Two Harbors Investment - Q1 2024

Transcript

Operator (participant)

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.

Margaret Karr (Head of Investor Relations)

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 (President and CEO)

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 31st 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 ballast to our portfolio when agency spreads fluctuate. 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.

At the start of the year, Fed funds futures implied more than 6 interest rate cuts in 2024, though by quarter end that number had fallen to just under 3, 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 operations. We completed the 10th transfer of our servicing to RoundPoint platform on February 1st, 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 rate and prepayment risks. With that, I'd like to hand the call over to Mary to discuss our financial results.

Mary Riskey (CFO)

Thank you, Bill, and good morning. Please turn to slide 6. Our book value increased to $15.64 per share at March 31st, compared to $15.21 at December 31st. Including the $0.45 common dividend results in a quarterly economic return of +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 $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 float income due to seasonality at 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 18-24 basis points. At quarter end, our weighted average days to maturity for our agency repo was 88 days. We financed 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 (VP and Chief Investment Officer)

Thank you, Mary. Please turn to slide 9. Our portfolio at March 31st was $14.7 billion, including $11.3 billion in settled positions and $3.4 billion in TBAs. We maintained 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 six times. Over the quarter we shifted our mortgage exposure up in coupon, which we will detail in our agency portfolio commentary. This benefited 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 10-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 10-year swap rates, declined to about 98 basis points annually, close to the bottom end of its range since 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, this 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. Belly 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 twos and two-and-a-halves, widened by around 5-10 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 owned throughout this quarter.

We replaced approximately $2.4 billion notional of 2.5s through 5s TBA with an equal amount of higher coupon 5.5s through 6.5s TBA, reversing the down-and-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 payup 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 low origination volume and the large amount of low coupon servicing that has 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 a better 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 a 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 remained 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 31st, which includes the addition of $3.1 billion UPB through bulk and float 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 5.7x from 5.6x. 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%-15%. The remaining capital is allocated to securities, with a static return estimate of 12%-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%-11.7% 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 10.1%-14.1%, or a prospective quarterly static return per share of $0.39-$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 spreads 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 (participant)

Thank you. If you'd like to ask a question, please signal by pressing star 1 on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press star 1 to ask a question. We'll pause for just a moment to allow everyone an opportunity to signal for questions. We'll go first to Doug Harter with UBS.

Douglas Harter (Senior Research Analyst)

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 (President and CEO)

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

Nicholas Letica (VP and Chief Investment Officer)

Hey, Doug. Thank you for the question. This is Nick. So no, it really has not changed our outlook or positioning. Spreads have widened a little bit. They continue to be within the range that they've been for the year. And as we've talked about, we still believe that the construction of our portfolio, our capital allocation as it stands between MSR and securities, is where we would like it to be. And I would say that there has not been a sufficient amount of disturbance or widening in the mortgage market to really change our outlook 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 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.

Although things have changed to some degree with regard to the range of spreads, the range of spreads do seem to be tighter than they were at some periods in the last two years, the market is still subject to these shifts in sentiment about the Fed and mortgages definitely react to it. We continue to have, as you see from our numbers, we continue to have positive exposure to spreads tightening, which again is likely the long-term trend, but in the near term, we prefer to keep our mortgage exposure in a neutral range.

Douglas Harter (Senior Research Analyst)

That's just a follow-up on that. I guess how willing are you 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 (VP and Chief Investment Officer)

Look, we respond to markets as they develop. Every day is a new day in the markets, as we know. We're absolutely positioned to take advantage of spreads. If we believe they are opportunistically wide, we will do so. In the current market, as said, look at the spread range 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.

Douglas Harter (Senior Research Analyst)

Great. Thank you, Nick.

Nicholas Letica (VP and Chief Investment Officer)

Thanks, Doug.

Operator (participant)

We'll go next to Trevor Cranston with JMP Securities.

Trevor Cranston (Managing Director and Senior Equity Research Analyst)

Hey, 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 (President and CEO)

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

Trevor Cranston (Managing Director and Senior Equity Research Analyst)

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.

William Greenberg (President and CEO)

Sure. Spec pools, a lot of that is just governed by how rolls 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 you guys know, 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 don't see a compelling reason to move our exposure right now. The value proposition across the stack is pretty flat. We do like the higher coupons right now. Just the lower coupon market 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 the 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 (Managing Director and Senior Equity Research Analyst)

Okay. Appreciate the comments. Thank you.

William Greenberg (President and CEO)

Thanks, Trevor.

Operator (participant)

We'll go next to Bose George with KBW.

Bose George (Senior Equity Research Analyst)

Hey, 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, the range you've provided?

William Greenberg (President and CEO)

The drivers are primarily, hey, Bose, the drivers, excuse me, are prepayment and funding rates.

Bose George (Senior Equity Research Analyst)

Okay. Great. And then actually, given, just can you talk about the comfort level with your dividend? I guess it's slightly below the midpoint of the range. Does that suggest a level of comfort there?

William Greenberg (President and CEO)

Yeah. The dividend, as you can see from our return projection, it's squarely within the range of those outcomes. And yes, we feel good about being able to support the dividend on a go-forward basis.

Bose George (Senior Equity Research Analyst)

Okay. Great. Thanks.

Operator (participant)

We'll go next to Jason Weaver with Jones Trading.

Jason Weaver (Equity Research Analyst)

Hi. Good morning. Noting 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 seasoned deals?

William Greenberg (President and CEO)

Yeah. Good morning. Thanks for the question. We see the value proposition between low coupons and high coupons to be pretty flat. The range of returns is probably, on 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 we look at the relative values between high coupons and low coupons. But every pool is different. Every situation is specific. And we're willing and able to participate right across the sector in terms of coupons.

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

Jason Weaver (Equity Research Analyst)

Okay. Thank you. That's helpful. 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 for longer environment with potential volatility ahead?

William Greenberg (President and CEO)

No, I don't think so. We've always had an approach of keeping 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 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. And so we keep our exposures pretty flat, as you can see from our disclosures, the kinds of sensitivities that we show.

Jason Weaver (Equity Research Analyst)

All right. Thank you. And just one more, and I'll drop back in a few. Are you seeing any changes in the willingness of counterparties to extend additional MSR financing?

William Greenberg (President and CEO)

No. In fact, the opposite. 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 MSR financing supply out there in the market.

Jason Weaver (Equity Research Analyst)

All right. Thank you again for taking my question.

William Greenberg (President and CEO)

Thank you.

Operator (participant)

We'll go next to Rick Shane with J.P. Morgan.

Richard Shane (Managing Director and Senior Equity Research Analyst)

Hey, 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?

William Greenberg (President and CEO)

Sure. Good morning, Rick. So I will just note that the details of the interest income and interest expense will be included in our 10-Q, 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?

Richard Shane (Managing Director and Senior Equity Research Analyst)

What was the other interest income line?

William Greenberg (President and CEO)

Let's see. I believe it was $17 million. Yeah. So on 21, you can see RMBS interest expense of $100.6 million. So the remainder would be other.

Richard Shane (Managing Director and Senior Equity Research Analyst)

Okay. Terrific. Thank you very much. Sorry to do that, but it just seemed as a lot of hassle with the model. Thank you.

William Greenberg (President and CEO)

You're welcome.

Nicholas Letica (VP and Chief Investment Officer)

Thanks, Rick.

Operator (participant)

We'll go next to Eric Hagen with BTIG.

Eric Hagen (Managing Director, Mortgage, and Specialty Finance Analyst)

Hey, good morning, guys. Hey, 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 (President and CEO)

Good morning, Eric. Thanks for the question. In terms of, I think, whether spreads will evolve, the answer to 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 byproduct of that. One thing to keep in mind, however, though, is that our financing facilities, generally, these are not overnight repos kind of thing. These are generally longer-term facilities. And so it takes a little bit longer for these things to reset and so forth. But as these things come up, we do renegotiate rates 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. Your other question in terms of whether our lenders are giving us credit for the subservicing operations, I'm not sure what you mean by that and how it affects our lending profile or how lenders view us. But all our lenders are aware that we brought our servicing in-house, and that's incorporated into their analysis and the rates they give us and the credit analysis that they do. So yes.

Eric Hagen (Managing Director, Mortgage, and Specialty Finance Analyst)

Yep. Okay. That's helpful. Hey, I mean, 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 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 (VP and Chief Investment Officer)

Hey, Eric, this is Nick. No, we do not think that there's a risk that there's any sales of mortgages out of the Fed. 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 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 volatility or kind of surprise volatility at higher rates. So I think that's a function of the fact that the market still does believe that I think the market does overall believe that the Fed will still cut at some point this year. But I do think that 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 (Managing Director, Mortgage, and Specialty Finance Analyst)

Yeah. That's helpful. Thanks for the perspective. Appreciate it.

William Greenberg (President and CEO)

Thanks, Eric.

Operator (participant)

At this time, I'll turn the call back to Will Greenberg for closing remarks.

William Greenberg (President and CEO)

I'd like to thank everyone for joining us today. As always, thanks for your support.

Operator (participant)

This does conclude today's conference. We thank you for your participation.