Western Asset Mortgage Slashes Its Dividend

| About: Western Asset (WMC)

Summary

The dividend just got hammered as WMC went to a level close to what can be earned from its operations.

The dividend is still on the high end of what I would consider reasonable, but it could be covered in future periods with strong leverage.

Further flattening of the yield curve could produce additional problems for the sector.

Western Asset Mortgage Capital Corporation (NYSE:WMC) just cut its dividend from $.58 to $.45 per share. The substantial decrease shouldn't be a complete surprise. I called out the dividend as being significantly unsustainable and suggested that Core EPS was being strengthened by the hedging techniques, sending the economic costs directly into book value instead of passing them through Core EPS.

When I was analyzing the dividend sustainability back in November of 2015, I wrote:

"My estimate on the sustainable dividend from Core EPS with all the hedging costs worked in suggests that a sustainable dividend would be in the range of $.40-.43 per share. I'm not a fan of treating drop income as a source of income for paying the dividend, but many mREITs have started to incorporate the numbers with their Core EPS. If we assume that the TBA positions are being consistently rolled and agree to buy into the philosophy of drop income as a way to cover dividends, then the potential sustainable dividend would be close to $.50 per share, but that would require fairly substantial leverage. To get to the point of covering a $.60 dividend per quarter on book value of $13.26 per share would suggest a Core + Drop return on equity of 18.1% per year. To reach that as an mREIT in this interest rate environment would require a very exceptional amount of risk. It is significantly more risk than I would want to take on."

For the third quarter, the company was reporting drop income + core EPS of $.54. In the fourth quarter, the earning metrics fell dramatically. The values went from $.54 to $.39. Specifically, Core EPS (excluding drop income) was $.36 per share and drop income was $.03 per share for a combined total of $.39.

New Dividend

The dividend at $.45 is still pushing the limits of what could reasonably be sustained at its last reported book value with anything less than extreme levels of leverage or credit risk. WMC already takes on fairly significant levels of risk in reaching the current level of earnings. I wouldn't be surprised to see further cuts into the dividend if there is no further leverage used on the portfolio. On the other hand, it wouldn't be shocking if management opted to increase leverage, hedge part of the risk, and try to maintain the new level of the dividend.

Investors looking at the presentation may see leverage of 5.1x as being fairly low, but counting TBA positions, the leverage was running 6.7x, which is fairly high for an mREIT with a substantial allocation to non-agency MBS.

New Strategy

The latest earnings presentation did not include the typical disclaimers for forward starting swaps and its net interest expense on the hedge portfolio increased substantially so the full cost of hedging may be flowing through the Core EPS metrics now. There are quite a few ways for those costs to be passed outside of Core EPS, so it'll take some digging to confirm.

Flattening

While further leverage could allow WMC to cover the dividend currently, the flattening of the yield curve creates a serious challenge to the agency MBS portion of the portfolio. WMC also uses some IO (interest only) strips in its portfolio. These assets are great when MBS rates are increasing and prepayment projections are declining, but the fourth quarter has seen prepayment expectations rise and yields decline.

If this trend continues, it could create additional headwinds for the dividend because it reduces the net interest income from agency MBS and IO strips due to higher amortization costs.

Conclusion

WMC finally put the big cut into its dividend. I've been projecting this to happen for months, but the strong fourth quarter dividend may have caused some investors to doubt my estimates. The combination of weaker earnings performance in the fourth quarter (with hedging costs recognized in Core EPS) and a sharp dividend cut serve to confirm my initial research.

My view on the typical agency mREIT is bearish and WMC tends to trade at smaller discounts to book value than peers which causes me to feel even more bearish. Shares closed trading at $10.08, which is high enough that I don't think there are any attractive risk-adjusted returns here.

In my experience, when an mREIT cuts its dividend this way, it can lead to a couple of selling events. One can happen after the cut and the other after the next dividend payment is collected. I wouldn't be surprised if the next ex-dividend date has shares moving by more than the dividend payment. This is a violation of efficient markets, but emotions can play into these factors and small mREITs frequently lack sufficient coverage and liquidity to prevent these kinds of events.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.