for comparable security on the trade date.

For the quarter our core earnings plus drop income excluding estimated catch-up premium and amortization was approximately $16.5 million or $0.61 per basic and diluted share. This compares to core earnings plus drop income excluding estimated catch-up premium amortization of approximately 18.9 million or $0.70 per basic and diluted share for the fourth quarter ended December 31, 2013. After adjusting for additional shares issued as a result of the stock portion of the dividend declared on December 19, 2013 and paid on January 28, 2014, core earnings plus drop income excluding estimated catch-up premium and amortization would have been approximately $0.70 per basic and diluted share for the fourth quarter of 2013.

For the quarter ended March 31, 2014, our average amortized cost of MBS held, including agency and non-agency interest-only strips accounted for its derivatives and linked transactions was approximately $3.09 billion, as compared to approximately $3.47 billion for the fourth quarter ended December 31, 2013. Our net interest income for the first quarter was approximately $20 million this number is a GAAP financial measure and does not include the interest we received and paid on our linked transactions interest we received from our IO securities that are treated as derivatives nor does it take into account the cost of our interest rate swaps. The latter two are included in the gain on derivatives instruments lined in our income statement.

On a non-GAAP basis our net interest income including the interest we received from our IO securities treated as derivatives and interest we received from linked transactions was approximately $15.7 million. Included in this calculation was approximately $46.1 million of coupon interest offset by approximately $18.9 million of net premium amortization -- discount accretion and amortization recovery of basis. This compares to non-GAAP net interest income including interest we received from IO securities treated as derivatives and interest we received from linked transactions of approximately $24.4 million for the fourth quarter of 2013.

Our weighted average net interest spread for the first quarter of 2014 which takes into account the interest that we received from our non-agency RMBS and IO securities, as well as the fully hedged cost of our financing was 1.8%, reflecting a 3.57% gross yield on our portfolio and a 1.77% effective cost of funds. This compares to a weighted average net interest spread of 2.15% reflecting a 3.61 growth yield on our portfolio and a 1.46% effective cost of funds for the fourth quarter of 2013.

Our cost of funds increased by 31 basis points compared to the fourth quarter which is primarily attributable to the increased hedging we put into place into the end of fourth quarter, as well as some of our previously entered into forward starting swaps becoming effective.

During the first quarter, our constant prepayment rate or CPR for our agency RMBS portfolio was 3.8% on an annualized basis, this compares to 5% for the fourth quarter of 2013. We believe our CPR continues to remain low due to our focus on buying securities that exhibit low prepayment characteristics.

Our operating expenses for the quarter were approximately $3.9 million, which includes approximately $2.1 million for general and administrative expenses and approximately 1.8 million in management fees, included in the G&A expenses for non-cash stock-based compensation of approximately $600,000.

On a book value per share -- our book value per share as of March 31, 2014 was $14.19 which takes into account the $0.67 where our cash dividend that we declared on March 20, 2014. For purposes of comparison, our December 31, 2013 book value per share was $15.27. As Gavin previously mentioned, our book value per share declined during the first quarter primarily as a result of unrealized losses in our interest rate hedges as rates moved towards the low-end of our expected range.

We estimate that our book value per share has partially recovered say between $14.92 and $15.02 per share as of May 5, 2014 impart due to our investing of the approximately $200 million in proceeds that we received on April 9, 2014 from our common stock offering and concurrent private placement that occurred shortly after the quarter’s end.

It should be noted that this is estimate of book value is an unaudited number which does not include any adjustment for the catch-up premium amortization. Our book value may change due to a number of factors including market conditions and our actions in managing the portfolio and our actual book value as of today may be different than the estimated number from May 5th.

As of March 31st, the estimated fair value of our portfolio was approximately $3.3 billion and we had borrowed a total of approximately $2.8 billion under our existing master repurchase agreements. Our leverage ratio was approximately 7.4 times at quarter-end. Our adjusted leverage ratio was approximately 8.2 times at quarter-end adjusted for $22 million notional value of net long positions in TBA mortgage pass-through certificates that we held at the end of the quarter. As Gavin mentioned since quarter end we’ve increase our leverage to approximately 8 times.

We continue to be in the attractive position of having repo capacity well in excess of our current needs. At March 31st, we had master repurchase agreement with 20 counterparties with outstanding borrowings with 16 counterparties. We continue to have excellent relationships with our bank counterparties and we feel comfortable with our existing group. We have a highly diversified repo lender book 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 Anup Agarwal, Anup?

Anup Agarwal

Thanks Steve. Good morning and thank you for joining us today. Let me spend a few minutes discussing our investment results for the quarter and update you on our portfolio strategy. As indicated earlier, our book value declined by approximately 2.7% during the first quarter after adjusting for the $0.67 dividend we declared. This was primarily due to the decline in value of our liability hedges which were negatively impacted by approximately 30 basis point decrease in 10 year treasure rate during the quarter.

Our agency and non-agency MBS positions increased in value during the quarter but not enough to offset the decline in value of our hedges. You made a call that we reported an economic return of 4.8% in the fourth quarter of 2013 primarily due to the increase in value of our liability hedges. So in the first quarter of 2014, we gave some of that return back when the rates decreased to a lower end of our expected range.

On our call last quarter, we talked about our belief that long-term interest rates would remain range bound given the slow growth environment of the economy, while we continue to believe that this will be the case we believe that we are presently at the low-end of the range and that there is a meaningful probability that rates will gradually head back up toward the mid or high-end of the range over the remainder of the year.

And therefore we have continued to position our agency portfolio with the modest negative duration of one and a half year. Interest rate volatility remains low and we feel comfortable increasing our exposure to TBA securities as a rate to supplement our core earnings with incremental drop income.

Which as Steve mentioned contributed approximately 2.7 million in the quarter. During the quarter, we increased our exposure to higher coupon 20 year and 30 year fixed rate pools as we believe that these securities offer an attractive relative value on a hedge adjusted basis. We maintained our exposure to non-agency MBS which performed well during the quarter and we believe we’ll continue to do so in a gradually improving economy while also exhibiting less interest rate sensitivity.

We want to emphasize that we intend to continue to be proactive portfolio managers continually monitoring the relative value opportunities we have across the broad mortgage universe. We have access to and benefit from Western Assets’ comprehensive platform where we are able to drop on the experience of a full team of experts across a number of sectors in mortgage market and the broader fixed income in credit markets. We are currently seeing opportunities to generate levered ROE at relatively attractive levels on new capital invested in non-agency assets including GSE credit risk transferred securities and other asset backed securities. We also continue to explore potential investments in residential and commercial whole loans.

With that let me turn to some of the portfolio details as of the end of the first quarter. As of March 31, 2014, the total estimated market value of our portfolio was approximately 3.3 billion and consisted primarily of agency mortgages complemented by holdings in non-agency RMBS and agency and non-agency IOs and inverse IOs and CMBS.

Our portfolio remains weighted towards 30 year fixed rate mortgage pools which represented approximately 52% of the value of the total portfolio. Our exposure to 20 year fixed rate mortgage pools at the quarter end was approximately 25%. Non-agency RMBS represented 30% of our portfolio agency and non-agency interest-only strips and inverse interest-only strips represented 9% of the total. And agency and non-agency CMBS represented just under 1% of the portfolio. Our agency specified pools continue to be invested in mortgage pools with low loan balance or high LTBs which is consistent with our investment strategy of minimizing our prepayment risk. Our non-agency pools consist of approximately 16% of prime loans, 42% all paid and the remaining 41% being in subprime loans.

Now turning to the liability side of our balance sheet, as Steve mentioned we have funded our portfolio through the use of short-term repurchase agreements or repos. As March 31st we had borrowed 2.6 billion under these agreements resulting in leverage of approximately 7.4 times prior to adjusting for our 300 million net long TBA position that we carried at the end of quarter. As of March 31st we had entered into approximately 4.1 billion in notional value of fixed interest rate swaps of which approximately 654 million are forward starting and 527 million are pay variable interest rate swaps giving us net pay fixed swap position of approximately 2.9 billion.

At the quarter end, we increased our hedges in anticipation of the increase in our portfolio due to stock offering additionally we have entered into approximately 2.1 billion notional amount of net paid fixed interest rate swaptions with swap terms that range between seven and 10 years and have exercised exploration dates that range from May 2014 to October 2014. As a result of our hedge positions our agency portfolio had a net duration of negative one and a half year at quarter end up modestly from negative one year at December 31, 2013. We continue to have slightly positive duration at the short-end of the yield curve which is more than offset by negative duration at the longer end.

Since quarter end we have increased our leverage to approximately 8 times and our estimated and unaudited book value as of May 5th is approximately in the range of 14.92 to 15.02. We are comfortable with our current leverage given our view of environment of continued lower interest rate volatility. We can adjust our leverage fairly quickly through the use of TBAs and we determine our leverage based on what we believe will enable us to optimize our core earnings on a risk adjusted basis and maintain a relatively book value.

Our primary investment strategy remains unchanged that is to assemble our diversified portfolio with securities that offer the best risk and hedge adjusted carry over our investment horizon. While we are pleased with that composition of our portfolio we are always looking for ways to improve our returns without increasing the overall risk level of the portfolio. We expect to remain proactive and as opportunities present themselves to further diversify our sources of return by increasing our exposure to non-agency RMBS and CBMS, GSE credit risk transferred securities and other asset backed securities.

Though our allocations to these asset classes will vary based on market conditions. We also continue to explore potential exposure to residential and commercial real estate whole loans. We are confident that given our broad opportunity set of investments and with our world class investment expertise we’ll be able to generate a consistently strong dividend for our shareholders while reducing the overall volatility of our book value per share.

With that we will entertain your questions. Operator, please open up the call. Thank you.

Question-and-Answer Session

Operator

Thank you (Operator Instructions). Our first question comes from Dan Furtado with Jefferies.

Dan Furtado - Jefferies

Good morning everyone and thank you for taking my questions. The first question is just I think you went over it relatively clearly but I want to be absolute here, is that the pro forma book value after quarter end, that’s entirely due to the capital raise or is there some asset appreciation baked in that number as well?

Gavin James

There is a -- listen I think that is based on asset appreciation since the quarter-end.

Dan Furtado - Jefferies

Okay, got you. And then the other question I had is, I get it that you in essence bought the swaps in front of buying the assets but when we roll out a quarter or two from here, is it safe to -- I mean is the way to think about and I know this is imprecise but like kind of like a ratio of derivatives to the portfolio to be in that 80% to 100% range like it’s been running in the last couple quarters or how should we think about the kind of that ratio? And again I know that duration is more important than the ratio but duration is harder from our end frankly to model.

Gavin James

Yes I mean, look I think you exactly hit it on the head between I think, I kind of focus more on the duration and the duration gap then necessarily the ratio but the way I would also kind of think about is more driven by that as we transition the portfolio more and more towards credit opportunities then you will kind of see the ratio continue to decrease, because when I think about as we’re adding more and more non-agency or CMBS securities than the duration for those securities it’s significantly different. For example most of the non-agency securities are floaters or GSEs transfer deals are floater, so what you kind of see is that ratio will continue to come down as we shift our portfolio more and more towards hybrid or more credit spectrum.

Now the other part also within that for that ratio is also driven to a great degree by our view on mortgage spreads. Look I mean I think the way I think about the portfolio is that if we are very constructive on mortgage spreads, we will still have more TBA positions and effectively hedge the duration or keep the duration gap to minimal based on our views on the rate and kind of have TBA position to express our view on mortgage spreads.

Dan Furtado - Jefferies

Understood, that makes perfect sense. And turning to the whole loan, the potential for a whole loan strategy moving forward, I assume this is likely to be in the non-agency space but could be incorrect and then the follow-up to that would simply be what options so you currently see to fund those whole loans on a go forward basis?

Gavin James

Yes so I mean I think close to our peripheral loans I think one our focus in whole loans is primarily on non-QM more than anything else. And I think that is and our whole loans our focus is on both commercial and residential side and on the commercial side our focus right now is more on legacy AJs but on the whole loan the efforts are both on the residential and commercial and within residential our focus is on non-qualified mortgage pool. And the funding for that is with the thought process that we already have funding facilities or we’re working towards putting funding facilities together as we partner up with originators and servicers to originate these loans. And ultimately along the way we’ve been working with the rating agencies and there have being more clarity in for non-QM loans. So our expectation is that as these loans get originated they will get funded from repo facilities and ultimate path to securitization.

Dan Furtado - Jefferies

Understood, and can I speak one more if you don’t mind on the whole loan strategy. I guess there is a little bit of a chicken in the egg issue here where I believe there is demand from originators to originate them but not necessarily to exit the positions if they don’t want to balance sheet them. So is the strategy here to approach originators and say hi look we’ll be in the market for you on a consistent basis for loans that fit these parameters, we’ll buy a certain amount off of you over certain period of time and then that gives them the surety of a back stopper for lack of a better word. Or how should we broadly think about the strategy?

Gavin James

Yes I mean I think this is there kind of we have the benefit of Western as an organization that in that same framework when we talk to these originators that hi we’ll be there to have access to these loans. We have the benefit that as a larger AUM be responsible for significant size of agency, non-agency book as part of Western platform and we carry bigger value in terms of our capability to be able to effect that versus somebody else. But that’s how we’ve been going to the originators, hey that this is kind of the box we like within non-QM kind of framework and if you originate these we will be -- you will have access to us there, we will be buying them along the way, I am not stabbing you I just want to chip on the end of that…

Dan Furtado - Jefferies

Sure.

Gavin James

It’s -- as Anup said it’s great having a larger AUM of Western behind us. We’re seeing a lot of demand from clients outside of the REIT bore to the whole loan strategies, especially people -- entities like Sovereign Wealth Funds, Central Banks around the world. So we’re privileged to see those inquiries. And put that money to work for them so will it be a pretty constant bid in the market for the banks.

Dan Furtado - Jefferies

Great. Thank you for the commentary. I really appreciate it everybody.

Operator

The next question comes from Richard Shane at JPMorgan.

Richard Shane - JPMorgan

Hey guys, thanks for taking my questions. It is sort of a follow-up what Danny just asked. So, you provided an update or an estimate of where you think book value might be as of May 5th. Can we disaggregate that, so there is basically somewhere between $0.17 to $0.18 of increase since the end of the quarter, some of that comes from REIT of stock offering, some of that comes from appreciation on the non-agency book, some of that comes from appreciation on the agency book presumably. Can you at least sort of give us thinking about that $0.17 can you give us a pie chart of what the contribution from each of those three elements would be?

Gavin James

Look I mean, I think it’s I mean I think Rick it’s a great question. I think it’s something which will be difficult for us to provide, I mean as we just -- I know exactly, I think we know exactly where the -- it’s a combination of both agency, as well as non-agency market, I mean, you have seen in last one week mortgage spreads have come in very dramatically. And I think if you talk to all the different investors in the marketplace, you would kind of see for example yesterday was the mortgage spread tightened very, very dramatically.

And I think at the same time, we’ve seen non-agency market coming in for bid, just as a framework of non-agency market look I mean I think just GSE risk transfer deal. At month end, kind of at the end of March, you kind of saw the risk transferred deals were trading more at 340, 340 basis points broadly in the marketplace bid ask. Right now those risk transferred deals are at -- this morning it was at 282, 288 market. So that takes you that both of these markets have come in quite dramatically and same is true for CMBS. I mean I think as the CMBS has been added in the market and that market has been on fire. So offering was accretive to the book, but the main driver really was kind of that spreads tightening all across the board. This is -- and the reason for that is -- look I mean, I think our long held belief has been that rates will be range bound and the slow growth in economy in that environment as I have said in my prior calls, that mortgage spreads will continue to tighten, they will stay stable as well as our credit spreads will continue to tighten.

And that’s certainly why we have kept the leverage at the higher level at eight times leverage because I believe that the spreads will continue to tighten while we keep the duration gap as close to zero as possible. You have seen from us given our view that we have kept the duration gap anywhere from negative half year, negative one year to zero, while keeping the leverage high. And they kind of continue to increase in the credit book. And it’s all driven by the same view that global slowdown in economy, kind of, U.S. to have a slow growth but continued growth and the rates to be range bound.

Steve Sherwyn

Rick the vast majority of that appreciation is portfolio performance as opposed to the stock offering. I can’t identify the exact number but it’s -- the vast majority would be more -- would be the portfolio.

Gavin James

Absolutely.

Richard Shane - JPMorgan

Got it. And to follow-up in this a little bit, I mean the trade-off here is this that the tighter spreads, the enhanced security values are good from a book value perspective but the tighter spreads from a margin opportunity perspective diminish things. And I think the hope that as we enter taper, that there would be opportunity for margin expansion and what’s ended up half of these limited supply is to constraint that? Do you think that there is still that opportunity for margin expansion out there or is that just not realistic?

Steve Sherwyn

Given where we are right now.

Anup Agarwal

Look I think this is where I get excited about. When I think, I love this part of the question because look this is where we have the benefit of Western Asset as an organization that this is there one. Depending upon our view of the mortgage rate, we can increase and decrease our leverage from just adding more TBAs, less TBAs and as the spreads widen we reduce our position in TBAs and then has the spread widen out back again, we can increase that position. The second is this is where we can diversify pretty actively in kind of other asset classes so as on one end you have kind of seen the spreads for GSE transfer deals and non-agency have come in but you know we have diversified into CMBS or CMBS or CREB notes or whole loans to non-QM so this is where we -- I have the benefit of having large team we are not only for the REIT but for broad investor base we can take advantage of these opportunities so when you kind of think about another REIT or another manager to shift the portfolio from GSE to CMBS to whole loans to CREB notes other people don’t have the capability as we do. So I think this is where our active management of portfolio and to find opportunities wherever the spreads are still exists. So for example we can still buy the notes for at 70 LTB at 7% to 8% yield and you can add half return on leverage or little more to get better risk award or you can buy the legacy CMBS AJ which have 6%-6.5% yield so this is where our capability as a REIT and as a part of broader Western Asset platform really gives me and gives us as an organization an edge versus anybody else.

Richard Shane - JPMorgan

Got it. Thank you very much guys.

Operator

Our next question comes from Mike Widner, KBW.

Mike Widner - KBW

Hi. Good afternoon guys. I think I might be a little confused and so maybe just a couple of points of sort of big picture clarity on some of the things you said. In the press release and I think in your opening remarks you said that a lot of the results in the quarter reflected the strategic decision to move away from the pure agency model and sort of more towards hybrids and I mean is that -- so I mean that seems to be the theme you guys are talking about quite a bit. I mean is that right?

Gavin James

Correct.

Steve Sherwyn

That’s right.

Gavin James

And Mike I mean if you remember that I think even in past calls we have kind of guided in that direction but I think that has been a constant theme from us for a while because and I think it’s driven by kind of our where we see the opportunity set.

Mike Widner - KBW

So I mean that makes sense and certainly we hear no sure as your peers kind of talking about the same thing I guess where I am sort of puzzled is if I look at your portfolio breakdown whether I look at it on a percent of the portfolio basis or an absolute dollar basis your allocation the gross amount of dollars on the percentage of assets in non-agency RMBS for example was down Q-over-Q and your agency mix is up Q-over-Q so I guess so there is that piece that I am just not sure how I reconcile it Q-over-Q and then also what you’ve talked about in terms of deploying the capital is saying that again if I heard you right your backup I mean you grew your equity base by basically 50% and you’re backup to 8 times leverage already and you did so largely through use of the TBA market which I mean is agency. So I guess I am sort of struggling to reconcile the transition and what you describe as an impact to the operating results in the quarter from a transition toward a portfolio that doesn’t -- it just I guess I am not making the connection between the shift and what I am actually seeing in your disclosure of the portion composition.

Gavin James

Sure. Look I mean I think Mike what you would kind of see is that you will see continued transition and I think what you will kind of see that as we see kind of future over a period of time you would kind of see that both non-agency bucket, CMBS buckets all of those buckets will continue to increase. So what we kind of the way I think about it is that as we had 50% more in our equity offering the percent of capital to non-agency will continue to increase so as we deployed the capital the rate we look at it as that initially we deploy the capital in agencies and as a placeholder and then continue to actively go out in the marketplace and find opportunities in non-agency and CMBS and lot of those have little longer lag time.

So for example the whole loans they just have little longer lag time same way CMBS B notes they just have little more lag time than I would like to kind of have but it does. So I think the second part in terms of the leverage look that’s also part of it is driven by our views in the mortgage spread. So the way I kind of think about the world is think about the world where we want to continue to develop into more credits of the portfolio composition continues to transition more and more into credit the spread product whether it’s whole loans or whether it’s on CRE loans or whether it’s B notes or non-agency. What is the same time if you’re constructed on mortgage spreads what you would kind of see what you can expect is the overall leverage without TBAs come down but we have more TBAs just because we are very constructive on mortgage price.

Mike Widner - KBW

Okay. So I think what I am hearing in there is that the migration more towards non-agencies and credit is sort of a slow transition it’s still in process and we should expect that to continue but my eyes are not deceiving I mean the portfolio is the portfolio and where we stood at Q end was pretty much still 77% of the portfolio was in agency and it sounds like as of today it’s probably still roughly in that -- I get to pick something for modeling purposes and I mean is that the ballpark today including the TBAs?

Gavin James

I think what you’re trying to see is it will continue to increase at a good pace along the way for both credit and non-agency in CRE we note that whole loan bucket will continue to increase at pretty good pace.

Mike Widner - KBW

Okay. So let me ask you second one if I could on the swaps. I know you talked about this a little bit in your comments but I am not sure I got everything. At quarter end you had about 4 billion in pay fixed swaps were more than that. You talked about still having a net negative slightly negative perhaps duration gap but adding a lot to TBA positions. Did you say how much you added in swaps because I think you sort of said when we added swaps in advance to the capital raise and then I also heard that maybe you added swaps since then. So I guess how should we think about that?

Gavin James

I think one of the swaps were added just in anticipation of the offering.

Mike Widner - KBW

So…

Gavin James

It takes about 2.9 billion and I think of the decent amount was added just with the anticipation of offering. And we expect -- the way we talk about is that with the expectation of offering we will add the -- initially we’ll take all our offering proceeds and convert it into and invest in agency collateral. And then we will rotate out of that into and we will continue to rotate into non-agency and CMBS and CRE opportunities, but initially we invested the capital within 24 hours and that was just in anticipation of adding swaps for that. But looking forward would we add more? I mean I think we’re in a pretty good place everything, the right thing about it is if we continue to add more non-agencies we would just see those notionals come down.

Mike Widner - KBW

Okay. So let me just make sure I understand what you’re saying correctly, I mean at the end of Q4 you had 2.7 billion in pay fixed swaps, you finished Q1 at basically 4.1 billion so that’s net addition of 1.4. I think I just heard you reference adding 2.9. So I guess I am just trying to square the numbers and understand sort of again for modeling purposes where the swap book stands today?

Gavin James

I think the way you were thinking about it was right, net added pay variable but I think the way you were thinking about is, is exactly correct.

Mike Widner - KBW

But the way I am thinking about is I am confused on what number, again the 4 billion does that represent the 4 billion where you were at the end of Q1? Does that represent having put on swaps in anticipation over the capital raise, are you saying that you added swaps in April in anticipation of the capital raise.

Gavin James

We added swaps in anticipation of raise.

Mike Widner - KBW

Okay, I still don’t think that answers my question but it doesn’t sound like I am going to get one. Thanks guys.

Gavin James

We added after the end of the quarter.

Operator

The next question comes from Jackie Earl at Compass Point.

Jackie Earl - Compass Point

Hi. Thanks, just a specific question on pay ups, on specified pools, any movement in the quarter on pay ups there?

Gavin James

I mean I think just that, but we’re going to think…

Jackie Earl - Compass Point

Yes so we’re not seeing pay ups move either and I am wondering why the market is describing such little optionality to and whether it’s a CQ pool or loan balance performing. What’s your thought on why there is virtually zero optionality priced into those bonds?

Gavin James

Yes, I mean I think you have seen market kind of give credit to that jus this week and I think you have seen the spread and I think you have seen that get impacted right now. So I think in last week we have seen pretty significant impact.

Jackie Earl - Compass Point

Could you be more specific in terms of what you own you have seen an impact in terms of price appreciation on specified pools is that what you’re saying?

Gavin James

I mean I think the only words we own we have seen the application but kind of broadly in the marketplace you see that optionality getting priced.

Jackie Earl - Compass Point

Okay, alright all other questions were answered thank you.

Operator

There are no further questions at this time Mr. James.

Gavin James

Well thank you everybody for joining us on the call this morning. We look forward to speaking with you in person in the months ahead. You may close the call operator.

Operator

This concludes today’s conference. Thank you for attending, you may now disconnect.

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Source: Western Asset Mortgage Capital's (WMC) CEO Gavin James on Q1 2014 Results - Earnings Call Transcript
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