Two Harbors Investment Corp (TWO) 2011 Q1 法說會逐字稿

Good morning, my name is Mimi and I will be your conference facilitator. At this time, I would like to welcome everyone to Two Harbors' First Quarter 2011 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer period.

(Operator Instructions)

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

Thank you, Mimi, and good morning. Welcome to Two Harbors' First Quarter 2011 Financial Results Conference Call. The press release and financial tables associated with today's conference call was filed yesterday evening with the SEC. If you do not have a copy you may find them on the Company's website at www.twoharborsinvestment.com.

The call is also being broadcast live over the Internet and may be accessed on our website in the Investor Relations section under the Investor Presentations link. In addition, we'd like to encourage you to reference the accompanying presentation of this call. This presentation can also be found on our website.

Before management begins the discussion of the first quarter results, we wish to remind you that remarks 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, and are typically associated with the use of words such as anticipate, expect, estimates, believes, assume, project and should, or similar words.

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 obligation 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, and thank you to our audience for joining us for Two Harbors' first quarter earnings call. With me this morning to discuss our 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'd like to apologize for moving this call back by one hour today, as we know people are busy. However, it was due to a circumstance beyond our control, and we thank everyone for their patience.

For those of you with access to the slide presentation, please refer to slide three. During the first quarter, total comprehensive income was $31.5 million, or $0.69 per diluted weighted share. Book value increased 4.9% on a sequential quarterly basis from $9.44 per share on December 31st to $9.90 per share on March 31st, with roughly equal positive contributions from both our Agency and non-Agency allocations. This marked yet another quarter of book value growth for Two Harbors.

These increases have occurred over a variety of market conditions. We are pleased with this growing track record, which is a noticeable positive outlier in the sector. The environment was challenging during the quarter, given the uncertainties caused by the US debt conundrum and the tragic events in Japan. Despite the interest rate and credit volatility that this caused, our portfolio did quite well again. We feel the sophistication of our investment approach distinguishes us amongst our peers.

On March 2, we declared a dividend of $0.40 per share for record holders as of March 14. This dividend was unchanged from the prior quarter and represented a 15.3% yield on an annualized basis based upon our stock's March 31, 2011 closing price of $10.47. For the first quarter, we reported adjusted GAAP earnings of $0.39 per share, representing a 15.9% return on average equity on an annualized basis.

In February, Two Harbors transferred the listing of its common stocks to the New York Stock Exchange from the AMEX. This change helps liquidity and visibility of our shares.

During the first quarter of 2011, we completed an accretive secondary stock offering of 28.8 million shares for net proceeds of approximately $287.8 million. The successful completion of this offering benefits our shareholders in the form of increased share liquidity, a broader investor base and lower expense metrics.

Recent events have convinced us that the role of government sponsored enterprises such as Freddie and Fannie will not be as it was as we looking forward, effecting inevitably the mortgage and RMBS markets. The need for private capital will undoubtedly rise. Mortgage REITs are natural candidates to meet the needs created by these changes.

At Two Harbors, we spend the preponderance of our time on our goal of portfolio optimization, but we also have an eye to the future in the interest of our shareholders.

This concludes my opening remarks. I will now turn the call to Jeff to discuss our financial results for the quarter.

Thank you, Tom. I would like to at this time deliver some detail on the financial results and key earnings metrics for the quarter. Please refer to slide four of the presentation.

For the first quarter, Two Harbors' core earnings increased $4.9 million on a sequential basis to $14.8 million or $0.32 per weighted average share. This increase is primarily attributable to higher asset base resulting from the deployment of the December 2010 capital raise, which was completed during the quarter.

For the first quarter, the average investment portfolio was approximately $1.7 billion compared to approximately $1 billion in the previous quarter. Although reported yields came in line with our expectations, the earnings results of the portfolio were muted due to the timing around the deployment of proceeds from the December 2010 and March 2011 capital raises. Looking backward, we estimate that the aforementioned capital raises created a drag on core earnings by approximately $0.05 for the quarter.

Let us caution that the foregoing information should not be perceived as forward guidance, consistent with our reticent policy in that regard.

GAAP earnings for the first quarter increased $5.9 million on a sequential quarterly basis to $22.4 million, or $0.49 per weighted average share. Swaps and swaptions positively impacted the GAAP earnings as result of the change in interest rates we experienced in the quarter.

Adjusted GAAP earnings for the first quarter increased to $17.9 million, or $0.39 per weighted average share. During the quarter, Two Harbors realized gains on securities and other derivative instruments of $1.9 million. Bill will elaborate on this later in the call.

Please refer to slide five of the presentation. Two Harbors achieved another strong quarter in regard to comprehensive income. For the first quarter, the Company reported comprehensive income of $31.5 million, representing a 27.9% annualized return on average equity.

Book value increased 4.9% to $9.90 per share during the quarter. Approximately 75% of this increase came from the investment portfolio performance. The Agency and non-Agency portfolios contributed, as Tom mentioned, more or less equally on an absolute basis, with non-Agencies adding more on an allocated capital basis. The remaining 25% of the increase in book value was attributed to our accretive capital raise in March.

Our operating expenses ratio continues to improve as we grow our equity base. The operating expenses as a percent of average equity was 1.3% for the quarter. Due to timing and certain other considerations we estimate our operating expenses ratio to be in the range of 1.3% to 1.5%, respectively.

I would like to now turn the call over to Bill to discuss the portfolio in further detail.

Thanks, Jeff. At Two Harbors, we believe that book value preservation is essential to future dividend generation over time. With this in mind, we continue to construct a portfolio with the intention of delivering attractive dividends to our shareholders while maintaining or increasing the book value of our portfolio. As such, we continue to carry low interest rate exposure and moderate leverage. More on both of these items later.

Please refer to slide six. For the first quarter, Two Harbors reported an annualized yield on our average portfolio of 5.2% and all-in liability costs of 1.4%, which includes interest rate swap spread expense. Net interest spread came in at 3.8%.

Our net interest margin was slightly lower versus the fourth quarter as a result of carrying a portfolio weighted more heavily towards an Agency strategy. Our non-Agency yields reflect purchases from the December deployment at attractive but lower overall yields than our legacy assets. As you might expect, our portfolio yield, net interest margin and leverage, are determined by our asset mix and will change over time as our capital allocation changes.

Please turn to slide seven. During the quarter, the portfolio continued to shift in favor of the Agency strategy, reflecting our opportunistic approach towards investing. At March 31, the portfolio composition was $2.4 billion in agency securities, including inverse IOs and $525 million in non-Agency. This represents a percentage asset mix of approximately 80/20, favoring Agencies.

On the Agency side, we continue to focus on bonds with predictable cash flows, which we believe contributes to the sustainability of realized yields and increases the effectiveness of our hedging strategies. You will note on the bottom left that for the first quarter over 90% of our Agency securities had explicit or implicit prepayment protection or were discount bonds. The discount agency pool category is new this quarter, and was an attractive addition available during the first quarter sell-off in rates.

At this point, I would like to highlight two sectors we found particular value in during the quarter. As I've just mentioned, the first is discount pools. These are exclusively 15-year bonds, many of which are lower loan balance pools and where the average rate for the borrower is only 3.5%.

These bonds were bought at a discount and are expected to pay slowly. They likely will not extend any further in average life and fast pre-pays actually are a benefit for them. As such, we expect their cash flows to be very stable and for them to exhibit very little negative convexity. This asset now represents 26% of our Agency RMBS holdings.

Secondly, we found high LTV bonds to be attractive. These are pools where the borrower has just refinanced and the current loan-to-value is over 80% and in some cases, over 100%. Most of these borrowers came through the HARP program, and it is expected that these pools will also pay slowly. This is because there is likely no outlet for refinancing any time soon, given the high LTV of these loans and current Agency underwriting guidelines.

On the non-Agency side, our portfolio performed quite well during the first quarter. Reported yields were strong and the composition of the portfolio evolved once again as we opportunistically sold some option-ARM bonds to capitalize on the rally that occurred during the early part of the quarter. We've reallocated this capital into the subprime sector. As a result, the allocation of subprime bonds increased to 48%.

We continue to prefer lower dollar priced bonds as these are pools where we can typically be quite punitive as to defaults and losses and yet still have an attractive yielding asset.

Please turn to slide eight. There are a few items I would like to highlight on this slide. Agency securities we held as of March 31 continue to experience a favorable three-month CPR, with the first quarter registering in at 6.3%. We continue to be pleased with the stability of our Agency speeds, which allows for greater hedging efficiency. This has been a major contributor to our Agency strategy book value increase for the past three quarters.

In the non-Agency book, our securities experienced a three-month CPR of 3.4%. As in the fourth quarter, the speeds of subprime and option-ARM securities reflect seasonally low pre-pays as well as the slow down in servicer liquidations of bad loans.

Let's talk about interest rates and duration exposure for a minute. While we are not expecting any immediate change in rates it has been our experience that when rates do begin to move, they can move violently and it becomes too late to hedge your exposure. Consistent with our focus on preserving book value, we continue to maintain an overall low exposure to interest rate risk.

For the first quarter, as in the fourth quarter, the expected variance in equity value for an up 100, down 100 interest rate move was only 2.1%. Note that this is an equity value change over a 200 basis-point range and not an asset value change.

Please turn to slide nine. In addition to our use of interest-only products, a big part of our hedging activity is conducted using interest rate swaps and swaptions. As of March 31, Two Harbors carried an aggregate notional amount of $2.7 billion, of which $2.4 billion was used to hedge the repos for the RMBS books. There are two key takeaways from this slide.

First, swaps and swaptions will total over 90% of our anticipated borrowings after accounting for future settlements of Agency bond purchases. And second, swaptions, which is an optional form of rate protection, are a full 28% of our hedge book. This enables us to benefit if rates fall, but have protection if rates rise. Finally, our average pay rate on swaps is only 1.41%.

Please turn to slide ten. Total borrowings to fund our RMBS securities were $2.3 billion at March 31. Consistent with the prior quarter, we laddered our repo maturities and 42% of our maturities were greater than 90-days. Frankly, it just does not cost that much to extend repo maturities today, and it also provides protection against both higher rates and any funding market hiccups.

Diversification also remains a priority. We now have a total of 19 financing counterparties as a result of adding four new relationships since our last earnings call. In addition, we increased our Treasury interest-rate swap paired position from $200 million to $300 million, as a hedge to our aggregate funding cost of non-Agency bonds. To-date, this position has had a negligible impact on results as the funding market for non-Agency securities continues to be vibrant.

Please turn to slide 11. Before turning the call back to Tom, I would like to provide a few highlights regarding the deployment of proceeds from our March capital raise. I am happy to say that we have recently completed deployment of this capital, which is in line with our historical deployment experience of one to two months. Most bonds that we purchased will have settled by mid-May, although a small percentage will settle in June.

Upon receiving the proceeds in March, we plan for the capital allocation to be largely deployed into the Agency space. After deployment, our asset mix is roughly in the low 80s percentile in favor of Agencies, which results in an overall current capital allocation to the Agency strategy of about 65%. We expect that the increased allocation to the agency strategy from the March raise to result in a debt-to-equity ratio in the high fours.

Finally, as the government continues to shrink its involvement in the mortgage market over the next several years, we believe there will be terrific opportunities for Two Harbors. The good news is that this process will likely take many years to unfold, leading to a longer runway of opportunity for our investors. Our endeavor is to take advantage of the opportunities that arise and to continue to deliver strong returns overtime to our shareholders as the new landscape unfolds.

I would now like to turn the call over to Tom for his closing remarks.

Thanks, Bill. We are very please with our first quarter financial results. We hope this discussion has been helpful, and we thank you for your interest in Two Harbors.

We will be presenting at several conferences in the coming months. Next Monday, on May 9, we will be presenting at the 10th Annual JMP Securities Research Conference in San Francisco. Additionally, we will be presenting at the KBW Investment Management and Specialty Finance Conference on June 8. We invite you to attend our presentation if you are participating in those events.

With that, I will open the call to questions. Mimi?

Thank you.

(Operator Instructions)

Our first question comes from Bose George of KBW. Your line is open.

Hi. Good morning. Thanks for taking the call. Actually this is Ryan O'Steen on for Bose. Just a couple questions. First of all, just in regards to the allocation in the first quarter, did the increase in the discount Agency bonds -- is that something we could see going forward? I know you're going to take an opportunistic approach and I assume that kind of drove the lower cost basis in the first quarter. Has your outlook for purchasing higher premium bonds changed at all?

Yes, thanks for joining us today. As you mentioned we're actually opportunistic about what we purchase so it just so happened in the first quarter when we saw a sell off in rates, some of the lower coupons in the 15-year sector looked particularly attractive, which is why we added so substantially.

It's not that we dislike any other sectors it's just we're trying to buy what we think is the cheapest particular security at a given time. So I would say it's hard for me to predict. Certainly we've had a little bit of a rally here and there are less discounts available today than there were before. We're also fully deployed. But to the extent that valuations change and either high coupons or low coupons outperform, we might shift to different parts of the market.

Okay, thank you. And just another question on repo. It sounds like, just speaking with some of the other companies, it sounds like repo rates on Agency, on the Agency side, have dropped about five basis points. So is that something that you're seeing? And then, also, how have repo rates changed on the non-agency side, if at all?

Sure. Yes -- the first point relates to the change in the insurance premium that the FDIC charges banks. It use to be just on deposits and now it's on their whole liability structure. That has basically driven very short-dated repo and by that -- I mean, one month and in, on governments as well as Agency pools lower.

As you saw in slide 10, we're generally focused more on a laddered approach, which basically means that we have -- we don't focus just on the one month. So while some of our one-month funding cost has dropped slightly, it's only on a small percent of what we fund.

And then, on the non-Agency side, funding continues to be very plentiful. There are more dealers that have gotten into the market in the past quarter. That being said, I'd say haircuts and rates are roughly about where they were a quarter ago. So I'd say the average haircut is probably 30%, 35% and funding rates range from LIBOR-plus to 125 to 200, with the average sort of in the 150 to 175.

Great, thank you. And it looked like you added four counterparties during the quarter. Do any of those provide non-Agency repo?

I don't think we detailed the specifics of who provides what, but we have plenty of counter parties that do provide non-Agency repo.

All right. Thank you.

Thanks, Ryan.

Thank you. Our next question comes from Douglas Harter of Credit Suisse. Your line is open.

Thanks. Good morning. I was hoping that you could just talk a little bit about the hedge -- the swap position. Obviously you took it up to the 90% range. Is that a level that you would expect to sort of continue at going forward?

Yes, hey Doug. Good morning. Thanks for joining us. If you notice, basically our fixed rate percentage of our book went up quite a bit relative to adjustable. So as a result, we like to hedge that.

So you'll see that a few things occurred during the quarter. The IO products, that bucket went up quite a bit, as did our swaps and swaptions. So to the extent that we maintain a high level of fixed rate exposure -- in this case, as we mentioned, the 15-year discounts. We think it's appropriate to hedge those exposures. To the extent that it changes and we end up with a lot of adjustable rates then clearly it would make sense that our swaps and swaptions might come down.

Great. And then, if you could just touch on how the -- in the non-agency market, how it's handling the Fed sales of Maiden Lane?

Sure. They have about 31 billion notional -- total -- that they could sell. They've gone through a little over 15% of that so far. There was a big auction yesterday. I don't have the exact percentage handy but I want to guess it was about 80% of the bonds that have been out for bids or traded.

As they said, they're not forced sellers and their desire is to sell in the context of where the market is so the implication there is that the market is receiving the supply reasonably well to about -- call it -- I think it's 5.5 billion that's so far come to market.

Great, thank you.

Thanks, Doug.

Thank you. Our next question comes from Trevor Cranston of JMP Securities. Your line is open.

Hi. Good morning, guys. Good quarter. I was wondering if you could give any more details about any swaps or swaptions that you've added so far in the second quarter, given that it sounds like you've continued to add probably some more fixed-rate and discount pools with the capital that was un-deployed as of the end of the quarter?

Yeah, sure. Unfortunately, I can't give you any specifics today. But I think the way you want to think about it is -- if you note on the bottom of slide eight, and I think you're familiar with our position with regard to the exposure that we like to take on the interest rate side. We generally are maintaining a very low exposure to rates.

So to the extent that we add securities that have duration, it wouldn't be unreasonable to expect that we would have hedges that would be appropriate for those positions.

Could you tell us what you would expect the duration of some of the discount pools you added to be like?

If you went to Bloomberg and you put in a 3% 15-year coupon at a slight discount, you assume slow speed. I think you would come up with something that's in the five-year average duration range.

I don't have Bloomberg in front of me -- but you could do that or ask one of the people on the trading floor to do that and you'd come up with something that looks like that.

Okay. That's helpful. And then, last thing, can you just talk about, more generically, how you think about asset allocation going forward, if we continue to see spreads tighten in the non-Agency space -- like how high you'd be willing to go on the allocation towards Agency versus non-agency?

Sure. Well, basically it will certainly depend on what's available and where the market's trading. As we all know, the non-Agency distressed discount opportunities will ultimately go to zero because it's shrinking by about $20 billion a month and as these loans are liquidated or otherwise resolved at some point they're going to be gone.

In the short run, however -- and that's obviously going to play out over several years. In the short run, frankly, the fact that we saw a sell-off in rates, the curve was a little bit steeper and mortgages widened a little bit on the Agency side, was really sort of the attraction.

To the extent that non-Agencies suffer and widen and provide higher yields, we're not afraid to go either way. Now the question about how high would we go, I think that just depends on how sectors perform and where the opportunities are. We don't have any specific minimum or maximum.

Yes, as you know, Trevor, it's the beauty of the hybrid model. We can just go where the grass is greenest.

Yes. Okay. Thanks, guys.

Thank you, Trevor, and thanks for your kind words.

Thank you.

(Operator Instructions)

Our next question comes from Daniel Orlow of Orlow and Orlow. Your line is open.

Thanks for taking the call. I was wondering if you could give a little bit of color. I appreciate the comps that you laid out in terms of the slide chart. But if you were to try sort of look under the covers a little bit more and give us a little more of a granular mathematical understanding of why your risk profile is so different from your peers? Is there anything you could add other than what you've laid out in the presentation?

A second question is, as you think about the agencies, do you have a view -- and this is a much more philosophical question, I guess -- around what do you think will happen with FHA and FHA available inventory? Thanks.

Hey Dan. Thanks for joining us. This is Bill. I can't speak to other firm's strategies. It's been our experience that mortgages involve a number of risks, which you're well aware of -- the duration risk, pre-payment risk and convexity risk. And the key to performing over different cycles and over time is hedging those risks. So our security selection strategy specifically focuses on stable pre-payment bonds because that minimizes the variability and the convexity. And then the rate component is addressed with the IOs and the swaps and swaptions.

I can only speak to that's the way we think about it. But I can't speak to the way other firms posture themselves.

Do you feel that you're still finding attractive places to pick up nominal gamma exposures at attractive price points that give you more comfort with your convexity exposure?

In mortgage land, inevitably you're selling options to drive your yield. So to the extent that we can buy some of those back attractively, we've done that.

Yes, as a broad statement, we just think that the way that we look at the world from our security selection process, the ability to be a niche player and the sophistication of how we pick securities and how we hedge those securities, we think that sets us apart from the competition.

One of the manifestations of that, we feel, is just that we feel that there's less risk within the portfolio and yet we're able to drive a dividend and maintain our increased book value. So it's -- that's how we think about it. Obviously, we use securities and hedging techniques that aren't common, broadly through the RMBS REIT space.

For instance, we use swaptions, which is relatively rare. We use IOs, which are very, very rare. Inverse IOs, which are very, very rare -- rarely used, et cetera. And so that and our security selection, on both the Agency and non-Agency side, lets us mitigate the risk that Bill identified on the Agency. And obviously, also guides use with regard to credit risk on the non-Agency side.

And then, regard to your second question --

Do you think that optionality is fairly reflected -- I realize everything is sort of marked as it is. But do you think that that -- I'm going to say, equity value in the franchise is properly carried? Because it's such a -- it seems you do it very well and it seems like there isn't any supply risk for you. So your ability to continue executing against that strategy seems to have a durational value?

Well, that's a big question and I don't know that I have a great answer to it. Yes, we feel that the way we look at the world is somewhat different and we believe that we drive alpha through the portfolio.

Our experience in book value over the past several quarters has set us apart from the competition. Whether or not the market gives us credit for that I guess is a pretty subjective consideration. But thanks for the compliment.

Well, in terms of FHA, do you have any observations?

Yes, Dan, can you remind me -- we spent a little time on this. Could you restate the question?

Yes, sure. A fair amount of lending activity went into the FHA coffers, even as the GSEs were sort of withdrawing capital from the market. And I'm wondering if that is going to create another area of growth potentially? FHA is going to have to start managing those credits appropriately.

Well, yes. And we started to see that. You touch on something that's clearly noted in the volume of their business. But one of the things that we've seen is - over the last I want to say nine months, roughly, we've seen them raise their insurance fees several times.

So their experience with some of the loans that did come through the door hasn't been that great on the credit side. So they've sort of adopted -- they've gotten a little bit of religion on their insurance side and basically changed their pricing.

So, I think what you'll see is you'll definitely see certain vintages of Ginnie Mae pools have higher defaults than would have been expected before this. But I think that the volumes that they're seeing now are going to be lower, and I think the credit quality will generally be better.

Thanks for joining us.

Thanks for having me.

Thanks, Dan.

Thank you. Our final question comes from [Donald Golberd], private investor. Your line is open.

Yes, thank you. I'm just an average investor. I bought your stock when it was over $11.00 a share and I'm questioning my decision. I've been an investor for many years and I never saw a company do public offerings as fast as you folks are doing them and I was curious as to what your thought process is on doing these public offerings?

It seems there will never a shortage of shares or demand for shares in your company, and apparently any time the stock is above book value you may consider and do a public offering. So that's my question. What criterion do you use in deciding to do an additional offering?

Sure. Thanks for your question. We've stated in the past, and it is the mindset of management that any capital rate has to jump over two hurdles. The first one is there must be a very compelling investment case for any incremental capital that -- we think that it has to be an attractive risk for reward scenario for our shareholders.

Firstly, if that's not present we will not raise additional capital. Secondly, any additional capital raises have to be good for our existing shareholders. And what I mean by that is there are clear benefits to a bigger share count which is that it lowers our expense metric, which is a very tangible benefit to shareholders and increases the liquidity of our shares and increases our investor base -- all of which reduces the volatility of our shares. And so, we think of those things as very tangible benefits to shareholders.

All that being said, we may or may not raise capital in the future, but it must meet those two tests, otherwise we will not raise additional capital.

Okay. Thank you.

Thank you.

I'm showing now further questions in the queue. I'll hand the call back over to our CEO, Tom Siering.

Well, thank you very much for joining us today. We hope this was a benefit to our listeners. We thank you very much for your consideration of Two Harbors, and have a great day. Good day.

Thank you. Ladies and gentleman, this concludes the conference for today. You may all disconnect, and have a wonderful day.