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Western Asset Mortgage Capital Corp (NYSE:WMC)
Q3 2020 Earnings Call
Nov 6, 2020, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Welcome to the Western Asset Mortgage Capital Corporation Third Quarter 2020 Earnings Conference Call. [Operator Instructions] And will be available for replay beginning at 5:00 P.M. Eastern Standard Time. [Operator Instructions] And the floor will be opened 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.

Larry Clark -- Investor Relations

Thank you, operator. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the third quarter of 2020. 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 that you can refer to during the call. You can also access these slides on the website. With us today from management are Jennifer Murphy, Chief Executive Officer; Lisa Meyer, Chief Financial Officer; and Harris Trifon 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 in 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 Securities and Exchange Commission. Copies are available on the SEC's website. 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?

Jennifer Williams Murphy -- President and Chief Executive Officer

Thanks, Larry. Welcome, everyone. As Mortgage Credit Markets rallied in the third quarter, Valuations on Western Asset Mortgages residential and commercial credit assets benefited meaningfully. WMC's GAAP book value increased to 29.2% in the quarter to $4.07 per share. GAAP net income was $59.8 million or $0.98 per share and core earnings were $6.4 million or $0.10 per share in the quarter. Our net interest margin improved to 2.27%, which together with the underlying performance of the portfolio contributed to solid core earnings despite a significant reduction in recourse leverage from 3 times as of June 30 to 2.2 times as of September 30.

Over the last two quarters, we fortified the Company's balance sheet, improved funding terms increased liquidity and equity, and reduced recourse leverage to ensure that our shareholders could benefit from the performance of the underlying assets of our portfolio. In light of our results this quarter including the strengthening of our balance sheet, improved liquidity and solid core earnings, the Company declared a cash dividend of $0.05 in the quarter. The payment of an attractive dividend is an important priority for our shareholders and the resumption of the dividend was a key milestone for the company. The recovery and asset prices across the portfolio and the redemption of our dividend contributed to an economic return on book value of 30.8% for shareholders this quarter. We remain highly focused on our long-term objectives of generating sustainable core earnings that support an attractive dividend with relative stability in our book value.

We believe our portfolio's earnings power is likely to provide a solid underpinning for future dividends. And while we have seen substantial recovery in asset values across our portfolio this quarter, we believe there is the potential for additional improvement, particularly in our commercial mortgage investments. Much of this will be dependent on the path of the virus as well as the pace of recovery in economic activity. In our view, our diversified investment strategy focused on high-quality commercial and residential borrowers is well-positioned for the uncertainties of this environment.

To talk more about our investment strategy and outlook, I'll turn the call over to our Chief Investment Officer, Harris Trifon.

Harris Trifon -- Chief Investment Officer

The third quarter of 2020 saw the equity and credit markets continued to rebound, driven by improved liquidity conditions across financial markets and the ongoing reopening of the economy, which translated into higher valuations for a number of our portfolio holdings. The recovery of our residential portfolio combined with improvement in our commercial holdings translated into a significant improvement in our GAAP book value. As the market and our portfolio have improved, so has our liquidity position, which contributed to our decision to reinstate our dividend for the third quarter. Over the course of the quarter, we saw continued improvement in the credit performance from both our residential and commercial holdings.

Our non-QM residential loan portfolio is performing well and experienced a decline in the percentage of loans that were part of a forbearance plan dropping to 10% at September 30, from 16% at the end of the second quarter. We see this as a strong indication that borrowers with meaningful equity in their homes will prioritize their mortgage payment in order to remain current on that obligation. We believe that this trend will continue given the positive data coming out of the U.S. housing sector including robust purchase and refinance demand and ongoing home price appreciation in many major markets across the country. Our commercial loan and non-agency CMBS portfolios are performing in line with expectations even though those expectations have shifted as a result of the pandemic.

The commercial whole loan portfolio carries an approximate 65% original LTV and all but one of the loans remains current. As we mentioned last quarter, the delinquent loan has a principal balance of $30 million which is secured by a hotel. We are currently exploring various workout strategies and believe that there is a reasonable likelihood that the majority of the principal and missed interest payments will be recovered. Although, there is no guarantee that will be the case. Our large low non-Agency CMBS portfolio has an original LTV of 60% and despite exposures to some retail and hotel assets over 82% of the loans by principal balance remain current compared with 70% at June 30. We are in forbearance and modification discussions with the delinquent borrowers in this portfolio.

In fact, we have been active with many of our commercial real estate borrowers, monitoring their situations and working with them to help preserve the value of the underlying properties in order to protect our collateral and increase the probability of an eventual recovery in asset values. That being said, we believe that our focus on high quality properties with well-capitalized sponsors capable of withstanding short-term disruptions should enable our commercial real estate portfolio to emerge from the crisis without significant overall impairment. We have spent a significant amount of time and effort over the last two quarters to improve the terms of our financing arrangements and the company's risk profile. These ongoing efforts continued in the third quarter as we amended our existing residential home loan facility to convert it to a limited mark to market facility with more attractive terms. With respect to our outlook going forward.

While the US economy rebounded during the quarter most economic measures remain well below where they started the year. We believe that the recovery will continue to be dependent on the future trajectory of COVID 19, the availability of improved therapeutics and vaccines and continued fiscal and monetary support. We also expect that the Federal Reserve will follow through on its commitment to keep interest rates at or near zero for an extended period of time. We continue to believe mortgages secured by real estate assets with meaningful equity in the properties and higher quality credit will continue to perform well over the long term. While many sectors of the mortgage market currently offer historically attractive valuations, our primary focus remains on maintaining sufficient liquidity, protecting the value of our assets and positioning the portfolio for continued future appreciation.

With that, I'll turn the call over to our CFO, Lisa, Meyer.

Lisa Meyer -- Chief Financial Officer and Treasurer

Thank you Harris. We have provided a great amount of detail regarding our portfolio and our third quarter results in both our press release and our earnings presentation. So I'm only going to focus on the items that warrants' some additional explanation. During the quarter we continue to focus on optimizing our portfolio financing, increasing liquidity and improving shareholder's equity. In July, we retired $5 million of our convertible senior notes at a 25% discount to par value. In exchange for the issuance of $1.4 million shares of our common stock.

We were once again active in improving the financing of our assets during the third quarter. We amended our existing residential home loan facility in October to converted to a limited mark to market facility with more attractive term. Among other terms the amended facility has a 12-month term and bears interest at one month LIBOR plus 2.75%. We reported core earnings of $6.4 million or $0.10 per share for the third quarter. Our core earnings came in higher than the $4.3 million generated in the second quarter, primarily driven by a higher net interest margin and a full quarter's benefit of the lower financing costs associated with last quarter's Arroyo securitization, which allowed us to reduce the income drag experience under the original Residential hold on facility.

Economic book value for the quarter increased 2.2% to $4.11 per share. As mentioned last quarter, we believe that this non-GAAP financial metric provides investors with a useful supplemental measure to evaluate our financial position. It reflects our actual financial interest in all of our investments and eliminates the accounting mismatch that arises from our Arroyo securitizations where we fair value the loans, but not the debt. This quarter the difference between our GAAP book value and our economic book value narrowed only $0.04 due to the sharp rebound in asset values, mainly in the residential whole loan portfolio, which reduce this accounting mismatch.

In summary, we believe these steps solidify our capital structure, increase our liquidity and will enable us to participate meaningfully in the economic recovery. Our Recourse leverage was 2.2 times at September 30, significantly lower than the 9.5 times level at the end of March and 5.4 times at the beginning of the year. Our net interest margin remains healthy and with a significant portion of our assets now finance with attractive longer-term financing. We believe that we are well positioned for another quarter of positive financial results in the fourth quarter.

With that, we will now open up the call to your questions, operator. Please go ahead.

Questions and Answers:

Operator

[Operator Instructions] First question comes from Mikhail Goberman of JMP Securities. Please go ahead.

Mikhail Goberman -- JMP Securities -- Analyst

Thank you very much. Good morning, everybody. Hope everybody is doing well. Could you potentially give an update on book value thus far in the fourth quarter?

Lisa Meyer -- Chief Financial Officer and Treasurer

Hi, this is Lisa. So our book value, we haven't seen a substantial move either up or down as far as valuations go. And so our book value, I think it's pretty stable from the end of the third quarter.

Mikhail Goberman -- JMP Securities -- Analyst

Okay. And the securitization market going forward, could you perhaps opine a little bit on what you guys are seeing and if it's continuing to look a little bit better than it did two quarters ago?

Harris Trifon -- Chief Investment Officer

Sure, this is Harris. I'll take that one. As we discussed during our opening remarks, we've seen a continued improvement in mortgage credit markets over the last two quarters that certainly has remained true so far in the fourth quarter. So I think the viability of and underlying strength securitization for mortgage credit assets particularly residential assets is going to remain robust over the next, over the foreseeable future.

Mikhail Goberman -- JMP Securities -- Analyst

Okay. In terms of adding to the portfolio at the margin are you leaning toward investing in Commercial Loans versus residential whole loans or is there I guess my question is, which way are you leaning going forward?

Harris Trifon -- Chief Investment Officer

Sure. Well, I think it's beyond argument that there are a lot stronger outlook for housing and commercial real estate at the moment. Just given the impact of this pandemic has had on commercial real estate particularly the use of space and potential change in behaviors. As I mentioned earlier, the data that we've seen on housing really only every metric you look at is been exceptionally strong and has really continued to get better quite frankly, over the last few months.So I think with that in mind, in conjunction with the amount of commercial risk that we have in the portfolio, already, I think incremental investments certainly we would be more heavily focused on the residential side than the commercial side. That all being said, as we've always said we could look at all investments of regardless of what sector asset class they come from through our relative value lens and of course our underwriting analysis. And that will continue to remain the case.

Mikhail Goberman -- JMP Securities -- Analyst

Got you. Thank you for that. And if I may one more. Kind of a more of a macro Fed related question, given the events of this week in the election seemingly if it is true that we're going to have political gridlock and that would decrease the chances of a bigger stimulus package and maybe even delay the passage of a stimulus bill for a while longer. What are your thoughts on how that will play out in terms of the credit market? And sort of a second part of the question, do you think that that will increase pressure on the Fed to do more? And if so, how do you see that playing out?

Harris Trifon -- Chief Investment Officer

Sure. I'm not going to comment on the election and the potential outcome of it. Although I will say this, Mitch McConnell was on the tape earlier this week, talking about the need for more fiscal stimulus share during his comments yesterday. Also reiterated the need for the combination of both monetary and fiscal support and so I think that remains certainly our base case that we will see additional stimulus from the government. What form it comes in, how much and when are obviously all open questions. But we do expect that we will continue to see additional fiscal stimulus in the weeks and months ahead. I think in terms of monetary support again again was very clear during his remarks this week. And there is absolutely no gray in his desire to continue with the programs that they have in place and continuing to support the economy and financial markets.

Mikhail Goberman -- JMP Securities -- Analyst

Okay, thank you. That's it from me. Thank you very much everybody.

Operator

Next question comes from Derek Hewett with Bank of America. Please go ahead.

Derek Hewett -- Bank of America -- Analyst

Good morning, everyone. My first question is, I think the portfolio is almost exclusively credited at this point versus kind of a more balanced approach between rate and credit sensitive investments pre-COVID. Is a more balanced portfolio a priority in recent intermediate or longer term at this point? Or will that portfolio remain exclusively credit?

Harris Trifon -- Chief Investment Officer

Thanks for the question, Derek. I think in the foreseeable future, we anticipate that the portfolio composition is going to remain largely focused on credit-sensitive investments. As I mentioned earlier, we continue to evaluate relative value opportunities across both rate-sensitive as well as credit-sensitive investments. And given the degree of the dislocation in markets earlier this year and even with the improvements, many assets in mortgage credit markets are still trading at very attractive valuations, conjunction. With the convexity risk and rate valve that we've seen recently, I would expect our focus is going to remain on the credit-sensitive side of the market. However, things change and clearly we've seen we've seen that over the course of this year, certainly. And as market conditions change and as the economic environment changes and evolves, we'll continue to assess the investment opportunity set within the agency market.

Derek Hewett -- Bank of America -- Analyst

Okay, great. And then looking at some commercial near-term maturities, I think it's on Slide 10. Could you provide any additional color on that hotel loan and the nursing home loans that mature mid next year?

Harris Trifon -- Chief Investment Officer

I'm not going to provide any specific color on those assets other than just to say we continue to monitor upcoming maturities, particularly on the nursing asset that you referenced. We feel good about the performance that we've seen over the course of this year. And in regards to the hotel asset, as I mentioned during the opening remarks, we continue to evaluate various worked out strategies in regards to that specific asset and remain comfortable that we should see a near or full recovery in principal and missed interest. But obviously, there is no guarantee that ultimately that will be the outcome.

Derek Hewett -- Bank of America -- Analyst

Okay. And then last one for me, was there anything kind of more one-time in nature with the $0.10 of core earnings? And if not, should that be the new baseline for trying to determine growth in the dividend at this point?

Lisa Meyer -- Chief Financial Officer and Treasurer

Hey Derek, it's Lisa. So quarter earnings is pretty much in line with our expectations. I think that we spent a lot of time in restructuring our financing facilities into more -- to get more attractive terms. So we are comfortable with the earnings power of our portfolio given our current leverage. As far as the dividend, anytime we look at the dividend, we look at it as a team and we assess the long-term earnings power of the portfolio. So every quarter we will revisit that along in discussion with our Board of Directors.

Derek Hewett -- Bank of America -- Analyst

Okay. And actually, one additional one. You had mentioned that book value was pretty much kind of flat quarter-to-date. Is there any sort of estimate in terms of if we get a vaccine sometime next year and we get more of a normalized economy, how much of unrealized loss is still kind of embedded in book value at this point?

Lisa Meyer -- Chief Financial Officer and Treasurer

What I can do is I can direct you to our 10-Q. We have schedule in there that summarizes our unrealized losses for the nine months and that can give you a range of what the potential recovery is. I would focus on looking at the cumulative unrealized losses related to our non-Agency CMBS, the residential whole loans and commercial loans as well as our other securities, which are IGSE. So that will kind of give you a range. And of course as you mentioned, the recovery of these assets, the timing and the amount will all be contingent on what happens in the markets and the pandemic.

Derek Hewett -- Bank of America -- Analyst

Okay.

Jennifer Williams Murphy -- President and Chief Executive Officer

Lisa, the dollar amount of that range, of the categories you just mentioned, is about $100 million, is that about right?

Lisa Meyer -- Chief Financial Officer and Treasurer

That is correct, Jennifer.

Jennifer Williams Murphy -- President and Chief Executive Officer

Yes. So Derek, that's on 60 some million shares. It's $50-ish or so share.

Derek Hewett -- Bank of America -- Analyst

Okay. So very sizable. Okay, great. Thank you very much.

Jennifer Williams Murphy -- President and Chief Executive Officer

Thank you.

Operator

Thank you. The next question is from Jason Stewart of JonesTrading. Please go ahead.

Jason Stewart -- JonesTrading -- Analyst

Thanks, good morning. Are there any incremental opportunities to execute on the convertible debt for equity exchange? Or is that opportunity largely passed?

Lisa Meyer -- Chief Financial Officer and Treasurer

Hi. So we continue to look for opportunities for that. I mean, we did do $5 million during the quarter and we continue to look for opportunities to do that, which would be accretive to our shareholders. So that's something that we're continuing to look at and if there are opportunities out there, we will consider them.

Jason Stewart -- JonesTrading -- Analyst

Okay, great and Harris, I think I heard you say you're not going to update us on any assets but specifically on a $30 million hotel loan. Do you have any sense of a timeline of what investors can expect on that work out?

Harris Trifon -- Chief Investment Officer

Sure. As I said, we're in the process of evaluating a number of different strategies in terms of resolving that asset. I'm hopeful that, we will be able to move forward with the path and see resolution over the next couple of months. Of course, it's contingent on all the macro issues that we've talked about. But I think over the next, call it, one to two quarters; we hopefully should be in a position where we can resolve that asset.

Jason Stewart -- JonesTrading -- Analyst

Okay. And then one more on the residential side, it sounds like that's going to be the investment focus for at least the near term. Are there opportunities to trade out of securities that have appreciated and move around perhaps within capital structure to take advantage of your view there?

Harris Trifon -- Chief Investment Officer

Yes, is the short answer again myself, Sean and the team are constantly evaluating opportunities in the market and obviously mining them up with, what we think the value proposition is for each of the holdings in the portfolio currently. So that's something that we're going to continue to do. The market environment has been positive overall, as we've discussed, but it also remains fluid. And so, yes, I do expect that there will be more opportunities as we continue to see the recovery in markets and our assets within WMC.

Jason Stewart -- JonesTrading -- Analyst

Okay. Thanks for taking the questions.

Operator

Thank you. [Operators Instructions] At this time we have no further questions. I'd I like to turn the conference over Ms. Jennifer Murphy for closing remarks. Please go ahead.

Jennifer Williams Murphy -- President and Chief Executive Officer

I just want to thank you all for joining us and we look forward to talking with you next quarter. Have a great day.

Harris Trifon -- Chief Investment Officer

[Operator Closing Remarks]

Duration: 27 minutes

Call participants:

Larry Clark -- Investor Relations

Jennifer Williams Murphy -- President and Chief Executive Officer

Harris Trifon -- Chief Investment Officer

Lisa Meyer -- Chief Financial Officer and Treasurer

Mikhail Goberman -- JMP Securities -- Analyst

Derek Hewett -- Bank of America -- Analyst

Jason Stewart -- JonesTrading -- Analyst

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