Checking In On Western Asset Mortgage Capital

| About: Western Asset (WMC)

Summary

WMC’s portfolio heavily uses the 30 year fixed rate agency RMBS; the asset class provided only slight gains so far in Q2 2016.

The non-agency RMBS and CMBS should provide much larger gains but it is more difficult to put together a precise estimate on this kind of asset.

The hedge portfolio should provide a significant net unrealized loss if the company is still holding the same hedges as they had at the end of Q1 2016.

WMC might cut their dividend or sustain it, but they are not likely to cut it to a level that would actually be sustainable.

I don’t see any reason to buy WMC around $10 (last seen $9.94), but around $8.50 to $8.00 it would get interesting.

Since readers asked about Western Asset Mortgage Capital Corporation (NYSE:WMC), I'll put in a quick check up on the company. This is also going to be a quick lesson in how to ball park the performance of a mortgage REIT.

Assets

Start by assessing the portfolio:

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The yellow box on Agency RMBS highlights the largest portion of the portfolio. At the start of Q1 2016 WMC had total shareholder's equity of about $457 million. That means the agency RMBS portfolio is about 3.65x the value of shareholder's equity. Digging a little deeper into the agency RMBS position shows that the positions are primarily in the 30 year RMBS. In most quarters the price movements would be materially different across low coupon RMBS and high coupon RMBS, but Q2 of 2016 saw the 30 year fixed rate RMBS moving in roughly similar amounts with the changes ranging from about .53% to .26%. With the exception of the 30YR FNMA 3.0, the rest of the 30YR FNMA securities gained in the range of .26% to .33%. The portfolio for WMC doesn't include the 30YR FNMA 3.0 so we can ball park that there was about a .30% gain across a position that was 3.65x the value of equity. That means agency RMBS created a gain of about 1.1%.

The green box shows non-agency RMBS and CMBS. These positions should have increased dramatically more during the quarter as the market became less averse to credit risk. The real value of the portfolio is going to be heavily determined by the way management values these positions. The total value here is about twice the value of equity. I would expect this position to get boosted in the range of 2% to 5% so this adds somewhere between 4% and 10% to the value of equity. Unfortunately one of the hardest things as a mortgage REIT analyst is nailing down the change in the estimated fair value of non-agency MBS.

Hedges

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The red box indicates the value of the hedges where WMC is paying (or will eventually be paying, if they don't cancel) the fixed rate. Since LIBOR rates fell dramatically these positions produce unrealized losses.

The green box indicates swaps that are effectively going in the opposite direction. These swaps will have large unrealized gains so far.

The orange box shows other hedging assets in the form of swaptions and a couple kinds of "interest only strips". Both should have unrealized losses on the quarter.

The purple box indicates that a substantial portion of swaps were forward starting which means the "net interest expense on swaps" for Q2 of 2016 will be a joke. The economic cost of hedging will flow through book value instead of Core EPS.

Net Effect of Swaps

By my estimates on revaluing the swap positions the change in values during the quarter would've been around a net loss of $20 million. Adjust that for the amount of equity and the forecast is about a 4.4% decline from swap positions.

Beware Active Management

My estimates on the movements in swap values are dependent upon those swaps actually existing during the quarter. WMC occasionally manages their hedge book to a material extent during the quarter so there is no guarantee that they kept these positions. As an analyst there isn't much you can do beyond modeling the last reported positions.

The combination of non-agency MBS and active management of swaps makes WMC one of the hardest mortgage REITs to predict.

Combining the Impact

The total estimated impacts are around +1.1% for agency MBS, +4% to 10% for non-agency MBS, and minus 4.4% for swaps. I didn't try to revalue the IO positions or the swaptions. They should materially smaller in their impact compared to the positions I was valuing. The net impact on book value would be plus .7% to 6.7%. However, I believe the reason forward starting swaps were used was to enhance the amount of net interest income reported (by reducing net interest expense on swaps) so higher "Core EPS" could be achieved and a stronger dividend could be maintained. Therefore, regardless of what the company declares for Core EPS, I don't see the dividend being covered. As a result, I would expect book value to perform worse than the .7% to 6.7% estimate since I see the dividend paying out part of book value.

Pricing

WMC trades at a much larger discount to trailing book value than the levels seen in previous quarters. That seems very positive but the discount isn't large enough for me to feel comfortable with the idea of investing in the mortgage REIT. If they cut their dividend by a substantial amount and share prices cratered, I would be very interested in buying into the weakness. If I could get a share price below $8.50, it would be an interesting play. Under $8.00 I would be bullish. The share price is currently around $10. It could rally higher if they sustain the dividend but I'm not seeing a strong case for risk adjusted returns without getting a much lower entry price.

This article is tagged that I might buy WMC. That is simply because I might leave an order open with a price around $8.50 to $7.75 over the next week or two while waiting for WMC to declare their dividend.

Rating - Avoid Unless Price Falls Significantly

Since WMC could pass hedging costs through book value rather than Core EPS the potential to sustain the dividend and create a small rally ruins the potential for any short opportunity. At the current price I see it as unattractive, but shorting is reserved for opportunities where there is a clear catalyst or an excellent hedge.

Disclosure: I/we 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.

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. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. 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.