Western Asset Mortgage (NYSE:WMC) is a mortgage real estate investment trust, or mREIT, that had seen performance fall over the last few years. It has been decimated since the COVID-19 selloff in March. Things really fell apart for much of the sector in Q1 with big margin calls and severe book value erosion. In recent months, the company has positioned its portfolio and accounting structure in a way to try and help it survive the downturn. The outlook for mREITs is less dire than it was a few months ago. In the recently reported Q2, the company significantly improved its balance sheet by reducing debt and leverage, increasing liquidity and shareholder equity, and completing new financing arrangements that significantly reduced its exposure to short-term repurchase agreements. In this column, we check back in on the critical metrics you should be aware of.

The critical metrics have been decimated

Let us summarize the critical metrics which you should examine for all mREITs. These are summarized below for WMC as of Q2 2020:

Critical metrics of interest

WMC’s performance

Q2 2020 Book value and % change from Q1 2020

$3.17 (-7.0%)

Net interest rate spread in Q2

1.91%

Dividend (yield)*

$0.00

Q2 core income per share

$0.11

52-week share price range

$1.37-$11.33

*Dividend was suspended in Q2

**Determination based on estimate of core earnings covering dividend paid

Data table source: WMC’s Q2 earnings, graphics by BAD BEAT Investing

Regardless of the high expenses the company may be incurring, there are some positive takeaways from this quarter. We remain less than confident in management; if we have investors holding for income, there is none. That said, the goal is for the company to get back to paying the dividends. Overall, the spread was decent, core plus drop income was positive; however, book value pulled back. Let us discuss.

Dividend suspended/earnings results

At the end of the day, we care about whether the dividend will be paid (and covered) if we own an mREIT. That is why investors buy them – for income. Every major decline in this company’s stock has been the result of a dividend cut until the decimation from COVID-19. As previously announced, due to the turmoil in the financial markets resulting from the COVID-19 pandemic, management suspended the first- and second-quarter dividends to preserve liquidity.

The company saw a GAAP net loss of $15.6 million, or $0.29 per share. The second quarter of 2020 stood in sharp contrast to the first as global risk sentiment, equity and credit markets rebounded from their lows in March. On a GAAP basis, this was a bit concerning. While GAAP is informative, and we like to see a positive move on this metric from the carnage of Q1, a better gauge is core earnings. While the company does try to engineer positive numbers here, as we detailed in the past, Western Asset Mortgage reported that it saw core earnings of $5.8 million, or $0.11 per share. This was a decline from Q1’s $0.29. We believe that Q2 represents the bottom in performance.

Strength in the net interest rate spread

One of the major drivers of earnings potential is the net interest rate spread, which has been narrowing recently. In fact, the spread was over 3% in 2016, fell to under 2% in late 2017, and started recovering in 2018-2019. This volatility was a problem, but the recent pressure has been strong. A falling net interest rate spread has been common across the whole sector in recent quarters. This trend has a direct relationship to performance. In Q1 2020, we saw the spread narrow to 1.84%. However, it recovered to 1.91% in Q2 2020.

As the spread widens, it means the company has greater earnings potential. In this quarter, the cost of funds rose heavily, but the rise in average yields was even greater, leading to a widening spread. Average yields from assets rose from 4.90% to 5.40%, while the cost to acquire those funds rose from 3.28% to 3.69%. This certainly is a large move on both ends, and we expect such volatility to continue in 2020.

Book value still suffering

Although we have been bearish because of the dividend concerns in the sector as a whole, and WMC isn’t paying theirs, we have always worried about the book value. Book values have been pressured for all mREITs in recent years, but ridiculously so in the last two quarters.

While the book value decreased 7% to $3.17, we were pleased with this result. We thought it would be worse. Investors should most certainly view this as a mixed quarter. Right now, shares are at $2.18, so the discount-to-book is significant.

Other considerations

Here is the thing. In this still challenging environment for credit-oriented mortgage assets, WMC’s management has taken actions to fortify the balance sheet and improve the future earnings power of the portfolio. The biggest moves were the reduction in portfolio leverage to 3.0x down from 9.5x a few months ago. To ensure longer-term survival, the company also worked on securing longer-term, fixed-rate financing and significantly reducing exposure to short-term repurchase agreement financing arrangements. The company also issued common equity at a premium to book value.

What is more, the equity and credit markets rallied in the second quarter, driven by improved liquidity conditions across financial markets and the reopening of the economy, which translated into higher valuations on a number of mREIT portfolio holdings. While that should have been very positive, the pace of the recovery in asset prices has been uneven across the residential and commercial mortgage credit markets. It is going to take time.

Take home

Looking ahead, our current expectations are for a rebound in economic growth with slightly higher inflation. Residential and commercial real estate markets across the country remain healthy and robust, but the credit markets are still questionable. The current recession will eventually pass and give way to an economic recovery, but what remain unknown are how long this will take and what the strength of that recovery will be. It will of course be dependent on the future trajectory of COVID-19 and fiscal and monetary stimulus. WMC positioned its portfolio to play defense until there is clarity. If you have the iron will power to remain invested here, capital gains could be had down the road, and the dividend is likely to return. Book value is likely to remain pressured until the recovery really is underway however.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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