Q1 2022 Two Harbors Investment Corp Earnings Call
Greetings and welcome to the two harbors investment Corp, first quarter 2022 financial results call. At this time all participants are in a listen only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference. Please press star zero on your.
Telephone keypad.
As a reminder, this conference is being recorded I would now like to turn the conference over to your host Polina Sims head of Investor Relations for two harbors investment Corp. Thank you you may begin.
Good morning, everyone and welcome to our call to discuss two harbors first quarter 2022 financial results.
With me on the call. This morning are Bill Greenberg, our President Chief Executive Officer, and Chief Investment Officer, and Barry risky, 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 dotcom.
In our earnings release and presentation, we have provided a reconciliation 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 two 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.
Thank you paulino.
Morning, everyone and welcome to our first quarter earnings call.
Please turn to slide three.
At quarter end book value was $5 53 per share representing a negative two 9% total economic quarterly return.
The speed and magnitude with which the bond market reprice. This quarter was historic by many measures as the market rapidly adjusted its expectations that the federal reserve will move aggressively to contain rising inflation.
The steps taken last quarter to meaningfully reduce leverage and a significant reallocation of capital from MBS to MSR helps insulate our portfolio from the large widening in MBS spreads.
Although the portfolio was not completely immunize from the move in spreads. This quarter's performance demonstrates the benefits of the pair to agency plus MSR construction as well as active management of the portfolio.
Please turn to slide four.
During the quarter inflation continued to trend higher as the war in Ukraine, and Russian sanctions contributed to the upward pressure.
With CPI rising by eight 5% year over year its fastest acceleration since 1981, the fed vowed to do whatever it takes to combat increasing prices and re anchor inflation expectations.
The market received this message clearly and swiftly incorporated 9% to 10 rate hikes through the end of 2022 after pricing in only three hikes for the same period at the beginning of the quarter.
With only five fed meetings left in 2022 after yesterday's meeting the market is pricing in at least several more of a 50 basis point increases, which hasnt been done in more than 20 years.
Further as seen in figure one the market is clearly expecting short term rates to rise above the so-called neutral rates before coming back down implying an interest rate cut as early as the end of 2023.
To put the magnitude of this quarter's rate movements. It's perspective, we showed the distribution by size of quarterly changes in rates since 1989 figure too.
The repricing across the rates complex was historic with current coupon in two year Treasury rates rising by 142, and 160 basis points, respectively, which was the largest quarterly increases in over 30 years and are shown by the outlines observation on the far right of the histograms.
The 10 year Treasury rate rose at more modest 83 basis points.
But which was still in the 96% pilot changes over that period.
In addition, and equally important the spread between the two year and 10 year Treasury rates decreased by a dramatic 77 basis points, causing the treasury curve to briefly inverts.
Indeed, the forward Treasury rate curve is showing twos tens inversion from six months to two years forward.
To the extent that an inverted curve has sometimes been a signal for recession. This is something we will continue to monitor.
The sharp rise in the current coupon rates translated nearly one for one in primary mortgage rates as the Freddie Mac survey rate rose from $3, one 1% to 467% during the quarter as shown in figure three.
Mortgage rates have continued to rise into the second quarter and are now above 5%.
With mortgage rates at their highest levels in more than a decade, the percentage of mortgages with more than 50 basis points of refinance incentive is now essentially zero.
Please turn to slide five.
In figure one we've updated the chart that we have been showing since the beginning of last year to make the point that the mortgage spreads prevailing in 2021 were too tight and we're expected to widen.
Almost as soon as the calendar turned to the new year mortgage spreads came under pressure and began to rise significantly.
During the quarter current coupon option adjusted spreads widened out by 33 basis points ending right around long term average at 27 basis points.
Subsequent to quarter end spreads widened even further to around 38 basis points, which is very near the bottom of the blue band, which indicates the 19th percentile of spread widening seen during the last period of quantitative tightening in 2018.
Although spreads are now at or wider than historical norms. This market environment is far from normal.
With the large increases in primary mortgage rates. The mortgage universe has evolved with almost entirely discount environment and prepayment speeds will be dominated by housing turnover.
Historically turnover speeds have typically range from five to 10, CPR and we expect prepayment rates to decline to speeds within that range in very short order.
Single digit speeds will be especially beneficial to holders of interest only securities such as MSR, who will enjoy significantly higher carry than that experienced in the last several quarters.
With rates haven't risen so much and so fast the duration of the mortgage universe is nearly fully extended while convexity risk is at all time low levels as seen in figure two.
For those market participants, who are holding low coupon mortgages.
Less negative convexity makes for easier hedging, but comes at a cost of long spread duration and high spread exposure.
As we will discuss later, we have actively managed our portfolio and our exposure is still mostly in the near current coupons.
Low coupon mortgages the ones that the fed was recently buying are still not very interesting investments, but we think that current coupon mortgages are starting to look attractive from a fundamental valuation perspective.
However, the technical backdrop is not very friendly.
During the quarter, the fed announced that it would stop by RMB and treasuries and that it would impose a $35 billion per month cap on declines in its <unk> portfolio.
At the current mortgage rates the projected prepayment speed on its RMB holdings could drop below 10 CPR.
In that event, the organic portfolio run off will not be enough to hit the cap and so the fed is not expected to be reinvesting at all.
Furthermore, chairman Powell and other fed speakers have raised the possibility of asset sales to more quickly reduce the fed's balance sheet and transform it back into our portfolio of Treasury only holdings.
Putting all this together and figure three we see the potential balance sheet reduction that might need to be absorbed by the private market over the next three years.
The light Blue bars show the organic run off of the fed's existing portfolio, while the dark blue bars assumed asset sales sufficient to bring the monthly balance sheet reduction to the $35 billion cap beginning in mid 2023.
It's worth noting that while some analysts think that portfolio sales could occur even sooner than that others don't think sales will occur at all.
The Gray line shows the cumulative amount that the private market might have to absorb through the end of 2024, which is almost an additional one trillion dollars of RBS, assuming this level of asset sales above and beyond the usual organic supply of mortgages that occurs during normal times.
Even if the fed doesn't sell any RMB, yes, we still expect an additional $700 billion of supply just due to the runoff.
We are at the very beginning of a transition in which the 30% of mortgages that had been bought by a price agnostic fed now needs to find a home with price sensitive investors.
While it is true that origination volumes are going to be lower than that in the past someone is still going to have to buy all of those mortgages.
While the fundamentals are starting to look attractive as a result of the significant widening seen in the quarter.
We believe the feds quantitative tightening and continued near term interest rate volatility warrants a cautious approach to increasing leverage.
However, given the fast moves and Titanic shifts in the market. We expect there will be ample opportunities in the near and intermediate term to actively allocate capital to take advantage of market dislocations and fundamentally attractive valuations.
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 six.
For the first quarter the company reported a comprehensive loss of $63 million, representing an annualized return on average common equity of negative 12%.
Our book value was $5 53 per share compared to $5 87 at December 31st.
Including the 17 common dividend resulted in a quarterly economic return of negative two 9%.
Results were mainly driven by the substantial spread widening and RMB asked and higher hedging costs, which were largely offset by spread tightening in MSR.
Furthermore, our decision to reduce our MBS position in the fourth quarter and keep leverage low through February also muted the impact of the spread widening in the quarter.
Moving on to slide seven earnings available for distribution was <unk> 18 per share compared to 22 cents for the fourth quarter.
Interest income, which grew by $12 million benefited from lower amortization as prepayment speeds slowed as well as incremental investments in agency MBS.
Interest expense rose by 2 million to $22 million due to a combination of rate increases and higher average RMB asked an MSR borrowing balances.
This was partially offset by a reduction from the January maturity of our 2022 convertible senior notes.
Which should result in annual savings of approximately $9 million.
TBA dollar roll income decreased to $22 million on a lower average notional position during the quarter.
U S. Treasury futures income was also lower as we move to a net short position.
Turning to MSR servicing income grew by more than $11 million to almost $137 million on higher <unk> from the settlement of bulk purchases in the quarter, while servicing expense increased by $2 5 million.
Lastly, operating expenses rose to $13 $9 million, a level, which is more in line with our expected run rate.
The increase reflects the impact of favorable compensation accrual adjustments in the prior quarter.
Yeah.
Turning to the portfolio yield on page eight.
Our realized net spread in the quarter was $2 eight 9% compared to $2, 99% in the prior quarter.
Portfolio yield increased 18 basis points to 390%.
This is more than offset by the increase in the cost of funds from the addition of payer swaps and to a lesser degree higher rates.
That spread as of March 31st is estimated at 283%.
Please turn to slide nine.
Funding in the repo market remains liquid and well supported.
Funding costs for agency MBS continued to rise on an absolute basis. However, as shown in the chart in the upper right. The spreads itself remains slow currently right around 10 to 12 basis points or about three months and six months maturities.
We maintained access to diverse funding sources for MSR.
Our unfunded and committed MSR asset financing capacity stood at $179 million at quarter end with an additional $470 million in available uncommitted capacity.
Please turn to slide 10.
As I mentioned earlier, we significantly reduced our overall mortgage exposure in December in anticipation of more hawkish positioning by the fed.
Which lowered our portfolio leverage to four seven times.
During the first quarter, our portfolio leverage rose modestly to five one times as we settle down $37 billion UTV of mortgage servicing rights and in March we began to cautiously add mortgage exposure at wider spreads.
Average economic debt to equity in the first quarter was four seven times compared to the fourth quarter average of five one times.
I will now turn the call back to bill for a portfolio update.
Thank you Mary.
With origination no longer adding supply in lower coupons and much of the past production locked up in the fed bank balance sheets, lower coupon spreads stay tight relative to higher coupons.
To take advantage of the additional spreads offered by higher coupons specified pools, we sold our two 5% Bank service collateral and added loan balance and geography stories in three through three 5% coupons.
We also adjusted our TBA positions up in coupon as current coupon rates increased from around two 5% to 4%.
Besides improving the hedging correlation to our MSR moving up in coupon and TBA also allowed us to take advantage of the very strong dollar rolls in higher coupons as roll Specialness in lower coupons has largely disappeared.
In particular, we added $4 $7 billion of three 5% and 4% TBA, while selling $4 3 billion, a 2% through 3% TBA.
Please turn to slide 11.
Our specified pool position as seen in figure one remains mostly allocated to high quality loan balance geography, and investor collateral and 3% in higher coupons.
But the main story of the quarter displayed in figure two was a massive underperformance of specified pools and TBA contracts all across the coupon stack.
Aside from 5% specified pools mortgages underperformed their interest rate hedges by one in the quarter to two 5% on an asset basis before applying any leverage.
3%, three 5% specified pools underperformed TBA as they have longer cash flows and longer spread duration of about 4% four 5% and 5% specified outperformed TBA as the TBA deliverable worsened on a relative basis in those coupons.
With a sharp selloff in rates and mortgage spreads mortgage rates spiked higher and prepayment speeds dropped precipitously as shown in figure three.
Our specified pool speeds dropped 38% during the quarter from 27, seven CPR to $17 three CPR.
We expect speeds to drop a similar amount or more in the second quarter on their way to their terminal turnover levels of between five and 10 CPR.
Slightly premium dollar price $4, <unk> and fives might floor out somewhere between 15 and 20 CPR.
Please turn to slide 12.
Activity in the MSR market continues to be very robust with approximately $200 billion of UBB or typical years worth of volume traded through April .
Sellers have been the regular cast of originators and Servicers and buyers have been the typical mix of large banks investment funds and other originators and servicers and reach like us.
In figure one we show some of the characteristics of our MSR portfolio.
Our <unk> grew to almost $233 billion.
Our weighted average coupon continued to decline to three 2% and.
Our 60 day delinquency rate continued to fall towards pre COVID-19 levels, ending the quarter at one 1%.
Our MSR price multiple has climbed to five one times in conjunction with the higher interest rates and mortgage spread widening observed in the quarter.
In figure two we show the trend of our settled <unk> for flow and bulk channels over the last five quarters.
We are buying bulk MSR opportunistically and settled on over $37 billion <unk> during the quarter.
Flow and recapture volumes totaled almost $8 billion UBB.
<unk> to decline further as refinancing activity continues to slow.
Figure three we compare our servicing prepayment speeds versus TBA.
Overall prepay speeds on our MSR portfolio declined by 36% from 22, 1% to $14 two CPR.
Similar or greater declines are expected in Q2.
Please turn to slide 13.
As we have discussed previously the MSR asset acts in many ways like a short position in RBS as shown by the gray bars in the top left chart.
The blue bars represent the RBS that hedge MSR and the amounts has chosen to be equal and offsetting by construction.
As you can see the selloff in the current coupon has moved to the effective short RBS position from two to <unk> all the way to force an unprecedented large change for a single quarter.
After allocating the RMS positions necessary to MSR, we are left with additional RMB, yes that we hedge with rates as seen in the Middle chart.
With most of the 4% specified pools and TBA allocated to hedge the MSR that net position in that coupon is slightly negative with small long positions elsewhere on the stack.
This 4% and higher coupon pools have not been made for some time and liquidity in the TBA needs time to catch up to production our largest position at quarter end was in <unk>, even though that was below par.
In the second row, we show book value exposure to changes in the current coupon mortgage spread.
The bottom left graph shows the contributions to book value from changes from the MSR and its hedges separately.
The other they have almost zero mortgage spread exposure.
The chart on the bottom right shows the total of minus two 8% exposure or 25 basis point widening in the current coupon mortgage spread.
Although leverage has not materially increased from last quarter, our sensitivity to a widening in MBS has increased by about two 5%.
This is mainly a result of two factors.
First just the weighted average note rate of our MSR portfolio is three 2% those borrowers have become somewhat more insensitive to changes in the mortgage rates higher rates won't make them prepay more slowly and it would take more than a few basis points of lower rates to make them prepay more quickly.
The MSR asset hedges fewer RMB, yes than it does at lower rates, even after the large additions that occurred this quarter.
Indeed at quarter end, the MSR portfolio had an effective risk position of short approximately $5 5 billion of mortgages, whereas at the end of Q4 that number was roughly $6 6 billion.
Secondly, higher rates also increased the spread duration of our unallocated RBS, even as we actively manage the portfolio by selling low coupons and buying higher coupons.
While our active portfolio management reduced the spread exposure somewhat.
The net result was still an increase in that part of the portfolio.
We view this net exposure is still low.
As we add more current coupon exposure in the MSR asset the amounts of effective short position can increase again.
However, with mortgages beginning to look attractive. This exposure is more likely to go up rather than down as we increase leverage and allocate into RMB, yes.
Please turn to slide 14, we show our interest rate and curve exposures.
Interest rate sensitivity of the portfolio components changed drastically from the prior quarter.
With the MSR almost fully extended it has very little duration.
25 basis point parallel shock up.
Has an effect of plus two 9% that book value compared to a plus five 8% in the prior quarter.
The MBS position on the other hand had its sensitivity increased to minus six 6% up from minus four 5%.
The net result is that our hedge position of swaps futures and options moved from minus one 9% all the way to a positive three 6%.
As always we carefully monitor and hedge our exposure to the entire yield curve and this has been especially important recently as the yield curve flattened 77 basis points from two <unk> in this quarter alone.
In today's environment with fed expectations changing almost daily we are particularly focused on the very front end of the curve.
Figure three we.
We show that our sensitivity to changes in short term rates is very low with only a minus 0.2% impacted book value and an up 25 basis point bare flattening shock.
Taken together these three charts demonstrate our commitment to hedging the full yield curve exposure in the active management required to maintain a duration neutral portfolio.
Finally, I'd like to discuss our outlook for two harbors and our return expectations for new investments on slide 15.
Spread widening during the quarter has moved static gross returns for our assets to attractive levels for both MBS hedge with rates and the paired strategy.
Levered pools hedged with rates now return low to mid teens up from mid to high single digits during the prior quarter.
TBA hedge with rates and here, we are showing current coupon TBA continued to benefit from real specialists and have static returns in the mid teens.
The higher end of the range assumes role specialists last forever or the lower end of the range assumes participates in 12 months.
However, it should be noted that it is the changing deliverable characteristics of the TBA that are causing roles to look optically rich has a price in the worst collateral for the future.
We expect that once origination in these coupons catch up to demand that roll Specialness will also begin to decline.
Static returns on the paired strategy remain attractive.
Our MSR spreads tightened the wider RBS spread dominated and resulted in increasing returns of the parent strategies.
We see paired returns in the low to mid teens and static scenario.
The longer term outlook for two harbors has decidedly improved as a result of the market movements during the quarter.
The rise in mortgage rates and the resulting decrease in prepayment speeds with actual unexpected should be an ideal environment for the MSR, while the widening of mortgage spreads is materially improve the return profile of MBS.
Although near term volatility in interest rates as expected and could weigh on short term returns both the MSR and MBS should benefit when volatility eventually subsides.
Thank you very much for joining us today and will now be happy to take any questions you might have.
Thank you at this time, we'll be conducting a question and answer session. If you'd like to ask a question. Please press star one on your telephone keypad confirmation tone will indicate your line is in the question Kim.
You May press star two if you'd like to remove your question from the queue for participants using speaker equipment. It may be necessary to pick up your handset before pressing the star keys.
Our first question comes from the line of Rick Shane with Jpmorgan. Please proceed with your question.
Good morning, everybody. Thanks for taking my question.
Good luck.
I wanted to ask.
Our strategy has really been validated by what we've seen over the last quarter and frankly over the last several quarters.
But I am curious when you think about the strategy long term I think the one consideration is that you are hedging a highly liquid.
Product with a much less liquid product and as we sort of move through the cycle can you talk about how you manage that balance.
Sure Good morning, Rick Thanks for the question.
We consider the liquidity profile of the portfolio in the company.
Across various different scenarios and cycles.
And when we think about how much excess liquidity, we need to to protect us in different rate movements and spread movements that is built into our portfolio management and our strategy and our expected returns and all of that and.
I think you've ever if ever there was a test of such a thing this last quarter with its very large rate movements.
<unk>.
150 basis points or more shows that we manage that very well and.
<unk>.
Right into the into our strategy.
Got it and as you know.
And again.
We're obviously very early in the tightening cycle, but as we think about.
Again.
<unk> way down the road, how things will evolve.
Is the strategy there.
Because you will have ultimately less liquidity on the MSR portfolio in time.
When that will become a headwind is the strategy just ultimately to us.
The TBA market and.
The MBS market to lever up and basically use that as your flex and Keith.
The MSR portfolio rather.
Excuse me relatively static inside.
Well.
Youre right Theres no question, our MBS and TBA as our more liquid than MSR, but msos are not completely illiquid radar trades that take place and.
People do move around portfolios right and so when we think about.
Our liquidity needs in short time periods, yes, it's the liquid part of our portfolio that were primarily relying on right, but when you think about longer time scales and.
And how portfolios evolve through time.
I think it's fair to also.
Consider that there can be movements in the MSR portfolio, if necessary or desired.
From a portfolio strategy perspective.
Great. Thank you Bill.
Thank you.
Thank you. Our next question comes from the line of Kenneth Lee with RBC Capital markets. Please proceed with your question.
Hi, Thanks for taking my question.
You talked about this.
<unk> underperforming relative to television in the quarter, just wondering if you could just share with us what's.
Is your expectation going forward do you expect that to reverse.
Thanks, Ken very much I think it depends a little bit on the coupons and the stories on page.
On page 11 of our presentation. We showed this a little bit where we're the specified pools in two and a half through three halves.
Underperform, TBA and fours and above outperform TBA is and I tried to make a comment about that in my prepared remarks about but for the lower coupons it was a longer spread duration.
Mostly.
<unk>.
That was mostly the cause of that.
Were the catalyst for that and then the higher coupons.
You have this.
This effect of that is where the production is going to occur and the deliverables are going to be changing there.
Making the TBA worse than specified pool, so it depends a little bit.
Hi.
We're starting to find.
Attractive valuations in the.
What I used to call high coupons, but maybe now I'll call current coupons.
In terms of specified pools, where the production is.
<unk>.
And so while there is continued roll specialness in those coupons.
For us four fives fives.
Where we have some TBA exposure, we have been increasing our allocation to specified pools. There. We think we think that is attractive in and as production catches up with the right market and you start seeing those new bonds being created the role specialists as high coupons I do expect to dissipate and diminish.
And.
When that happens I think.
If that happens I think you can expect to see our allocation to specified pools.
The increase relative to TBA overtime.
Gotcha very helpful. There.
And for my follow up I Wonder if you could share.
Thoughts on where we're at.
Spreads.
And how you think about the potential for any kind of further widening.
Driven by <unk>.
MBS run off.
That starts starts their actions thanks.
Okay, well, yes, that's the key question.
As I said in my prepared remarks, I think and then the chart that we showed on slide.
Slide four slide five.
Where where OAS as our back to long term averages maybe the cheap side a fair.
But interest rate volatility has been high.
And so static spreads Z spreads are certainly.
In a in a quite attractive.
<unk>.
There is.
<unk>, both as I said from interest rate volatility as well as.
The runoff from the fed as well as potential fed sales that could make them widened somewhat.
And we'll have to see how those dynamics unfold, a little bit I would say the risk to wider spreads is probably greater than the risk to tighter spreads.
But they are they are looking attractive on a fundamental basis.
And we.
As we said during the during the prepared remarks, we've increased our leverage somewhat from quarter end and we've done a little bit more since quarter end.
Our current leverage is probably now in the 504 area.
Alright.
To to express.
Our interest in these attractive valuations.
But we want to be cautious given given the supply demand dynamics that you just said and so we're trying to balance those two effects.
Got you very helpful. Thanks again.
Thank you.
Thank you. Our next question comes from the line of Trevor Cranston with JMP Securities. Please proceed with your question.
Alright. Thanks.
Bill you mentioned.
The sort of marginal increase.
Net spread exposure.
Because because of the low coupon of the MSR relative to kind of work or mortgage rates are.
Can you talk about sort of how how quickly.
The hedge effectiveness of the MSR would be expected to change if rates continue to move up.
If there's a level of grade that what you would actually expect that.
Duration.
Or is it to.
Turn positive sort of how you manage the.
Overall hedging of the portfolio through that thanks.
Yeah sure. Thanks Trevor.
Yes, so as you know in April .
Loan or since quarter end rates are another, especially the long end, rather 65 basis points higher.
And with our with the gross coupon of our servicing remaining fixed at three 2% the hedging effectiveness or the or the duration of the MSR asset has become even less negative right.
Alright.
Rates have to go up an awful lot for them to be positive.
Probably another.
A couple of hundred.
But the duration of the MSR asset is pretty low here.
And in order to to get that back up.
Some amount of new new mortgage servicing that's at the money needs to be created.
And the portfolio need to be recycled a little bit in order for that to happen. So thats something thats going to happen organically over time.
And and it's just part of the lifecycle of a servicing portfolio.
Okay sure that makes sense.
And in terms of supply of MSR you guys bought some bulk this quarter can you talk about what you expect to see.
On the bulk side of the market going forward and.
The bulk stuff coming out is tends towards the lower coupon how.
How much appetite you guys would have to add more of that to the portfolio.
Yes. Thanks.
So as we said in the prepared remarks in the MSR market has been very active very robust we've seen more than a full year of typical bulk activity already.
In 2022.
<unk>.
Okay.
Rate movement has been so fast that there hasnt really been time to adjust so so all of the portfolio is that that we saw and that we are continuing to see in the market are generally.
The lower WAC variety right and as you pointed out our appetite for that stuff is probably less than it was given that where we're probably more on the on the lookout for things that are going to hedge our portfolio more and so we're going to be focused more on trying to find the <unk>.
New at the money stuff rather than focused on the lower coupon.
High multiple high priced off.
Okay got it.
And then last thing do you.
You guys have an estimate as to how much book values change since the end of the quarter.
Yes, thanks, very much as I said, it's been a very very.
Volatile April into May as rates are up another 65 basis points. Since then mortgage spreads have continued to widen especially down in the low coupons.
But with that said and the way that we've been able to position our portfolio and.
And we've been.
Relentless and keeping our mortgage exposure with current coupons, we've been able to to to maintain a positive <unk>, 5% book value change since since the end of the quarter.
Okay perfect. Thanks very much.
Yeah.
Thank you. Our next question comes from the line of Eric Hagen with BTG. Please proceed with your question.
Hey, Thanks. Good morning Hope you guys are well I think I have three questions.
First is just how do you see the prepayment profile for spec pools developing here.
How sensitive do you think some of the low balance borrowers are the home price appreciation and cash out refi.
Sure I've heard anyone ask you guys. Your perspective on how much value is left for upside in the MSR.
To get your thoughts there and maybe just an approximate <unk> <unk> one in dollar terms for the MSR if you have that.
And then in the past the company has been short some TBA is within the coupon stack.
Curious how what the value is.
And Brendan.
Brendan that strategy now thanks.
Sure. So your first question was on what I think prepay speeds or how I think HPA or thing that that will effect of low loan balance. So that's alright alright.
All right.
The conventional wisdom.
I think of low loan balance pools is that not only do they provide refi protection, but they also gen.
Generally have have higher turnover speeds discount speeds.
Lower Larkin.
I think I think that's probably borne out in the data.
We are two very large degree in in unchartered waters here I don't think that we've ever had an environment, where we've had so many mortgages so deep.
Out of the money.
To be able to see how these things will will behave and of course, just kind of environments in general let alone one as deep as this one.
There are few and far between and so everyone every economic environment is different and so forth.
HPA has obviously been very high that has been.
The cause behind.
Some pretty fast cash out refinance.
Activity in the last year and two years.
But we have a significant number of mortgages today that are 200 basis points out of the money right and.
And to be if people want to take cash out.
At that stage Thats.
You've talked about taking 10% of your mortgage balance of 120% of your mortgage balance out.
The implied.
<unk>.
Rates on that marginal amount is very very high.
And if the market starts to start producing some HELOC or some second liens that would almost surely be a more attractive option for.
For borrowers to do so.
I don't know how big that effect will be.
Intuition is that with the fed raising rates and the overall.
<unk> two to cool things down a little bit that the cash out activity will generally slow and I think that turnover speeds as I said during my prepared remarks, which have historically range between five and 10 CPR.
I think many people are thinking that there would probably be at the higher end of the range now because of the cash out activity that you said I actually think it has a possibility to surprise to the slow side, but we'll see how that unfolds of course.
Your second question was about.
Remind me I am sorry, yes, sorry, it was about the value upside.
Often the MSR and an MSR sure.
So so again you can look back at historical periods to see.
How high servicing prices have been.
The floating rate components are one value that that sort of.
Increase.
<unk>.
Quickly when rates rise, especially short term rates rise ending a steep curve, especially.
If you look back to other periods of Av.
<unk>.
Higher rates.
As you to see.
Periods, where the floating rate components alone.
Can add a full multiple or more to the value of servicing.
The highest I've seen servicing malts b.
In the world and have been doing this since the late nineties.
Is probably.
Mid sixes is about as high as I've ever seen them go.
Depending on the shape the curve level of short term rates amount of floats servicing costs all of those things and those days people didn't even build in never mind about that Scott I would just say people didnt, even building recapture but discount environment with high most of that's not going to be a very big effect.
And your last comment is what is our duration.
Of our servicing at the moment.
It's pretty low.
I would say that that for the entire servicing portfolio right now for 100 basis point move right on a model basis of course, it depends on all market.
Market environments and shape of curve and all of those things.
It is probably around 50 million Bucks.
For an uplift for a parallel shift up 100 basis points.
Got you John on the MSR asset to be clear.
Yes, that's really helpful. And then in the past you guys have done the coupon swap strategy a little bit within the coupon stack can you talk about the attractiveness there appreciate it.
Yeah.
Right now we have.
We have.
I don't know what we had at the end of the quarter, but certainly you had no net.
Short positions as you see from from the chart on.
On page 13, I think right.
There was no net positions.
We've been diligent and quick and moving our exposure up in coupon so.
So we don't have as.
As you see on the chart on page 13, we have very little exposure.
Below three <unk>.
At all.
And.
Yes.
We.
We have no we have no exposure.
In short positions in and any TBA is in low coupons in particular.
Obviously the market changes.
All the time should the valuations warrants such a thing we could consider that.
But.
We're not particularly taking a strong view about the the price or the valuation of low coupons at the moment relative to.
The turnover speeds that are priced into the market. There. So we're happy being flat down there at the moment.
And all of our exposure is up in the current coupons.
That's really helpful color. Thanks, a lot.
Okay.
Thank you. Our next question comes from the line of Bose George with Keyw. Please proceed with your question.
Hey, good morning.
First in that slide 10, where you give the.
Our return expectations is that based on your current leverage.
Slide 15, you mean.
Sorry, yes.
No those would be based on more more market standard leverage numbers.
And so you said you were at 504.
What would be sort of a market and more normal leverage.
A couple of times higher.
Yeah, I think that.
That.
We've said in the past that we can operate with leverages in the eight to nine times that depends of course on the on the amount of servicing that we have in the portfolio. We have more servicing today than we did when we said.
That number in the past so so.
A natural resting place for us is probably.
In the in the.
And the seven handle eight handle areas.
Okay. Great. That's helpful. Thanks, and then can you just talk about your expectation for specialness into the back half of the year.
Sure.
So as as I said in the in the prepared remarks role specialists on.
On the formerly fed coupons has all but disappeared.
Right.
We're seeing.
Reasonable ROE specialists babies call it 50 basis points.
In the production coupon here.
In the higher coupons.
$4 five since <unk>, it's even more pronounced.
More than a 100 basis points of specialists, but that is as I've said, sometimes is optical.
By that I mean that.
The role mechanics.
Back into an implied financing spread by looking at the difference between the price in the front month and the price in the back months.
And today again because.
The market has moved so far so fast and the production mortgage market hasn't really had time to catch up the collateral characteristics of bonds in the front months are pretty different than the collateral characteristics.
<unk>.
For bonds in the back months right and so those are really two different bonds and so it's a little bit unfair to imply a financing spread from those two different bonds. Nevertheless, you can do that and thats in there and those are big numbers here, but as the as the market catches up as the production in the current coupons.
<unk> premiums begins to normalize.
In the back half of this year I also expect that to diminish.
So I would expect by the end of the year things should be pretty normal.
Okay, great. Thanks.
Thank you, ladies and gentlemen, as a reminder, if you'd like to join the question queue. Please press star one on your telephone keypad. Our next question comes from the line of Doug Harter with Credit Suisse. Please proceed with your question.
Thanks, just another question on leverage can you just talk about how you think about or remind us how you think about leverage on.
Agency paired with MSR versus agency paired with rates.
Yes.
Sure Yeah, thanks for bringing that up Doug.
So in a portfolio without MSR.
There's really a very direct and straight line correspondence between between leverage and risk and drawdown risk how much money can you loose right for spread widening with the portfolio with MSR.
As current coupon mortgage spreads widen the MSR will will benefit from that will have a natural increase in price from that and so.
We always look at leverage.
Through the lens of of what that.
Drawdown risk number is right.
Do you want to be respectful of of nominal leverage numbers, but.
Another important number for us is.
You see on the bottom right slide of page 13, which is which is what does the portfolio exposure for a 25 basis point widening in mortgage spreads and that number which is which currently at the end of the quarter was minus two 8% is a lower number than you would get.
For portfolio without MSR.
The same leverage.
Alright.
And so and so we look at both of those things obviously.
And and account for both of those things when we when we say when we determine how much risk we're comfortable with and what we think the appropriate amount of our portfolio is.
Great. Thank you Bill.
Thank you. Our next question comes from the line of.
<unk> with Citi. Please proceed with your question.
Hi, Thanks.
I was interested in kind of your your return profiles, obviously your slide 15 shows that much.
A much better environment for investing.
Talked about being.
Still a little bit cautious with.
The potential fed sales.
Coming onboard when do you think you might.
Feel comfortable.
It's really kind of expanding your your leverage is it is it just kind of seeing how the initial roll off does or do you are you waiting until they actually start to sell their portfolio.
Thanks, Thats a good question.
Look that's a hard one right.
Obviously very market dependent and will depend exactly on how things unfold.
As I said before.
The things that are that are giving us pause here are our potential.
Potential fed sales potential.
Appetite they have the private market in general of who's going to buy all the bonds that are going be running off and interest rate volatility.
Right.
I think we need to see some progress some clarity on at least some of that.
Before we start to meaningfully be adding.
But as I said from a valuation perspective.
Fundamentally.
We actually look pretty good I think I think chairman <unk> comments yesterday.
Took some of the tail risks off the table a little bit right.
Pre firm commitment to to $9 75 to to not keep.
Keep hiking until something breaks to be looking at the trends of the economy and watching it as as the hiking processes underway. So I think those those were pretty friendly comments, which have been interpreted as such by the market in general so.
That was helpful, but I think I'd like to see just a little bit more progress.
In at least some of those three dimensions.
Okay.
Yes.
It did look like you took up the portfolio a little bit do you expect that your ROE you might.
Expand a little bit.
From here just from from the portfolio changes that you've made thus far.
Well.
I mean, let me give it given the static.
Static expected returns on page 15.
Increasing leverage will increase decrease the carry of the portfolio and and can increase expected returns right, but of course spread movements.
Due and we'll always dominate those sorts of things. So it's of course impossible to predict what the returns will be but.
Your line is static basis increase in leverage will do that.
Okay, and then just lastly.
I think Mary.
Referenced repo prices were rising a little bit, but I'm, assuming that it takes that into account.
<unk> 15, so there.
It is the <unk>.
Financing readily available to create the types of returns that you are.
You're highlighting there.
Yes. So so one thing I'll say is you know.
Rising financing costs in and of themselves don't particularly change returns right because.
On the fixed rate mortgage side.
We are hedging our interest rate risk, which.
Some people.
I'd like to explicitly say that that hedge hedges. The funding right you pay fixed swaps you pay fixed up right at some fixed rate and you receive some floating rate some sulfur radar OIS rate that generally.
Offsets the increase in funding that you would have.
Right from from rising.
Fed rates rising repo rates and so forth how does it exactly on the MSR side.
Floating rig components that we generally receive right the float on taxes and insurance on principal interest.
This is a little less intuitive to understand but nevertheless is true.
Also offsets the increase in funding.
On the short term rates from our MSR facilities, and so in and of themselves rising short term rates rising funding rates don't change the economics of our portfolio very much in fact, they increased it right because there is the equity piece in all of these things that that that matters.
And the thing that matters. Most is is the spread too.
A risk free rate that you would get on a fixed rate swap or something like that of sofar, OIS or something like that relative to two repo rates and relative to swaps and so far we have seen.
Repo rates being very stable.
At a spread to say sofa.
The chart that we have in our portfolio.
On page nine.
Right and we've seen that spreads in both three months six month tenors.
To be stable or at right around 10 basis points for for quite a long time.
Okay. Thank you.
Thank you.
Thank you, ladies and gentlemen that concludes our question and answer session I will turn the floor back to Mr. Greenberg for any final comments.
Just want to thank everyone for joining us very much today and as always thank you for your interest in two harbors.
Thank you. This concludes today's conference you may disconnect. Your lines at this time. Thank you for your participation.
Yes.