Q2 2023 Two Harbors Investment Corp Earnings Call
Speaker 1: Ladies and gentlemen this is the operator.
Speaker 1: Just an update that the conference will be starting shortly. Please stand by while we begin the conference in the next...
Speaker 1: Thank you.
Speaker 1: At this time, I would like to welcome everyone to 2 Harbor's 2nd Quarter 2023 Financial Results Conference Call. All participants will be in a listen-only mode. After the speaker's remarks, there will be a question and answer period. I would now like to turn over the call to Maggie Carr. Good morning everyone, and welcome to our call to discuss 2 Harbor's 2nd Quarter 2023 Financial Results. With me on the call this morning are Bill Greenberg, our President and Chief Executive r damage.
Speaker 2: and are available on the SEC's website as well as the investor relations page of our website at twoharborsinvestment.com
Speaker 2: In our earnings release and presentation, we have provided recommendations of GAP to non-GAP's financial measures in the urge you to review this information in conjunction with today's call. As a reminder, our comments today will include forward booking statements, which are subject to risks and uncertainties that may cause our results to differ materially from expectation.
Speaker 2: These are described on page 2 of the presentation and in our form 10K and subsequent reports filed with the SEC. Accept as need be required by law to harbor it's not-update forward-looking statements and disclaim any obligation to do so.
Speaker 2: I will now turn the call over to Bill.
Speaker 1: Thank you Maggie.
Speaker 3: Good morning everyone and welcome to our second quarter earnings call.
Speaker 3: Today I'll provide an overview of our quarterly performance and I'll review our decision to reduce our second quarter dividend.
Speaker 3: Then, after summarizing the current market environment, I'll take a few moments to illustrate our thoughts on the effects of hedging in an inverted yield curve environment.
Speaker 3: Mary will cover our financial results in detail and Nick will discuss our portfolio activity, positioning and return outlook.
Speaker 3: Let's begin with slide three.
Speaker 3: Much like the first quarter of this year, market sentiment at the end of the second quarter was very different than where it began.
Speaker 3: Initially, risk assets underperformed and RMBS spreads widened as investors were faced with ongoing concerns about stress in the banking system, coupled with how a divided government would address lifting the debt ceiling ahead of an early June deadline.
Speaker 3: However, that sentiment shifted at the end of May as bipartisan legislation was passed to raise the debt ceiling and confidence began to grow that the worst of the bank stress was in the past.
Speaker 3: This resulted in strong performance for both equities and spread assets by the end of June as investors returned their focus to economic fundamentals like growth and inflation.
Speaker 3: Book value at June 30th was $16.39 per share, representing a 2.2% total economic return.
Speaker 3: We opportunistically repurchase shares of both our common and preferred stock in the second quarter, which positively benefited our book value.
Speaker 3: Income excluding market-driven value changes, or IXM, was 60 cents per share, representing a 14.8% annualized return on average common equity.
This backward looking metric of realized return is meant to be viewed together with the forward looking metrics on slide 15.
This quarter our Board of Directors approved a reduction in our dividend to 45 cents per share from 60 cents. Importantly, this decision was neither a reflection of downward pressure on current earnings nor our earnings outlook. We believe that the current investing environment for agency RMBS and MSR is very attractive and retaining additional capital to put to work is a critical part of our investment strategy.
should result in positive returns. Further?
By definition, reducing the dividend will allow more of an opportunity for book value to increase, which we also view as positive for shareholders.
The new dividend level translates to an 11% return on book value, which remains a competitive return and is in line with our historical dividend yields. We believe that this level is sustainable, given our current market outlook, while allowing us strategic flexibility.
The new dividend level translates to an 11% return on book value, which remains a competitive return and is in line with our historical dividend yields. We believe that this level is sustainable, given our current market outlook, while allowing us strategic flexibility. Please turn to slide four.
I'd like to spend a few minutes on the markets in the second quarter. Amid ongoing concerns about stress on the banking system and the debt ceiling debate, the Fed raised its target rate only once to 5.25% while pausing at the June meeting.
Last week, the Fed raised rates again to 5.5% and signaled that any future rate hikes will be data dependent.
The market considers this to be about as high as the Fed funds rates will go and there are no more hikes priced in the market in 2023 as seen in chart 1 on
From a long-term perspective, the Fed's aggressive rate hiking has led to short-term rates at levels not seen since 2001, and many marker participants are expecting a recession.
As future interest rate cuts are priced into the market beginning in 2024, longer term interest rates are lower than short term rates. Indeed, as of June 30th, 2 year treasury rates were 4.87%, while 10 year treasury rates were 3.82%, a spread of a negative 105 basis points, which is near the most inverted in more than 40 years.
This spread is shown by the green line in chart two, where the widening of the spread between the short-term and long-term rates has reached extreme levels towards the bottom of the chart.
The blue line shows the spread between the current coupon mortgage rate and general collateral repo rates.
As of the end of June , this spread was 23 basis points.
With funding rates at or above the yield of the asset, many investors have wondered how does two harbors or any mortgage REIT for that matter generate positive returns in such an inverted yield curve environment?
Please turn to slide five and I will take a few moments to illustrate at a high level how we think about that.
Let's first consider a hypothetical mortgage rate consisting of a portfolio of agency RMBs that has a debt to equity ratio of nine times and funded with short term funding such as a repurchase agreement that is otherwise unhedged as shown on the left hand side of slide five.
For simplicity, let's assume that short-term funding rate is overnight SOFR, which applies to a funding spread of zero.
Also, for concreteness, let's assume that the REIT has equity of $100, the yield on the RBS asset is 5% and SOFR is 5.5%.
These are not current rates, but they illustrate the point well.
This REIT receives the yield on the invested assets, say a thousand times times the asset yield, and has to pay funding on the amount that it borrows. In this example, $900 at five and a half percent as seen in equation one.
These economics can be rephrased to say that the REIT earns the asset yield on its equity of $100 and then, additionally, the spread between the asset yield and the funding rate multiplied by the amount borrowed of $900.
as seen in equation 2.
We can easily turn these numbers into rates of return by dividing by the equity balance of $100.
With the illustrative interest rates that we have chosen, the spread between the asset yield and SOFR is negative 0.5% and the expected return of this REIT is only positive 0.5% as seen in equation 3.
Indeed, if the yield curve were further inverted, this expected return could even be negative.
For instance, if SOFR were to rise 100 basis points and mortgage yields were unchanged, then the expected return would decline to minus 8.5%.
More generally, the expected return of this portfolio, as it's constructed, is significantly exposed to changes in interest rates in either direction.
This is due to the positive duration gap that exists between the RMBS asset and the repurchase agreement liability.
The duration of the RBS asset is long, say five years, and the duration of the liability is short. We assumed only one day.
Now let's consider the same hypothetical mortgage reach, but let's add in some hedges to eliminate the duration gap between the RMBs asset and short-term funding.
In this example, let's use a fixed rate payer interest rate swap.
The situation is shown on the right hand side of slide 5.
The reality of hedging the duration gap is more complex than this example. We typically hedge multiple points along the yield curve.
But for the purposes of this example, let's assume we hedge with a single interest rate swap instrument that pays a fixed rate of, say, 3.5% and receives a floating interest rate of sofa flat.
The interest rate swap is constructed to hedge, or transform, the short-term nature of the funding into a longer-term maturity that more closely matches the duration of the assets.
The expected static return of the hedge portfolio is the same as on the left-hand side, but also includes the cash flows from the swap.
The economics shown in the equation 5 can be expressed as earning sofa on the rate equity of $100 and then additionally the leveraged balance of $1000 multiplied by the spread between the asset yield and the fixed rate of the swap.
Converting again to returns instead of dollars, if we use the interest rates that we chose in this hypothetical example, the expected static return is 20.5% even though the curve is inverted and funding rates are higher than asset yields.
This happens cleanly in this example because both the funding rate on the asset and the floating leg of the swap are tied to the same short term index so far. But it is also generally true for any short term index to the extent that most of those rates are highly correlated.
In particular, the same math works if we use treasuries to hedge instead of swaps where the treasury repo rate enters instead.
Now let's return to this example and imagine that SOFR rises unexpectedly by 100 basis points and mortgage yields are unchanged.
In this case, the expected static return of the hedged and levered REIT changes from 20.5% to 21.5%, a very modest increase of 100 basis points.
compared to the unhedged reach which changed by 900 basis points.
A REIT or portfolio which is hedged is largely immune to changes in funding. That's what it means to be hedged, with the caveat that changes in short-term rates or risk-free rates affect the leveraged expected static return one for one.
all cases the main effect contributing to the static return of the hypothetical REIT is the same the spread between the asset yield and the fixed rate on the hedge no matter the shape of the yield curve or whether borrowing rates are higher or lower than the asset yields. While I have tried to give a flare of how we hedge in an inverted yield curve environment we have simplified the assumptions in our hypothetical example because the format of this earnings call limits the amount of time we can spend. To that end I'm excited to share that we are starting a series of short videos called two harbors conversations.
where we can delve a little deeper into special topics of interest to investors. We plan to release a conversations video that goes into further detail on this topic. Each quarter we plan to release videos on special topics in the REIT industry or specific to two harbors. We hope that you will find these helpful and interesting. Looking ahead we are excited about the investing environment in both agencies and MSR.
High rates will continue to keep prepayment speeds slow, which is beneficial to our MSR assets. Many of the unknown variables in the first half of this year have been resolved, leading to lower volatility, while spreads in RMBs remain at historically attractive levels.
We believe that the overall environment is excellent for our unique agency plus MSR strategy.
Furthermore, we continue to make progress on transitioning our MSR to roundpoint, having transferred 63% of our portfolio from our subservicing network through the end of June .
including the 45-cent common dividend, results in a quarterly economic return of 2.2%. Both components of our strategy contributed positive returns this quarter, which reflected the high carry of the portfolio partially offset by a small widening and higher coupon spreads. As Bill highlighted, we repurchased 514,000 shares of preferred stock at an average price of $19.39 per share.
Thank you.
Okay.
Thank you our next.
Next question is from Trevor Cranston with JMP Securities. Please proceed.
Alright. Thanks.
You guys characterized your leverage positioning as neutral throughout the quarter.
I'm curious.
We go forward if you if your view is to shift pick.
Particularly on the MBS market in terms of having a higher probability of.
Spread tightening and maybe less risk of widening.
Can you talk about what you.
What how are you guys would take about leverage and what should we view it as sort of a.
More aggressive leverage level.
If you're starting to see a change in the probability of spread tightening going forward. Thanks.
Hey, Thank you for the question.
So first of all you know, we really do like our leverage and where our risk is currently.
Once again as as we as we demonstrated this past quarter at current spread levels. The return you know their actual return of the portfolio has been good and our return potential is as as.
You can see from the presentation.
It is also very supportive of our dividend or potentially could you know out earn our dividend, which could generate extra return and.
Growth in book value overtime. So at the moment, we don't have any particular plans for increasing.
Leverage is.
As Ed said.
Really doesn't feel like we need to do that should we be at that point in the cycle, where we.
We do see the fed truly being done with raising rates.
That.
I still believe is the single most important element to having a materially.
Tighter spread environment.
The the the difficult the paths that we have experienced in terms of higher rates or unbounded higher rates on the fed side.
Think that's held back our how spreads can do and how investors are.
How how are you.
Optimistically investors can be about spread movement. However.
Uh huh.
You know I think that if the I think the single most important thing to drive spreads spreads materially tighter would be the fed really being done and then we should see a decline in volatility along with that and that would that would be a big big driver of spread tightening of extra performance, but once again I don't I don't really think that's necessary.
Our portfolio now we've seen over the as we described where we're trying to keep our ourselves balancing a high amount of leverage versus the still uncertain environment. We're in and no rate volatility has kind of ebbed and flowed you know we it spiked a couple of times in the last you know.
Six to 12 months come back down and then come back up a little bit and we've even seen it come back up a little bit in this quarter again in terms of implied rate volatility.
That's an important driver in an all spread models out there, which you know a lot of investors look at.
So we're trying to balance those things, but at the at the at the end of the day, we look at how our portfolio can generate returns and if we are generating returns that are supportive of our dividend and our book value growth.
That's really what we're after.
If there is if there is a clear sign that it makes it makes absolute sense to increase our leverage we will do so.
Got it okay. That's helpful. Thank you.
Thank you.
Our next question is from Kenneth Lee with our VC capital markets. Please proceed.
Hey, good morning, Thanks for taking my question I'm, just about the the book value per share you talk about how.
Our repurchases helped the book value increase in the quarter, but wondering if you could just talk a little bit more about how the underlying investment strategy the rates in MSR parent's strategy also potentially contributed to the book value increase there. Thanks.
Yeah, Thanks, very much Ken and good morning.
The amount of of of of share repurchases that we did during the quarter was reasonably small and so it had it had a correspondingly small impact to the book value return that we that we announced we think that was roughly around <unk>.
The bulk of the of the return was from the performance of the portfolio, which given what it was there's pluses and minuses that offset one another and it was largely the result of carry in the portfolio.
Such as it is being being as high as it is as we show on slide 15.
<unk> been relatively eye exam that was the bulk of the richer.
Got you thanks.
Thanks for that color there and then I guess in terms of the the investment opportunities.
Where you look at right now what are some of the more attractive investment opportunities that they see over the near term.
<unk>.
Yeah.
Thanks, Ken So you know I I think we can see it on slide 15 here, which you know which is the same thing we've been saying for a little bit spreads are wide in both RMB S and in MSR.
We happen to like the the hedged MSR, a little bit better than.
And then the RBS although.
The supports amongst amongst our MBS that's shown by the the investor demand from the FDIC sales was clearly robust.
And encouraging.
Although as Nick just said.
Rate volatility remains side, there's other uncertainties in the market.
But we like our target assets here of RBS and hedged MSR, we like our capital allocation between between those asset classes and so we're going to continue to to to participate and invest in those sectors.
Great very helpful. There. Thanks again.
Okay.
Thank you.
Our next question is from Rick Shane with J P. Morgan. Please proceed.
Thanks, guys for taking my questions.
I'm really interested in the interplay at this point between Q.
<unk> PON and hedging strategy.
And in particular, I'm kind of looking at comparing the potential return outlook from the first quarter to the second quarter.
One of the things and again, it's modest but theres a slight decrease in the static return estimates for the rates in our MBS strategy is that a function of with where we are in the market pay ups are increasing is that whats sort of tweaking that a little bit.
Hey, Rick This is Nick Thank you for the question.
You know many things go into the static return.
Slide you know potential one of them as we noted.
In.
The commentary is we did go down in coupon a little bit which does have.
A lower amount of.
Nominal spread than higher coupons do so you know natively.
A portfolio of lower coupon MBS will will be tighter and consequently on a levered and hedge basis, you will have a lower.
You know static return potential and I think that's probably the biggest thing that has affected those numbers quarter over quarter.
As we noted in the commentary as well.
This past quarter. There was there was a big divergence in performance over the quarter current coupons were a little bit wider nominally.
Lower coupons were tighter.
So to the extent that we shifted down in coupon I think that probably that that is.
The largest reason why we've seen a little bit of a lower return potential on that component of our of the return slide.
Got it Okay. That's helpful and again, when we look at the premium in the portfolio, it's relatively modest I'm assuming.
Given.
Where we are in the rate cycle and all of the uncertainty that that will continue to be the strategy to either buy a par or slight discount securities.
I'm sorry, I didn't understand your question when you say premium what do you mean.
If I look at the amortized cost of the portfolio versus the par value you don't have a ton of premium so that if at some point in the intermediate term, we see a big pickup in speeds.
You won't have a ton of.
Realized losses.
Oh I see yeah, I know that that is I think that that's that's accurate.
The.
Yeah.
The World right now is a little bit.
As a little bit as Bill says you know kind of upside down in the sense of we have.
You know we have a.
We have a mix of securities across the portfolio.
To the extent you know and you're right we don't have a.
The amortized cost basis of the portfolio from from that measure, which you know we're always looking at things more on <unk>.
We Mark our book you know every day every month, you know where we're looking at things more on a total rate of return basis, but on an amortized cost basis. You are correct. The average cost is is pretty close to par. So that we wouldn't have a big effect in terms of the you know the.
The the nominal yield or some of these more and more.
I would say.
Our accounting measures of the book.
I might add just a couple of other points to that Rick if I can which is number one there's not very many.
Above par dollar price securities in the World. These days right I mean, Fannie six is today or our par dollar price handle and so forth.
Looking at the amortized cost is also a it's sort of just suffers for a little bit from the U D problem, which is asynchronous it refers to what the prices of the things were when we bought them.
Brian It doesn't refer to current market prices of things too so that is potentially a little bit misleading about what the actual prepayment risk is of the securities right in terms of prepayment risk.
As Nick said that I always say, we're in an upside down world when a discount environment.
Slow Prepays are are bad fast prepays are good in RMB, yes of course in MSR. The exact opposite is true in slow prepayments are always good but you're right. The average dollar price of our current holdings.
<unk> does not have a lot of premium in it.
Yeah look I think at the end of the day you guys are managing a portfolio when tail risks are a lot closer than they normally would be.
These are uncertain times I agree.
Thank you guys very much.
Thank you Rick.
Thank you Nick.
Question is from Eric Hagen with B P. I G. Please proceed.
Hey, good morning, how are you doing.
A couple of questions here on round point, I mean, how much operating leverage do you feel like you have there how scalable do you feel like the platform is and maybe both a scenario where you're scaling up the MSR or even if there's a prepay wave and how would it look you know in light of that.
Maybe stepping back even more philosophically like talking about the Onboarding of Ron point, and how you think about your appetite to grow the servicing portfolio.
Would you say that you have even more appetite for like bulk servicing because he brought that platform on platform. Thank you guys.
Yeah sure good morning, Eric Thanks for the question.
So we haven't closed on Ron point, yet, where we're still waiting on a few remaining states as we said in our prepared remarks, we've transferred around 63% of our portfolio.
To round point already ends and Rob what he's been able to absorb that capacity well.
And easily and you know the the.
The E. Two the reports that we've gotten post transfers have been very good.
And that's all happened smoothly, which gives us confidence that we can continue to.
To scale up that platform even more.
And you know what.
While we don't own the platform yet you know we saw we have been able to.
So appear inside a little bit and we're still confident that the that the operating leverage in the end the earnings that we said when we announced the deal are still in the context of what we expect to achieve once we do close.
And terms.
The platform itself does.
As we as we have moved our loans over there and as we see what Ron point can do and and and and and what it's capable of doing and we do imagine that the that the cost of service for loans on the ramp up platform will be lower than what we are currently paying.
In sub servicing right and so you know as a as a marginal cost exercise that we'll make.
Servicing that we acquire are more attractive.
To our investors on that platform.
So.
All else equal you know.
Adding to our MSR portfolio will be advantageous it will look even better than just the numbers that you see on slide 15, but we're balancing that with with some amount of diversity and ability to have liquidity in the RBS sector and and you know that.
Nick said markets are cyclical and then there is we believe and mean reversion and so we think there are still good opportunities. There. So our capital allocation is is something close to what we want it to be and we like that.
Round point will give us the opportunity to participate in the other parts of the of the of the mortgage finance sector can we you know what we're looking to be able to increase our presence in the third party sub servicing space round point has a little bit of that already we see opportunities there.
To grow that which will be able to benefit from that low cost of service and the operating platform. The scalability from that perspective, and there's other other opportunities that we'll be able to have two you mentioned what will happen in a in a in a refinancing wave.
Ramp right now does not have.
Capabilities to do that but we're working with other partners in order to be able to provide portfolio protection.
In various ways.
So we think that that's another opportunity that we'll be able to have to participate in that space as the markets evolve and as time unfolds.
Thank you so much.
Thank you Eric.
Thank you.
As there are no further questions at this time I would like to turn the floor over to Bill Greenberg for closing comments.
I just want to thank everyone for joining us today and thank you as always for your interest in two harbors.
This concludes today's teleconference. Thank you for your participation you may now disconnect your lines.
Yeah.
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