Two Harbors Investment Corp. (NYSE:TWO) Q1 2024 Earnings Call Transcript

Two Harbors Investment Corp. (NYSE:TWO) Q1 2024 Earnings Call Transcript April 30, 2024

Two Harbors Investment Corp. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning. My name is Jennifer and I will be your conference facilitator. At this time, I’d like to welcome everyone to the Two Harbors First Quarter 2024 Financial Results Conference Call. All participants will be in a listen-only mode. After the speaker’s remarks, there will be a question-and-answer period. I would now like to turn the call over to Ms. Maggie Karr.

Maggie Karr: Good morning, everyone, and welcome to our call to discuss Two Harbors’ first quarter 2024 financial results. With me on the call this morning are Bill Greenberg, our President and Chief Executive Officer; Nick Letica, our Chief Investment Officer and Mary Riskey, our Chief Financial Officer. The earnings press release and presentation associated with today’s call have been filed with the SEC and are available on the SEC’s website, as well as the investor relations page of our website at twoharborsinvestment.com. In our earnings release and presentation, we have provided reconciliations of GAAP to non-GAAP financial measures, and we urge you to review this information in conjunction with today’s call. As a reminder, our comments today will include forward-looking statements which are subject to risks and uncertainties that may cause our results to differ materially from expectations.

These are described on Page 2 of the presentation and in our Form 10-K and subsequent reports filed with the SEC. Except as may be required by law, Two Harbors does not update forward-looking statements and disclaims any obligation to do so. I will now turn the call over to Bill.

William Greenberg: Thank you Maggie. Good morning everyone and welcome to our first quarter earnings call. Today, I’ll provide an overview of our quarterly performance, then I will spend a few moments discussing the markets and finish with an update on RoundPoint operations. Mary will cover our financial results in detail and Nick will discuss our investment portfolio and return outlook. Let’s begin with Slide 3. Our book value at March 31 increased to $15.64 per share, representing a positive 5.8% total economic return for the quarter. Our results were driven by the performance of our RMBS portfolio in a declining volatility environment and MSR, which experienced slower than expected prepayment speeds. MSR continues to benefit our portfolio with a very attractive yield combined with limited prepayment risk and low-interest rate sensitivities.

As we have previously emphasized, our high capital allocation to MSR acts as a balance to our portfolio when agency spreads fluctuates. I’m confident that our portfolio design and current allocation between MSR and Agency RMBS positions us well for what we expect to be a higher for longer interest rate environment. Please turn to Slide 4 for a brief discussion of the markets. Stronger than expected economic data and sticky inflation readings pushed interest rates higher in the quarter and led the market to the realization that higher for longer rates is the most likely path. The employment report came in stronger than expected in each month of the quarter, averaging gains of 281,000 new jobs per month. Similarly, both consumer and producer price indices surprised higher, with three-month annualized core CPI, a metric closely watched by the market, and the Fed reaching 4.5%, its highest level since June 2023 as seen in Figure 1.

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Q&A Session

At the start of the year, Fed funds futures implied more than six interest rate cuts in 2024, so by quarter end that number had fallen to just under three as you can see in Figure 2. Sentiment continues to evolve, and following the Fed’s mid-April meeting, those expectations had fallen to about 1.3 interest rate cuts for 2024. Please turn to Slide 5 for a brief discussion on RoundPoint’s operations. We completed the tenth transfer of our servicing to RoundPoint’s platform on February 1 and we have one final transfer of approximately 52,000 loans in early June as shown in Figure 1. We are still in the early stages of building our subservicing platform and in the quarter we added one new subservicing client. We expect to transfer in approximately 17,000 loans from this client in the near term.

We are continuing to build out the team and supporting infrastructure for our direct to consumer recapture originations channel and we still expect to begin taking locks in the second quarter. This direct to consumer portfolio retention business should be thought of as a way to hedge faster than expected prepayment speeds in a refinance environment. Though that may seem distant, we intend to offer ancillary products, including second lien loans, to our customers in the meantime. The ability to build this critical piece of our servicing business from scratch without any legacy issues or risks is exciting and something that few companies have the opportunity to do. Institutional demand remains high for investors who are looking to participate in the MSR market given the never before seen risk profile of the current servicing universe, with the majority of outstanding MSR being hundreds of basis points away from an economic incentive to refinance.

Given our deep expertise as an MSR investor, we believe that we are the ideal partner to service MSR for this new capital and we are actively working on the ability to support various structures. With over 60% of our capital allocated to servicing and the remaining 40% to securities, we believe that we are positioned to benefit in the current market environment and beyond. Our high allocation to MSR means that our portfolio is less exposed to fluctuations in mortgage spreads than portfolios without MSR and we believe that this is an attractive position, particularly amid uncertainty over the future paths of Fed actions or inactions, interest rate volatility and mortgage spread performance. In addition, owning an operating company allows us to significantly impact our results through our own actions in a way that’s not possible when only owning a portfolio of securities.

Our future success will be determined by remaining disciplined and sticking to our areas of expertise, managing interest rates and prepayment risks. With that, I’d like to hand the call over to Mary to discuss our financial results.

Mary Riskey: Thank you, Bill and good morning. Please turn to Slide 6. Our book value increased to $15.64 per share at March 31 compared to $15.21 at December 31. Including the $0.45 common dividend results in a quarterly economic return of positive 5.8%. As a reminder, total economic return is the primary metric we consider as an indicator of our performance. We repurchased approximately 485,000 shares of preferred stock in the quarter, lowering the ratio of preferred stock to total equity. Please turn to Slide 7. The Company generated comprehensive income of $89.4 million, or $0.85 per weighted average common share in the first quarter. MSR values increased during the quarter on higher rates and spread tightening, offset somewhat by the RMBS allocated as a hedge.

RMBS values decreased as a result of rate movement more than offset by gains on swaps and futures, which is consistent with the mortgage spread tightening that we observed in the quarter. Net interest expense of $42 million was favorable $3 million to Q4 from lower average borrowing balances and lower cost of funds partially offset by lower RMBS interest income from net sales. Net servicing income of $159 million included a $134 million of servicing fee income and $32 million of float and ancillary income, offset by $7 million of third party subservicing fees and other MSR related servicing costs. Overall, net servicing income was unfavorable to Q4 by $7 million on lower flowed income due to seasonality of escrow balances and lower servicing fee collections, partially offset by lower third party servicing and other MSR related costs as we continue transferring loans to the RoundPoint platform.

Please turn to Slide 8. RMBS funding markets remained stable and liquid throughout the quarter with ample balance sheet available. Spreads on repurchase agreements tightened slightly with financing for RMBS between SOFR plus 18 basis points to 24 basis points. At quarter end, our weighted average days to maturity for our agency repo was 88 days. We finance our MSR across five lenders with $1.6 billion of outstanding borrowings under bilateral facilities and $296 million of outstanding five-year term notes. We ended the quarter with a total of $602 million of unused MSR financing capacity and $135 million of unused capacity for servicing advances. I will now turn the call over to Nick.

Nicholas Letica: Thank you, Mary. Please turn to Slide 9. Our portfolio at March 31 was $14.7 billion, including $11.3 billion in settled positions and $3.4 billion in TBAs. We maintain the belief that now is not the time to go out on a limb in terms of risk or leverage given the current market conditions and level of spreads, and as a result we kept a neutral risk profile with ending economic debt to equity of 6 times. Over the quarter, we shifted our mortgage exposure up in coupon, which we will detail in our agency portfolio commentary. This benefitted the portfolio and resulted in lower spread sensitivity as you can see in the spread exposure summary chart on this page. Please turn to Slide 10, in the first quarter, despite a 30-basis point rise in rates on the ten-year treasury and less optimism about the Fed cutting rates this year, volatility declined, driving positive performance for RMBS.

Though still high by historical standards, realized volatility across the yield curve fell from the prior quarter, as did implied volatility. Our preferred gauge implied volatility on two-year options on ten-year swap rates declined to about 98 basis points annually, close to the bottom end of its range at the beginning of 2023. The nominal spread to treasuries for the current coupon finished at 119 basis points, essentially unchanged over the quarter. As you can see from Figure 1, the spread continues to closely track implied volatility and remained well above the 50th percentile of long-term history. Spreads for current coupons were aided by lower than expected supply, strong fixed-income fund inflows, and tame prepayment rates. Although the overall performance of RMBS was positive in the first quarter, performance varied widely.

Deli and higher coupons outperformed lower coupons and specified pools outperformed TBAs. Specified pools broadly outperformed the same coupon TBA owing to elevated demand typical of the beginning of the year and for higher coupons, investors seeking to protect performance against potential fast prepayment speeds, lower coupons like 30-year 2s and 2.5s widened by around 5 basis points to 10 basis points on concerns of bank portfolio reallocations. As is evident in Figure 2, spread curves flattened over the quarter, with higher coupons tighter versus lower coupons wider. Please turn to Slide 11 to review our agency portfolio. Figure 1 shows the composition of our specified pool holdings by coupon and story, and on Figure 2 you can see the performance of TBAs and the specified pools we own throughout this quarter.

We replaced approximately $2.4 billion notional of 2.5% half through 5% TBA with an equal amount of higher coupon 5.5% through 6.5% TBAs, reversing the down in coupon trade from the fourth quarter and more defensively positioning our portfolio from a spread perspective. We also rotated approximately $350 million notional of lower coupon specified pools into 6% specified pools to capture positive payout performance. We continued to favor pools over TBAs, with pools accounting for about 70% of our exposure. Figure 3 on the bottom right shows our specified pool prepayment speeds decreased slightly to 5.1% CPR in the first quarter from 5.4% CPR in the fourth quarter. Please turn to Slide 12 as we discuss the market environment for investments in MSR.

Activity in the MSR market remained brisk, with bid wanted activity totaling $160 billion, although a sizable number as is shown in Figure 1, this is down slightly from the first quarters of the prior two years. We expect MSR supply to be lower compared to prior years given lower origination volume and the large amount of low coupon servicing that is already traded hands. This lower supply, combined with a growing investor base should keep MSR values well supported, as evidenced by the strong traded levels of servicing so far this year. Mortgage rates drifted higher over the quarter with 30-year rates averaging around 6.75%, still hundreds of basis points above the gross coupon of our MSR. Being so deeply out of the money, prepayments on our servicing are predominantly from housing turnover, rather than a homeowner refinancing their loan to better a rate.

In prior quarters, we have discussed the disincentive or so called lock in effect that a very low rate mortgage has on a homeowner to move or sell their home. This is the primary reason for today’s historically low turnover rates. A direct proxy for turnover is existing home sales, and in Figure 2 you can see on a monthly basis how closely prepayment speeds on our MSR track this time series. Existing home sales so far in 2024 have been in line with last spring and remain at a pace far below recent years, something you can see on Appendix Slide 19, along with a few other market data charts we added this quarter. Though there are signs that the housing market is beginning to normalize to this high level of mortgage rates, it is our expectation that turnover on low rate mortgages will continue to run at historically low levels.

Please turn to Slide 13 to review our MSR portfolio. The portfolio was $215 billion UPB at March 31, which includes the addition of $3.1 billion UPB through bulk and flow purchases in the quarter. Note that post quarter end we committed to purchase a $2 billion UPB bulk package. The price multiple of our MSR increased slightly to 5.7 times from 5.6 times. For the entire quarter, speeds paid 3.8% CPR slower than our projections. Assuming unchanged mortgage rates, we expect prepayment rates to rise modestly in the second quarter, reflecting turnover seasonality. Even so, less than 1% of the mortgage loans that back our MSR are likely to refinance at current rates and over 80% of balances are at least 250 basis points below current mortgage rates.

Finally, please turn to Slide 14, our return potential and outlook slide. The top half of this table is meant to show what returns we believe are available on the assets in our portfolio. We estimate that about 63% of our capital is allocated to servicing, with a static return projection of 12% to 15%. The remaining capital is allocated to securities with a static return estimate of 12% to 13%. With our portfolio allocation shown in the top half of the table and after expenses, the static return estimate for our portfolio is between 9.1% to 11.7% before applying any capital structural leverage to the portfolio, after giving effect to our outstanding convertible notes and preferred stock, we believe that the potential static return on common equity falls in the range of 10.1% to 14.1%, or a prospective quarterly static return per share of $0.39 to $0.55.

Though fixed income markets remain subject to periods of high realized rate volatility and the near-term likelihood of significant tightening of RMBs spreads remote, nominal spreads for agency RMBs are wide on a historical basis and the return potential of our portfolio is strong. We are content to let spread sit here at their current levels while our low duration and low convexity MSR portfolio continues to generate attractive cash flows with low spread volatility. Thank you very much for joining us today and now we will be happy to take any questions you might have.

Operator: [Operator Instructions] We’ll go first to Doug Harter with UBS.

Doug Harter: Thanks. First, hoping you could give us an update on how book has performed so far in April and then sort of in that context, given spread widening, is that enough to kind of change your kind of outlook on the market and moving off a neutral stance?

William Greenberg: Good morning, Doug. Thanks for joining us today. So far in, in April, as of last Friday, we estimate our book value to be down between 1.5% and 2%. I’ll let Nick answer the question of how he thinks that’s changed our outlook and positioning.

Nicholas Letica: Hi Doug, thank you for the question. This is Nick. So, no, it really has not changed our outlook or positioning. It is spreads have widened out a little bit. They continue to be within the range that they’ve been for the year. And as we’ve talked about, we, we still – we believe that the construction of our portfolio, or our capital allocation as it stands between MSR and securities is where we would like it to be. And I wouldn’t – would say that there has not been a sufficient amount of disturbance or widening in the mortgage market to really change our outlook on, on spreads. We remain somewhat defensive about spreads relative to others, I would say. We continue to believe that while mortgages from a longer-term value, longer-term perspective do have value, in the near-term, the market is subject to these bouts of volatility, as we’ve seen for this quarter already and although things have changed to some degree with regard to the range of spreads, range of spreads do seem to be tighter than they were at, at some periods in the last two years.

The market is still subject to these shifts in sentiment about the Fed, and, and the, and mortgages definitely react to it. So, we would – we continue to have, as you see from our numbers, we continue to have exposure to, positive exposure to spreads tightening, which again is, is, is likely the long-term trend, but in the near-term, we prefer to keep our mortgage exposure, in a neutral range.

Doug Harter: Just to follow up on that, I guess, how willing are you to, to kind of be opportunistic and more tactical kind of during those bouts of volatility, sort of trading the range, if you will, versus kind of holding the longer-term neutral, defensive position?

Nicholas Letica: Look, we respond to markets as, as they develop. Every day a new day in the markets as we know. So, we’re absolutely positioned to take advantage of spreads. If we believe they are opportunistically wide, we, we will do so. But, in the current market, as said, look at the spread range and, and how it’s done over the last couple of years, and we still believe, we’re well within that range and like the portfolio construction as it is right now.

Doug Harter: Great. Thank you, Nick.

William Greenberg: Thanks, Doug.

Operator: We’ll go next to Trevor Cranston with JMP Securities.

Trevor Cranston: Hi, thanks. Following up on the question about, performance in April, can you comment on whether or not there’s been any significant changes to the portfolio in April in terms of, coupon composition in particular? Thanks.

William Greenberg: No, no, there has not been. Our portfolio from quarter end has changed very little to date.

Trevor Cranston: Got it. Okay. And then, given the outperformance of spec pools relative to TBAs over the last few months, can you give us an update on how you sort of think about the relative value between specs and TBAs right now? Thanks.

Nicholas Letica: Sure. Spec pools, a lot of that is discovered by how roles are in the TBA market. Frankly, we’re always, of course, comparing where pools are trading to TBAs and making relative value judgments and as, as you guys know, we, we do tend to move our position in the coupon stack around not infrequently. Right now, I would say, to elaborate on your first question a little bit, we, we don’t see a compelling reason to, to move our exposure right now. We – the value proposition across the stack is, is pretty flat. We do like the, the higher coupons right now, just the lower coupon market is, seems to be fairly well priced. And there have been these, as we noted in our commentary, there has been, some amount of selling related to some bank portfolio reallocations. We think that could persist in lower coupons. So, we have not moved our performance over the quarter – we have not moved our positioning materially over the quarter from where we were at the end.

Trevor Cranston: Okay. I appreciate the comments. Thank you.

William Greenberg: Thanks, Trevor.

Operator: We’ll go next to Bose George with KBW.

Bose George: Hi, everyone. Good morning. Can you remind us what are the drivers that sort of push you to the high end or the low end of the target range, ROE range you’ve provided?

William Greenberg: The drivers are primarily, hi, Bose. The drivers, excuse me, are prepayment and funding rates.

Bose George: Okay. Great. And then actually in short given just can you talk about the comfort level with your dividend, it’s – I guess, it’s slightly below the midpoint of the range, does that I presume – does that suggest level of comfort there?

William Greenberg: Yes, the dividend, as you can see from our return projection, it’s squarely within the range of, of, of those outcomes. And yes, we feel good about being able to support the dividend on a go forward basis.

Bose George: Okay, great, thanks.

Operator: We’ll go next to Jason Weaver with Jones Trading.

Jason Weaver: Hi, good morning. I noted your comments expecting lower supply. Where do you see incremental returns on new MSR today and where the relative value looks like between, say, production coupons and, and season deals?

Nicholas Letica: Yes, good morning. Thanks for the question. We see the value proposition between low coupons and high coupons to be pretty, pretty flat. The range of returns is probably, at an unlevered, unhedged basis in the low-teens, levered and hedged. We think it’s mid-teens probably. One of the things that we’ve observed in the market and there’s been lots of demand in the market. The servicing has been very well bid this quarter, is that the recapture assumptions that are embedded in some of the higher coupons can be pretty high, pretty efficient. And so this is something to keep in mind as, as we look at the relative values between high coupons and low coupons. But, every pool is, is different, every situation is specific and we’re willing and able to participate across the – right across the sector in terms of – in terms of coupons.

As we noted in our prepared remarks, we bought, a small pool post-quarter end. We continue to, to be active in the market and active bidders, and we’re being very disciplined on, on the price that we pay in order so that we can get, get returns that we think are worthwhile in, in the market.

Jason Weaver: Okay, thank you. That’s helpful. And then I’m just curious, outside of the interplay between MSR and Agency RMBS, are you making any additional changes to your hedging approach, given that we’re coming to a consensus view of a higher longer term, higher for longer environment with potential volatility ahead?

William Greenberg: No, no, I don’t think so. We’ve always had an approach or, of keeping our interest rate –our interest rate exposures low generally. And so embedded in that is, the full range of the portfolio and whether the MSR has more or less interest rate risk, which hedges the MBS, that just gets put into the, the mix and the calculations that we do in order to figure out how much other hedges we need in our portfolio. But we’re generally trying to keep our interest rate exposures low. We don’t feel that we have particularly an edge in knowing which direction interest rates are going, so, we, we keep our exposures pretty flat, as you can see from our disclosures, the kinds of sensitivities that we show.

Jason Weaver: All right, thank you. And just one more and I’ll drop back in the queue. Are you seeing any changes in the willingness of counterparties to extend additional MSR financing?

William Greenberg: No, in fact, the opposites. We’re seeing lots of demand for new balances on the MSR side. We’re seeing new participants enter the market regularly. There’s lots of, of, of MSR financing supply out there in the market.

Jason Weaver: All right, thank you again for taking my question.

William Greenberg: Thank you.

Operator: We’ll go next to Rick Shane with JPMorgan.

Rick Shane: Hi, guys, thanks for taking my questions. How are you? Look, most of my questions have been asked and answered. I do have a housekeeping question simply because you guys have tweaked the way you report line items and we need to reconstruct our model a little bit. You historically broke out other interest income from securities income. Can you break that out for us and also what was the converts expense on the quarter?

Mary Riskey: Sure. Good morning, Rick. So, I will just note that the, the details of the interest income and interest expense will be included in our queue, which will be filed today. You can also find the breakdown on Page 21 of the deck on our portfolio yields and financing costs. So, specific to your question, convertible senior notes quarterly expense was $4.6 million and what was your other question?

Rick Shane: What was the other interest income line?

Mary Riskey: Let’s see. I believe it was $17 million. Yes. So, on, on 21 you can see RMBS interest expense of $100.6 million. So the remainder would be other.

Rick Shane: Okay, terrific. Thank you very much. Sorry to do that, but it just saves us a lot of hassle with the model. Thank you.

William Greenberg: Thanks, Rick.

Operator: We’ll go next to Eric Hagen with BTIG.

Eric Hagen: Hi, good morning, guys. Okay, following up on the MSR financing, I mean, do you see that maybe leading to improved economics or terms that you get in the market? And do you think your counterparties are giving you guys credit for having brought in the subservicing function?

William Greenberg: Good morning, Eric. Thanks for the question. In terms of, I think, whether spreads will evolve, the answer, that’s a definite maybe. I don’t know, we haven’t seen that yet. But, these things, typically have a way of doing that when there’s lots of competition and so forth. Tighter spreads is often one, one byproduct of that. One thing to keep in mind, however, though, is that our, our financing facilities generally, these are not overnight repos kind of thing. These are generally longer term facilities. So, it takes a little bit longer for these things to, to reset and so forth. But as these things come up, we do renegotiate rates as, as they occur. And in fact, the last couple of facilities which have recently come up for renewal, we did actually renegotiate to lower rates.

So that is beginning to happen and could it happen more, that remains to be seen. And your other question in terms of whether our lenders are giving us credit for the subservicing operations, I’m not sure what, what you mean by that and how it affects our lending profile or, or, or how lenders view us, but all our lenders are aware that we brought our servicing in house and, and that’s incorporated into, into their analysis and the rates they give us and the credit analysis that they do. So, yes.

Eric Hagen: Yes. Okay. That’s helpful. You guys are always very thoughtful on the mortgage market. Just generally. I mean, do you feel like there’s a lot of risk at this point that the Fed could actually sell Agency MBS from its portfolio. That was a conversation at one point. I mean, do you even see that being a risk on the table at this point. And then, like adjacent to that, I mean, how much risk do you think is priced into the mortgage basis that, the Fed actually hikes rates at some points this year.

Nicholas Letica: Eric, this is nick. No, we do not think that there is a risk that the – that there is any sales of mortgages out of the Fed as far as the – as far as whether things are priced in. The market’s very efficient. So, it’s an extremely hard thing to say. I would, say that the, overall, in the first quarter and to today, we’ve seen a little bit more of a muted response out of the mortgage market than we had in prior periods of, of volatility or kind of surprise volatility in higher rates. So, I think that’s a function of the fact that the market still does believe that is – I think the market does overall believe the, that the Fed will, will still cut at some point this year. But I, I do think that the spreads have been reasonably well calibrated to Fed expectations.

But like we’ve said, the things have stayed in a range, and, we like the long term exposure of being long mortgage spreads. But, you have to balance that against this near term volatility that can seemingly pop up at any time. We’re not done with the volatility in the market, that’s for sure.

Eric Hagen: Yes, that’s helpful. Thanks for the perspective. Appreciate it.

William Greenberg: Thanks, Eric.

Operator: And at this time, I’ll turn the call back to Bill Greenberg for closing remarks.

William Greenberg: I’d like to thank everyone for joining us today. And as always, thanks for your support.

Operator: This does conclude today’s conference. We thank you for your participation.