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spk06: Welcome to Western Asset Mortgage Capital Corporation's second quarter of 2021 earnings conference call. Today's call is being recorded and will be available for replay beginning at 5 p.m. 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. Please go ahead, Mr. Clark.
spk02: Thank you, Tom. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the second quarter of 2021. 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 team are Jennifer Murphy, Chief Executive Officer, Lisa Meyer, Chief Financial Officer, Greg Handler, Chief Investment Officer, and Sean Johnson, Deputy 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 factor 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 Jennifer Murphy. Jennifer?
spk00: Thank you, Larry. Welcome, everyone. As you know from our previous quarterly updates, our expectation for the last several quarters has been that the U.S. economy would continue to recover and that our portfolio's credit-oriented holdings were likely to benefit. That was broadly the case in the second quarter, as narrowing credit spreads resulted in improving prices across a number of our portfolio holdings, but with one very notable exception. A commercial junior mezzanine whole loan in our portfolio was very negatively impacted, as its specific operational challenges resulted in it becoming nonperforming, among other issues, contributing to a significant decline in its fair value. This, in turn, negatively affected the company's book value and earnings, as our GAAP book value fell 16.9% from the first quarter to $3.55 per share, and we reported a GAAP net loss of $40.2 million, or 66 cents per share. This commercial junior mezzanine loan is a very meaningful exposure for the company. Our management team is devoting significant time and resources to it with support from the broader Western Asset Platform. We are focused on doing everything we can to improve the potential outcome of this situation for WMC shareholders and continue to make it a very high priority. Greg will discuss more of the details of this situation later in the call. WMC's distributable earnings, which we used to call core, for the second quarter were $2.8 million, or 5 cents per share, and were also impacted by this commercial junior mezzanine loan's move to non-accrual status during the quarter. In addition, we experienced an increased level of prepayments in our residential hold loan portfolio, which resulted in higher loan premium amortization during the quarter, also impacting earnings. Aside from the challenged junior mezzanine loan I've discussed already, the value of our portfolio holdings have continued to steadily improve as the underlying properties are benefiting from the reopening of the economy, which Greg and Sean will discuss. During the quarter, we amended two key financing facilities under more favorable terms and conditions and also extended their maturities. Lisa will have more details on this. Last week, our board of directors appointed Greg Handler to serve as chief investment officer of the company and Shawn Johnson as deputy chief investment officer. As you know, both Greg and Shawn had been serving as interim co-chief investment officers since being appointed to those roles last December. Greg is the head of the Mortgage and Consumer Credit team at Western Asset. He's been investing in the mortgage sector for more than 18 years and is also a member of Western Asset's U.S. Broad Strategy Committee. He has played a key role in shaping investment strategy at both WMC and at Western, and we look forward to his continued leadership in the CIO role. You all know Sean as he's been an integral part of the company's investment team and strategy since our initial public offering in 2012. Sean has more than 31 years of investment experience and has critical roles at WMC and at Western Asset, and we look forward to his continued contributions as Deputy CIO. In June, we declared a cash dividend of $0.06 per share for the second quarter, in line with the previous two quarters. We remain committed to paying sustainable and attractive dividends. While our second quarter results were significantly affected by the decline in fair value of the commercial junior mezzanine home loan, we are encouraged by the progress we see in the economy and at WMC. We continue to focus on delivering on our long-term objective of generating sustainable core earnings that support an attractive dividend while enhancing shareholder value. Now I'll hand it over to Greg and Sean to go into more detail about the investment portfolio. Greg?
spk08: Thank you, Jennifer. Our commercial mortgage portfolio, which carries an approximate 65% original loan-to-value, is generally performing according to our expectations, and all but two of these loans remain current. As Jennifer mentioned, it was the junior mezzanine loan backed by a high-quality retail and entertainment complex located in the northeast U.S. that drove the decline in our book value during the quarter. The pandemic has adversely impacted the operating performance of this asset. While the majority of the entertainment complex is operating and seeing good activity, the retail portion has been delayed. As a result of the uncertainty around the potential outcomes, the fair value of the loan was marked down by $49 million to $32.7 million, which reflects the new facts and circumstances. We are currently in discussions with the borrower and certain other senior lenders regarding a variety of options towards reaching a resolution. These could potentially include modifications of loan terms, deferral of payments, or the funding of new advances. As Jennifer noted, we are spending significant amounts of time and resources in order to optimize the recovery of our investment. However, there are no assurances that a resolution will be reached with the borrower or with the senior lenders, so there is a risk of further impairment of this loan. The second non-performing loan, a $30 million hotel loan that we have previously discussed who is still in bankruptcy proceedings, and we are actively monitoring the process. The hotel is listed for sale, and there is significant interest in the asset. Based on the value of those offers that have been received, we feel there is a reasonable likelihood that the majority of the principal and missed interest payments will be recovered, and as a result, this loan was written back up to par during the quarter. We hope to have final resolution on this situation in the near future. although there is no guarantee that we will realize a full or partial recovery on the asset. Taking a step back, we are encouraged by the improvement in the fundamentals of the remainder of our commercial real estate loan portfolio. In July, we received a full repayment of a $45 million loan secured by two skilled nursing facilities, and we also expect to have another loan payoff in this portfolio in the near future. As the economy has continued to gain momentum, we have seen signs of improvement in many of the commercial real estate markets across the country. The resurgence of consumer spending has led to higher retail sales, which have been strong since the beginning of the year. Sales have picked up again this summer after briefly pausing in late spring. As a result, retail occupancy rates and rental collections are improving in many markets. We have also seen a healthy rebound in leisure travel, which has fueled a recovery in the hotel sector. hotel operating metrics have nearly recovered to pre-pandemic levels, particularly in the resort and limited service segments of the market. Given this backdrop, we are seeing increased activity and favorable trends in the large loan commercial securitization market. June was the biggest securitization month post-COVID, and we see lending activity is coming back to the space. There were some major hotel and office transactions that got securitized and saw significant demand. We are pleased to see this market reopening again, as we believe that it will ultimately benefit our non-agency commercial mortgage-backed holdings. Within non-agency commercial mortgage-backed securities, our large loan credit portfolio consists mainly of Class A retail and hotels that cater to the leisure traveler, and we are starting to see positive operating momentum at a number of these properties. This portion of our portfolio had approximately 66% original loan-to-value, and all but one of these loans remains current. representing less than $2 million of our investments in this bucket. These properties are generally high-quality assets with strong sponsors, so we believe that their collateral values have not been materially or permanently impaired. In our CMBS conduit exposure, delinquency trends are improving, as some loans have become current through a mix of improved cash flows and equity infusions. We continue to believe that these near-term challenges will eventually be overcome as COVID restrictions are lifted and the economy moves towards a full reopening. In the meantime, we remain focused on maintaining sufficient liquidity and positioning our portfolio for future appreciation, which we expect to occur as the economy continues to strengthen. I'll now turn the call over to Sean to discuss our residential holdings. Sean?
spk07: Thanks, Greg. As we've noted, the U.S. economic recovery continued to build momentum in the second quarter. Consumer spending was the biggest contributor to growth, boosted by the loosening of COVID-19 restrictions and more businesses fully reopening. As a result, equity and credit markets responded positively, continuing the trend that began last year. This generally translated into higher valuations across our portfolio. Our residential whole loan portfolio continued to appreciate during this quarter, benefiting from a strong housing market fueled by historically low mortgage rates, very tight supply, and favorable consumer sentiment. Second quarter national home price indices again rose at double-digit annual rates. Nomura Research notes that the average non-QM borrower has seen an increase in home equity of 9% in the last 12 months. While credit availability loosened from the tightness seen during the COVID period, new loans still continue to have lower LTVs and higher FICOs than those made in the months before COVID. Residential credit performance continues to improve as a result of lower overall delinquency and forbearance metrics for the universe of non-agency mortgages. our residential loans continue to perform well. The percentage of loans that were part of a forbearance plan declined to 2.4% at quarter end from 6% at year end and a high of 19% in May of last year. Nearly all the loans of forbearance are now in their repayment period, and those that aren't represent less than one-half of 1% of the total residential loan portfolio. We see this good performance as a confirmation of the effectiveness of our credit underwriting as we focus on borrowers who have meaningful equity in their homes. This equity creates a strong incentive for borrowers to remain current on their mortgage payments. Given the strong refinancing market and pent-up refi demand, we did experience an elevated level of prepayments during the second quarter in our non-QM portfolio. Non-QM origination volumes continue to grow as originators refocus on non-QM production and agency refinancing slows. We continue to engage with existing and new non-QM originators, closing a small purchase with a new originator during the second quarter. With that, I'll turn the call over to our CFO, Lisa Meyer. Lisa?
spk01: Thank you, Sean. Before reviewing our second quarter results, I want to highlight some of the recent improvements we have proactively made on our financing arrangements. We continue to benefit from the broader Western asset platform, facilitating our ability to work with our strategic partners to improve liquidity and secure attractive longer-term financing. We amended our primary securities repurchase facility during the second quarter, which finances mainly our non-agency CMBS and RMBS assets. The term of the facility was extended by one year. We obtained improved advance rates and secured more attractive pricing, significantly lowering our borrowing costs from LIBOR plus 500 to LIBOR plus 200. At June 30th, we had outstanding borrowings on this facility of $117.5 million, secured by assets with a fair value of $204 million. In addition, we amended our commercial whole loan facility during the quarter, converting it from a facility that automatically rolled every 30 days to now having a one-year maturity. At June 30th, we had outstanding borrowings on this facility of $115.3 million, secured by commercial loans with a fair value of $165.8 million. Moving to earnings, we have provided great detail regarding our portfolio and our second quarter results in our press release and our earnings presentation. So I am only focusing on items that warrant additional explanation. As Jennifer mentioned, we decided to rename core earnings to distributable earnings during the second quarter to address SEC comment letters recently received by some of our mortgage peers. There were no changes to the calculation. We reported distributable earnings of $2.8 million, or 5 cents per share, for the second quarter, down from the first quarter's level of $6.1 million, or 10 cents per share, two primary factors drove the decline. First, we recorded 2 million of lower net interest income from our investment in the junior mezzanine loan that became non-performing in May of 2021 that was put on non-accrual status. Second, we experienced an elevated level of prepayments in our non-QM portfolio that led to an increase of $2.4 million in loan premium amortization. Our distributable earnings were one cent less than our quarter dividend of six cents per share. However, we evaluate the level of our dividend every quarter based on several factors, including, among other things, our outlook for the sustainable earnings power of the portfolio and our taxable income. GAAP book value for the quarter was $3.55, a decrease of 72 cents per share. 80 cents per share of the decline was driven by the lower valuation of the junior mezzanine loan discussed earlier. However, generally, we saw improved valuations across the remainder of a portfolio, which partially offset this decline. Economic book value, which reflects the value of our attained interest in the consolidated securitization trust, rather than the gross assets and liabilities, decreased by 18.4% for the quarter to $3.28 per share. The decrease was mainly driven by the lower valuation of the junior mezzanine loan and a slightly lower value of the retained interest in our royal securitizations due to paydowns in these securitizations. Our recourse leverage was 2.5 times at June 30th, up from two times at March 31st. The modest increase was primarily due to a decrease in book value and slightly higher leverage from a purchase of 10 million in non-QM loans, combined with an improved advance rate on our securities repurchase facility. In summary, We continue to focus on actions that will solidify our capital structure and increase our liquidity and position us to benefit from the rebounding economy and the recovery of certain commercial real estate sectors that were most impacted by the pandemic. With a significant portion of our assets now financed by attractive, longer-term financing, we intend to focus on selectively growing our portfolio with the objective of improved financial results in the quarters ahead. With that, we will open up the call to your questions. Operator, please go ahead.
spk06: We will now begin the question and answer session. To ask a question, press star then one on a touch-tone phone. If you are using a speaker phone, please pick up your handset before pressing the keys. To withdraw your question, press star then two. And the first question comes from Trevor Cranston with J&P Securities. Please go ahead.
spk04: Hey, thanks. Good morning. I guess my first question on the Junior Med loan. In prepared remarks, you guys said you're working on some resolutions with respect to that loan, but obviously nothing could be assured. Can you help us understand what kind of scenarios exactly are factored into the current valuation of the loan where it started June 30th and, you know, what type of scenarios would potentially lead to further breakdown of that value. Thanks.
spk08: Hi, Trevor. This is Greg. So, yeah, there's a lot of scenarios being priced in, and you can see by the markdown that there's a lot of uncertainty around those scenarios, and so the discount rate that's being applied is quite high. I think as negotiations continue, we'll get more clarity on those resolutions, but for the time being, we have to factor in several potential outcomes, including further write-down of the position, either through a through foreclosure on the asset or through bankruptcy potentially. And we also need to factor in, you know, extension of the maturity date, potential decline in income or accrual rates. And so given, you know, the wide range of scenarios potentially that could affect this outcome, you know, we have a meaningful opportunity distribution across those scenarios.
spk04: Okay, that makes sense. And is there any sort of comment or context you could provide around sort of how long you think negotiations are likely to be ongoing for that loan and when we might see some sort of agreement or resolution?
spk08: I would say that the timing is still very uncertain. It's a fluid situation. Um, but the negotiations are ongoing. Um, it's a, you know, we believe it's a very valuable property and it's a tremendous attraction. We think that the lenders have an incentive to work together on this one. And, uh, you know, we think that there is progress being made towards that, but, uh, uncertainty still around the timing.
spk04: Okay. Fair enough. Um, and on the, on the rest of the commercial loan portfolio, um, I think you mentioned that one of the loans had paid off in July. It looks like several others are set to mature over the second half of this year. At this point, as you're thinking about those upcoming maturities, is the expectation that you believe most of those loans are likely to pay off, or do you think there could be some loans that end up extending? And then I guess the second part of that question, as you do get some payoffs of these loans, can you talk about sort of your prioritization of redeploying that capital into different investment opportunities? Thanks.
spk08: Yeah, sure. So, yeah, we're seeing a mix of loans paying off at maturity or prior to maturity or to their earliest maturity, that is. And we have a couple loans that are going to have moderate extensions for But, you know, we feel very strongly that these loans are still, you know, very well on track to pay off. And cash flows continue to improve on the underlying assets. And, you know, as noted in the comments, the lending market continues to open for, you know, across all property types. So, you know, we are, you know, encouraged by that progress. In terms of, you know, deployment of paydowns. We're always looking for the best risk-adjusted return possible for the portfolio. We do believe that the opportunities, as I mentioned, as lending is opening back up, that we will continue to see more deal flow, whether that's from non-qualified mortgage originations, other residential whole loans opportunities that we're reviewing, as well as commercial real estate opportunities as well.
spk04: Okay, got it. On the non-QM portfolio, you mentioned the increased prepayment speeds in 2Q. It sounded like that was attributable mostly to just increased origination activity in that space. I guess as you look forward in that portfolio, it seems like the non-QM origination activity and focus from lenders is, if anything, increasing. How are you thinking about the outlook for prepay speeds within the non-QM books? Do you think they're going to remain around 2Q levels, or is there some chance that they could elevate further as more lenders bring out products in that market?
spk07: Hi, it's Sean. We've already seen the most recent prepayment print be lower than the peaks that we saw earlier in the second quarter. We do think some of that prepayment activity was pent-up demand during the COVID period when prepayment speeds were a little artificially low. We do think that just naturally the prepayment speed should decline a little bit due to that. But interest rates do remain near the all-time lows on mortgages. And as you said, the activity and focus of originators is increasing in the space and the competition is increasing. So we do think it will be higher than it was during the COVID period, but but probably not as high as we saw last quarter. You know, our portfolio is generally a little bit lower note rate on average than most, and our prepayment speeds have been slower than, you know, many of the other non-QM, you know, our competitors. So we do think we're positioned pretty well for these rates. We've avoided paying extremely high premiums on the loans that we did buy, so Despite the, you know, amortization that we saw this last quarter, you know, it isn't as bad as it could have been had we paid much higher premiums. We're going to continue to focus on that strategy. And, you know, the increased activity in non-QM space is an opportunity for us that we intend to manage it. Okay.
spk04: That's helpful. Appreciate the comments. Thank you, guys.
spk06: The next question comes from Derek Hewitt from Bank of America. Please go ahead.
spk05: Good morning, everyone. How should we think about portfolio growth over the next year or so, given kind of those non-QM opportunities plus other residential credit opportunities? Will the portfolio remain relatively flat as you get commercial payoffs? and that will just be replaced by residential credit, or will we actually see portfolio growth over the next, say, 12 to 18 months? And then what are your thoughts in terms of taking leverage a little bit higher at this point?
spk08: Sure. Obviously, you know, we are evaluating the opportunity set in real time, so it's subject to change, but... You know, I think the encouraging signs in terms of the lending market, you know, are very positive. Although, you know, I'd say on the commercial real estate side, you really are still seeing most of the lending, you know, really being targeted towards the COVID winners. And you're seeing cap rates, you know, decline meaningfully. So, you know, I would say somewhat price to perfection. on some of the higher quality COVID winning type assets and still, you know, more uncertainty and risk premium surrounding the things like offices and hotels. So, you know, I think in terms of, you know, the opportunity set, you know, we do believe right now it's more focused on the residential side. You know, clearly the fundamental backdrop there is quite strong. And we do see some of the GSE limits being triggered and pushing some product back into the non-agency space where there's pretty much no non-agency mortgage origination in 2020. So that is encouraging. But, you know, we are evaluating the landscape, and we do believe that, you know, given the relative tightness of the credit box that still remains, that we have, you know, the ability to really, select the best quality assets and priced appropriately.
spk07: Yeah, we've seen some interesting products coming out of some of our non-QM originators, including a 15-year product, which really fits into our more conservative focus in the non-QM space. So We're encouraged by that. We've had discussions with our current originators and ones that are new to us as well that have been very productive. So we do think that we'll see some growth in the non-QM area and, as Greg had mentioned, potentially some of those loans targeted towards agency where the limits from the FHFA have pushed some of that product into the private label space. So we're looking at those opportunities right now and making progress there.
spk08: And just one more point on leverage. You know, we do think that we're pretty considerably leveraged at this point. You know, depending on opportunities, you know, we would love to grow that, you know, and reduce some of our cash drag on the portfolio. And we do have, you know, we believe, you know, a fair amount of room still on the lines that we have in place. And as Lisa mentioned, you know, these lines are much more conservatively structured now with longer term, less rollover risk. So we feel comfortable, you know, increasing the leverage, you know, should we find the appropriate opportunities.
spk05: Okay, great. And then I believe it was roughly there was a $2 million drag in terms of prepayments, right? higher prepayment speeds this quarter. Has that normalized in Q3 so far?
spk07: We've seen only one prepayment print so far. It's really the speeds from collections in June, and that was lower. So we have seen prepayment speeds decline slightly. But, you know, it's only one observation so far. So it remains to be seen what the prepayment speeds will be, say, over the next couple months. But it does make sense for us to see them come down a little bit.
spk05: Okay. And then lastly for me, did you provide any sort of timeline in terms of the resolution of that hotel loan that's in bankruptcy?
spk08: Um, it's still uncertain, so I don't believe we gave, uh, any definitive timeline, but, um, there's definitely, um, the, the bankruptcy proceedings, um, you know, continue. Um, and, uh, uh, you know, I think it's.
spk05: I mean, I guess given the given the write-up, is it, could it be resolved by the end of this year or. Are there certain technical issues where it could drag out a little bit longer?
spk08: I think there's definitely a good chance it could get resolved by the end of the year.
spk05: Okay. Thank you for taking my questions. Thank you.
spk06: As a reminder, if you have a question, press star then 1 to join the queue. The next question comes from Jason Stewart of Jones Trading. Please go ahead.
spk03: Hey, thanks for taking the questions. First, I think everybody appreciates, investors certainly do, Western's commitment to resolve this junior MES loan. So thank you for putting all the resources behind that. I guess a technical question on it, what factors have led to the senior lenders extending this assignment for the third time? Or maybe if you could give us an update, have they done it again since July 15th?
spk08: Yeah, so the negotiations, which started in earnest, I would say, in May of this year, has definitely brought all the parties to the table. We've seen a good amount of back and forth and, I would say, progress towards a resolution. But you know, still very uncertain in terms of the timing and the eventual, the eventual, you know, shape thereof, but there has not been, Apologies. So that's, you know, again, it's a fluid situation, and those negotiations are ongoing.
spk03: Okay. And I guess technically there, though, you do have the right as a junior MS lender to force the entity into bankruptcy?
spk08: I think it's a much more complicated – that side would be a complicated – I don't think that that's a high probability.
spk03: Okay. I'll leave that part there. And then on the convert, any plans to – I mean, we're 14 months out. It's $160-plus-ish million, something like that. What are the plans for the retirement of the converts?
spk01: Hey, Jason, it's Lisa. We're very mindful of the maturity in 2022. So we continue to evaluate opportunities to refinance that convert, which would include us continually buying back more notes in the open market, as well as, you know, an outright refinancing of a smaller portion of what's outstanding.
spk03: Okay. I mean, it trades at a 9% yield to call, so a yield to maturity at this point. Would you think that you could refinance it at a tighter spread? I mean, or are you looking at this more holistically? And I guess, Jennifer, this question goes to you. I mean, when we pull all this together, regardless of how you resolve these challenge credits, which seems like some go one way, some go the other, what does WMC look like in, you know, 2023? Once this converts on, challenge credits are resolved, it's a little bit less scaled of a platform. What does it look like to you going forward from that point?
spk00: Yeah, thank you. You're right. I think we're, I mean, at this point, I think with, as Greg and Sean have, you know, come into their new roles and really as they and the broader team at Western Asset have engaged in, you know, helping to sort through the issues in the portfolio, mostly, you know, stemming obviously from the pandemic and, I think we're really encouraged by the holdings beyond the two trouble ones we've talked about. The hotel holding, as Greg said, I think we think is likely to get resolved in the near term, and the other we're sort of actively, very actively working on. So I think looking ahead a year or two, I think we're optimistic about our ability to construct the portfolio in a way that will allow it to perform again. Again, there's a lot of good assets and performance in there. Sean highlighted them. I think certainly our non-QM strategy is a highlight of the portfolio, so I'd expect us to continue to focus on that. Also at Western, we've added to our commercial team some additional professionals, and I think Greg and Sean are very optimistic about our ability also to add there. So I think we're looking towards, you know, rebuilding our high-quality portfolio, and that will allow us to access capital markets. And also, as you know, in the past we've considered M&A. Yes, we're small. Some of our fellow peers are also small. We've considered M&A in the past. I would expect us to do that again. So I think it will be a combination of performance, which will allow us to access capital markets, and looking for potential M&A opportunities that could be beneficial to WMC shareholders.
spk03: Got it. Thank you. Appreciate the call.
spk06: This concludes our question and answer session. I would now like to turn the conference back over to Jennifer Murphy for any closing remarks.
spk00: Just want to thank you all for joining us today, and we'll look forward to talking with you soon. Thank you.
spk06: The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.
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