Q3 2021 Two Harbors Investment Corp Earnings Call
Good morning, My name is John and I'll be your conference facilitator.
At this time I would like to welcome everyone to two harbors third quarter 2021 financial results Conference call.
All participants will be on a listen only mode. After the Speakers' remarks, there'll be a question and answer period I would now like to turn the call over to Paul in a sense head of Investor Relations you may begin.
Good morning, everyone and welcome to our call to discuss two harbors third quarter 2021 financial results with me on the call. This morning are Bill Greenberg, Our President Chief Executive Officer, and Chief Investment Officer, and Mary risky, our Chief Financial Officer.
The press release and financial tables associated with today's call were filed yesterday with the SEC and are available on both the two harbors and SEC website.
In our earnings release and slides, we have provided a reconciliation of GAAP to non-GAAP financial measures.
Urge you to review this information in conjunction with today's call.
I would also like to mention that this call is being webcast and maybe accessed in the Investor Relations section of our website.
As a reminder remarks made by management during this conference call and the supporting slides may include forward looking statements.
These statements are based on the current beliefs and expectations of management.
Actual results may be materially different because of a variety of risks and other factors.
We caution investors not to rely unduly on forward looking statements.
Except as may be required by law.
Two harbors does not update forward looking statements and expressly disclaims any obligation to do so.
I will now turn the call over to Bill.
Thank you Paulino and good.
Good morning, everyone and welcome to our third quarter earnings call.
Please turn to slide three.
Quarter end book value was $6 40 per share representing a two 3% total economic quarterly return.
The performance, which was largely in line with the dividend reflected the partial retracement titer of high coupon spreads as recent data pointing to early signs of burnout and slower prepayment speeds.
Earnings available for distribution, formerly known as core earnings were 24 cents per share.
Elevated activity in the MSR market continued in the third quarter and into the fourth.
We saw 120 billion <unk> in bulk deals come to market in Q3, and another 100 billion in October bringing the year to date volumes to approximately 400 billion.
This is more than double the volume that we might typically see for full year and we expect this heightened activity to continue for the rest of the fourth quarter.
In the third quarter, we acquired 15 billion <unk> through bulk transactions and have committed to add another 21 billion over the next two quarters.
Additionally, we settled on 14 billion through our flow program.
Lastly, post quarter end, we issued common equity for net proceeds of approximately $194 million in a transaction that was accretive to book value.
We are seeing attractive opportunities in the MSR market and have already committed additional capital in that area.
Furthermore, with the fed taper upon us we expect we will be able to increase leverage and deploy more capital in RBS and attractive spreads in the near to intermediate term.
Please turn to slide four and I'll briefly discuss the overall market environment.
The 10 year swap rate fell from 1.44% on June 30th to a low of 1.16% in the middle of July and then subsequently rose 40 basis points to end the quarter at 155% as the market considered increased inflationary pressures and more precise communication on tapering from the federal reserve.
Indeed, as announced last Wednesday, the federal reserve will reduce its monthly purchases of U S. Treasury Securities by 10 billion in agency MBS by 5 billion beginning this month and expects to complete the process by mid 2022.
Although the last taper in 2013 resulted in a tantrum of high market volatility, we expect the market reaction to be more orderly. This time all else being equal.
Firstly, the fed is expected to continue to be a source of demand for some time as paydowns from its our MBS portfolio are reinvested as shown by the blue bars in figure one.
Secondly, the fed has clearly communicated the timing and pace of its tapering and is clearly associated the decision to paper from the decision to raise rates.
Lastly, even while banks have significantly reduced their purchases of agency arm B S. As long as loan growth is tepid and deposit balances remained high. Thanks will also likely be a source of demand when spreads become more attractive.
Current coupon spreads have widened out somewhat as shown in figure two but remain at very tight levels with current coupon OAS currently sitting at minus seven six basis points as of October 29th.
This spread is more than 15 basis points rich to past periods of quantitative easing where the fed was buying mortgages and about 35 basis points lower compared to periods, where the fed was not actively buying mortgages.
While we don't expect these spreads to normalize immediately we do expect spreads to gradually widen over the course of the tapering process.
Turning to figure three we showed the effect that the refinancing wave has had on the distribution of conventional mortgages by rates.
By comparing the gray bars, which show the coupon distribution at the end of March and the Blue bars, which showed the coupon distribution at the end of September.
We can see that the distribution has shifted significantly to the left indicating that a meaningful number of mortgages have already refinanced into lower coupons.
The gray and Blue lines show the cumulative distributions of mortgages from March and September respectively.
At the end of March the percentage of mortgages that were refinanced a bowl with at least 25 basis points of incentive had declined from about 85% at the end of 2020 to about 64% as shown by the light Gray circle.
At the end of September although mortgage rates were eight basis points lower than in March there were actually fewer refinances mortgages, 56% as shown by the dark Gray circle as a result of this re striking of the mortgage universe.
With the current mortgage rate at $3 one for the amounts of refinanced mortgages falls further to 54% as shown by the Green Circle.
Taken altogether this chart points to overall slower prepayment speeds, which should be beneficial to our agency pools MSR strategy.
Now I will turn it over to Mary to discuss our financial results in more detail.
Thank you Bill and good morning, everyone.
Please turn to slide five to review our financial results for the third quarter.
Comprehensive income was $45 2 million.
Representing an annualized return on average common equity of nine 1%.
Our book value was $6 40 per share compared to $6.42 at June 30th.
Including the 17, some common dividend resulted in a quarterly economic return of two 3%.
As Bill mentioned earlier, the result reflects spread tightening and high coupon specified pool.
Offset spread widening in our coupon RBS.
Moving on to slide six as we note at the top of the page core earnings will now be referred to as earnings available for distribution or AAD in line with evolving industry practice.
Earnings available for distribution increased to 24 cents per share compared to <unk> 19 in the second quarter.
Beginning in the third quarter E. D includes U S Treasury futures income.
As the economic equivalent to holding and financing a relevant cheapest to deliver U S. Treasury note or bond using short term repurchase rates.
As a hedging instrument, we use futures interchangeably with swaps and we think the treatment of hedging instruments and the <unk> should be consistent.
Interest income in <unk> was approximately <unk> <unk> per share for Q3.
It features incumbent included for Q2.
It would have increased by two cents for a total of 21 per share.
Interest income decreased from $43 5 million to $36 million and our RMB as position continued to decline through a combination of sales and paydowns.
Interest expense declined by $2 5 million, reflecting lower our MBS and MSR borrowings.
Turning to MSR net servicing income increased by 9 million to $56 7 million as a result of higher balances and collections and slower prepayments.
Gain on other derivatives rose by almost 20 million as we benefited from a larger position and continued roll specialness and TBA as well as the inclusion of future income.
Expenses increased by $3 2 million to $34 2 million.
And largely by one time nonrecurring credits and servicing expenses in the second quarter as we mentioned on our last earnings call.
In the table on the lower right Michel our portfolio yield.
Our realized net spread in the quarter rose by 62 basis points to 2.55%.
This net increase was attributable to the combination of higher yields on newly purchased MSR.
And a greater proportion of MSR in the portfolio.
Net spread as of September 30th.
Flex our estimate for the near term increased further to 277%, but will be dependent on our portfolio mix.
Please turn to slide seven.
We continue to maintain a strong liquidity position with unrestricted cash of one 1 billion at quarter end.
Which includes net proceeds from our July common stock offering of $256 million.
Funding for agency RMB as to the repo market remains attractive and continues to remain attractive. Despite the recent increase in rates.
They maintained access to diverse funding sources for MSR, and our unfunded and committed MSR financing capacity stands at $413 million.
Finally leverage declined from the prior quarter in conjunction with the lower RMB as balance.
Average and quarter end economic debt to equity in the third quarter were 6.0 times and six one times respectively.
Compared to the second quarter average and ending of six five times.
Expect our leverage to increase in coming quarters, as we add MSR and RBS.
I will now turn the call back to bill for a portfolio update.
Thank you Barry.
Let's turn to slide eight to discuss our quarterly portfolio activity and composition.
During the quarter, our portfolio grew to $17 9 billion.
As we deployed some of the capital that was raised in July into MSR and RMB, yes.
We adjusted our allocation in our MBS by selling some higher coupon pools that had tightened to unattractive spreads and reinvested into TBA, which continued to benefit from roll Specialness.
We also added to our hedging mix by increasing our options positions utilizing both interest rates and mortgage options, which are expected to benefit from volatility and a sharp break out to higher rates should that occur.
Please turn to slide nine as we discuss our specified pool positioning prepayments and performance.
As you can see in figure one we remained positioned in loan balance and geography stories.
Although prepayment speeds have generally been very fast the New York collateral has performed particularly well with speeds in the 4% and four 5% coupons coming in around 30, CPR during the third quarter compared with generics, which came in higher than 50 CPR.
Figure two shows the quarterly total return performance by coupon on TBA contracts shown by the gray bars, and our specified pool holdings shown by the Blue bars.
C that are up in coupon pools outperformed TBA is as the market reacted to data published during the quarter pointing to nascent but clear evidence of burnout.
Finally figure three compares by coupon observed prepayment speeds from pools delivered into TBA contracts to observe prepayment speeds on our specified portfolio.
Overall prepayment speeds in our specified pools declined 8% to 30, CPR and remained significantly slower than pools delivered into TBA showing the value of the prepayment characteristics of that collateral.
Please turn to slide 10.
Our MSR portfolio is currently valued at $2 $2 billion as of September 30th based on $200 billion U P b and with the gross coupon of three 4%.
That translates into a price of about 111.
Or right around a $4 two multiple.
The percentage of MSR in forbearance continued to decline and ended the quarter at one 7% by loan counts.
Forbearance rates have continued to decline even further in October to one 2% by loan counts.
During the quarter, we settled on 14 billion <unk> of MSR through our flow program and $15 billion in bulk purchases offsetting the runoff and growing the <unk> by $9 billion.
Additionally, we have executed term sheets to acquire a further $21 billion in bulk transactions in future quarters.
Year to date, we have committed to purchasing 44 billion through the bulk channel alone.
In figure two we show the trend of our settled <unk> for the flow and bulk channels over the last four quarters.
Flow channel settlements have continued to decline mirroring the drop in overall refinancing activity.
The bulk market on the other hand has been very active and that trend has accelerated throughout the year.
Although bulk supply has been robust pricing has held steady with demand rising to meet the increased supply as some large participants re entered the market and some new participants expand their interest in the asset class.
Figure three we compare our servicing prepayment speeds and blue bars versus TBA speeds and gray bars.
Since more than half of our portfolio has some kind of specified characteristic such as low loan balance or high LTV or has some significant seasoning to it that makes it more prone to burnout, our prepayment speeds are significantly slower than generic.
Overall prepay speeds on our MSR portfolio declined by 7% to 2007 CPR.
Please turn to slide 11.
Place of the charts that we have historically shown we thought it would be helpful to show a slightly different risk view of our agency force MSR portfolio.
On this page you can see a snapshot view of our effective coupon exposure and spread risk for agency MBS paired with MSR and agency RBS hedged with rates.
Because the MSR asset is negative interest rate duration and negative current coupon spread duration.
<unk> asset looks and acts in many ways like a short position in RMB, yes.
This effective short position, which is shown in the top left chart by the gray bars can be hedged perfectly for both rates and spreads by adding TBA as indicated by the blue bars.
The chart in the top middle shows our portfolio is remaining our MBS exposure after setting aside the exposure already accounted for in the top left chart.
These are MBS assets are hedged with interest rates and are largely distributed in the 3% three 5% coupons.
Lastly, the top right chart shows our aggregate position.
The RMB S plus MSR chart in the top left net to zero by design. The combined chart showing the current coupon risk position.
Denticle to that expressed in the top Middle chart.
In the second row, we show book value exposure to changes in current coupon mortgage spreads in.
In the left chart book value declines about 0.5% and both spread widening in spread tightening scenarios.
The fact that these numbers are not exactly zero. Despite a perfect hedge is just the result of negative spread convexity.
Remaining current coupon spread exposure shown in the bottom Middle chart is three times higher than in the bottom left chart because it doesn't have any MSR to act as a spread offsets.
In a hypothetical portfolio consisting of only RMB, yes, with no MSR. The current coupon spread exposure would be expected to be 5% to 10% for 25 basis point shift.
The fact that this exposure in the bottom Middle chart is only one 5% is the result of dividing the sensitivity by the book value of our entire portfolio, where a significant amount of capital is allocated to the parent construction shown in the charts on the left.
The chart on the bottom right. Some of these risks exposures together for a total of 2% exposure for 25 basis point widening in the current coupon mortgage spread which we consider to be very low.
Of course, this exposure assumes a parallel shock across the coupon stack and is not a relevant estimate for the book value sensitivity to spreads and higher coupons moving in isolation or on MSR.
Please turn to slide 12, where we show our interest rates and curves exposures.
Figure one we show our exposure to an instantaneous parallel shift in interest rates with a total exposure of minus 0.7% or 25 basis point shock.
We can see the total interest rate exposure for MSR shown in gray is roughly hedged with our RMB as portfolio shown in blue.
Relatively little impact from swaps and futures.
In figure two we show our exposure to changes in the long end of the yield curve keeping the front end Constance.
With rising rates more of a concern today, we see that our portfolio exposure to a bare steepening shift of 25 basis points, resulting in the plus 0.1% gain in book value.
Figure three is a new addition, this quarter.
With fed hikes on the horizon. It is interesting to look at our portfolio exposure to changes in the front end of the yield curve, while leaving the longer end unchanged.
With inflation fears in the foreground the obvious concern is to a shock upward in the front end and a bare flattening move.
In this scenario our portfolio has low sensitivity with only a minus 0.8% impact to book value.
Taken together these three charts demonstrate our commitment to hedging the full yield curve exposure and our desire to have little book value volatility no matter the rate environment.
Finally, I'd like to discuss our outlook for two harbors and I'll return expectations for new investments on slide 13.
Spreads and returns on target assets largely remained constant over the quarter with exception of high coupons specified pools.
With the tightening we experienced in the quarter, we now seen return expectations in the mid to high single digits down from the high single to low double digits at the end of Q2.
Current coupons specified pools remained unattractive with expected returns in the mid single digits.
Current coupon TBA rolls remained around 50 basis points special and they continue to carry well so that TBA is hedged with swaps offer low double digit returns assuming this role specialists last forever.
Spreads however continue to be tight and returns with decrease to mid to high single digits, depending on how fast Specialness goes away.
Moving to the lower half of the chart. We continue to be excited about our investment opportunities and the pair to agency plus MSR construction and we are focused on investing here.
Expected returns on new investments in a paired MSR and pools construction can be the high single digits to low teens.
<unk> paired with current coupon TBA is can offer returns in the low to mid teens.
As I mentioned previously large supply in the MSR market is creating currently attractive opportunities to deploy more capital in the paired agency plus MSR construction, and that's where we're spending most of our effort and capital.
Additionally, we expect to see more opportunities to RBS hedged with rates in the coming quarters as we expect the weight of robust mortgage origination and the absence of offsetting fed purchases to push spreads gradually wider.
With the fed finally, removing accommodation and prepayment speeds beginning to slow materially we are very constructive and optimistic about the forward outlook for two harbors and our pair to agency plus MSR strategy.
Thank you very much for joining us today, and we will now be happy to take any questions you might have.
Thank you at this time, we will be conducting a question and answer session.
If you would like to ask a question. Please press star one on your telephone keypad, a confirmation tone will indicate that your line is in the question queue.
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One moment, please while we pull for questions.
Our first question comes from the line of Trevor Cranston with JMP Securities. You May proceed with your question.
Alright, thanks and.
Thanks for all the new Turkey, and data that you put in the deck this quarter its very helpful.
I was curious you talked about.
Level.
Current coupon spread today versus historical levels.
And what are likely to widen over the next few quarters.
I was curious if you could share your thoughts on that.
The roll Specialness.
Where that is today versus maybe like an average historical level and how do you think that evolves.
<unk> starts to get implemented.
Sure. Thanks, very much for everyone. Thanks for joining us.
I think that the.
The role specialists and the reason for the role specialists at about 50 basis points special.
As you know, we've certainly seen it slightly more special over certain periods than it is today, we've certainly seen it less special and in a normal <unk>.
Environments.
It's typically the case that rolls are not very special at all.
And in fact, one of the main sources, probably the main source of real specialist today is is the activity of the fed and large banks buying in creating this supply demand imbalance between front month and back with contracts.
I do fully expect that that roll Specialness will follow.
Mortgage spreads.
And that as as the market returns to normal as the fed reduces its involvement spreads will.
Likelihood normalize and roll Specialness will probably also normalize along with it in.
In roughly the same kinds of time periods.
Would think by the time.
That the fed is done tapering spreads will be somewhat more normalized enroll specialists will mostly be gone.
That's my expectation.
Okay that makes sense.
Then you also commented that the the flow MSR purchase volume was declining a bit as originations come down.
And the bulk activities picked up do you.
You see any opportunities to add more flow partners are there more originators, who are looking for partners too.
Provide deck provide that capital.
Given the lower profitability of the origination business today.
Sure.
We have a group of of flow seller partners that have been.
Among the larger participants in that market over time.
The reason that people choose to be in the flow market because they don't want to accumulate.
The interest rate risk and prepayment risk and they don't want to bother hedging either because they don't want to where the cost too much then the implant, but implement a program.
As as the market.
Interest rates fell off as refinancing volumes go down there is less of that to do.
Right.
And so that's why we expect flow volumes to continue to decline.
It's possible I guess that some people have capped.
Servicing because they thought that rates were low and we are going to arise in that multiyear low and they wanted to hold thats been one of the sources of of bulk supply over the last year as those participants have chosen to monetize their holdings, it's possible that maybe some of those guys with compressed margins could want to.
Restart flow relationships some of those guys have been in <unk>.
The flow market over time, so we may see some of that we are well positioned in already in touch with those guys in order to to be able to to reengage with them should they desire.
Alright, I appreciate the color. Thank you.
Thank you.
Our next question comes from the line of Eric Hagen with BTG. You May proceed with your question.
Hey, Thanks, good morning.
Seems like you're you're active in growing the MSR portfolio, you've identified an opportunity with all the bulk.
Paper coming to market on the $21 billion in bulk that you've bought since quarter end can you clarify when those are expected to settle and then the 400 and I think it was $13 million and funding capacity for MSR that you noted.
I assume thats before the bulk.
Settles that you've bought since quarter end, but maybe you can clarify that too. Thank you.
Okay.
Yes, thanks for the question.
Eric.
Mary can you take that one do you have that information handy.
Sure.
The bulk settlements are.
<unk>.
Expected in the December and January timeframe.
Okay got it.
The other question was.
Related to.
Unused committed capacity at and Youre correct that is at.
That capacity before.
That.
Transactions that have not yet closed.
Got it.
Can you can you say kind of how you expect to finance the B 21 billion that Youre closing on.
In December and January is it kind of the breakdown of capital and funding capacity that's going to be.
Arbs.
Yes, we actually took down our financing and MSR bet in the third quarter, just due to our excess cash position. So I think the answer is it's going to depend on opportunities to deploy capital.
We have plenty of.
Options to finance that Chad should we need to from a cash perspective.
Got it thank you.
Thank you Sir.
Our next question comes from the line of Bose George with <unk>. You May proceed with your question.
Hey, everyone. This is actually Mike Smith on for Bose.
Just a few related to the equity raise can you just talk about your pro forma leverage how much of the capital is deployed and then whether or not there's any expectations for a drag on core earnings in the fourth quarter.
Yes. Thanks for the question I'll start with that and maybe Mary can can add with the pro forma numbers.
We've already started to deploy some of that capital as we indicated previously with some of the MSR purchases that that we have.
We've settled on as well as committed to we continue to see attractive opportunities in the MSR market and when we do that we often pair it with RBS. So that capital is already in the process of being <unk>.
Being deployed of course.
We are cognizant of the overall level of mortgage spreads, which are still very tight so.
To the extent that we're deploying capital.
It's in it's in the MSR assets right now or in the paired construction, we're not adding.
Outright rmb's versus rate investments here, yet because spreads are still unattractive as we said.
15 basis points rich too.
Period, where the fed is buying and 35 basis points rich to other periods. So.
So we expect that to occur.
In coming quarters.
And we're prepared to deploy more capital there as well, but when you look at how much capital is being deployed here looking at the overall overall leverage number is not necessarily a good indication of that rather than looking at the at the assets that we're buying and how were funding.
Mary do you want to speak to the pro forma numbers.
Okay can you repeat that pro forma part of the question. Please.
Yes, I was just wondering if you could talk about you know how leverages trended since quarter end and then if there's any expectation for a drag on earnings in the fourth quarter.
I don't there has not been a material change in leverage since quarter end.
We're about where we where we were.
Okay, and then is there any expectation.
And expectation.
Go ahead.
I was going to say on the earnings part of the question is there any expectations for a drag in the fourth quarter with capital deployment.
Aye.
I would say.
No not directly.
We're expecting that the taper to start and to be able to see more opportunities in wheat that MSR in the pipeline so not connection expectations for that.
Great and then just one more could you just provide any updates on on how book value has trended since quarter end and you know what are the drivers of this.
Yes, since since quarter end as of last Friday were down around 2%.
And thats been driven by some slight widening in both.
MSR to the tune of around 20 basis points.
In in spreads and some slight widening in high coupon specs as well.
Great. Thanks, a lot for taking the questions.
Thank you.
As a reminder, we are in the question and answer session. If you would like to ask a question. Please press star one on your telephone keypad.
Our next question comes from the line of Rick Shane with J P. Morgan you May proceed with your question.
Hey, guys. Thanks for taking my questions. This morning, and thank you for the additional disclosure, it's certainly very helpful. Bill.
When we look at slide 13, it obviously.
Really interesting in terms of how it differentiates both assets and hedging from a performance perspective.
What is interesting to me is that the at this point that this positive factor.
Driving performance as the hedge hedging strategy more than the asset gathering strategy.
When we look at hedging.
Swaps and MSR Youre certainly growing MSR.
Much faster than swaps, but you've grown swaps a bit as well, but when we compare TBA versus.
Pools, youre growing TBA, a lot faster than pools I'm, just trying to think about what that means are you, creating in the short term sort of less durable assets with the idea that that way when spreads widen as we moved through taper.
Youll move back into pools.
Thanks, Rick Thanks for joining us today those are good questions I'm not sure I totally understand the model, let me talk for a little bit and see if I answer them.
And if not you can you can ask more explicitly.
Yes.
Recently as we pointed on the presentation, we have let our high coupons pools pay down and we've sold some and replace them with low coupon TBA is because the roll specialness.
<unk> is adding incremental return if you look at the charts on page 13.
The TBA hedge with swaps the higher end of that range in the low teens as assuming that role specialists last for a long time and the lower end of that range, assuming that roll Specialness disappears tomorrow.
And so.
Given given the fed's posture and the statements they've made we think that rule specials will continue for a little bit.
It should follow spreads so that.
As spreads begin to widen from reduced asset purchases.
And continued mortgage supply we expect a roll specialness to also decline in that way when roll Specialness declines.
That will also come with it in all likelihood.
More attractive spreads not just in the TBA, but also in the specified pools that are associated with those coupons because as as roll Specialness goes down those specified pools become more attractive and I think it is fair to expect that during a period like that.
That we would be rotating out of TBA into specified pools.
In the lower coupons as that happens.
Got it okay.
I was looking for yes, and then so when we think about it clearly the strategy youre going to lean different directions, but youre also clearly not putting all of your eggs in any one basket either from an asset or a hedging perspective.
As you look forward and see the scenario that would create an opportunity.
To migrate back into pools I'm curious what the.
I really just don't know the answer here looking forward what would be the implications for the swap market would that become a more compelling element of the strategy as well in that same environment.
So first thing I would say is that one of the great things about our MSR plus MBS strategy is that we don't care very much about what the.
With this with this current coupon spread does and so the fact that we're able to add.
Investments in that pad construction.
Is independent of our view as to whether spreads widened or or not and the fact that.
Got back and still be in the low teens.
He is a very good fact.
And we're continuing to add capital in that strategy.
To the extent that we have additional capital to invest in the.
RBS plus rates strip.
Part of the portfolio.
Then as we said we're going to be looking for.
For some widening there.
The hedge.
Or that exposure, whether it exists in current coupon TBA or in specified pools will depend on the relative attractiveness.
Of those of those asset classes, which in turn will depend on fed involvement role specialists and those dynamics.
Not sure if I got your question there.
You did.
Exactly perfect. Thank you so much.
Thank you Rick.
At this time, we have reached the end of the question and answer session and I would like to turn the call back over to Bill for any closing remarks.
I'd like to thank everyone for joining us today and as always thank you for your interest in two harbors.
This concludes today's conference you may disconnect. Your lines at this time. Thank you for your participation and have a great day.
Okay.
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