Q3 2019 Earnings Call

Welcome to Western asset mortgage Capital Corporation third quarter 2019 earnings Conference call.

Today's call is being recorded and will be available for replay beginning at five P.M. Eastern standard time.

This time, all participants have been placed in listen only mode and the field. The open for your questions. Following the presentation.

Now first I'd like to turn the call over to Mr., Larry Clark Investor Relations. Please go ahead Mr. Clark.

Thank you Charlie.

What do they get everyone for joining us today to discuss western asset mortgage capital Corporation's financial results for the three much ended Septemberthirty 2019.

The company issued its earnings press release yesterday.

Bill on the company's website at Www dot western asset MCC Dot com.

In addition, the company has included an accompanying slide presentation that you can refer to during the cold.

To access the slides in the Investor Relations section of the website.

With us today for management, our Jennifer Murphy, Chief Executive Officer.

Lisa Meyer, Chief Financial Officer, and Here's your bond 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 are results could differ materially from those forecast due to the impact of many factors beyond the control the company.

All forward looking statements included in this presentation are made only as of the D. This presentation are subject to change without notice.

Certain factors that could cause actual results could differ materially from those contain forward. Looking statements are included in the risk factor section of the company's reports filed with the FCC.

Copies are available in the Fccs web site.

We disclaim any obligation to update our forward looking statements unless required by law.

With that I'll turn the call over to Jennifer Murphy Jennifer.

Thank you Larry welcome everyone.

I'm pleased to report that we delivered another quarter of solid performance. Despite a market that continues to exhibit increased rate volatility.

We generated GAAP net income of 37 cents per share for the third quarter and core earnings of 28 cents per share for the quarter and 91 cents for the first nine months of the or.

The company's book value increased just under 1% in the quarter. Despite the volatility in fixed income markets.

Our differentiated strategy of holding a diverse portfolio of credit sensitive residential and commercial real estate assets complemented by our investments in mostly agency CMBS continued to largely balance our portfolio and mitigate the interest rate risks that impacted a number of other reach this quarter.

This is the main driver of our strong book value performance.

The book value increased together with our dividend provided our shareholders with an economic return on book value of 3.8% for the quarter and 10.3% for the first nine months so the here.

Our core earnings were down modestly from the second quarter, primarily due to heightened volatility in the repo market it temporarily impacted our cost of funds.

That being said our quarterly core earnings have been relatively consistent over the last three years, where they've averaged just over 33 cents per share, which averages higher than our quarterly dividend of 31 cents per share over that same time period.

We're comfortable with the earnings power of our portfolio currently and continue to find attractive investment opportunities. That's Harris is going to talk about.

As we've discussed in the past our dividend decisions in consultation with our board reflect our long term view of the earnings power of our portfolio rather than the level of core earnings in any given quarter.

We paid a consistent dividend for 14 quarters.

14 quarters and system stability in our dividend continues to be an important corporate goal for us.

I'm also pleased to report that in August we issued an additional $40 million a bar sixthree quarter percent convertible senior notes due in 2022, allowing us to further invest an attractive assets.

We believe this financing is it is an attractive source of longer term capital and we expect the assets for adding to contribute to the earnings power up our portfolio in coming quarters.

In addition, this financing supports our long term goal of growing the company to achieve increased scale, which we believe will also benefit our shareholders over time.

Our investment team was quite active again during the quarter selling over 560 million in agency MBS and redeploying the capital with the majority going into credit sensitive investments.

This investment activities similar to our past quarters is reflective of our active management approach.

During the quarter, we made a number of investments, where we were able to leverage the western asset investment platform to gain access to opportunities that we would not happen as a standalone mortgage riet.

This included investments, where we've deployed we've developed strategic relationships with residential and commercial mortgage loan originators, who understand what we're looking for and are able to provide us with attractive opportunities that meet our disciplined investment criteria.

So in conclusion, we're very pleased with our ongoing strong financial results, we've assembled a diversified portfolio of residential and commercial assets and we remained focus on our investment in operational execution that better enables us to deliver strong and consistent returns to shareholders.

Our performance is a testament really to the efforts of the entire investment team headed by Harris to fund, our Chief investment Officer, and Shawn Johnson, our Deputy Chief investment officer, and demonstrate the effectiveness of the strategic initiatives that we've been implementing over the last two years.

That I'm going to turn the call over to Lisa Meyer Lisa.

Thank you Jennifer.

What it could be another challenging quarter with significant interest rate volatility.

However, despite this turbulent market environment, our book value increased modestly to $10.60 and we generated an economic return on book value up 3.8%.

The key contributor to our ongoing strong performance is our diversified investment portfolio, which balances mainly agency CMBS and credit embedded with both residential and commercial loan exposure.

As Jonathan mentioned and I will provide more detail we were again quite active during the quarter rotating out of securities that were fully valued into investments that we believe well, it's a better relative value.

We continue to shift the mix about portfolio towards more credit investment.

Selling $562 million, even see Mds and re investing 327 of the millions of those proceeds.

Like combination of non agency CMBS commercial loan residential whole, though.

In the quarter, a portfolio generated net interest income of $19.3 million inclusive hedging call.

Our credit sensitive investments contributed 79%.

To that total compared to 72% in the second quarter.

Annualized net interest margin in the quarter was 1.9% down 45 basis points from the last quarter. The decline was the result of a lower weighted average yield on our portfolio combined with a higher effective cost the fun inclusive of our net hedging costs.

We generated net income of $19.7 million or 37 cents per share a core earnings.

He million dollars for 28 cents per share as Jennifer mentioned, our core earnings was down modestly from second quarter, mainly due to increased volatility in the repo market.

Oh, no short term interest rate declined in the third quarter did not experience a parallel don't decreasing repo rate, resulting in a higher effective cost of funds.

We have actively bagger, Oh, we purchase agreement maturity and mitigate our Oh just to the volatility in the market.

In the fourth quarter. The repo market has begun stabilized so we expect to see less of a negative impact inquiry.

At September Thirtyth, we had $2.5 billion repo borrowings under 20 about three re master repurchase agreement and $397 million outstanding under our longer term financing facility.

We continue to evaluate additional traffic sources of financing.

We continue to operate really significant your degree of interest rate protection from Alvin.

Production on our repo financing from interest rate swap position.

I Wonder and we held interest rate swaps that they know notional value.

<unk> point 5 billion dollar covering over 86% about outstanding variable rate debt.

The next to reaching DAC when our agency portfolio was <unk> 0.3 years.

A leverage ratio was 5.4 times at quarter end, excluding $1.5 billion of non recourse debt.

Which was down from 5.6 times at June Thirtyth 2019, as Jennifer mentioned, we issued an additional $40 million a 6.75 convertible senior notes maturing 2022.

Allowing us to further invest an attractive assets.

Over time, we expect adjusted leverage ratio will vary depending on the Nick about you can see and credit sensitive assets in the portfolio.

With that I will now turn the call with her shuffle <unk>.

Thanks Lisa.

Third quarter group to be another quarter of significant interest rate volatility.

To recap we saw rally in the waste market early in the quarter with a partial retracement in September prepayment fees on agency mortgages picked up due to an increase in refinance activity and I. Previously mentioned there was significant volatility in the repo market due to a variety of technical factors, which caused the federal reserve.

Measures to stabilize market.

Our view of the macro environment has not changed materially nor do we anticipate any near term changes to our broad market.

Interest rates continue to remain low with episodes of increased rate volatility. The U.S. economy continues to grow at a subdued yes study and it's modestly outperforming the lower global economy.

Inflation remains well below target level and central banks around the world continue to be accommodated in light of the slower global growth outlook.

Despite some do hey of economic growth in the U.S. consumer balance sheets remains solid and the robust labor market is supporting the housing sector, which continues to show positive improvement.

We believe that this backdrop should continue to provide a supportive environment for credit asset.

In general we have seen an increase in compelling investment opportunities across a number of the credit subsectors throughout the course of the ER and as a result, we continue to rotate the portfolio into more credit sensitive assets during the quarter.

Our investments were focused on remains jumped up there's commercial real estate whole loans non agency MBS and residential whole loans.

We invested $130 million into two sizable commercial real estate loan, where the collateral where new luxury retail mall.

These investments are very much consistent with our disciplined and selective approach to the space, where we focused on high quality property short duration loans and situations, where we generally are able to play significant role in shaping the credit protection and structural terms of the transaction.

We also invested and over $100 million in non agency CMBS during the quarter. We continue to hold a favorable view of commercial real estate fundamentals in the U.S. as demand drivers remain positive and new construction continues to be muted both factors being supported increased Ryan as.

Well as improved cash flow that property level.

We continue to find interesting opportunities in the residential whole loans day.

The U.S. housing sector continues to exhibit positive fundamentals a strong household formation is solid labor market and historically attractive mortgage rates are all contributing to ongoing demand and continued home price appreciation, albeit at a slower pace than the last few years.

Against this backdrop the supply of new homes remains somewhat constrained due to increased discipline, among the public homebuilders as well as tighter lending standards.

While we invested $80 million of capital into this asset class during the quarter a number of transactions that we have classic complete in the quarter were delayed to the fourth quarter.

We also believe that our agency MBS holdings, both commercial and residential provide an important balance to our credit sensitive assets and will remain a core component of our portfolio. However, we did sell about third of our agency RMBS holdings that we acquired during the second quarter as these securities performed well.

And in our view, we're fully valued.

He rotated a small portion of our agency MBS holdings during the quarter as well.

These were all security Pacific relative value trading as we generally continues to favor agency MBS over RMB.

As we have they didn't the path agency CMBS will remain a core component of our portfolio due to with attractive risk adjusted returns as well as its lower sensitivity to interest rate risk due to its built in prepayment protection and also because it's more efficient to hedge relative to agency RMBS.

Well agency MBS spreads widen modestly during the quarter, we where we saw significant volatility and interest rate. It did outperform agency RMBS, which is more strongly impacted my interest rate volatility and prepayments.

Our overall performance in the third quarter highlighted why we like this stuff throughout the market.

In summary, we're very pleased with the performance of our portfolio during the quarter and we continue to focus on our goal of delivering solid core earnings and preserving book value. Our differentiated approach is built on a barbell investment strategy that pairs agency MBS and to a lesser degree armed yeah with credit investments, which includes both.

Residential and commercial loan exposures.

We maintain an active approach to portfolio management continually seeking the best relative value opportunities within our target universe. We believe this approach is the best way to pursue our objective while continuing to enhance shareholder value.

With that we will open the call up to your question operator. Please go ahead.

We'll now begin the question and answer session to ask a question Press Star then one on your telephone keypad. If you are using a speakerphone. Please pick up your handset before pressing the keys.

Your question. Please press Star then too.

Our first question comes from Eric Hagen with KBW.

Hey, Thanks, guys. Good morning, I noticed that you didn't mention the residential bridge loan opportunity in your prepared remarks, and the portfolio has gone down a little bit over the last few quarters and [noise].

Just curious you know why you guys might not be that is.

And attractive opportunity set right now it just maybe runs a little bit in contrast, with some of the commentary you've heard from other rates.

Okay.

Thanks for the question there.

Let's say, it's not that we don't find the investment opportunity attractive. It's just on a relative basis, Judy compared to the other favored credit assets and Subsectors that we've been investing in namely non qualifying mortgages residential loan. That's some of the large transitional commercial loans as well as some of that.

Non agency security that we've been active and over the course of the last quarter. It's just simply not as attractive I'm. There's also a number of operational risk.

And and volatility that those types of bone import into the portfolio. As a result, we thought they were better opportunities away from this out there.

Okay. So it's not necessarily the credit that you dislike it's just the pricing it sounds like of the of the loans themselves that might not.

Might not be as attractive to.

That's correct, particularly relative to say a year ago sure sure sure sure. Thanks, and then just on the non QM side, how selective can you be with respect to the loans that you're buying from your.

Origination partners I mean, I think it's no secret that.

The prepayment speeds on those loans have been relatively fast. So I'm just curious that as you guys redeployed capital into that segment just.

How you know again, just how selective can you be <unk>.

I guess, that's the question thanks.

Yeah, Hey, it's Sean how you doing and John how are you. Good. Thanks, what would you know the originators that we we've been buying from continued to produce.

A.

A consistent product and so we continue to see the higher quality stuff coming coming out of them and we've been able to purchase more of that it's become a bit more competitive.

From a price standpoint, but but we still are able to the by what we need to buy.

We've also.

Ben or adding some new new originators that that are producing loans in the in the quality sector that we care about.

We've seen tremendous growth in sectors that are.

Sort of outside of our target.

Corporate credit and a and rate and so.

So it feels like a whole market is growing pretty rapidly and you know demand as well is growing.

But we still feel like we're in a good place with with our target for the Sunset.

I would I'd, just add more broadly or even away from non QM. You know the one thing that's critically important for myself and Sean and the rest and investment team is never to sacrifice our discipline on credit.

So you know thats simply means that we step away from it's not fair as we were talking about a few moments ago, then we're completely comfortable with that.

Got it yeah, that's helpful, but a that definitely answers. The question how many origination partners are you guys working with on the non QM side.

We we have seven active partners and we have a couple more that are coming onboard here and then that's a couple of weeks.

Okay Super and then one housekeeping item just the transactions that were delayed into the fourth quarter or am I hearing you that the yield will improve because of those transactions in the fourth quarter.

Stay relatively the same.

Yes, it will stay relatively the same.

Okay.

Thanks, guys for the comments I appreciate it thanks to the question there.

Our next question comes from Trevor Cranston JMP Securities.

Alright, thanks, good morning.

So a question on the non QM portfolio.

Yeah. It sounds like there's some transactions pending for Fourq you can you guys talk about how you're currently thinking about the accessing the securitization market again sort of loans that you're currently holding a outside of securitization.

And how you're viewing the profitability of financing parts securitization, given how far rich corrado. Thanks.

Yeah, I think you know, we still view that securitization market for for those assets that as wide open. So in terms of your question on profitability. You know what are you in the attractiveness of securitization hasn't really changed much over the course of the year anything it's become more attractive as a fund.

Good thing option over the course of the year you know one in terms of our plan.

You know as as as Sean mentioned, we are in the process of Onboarding, a couple new originator counterparties and so we certainly expect to be able to access the securitization market at some point in 21.

Okay, great. Thank you.

And then I understand I understood from the in her prepared comments you guys made the.

The core focus of the portfolio continues to be.

The barbell between agency CMBS in credit.

But you did note the agency RMBS, obviously underperformed during the third quarter quite a bit.

Over the short term or you're going to seeing any opportunities to to add to that portion of the portfolio or would you still see the within the agency sector, even given that widening the RMBS space you continue to favor agency CMBS near term.

I I think generally speaking, we still do favor agent and yes, because as I mentioned earlier during the prepared comment there are just structural advantages to that market relative to RMBS that said of the agency RMBS market to your point has continued.

She cheesy not a and it's currently trading that multi year wise relative to any comparable restaurant that certainly is much more attractive. Now then then it has been in quite some time as a result.

Okay Gotcha that last question.

You guys mentioned that repo and improve somewhat in the fourth quarter can you provide any additional color sort of on where you're seeing agency repo rates are currently, particularly after the fed <unk> we had recently.

Yeah, Hi, it's Sean we've.

We saw.

No pre craziness a in September .

Agency repo trading close to LIBOR floor, and when things got a weird it why that's about LIBOR plus 20.

Right now we're back to you know for a three month LIBOR <unk> Fremont repo, we're looking at LIBOR or LIBOR, plus two something something in that area. So it's really normalize back where it was before you know the real stresses hit the market.

Okay, great appreciate the color. Thank you yeah.

Again, if he would like to ask a question. Please press Star then one.

As we have no further questions. This will conclude our question and answer session I would like to turn the conference back over to Jennifer Murphy for any closing remarks.

Thanks, everybody for joining us in for your questions today, and we'll talk too soon.

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

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