Q1 2024 Two Harbors Investment Corp Earnings Call

Participants

Margaret Karr; IR Contact Officer; Two Harbors Investment Corp

William Greenberg; President, Chief Executive Officer, Director; Two Harbors Investment Corp

Mary Riskey; Chief Financial Officer, Vice President; Two Harbors Investment Corp

Nicholas Letica; Chief Investment Officer, Vice President; Two Harbors Investment Corp

Doug Harter; Analyst; UBS

Trevor Cranston; Analyst; JMP Securities

Bose George; Analyst; Keefe, Bruyette & Woods North America

Jason Weaver; Analyst; JonesTrading

Rick Shane; Analyst; JPMorgan

Eric Hagen; Analyst; BTIG

Presentation

Operator

Good morning. My name is Jennifer, and I will be your conference facilitator. At this time, I'd like to welcome everyone to Two Harbors first-quarter 2024 financial results conference call. (Operator Instructions) I would now like to turn the call over to Ms. Maggie Karr.

Margaret 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 Two Harbors Investment.com.
In our earnings release and presentation we have provided reconciliations of GAAP to non-GAAP financial measures in the 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 and 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 for TMNG.

William Greenberg

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 round point 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 MSRX. is a balanced 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 higher for longer interest rate environments.
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. 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. and metric closely watched by the market and the Fed reaching 4.5%, its highest level since June 2023, as seen in figure one 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 two sentiment continues to evolve. And following the Fed's mid-April meeting, those expectations had fallen two about 1.3 interest rate cuts for 2024.
Please turn to slide 5 for brief discussion on round Point's operations. We completed the 10th transfer of our servicing to run points platform on February first, and we have one final transfer of approximately 52,000 loans in early June, as shown in figure one, we are still in the early stages of building our subservicing platform. And in the quarter we added one new subservicing clients. We expect to transfer 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 environments. So 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% securities. We believe that we are positioned to benefit in the current market environment and beyond. Our high allocation to MSRs 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 and 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 31st compared to $15.21 at December 31st, 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 increase 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 movements 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 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 round point 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 sulfur plus 18 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 $6.2 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, Murray. Please turn to Slide 9. Our portfolio at March 31st was $14.7 billion, including 11.3 billion in federal positions than $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 six times over the quarter, we shifted our mortgage exposure up and coupon, which we will detail in our agency portfolio commentary this benefit of 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. So 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 unto your options on 10-year swap rates decline to about a 98 basis points annually, close to the bottom end of its range since the beginning of 2023. Nominal spread to treasuries for the current coupon finished at 119 basis points, essentially unchanged over the quarter. As you can see from figure one, 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 contained 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 2.5 widened by around five to 10 basis points on concerns of bank portfolio reallocation, as is evident and Figure two 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. One shows the composition of our specified pool holdings by coupon and story. And then figure to 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 through five TBA. with an equal amount of higher coupon, 5.5 through 6.5 TBA, reversing a 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 payer performance. We continue to favor pools over TBAs with pools accounting for about 70% of our exposure figure.
Three 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 one, this is down slightly from the first quarter 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 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 the primary reason for today's historically low turnover rates, a direct proxy for turnover is existing home sales. And in figure two, 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. So 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 flow purchases in the quarter. Note that post quarter end, we committed to purchase a $2 billion UPB bulk package 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 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% to 14.1% or a prospective quarterly static return per share of 39 to $0.55. No fixed income markets remained 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.

Question and Answer Session

Operator

(Operator Instructions) Doug Harter, 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 on given spread widening, is that enough to kind of change your year kind of?

William Greenberg

Yes.
Look on the market and moving off of a neutral stance 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 asked the question of how you think that's changed our outlook and positioning.

Nicholas Letica

Hey, Doug, thanks for the questions, 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 as we've talked about, we still, we 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 wouldn't 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 them 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, you know, for this quarter already. And although things have changed to some degree with regard to the range of spreads within a 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 the shifts in sentiment about the Fed 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 likely the long term 10 trend. But in the near term, we prefer to keep our mortgage exposure in a neutral range.

Doug Harter

As just a follow-up on that, I guess how willing are you to kind of be opportunistic. And yes, and more tactical kind of during those bouts of volatility on the sorry, trading the range, if you will, versus kind of the I'm kind of holding a longer term on neutral defensive position.

Nicholas Letica

Look, we respond to markets as they develop every day and every day is a new day in the markets, as we know. So we're absolutely positioned to take advantage of spreads. If we believe they're opportunistically wide, we will do so. But at this in the current market, as said, if you look at 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 Perkins portfolio construction as it is right now.

Doug Harter

Great.
Thank you, Mick.

Operator

Trevor Cranston, JMP Securities.

Trevor Cranston

Thanks. Following up on the question about their performance in April. Can you comment on whether or not there's been any significant changes to the portfolio in April in terms of the of coupon composition in particular. Thanks.

Nicholas Letica

Yes, no, no, there has not been or the the portfolio from quarter end has changed very little to date.

Trevor Cranston

Got it.
Okay.
And then just given the outperformance of spec pools relative to TBAs over the last few months, on. 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, spectacles, a lot of that is just governed by how roles are in the TBA market, frankly, I mean, 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. I'm not infrequently right now. I would say to elaborate on your on your first question a little bit we don't see a compelling reason to to move our exposure right now. We the value proposition across the stack 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 persistent lower coupons. So on we are we have we are we have not moved our performance over the quarter. We have not moved our positioning materially over the quarter from where we were at it at the end.

Trevor Cranston

Okay. Appreciate the government's. Thank you, Nextra.

Operator

Bose George, KBW.

Bose George

Several 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 or the range you've provided the drivers are primarily those are the drivers excuse me, our prepayment and funding rates.
Okay, great. And then actually in terms, given just can you talk about the comfort level with your dividend is, I guess it's slightly below the midpoint of the range. So does that jump presumably that suggests a level of comfort there?

Nicholas Letica

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

Bose George

Okay, great.
Thanks.

Operator

Jason Weaver, JonesTrading.

Jason Weaver

Good morning. Noting your comments expected 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 deal?

William Greenberg

Yes, good morning.
Thanks for the question.
On a number, we see the value proposition being low coupons and high coupon to be to be pretty pretty flat. The the range of returns is probably on an unlevered unhedged basis in the low 10s on levered.
And how should we think it's and we think it's some mid 10s, probably, um, you know, one of the things that we've observed in the market and there's been lots of lots of demand in the market. The service has been very well bid this quarter is that the recapture assumptions that are embedded in some of the higher coupons can be I'm pretty high, pretty 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 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 on post-quarter end. And we continue to be active in the market and active bidders, and we're being very disciplined on the price that we pay in order so that we can, yes, get returns that we think are worthwhile in the market.

Jason Weaver

Okay. Thank you.
That's helpful. And then I'm just curious, you know that outside of the interplay between MSR and agency RMBS are you are you making any additional changes to your hedging approach given that we we're coming to a consensus view of a higher longer-term higher for longer environment with potential volatility ahead No, I don't I don't think so on.

William Greenberg

We we've always had an approach or are are you of keeping our interest our interest rate exposures low generally.
And so included embedded in that is is the full range of the portfolio and whether the MSR has more or less interest rate risk and which hedges the CMBS 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 exposures low we don't feel that we have, particularly in the edge and knowing of which direction interest rates are going. And so we keep our exposures pretty flat. As you can see from our disclosures on the kinds of sensitivities that we show.

Jason Weaver

All right, thank you. And just one more and I'll jump 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 opposite on we're seeing lots of lots of demand for new balances. On the MSR side, we're seeing new participants enter the markets regularly on and there's lots of MSR financing supply.

Jason Weaver

Yes.
All right.
Thank you again for taking my questions.
Thank you.

Operator

Rick Shane, JPMorgan.

Rick Shane

Hey, guys. Thanks for taking my questions. As smart, 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 in 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

I'm sure.
Good morning, Rick. And so I will just note that the details of the interest income and interest expense will be included in our Q, which will be filed today. And 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 on quarterly expense was 4.6 million. And what was your other question?

Rick Shane

What was the other interest income line, let's see believe it was EUR17 million.

Mary Riskey

Yes.
So and on 21, you can see RMBS interest expense of 100.6. So the remainder would be either Okay, terrific.

Rick Shane

Thank you very much. Started starting to do that, but it just seems there's a lot of hassle with the model. Thank you.

Mary Riskey

Thanks.

Operator

Eric Hagen, BTIG.

Eric Hagen

Hey, good morning, guys. Following up on the MSR financing, I mean, do you see that maybe leading to improve 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, and thanks for the question, um, you know, I in terms of I think weather spreads will evolve the answer. That's a definite. Maybe I don't know. We haven't seen seen that yet on, but these things typically have a way of doing that when there's lots competition and so forth, your tighter spreads is often on one one A byproduct of that. But one thing to keep in mind, however, though, is that our our financing facilities generally are 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 to reset and so forth. But as these things come up come on, we do renegotiate rates as they occur. And in fact, the last couple of facilities and which have recently come up for renewal, we did actually renegotiate to lower rates. So that is beginning to happen.
Then could it happen more that remains to be seen.
And your other question in terms of whether our lenders are giving us credit for for the subservice for the servicing operations on. I'm not sure what you what you mean by that and how it affects our our lending profile or how lenders view us. But our lenders are aware that we run our servicing in house and that's incorporated into into their analysis and the reach they give us and then the credit analysis that they do.

Eric Hagen

So yes, yes.
Okay.
That's helpful. 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 see that being a risk on the table at this point and there might be 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 point this year?

Nicholas Letica

Eric, this is Nick on. No, we do not think that there's a risk that the that there's any sales of mortgages from the Fed as far as the, um, as far as whether things are priced in the market is very efficient. So it's yes, it's extremely hard thing to say. I would say that the overall the first quarter until today, we've seen a little bit more of a muted response out of the mortgage market than we had in period and prior periods of volatility or kind of surprise volatility and higher rates. So I think that's a function of the fact that the market still does believe that the I think the market does overall, believe the that the Fed will will still cut at some point this year. But I do think that the spreads have been reasonably well calibrated to Fed expectations, but like we've said now that things have stayed in a range and we like the long term 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?
You know, we're not we're not we're not done with the volatility in the market.
That's for sure.

Eric Hagen

Yes, that's helpful. Thanks to the respective pressure.

Operator

Is there any 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.