Western Asset Mortgage Capital Corp (NYSE:WMC) Q2 2022 Earnings Conference Call August 5, 2022 12:00 PM ET
Corporate Participants
Larry Clark – Investor Relations
Bonnie Wongtrakool – Chief Executive Officer
Greg Handler – Chief Investment Officer
Bob Lehman – Chief Financial Officer
Conference Call Participants
Operator
Welcome to Western Asset Mortgage Capital Corporation’s Second Quarter 2022 Earnings Conference Call. Today’s call is being recorded and will be available for replay beginning at 5:00 PM 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
Thank you, Anthony. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation’s financial results for the second quarter of 2022. 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 the call.
With us today from our management are Bonnie Wongtrakool, Chief Executive Officer; Bob Lehman, Chief Financial Officer and Greg Handler, Chief Investment Officer.
Before we begin, I’d like to remind everyone that yesterday the company announced that its Board of Directors has authorized a review of strategic alternatives for the company aimed at enhancing in shareholder value, which we include a sale and merger of the company. No assurance can be given that the review being undertaken will result in a sale or merger or other transaction involving the company and the company has not set a timetable for completion of the review process.
The company does not intend to make any further statements regarding this process, unless and until a definitive agreement has been reached, or until the process of exploring strategic alternatives has ended. Therefore, as a result of embarking upon this process, we will limit this call to our prepared remarks and will not be conducting a question-and-answer session during the call.
I will 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
Thank you, Larry, and welcome, everyone.
Before I discuss our second quarter financial results, I’d like to say a few words about our Board’s decision to review strategic alternatives for the company. As many of you know, while we’ve continued to benefit from the global scale of our manager Western Assets, we have always viewed the benefits of scale as essential for WMC to support our long-term goals of increasing value and liquidity for our shareholders. The primary way to achieve scale as a mortgage REIT is to issue additional common equity. But our philosophy and practice has been to conduct equity offerings only at such times when they have not been materially diluted to existing shareholders.
The last time we issued any meaningful amount of equity within the second quarter of 2019, when we raised nearly $50 million, which was done at a modest discount to our book value at that time. Unfortunately, when COVID hit the following spring, our portfolio experienced a significant decline in value and our stock price experienced an even greater decline relative to book value. Since then, our overarching goal has been to improve and stabilize our futures earnings power.
Over the last few years, we’ve made significant progress by taking actions to improve our liquidity and balance sheets, and by shifting our investment focus towards residential real estate. Nonetheless, we do not see these positive actions being reflected in our stock price. Therefore, we believe that yesterday’s announcement regarding our decision to review strategic alternatives is the best path forward towards unlocking shareholder value. And we are committed to analyzing alternatives that may involve a sale, merger or other transaction involving the company.
In the meantime, we will continue to run the company in a manner consistent with our goal of optimizing the value of our assets and achieving improved and stable earnings, which will in turn support our ability to pay an attractive dividend. We truly appreciate our shareholders who have remained with us through this challenging period. And we as fellow shareholders are excited to initiate this process. With that, I will now turn to our quarterly results.
Our second quarter results continued to reflect the ongoing challenges of interest rate volatility and fluctuating asset values, which again translated into credit spread widening across our holdings. This market volatility puts pressure on our guest book value per share, which declined 15% from the prior quarter. While economics book value per share declined 12.4%. However, we are pleased to report that we generated higher distributable earnings in the quarter driven by higher net interest income from our larger residential home loan portfolio and lower prepayments in that portfolio.
On our last call, we shared our view that prepayment activity would moderate in the coming quarters. This indeed began to happen in the second quarter. We’re also beginning to see the benefits of our transition to a residential investment focus, as the increase in our net interest income in the quarter was substantially driven by our deployment of incremental capital into residential assets.
Consequently, our distributable earnings were $2.7 million, or $0.44 per share in the second quarter, which represented an increase of $2.3 million from the first quarter. In addition, our earnings more than covered our dividend for the quarter, which is consistent with our goal of paying dividends that are supported by the long-term earnings power of the portfolio. During the second quarter, we continued to implement our strategic portfolio shift with the focus on residential real estate related investments as we acquired $293 million of residential holders in anticipation of executing our fourth whole loan securitization, which was completed in early July. Greg will provide more detail regarding the economics of the securitization in his remarks.
We continue to strengthen our balance sheet during the quarter, selling approximately $42 million of investments, including non-agency RMB, and CMBS as well as repurchasing another 7.2 million aggregate principal amount of our existing 2022 notes at an approximate premium to par value of 1%.
We are confident that we have sufficient liquidity to retire the remaining 27 million of outstanding 2022 notes on or prior to their October maturity date. The ongoing market volatility fueled by concerns of elevated inflation level and rising interest rates clearly put pressure on our asset values during the quarter. However, we were able to mitigate some of this pressure through our hedging strategies and remain comfortable with the overall credit quality of our portfolio.
The residential loans that we target are rigorously underwritten and supported by significant homeowner equity, and the residential loan portfolio is performing as expected.
In summary, we continue to take steps to resolve our challenge investments and to further strengthen our balance sheet and improve the earning power of the portfolio. As always, we remain committed to building value for our shareholders.
Now, I’ll hand it over to Greg to go into more detail about the investment portfolio. Greg?
Greg Handler
Thanks, Bonnie.
We were active again this quarter and repositioning the portfolio, adding non-qualified residential mortgages to our holdings as spreads widen and selling some non-core assets.
During the quarter we acquired 293 million of residential whole loans in anticipation of executing our fourth securitization, which we completed in July, as Bonnie noted. Through the first half of the year, we have purchased over 400 million of non-QM loans, which has enabled us to grow this portion of our portfolio by approximately 27% year-to-date, net of payoffs and before the impact of mark-to-market adjustments.
In our last latest securitization, we contributed 402 million of principal amounts of loans as collateral for the 352 million of fixed rate long-term financing we obtained. The weighted average coupon rate on an offer notes was 4.95% and weighted average interest rate on the pool of mortgages was 5.45% because both the mortgages and the notes were placed into the securitization trust, and modest discount to par value, our economic spread on the transaction was approximately 90 basis points, which we estimate translates into an approximate return on equity of between 8% and 12%. While this spread is lower than in past securitizations, we believe it was the right time to lock in long-term permanent financing.
Our non-QM portfolio continues to perform well, with less than 1% of our total loans in terms of dollar value being more than 60 days delinquent at quarter end. This underscores the effectiveness of our credit underwriting standards, focusing on high quality borrowers that have meaningful equity in their homes.
Our weighted average original loan-to-value ratio is 65% and the average FICO score for our borrowers at origination was 748. While we expect home price appreciation to moderate from its recent historic levels, we believe the housing market will remain well supported with more normalized supply and demand dynamics and higher mortgage rates.
As a result, we have adjusted our national home price forecasts for the second half of 2022 to be flat, which would still leave the year appreciation at around 9%. In 2023 and beyond, we anticipate a return to pre-pandemic appreciation rate of 2% to 4% per year. Non-QM lending is expected to contract meaningfully in the second half of the year, as fewer borrowers will qualify or have demand at higher levels of mortgage rates, which today stand around 7%.
We also see market returns continuing to be pressured by higher cost of funds. While housing prices and activity are expected to moderate, we do not see the significant risk of defaults or home price corrections that current market pricing implies. We believe that inflation will moderate in the second half of 2022 and into 2023 and therefore expect the volatility and rates and spreads to decline significantly. We believe there is strong total return potential from spread normalization and that the benefit of the high carrying today’s market will provide incremental value to WMC.
Now, turning to our commercial portfolio. During the second quarter spreads generally widened across the commercial mortgage credit sector but our commercial holdings in aggregate were only modestly impacted by the market move. At quarter-end, we held seven commercial whole loans at a fair value of $128 million, although one of these loans have performed in line with expectations. The six performing loans represent $102 million of principal balance and are currently marked at just over $101 million a negligible discount to cost. We expect these loans to pay off over the next several quarters as properties are either sold or refinanced. However, the ultimate timing and realization of loan payoff depends on the specific factors pertaining to each property, and there could be no assurance as to whether or when these pay offs will occur.
With respect to the junior mezzanine loan, backed by our retail and entertainment complex located in the Northeast, we continue to engage in discussions with the borrower and certain other lenders regarding potential alternative to a judicial process. These negotiations have been ongoing for several months and are taking somewhat longer than expected due to the number of parties involved and the complexity of potential resolution structures.
We continue to believe the property has significant upside and are seeing encouraging growth in sales and attendance, as well as positive momentum in meeting activity. As we have noted previously, there remains a risk of further impairment under certain scenarios, given the ongoing uncertainty regarding these possible outcomes our loan is currently marked at a value of $27 million, similar to the first quarter.
Within non-agency commercial mortgage-backed securities, our large loan credit portfolio is valued at $82.3 million down slightly from the prior quarter. This portfolio consists mainly of Class A retail and hotel properties that cater to leisure travelers. We are continuing to see positive operating momentum at a number of these properties. This portion of our portfolio had an approximate 65% original loan-to-value and either one of these loans representing less than $1 million of the $82 million portfolio remain current. These properties are generally high-quality assets with strong equity sponsors. So we believe that their collateral values have not been materially or permanently impaired.
Our CMBS conduit exposure is now valued at $10.8 million as we sold our holdings that were non-accrual during the quarter. All together, we sold over $42 million of non-core investments, including non-Agency RMBS, CRT securities and the conduit CMBS investments just referenced. The proceeds from these sales were used to partially fund the equity portion of our residential whole loan purchases during the quarter.
We remain focused on optimizing the recovery values in our commercial portfolio and intend to use those proceeds to pay down our recourse debt levels and to 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?
Bob Lehman
Thank you, Greg. We provide a great detail regarding our portfolio and our second quarter results in our press release and our earnings presentation. So I’m going to focus here only on items that warrant additional discussion. And as we noted in the early earnings release, all per share amounts have been adjusted to reflect the 1 for 10 reverse stock split that we implemented on July 11.
We reported distributable earnings of $2.7 million, or $0.44 per share for the second quarter, up from the first quarter’s level of $379,000 or $0.06 per share. This increase was primarily due to approximately $2.1 million of higher net interest income on our residential investments driven by a larger portfolio as well as a lower level of prepayments in our residential whole loan portfolio. There were $59.6 million of residential whole loan paid down during the quarter, down from $95.6 million in the first quarter. This resulted in $1.8 million of premium amortization, which was down from $2.5 million in the first quarter. We expect to see an even lower level of premium amortization in future quarters, as we expect the level of prepayments to continue to moderate.
We also benefited from lower operating expenses in the quarter, when excluding the costs associated with completing the residential whole loan securitization in the first quarter, our focus on discipline expense management resulted in a decrease in total operating expenses of $303,000. We experienced lower management fees of $98,000 due to a lower capital base, lower compensation expense of $368,000 due to recent personnel turnover and lower general and administrative expenses of $133,000. This was offset by higher professional fees of $296,000 as a result of higher accounting related consulting fees.
In the second quarter, we generated distributable earnings that exceeded our dividend to $0.40 per share. We will continue to evaluate the level of the dividend every quarter based on several factors, including our outlook for the long-term sustainable earnings power of the portfolio, and our taxable income. GAAP book value for the quarter was $23.23 per share a decrease of $4.10 or 15% from the first quarter. Decline was driven by spread widening across our holdings, but mainly from our residential whole loans due to the relative size in the overall portfolio.
The wider spreads lead to unrealized losses of $38.3 million or $6.35 per share, while we also recorded $45.7 million of realized losses in the quarter primarily due to the sale of our CMBS holdings that were on non-accrual and these losses were substantially offset by the recapture of previously recorded unrealized losses.
We also recorded $6.5 million or $1.7 per share of net gains from our derivatives due to our hedging activity during the quarter. Economic book value which reflects the value of our retained interest in the consolidated securitization trust, rather than the associated gross assets and liabilities decreased by 12.4% for the quarter to 24.58 per share.
Turning to leverage, our recourse leverage ratio at quarter end was 4.7x up from the 2.8x at March 31, 2022. The increase in leverage was due to the addition of non-QM loans in the portfolio and temporarily financing them through our residential whole loan facility. Following the completion of our securitization in July, our recourse leverage ratio fell to approximately 2.4x.
Turning to liquidity, we ended the quarter with unrestricted cash of $15.9 million. The securitization freed up additional cash and as of the end of July, we had $24.1 million of unrestricted cash plus access to additional borrowing capacity. We believe we have sufficient liquidity to address the remaining $27 million outstanding balance of the 22 notes and plan to continue to repurchase them between now and their October 1 maturity date.
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’re well positioned to generate consistent distributable earnings with the objective of supporting our dividend in the quarters ahead.
With that, I will turn it back to Bonnie for closing remarks. Bonnie?
Question-and-Answer Session
Q – Unidentified Analyst
Bonnie Wongtrakool
Thank you, Bob. And thank all of you again for joining us for today’s call. We appreciate your continued interest in WMC and look forward to keeping you apprised of our progress in the months ahead. Hope you have a good day and stay healthy and safe.
Operator
The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.
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