Two Harbors Investment Corp. (NYSE:TWO) Q4 2023 Earnings Call Transcript

Two Harbors Investment Corp. (NYSE:TWO) Q4 2023 Earnings Call Transcript January 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: Hello and welcome to the Two Harbors Investment Corp. Fourth Quarter 2023 Financial Results Conference Call and Webcast. [Operator Instructions] A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to turn the call over to Maggie Karr, Head of Investor Relations. Please go ahead Maggie.

Maggie Karr: Good morning everyone, and welcome to our call to discuss Two Harbors’ fourth quarter 2023 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 fourth quarter earnings call. Today, I’ll provide an overview of our quarterly and annual 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 December 31st was $15.21 per share, representing a positive 2.0% total economic return for the quarter. IXM was $0.39 per share, representing a 10.3% annualized return. In the fourth quarter we issued 7.0 million shares through our ATM program, raising $97.8 million in common equity. Taking a step back and looking at 2023, I’m proud of what our company achieved for the benefit of our stockholders, both through the active management of our portfolio and our capital structure, and through the addition of our new operational platform.

In February, we raised $176 million in common equity and allocated all of those funds to investments in MSR, which increased our capital allocation to this asset class to 62%. Without a doubt however, the highlight of our year was the acquisition of RoundPoint Mortgage Servicing, which reinforced our commitment to MSR as a core and essential part of our business. Please turn to Slide 4 for a brief discussion on the markets. The fourth quarter of 2023 was punctuated by continued volatility in rates and spreads on the back of a stronger than expected September jobs reports. Coupled with the outbreak of war in the Middle East, interest rates moved steadily higher in early October. At its peak, the 10-year treasury yield briefly touched 5%, approximately 40 basis points higher than it was at the beginning of the quarter.

An abrupt turn of sentiment followed in early November after Chairman Powell’s [ph] optimistic assessment of the Fed’s efforts to bring down inflation and engineer a soft landing. Interest rates quickly reversed course and declined 36 basis points over the next three trading sessions. Supportive economic data in November, as well as dovish Fed commentary, drove the market to price in as many as six interest rate cuts in 2024. The entire yield curve responded as the 10-year treasury rate finished the quarter at a yield of 3.88%, 59 basis points lower than it started at the beginning of the quarter. And the two-year treasury rate declined 79 basis points to 4.25%, resulting in a net 10 basis points steepening of the yield curve. You can see these changes in figure one on the slide.

From peak to trough, the five-year and 10-year treasury yields moved a jaw dropping 120 basis points in the quarter. It’s interesting to look at these rate moves in a historical context, which you can see in figure two on the bottom of this slide. Market practitioners often quote measures of realized volatility as the variance or standard deviations of historical price movements, or sometimes their percentage changes, and that’s meaningful for those who are adept in statistics. In this chart, we aim to show something simpler and we believe, more intuitive. We simply look at how many days over the past 20 years had a move in the five-year treasury rate of more than 10 basis points. In 2023, the market experienced more than 50 days of such moves.

That is, the five-year rate moved more than 10 basis points on more than 20% of the trading sessions during the year. This was the second highest instance of this metric, right behind 2008 during the great financial crisis. For essentially a decade prior to 2022, there were only two years where there were 10 such days. Many years during that period had less than 5. There are, of course, many differences between then and now, but this time series plot is meant to provide some perspective on the market that we have been managing through. Please turn to Slide 5 for a brief discussion on RoundPoint’s operations. We closed the acquisition of RoundPoint effective September 30th and have been actively integrating all systems and people. The 10th transfer of our servicing to RoundPoint’s platform is expected to occur on February 1st, and we will have one final cleanup of 60,000 loans in early June, as shown in figure one.

In all, we expect the total number of loans on the RoundPoint platform to be just north of 900,000, making it the 8th largest conventional servicer in the country. Transferring almost a million loans in this time frame is quite an accomplishment, and the team at RoundPoint has done an excellent job of keeping up with the expanding portfolio while maintaining a commitment to delivering exceptional service to every homeowner. Since the closing of the acquisition, we have made large strides in integrating RoundPoint’s functions, operations and overall platform into Two Harbors. We continue to see this acquisition as providing a lot of opportunity going forward for our shareholders. In particular, we still believe that the RoundPoint servicing platform should benefit the combined company by approximately $25 million in pretax income in 2024, the result of both incremental revenue and cost savings.

Figure two on the bottom right of this slide highlights our top key strategic initiatives for RoundPoint for 2024. Our first focus is to render additional cost savings and economies of scale from the platform. This involves being smart about our technology, knowing when to buy versus build, and to streamline processes and create additional efficiencies. The second area of focus is to develop a best-in-class direct-to-consumer originations channel to provide recapture on our portfolio. The note rate on our MSR portfolio is below 3.5% and so with mortgage rates north of 6.5%, we are a long way away from serious refinancing activity. Unless interest rates fall precipitously, we think that we have the time to build the platform that we want. We have hired a very experienced individual to lead this effort who has spent his entire 30-year career building and running direct-to-consumer businesses.

We are in the process of expanding the team and we expect to be able to begin making loans in the second quarter. The ability to create something from scratch without any legacy issues or risks is tremendously exciting and few companies get the chance to do that. With a direct-to-consumer origination platform we also expect to be able to offer our borrowers second liens, home equity loans and other ancillary products. Lastly, we are keenly focused on the growth of RoundPoint’s third party subservicing business. As of yearend, RoundPoint serviced a total of seven true third party clients, including one new client added in the fourth quarter. This new client is the operator of a newly formed MSR exchange which matches MSR buyers and sellers. While they have yet to add any new loans to our platform, we are optimistic about this new partnership.

Additionally, there has been increasing demand and activity from institutional investors who are participating in the MSR market through separately managed accounts. The opportunity exists because the market has never before seen a risk profile like the current MSR asset class, with most of the universe being far away from the refinance window. We believe the best way to grow our subservicing business is by being the subservicer of choice for this new capital. We think there are many reasons why we are a great partner for this new capital and we are actively working to ensure that we have the ability to support various structures. Indeed, we’ve recently signed a term sheet to sell a small pool of our own MSR to a nontraditional market participant on a servicing retained basis, which will bring the number of true third party subservicing clients up to eight once that deal closes.

Bringing this all together, let’s discuss how we are thinking about our portfolio of securities and MSR and our operational platform in the current environment. While agency spreads are attractive, especially in a historical context, the market is in the midst of transitioning from a period of Fed tightening to one with a more neutral posture and one where we think spreads on RMBS are roughly fair. Therefore, we do not think this is a great time to climb far out on a limb in terms of risk or leverage. Second, the current environment reinforces why MSR is such a valuable asset in our portfolio, having low prepayment and convexity risks and producing a highly positive cash flow and attractive yield. Whether or not the Fed cuts three times or six times or zero times in 2024, we still expect prepayment speeds on our MSR portfolio to remain slow for quite some time, though we are preparing for the unexpected through the development of our direct-to-consumer recapture channel.

The nature of our portfolio construction means that when the MBS underperform, our capital allocation will outperform pure agency strategies, and when the MBS outperform, our portfolio will underperform pure agency strategies. This is by choice and by design. A good example of this can be seen in just the last two quarters. While we expect to have underperformed pure agency strategies this quarter, as MBS tightened, we significantly outperformed last quarter when they widened. Our high capital allocation to MSR acts as a ballast to our portfolio when agency spreads fluctuate. Looking further ahead, we are forging a path that lies not merely in watching mortgage spreads flicker by on the screen, but rather through the financial investment in an asset class MSR, where we can more meaningfully impact our results through our actions.

The uniqueness of two harbors is that we are not a pure agency only REIT. We have built our portfolio with the intent of delivering high quality returns, not just over the next quarter or even the next rate cutting cycle, but over the long-term, despite interim interest rates and spread volatility. Ours is not a stagnant portfolio and we constantly evaluate opportunities across our core competencies all through the lens of creating sustainable shareholder value. 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. The company generated comprehensive income of $38.9 million, or $0.40 per weighted average share in the fourth quarter. Our book value was $15.21 per share at December 31st, compared to $15.36 at September 30. Including the $0.45 common dividend results in a quarterly economic return of positive 2.0%. Before turning to Slide 7, I’d like to call your attention to Appendix Slide 30, where we have included the customary information on REIT taxable income and the tax characterization of our dividend distributions. For additional information regarding the distributions and tax treatment, please refer to the dividend information found in the investor relations section of our website.

Please turn to Slide 7. IXM for the fourth quarter was $38.2 million or $0.39 per share, representing an annualized return of 10.3%. Lower IXM quarter-over-quarter was impacted primarily by spread volatility and related portfolio activity. Moving to Slide 8, let’s look at some detail of the quarter-over-quarter variances in IXM. IXM is lower quarter-over-quarter by $11.1 million. This was driven primarily by decreased income on RMBS from lower balances and moving our mortgage investments down in coupon. Additionally, IXM was affected by certain yearend expense accrual adjustments. As a reminder, IXM reflects our daily adjusted holdings over the quarter. There can be quarterly distortions in IXM like coupon positioning, timing of MSR cash flows, funding rates and leverage and expense adjustments, but we believe that it is the most helpful way for our investors and analysts to understand the current quarter return contributions.

IXM is complementary to the return potential and outlook slide later in the presentation, which reflects our view on prospective returns. Please turn to Slide 9. RMBS funding markets remained stable and liquid throughout the quarter with ample balance sheet available. Spreads on repurchase agreements widened slightly into the fourth quarter and yearend with financing for RMBS between so far [ph] plus 23 to 25 basis points. At quarter end, our weighted average days to maturity for our agency repo was 48 days. Our days to maturity are typically lower at December 31 as we intentionally roll repos past year end to avoid any disruption in funding that can occur in December. Post quarter end, we’ve rolled repos at very attractive spreads given that even longer term repos are pricing in 5 to 6 rate cuts into 2024.

Currently, about 16% of our repos have floating rates. 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 $591 million unused MSR financing capacity and $168 million unused capacity for servicing advances. I will now turn the call over to Nick.

Nicholas Letica: Thank you, Mary. Please turn to Slide 10. As bill discussed, there was no lack of volatility in the fourth quarter. Following the rise in interest rates in October, mortgage spreads underperformed, widening by about 20 basis points. Rates reversed course in November and spreads tightened back by about 35 basis points. This tightening trend continued in December, with the Fed strongly signaling that the period of rate hikes was over. Ultimately, current coupon mortgage spreads on a nominal basis finished the quarter at 118 basis points, tighter by 33 basis points. This is at the tighter end of the 2023 range of 100 to 167 basis points. You can see this in figure one. Though the spread is still much wider than the longer term non-QE average of 80 basis points, it reflects an environment of high realized rate volatility and tepid demand from depository institutions.

Being at the tighter end of the range is likely the result of the market’s expectations of more than five fed rate cuts priced in for 2024, a steeper forward curve and lower forward implied volatility. Putting all that together, while we are positioned to benefit from spread tightening, we still see enough risk to, as Bill said, not go out on a limb. As anticipated, reported prepayment rates broadly declined by 16% in the fourth quarter. This decline reflected weaker seasonals and effective mortgage rates of over 7%, the highest in 20 years. Despite 30-year mortgage rates falling by 70 basis points over the quarter to 6.4%, 96% of mortgages remained outside the refinance window. One thing I’d like to detail today is how decreasing rates and increasing prepayments could affect our portfolio of MSR.

Let’s look at this in more detail in figure two, which shows projected prepayment rates for our MSR versus a typical current coupon MBS in varying interest rate scenarios. Being about 300 basis points out of the money, prepayment speeds on our MSR remain very insensitive to falling rates. In fact, less than 1% of our balances have 50 basis points or more of rate incentive to refinance. The green line in this chart represents our portfolio of MSR. As you can see, even with an instantaneous 200 basis point decline in rates, speeds are projected to only increase to ten CPR. Compare that to the current coupon whose speeds could top 60 CPR. I’m sure some of you are thinking that although 10 CPR is still absolutely slow, it’s a big increase from what we are experiencing now.

That’s true, but those expectations are also built into how we actively hedge our MSR. Turning to the MSR marketplace, as is typical, the pace of sales slowed in the fourth quarter with $53 billion offered in the bulk market. This brings the total MSR offered for the year to just under $500 billion. 2023 finished as the second most active year in the MSR market, falling just behind 2022’s total of $525 billion. Lower supply in the fourth quarter did little to affect the traded spreads of MSR. Bids remained well supported, as evidenced by sellers typically receiving a high single digit number of bids. Now let’s turn to Slide 11 and discuss our portfolio positioning and activity in the fourth quarter. At December 31, our portfolio was $14.6 billion, including $11 billion of settled positions.

On the top right of this slide you will see a few bullets about our risk positioning and leverage. As spreads widened in October and our book value declined we responded by selling some MBS, actively lowering our leverage to protect against further losses. Our average leverage for the quarter reflects this, decreasing to 5.8 times from 6.3 times at third quarter end. Following optimistic signs from the Fed in November, we strategically increased our risk and added leverage to the portfolio. This decision proved to be effective and captured most of the retightening of spreads through year end. Our quarter end economic debt-to-equity was 6 times. For similar reasons that we have outlined in prior calls, we continue to think it is prudent to maintain a neutral leverage position.

We don’t believe that we need to add more leverage to generate strong returns, as you will see in a few slides when we detail our return outlook. Please turn to Slide 12 to review our agency portfolio. Figure one shows the composition of specified pool holdings by coupon and story, and on figure two you can see the performance of TBAs and the specified pools we own throughout this quarter. We migrated the portfolio down in coupon by replacing approximately $2.5 billion, 4.5% and 6.5% TBAs with an equal amount of 2.5% to 4% TBAs in order to take advantage of the sharp cheapening of lower coupons that occurred in October. Additionally, we enhanced liquidity by rotating approximately $1 billion 4% to 4.5% specified pools into same coupon TBAs. At quarter end, about 70% of our MBS holdings were in specified pools that we believe offered better relative value than TBAs. Figure three on the bottom right shows our specified pool prepayment speeds decreasing to 5.4 CPR in the fourth quarter from 6.7 CPR in the third quarter.

As you can see from the chart, on aggregate speeds for these predominantly discount pools were materially faster than TBAs, hence providing more return. Please turn to Slide 13. Our MSR portfolio was $3 billion in market value at December 31, which includes the addition of $829 million UPB through flow purchases in the quarter. As rates declined in the quarter, the price multiple of our MSR declined from 5.8 to 5.6 times. The prepayment speed of our MSR dropped by 22% to an historically low 3.8 CPR, and our expectation is that prepayment rates for deeply out of the money mortgages will continue to remain at historically low levels through 2024, providing a tailwind for this strategy. Post quarter end, we signed two term sheets, one to purchase $3 billion UPB of MSR to settle in the first quarter and another to sell $1.5 billion UPB on a servicing retained basis.

At current spread levels, we prefer investing capital in hedged MSR rather than hedged securities. 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 in the market. We estimate that about 62% of our capital is allocated to hedged MSR with a market static return projection of 12% to 16%. The remaining capital is allocated to hedged RMBS with a market static return estimate of ten to 11%. The lower section of this slide is specific to our portfolio with a focus on common equity and estimated returns per common share. With our portfolio allocation shown in the top half of the table and after expenses, the static return estimate for our portfolio is between 8.9% to 11.5% before applying any capital structure 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 9.9% to 14% or a prospective quarterly static return per share of $38 to $0.53. Thank you very much for joining us today and now we will be happy to take any questions you might have.

See also 12 Best Prenatal Vitamins For Pregnant Women and 15 Highest Quality Olive Oil Brands in the US.

Q&A Session

Operator: Thank you. Our first question is coming from Doug Harter from UBS. Your line is now live.

Douglas Harter: Thanks. Can you talk about what were kind of the factors that are leading you to see the lower returns in the lower returns in the agency MBS hedged with rates and kind of other participants are still seeing kind of teens returns and kind of hoping you could sort of offer your opinion as to why you’re seeing 10% to 11%?

Nicholas Letica: Hey Doug, this is Nick. Thank you for the question. Yes, over the quarter, well spreads did tighten over the quarter, as you know. For us specifically, we and again this is through the lens of our spreads and how we construct our portfolio on that page and capital structure of the portfolio, which can cause differences from person to person or institution to institution. But in addition to all those things we did, as you can see from our other slides, we did materially go down in coupon over the quarter and these are nominal spreads. And when you go down in coupon in mortgages you do lose spreads. So a lot of this spread potential is driven by the coupon selection for mortgages. And it is also just to remind everyone that it is a moment in time.

Right? It is just a snapshot of the portfolio at the end of the quarter. And it so happened that last quarter from relative value reasons, we did think that it made sense to go down in coupon as we went through the quarter, and that does negatively impact the return potential of that segment of the portfolio. But it is by no means something that we think is long-term in nature, in the sense that, as you well know, we do move our coupon exposure around quite a bit from quarter to quarter and in fact, over this quarter, we have gone back up in coupon. And if we were to rerun this projection today, you would see materially higher return projection out of that segment of the portfolio. So it really is just a snapshot at the end of last quarter reflects predominantly a down in coupon bias.

William Greenberg: And I might just add, Doug, good morning, by the way, is that the down in coupon movement in the portfolio that Nick mentioned, we did that from a relative value perspective, because we thought the total return potential of those mortgages would be better than some of the up in coupon ones as we moved a portion of the portfolio there. So the lower return potential is an artifact, if you will, even though we thought the total return was going to be better by making that move.

Douglas Harter: Got it. And just on that total return comment, I guess, how do you think about the time frame for kind of capturing that total return, and how do you think about the tradeoff there between current and total return and time to recognize that?

Nicholas Letica: Yes, that’s a good question. It’s one that we talk about frequently when we’re making these decisions. I’d say generically, we’re thinking about months in terms of seeing the relative value opportunity play out over time, but it’s certainly not days. We’re thinking about longer timescales than that, and we generally expect them to occur less than a year. So I’d say the timescale is generally a few months.

William Greenberg: The other thing I just want to mention about the return potential calculation as I’m sure as you guys know, there’s a lot of technicalities in our market and how people look at things. We tend to look at things, our spreads, we look at them versus the entire curve, rather than just looking at things versus a blend of, for example, the 510 part of the curve. The curve is inverted. So if you do run mortgages against the whole curve, you tend to get tighter spreads than you do if you just look at something versus the longer end of the curve. And I think that also is a factor that plays into how we look at things versus others. And of course, it just depends on the leverage people assume. Also, that’s a big factor as to how those numbers got determined. But it’s really, as I said, a moment in time and it is something that will move around, as you know.

Douglas Harter: Thanks.

William Greenberg: Thank you.

Operator: Thank you. Next question today is coming from Trevor Cranston from JMP Securities. Your line is now live.

Trevor Cranston: Hey, thanks. Good morning.

William Greenberg: Good morning.

Trevor Cranston: Another question on the return potential slide. You guys have been earning a pretty decent amount of floater income on the MSR portfolio. When we look at the forward return projections on Slide 14, does that incorporate the impact of lower forward Fed funds on the floater income component of the MSR and also funding expenses? And I guess generally, if you guys could just comment on kind of how you think about the impact of lower Fed funds being on the portfolio as a whole? Thanks.

William Greenberg: Yes, good morning. Thanks for the question. So, yes, the downward sloping curve is incorporated into the float earnings of the MSR asset. And of course, the entire subject of floats is one that we actively hedge the interest rate risk of, so that, I wouldn’t say that we experienced a windfall when rates rose, and we won’t experience a large decline in book value when and if rates fall, because we’re hedging that exposure. Right? And so that is also the answer to the question of what happens to our portfolio if the Fed cuts and if funding rates or short-term rates fall. Right? Is that because our portfolio is hedged across the curve and as a result, our portfolio returns in how that slide of the return potential was really constructed depends really on the spread between the asset and the, I’ll say, longer term rates, but understanding what Nick just said about not being one point on the curve.

That is true of every point that we hedge on the curve. But that’s a complexity. It’s the spread of the asset relative to the risk free curve that matters and not the funding rate itself. And so I’d say to zero that’s hedged. And if you want to talk about it more completely, I think it actually — the returns would go down slightly because of the risk free rate that’s earned on the equity.

Nicholas Letica: But to your base question, those calculations all assume that the forward curve is realized. So those are all embedded in the calculations.

Trevor Cranston: Right. Okay. That makes a lot of sense. And then, Bill, you talked about some of the opportunities for growth in the subservicing business in particular. I was wondering if you could maybe expand a little bit on that and talk about sort of how you see the magnitude of potential growth on the subservicing side of things, specifically over the next couple of years? Thanks.

William Greenberg: Yes, sure. Well, as I said in my remarks, the interesting thing that’s happened in the servicing market over the last year or two is that rates have risen so much, and the mortgage universe as has been well described by us and others, has an average dollar price of 80 and is more than 300 basis points out of the money. And so the risk characteristics of the asset is something that hasn’t really been seen before. Right? You see it a little bit on the chart that Nick talked about in his presentation where we showed the relative S curves of the portfolio on page, what page is that there? Whatever, where we showed that if rates fall 200 basis points, Page 10, that the prepayments on our portfolio aren’t expected to increase very much.