Q3 2022 Two Harbors Investment Corp Earnings Call
[music].
Good morning, My name is Latanya and I will be your conference facilitator at this time I would like to welcome everyone to two harbors third quarter 2022 financial results conference call.
All participants will be in a listen only mode.
After the Speakers' remarks, there will be a question and answer period.
I would now like to turn the conference over to Paulina Sims. Please go ahead.
Good morning, everyone and welcome to our call to discuss two harbors third quarter 2022 financial results.
With me on the call. This morning are Bill Greenberg.
Didn't and Chief Executive Officer, Nick <unk>, our Chief investment Officer, and Barry risky, our Chief Financial Officer.
Yeah earnings press release and presentation associated with today's call have been filed with the FTC and are available on D. S. T C website at.
Well as the Investor Relations page of our web site at two harbors investment dotcom.
In our earnings release and presentation. We have provided a reconciliation of GAAP to non-GAAP financial measures and he 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 X.
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 and good morning, everyone and welcome to our third quarter earnings call.
I'd like to begin by extending a very warm welcome to nicoletta car or a new chief investment officer.
Nick brings more than three decades of experience in the fixed income and mortgage backed securities markets and we are very excited and fortunate to have him on our team.
This morning, I will provide some color on the market environment and our performance.
Mary will give more detail on our financial results and Nick will discuss our portfolio activity risk profile and outlook.
Please turn to slide three.
Our book value at September 30th was $16.42 per share representing a negative 16.2% total economic quarterly return.
The portfolio performance reflects one of the most challenging market environments in decades.
Risk assets widened against the backdrop of stubbornly high inflation uncertainties surrounding monetary policy and higher interest rates.
The volatility of interest rates and spreads intensified during the third quarter and peaked in the last week of September .
As mortgages cheapened and its book value decline in September we allowed our economic debt to equity ratio to drift higher from 6.4 to seven five times.
In October being respectful of market volatility.
We thought it prudent to somewhat reduce our leverage.
We sold our MBS and use some of the proceeds to repurchase 2.9 million shares of preferred stock at a deep discount to par.
At the end of October our debt to equity ratio was right around seven times.
Okay.
We felt this was a good use of capital given that the preface to have a low to mid teens yield with zero convexity risk zero prepayment risk and zero credit or market risk.
The accretion to common book value of 26 cents can be thought of as recouping certain our MBS losses over the period that were funded with that capital.
In rough terms, a portfolio of three and a half through 5% coupon RBS with eight times leverage would have lost a little over 20% on equity over the last two quarters.
While our preferred shares at a total return around negative 25%.
It's also possible to think of this trade is selling our MBS at spread levels as they existed two quarters ago.
Please turn to slide four.
Although headline CPI in December it ticked down slightly to eight 2% core CPI accelerated to 6.6% to reach new multi decade highs.
Nevertheless, the market has confidence that the fed will be successful in bringing inflation lower than expectations as determined by the tradable market in the future CPI fixings.
The year over year C. P I.
I have a 3% handled by next summer as seen in figure one.
After delivering a fourth straight 75 basis point hike last week Chairman Powell suggested that even though the fed may slow its pace of hikes in the near term the terminal rates, there's still a long way away and it is very premature to talk about a pause.
Indeed in the wake of the Fed's meeting current market pricing implies another 125 basis points of hikes over the next four meetings, which would bring the implied fed funds rates are north of 5% by mid 2023 before the fed pauses as seen in figure two.
State officials, including the chairman had been very outspoken that they are not expecting to pivot and to cut rates in 2023.
Mortgage rates reacted in line with the outsized macro volatility as the depth and liquidity of the mortgage market allowed participants to adjust their exposure to risky assets very quickly.
Figure three we showed the performance versus rate hedges on the RMB is coupon stack for each of the three months of the third quarter.
July saw larger outperformance across coupons, followed by significant underperformance in August and September .
Overall belly coupons of three and a half and forest performed the worst underperforming rate hedges by about 50 ticks.
Please turn to slide five.
The third quarter environment for mortgages was a continuation of what we experienced in the first half of the year.
Current coupons static spreads widened another 38 basis points during the quarter, while option adjusted spreads increased 39 basis points as seen in figure one.
With this recent repricing spreads are now at levels that have only been seen in acute phases of previous crisis periods.
Indeed, the current spread levels are above the dotted lines in the figure which represent the 19th percentile spreads over the last 20 years.
One side effect of the rapidly rising rate environments and the mortgage index that has a dollar price in the Eighty's is that the convexity of the index is at all time highs as seen in figure two.
Mortgages are famously negatively convex, which means the changing duration of the securities needs to be constantly rebalanced as rates move.
At these rates and dollar prices. However, the mortgage index has essentially zero convexity and it becomes easier to hedge at deep discount securities.
Even the so-called higher coupons are below par and benefit from our convexity profile, which is relatively benign.
Figure three shows static and the OAS spread curves across the coupon stack and their changes from last quarter.
Your student Observer may recognize that these curves are somewhat different from what we showed last quarter.
The reason is that we have updated both our expectations around prepayments in this deep discounts environments. It also moves from showing LIBOR spreads did those relative to treasuries.
From this chart, it's easy to see that rates rose as the curves all shifted to the right and spreads widened as the curve shifted upwards.
While interest rates have risen very quickly this year and durations on these lower coupon bonds have fully extended.
Yet to actually see prepay speeds also fully bought a mouse.
Needs on one and the haves are still slower than twos and speeds on twos are still slower than two and a half.
Many models have put floors on how slow prepayments can be and many of those models are now starting to over project speeds.
Very low spreads on the lowest coupons are indications that our speed expectations are likely slower than the rest of the markets and despite significant underperformance in these coupons last quarter, we see further downside performance risk.
The higher coupons offer significantly more value with static spreads above a 150 basis points and Oes is around 50.
With the duration of the 5% coupon being only 60% of the duration of the 2% coupon.
You see the value of higher coupons to be even greater when the spreads are expressed per unit of risk or duration.
Nick will also have a few words to say about the comparison between higher and lower coupons and a special topic in a few moments.
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 as a REIT.
Minder the discussion of our financial results today reflects the one for four reverse stock split effected on November 1st.
For the third quarter, the company reported a comprehensive loss of $287.8 million or $3 35 per weighted average basic common share.
Our book value was $16 42 per share compared to $20.41 at June 30th.
Including the 68 cent common dividend resulted in a quarterly economic return of negative 16.2%.
The results primarily reflect the market spread widening bill discussed earlier and to a lesser degree higher hedging costs as a result of the elevated volatility during the quarter.
Post quarter end, we repurchased two 9 million shares of preferred stock contributing approximately 26 cents to common book value and lowering our ratio of preferred stock the total equity from 35% to 31%.
Moving on to slide seven.
He was available for distribution was 64 cents per share compared to 87 for the second quarter.
Interest income increased by $37 4 million to over $95 million, primarily due to a larger our MBS portfolio and rotation into up in coupon securities.
Interest income also benefited from lower amortization as prepaid payments.
Payment speeds continue to soar and from higher rates on cash balances.
Likewise interest expense rose by $46 3 million to $83 4 million.
The increase was driven by an overall rise in interest rates and higher borrowing balances and agency repo and MSR revolving credit facilities.
He'd be with TBA dollar roll income declined by almost 20 million to $37 8 million as a result of lower average notional balances as well as the absence of roll Specialness.
Finally losses from U S Treasury futures decreased by $4 million as short term rates rally and the yield curve flattened.
Turning to MSR net servicing revenue decreased by $2 9 million to 73.2 million the.
The decline reflects the impact of the sale of 20, New P D and MSR during the quarter.
We expect our calculation of E D will moderate over the next several quarters as a result of rising rates and an inverted yield curve and the other factors impacting our income and hedge financing costs differently under our accounting methods.
D. A D for our agency fixed rate MBS is calculated using a GAAP concept of amortized cost and yield to maturity determined at the time of purchase.
Helping and couponing premium amortization not being impacted by rising rates on mortgage spreads.
Net MSR servicing income and amortization is based on original pricing yield. So does not include the benefit of either increase float income from rising short term rates are lower compensating interests due to slower prepayments.
Financing costs are largely variable and short term, therefore react more quickly to rising rates and yields on our longer term assets, which will increase over time as we reinvest at current yields to maturity.
And finally E D for U S. Treasury futures income represents the sum of the implied net cash unexpected change in price of our finance U S Treasury, which differs from the alternative debt hedging in cement or a payer swap that only considers that net cash paid or received any E D, but not the change and expected price.
Unexpected changes in futures prices is not included in <unk>, which was a significant gain during Q3.
We also utilized euro dollar and fed funds futures and our interest rate hedging mix.
And those gains or losses are also not included E D.
In this environment, where E D diverges from the earnings potential we know to be available in the market.
We emphasize our portfolio return outlook, which we will review in more detail later in the presentation.
Turning to page eight.
The portfolio yield increased 22 basis points to 4.61%.
Primarily by our investment in higher coupon MBS.
Our net realized spread in the quarter was 1.77% compared to 2.70% in the prior quarter.
As higher portfolio yields were more than offset by an increase in the cost of funds.
Please note that beginning this quarter, we're including U S Treasury futures income and implied financing costs in the yield table.
Please turn to slide nine.
By most measures there was a substantial amount of rate volatility during the quarter.
Part of that funding in the repo market remained liquid and well supported.
Similar to prior quarters funding costs for agency MBS notched higher on an absolute basis.
Mostly following actual unexpected fed hikes.
However, as shown on the chart in the upper right spread yourself or remains low.
The weighted average maturity increased to 96 days as of quarter end.
We have since we're all substantially all of our balances beyond that turn in a year.
We maintained access to diverse funding sources for MSR.
Unused uncommitted MSR asset finance capacity.
199 million at quarter end.
Please turn to slide 10.
Portfolio leverage rose to seven five times at September 30th from six four times at the end of the second quarter.
Average economic debt to equity in the third quarter was seven one times compared to the second quarter average of five six times.
I will now turn the call over to Nick for a portfolio update.
Thank you Mary and thank you Bill for the nice introduction earlier.
I'm, so grateful for the opportunity to join two harbors and contribute to such a high caliber organization.
Although I might've scripted a slightly less interesting time in the markets, while settling into the role the opportunity set is exceptionally good and I could not be more optimistic about our future.
As you can see in the portfolio composition chart on slide 10, the market value of the portfolio declined to $16 6 billion over the quarter down about 10%.
The bulk of the decline came from the our MBS portfolio and over half of that was price declines due to the rise in rates and widening of spreads.
The overall reduction in the RMB S position wasn't TBA is as our pool position net increased by about $700 million.
The market value of our servicing portfolio was pretty stable ending the quarter at $3 billion.
In terms of interest rate curve risk, we continue to keep exposures low more detail can be found on page 17 in the appendix.
In terms of our MBS portfolio composition, we continued to rotate up in coupon both in TBA and pool positions, increasing the portfolio's nominal yield in OAS and to reduce exposure to prepayments, which we expect on average to be slower than market expectations more detail can be found on page 16 in the.
Appendix.
Turning to slide 11 figure two shows the underperformance of MBS by coupon for TBA and specified pools.
The entire mortgage complex was wider relative to rates by about one and a half to two points.
The performance of lower coupon specified pools were largely in line to TBA is while the higher coupon pools underperformed TBA is into the sharp rate sell off.
<unk> speeds for our specified book declined by 36% to 9.1 CPR.
Who additions were focused on 5% coupon loan balance stories that have considerably more prepayment stability than TBA is while offering attractive spreads and levered returns.
The U P V of the MSR book as captured by Slide 12 declined to 208 billion, resulting from the settlement of two sales in which term sheets were executed in the second quarter.
Overall market activity moderated with 100 billion of conventional packages offered bringing the year to date volume of sales to a record 440 billion.
Portfolio growth came from our flow channel, including recapture which added $4 4 billion.
The valuation of the book Rose very modestly by 110th of a multiple to five and a half times. Despite a 100 basis point rise in mortgage rates.
The three months prepayment rate favorably declined by 31% to 6.9 CPR.
Since quarter end the prepayment rate has declined by another 15% to five three CPR in October .
Please turn to page 13, this slide illustrates why we prefer a higher higher coupon MBS exposure and why we remain optimistic about our MSR book.
These stories are linked both are predicated on our belief that prepayment speeds, particularly for the lowest coupons will be historically low.
30 year mortgage rates after spending nearly two years at or near all time low levels have risen about 400 basis points. This year.
Going to the huge amount of refinance activity that occurred in this cycle and the rapid rise in rates. This year. The mortgage universe has never been as concentrated in discount coupons.
30 year, two and a half coupons and below for example, with an average dollar price around 81 now comprise more than 50% of the market value of the MBS index.
With hundreds of basis points of negative rate incentives prepays on these far out of the money coupons are virtually 100% related to housing turnover.
However rates vary through time, but as a rule of thumb six CPR has been considered to be a good long term assumption.
This can be thought of as a baseline prepayment rate.
Prepayment speeds released on Friday showed another decline with conventional twos in two and a half prepaying at four and five CPR, respectively already below the six CPR rule of thumb if.
Fannie Mae one of the house paid at 3.1 CPR.
There are reasons to believe the twos and two in a house might be a little faster than the one in the house, but nonetheless, we believe these speeds will continue to fall as homeowners are justifiably reluctant to give up a two or 3% mortgage and a 7% mortgage world.
Amongst practitioners this is referred to as lock in.
We can point to several periods in time, when rising rates created some deep discounts.
Really the best period is 19, 93% to 1994 when rates increased by about 250 basis points.
Turnover speeds, then we're around five CPR speed.
Speed should be slower this time as the current set of discounts is more out of the money much lower coupon say, 3% now versus 7% them.
And loan sizes are larger now amplifying the rate change.
Other factors are adding to the story just last week, the FHFA announced changes to their loan level pricing grids to make cash out refinances more expensive.
For deep out of the money mortgages. These refis already made little sense from a marginal rate perspective.
But this makes them even more unattractive.
After that long windup, let's look at some numbers looking at figure one the dark Blue line is the leveraged static return of Fannie two in a house is a function of prepayment rate.
First node how sensitive the return is to small changes in prepayments, but two CPR change moves the levered return by 4%.
At around five CPR of slower the Levered return is 9% to 11%.
Now look at the light Blue line that is for Fannie fives priced in the mid Ninety's dollar price look at the stability of the return pattern from 2% to 10% CPR. The Levered return is 16% to 18%.
These bonds possess more spread and being priced much closer to par are not dependent on early return of principal to generate a high level of return.
In order for the two and a half to achieve the same levered return speeds would have to come in at eight CPR, which we see as a low probability outcome for these reasons, we are positioned in higher coupons.
On the other hand slow speeds are beneficial for M. S ours, because they extend the life of the cash flows.
Our MSR book as you can see from figure two is approximately 385 basis points out of the money with over 90% at least 325 basis points out of the money.
The solid line represents actual speeds by incentive bucket reported for October .
Given lags these speeds reflect mortgage rates from August and September which were on average about 100 basis points lower than current levels as already discussed we expect a further decline in speeds.
The Dash line incorporates our model projections for the average speed of our 12 month period.
For most of the buckets. The 12 month projection is between four and five CPR with an aggregate production of four and a half CPR.
Slower speeds will boost the return of the MSR portfolio figure three shows the Levered return of our MSR portfolio as a function of prepayment speed.
Should speeds follow our projection the levered return should be moving up the curve to 13% or higher.
The bottom line here is it slowing speeds will provide a tailwind to the performance of the MSR.
Finally, I'd like to discuss our outlook for two harbors and return expectations on slide 14.
I'm sure. Many of you will notice that this is a new format for the outlook slide which provides transparency around our capital allocation estimate a return and portfolio composition for the primary components of our strategy on both the portfolio and common equity basis.
About 55% of the capital is allocated to the hedged MSR strategy.
With a static return estimate of 12% to 14%.
The balances hedged our MBS securities with a static return estimate of 16% to 18%, reflecting our MBS spreads that are near record wides.
The aggregate static return estimate for the portfolio. After expenses is 10.6 to 12, 8%.
These returns are static net yields before applying any capital structure leverage to the portfolio.
The lower section of the slide breaks out the estimated static return on three components of our invested capital with a focus on common equity as well as an estimated return per common share.
The potential static return on common equity falls in the range of 13% to 16, 8% or a quarterly static return per common share of 53 to 69 cents.
While the fact that last quarter's dividend falls in the range of the static earnings potential is comforting.
As much to the estimates on this page leave out.
By definition. These estimates do not include any price changes and hence do not include any benefit to the potential spread tightening for any loss due to potential spread widening.
With mortgage spreads at historically wide levels. We think it is exceedingly likely that one year from now spreads will be tighter than they are today.
These return estimates do not include any benefit from our team's skilled asset management, including asset allocation security selection and hedging acumen.
Finally, these estimates do not include any benefits arising from increased revenue or cost savings from the acquisition of round point, which is still expected to close sometime in the third quarter of 2023.
To be clear we provide these estimates not only to show current returns on our target assets, but also to show where market economics diverged from our measure of AAD.
Of course decisions on future dividends will depend on many factors, including the static Levered return estimates as well as E. A D REIT distribution requirements and sustainability.
Ultimately our board of directors and makes the final decision on dividends.
We hope that you find this new outlook slide informative.
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 conduct a question and answer session. If you would like to ask a question. Please press star one on your telephone keypad.
One moment, while we poll for our first question.
Our first question comes from Kenneth Lee with RBC capital markets. Please proceed.
Hi, Good morning, Thanks for taking my question and really appreciate the slide that new slide number 14 with the expected returns.
My first question just relates to that you.
You mentioned that the expected return assumptions are static return then are they come before either hedging or expense saves or otherwise active management. Just wondering if you could just talk a little bit more about.
What sort of like in rough ballpark, how much incremental earnings are expected returns are.
Could you potentially generate from some of these other items on top of these base static returns. Thanks.
Yes, thanks, very much Ken for the question good morning.
As we said in the slide.
As Nick said.
Excludes lots of things, including portfolio selection and active management and all the savings from Ralph what we've already disclosed what we thought the round point activities would be last quarter and so thats not in here and then the other.
Other things depend on you know a host of market factors and and hedging decisions in real time things and so it's very hard to to estimate or quantify what they are if they were easier to estimate or quantify it we would've put them in here in fact.
And so.
Unfortunately, I have to leave it there but.
This is one snapshot in time.
By the way. This will this also is.
A snapshot of our 930 portfolio right. So it does include any any changes to the portfolio that we have made since then or could make.
Going forward.
And the idea here or what are the ideas and showing this this new look.
We viewed as an extension of the old outlook slide that we used to have with the top top section as market returns that we see it as available for hedged MSR or hedged RMB S. And then we did the additional arithmetic at the bottom.
Just two.
Put it in and common shares for them, but but in many ways. When we look at this when we compare to.
This is sort of what we think the thing but what.
Do you like measure would look like if we bought and sold the portfolio.
Hey.
And so it's very static snapshot.
It's very hard to quantify those other things.
Gotcha Gotcha.
And just one one somewhat related follow up if I may.
You mentioned in terms of the E D.
You know it.
It is expect to moderate over the next several quarters and granted he has a bunch of items are that that's going to differ from the underlying economic earnings.
Wanted to get your thoughts on how you think underlying economic earnings could be expected to trend over the next several quarters. Thanks.
So I think that you know that that close to the outlook slide is where we now look at the economic returns on the portfolio versus E. D, which you know has its nuances in our calculation.
As one example of that Ken you know rates have risen so fast in the last in the last several months and when we've been very.
Aggressive I would even say in moving up in coupon and rotating our exposures.
But even as we've done that right.
Rates have moved up so far so fast.
That.
The the <unk>.
Calculation, which which relies on historical prices original person.
Original purchase prices and amortize cost even those are at are at deep discounts now and so a lot of that will normalize and moderate as the as Mary said as the portfolio gets reinvested as we rotate.
More into.
Current yielding assets.
Where where the current yields and spreads.
I'm more consistent with what is used in the calculation. So that will happen over time of course, the inverted yield curve also has some some extra effects here that.
That make it diverge a little bit from from the slide 14 outlook thing so.
It's a complicated thing to to compare them, which is why we've shown page 14.
Gotcha very helpful. There. Thanks again.
Our next question comes from Trevor Cranston with JMP Securities. Please proceed.
Hey, Thanks, good morning.
A question on the MSR portfolio.
Just general sort of capital allocation decisions.
Yeah, historically part of the value for for owning MSR on your balance sheet has been.
That it provides a hedge to the MBS portfolio.
I guess, where MSR valuations are today it seems like the hedge component up your MSR is probably pretty minimal.
Can you talk about how you sort of think about.
Allocating capital between MSR, and MBS today and as that decision.
Sort of as we stand today and more so I'm just gonna be based around.
Do you see the best total return.
That happens to be better in the MBS market is it possible, we could see more MSR sales in the future. Thanks.
Good morning, Trevor Thanks, very much for the question.
Yeah, I mean, we're always looking at the relative value.
Differences between the two you're right as you said the hedging aspect of the MSR is lessened in this environment, where the average coupon of MSR is 400 basis points out of the money.
So it is not providing really spread.
Hedging capacity anymore.
<unk>.
We still like it a lot because it's as you saw the price moves very little in the 100 basis point move so theres not very much interest rate sensitivity, it's easy to hedge at this point and.
As Nick said, we have a view that speeds are going to be a.
Slower than than the market expects and could really surprise to the downside on speeds, which Fortunately MSR would really benefit coupled with that is as you pointed out and as we show on the slide and as we described.
Our MBS spreads are at historical Wides.
You are too and so you know we.
Those we don't mind that our MSR is not hedging spreads because spreads are wide and we are.
Look forward to either enjoying that spread right or having spreads tightened.
In some near to intermediate term and so either way, we like that but the overall mix.
You got to be determined by a combination of those factors and that's something we talk about every day.
Okay got it and I guess to that last point about being okay with being.
Having more exposure to spreads.
Yes.
I think you said, the new flow purchases and recapture replaced runoff in the MSR in the portfolio. You know have you guys considered just.
Turning off Hello purchases.
You know given that current coupon MSR.
We underperformed.
I mean, I suppose for taking interest in order to sort of maximize your exposure to potential spread tightening.
Yes, we've talked about that you know I mean, it's like everything right.
It's all a question of price and yield and what the what the expected return is and and you know relative to the alternative uses of capital and.
We still we still like that the additions of MSR have been small.
You've seen and that was last quarter mortgage rates have risen even higher since since the driving rates that we've shown in this quarter and so the amounts that we're pushing through the flow channel now are pretty small.
So it doesn't particularly move the needle either way.
Yeah.
Okay I appreciate the comments thank you.
Thank you.
Our next question comes from Bose, George with K B W. Please proceed.
Hey, everyone. Good morning, I didn't know if you said this but can I if not can I get an updated book value for the quarter.
Yeah. Thanks for the question so as I think everyone knows on the call. It's been a it's been a volatile quarter on the spreads have been moving around a lot.
<unk> quarter end.
Our book value was as low as it is down 5% post quarter end, but spreads have rebounded quite strongly here.
And the last bit of October and the early part of November here and so we stand right now quarter to date book value as of as of Monday's close up between 6% 7%.
Okay, great. Thanks, and then just because of the volatility as I said from from from down five six or seven like it speaks to that spread volatility that we've been having.
Yeah, Yeah, absolutely. Thanks, Thanks for that and then just in terms of your return and thanks for that disclosure that is helpful.
Your dividend kind of falls within that range, a little bit higher end of the range. So when we think about the dividend is it fair to say.
Your dividend can stay at these levels unless something changes in the market.
Hey, Bill.
Oh go ahead go ahead Nick.
Alright.
Yeah. So I would say you know reiterating what Nick said on the call.
You know teach dividends that kind of depend on many factors.
But you're correct in that.
Range on our outlook page.
That support the current dividend.
We'll just have to make those decisions based on market conditions and and ultimately at that point that makes the final decision.
Okay, Great now that makes sense. Thanks, Thanks a lot.
Yeah.
Our next question comes from Doug Harter with Credit Suisse. Please proceed.
Thanks.
You guys describe kind of your leverage is overweight and you know kind of the answer to your last question just showing the volatility.
Some of the markets right now I guess, just how are you balancing kind of why at attractive spread versus the volatility and kind of where does leverage today.
Yeah.
Thanks for the question.
Yes.
It's a decision complex decision.
We try to balance to your point.
They're very very attractive levels that are in the market today.
First is the amount of the risk that we manage on a day to day basis.
I would say that.
As Bill said, we did moderate our leverage.
Post quarter end.
We do see some potential upside on the leverage front, if we do the volatility kind of ticking down I think that's a big part of making a decision about increasing leverage or taking it down for that matter. It's not just it's not a one way train I would say that the.
What we need to see for that to happen is to see the fed Heather.
We communicated a stronger sense of where they see the term of a rate and how long it's going to last and then probably we see a decline in volatility that gives a little bit more of a green light of taking leverage up.
We were to take it up I think it would probably be somewhere between six to seven.
Or.
Potentially high Sevens kind of leverage if we if we didn't get that kind of signal out of the market.
And then I guess, you know with with spreads where they are I mean, I guess, how are you thinking about the path to normalization is it more of kind of a slow grind tighter where these attractive spreads might persist for a while or could it be kind of a snapback as you know it was kind of.
This said induced volatility kind of subsides, you know I guess, how how are you thinking about the the.
The longevity or the duration of this return opportunity.
Well I mean.
Firstly, if we could script that I think we would love spreads to just sit where they are right now because they're very very supportive of the strategy these kind of levels.
Very difficult question to answer Amit.
I need a crystal ball on.
How inflation is going to subside.
What the pesos.
I would say that overall I can't.
I can't say that I see any big.
Florida objections.
To the way the market is pricing for inflation.
But very very tricky question to answer at this point.
It really just depends on that path I think there could be a snapback.
It could be a grind.
For the moment, it's been this quarter, it's been a little bit friendlier than kind of a grind back in where I think we've gotten back about 10 basis points nominally just kind of across the stack, but yes.
Yes.
It's really going to be very very data dependent but like I said, if if it were to spreads with or just sit here I think that would be more than just fine with us.
Thank you.
Our next question comes from Rick Shane with J P. Morgan. Please proceed.
Thanks, guys for taking my question this morning.
We could just take a quick look at slide 14.
And I just want to make sure I understand this fully I understand the idea that this is a static analysis.
When we look at the R&D plus rate strategy and talk about the edges.
Obviously, the hedge there is the future of the futures positions.
How do we sort of account for that on this page.
Thanks, Rick Good morning, Thanks for the call.
Economically we would account for these are these are measured in terms of spreads, but theres, a levered spread sort of analysis.
Right.
And so like we would measure it with respect to swap or or or a cash treasury right. We're looking at this at the spreads of the RBS relative to.
So the treasury rates.
Talk about it versus a.
A blended five or 10 year or.
The spread at all along the curve on the <unk>.
Hydrocarbon so forth and then and then we apply we applied to usual.
<unk> leverage arithmetic too to that calculation in order to get.
Okay.
Look I understand the D.
There is an issue here, which is that.
Accounting given all of the different interpretations.
How different instruments are treated as is as much a narrative. It is it is a reality.
And that you were asking investors to look at the narrative in a different way.
In terms of the a D, which is fine and again I think that ultimately it all gets to the same economic reality, but one comment you made is that the way to think of this increasingly is if we were to sell the portfolio on a daily basis and the reason that the market to some extent it historically.
Simplified to an EAA type measure was in part it reflected.
In a very simplified way cash flows.
And I do wonder if.
With how you are structuring the portfolio today is there is a divergence between cash flows and dividend that we need to think about and given liquidity on some of these instruments, how you actually need.
The liquidity needs given the divergence in cash flows.
Sorry, it's a super long question, but I think it's an important issue.
Yeah, I'm not sure I understood the entire question exactly.
The cash flows.
Yeah.
Cash flows of mortgage backed securities with all the embedded options. They certainly do change with interest rates a lot right.
And so as you know.
All about prepayments that's going to be a large.
Large adjustment there you're going to have to make maybe if you were to do the things starting out in this environment, where there's very very low prepayments.
And the cash flows are more stable in general you might have better success.
But I don't know I'm, just guessing Mary do you have any other thoughts on that.
Yeah, I would just add a couple of things so.
E D is not necessarily cash flow.
Yeah at least our calculation E D. Yeah, we had significant realized gains on hedges this quarter that generated cash flow as I noted in my prepared remarks.
The SAR and because we use the original pricing yield doesn't benefit from that increased our cash are receiving a float income or paying less income setting interested in selling prepayment speed. So there there's a lot of factors that that caused.
E D to diverge from actual cash flows.
And Rick you tried to.
Or you did make a statement about linking so are these cash flow effects with with potentially.
How we think about our liquidity.
And I.
I think those are.
Separate items in our minds.
We.
Think about our liquidity and you know.
In terms of.
Our portfolio risks in general right and how much cash we need in order to withstand.
Certain you know.
Very significant stress events and those kinds of things and so it's not really so much a statement about projected cash on the assets and the stability of those cash flows it's really them.
Much more of a market dependent view.
View of the portfolio and end market volatility and the risks in the portfolio.
Okay look I think I'll I'll pick this up the offline, but you know I think one of the issues. We're just trying to understand.
Is that.
There are there are.
Cash flow fluctuations related to funding costs on an immediate basis and I'm just wondering if the.
Evolving hedging strategy.
<unk> liquidity in any way or a position with.
Less.
With instruments as an offset to movements in.
Repo rates for example.
Yeah. So I think the short answer that question is no it doesn't.
Slightly longer answer would be that this is sort of the reason why we introduced this slide 14 in a different way than we had before which is.
You're sort of putting your finger on exactly the reason we did this which is we bought.
Fannie fours at par at the beginning of the year when rates were rising and they were part of all our price then alright, and now Fannie fours are 91 dollar price right.
Alright.
The spread has of course widen that stuff why does it even if the spread has stayed constant right. The AAD would be reflecting a yield.
That reflected that lower rate environments, when we know that.
Because rates rose the yield and the spread reflect the higher rate environment. So that's not in it wouldn't be in the E D necessarily because it's still based on purchase yield.
The yield at the time of purchase rather than the current market yield right and so we felt it was important to show everything.
On.
A a a contemporaneous basis right and slide 14 shows the book value right as it was along with the spreads the market prices of the assets.
<unk>.
That were in effect at the time that that was our book value right.
Alright, that's what I say, so it's buying and selling every day, it's lining up those things, whereas the <unk> measure we're showing you the current book value, but the yields are based on some historical measures and amortize cost and it's it's very it's very difficult and complicated. This is a simpler view at least in my mind.
To see what the return potential is because everything is lined up on one day.
Okay fair enough and it definitely is complicated I was.
Flipping through textbooks last night trying to understand some of the stuff. So I appreciate the answers.
Okay.
I hope it helps.
Our next question comes from Aaron <unk> with Citi. Please proceed.
Hi, I just wanted to follow up on a question about the spreads and the potential tightening there what what kind of macro events or what events would would.
Lead or naturally lead to spread tightening over time.
Well.
Thank you for the question.
As I alluded to earlier the.
I think a lot of what's happened in the market right now is very inflation related.
Hi.
I think that's the focus of the market at the focus of the fed.
Yeah, it's almost a singular focus.
I don't want to make the world sound that simple, but I think right now that is really what is driving things. So.
If I had to put my finger on one thing it would be that and then through a direct linkage to mortgages. It would be a decline in volatility as bill mentioned in his comments.
As dramatic.
As it has been from the way mortgages have performed over the quarter a lot of it can just be attributed to volatility and combined with.
What has been a very poor technical situation for mortgages at the same time.
The.
The linkage really here is inflation.
Inflation to fed to volatility declining to better spread performance out of the sector.
Okay got it I might just add one thing which is that the current pricing of the mortgage market is incorporating this existing high volatility already right and we think it's still historically attractive even including.
That that higher volatility and so.
We do expect volatility to moderate eventually.
And we think mortgage will outperform at night.
In that period on the apps.
And then on the on the hedging side Hugh you. It looks like you don't have any interest rate swaps any longer can you just talk about.
The hedging positions in and in a decision to to remove this.
Yes. Thank you for the question it is I think a.
Fairly simple response, you know first of all you know we do believe that there is better.
Better correlation between treasuries futures.
Mortgages on swaps there was a lot more things that go into the swap market and almost introduces an extra amount of basis risk to that and finally going back to a prior question I don't know if it was it was exactly answered but.
Our.
With the how quickly the market is moving around and you know.
Shifting of current coupon everything else, it's frankly, it's a lot easier to manage the book with futures swaps swaps or.
<unk> continue to be more of a slightly negotiated transaction transaction as opposed to futures, which are you know.
Tayo electronic and easy to trade.
Okay, and then lastly, you had mentioned that you sold some.
Some of your portfolio.
And to to buy backs and some shares.
How much of that portfolio did you did you so.
Well well.
We said what the overall decline in the portfolio.
It was in our Leverages now seven times. So you know we you know we sold it to say we viewed it as as a little bit of a pair trade too to use the use of proceeds.
Selling mortgages to buyback.
Shares so it's wrapped up in the in the leverage decline that we had it was it was between.
I know we decline I don't know like how much do we reduce the position in October here.
I think 501 billion relative to the.
Yeah.
So or something like that to say between 501 billion, yes, that's right mortgages.
In order to fund the acquisition and that end and as we said right. It was.
It's a risk free.
Return right for US right in the low mid teens, no prepayment risks no convexity risks no credit risk market risk right and we were able to choose to.
When we think of the mortgages that were funded by that position. It was actually a positive P&L trading so it wasn't locking in any any losses actually locking in gains by evacuating that that repurchase.
Okay. Thank you.
Our next question comes from Eric Hagen with B T. I G. Please proceed.
Hey, Thanks, Good morning, I think I have three questions first.
First can you say, which preferred series you bought back.
And in October .
Can you talk about the Mark to market features on the debt supporting MSR are those daily mark to market or are they more of like that kind of credit Mark if you will.
Are there different mark to market features depending on the source of funding.
And then the third question is in the portfolio of specified pools can you guys talk about the liquidity and some of the trading dynamics, you see driving value for the higher versus lower coupons.
From that standpoint alone like what what's the value that shareholders are picking up in the higher coupons.
Versus being in the lower coupons, where there's a lot more.
Our supply.
Yeah.
Yes.
Sure. Thanks for the question Eric.
Good to have you.
Mary you want you want to take next I take Eric's question about about the preferreds there.
Something's wrong, Mary Youre on mute there.
Oh, sorry about that.
The preferred buyback was across all three of them here.
Terry.
And we'll be filing our Q today and the details behind it well will be included in the subsequent event footnote.
Okay.
Yes.
Yeah.
Yeah talking about.
The.
The position.
Positioning in the Morgan Stanley .
I think we kind of addressed it in that special topics slide if you look at our.
Levered return static level return projections occur.
Ross.
The various coupons.
We are.
The higher coupons.
For the most part it is hard to be entirely position in so called current coupons right now because rates have moved so far so fast that there really hasn't been a time enough.
No time too.
Originate really a stock of of.
Things that are priced right around par or in a low pars are they're just it's just the TBA market right now.
We.
So I would say no current coupons from a practical perspective right now.
<unk>, maybe some five and a half.
And we.
We are.
Continue to be.
Continue to be wanted to move into higher coupons from the lower coupons and I think the type of return.
Return potential that we see in those sectors is that's what you can see on our special topics fun.
Yeah. The third one I asked was about the mark to market features across the debt supporting MSR.
Yes.
Yes sure.
We have combination of bilateral facilities as well as well as our term note.
The Mark to market features vary.
From from daily to.
Being market dependent based on rate triggers.
Two.
I mean, everyone has the ability to to remark whenever they want right.
Alright.
So.
Some are more regular and some are more more periodic and basis.
Let you know.
One of the things that I think we've described in past periods in the past quarters is that.
Falling rate environment is actually.
From liquidity standpoint easier and better to manage for us because of the so-called imbalance between the haircuts.
And and the rising rate environment, which is protection more stressful, but as we sit here right rates rose 100 basis points right in our in the broker marks on our portfolio increased by eight tenths of a month, so we're pretty near the.
No.
We're in an environment, where there's not very much rate sensitivity to MSR prices.
Given.
Given that we're so far out of the money.
I think theres still interesting evaluation things happening at speed slow and as as the fed raises rates in float income is going to increase and all of that but.
In terms of in terms of the price sensitivity of MSR here, it's very very light.
That answer your questions.
Yep Yep, Thank you very much.
Yes happy. Thank you at this time I would like to turn the call back over to Mr. William Greenberg for closing comments.
I'd like to thank everyone very much for joining us.
And as always thank you for interest in two hours.
Thank you. This does concludes today's teleconference and webcast you may disconnect. Your lines at this time and thank you for your participation and have a great day.
Uh huh.