Two Harbors Investment Corp (TWO) 2010 Q1 法說會逐字稿

Good morning. My name is Chuck, and I'll be your conference facilitator. At this time I would like to welcome everyone to Two Harbors' First Quarter 2010 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks, there will be a question and answer period.

(Operator Instructions)

I would now like to turn over the call to Ms. Anh Huynh, Investor Relations for Two Harbors. Ms. Huynh, you may begin.

Thank you, Chuck, and good morning. Welcome to Two Harbors' First Quarter 2010 Financial Results Conference call. The press release and financial tables associated with today's call were distributed yesterday evening. If you do not have a copy, you may find them on the Company's website at www.twoharborsinvestment.com. This call is also being broadcast live over the internet and may be accessed on the website under the Webcast link.

In addition, we'd like to encourage you to reference the accompanying presentation to this call. The presentation can be found on the Company's website under the webcast link.

Before management begins the discussion of the first quarter results, we wish to remind you that remarks made by Two Harbors' management during this conference call and the supporting slide presentation may include forward-looking statements. Forward-looking statements reflect our views regarding future events, including statements regarding our expectations regarding the future results of our operations, our anticipated expenses and liquidity, the composition and financial returns of our investment portfolio, trends in interest rates and prepayment speeds, regulatory developments, and general economic conditions.

Forward-looking statements are typically associated with the use of words such as anticipate, expect, estimate, believe, assume, project, and should. We caution investors not to rely unduly on forward-looking statements. They imply risks and uncertainties, and actual results may differ materially from expectations. We urge you to carefully consider the risks described in our filings with the SEC, which may be obtained on the SEC's website at www.sec.gov. We do not undertake any obligations to update or correct any forward-looking statements if later events prove them to be inaccurate.

I would now like to turn the call over to Two Harbors' President and Chief Executive Officer, Tom Siering.

Thank you, Anh. I would like to welcome everyone to Two Harbors' first quarter's earnings call. On behalf of the Company, I would like to thank you for your interest and support in Two Harbors. With me this morning to discuss the financial results for the quarter are Jeff Stolt, our Chief Financial Officer, and Bill Roth, our Co-Chief Investment Officer. Additionally, we are joined by Brad Farrell, our Controller.

We are quite happy with our first quarter's financial results as well as other recent developments. Before I turn the call over to Jeff, I would like to take a few minutes to summarize some highlights from the quarter.

As noted during our earnings call for the fourth quarter of 2009, we had substantially deployed our initial capital by the end of the year. We became fully invested in January by making additional investments in our target assets and particularly in senior non-agency securities. Last night the Company reported GAAP net income for the quarter of $5.3 million, or $0.40 per basic share outstanding. On March 12 we declared a dividend of $0.36 per share, reflecting our portfolio's strong performance.

On April 12 we announced that it was our expectation that book value per share, as of March 31, was in the range of $9.35 to $9.40 per share. I am pleased to say that the final figure for book value is $9.38 per share as of that date. Our accuracy in this regard is a testimony to our financial controls and the strong financial team that we have assembled. We should add that it is not our intention to preannounce this data routinely, but we thought it was appropriate, given the circumstances.

Subsequent to the end of the first quarter, the Company issued 11.5 million shares, subject to a typical green shoe arrangement in a secondary stock offering. That effort was led by Credit Suisse. Those of you who followed our progress closely during this time are no doubt aware that at one point we announced that we had suspended the offering, because the available pricing was too dilutive to the book value of existing stockholders. We subsequently went forward with a smaller transaction at a price per share that was meaningfully better than the first available. Both of these factors made the final transaction less dilutive than the original.

Of course, we take our responsibility to protect book value very seriously, but we saw compelling reasons to go forward with this sale nonetheless. This offering allows us to capture the still abundant opportunities that we see in the mortgage market, as well as to diversify our ownership base, increase the liquidity of our shares, and reduce operating expense ratios. We view all these considerations as strategic imperatives to optimize Two Harbors shareholder value. We have already made significant progress in putting that money to work.

Public policy changes continue to be a challenge and an opportunity for the mortgage market. On February 11 we announced that we expected a negligible impact on the Company's portfolio from the announcement the prior day by Freddie Mac and Fannie Mae that they had planned to purchase delinquent loans out of guaranteed pools of residential mortgage backed securities. Today our results have been consistent with that expectation.

On March 26 the Obama Administration and the Treasury announced updates to the Home Affordable Modification Program, or HAMP, and they combined this program with a new FHA short refinancing program. The goal of the updated HAMP remains the same -- to help "responsible" borrowers to remain in their homes. This latest announcement affirms our belief that the Government is willing to revise and revisit the loan modification program as necessary until a tenable plan between the borrower, the servicer, and investor is established, enabling more owners to remain in their homes. Obviously, such changes can impact mortgage security prices, and we have them firmly in mind as we shape Two Harbors' portfolio.

This concludes my opening remarks. I will now turn the call over to Jeff to review our financial results.

Thank you, Tom. We are pleased -- we are very pleased with our financial results. The quarter, 2010, was our first full quarter of operating results, one that was unobscured by our path to market, as it was in 2009. As I review the key financial highlights for the quarter, I invite you to refer to slide four of the accompanying presentation.

Our operating results for the first quarter of 2010 demonstrate both strong realized yields and security value appreciation. As Tom previously mentioned, Two Harbors reported GAAP net income of $5.3 million, or $0.40 per share, for the first quarter. The net interest income for the quarter was $5.6 million, which included $2.5 million of net premium amortization associated with our agency RMBS portfolio and $1.1 million of accreted discount amortization associated with our non-agency RMBS portfolio.

Net income for the quarter also included $1.2 million in realized gain on the sale of $10.4 million worth of securities and $0.8 million in realized gains on the settlement of to-be-announced, or otherwise called TBA, securities, which is included in our other derivative instruments' financial line item.

In addition, the Company recognized in our earnings an unrealized loss, net of tax, of $0.7 million associated with our interest rate swaps. As a reminder to our investor community and relative to our interest rate swaps and their impact on core earnings, the Company is not applying FAS133 hedge accounting. This decision was made for a variety of reasons, most importantly, the current challenges in meeting the rigid requirements of hedge accounting and the potential limitations on how we approach our economic hedging with a combination of maturity profiles.

In our income statement on the financial line, losses on interest rate swaps, we combine two components, the realized net interest spread on the swap of approximately $0.4 million and the unrealized loss on marking the swaps to fair value of approximately $1.1 million. For core earnings, to remain consistent with our peers, we only remove the unrealized mark on the swap, net of tax. We believe this provides the most meaningful view of core earnings.

For the quarter, Two Harbors reported approximately $1 million in operating expenses, or 3.2% of average equity. As Tom mentioned earlier on the call, Two Harbors recently completed a stock offering for the month of April, raising approximately $97 million in net proceeds. As a result of the transaction, the subsequent increase in our equity base should considerably reduce our expense ratio moving forward. We anticipate recurring operating expenses, or our run rate, to be reduced by over 100 basis points or a reduction in the expense ratio to a range of 1.8% to 2.2%, excluding any one-time or extraordinary expenses.

If you are following the accompanying presentation, you may turn to slide five now. During the first quarter, we achieve a 3.3% quarterly increase in book value. Book value as of March 31, 2010, was $9.38 per share, after adjusting for the $0.36 dividend that we declared in March, compared to a $9.08 per share as of December 31, 2009. This increase in our book value can be attributed to two primary drivers. First is the strong GAAP net income reported for the first quarter, supporting our dividend declaration of $0.36, and the second is a $3.5 million increase in other comprehensive income, which recognizes unrealized gains resulting from the appreciation of our underlying securities.

As promised on our last call, we plan to report return on equity, starting with the first quarter of 2010. On a GAAP earnings basis, the Company achieved an annualized return on average equity of 17.1%. Total comprehensive income for the first quarter was $8.8 million, or an overall investment return on equity of 26.6%.

One final note I would like to make. As disclosed in our December 31, 2009, Form 10-K, the Company's internal controls over financial reporting was concluded effective by the management of the Company and was audited by our independent public accounting firm, as stated in their report. Although not required in our first year as a public Company, we believe this accomplishment strongly demonstrates our philosophy of building sound controls and practices while building and infrastructure that can achieve economies of scale.

I will now the call over to Bill to discuss the performance of our portfolio and to provide additional color on the returns we achieved during the quarter.

Thank you, Jeff. The early part of 2010 is proving to be both an interesting and rewarding time for Two Harbors. Market opportunities continue to be abundant for the value investor, and, as a participant in this market, we are very excited with the composition and performance of our initial portfolio. I would like to begin today's discussion by referring you to slide six.

During the month of January, we continued to invest in senior non-agency bonds and consequently, completed the target allocation for our initial portfolio. The aggregate portfolio value, as of March 31, was $520 million, which was comprised of $413 million in agency and $107 million in non-agency bonds. Leverage continues to be moderate, with the debt-to-equity ratio of 3.6 times.

The portfolio exhibited strong performance during the quarter. The annualized yield on average earning assets was 4.9%, which is in line with our expectations. Agency securities realized a yield of 3.6%, while non-agencies realized a yield of 10.6%. A big contributor to our agency yield was the modest three month CPR of 16.2% realized during the quarter.

As many of you are aware, earlier this year, Freddie Mac and Fannie Mae announced their plans to purchase seriously delinquent loans out of existing mortgage pools, which were expected to increase prepayments on impacted agency pools. Our focus on analyzing public policy in the context of market conditions, coupled with appropriate diligence in selecting pools, enabled us to avoid any adverse impacts from the GSE buyouts and to report an attractive CPR on our agency portfolio.

In a press release issued in February, we noted that we expected the buyouts would have a negligible impact to our portfolio. We reaffirm that view today. We believe it is important to note that our expectation also includes the upcoming buyouts in the second quarter being conducted by Fannie Mae.

On the non-agency side, our bonds performed in line with expectations, and they experienced a three month CPR of 11.6%.

On the funding side, Two Harbors continues to be successful in securing low cost financing on borrowings. As of March 31, the Company's borrowings totaled $450 million. The annualized cost of funds was 0.5%, which led to a net interest spread of 4.4%.

Interest rate exposure and potential Fed activity continue to be concerns for mortgage REIT investors. Consistent with our philosophy of managing interest rate risk, the Company continues to utilize interest-only bonds and interest rate swaps to hedge our exposure. Duration remained low in the first quarter, with a reported duration gap of a quarter of a year at March 31. Thus, we feel we are well positioned for any future interest rate hikes.

As of March 31, the aggregate total notional amount of our interest rate swaps was $150 million, or 33% of the Company's outstanding borrowings. Interest-only bonds represented $14 million of the aggregate portfolio at quarter end.

One aspect of our business model is to be nimble. As such, our portfolio will continue to adjust to evolving market conditions as we allocate capital to opportunities that offer value on a risk adjusted basis. The first quarter provides an initial look into how we employ our value-driven approach to the portfolio. During the first quarter, we sold approximately $10.4 million bonds for a net realized gain of $1.2 million.

To provide you insight into our thought process, I would like to provide you with an example. During the fourth quarter of 2009, we purchased a mezzanine bond priced at just over $36 to yield 15% to conservative assumptions. We sold this bond during the first quarter of 2010 at approximately $45. Including the cash flows we received while holding this asset, along with the roughly nine point gain on sales, the total return on this holding was roughly 30% in only three months.

Importantly, at the time of sale, the $45 market price on the mezzanine bond was generating an estimated 10% yield, which we then replaced with a senior bond with a similar expected 10% yield, but with a lower risk profile. As the market opportunities change, we will continue to take a relative value approach to investing as we deploy capital to the most attractive sectors for the benefit of our stockholders.

Two Harbors also recognized and capitalized on market opportunities that occurred as a result of the GSE buyout announcement. During the first quarter, we took both long and short positions in to-be-announced securities, or TBAs, to capitalize on mispricings caused by uncertainties around the timing of the buyout. These positions, which have been closed out, generated a gain of approximately $0.8 million. Additionally, we were able to pick up some agency bonds at depressed prices as a result of the uncertainties surrounding the buyout.

We are very pleased with the portfolio we have constructed. It reflects our investment approach of balancing the various risks inherent in managing a portfolio of mortgage assets, including interest rate, prepayment, credit, and mortgage spread risk. We believe our portfolio provides an opportunity for investors to participate in the RMBS market with less exposure to these risks, while still earning an attractive return.

Before turning the call back to Tom, I would like to conclude by discussing our recent capital raise. As noted earlier, Two Harbors completed a stock offering in April. We believe that the successful completion of the capital raise reflects investors' recognition of the opportunities that are present in the RMBS market today. The timing of the transaction, with the current market opportunities, corresponds well with our value oriented investment approach.

Although we are not prepared to discuss the details of the capital already deployed, we are pleased to report that we have deployed over half of the capital in line with our target allocations. As we mentioned on our road show, our capital has been allocated roughly 50% to both the agency and non-agency sectors. Given the opportunities we see in the market today, we expect the allocation to be similar as we move forward. We do plan to provide a portfolio update illustrating the use of proceeds at an appropriate time in the future.

Thank you very much for joining us today. I would now like to turn the call back over to Tom.

Thank you, Bill. As we met with investors, as part of our recent stock offering, we were encouraged at the reception that we received, in respect of our portfolio construction approach, risk processes, and investment team. Our discussion of how we balance opportunity and risks in the mortgage space truly seemed to resonate with people. We consider all of these factors as distinguishing strengths for Two Harbors and as integral parts for our ongoing success story. This concludes our prepared remarks. We will now open the call to questions. Chuck?

(Operator Instructions). And our first question comes from Mr. Trevor Cranston of JMP Securities. Go ahead, sir. Your line is open.

Hi. Thanks for taking a question. Can you help us understand a little bit more on -- you talked about the trade you made in the quarter selling the mezzanine bond and buying a senior. But can you help us understand what the other factors were driving the decline in the yield from 16% in the fourth quarter to about 10.5% in the first quarter? Just on the non-agency portfolio?

Yes, sure. Thanks, Trevor. Good morning.

Morning.

As you may recall from our initial earnings, we mentioned that the realized yield in the fourth quarter was largely due to the purchases of the mezzanine bonds at the very beginning, and -- which obviously have higher yields.

Yes.

And that the senior bonds we filled in during the course of the fourth quarter and then very early in the first quarter of 2010, and you -- so, obviously, the senior bonds with the lower yields would impact that. And the other things you'll note, as you'll see on slide six, is that the relationship of the size of the senior bonds to the mezzanine bonds is -- the senior bonds are dramatically higher, over four times as many. So it partly was due to timing of the purchases and when they settled in the fourth quarter, as well as the size of the seniors versus the mezzanine.

Okay. That makes sense. And also, can you -- it wasn't in the slide deck, but if you can, can you tell us how much leverage is on the non-agency portfolio at March 31?

I don't -- I actually don't think that we have broken that out. As we've mentioned before, we look at our leverage on an overall portfolio basis, and we were 3.4 times at the end of the -- 2009, 3.6 times at the end of March, and we're very comfortable with that overall leverage number.

Okay. That's all I have for now. Thanks for the question. Thanks for the answers. Bye.

Sure.

One moment for our next question. And our next question comes from Mr. Douglas Harter of Credit Suisse.

Thanks. I was wondering if you guys could talk a little bit about what you're seeing in the agency marketplace today. Sort of, as we're working through the GSE buyouts, what type of opportunities you see?

Yes, sure. Good morning, Doug.

Good morning, Bill.

Yes, it's -- with the exception of -- the last few days have been particularly interesting with the rally in Treasuries, given the selloff in the equity markets. Most spread products have sort of not moved that much. So I'll just give you, without addressing the last couple days, just an overall. Basically, we've seen mortgage spreads widen only modestly since the end of the Fed purchase program. So relative valuations are actually fairly similar to what we saw in the first quarter.

Agency ARM pools -- in general, we continue to like the seasoned story, which we've discussed before. We continue to see multifamily pools -- pools basically that have better prepayment protection or better convexity, I would say, still, to us, seem to be relatively attractive. The overall mortgage market, given its spreads, haven't widened dramatically. Still require searching for these kinds of stories, but we feel like we're pretty well set up to do that.

And then, I guess, in the past couple days, have you seen any sort of pullback on non-agency prices, sort of, given people's changing viewpoints on risk assets?

Interestingly, we haven't seen that yet. The market in the last couple days has actually traded reasonably well. I think that the general consensus, in talking to people, is that most participants would like to see a pullback to be able to buy bonds cheaper, but we haven't seen that yet.

And I guess, sort of, with capital to deploy, how do you go about, sort of, trying to find the balance between putting the money to work quicker versus the risk of a pullback?

Basically, if a security -- if we see a security that we find attractive and meets our targets, then we're happy to purchase that, and if we're not finding securities to our liking, then we'll just keep looking. If we don't see anything today, we'll look again tomorrow. As I mentioned, we've already deployed over half of the capital in the first few weeks, so clearly, we have found enough to our liking, but it's really a day to day thing. Some days you find something you like, and some days you don't.

Great. Thanks, Bill.

Thank you, ladies and gentlemen. (Operator Instructions). Our next question comes from Mr. George Bose of KBW.

Hey. Good morning. This is Bose George. How are you guys doing?

Hi, Bose. Good morning.

I've got a couple of questions. One was the -- I was wondering how much non-agency prices have gone up, quarter to date, and whether that's resulted in any change in how you guys could potentially deploy capital?

Since March 31, you mean?

Yes, since March 31. Yes.

Yes, we've definitely seen prices firmer, and I guess it depends on the security, clearly. So let me -- maybe I should express it in terms of yields, which might be -- I don't know if that will be more helpful or not, but it might be an easy way to think of it.

In the first quarter, we saw yields on the best bonds in around the 6% area all the way up to, sort of, double digit, plus or minus, and I would say since, sort of, mid first quarter to date the best bonds, meaning the very seasoned prime bonds, are trading somewhere in the 5% to 6% range, and the bonds that are at the top end of the yield spectrum, which are either some version of Alt-A, subprime, or Option ARM, are in the high single digits. So I would say that the ability to get 12% on a senior bond today is very, very unlikely, and in fact, I'd say over the last, say, six weeks or so, I think 100 basis to 200 basis point move, depending on the sector, is probably a good ballpark.

Okay. Okay, great. That's very helpful. And the second question I had was kind of unrelated to you. It's a more of a macro question, but it's something that came up on the Annaly call about amortization of premiums related to the Fannie Mae buyouts. And a, I was wondering, do you guys amortize that -- the March buyouts from Fannie Mae in March or April? And secondly, do you have a feel for how much of the Fannie Mae buyouts happened in March?

Yes. Thanks, Bose. The amortization we are -- you know what, I'm going to turn this over to Brad.

Good afternoon. It's Brad Farrell. The amortization as the buyouts occurred is really based on when the factors change on the individual bonds. We did, obviously, see quite a bit of that activity in March, which would be reflected in our amortization of premium, as the factors would have changed.

So would that be when -- because the factors you get in early April, so would that mean in April, or you run that through the March numbers?

We usually reflect that in the March numbers, depending on when those bonds have -- when the factor comes down and when the cash settlement occurs.

Okay. And then, just the another question do you guys have a feel for -- I mean, Fannie, when they put out their numbers initially, said they'd be buying, I think it was, 220,000 loans out of March. Do you have a feel for whether those kind of numbers were done, or you know any kind of market color on that?

Yes, Bose, I don't have the numbers handy, but I can tell you that, in general, the highest coupons were bought out in the front months. So basically, anything 6.5 or higher, by and large, were completely bought out in the first month, and it makes sense for Fannie Mae to buy the highest coupons out first, because it saves them more money. So they were going to work their way from high coupons on down, but I don't have -- I can get those for you after the fact, if you like.

Okay. Thanks very much for the color, and that was a successful quarter. Congratulations on the offering.

Thanks, Bose.

And at this time, I'm showing no further questions.

Chuck, if there are no further questions in the queue, I'd like to thank everyone for participating in today's call. Thank you. Good morning.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Have a great day. Thank you.