Western Asset Mortgage Capital - Q1 2023

Transcript

Operator (participant)

Welcome to the Western Asset Mortgage Capital Corporation first quarter 2023 earnings conference call. Today's call is being recorded and will be available for replay beginning at 5:00 P.M. Eastern Standard Time. Now I'd like to turn the call over to Mr. Larry Clark, Investor Relations. Please go ahead, Mr. Clark.

Larry Clark (Head of Investor Relations)

Thank you, Sarah. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the first quarter of 2023. The company issued its earnings press release yesterday afternoon and it's available in the investor relations section of the company's website. In addition, the company has included a slide presentation on the website that you can refer to during this call. With us today from our management team are Bonnie Wongtrakool, Chief Executive Officer, Robert Lehman, Chief Financial Officer, Greg Handler, Chief Investment Officer, and Sean Johnson, Deputy Chief Investment Officer. Before we begin, I'd like to remind you that last August, the company's board of directors authorized a review of strategic alternatives aimed at enhancing shareholder value, which may include a sale or merger of the company.

No assurance can be given that the review being undertaken will result in a sale, merger, or other transaction involving the company. To avoid speculation, the company intends to refrain from making comments related to the strategic review process until definitive agreement has been reached or until the process of exploring strategic alternatives has ended. I'll now 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 forecasts 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 SEC. We disclaim any obligation to update our forward-looking statements unless required by law. With that, I'll now turn the call over to Bonnie Wongtrakool. Bonnie?

Bonnie Wongtrakool (CEO)

Thank you Larry, and welcome everyone. Before I discuss our first quarter financial results, I would like to say , few words about our ongoing review of strategic alternatives for the company. Last August, we embarked upon a process to review strategic alternatives for the company as the best path forward towards unlocking shareholder value. The market environment for mortgage rates over the last several quarters has been remarkably challenging, with record levels of interest rate volatility and increasing risks to economic growth. This has added complexity to our exploration of strategic partners. As fellow shareholders, we are committed to concluding this process as quickly and responsibly as we can, and we will provide an update at the appropriate time.

Meanwhile we continue to run the company in a manner that is consistent with our goal of optimizing the value of our assets and maintaining stable earnings, which in turn should support our ability to pay an attractive dividend. We truly appreciate our shareholders who have remained with us through this challenging period. I will now turn to our quarterly results. During the first quarter, we remained focused on strengthening our balance sheet and increasing our liquidity as the volatility in the equity and fixed income markets continued and was further punctuated by the news of two high-profile bank failures. Despite this, our first quarter results improved sequentially from the fourth quarter, driven by higher earnings and improved asset prices across most of our portfolios.

We also received approximately $67 million from the sale, repayment, or paydowns of investments and used these proceeds to further reduce our recourse debt. Our GAAP book value per share increased 4.8% from the prior quarter, while economic book value per share increased 1.8%. We generated higher net interest income during the quarter, driven by a higher net interest margin and higher income from our interest rate swap positions, while our operating expenses declined from the prior quarter. Consequently, our distributable earnings of $2.2 million or $0.36 per share in the first quarter were up $200,000 or 7.7% from the fourth quarter and exceeded the $0.35 per share dividend that we declared for the quarter.

In March we made the decision to reset our quarterly dividends to better reflect our earnings power as we continue to reposition the portfolio. Consistent with our dividend philosophy, we will reassess the level of the dividend based on a number of factors, including the future earnings power of the portfolio and the level of any taxable income that we anticipate for the calendar year. During the first quarter, with the exception of a small amount of rotation within our non-agency residential securities holdings, we did not acquire any target assets and instead focused primarily on strengthening our balance sheet through further debt reduction and increasing our liquidity. We remain confident that we have sufficient liquidity to execute our investment strategy as we continue to monetize our non-core commercial assets in an orderly manner. We also remain confident in the overall credit quality of our portfolio.

The residential loans that we own have been diligently underwritten and are supported by significant homeowner equity. Our residential portfolio is performing as expected. In summary, we continue to take steps to further strengthen our balance sheet and maintain the earnings power of the portfolio with the overarching goal of building value for our shareholders. Now I'll hand it over to Sean and Greg to go into more detail about the investment portfolio. Sean?

Sean Johnson (Deputy Chief Investment Officer)

Thank you, Bonnie. During the first quarter, interest rates remained volatile against the backdrop of the market's changing sentiment about future Fed actions. In February, the 10-year treasury yield rapidly increased by 60 basis points, topping 4%, only to completely reverse course after events in the banking sector, dropping back to 3.4%. Against this volatility, credit spreads widened across most risk assets, with some asset classes being impacted more than others. For example, residential credit spreads fared much better than commercial real estate spreads. The vast majority of our residential whole loans are held within our four securitizations, and those portfolios continue to perform in line with our expectations.

Of the nearly 3,000 mortgages that are securitized, fewer than 1% of them were more than 30 days delinquent at quarter end underscoring the effectiveness of our credit underwriting standards, which focus on high-quality borrowers who have meaningful equity in their homes. At origination, our weighted average loan-to-value ratio of the pool of mortgages was 66%, and the average FICO score for our borrowers was 749. Nearly half of our non-QM loan portfolio consists of adjustable rate mortgages. During the first quarter, approximately $11 million worth of loans reset to higher floating rates. More than $75 million of current non-QM loan holdings are scheduled to reset over the remainder of 2023, with more than $330 million resetting in the next 4 years.

Our NIM should benefit as these loans are almost entirely funded with fixed rate securitized debt. First quarter non-QM prepayments were 7.5 CPR compared to 6.2 CPR in the fourth quarter and 12.4 CPR in the third quarter of last year. As a result, premium amortization from loan prepayments in the quarter was $721,000, relatively consistent with $677,000 in the fourth quarter. We continue to believe that higher mortgage rates will weigh on refinancing activity in our portfolio, keeping it relatively low. We did not acquire any non-QM loans during the quarter as our focus was on paying down recourse debt and maintaining sufficient liquidity on our balance sheet. Now a few words on the overall housing market.

After booming during the last couple of years, home prices have begun to stall and even decline in certain markets under the pressure of higher mortgage rates and lack of affordability. The housing market surge during 2020 and 2021 was primarily due to inadequate supply relative to increased demand. More recently, new supply has come online. Demand has cooled in response to higher rates, creating a more balanced market. Given the potential for a recession, we believe that there will be continued modest downward pressure on home prices. While housing is expected to cool, we do not see a significant risk of widespread defaults or home price correction, particularly as it relates to our portfolio. This assessment is mainly due to underwriting standards remaining disciplined during the cycle and our approach of targeting high-quality borrowers.

In addition we do not see the risk of higher rates impacting borrowers who have already locked in ultra-low mortgage rates. We expect the volatility in interest rates and spreads to decline as we get more clarity on the conclusion of the Fed's tightening cycle. We believe that spread normalization combined with high carry should provide upside value to our residential holdings. With that, I'll turn the call over to Greg Handler to discuss our commercial holdings. Greg?

Greg Handler (Chief Investment Officer)

Thanks. Thanks, Sean. The overall market sentiment for commercial real estate credit remains challenged. We see three primary reasons for this. First, the Fed rate hikes have resulted in higher mortgage coupons negatively impacting cap rates and collateral valuations as equity investors adjust to the higher capital costs. Second, the recent banking industry stresses have impacted credit spreads broadly and over time are expected to drive further reductions in real estate credit availability and a tightening of underwriting standards. Lastly, the fundamental concerns over office values have escalated and some notable high-profile defaults have recently occurred. The office market faces a highly uncertain future with significant questions about the long-term viability of lower quality properties. Our exposure to office buildings is minimal across our commercial investments. We do not see as many fundamental concerns in the non-office CRE sectors.

Notably, the multifamily housing, industrial, hospitality, and retail sectors, where operating incomes and rents have predominantly recovered to, and in many cases are now outperforming pre-COVID levels. We believe that our commercial mortgage portfolio, while not immune to this negative market sentiment, is unique and well-positioned to withstand a deteriorating economic environment. Turning to our commercial portfolio. During the first quarter, spreads continued to widen across the commercial mortgage credit sector, but our commercial holdings were only modestly impacted. At quarter end we held five commercial whole loans with a combined fair value of $79 million, a slight discount to the $81 million par value.

All of these loans have performed in line with expectations, and we expect these loans to pay off at par over the next several quarters as properties are either sold or refinanced. However the ultimate timing and realization of loan payouts depends on the specific factors pertaining to each property and there can be no assurance as to whether or when these payouts will occur. During the quarter we received a partial repayment from one loan in exchange for a modest maturity extension. We also received a 50 basis point extension fee on this loan. This $13 and a half million dollar loan is backed by a skilled nursing facility and had an LTV of 49% at origination. Within the non-agency commercial mortgage-backed securities, our single asset, single borrower credit portfolio is valued at $53 million.

During the first quarter, we received a $20 million full repayment at par on one loan in this portfolio, which was backed by a hotel. This reduces our SASB exposure, which was $75 million at the beginning of the year. The remaining portfolio consists of eight loans, which are primarily backed by Class A retail and hotel properties that cater to leisure travelers. We continue to see positive operating momentum at a number of these properties. These properties are generally high quality assets with strong equity sponsors, we believe that their collateral values have not been materially or permanently impaired.

However, given the current negative sentiment for commercial real estate, this portfolio is currently marked at 71% of the combined principal balance, despite the fact that these loans had an approximate 65% original loan-to-value and all but one of them representing less than $1 million of the $53 million portfolio remains current. Our CMBS conduit exposure is valued at $10 million, down modestly from the fourth quarter mark of $10.5 million. We remain focused on optimizing the recovery value in our commercial portfolio and intend to use those proceeds to pay down our recourse debt levels and to opportunistically reinvest into new target assets that continue to offer attractive risk-adjusted returns. I'll now turn the call over to Bob Lehman, our CFO. Bob?

Robert Lehman (CFO)

Thank you, Greg. We have provided you with great detail on our portfolio in both our first quarter press release and our earnings presentation. I'm going to focus here only on items that warrant additional attention. We reported distributable earnings of $2.2 million, or $0.36 per share for the first quarter, up from the fourth quarter's level of $2 million or $0.33 per share. The $0.03 per share improvement in the first quarter distributable earnings was primarily driven by an increase in net swap interest income and lower core operating expenses, partially offset by a reduced net interest margin. With respect to our core expenses, we expect to benefit from additional operating efficiency improvements in the future, with offsets for costs we may incur with respect to our strategic review process.

GAAP book value for the quarter was $16.46 per share, an increase of $0.76 or 4.8% from the fourth quarter. The increase was driven by the increased valuation of our residential whole loan portfolio, partially offset by spread widening across our commercial holdings. Economic book value, which reflects the value of our retained interest in the consolidated securitization trust rather than the associated gross assets and liabilities, increased by 1.8% for the quarter to $17.54 per share. Turning to leverage. Our recourse leverage ratio at quarter end was 2.6x, down from the 2.9x at year end.

The lower leverage ratio was primarily due to the paydown of $28.1 million of recourse borrowings as a result of the maturity and payoff of commercial security and asset sales during the quarter. Our GAAP book value also contributed modestly to the lower leverage ratio. Turning to liquidity, we ended the quarter with unrestricted cash of $16.1 million and approximately $17 million of unencumbered assets. Subsequent to quarter end, we entered into a new repo financing facility for non-agency CMBS and RMBS portfolios as it was scheduled to mature on May 2nd of this year. The new facility matures in May 2024, with an initial amount outstanding of $60 million. In summary we remain focused on actions that will solidify our capital structure and maintain our liquidity.

With a significant portion of our assets now financed by attractive longer-term financing, we feel that we are well positioned to generate consistent distributable earnings with the objective of supporting our dividend in the quarters ahead. With that, we are happy to take your questions. Operator, you may now open the call to questions.

Operator (participant)

Thank you. We will now begin the question and answer session. To ask a question, you may press star then one on your telephone keypad. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. Our first question comes from Matthew Erdner with JonesTrading. Please go ahead.

Matthew Erdner (Director of Equity Research)

Hey, guys. This is Matthew on for Jason. Thanks for opening up for questions today. I appreciate it. Correct me if I'm wrong here but you said you had $330 million in adjustable rates. Could you tell me a little bit about the rate of origination and what it will reset at, and if there's any concerns on credit deterioration there?

Greg Handler (Chief Investment Officer)

Yeah. The $330 million is what's scheduled in the next 4 years. It is roughly 49% of the total non-QM loans are adjustable. Most of those are, you know, have a note rate for that is the either the start rate or the margin. There's interim caps involved and whatnot.

What we've been seeing in the resets is that the new note rate is just slightly below what market rates are right now. That, you know, continues to look comparatively lower than, you know, going out and trying to refinance into a new note. You know, I can get into, you know, some of the details, but essentially, the margins are between 350 and 500 over the SOFR, 1-year SOFR rate, generally.

Matthew Erdner (Director of Equity Research)

Okay, thanks. You mentioned continuing to reposition the portfolio. What do you think is the best allocation of capital going forward? Are you guys looking to stay in commercial, get out of commercial, increase in non-agency, non-QM? What's the plan there?

Sean Johnson (Deputy Chief Investment Officer)

Go ahead, Greg. I, you know, I think obviously we're committed to transitioning the portfolio still towards the residential side. That's been our focus as well as, you know, prudently managing liquidity and leverage. I think valuations are still pretty compelling across the board. You know, we see obviously today's note rates, there's not a lot of supply of new mortgages being created, but, you know, we do think that there's a lot of value at, you know, rates today in the 7%-9% range. You know, in the securities market, you know, we still see spreads at elevated levels.

Yeah, I think still focusing on optimizing, you know, the value, of what we do hold and, you know, I think opportunistically looking to rotate into residential-focused sectors.

Matthew Erdner (Director of Equity Research)

Gotcha. Following up on that, in terms of opportunistic investments, it's good to see you guys are paying down some of the recourse debt, but how are you valuing that versus MBS or RMBS at the current spreads?

Sean Johnson (Deputy Chief Investment Officer)

You know, I think it's a - we did do some reinvestment in the quarter. We've been rotating a bit within our position as well, you know, trying to take advantage of some of the opportunities as we see them. Yeah, obviously, you know, cost of financing, you know, continues to be elevated as well. It's a balancing act in terms of where we see, you know, liquidity management relative to, you know, I do believe attractive, you know, investment opportunities.

Matthew Erdner (Director of Equity Research)

Awesome. Thanks guys.

Greg Handler (Chief Investment Officer)

Thank you.

Operator (participant)

Again if you'd like to ask a question, please press star then one at this time. Hearing no further questions, this concludes our question and answer session. I would like to turn the conference back over to management for any closing remarks.

Bonnie Wongtrakool (CEO)

Thank you all again for joining us for today's call. We appreciate your continued interest in WMC. We hope you all have a good day. We look forward to keeping you apprised of our progress in the months ahead.

Operator (participant)

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