Book value

Western Asset Mortgage Capital: Declining Book Value (NYSE:WMC)

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Investment thesis

Western Asset Mortgage Capital Company (NYSE: WMC) had a tough 2021 and 2022 looks awfully similar. Management began restructuring the company’s investment portfolio in the fourth quarter to exit equity ownership value-destroying assets in commercial lending and instead focus on residential real estate assets. They also had to cut the dividend by 33% due to the 2021 losses. I am neutral on WMC as I see the possibility that after the portfolio transition the company will return to profitability and management may slowly increase the book value. There’s only one downside: it’s a bit off right now due to the likelihood that the portfolio restructuring will end in late 2022.

business model

WMC is a microcap mortgage real estate investment trust. It is the 40th by market capitalization among the 41 publicly traded US mREITs. The company went public in May 2012 and it has a total price return of -92.04% so far. The IPO price was $18.47 and now trades at around $1.5 per share. The biggest drop is due to the COVID-19 crisis. There was no liquidity in the MBS markets leading to margin calls and book value declines across the industry and WMC was heavily impacted by these market conditions. The credit-sensitive portion of their portfolio plummeted along with its book value and share price. WMC has become a much smaller mREIT than before the pandemic. The price rose from $10-11 per share to a shocking $2-2.5 per share just after the COVID-19 crash in March 2020. The company invests primarily in securitized commercial loans and whole residential loans . These 2 types of assets represent 88% of their current portfolio. Most of the company’s entire residential loans are in the West region (74.6%) while 81.2% of their commercial loans are concentrated in the Northeast region.

WMC investment portfolio

Presentation of the fourth quarter of 2021

Finances and income

Q4 and annual results

In December 2021, management made it clear that they wanted to make a major portfolio shift towards investments related to residential real estate. In the fourth quarter, we could have already seen this change, because looking only at the fourth quarter, 53.6% of the investments were residential whole loans, and another 10.4% were agency and non-agency RMBS. Management expects this portfolio transition to take at least 12 months. At the same time, the company is selling its commercial real estate portfolio assets, it has sold $27.5 million of non-agency CMBS, and management has also left a hotel, and the company will receive approximately $6.7 million from this sale.

The CMBS market collapsed in just a few weeks in 2020 due to the pandemic. “New issuance within CMBS fell 45% – led down 37%, SASB down 48% and CRE-CLO down 56% – due to lower issuer lending volumes as pandemic uncertainty persisted – Guggenheim.” As a result, management had to suspend dividends to preserve some liquidity. I wouldn’t blame the management for having a portfolio of commercial loans, many other mREITs had the same thing however, WMC’s net interest rate spread was shrinking long term since 2016. I think that was one of the main reasons why the portfolio fell apart so badly and management had no cash. Over the years, this net interest rate differential below the industry average has caused the liquidity crisis alongside the pandemic. Now management is trying to refinance operations as quickly as possible with longer term fixed rate borrowings to take advantage of rising interest rates. That is why they finalized the securitization of entire residential loan assets at a weighted average interest rate of 3.1%. In my opinion, if management succeeds in restructuring the residential real estate assets, it could stabilize WMC’s place among mREITs due to the expectations of the residential real estate market in the coming years. Total home sales and house prices are expected to rise in 2022 and 2023. Housing stock is expected to remain low (this is possible due to extreme increases in basic material and labor costs). work) while demand is expected to remain high, particularly in the Sunbelt region.

WMC had a tough fourth quarter and a tough 2021 and I don’t expect 2022 to be much better. The NII fell 46.8% in the fourth quarter from the previous quarter and 56.8% year-on-year. The company reported negative earnings of $0.11 per share and negative EPS of $0.21. The economic return to book value was also disastrous at -5.5% in the fourth quarter and the full year return was -18.1%. I think this trend is likely to continue in 2022 due to portfolio restructuring and more hawkish Fed policy.

Evaluation

In my opinion, the current share price reflects the transition of the portfolio and the company is valued at fair value. The price-to-book ratio fell from 0.7x at the start of 2022 to 0.45x at the end of April, while the year-to-date price return is -33.78%. The stock traded at an average P/E ratio of around 8x before the pandemic, but in 2022 the P/E ratio fell to 7.2x and in 2021 it fell further to 6.55x. However, this does not mean that the company is undervalued. At this time, I see no chance that the company can return to its pre-pandemic book value and pre-pandemic net interest income levels. After restructuring the portfolio, it is possible that the book value per share will start to increase, but that is at least 9 to 12 months away.

WMC price to books ratio

Looking for Alpha

WMC price and book value
Data by YCharts

Company specific risks

The biggest risk factor I see is portfolio restructuring. We can already see that several assets will be sold at a loss and that residential assets may not provide the expected return. This is why the stock has been under pressure for 8-9 months. Moreover, if the transition is not successful, the management will have to reduce the dividend again, which will not relieve the pressure on the company. We observed an inversion of the yield curve at the end of March. This is particularly bad news for WMC, because when short-term interest rates exceed long-term interest rates, the company’s borrowing costs can exceed its interest income. Rising long-term and short-term interest rates are currently unfavorable to the company. When short-term interest rates begin to rise, it will increase the amount of interest owed on repurchase agreements and the cost of funding will increase for WMC. Management is currently trying to solve this problem with the securitization of entire residential loans. When long-term interest rates rise significantly (and now that analysts expect the Fed to raise interest rates 6 times in 2022), the market value of WMC’s investments will decline, and the duration and the weighted average life of investments will increase.

My take on the WMC dividend

Don’t be fooled by the ttm dividend yield of 14.97%, as management recently cut the dividend by 33%. WMC paid $0.06 per share, but management had no choice but to cut the dividend in March 2022 to $0.04 per share. This means that the company has a forward dividend yield of 10.88%. With this reduction, the dividend looks sustainable in the short term, but due to the restructuring of the company’s portfolio, I cannot predict with certainty a long-term trend in the payout ratio. It highly depends on how many assets will be sold at a loss, how interest rates will rise in the second half of 2022, and how short and long-term interest rates will behave towards each other. others. What I see at the moment is that the recent 33% dividend cut was enough to make the dividend sustainable for 2022.

WMC Dividend Payout Rate

The table is created by the author. All figures are taken from the company’s financial statements and SA earnings estimates.

WMC could hardly be a first choice for investors. At the moment I see many risks associated with restructuring the portfolio, but there is a chance that the company can complete the transition with minimal losses and then the new portfolio of primarily residential assets will do well in the rising interest rate environment. Management is also keen to reduce its funding costs to protect WMC from rising interest rates. However, I believe there are several other MREITs with similar dividend yields that are a much safer choice for investors looking for income. If you are looking for a stable residential MREIT, you might want to take a look at MFA Financial (MFA) with a diversified residential portfolio or PennyMac Mortgage Investment Trust (PMT) with a 12%+ dividend yield.