Thursday, October 20, 2022

Western Asset Mortgage Capital: Trading Well Below BV, Exploring a Sale

Western Asset Mortgage Capital (WMC) ($56MM market cap) was one of the mortgage REITs caught up in the margin call wave of 2020 when otherwise safe mortgage back securities ("MBS") suddenly went no-bid.  Mortgage REITs often financed their MBS with daily mark-to-market short term financing, when MBS prices suddenly dropped (they would later recover), financing counterparties forced liquidations and significant shareholder value evaporated in the process.  WMC did survive, but in a wounded and subscale form.  Around the end of last year, they started to transition their portfolio away from commercial mortgages to residential mortgages, primarily in Non-QM loans (financed via RMBS under the Arroyo branded shelf).  Non-QM is short for non qualifying mortgages, those that aren't eligible to be purchased by the GSEs, most of these are actually to prime borrowers (746 average FICO) but those borrowers don't have regular W-2 income to meet tighter post-GFC mortgage underwriting standards.

Getting straight to the point, WMC trades for $9.35/share despite having an economic book value of $24.58/share, or WMC is trading at just 38% of book.  Their book value will likely come down a fair amount when they release Q3 earnings due to rates rising and spreads widening since 6/30, but it should still be very cheap to its net asset value.  WMC is managed by large fixed income specialist Western Asset Management, they've already cut their fees 25% for 2022, have no chance of raising additional capital to regain scale, and are thus waving the white flag by announcing they've commenced a strategic alternatives review process.  It is likely just not worth Western Asset's time at this size (their management fee is based on equity, not assets).

Here is WMC CEO Bonnie Wongtrakool discussing the rationale in their Q2 earnings call:

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 dilutive to existing shareholders. The last time we issued any meaningful amount of equity was in 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 future earnings power.

Over the last two years, we have made significant progress by taking actions to improve our liquidity and balance sheet 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.

I'm always a little skeptical of externally managed mREITs looking to sell themselves, sometimes it means they're simply selling the management contract to another asset manager that will just rebrand and the discount to NAV won't close much.  But here the discount is so wide and the language sounds slightly more focused on shareholders.  There is likely some middle ground in between the share price and book value to get a deal done that pleases all three parties: 1) WMC shareholders get some premium to current prices; 2) Western Asset rids themselves of the distraction and receives some value for their management contracts; 3) one of the countless potential acquirers gets a publicly traded permanent capital vehicle or a current mREIT gets some additional scale and fees for their manager.

Similar to LMPX, this is a completely commodity/fungible type business or balance sheet that trades hands regularly, even in this currently strained M&A market, a willing seller (which sounds like they are) should find no problem finding plenty of willing buyers.  Most likely this will be a stock-for-stock deal or reverse merger with a non-traded REIT, so the upside won't be as big as a liquidation or cash deal, but still an attractive risk/reward.  My best guess is $12-14/share in value.

Other thoughts:

  • Their balance sheet is a mess and difficult to untangle.  For example, one of their legacy commercial investments is a mezz tranche of the Mall of America CMBS (CSMC Trust 2014-USA) and due to accounting rules, WMC actually consolidates the entire SPV.  WMC's economic exposure is $10.7MM, but they consolidate the $1.4B in liabilities on their balance sheet.  Mall of America's future is certainly cloudy, they did restructure the loan during the pandemic, but as an important tourist attraction for the Twin Cities MSA, I would expect it to get political support to survive as a destination/entertainment mall.  In 2020, alongside the restructuring, Trep did put a $1.9B value on the mall, for whatever that's worth.
  • They also have one big problem CRE loan, "CRE 3" in their disclosures which is described as an entertainment/retail property in New Jersey.  I couldn't find it in their disclosures, but it wouldn't surprise me if that was the troubled American Dream mall as it shares ownership with Mall of America.  CRE 3 has been in non-payment status for about a year, if WMC needs to write down the full value of the loan, that knocks about $4/share off the book value.
  • Their Non-QM loans are highly concentrated in California, about 2/3rds.  LTVs look good (originally 65% at the time of underwriting) at the current moment, but we're early in any housing correction and California typically exhibits higher price volatility than other markets.  WMC disclosed that about 15% of their Non-QM loans have near term rate resets (these are ARMs) that will slightly help offset the price pressure of higher rates.

Disclosure: I own shares of WMC

16 comments:

  1. Thanks for this- I have been kicking this around too. Have you seen any comparable transactions to reference?

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    1. I wrote about CMO last year:
      https://clarkstreetvalue.blogspot.com/2021/10/capstead-mortgage-corp-reverse-merger.html

      They did a reverse-merger with a private mREIT at a book for book basis. Given where WMC trades, not sure that's realistic here, but maybe the overall high level deal structure will be similar.

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  2. The amount of debt they have is not sustainable going into a recession and housing bust. This is the external management way of doing things - load up the assets full of debt, collect the management fees for "growth" and dump the losses on shareholders. Wouldnt touch this equity with a 10 foot pole.

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    1. The management fee is based on equity, not assets, so the incentive to load up on debt is less here.

      Most of their debt is non-recourse and some of that non-recourse debt they consolidate (the Mall of America CMBS) is also non-economic to them. So I disagree. I've worked in the structured finance industry for a long time, their debt doesn't worry me.

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  3. https://investorrelations.westernassetmcc.com/press-releases/news-details/2022/Western-Asset-Mortgage-Capital-Corporation-Announces-Third-Quarter-2022-Results/default.aspx

    Q3 results are in, economic book value down to $19.25/share after they wrote down most of the CRE 3 loan which was confirmed to be the American Dream mall. After subtracting out a management termination fee (~$3/share) and expenses, still could get somewhere in that $12-14/share range. Although that assumes no further write downs in the portfolio, including the Mall of America CMBS.

    Oddly, their initial strategic alternatives press release gave out their banker's contact information, the Q3 results do the same. My skeptical side takes this to mean they're not as far along in the process as I had hoped. I guess we might hear more tomorrow on the earnings call.

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  4. Why the dump? No news or filings.

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    1. No idea, I bought a little more, hopefully that wasn't a terrible decision.

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  5. https://www.sec.gov/Archives/edgar/data/1465885/000162828023023668/ex991-projectmaverickpress.htm

    Merging with a non-traded REIT, Terra Property Trust, on a book-for-book basis. Both are externally managed, new entity will likely trade at a pretty wide discount. BRSP for example trades at 60% of book, probably not a ton of value add to this deal other than gaining some scale.

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    1. Agree. If there is opportunity here--not sure there is!--it's in the lightly traded Terra 6% notes; TPTA, trading at ~$19, maturing in almost exactly 3 years for a mid-teens effective compounded yield to maturity. VERY rough comp securities AAIN/RCC/SCCD (Finance REITS, ~6% face yield, mid-late 2026 expiry) trade at 23.80/23.50/20.85. So maybe there's a step-up in price soonish for a better IRR as the underlying goes from private to public and gets more trading liquidity plus a presumption of enhanced ability to pay off at maturity? Not sure yet, but maybe worth a look.

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    2. Interesting, good find!

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  6. https://www.businesswire.com/news/home/20230712848940/en/

    MITT submitted a bid.

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    1. Every one of these MREITs has hair on it, and the industry suddenly has consolidation fever: BRMK, AJX, WMC, AAIC. Probably a sucker move, but I might place some bets on who's next.

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    2. Any you think are likely next?

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    3. My first impulse was to assume someone would take another run at ACR, the eternal hot potato, but I wonder whether it's too small for an acquirer to figure out how good their (low) reserves and marks are, even with in-place CLO financing. I'm awfully lazy but I think I have to do more work on that to see whether it's dead money or what. My initial look-through doesn't suggest any high-percentage opportunity. I'm also going to spend some more time on GPMT to see just how dreadful their assets are and TRTX to see whether I can get any sense of TPG's intentions going forward. I thought SACH would have been a good bolt-on for somebody given their background, but the company has transformed itself over the past few years and is less well-positioned for hard times.

      On an entirely different but still REITy note, I have been looking at the PW prefs (alongside CORR-A and HCDIP, which I own). Management has basically worked as hard as it can to destroy value by chasing various phantoms, but it seems things might have turned as they are trying to shed assets and right the balance sheet. The prefs seem well-covered for now (very roughly land+railroad+cash+HFS cover mortgages, leaving $~45 million greenhouse assets to cover ~$9 million prefs), but that really depends on held-for-sale getting sold and even then the portfolio doesn't really look like it will do anything other than erode value. We're coming up on a year of non-payment, and with 2 more quarters the pref trustee election commences (for what it's worth; sometimes these things don't even get a quorum).

      The problem is that, even with significant haircuts to the assets, this is worth more dead than alive, but I think management's actions throughout its history indicates that they are unlikely ever to agree.

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    4. ACR could make some sense, but I won't hold my breath, the discount is large enough now that even paying a termination fee to the manager makes sense. Especially for someone like Oaktree that doesn't have liquidity.

      I have a feeling LADR might acquire BRSP, or at least I wouldn't be surprised if it happened.

      My hurdle for getting interested in preferred stock is pretty high, but I'll give a look to those, thanks.

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    5. A BRSP-LADR tie-up makes sense to me because of (among other things) Mazzei, but I also wonder whether he doesn't want to prove out his management a little more and then sell out and retire. No real sense of his motivation, so no real sense of deal shape and odds. But certainly seems like something that works out decently either way.

      The prefs I mention are all absolute trash trading at under 30% and under 20% of par when deferred dividends are backed out--a very high yield there's a very good chance nobody will ever see. So real dumpster-diving to suss out asset values, lender and client proclivities, degrees of impairment, and management incompetence/level of larceny; wouldn't blame anyone for passing on even looking at them.

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