Western Asset Mortgage Capital's (WMC) CEO Jennifer Murphy on Q2 2016 Results - Earnings Call Transcript

| About: Western Asset (WMC)

Western Asset Mortgage Capital Corporation (NYSE:WMC)

Q2 2016 Earnings Conference Call

August 04, 2016 11:00 AM ET


Larry Clark - IR

Jennifer Murphy - CEO

Lisa Meyer - CFO

Anup Agarwal - CIO


Rick Shane - JPMorgan

Joel Houck - Wells Fargo


Welcome to Western Asset Mortgage Capital Corporation's Second Quarter 2016 Earnings Conference Call. Today's call is being recorded and will be available for replay beginning at 5 PM Eastern Standard Time. At this time all participants have been placed in a listen-only mode and the floor will be open 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, Andrea. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months ended June 30, 2016. We issued our earnings press release yesterday afternoon and it is available on the company's website at www.westernassetmcc.com. In addition, we've included an accompanying slide presentation that you can refer to during the call. You can access these slides in the Investor Relations section of the website.

With us today from management are Jennifer Murphy, Chief Executive Officer; Lisa Meyer, Chief Financial Officer, 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 website at www.sec.gov. We disclaim any obligation to update our forward-looking statements unless required by law.

With that, I will now turn the call over to Jennifer Murphy. Jennifer?

Jennifer Murphy

Thank you, Larry, and thank you everyone for joining us today for our second quarter call. I'm going to begin the call with some opening comments. Lisa Meyer, our Chief Financial Officer is going to discuss our financial results and then Anup Agarwal, our Chief Investment Officer is going to provide an overview of our investment portfolio and our outlook. After his remarks we'll open it up for a brief question-and-answer session.

As this is my first earnings call as Chief Executive Officer of Western Asset Mortgage Capital Corp., WMC, I wanted to start off with an overview of the long term goal for the company on behalf of you, our shareholders and the strategy that we're pursuing to achieve those goals. WMC's goal as a hybrid mortgage REIT is to provide our shareholders with an attractive dividend that's supported by sustainable core earnings plus drop income as well as provide the potential for higher total returns while maintaining a relatively stable book value. As many of you know the security [indiscernible] investment can range from relatively straight forward to complex as can the tax and accounting rules that relate to them.

In addition the use of leverage and hedging in REIT portfolios may increase the opportunities for higher returns and reduce volatility but these tools can also introduce additional risks we managed and mitigated. In our view, WMC's strategic advantage in pursuing these goals is its ability to draw on the deep investment experience and team at Western Asset, our manager as well as the breadth of Western Asset's Global investment, risk management and operational infrastructure.

Western Asset is a global fixed income specialist with more than $450 billion in total assets under management and over 800 investment, risk, finance and accounting legal and compliance operations and other professionals in nine offices around the world. One of our most important goals as WMC's management team is to bring the strength of Western Asset to WMC for the benefit of WMC shareholders. WMC's investment team led by our Chief Investment Officer, Anup Agarwal seeks to optimized returns for shareholders while managing portfolio risk by combining a diversified portfolio of agency, non-agency, home loan and selected other securities with effective leverage and hedging strategies.

Anup is the Head of the Mortgage and asset-backed securities team at Western Asset. To build and manage WMC's portfolio Anup's supported by Western Asset's experienced team of mortgage and asset back investment professionals. Anup and his team also draw on Western Asset's Broad global fixed income and credit teams for research, perspective and insights.

We believe having access to Western Asset's depths and breadth of fixed income expertise, its comprehensive operational platform and its global institutional relationships provides WMC a key advantage in achieving our goal to create shareholder value.

On the business side I'm joined by two relatively new members of our senior management team; Lisa Meyer, our CFO and Elliott Neumayer, our Chief Operating Officer. Lisa became our Interim CFO in November 2015 and was appointed Chief Financial Officer in June 2016. Her strong background and experience in our industry has allowed her to quickly demonstrate the knowledge, skills and capabilities to effectively lead our finance team.

Elliott took over as WMC's Chief Operating Officer late last year, but has been at Western for 12 years and plays a significant role in building and managing our mortgage related efforts globally from a business perspective. So in addition to our investment objectives, which I've already mentioned, we have some important corporate goals, which include achieving operational excellence and the highest standards of financial reporting and disclosure.

Operationally, we're focused on best-in-class risk management and portfolio management practices, while increasing overall efficiency throughout our operations. We're continually reviewing operational aspects of how we run the company in order to ensure that we are implementing best practices and bringing the strength of Western Asset to WMC.

From a financial reporting standpoint we're committed to ensuring that you, WMC's shareholders are provided with disclosures and transparency that is comprehensive and relevant, which should enable you to make inform decision when investing in our stock. As always we welcome your feedback as this is an ongoing process.

Finally I'd like to make a few comments about our dividend policy. An important goal for us is to improve the stability of our dividend going forward. We recognize that the reduction in our dividend over the last several quarters have increased uncertainty about what shareholders might expect from us. So together with our Board we determined that future quarterly dividends will be based on a number of factors, including the current and expected earnings power of the portfolio, the sustainability of the dividend and the expected full year taxable income of the company. While we may also weigh other things such as potential tax accounting or regulatory considerations, we expect to give primary weight to the factors that I mentioned.

Consistent with this approach on June 23 we declared a second quarter dividend of $0.31 per share which was roughly equal to our second quarter core earnings plus drop income of $0.30 per share. Our current annualized dividend yield is about 12.5% based on yesterday's closing stock price and remains at the high end of the of our hybrid mortgage REIT peer group.

With that I will now turn over the call to Lisa Meyer to discuss our second quarter results. Lisa?

Lisa Meyer

Thank you, Jennifer. We have provided quite a bit of a detail in our earnings release and earnings presentation. So I will review our second quarter performance, I’m going to limit my discussion to particular areas where some additional commentary is warranted. I'm pleased to report that we delivered improved performance in the second quarter of 2016, generating an economic return on book value of 3. 9% and higher core earnings income plus drop income of $12.7 million or $0.30 per share.

On a GAAP basis we recorded net income of $17.3 million or $0.41 per share and increased our book value to $11.01, taking into account, our dividend declared in the second quarter. Our higher core earnings for the second quarter were primarily the result of higher gross yield on our assets, lower hedge, adjusted borrowing cost and lower expenses when compared to the first quarter. Both our agency and non-agency holdings increased in value over the course of the quarter, which helped contribute to our book value gain in the quarter.

Looking at it from another perspective, we generated approximately $22.4 million or $0.53 per share in net portfolio income, incurred $4.7 million in operating and general administrative expenses, excluding $346,000 of stock-based compensation or $0.11 per share, and declared dividends of $13 million or $0.31 per share, which all translated into an increase in book value of $4.6 million or $0.11 per share.

For clarification purposes, we defined net portfolio income to the GAAP net income excluding operating and general administrative expenses. Breaking down by source, the $22.4 million second quarter net portfolio income, approximately 7% of it was derived from our non-agency RMBS and CMBS holdings; 21% from our agency RMBS and CMBS holdings, which includes the impact of our hedge position, and the remaining 9% from our residential home loans and other securities.

Our average amortized cost of our investment was $2.6 billion, down 5% from first quarter, as we reduced the average portfolio leverage during the second quarter. Our weighted average net interest spread for the second quarter of 2016, which takes into account the fully hedged cost of our financing was 2.01%, reflecting a 4.45% gross yield on our portfolio and a 2.44% effective cost of fund.

Our net yield increased from the first quarter of 2016, due to a modestly higher gross yield on our portfolio and low effective interest cost as I mentioned earlier.

Our second quarter, our expenses for the second quarter excluding stock-based compensation of $346,000 was $4.7 million, decreasing 19% from $5.8 million in the first quarter of this year. While the decrease was mainly due to non-recurring expenses occurred in the first quarter, we continue to review our expenses to identify opportunities to operate more efficiently and further reduce our overhead.

As of June 30, the estimated fair value of our portfolio was $2.7 billion and we had borrowed a total of $2.3 billion under our existing Master repurchase agreements. Our leverage ratio was five times at quarter end and 5.5 times when adjusted for our net PDA positions.

We continue to have Repo capacity in excess of our current yield. At June 30, we had master repurchase agreements with 28 counterparties and outstanding borrowings with 20 counterparties. We continue to have excellent relationships with our bank counterparties. As of June 30, we entered into $4.2 billion in notional value fixed pay interest rate swap. Excluding four [ph] starting swaps of $1.7 billion and $4.0 billion in notional value variable pay interest rate swaps, giving us a net fixed pay swap position of $1.9 billion.

We are comfortable with our current leverage. We have and will continue to adjust our implied leverage fairly quickly through the use of our PDA, which enables us to optimize our earnings on risk adjusted basis. With that I will now turn the call over to Anup Agarwal. Anup?

Anup Agarwal

Thanks Lisa. Let me spend a few minutes discussing our portfolio management during the quarter and our outlook going forward. As we entered the second quarter we were operating with a view that both the U.S. and major global economies will continue to be in a slow growth environment and that inflation will remain subdued. We believe that this environment will cost the Fed to be slow to implement additional rate increases. We also believe that longer term treasuries and sovereign bonds will be underpinned by accommodative Central Bank policies in all major economies.

After experiencing a very volatile first quarter most spread sectors of the fixed income market staged a gradual recovery that began in late February and carried into the second quarter. However credit sensitive sectors in mortgage market lagged relative to the recovery in broader fixed income markets. We do expect that those spreads will tighten going forward in late June. Global markets were surprised by the result of [indiscernible] and the market appetite for risk on assets decreased dramatically for a very short period of time, as investors were concerned about the eventual impact of Britain [ph] leaving the EU. This led to a recovery in treasury markets and put pressure on the broader fixed income credit sectors.

Markets quickly rebounded from the levels initially experienced right after the news broke. All-in-all most of the credit sectors in the mortgage markets improved their value over the course of entire second quarter benefiting our portfolio as Lisa mentioned.

That being said, our current belief is that spreads across entire mortgage sectors offer attractive value relative to other fixed income alternatives. During the quarter we kept our sector allocations on a percentage basis fairly consistent, although we moderately reduced our overall portfolio leverage and repeated some of our closings within some sectors. With respect to our agency holdings we continue to hold a meaningful amount of longer duration lower coupon securities given our current view of lower but longer interest rates.

Agency mortgages continue to be supported by strong demand given their spreads over nominal sovereign debt. In addition we remain over weighed specified tools that have lower prepayment characteristics as we believe that re-financing risk continues to exist in this extremely low interest rate environment. While we believe that agency spreads will tighten over next 12 months they may widen in near term and we are well positioned to take advantage of opportunity if it arises.

The environment that we’ve outlined is constructive towards agency RMBS market and we continue to see long term value in the sector and expect it to be meaningful core holding. In the credit sensitive portion of the portfolio we opportunistically rotated out of some fully recovered lower yielding legacy non-agency RMBS into areas with greater recovery potential.

We also continue to be constructive on GSE credit risk transfer securities as we believe that they offer compelling risk adjusted returns relative to other sectors at present. And we will continue seek additional opportunities in this sector. Our non-agency CMBS holdings have yet to fully recover from the sell-off that begin late last year and continued into this year but we remain constructive on this sector.

We believe that these securities offer some of the most compelling spreads within our universe and also offer potential appreciation from what we believe are depressed levels. We expect that as new CMBS supply continues to slow down and risk redemption issues permitted [ph] to CMBS are resolved, CMBS spreads will tighten. With respect to our holdings in the residential home loans our exposure to this sector was stable during the second quarter. However we would expect that as we see opportunities we will increase our exposure to this asset class.

We are pleased with our financial results for the quarter and we remain optimistic going forward. As we’ve mentioned in the past we continue to position the portfolio to perform well over a longer investment horizon. As Jennifer mentioned at the beginning of this call, our goal is to generate sufficient core earnings to support an attractive dividend, while also maintaining our relatively stable book value. We plan on continuing to implement this strategy by holding a diversified portfolio of securities that offer what we believe to be best risk-adjusted returns over our investment horizon.

With that we will open up the call for questions.

Question-and-Answer Session


We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Rick Shane of JPMorgan. Please go ahead.

Rick Shane

Hi guys. Thanks for taking my questions and we really do appreciate the new slides. They are very helpful. Wanted to talk to two things, one is that on the agency book now you're showing a modest negative duration. I'm curious how we should be thinking about that over the near term in an environment where speeds are at least through the end of the year likely to remain relatively high.

Anup Agarwal

Sure. Rick great to talk to you. I think the way you should - the way I believe look and as we have mentioned that agency spreads - my thinking is that agency spreads will continue to - we may see some volatility in short term, but ultimately over a longer period of time by year-end or in six months they will be tighter. So in terms of duration our plan is to kind of continue to be close to home, pretty close to flat to slightly long. Again, as you know we shift our duration position actively based on the current market conditions we see. But over a long-term horizon I think the expectation and what I kind of see it as, it's pretty close to home in terms of our duration gap and opportunistically here they kind of have some slightly positive duration gap. But overall staying close to home.

Rick Shane

Got it. And my second question and I apologize for this. I frankly - probably we should understand this better than I do. But you are somewhat unique in at least as it appears to me you shared your swap position on a net basis, and rather than close out positions you've historically chosen to net them out. I'm curious is there a tax rationale for that in terms of avoiding realized and unrealized gains and losses. Why construct the portfolio in this the hedge portfolio in this way.

Lisa Meyer

Hi, this is Lisa Meyer. Yes, there is definitely a tax implication, because when buying some of these swaps you would recognize a realized loss. So it makes more sense to actually do offsetting transactions. So that this way you get the same economic impact but avoid the realized taxable losses.

Rick Shane

Got it. But the trade off to that - so I guess the advantage to avoiding the realized, the tax losses that it doesn't impact dividend. But to the extent you will realize losses in closing out these positions would you benefit shareholders in the form of lower management fees?

Lisa Meyer


Rick Shane

Got it, okay, thank you.


Our next question comes from Joel Houck with Wells Fargo. Please go ahead.

Joel Houck

Good morning everyone thanks for the additional disclosures and slides. So the last call it was - we talked about or I think you talked about how some of your assets to [ph] the non-agency holdings hadn't recovered as much as maybe people expected. And then in Q2 we saw the book value was up 1%. Can you maybe get a little more granular in terms of types of non-agency holdings that are improving in value, i.e. responding to a tighter spread environment versus those that aren't because my understanding is WMC is fairly diversifying its holding and I'm just a little surprised that we didn't see a bigger bounce back in book value in Q2 relative to how much it was down in Q1?

Anup Agarwal

Yeah I mean Joel, absolutely. Look I mean I think if you think about our overall mortgage credit book you have multiple segments of it. You have the legacy non-agency, then you have - on the residential side you have a non-agency legacy credit. Then you have a credit risk transfer securities. And then you have the commercial mortgage side. You have legacy CMBS as well as new issue CMBS junior, at BBB, BB and single B securities, or some of the mezz loans. And then you have [indiscernible].

So what you kind of saw in second quarter is significant movement in legacy side as well as credit risk transfer, the sector which lacked quite a bit and is starting to pick up the pace is really the CMBS sector. And I think you've kind of seen significant improvement on the sector in last even one week. I think one of the catalyst for CMBS or one of the technicals for CMBS has been on positive side there continues to be very low continued lower supply than expected.

But also market was trying to figure out where risk retention deals will come out, how it will come out and the benefit I have of speaking with you today is I can kind of say that there is actually one transaction which is risk retention compliant, which has come out. And the spreads on that - and actually Wells Fargo is one of manager in that transaction, and the triple B spreads for that transactions are at 450 or kind of [indiscernible].

So I think that was - those were the catalysts, that was a segment which was under performing. I expected a - we expected ultimately that is a sector which continues to be most opportunistic right now and over next three to six months I expect that's the segment where we will kind of see a bigger recovery.

Joel Houck

Okay, Anup. And prospectively would you say that where you sit today notwithstanding the widening, temporary widening we saw Brexit in early July that things are tighter today in your asset classes than they were at June 30, are there any –?

Anup Agarwal

Yeah, absolutely.

Joel Houck


Anup Agarwal

I mean Joel, kind of things are tighter today than Brexit - look I think as much as we were opportunistically ready for Brexit, and we wanted to add a lot. But we just did not see that much of spread widening in the market place. But overall things are tighter since kind of 6/30.

Joel Houck

Okay and then lastly maybe it's for Jennifer. As kind of new CEO coming in and we noticed that the duration has changed quite a bit from where it's historically been. Is that a function of more running kind of tighter books that we don't see as much book volatility or is it more expressed as a function of where you think rates or rate volatility could move from here?

Jennifer Murphy

Thanks. Whenever - whatever the duration position in the portfolio is entirely upto Anup and his team. So whatever you see reflected there reflects their views and their best positioning in the portfolio given what they know and what they see in the environment.

Joel Houck

Okay. So there is no change in terms of investment strategy or anything like that. It's still Anup and his team are going to run that as they see fit?

Jennifer Murphy

Absolutely. So I think our role as a management team, what Lisa and Elliot and I really focused on is again bringing the strength of Western Asset to WMC. That's been our focus. I think each of us has a role to play in doing that and we are finding, as we focus on that, [indiscernible] WMC has and Western Asset continues to grow and evolve and we are just seeing places where we could bring more of Western Asset's strength to WMC. So that's our focus and we want to support Anup and his team, so that they can focus on the portfolio as much as possible. So anything on portfolio or strategy it really reflects Anup and his teams best thinking.

Joel Houck

Okay. Thanks very much.


[Operator Instructions] We have no further questions Ms. Murphy.

Jennifer Murphy

Great. Thank you operator and thank you all for joining us for our call.


The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.

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