Two Harbors Investment Corp (TWO) 2018 Q1 法說會逐字稿

Good morning. My name is Carmen, and I will be your conference facilitator. At this time, I would like to welcome everyone to Two Harbors First Quarter 2018 Financial Results Conference Call. (Operator Instructions) I would now like to turn over the call to Maggie Field with Investor Relations for Two Harbors.

Thank you, and good morning, everyone. Thank you for joining our call to discuss Two Harbors' First Quarter 2018 Financial Results. With me on the call this morning are Tom Siering, our President and CEO; Brad Farrell, our CFO; and Bill Roth, our CIO. After my introductory comments, Tom will provide an overview of our quarterly results, Brad will highlight key items from our financials, and Bill will review our portfolio performance. The press release and financial tables associated with today's call were filed yesterday with the SEC. If you do not have a copy, you may find them on our website or on the SEC's website at sec.gov. In our earnings release and slides, which are now posted in the Investor Relations section of our website, we have provided a reconciliation of GAAP to non-GAAP financial measures. We urge you to review this information in conjunction with today's call. I would also like to mention that this call is being webcast and may be accessed on our website in the same location.

Before I turn the call over to Tom, I would like to remind you that remarks made by management during this conference call and the supporting slides may include forward-looking statements. Forward-looking statements are based on the current beliefs and expectations of management, and actual results may be materially different because of a variety of risks and other factors. Such statements are typically associated with the words such as anticipate, expect, estimate and believe or other such words. We caution investors not to rely unduly on forward-looking statements. Two Harbors describes these risks and uncertainties in its annual report on Form 10-K for the fiscal year ended December 31, 2017 and in other filings that it make or may make with the SEC from time to time, which are available in the Investor Relations section of Two Harbors' website and on the SEC's website at sec.gov. Except as maybe required by law, Two Harbors does not update forward-looking statements and expressly disclaims any obligation to do so.

I'd also like to inform you that in connection with the proposed merger between Two Harbors and CYS Investments, Inc., Two Harbors and CYS will file with the SEC a registration statement for the transaction, which will include a joint proxy statement relating to the shareholder meetings of Two Harbors and CYS Investments. This registration statement and joint proxy statement will contain important information about the transaction. Investors are urged to read these materials when they become available.

I will now turn the call over to Tom.

Thank you, Maggie, and good morning, everyone. We hope that you had a chance to review our earnings press release and presentation that we issued last night.

Please turn to Slide 3, as we take a moment to review our results. At March 31, our book value was $15.63 per share, which represented a negative 1.3% total return on book value, inclusive of our $0.47 quarterly dividend. Our book value declined quarter-over-quarter primarily due to spread widening in the latter half of March and higher coupons, especially specified pools. Bill will detail this further in his remarks. Beginning this quarter, we will report core earnings, including TBA dollar role income. As Brad will discuss shortly, we believe this metric is a better representation of our underlying earnings power and provides our stockholders with greater transparency. Core earnings, including dollar role income, was $0.48 per basic share in the first quarter, in line with our projections when we declared our quarterly dividend.

On April 26, we announced our proposed acquisition of CYS Investments, Inc. As we turn to Slide 4, I'd like to highlight some of the details of this transaction and why we believe this will be beneficial to our stockholders. As we stated on the joint conference call with CYS, we expect this transaction to close in the third quarter. After the transaction closes, we expect to reallocate the capital from CYS' portfolio into our target asset classes. In 2019, we anticipate that the combined company's capital allocation to Agency's MSR and credit will look substantially similar to how Two Harbors looks today. Bill will highlight this in further details in his remarks.

Furthermore, the combination of Two Harbors and CYS should create operating cost efficiencies, lowering our other operating expense ratio by approximately 30 to 40 basis points. This transaction represents a unique opportunity to create value for our stockholders. We believe our stockholders will benefit from the enhanced scale and liquidity of the combined companies, including a larger capital base that supports continued growth in our target investments. As we anticipate improved agency spreads in 2018, we believe this deal could be accretive to our earnings and endorses the capital raising attendant to this transaction. Importantly, as we stated on our joint conference call with CYS, we expect to maintain our quarterly dividend of $0.47 per share through 2018, subject to market conditions and the discretion and approval of our Board of Directors.

Please turn to Slide 5. The foundation of our success in 2018 and beyond is rooted in our key areas of focus, each of which supports our overall goal to provide book-value stability through a variety of interest rate environments. Following the close of the proposed merger, we believe the larger combined company will enhance our ability to deliver strong stockholder returns.

I will now turn the call over to Brad for a review of our financial results.

Thank you, Tom. Turning to Slide 6. Let's review our quarterly results. We incurred a comprehensive loss of $23.7 million or $0.14 per basic share, which represented a return on average common equity of negative 3.3%. Our book value at March 31 was $15.63 per share as compared to $16.31 in the fourth quarter. After accounting for our first quarter dividend of $0.47, we incurred a negative return on book value of 1.3%.

As we turn to Slide 7, let's review our core earnings results. As Tom mentioned, beginning this quarter, we will report core earnings, including dollar role income. In the first quarter, our investment team chose to take a net long position in TBAs rather than agency pools for various liquidity, hedging and leverage benefits. Historically, we did not view our TBA investment activities as meaningful enough to include. Additionally, our ability to invest in more significant TBA exposure over time benefits from our recent receipt of a tax opinion that allows us to hold these investments in the REIT and avoid any tax friction. As a result of these factors, and our view that TBAs will continue to be a part of our investment strategy over time, we believe that net TBA dollar role income, combined with our core earnings, is a meaningful indicator of our underlying earnings in 2018 and going forward. Core earnings of $0.46 per basic common share plus dollar role income of $0.02 combined for $0.48 on the first quarter, representing a return on average common equity of 11.8%. Our earnings were driven by MSR portfolio growth and additional servicing income, combined with slower prepayment speeds. Additionally, our earnings benefited from favorable spread income on our swaps due to increases in LIBOR. This was offset by increased financing expenses on agencies as well as higher servicing expenses due to some seasonal adjustments and higher other operating expenses. Our other operating expense ratio, excluding noncash LTIP amortization, was 1.4%, up from 1.1% in the fourth quarter. These higher expenses were driven primarily by brokerage and trading fees through the active management of our hedging position to protect book value in a changing rate environment.

As we turn to Slide 8, I'd like to highlight some of our accomplishments in the first quarter with respect to how we've optimized our financing profile to benefit future earnings performance. Our debt-to-equity ratio was 5.9x at March 31, unchanged from December 31. We are comfortable with this level of debt to equity and maintain plenty of liquidity to take advantage of market opportunities as they arise in 2018. The repo markets have continued to function efficiently for RMBS, with new counterparties entering the market. We believe that our diversified financing profile, and more specifically, recent positive changes in the non-Agency and MSR financing space will be positive to our future earnings performance.

As we noted on our fourth quarter earnings call, we have seen the repo market for non-Agencies become more competitive recently, resulting in improvements in advanced rates and spreads. We're consistently seeing spreads offered between 100 to 125 basis points over LIBOR, whereas a year ago, these spreads were approximately 150 to 175 basis points. We expect this positive trend to continue in 2018.

In the first quarter, we increased the capacity of one of our MSR financing facilities that we announced in the fourth quarter by $100 million, bringing the facility's total capacity to $400 million. As of March 31, we had $250 million outstanding on this facility. As a reminder, this facility finances Fannie Mae MSR collateral and offers 3 distinct competitive advantages: first, MSR financing allows us to generate incremental MSR returns on a levered basis; second, the multi-year financing term is at a favorable spread to LIBOR of 225 basis points; third, and importantly, the facility features 2-way margining. The 2-way margining feature allows us to better manage our liquidity in a changing interest rate environment, such as the first quarter when we experienced increases in the value of our MSR collateral. We continue to advance other MSR financing discussions, focused on substantially similar terms.

I will now turn the call over to Bill for portfolio update.

Thank you, Brad, and good morning, everyone.

Please turn to Slide 9. As of March 31, our investment portfolio was $22.4 billion, with substantially similar capital allocation as last quarter. 69% of capital was allocated to our rate strategy and 31% to credit.

Let's turn to Slide 10. As Tom noted in his remarks, we are excited about the investment opportunity presented by our proposed acquisition of CYS. We believe that the additional capital will support continued growth in our target assets and allow us to take advantage of market opportunities as they arise. I would like to highlight two key strategic portfolio considerations related to this acquisition. First, we intend to reallocate the capital from CYS' current portfolio into Two Harbors' target assets. As we execute on this plan, we anticipate that approximately 50% of our capital will be allocated to MSR and credit, which leads to roughly the same capital allocation that we have today. We expect to reach this target allocation in 2019. Second, upon closing, we intend to have a similar hedging strategy that is in line with our current low level of exposure. As we have emphasized frequently over the years, one distinguishing factor about Two Harbors is our acute focus on protecting book value, and part of this involves not taking undue interest rate risk.

Moving to Slide 11. I'd like to switch gears to discuss some of the drivers of our portfolio performance in the first quarter. Our net interest spread was 1.93%, down slightly quarter-over-quarter. In our rate strategy, our hedges in MSR performed as we expected them to in a rising rate environment. However, in the latter half of the quarter, as agency spreads widened, higher coupon agencies, particularly specified pools, underperformed lower coupon agencies. While the impact of interest rate in mortgage spread moves on our book value was consistent with our estimations from the fourth quarter, the underperformance of higher coupon agencies and specified pools, which is the majority of what we own, led to a further diminution of book value. On the other hand, residential credit continued to perform well, with spreads generally stable. As to performance so far this quarter, we have seen a modest reversal of the underperformance of both higher coupons and specified pools. In that light, despite interest rates being up over 25 basis points in April, our book value, after accruing for the dividend, is roughly flat since quarter-end.

As we move to Slide 12, let's discuss our rate strategy. Our agency position didn't change substantially, and we ended the quarter with approximately $18 billion of agency pools and $450 million net long TBAs. As Brad mentioned in his remarks, we use TBAs as both a pool of substitute and to manage our overall portfolio positioning. Going forward, we don't expect our TBA position to be a material part of our investment strategy unless the roles become very special.

With respect to MSR investment activity, we added $13.6 billion UPB through both a bulk purchase and our monthly flow sale arrangements. MSR is now about 20% of our equity capital allocation, and we expect that this allocation will remain similar, as we redeploy capital following the closing of the merger with CYS. Over the long term, we expect the amount of capital allocated to MSR will continue to grow. MSR is a key component of our hedging strategy, driving strong returns, while mitigating both interest rate and spread risk. This segues into our discussion about our current risk positioning, highlighted on Slide 13.

We continue to maintain a prudent approach to interest rate and spread exposure by actively managing our hedge positioning, utilizing a variety of tools, including swaps, swaptions and MSR. We believe that we will be able to continue to minimize book-value volatility. Looking at the left-hand side of this slide, you can see that in the rates up 25 basis points scenario, we expect that our book value would increase by 0.7%. On the top right-hand side of this slide, you can see that our net interest income would decline by 1.6%. We anticipate that both of these exposures will continue to be in a relatively neutral position. And as I mentioned earlier, we intend to maintain similar positioning after we close the CYS transaction.

Turning to net income exposure. A key contributor to our net income stability is MSR float income, which increases in value when rates rise. Consistent with the rise in short-term rates in the first quarter, our float income increased to $4.4 million compared to $1.1 million for the first quarter of 2017. We expect that for every 25 basis points increase in short-term rates, we would make an additional $3.2 million of income annually, which help stabilize our income as short-term rates move higher. Finally, from a spread widening perspective, you can see on the bottom of this slide that if agency spreads widen 25 basis points, we would expect our book value to be down by a relatively small 3.8%.

Moving to Slide 14. Let's discuss our credit strategy. Residential credit performed well, generating a positive return each month of the quarter. On prior earnings calls, we've highlighted the benefits of our credit strategy to book value and often get asked the question if there are opportunities to add more of these deeply discounted legacy assets at attractive levels. The answer to that is, yes. We continue to find and add to our portfolio non-Agency bonds that we think generate low- to mid-double-digit total returns. Importantly, this is in the absence of any real dislocation in the credit markets when we believe there would be an even greater opportunity to add legacy non-Agencies.

Additionally, as Brad mentioned in his remarks, improvements in financing for legacy non-Agencies has allowed us to allocate capital to our credit strategy in a much more efficient way. At a higher level, residential credit continues to benefit from fundamental improvement in the housing market, including re-equification by borrowers, resulting in increased prepayments, lower loan-to-value ratios and fewer delinquencies, defaults and severities. As an illustration of how that helps drive strong returns, let's take a look at the bottom left of this slide. Our current portfolio LTV is around 70%. If we apply assumptions of 3% HPA per year in the base case and 6% per year in an upside scenario, you can see that our LTV can drop substantially over the next 3 years- in the upside scenario, to 53% this would lead to lower defaults and losses. As you can see on the bottom right of this slide, subprime non-Agency CPRs also continue to increase. This clearly benefits our deeply discounted bonds. We believe these positive tailwinds can benefit our credit strategy by driving bond prices higher and generating strong total returns, benefiting our book value going forward.

I would now like to turn the call back to the operator for Q&A.

(Operator Instructions) And our first question is from the line of Bose George with KBW.

In terms of the timing for reaching the allocation of post-deal -- getting the allocation back to where it was pre deal. I'm just curious, in terms of asset classes, like MSRs, where it might be harder to ramp up, I mean, could we see more, sort of, bulk purchases? And also, just in terms of the timing, the 2019, is that, like, beginning of the year, end of the year or is that -- any sort of time line, a little more specific time line would be great.

This is Bill. So we said on our call last month that we estimated around 6 months to get back to our current -- roughly, our current allocations, and that's 6 months from closing. So it's a little hard to tell exactly when in 2019, but, obviously, we'll know more as we get closer to that. In terms of servicing, we've been continuing to grow our servicing book, both through flow and bulk. The bulk opportunities this year have been running very strong at over $100 billion on an annualized basis. As you know, we closed a decent-sized deal in the first quarter, and we continue to look at those opportunities as they come about. So I would say that we're pretty excited about that. I think the main point is, I mentioned earlier, is we expect to look substantially the same as we do now, roughly 6 months after closing.

Okay, great. Makes sense, thanks. And then, actually, one clarification on Slide 13 when you show the spread impact. You show the agencies, the MSRs. It doesn't mention credit. Is credit sort of expected to be neutral in this scenario?

Yes. We're just trying to isolate -- that's correct, we're trying to just isolate the sensitivity to agency spreads. And what we've seen in the last 6 months to 12 -- 2 years, as agency spreads have widened and tightened, non-Agencies, especially the legacy don't seem to have moved when agencies move. So we're just trying to isolate that.

Okay, makes sense. And then, actually, one more just back on the deal. The pro forma book value for the deal, is that roughly stable?

Sure. Good morning, Bose. This is Tom. So Bill made the comments on our book value in respect of what the ultimate consideration is. It'll be a function of the book values of the respective companies at the time the exchange consideration is set.

Yes, and one comment, we noted in our kickoff on the announcement that we would expect it to be less than 2% dilution, it was made -- noted in the public domain. Given the relative benefits, we wanted to comment on that.

Our next question comes from Rick Shane with JPMorgan.

Your presentation answered a lot, and the time line to deploying or redeploying the capital after the acquisition is helpful. I am curious about one thing. Presumably given liquidity and the need to or desire to be fully deployed following the acquisition, I'm assuming you would be relatively over concentrated in rate strategy, as you redeploy the capital. I want to understand how we should think about the hedging strategy during that period because, presumably, you will need to add some relatively long-duration swaps. And then, we will be in a position, once you redeploy, where those swaps are still in place. Help us understand, sort of, the implications of that or how you mitigate during that 6-month window the risk from a rate shock?

Yes, sure. Rick, thanks for joining us this morning. So I think there's a couple of different parts to that. I think the first thing is CYS is -- they are managing their book right up until the deal closes. And, I think the -- so that's their thing. And then, one of the things is -- one of the considerations is what the exposure is when the deal closes, which, obviously, we don't know what that is today. But let me talk about the -- our philosophy is basically that we don't, as you know, tend to take much interest rate risk, and our rate -- our intended rate exposure will be similarly low, both before the deal closes and after the deal closes. So right now, we're seeing agencies hedged with interest rate products, roughly around the 10% area. So we'll have to see what the CYS book looks like when the deal closes, and we'll have to just adjust from there. But basically, we have been growing our MSR and credit book all along, and we intend to continue to do that right up until close. So you can expect those allocations to move higher then you'll see things drop down and then they'll move back up higher over time. I think the main thing is that whatever the combined position is at the close, we will be making sure that we're maintaining the same low level of rate exposure that we have today as well as historically.

That's very helpful. And actually, it probably suggests how correctly and incorrectly I'm looking at this, which is, I was thinking about this almost exclusively from the acquisition of capital, but I -- and ignoring the fact that you are, in fact, acquiring assets that are coming on hedged. And so the differential between how you might hedge those assets and how the CYS team might hedge them is probably not as -- is narrow or gap that I'm giving a credit for.

Okay. I think that's right. So -- this is Tom. The punchline is, you shouldn't expect our interest rate exposure to look measurably different at post-closing than it looks today.

Our next question is from Fred Small with Compass Point.

Just following up on Bose's question. The 2% or under 2% dilution on the -- following the deal, is that -- you're confirming that or that's still the case, that's still your current thinking?

Yes. It will be very close to that we believe, yes.

Okay. And then on the -- you mentioned that the financing cost of the repo market for non-Agencies has become more favorable over the past few months or the past year. What's driving that?

Yes, basically -- I'm sorry, go ahead, Brad.

Yes, I think it's a combination of factors. One, it's, to a certain degree, the focus of lenders moving toward, kind of, higher spread products, combined with more comfort in those asset classes. As home prices improved, credit has stabilized employment metrics. So I think it's a combination of the meaningful lenders moving toward that because of various regulatory requirements as well as getting comfortable at the asset classes. And then, other more competition coming into the space as well. So with all things combined, we're seeing, and just sort of be rightfully so, the spreads have not really come in for quite some time as we saw the growth in the valuation of those products. The market is, kind of, adjusting and catching up for that, kind of, in the past 6 months.

Yes, to add to what Brad said, Fred, one of the chief determinants of the spread and financing has to do with the volatility of the assets. Non-Agencies have gone through quite an evolution in the last 4 or 5 years to where they're much more stable from a price standpoint and with good reason, because the underlying fundamentals have been rock solid, I mean, to the extent that there have been surprises, given surprises to the upside. So it's all the things that Brad said. But the price volatility of non-Agencies has become very muted over time.

One thing that I wanted to clear up, you wrote a note in respect of the merger. To remove any ambiguity, CYS -- Kevin said on our joint call, CYS had received an unsolicited inquiry from a third-party but that third-party was not us. We were brought into the process, ex-post that and the details of this will be outlined in a much more wholesome way in the proxy statement.

Okay, awesome. That's helpful. Then on just, I think, it's Slide 13 where you go through the sensitivities. I guess, just in terms of the sensitivities to book and to net income, how do you anticipate those will shift following -- at the time of the acquisition or shortly following?

Yes, this is Bill again. Yes, so I think we mentioned that our primary focus is to maintain, not just now but post-acquisition, very low exposure to both metrics. Now obviously, those will move around as the market changes and our hedge positions change. But you can expect that these numbers will remain fairly low, not only now until the closing but post closing as well.

Okay, got it. Is there any, sort of, minimum that you're trying to keep them to or trying to manage to through the process versus where they are now?

No, not necessarily. I mean, obviously, a lot depends on the market and what's going on in the economy and our general overall views. I mean, I think you've followed us for a long time, as some of the others on the call have. We generally are not inclined to take a lot of interest rate exposure, but sometimes those numbers are a little bigger than you see on the page today. It just happens. We're in an environment where the fed is raising rates. The economy is doing well, and there could be continued upward pressure on rates. So we feel particularly compelled to make sure that these numbers are pretty darn small for the time being.

Our next question is from Doug Harter with Crédit Suisse.

Bill, can you talk about your comfort and the ability to find enough attractive credit assets post the merger close to get to your target allocation?

Yes, sure. Thanks for joining us. Yes, look, we're primarily, as you know, focused on the deep discount legacy assets. And if you look in the presentation at slide, I think, it's 14, if you think about how long these assets have been out there, the -- you talk about 10, 12, 15-year old loans. Housing -- between all the tailwinds we discussed, if you think about on a forward basis, what the scenarios are going to look like, we're still very bullish on this factor. Now in terms of supply, this is still -- I think, it's north of $500 billion of this stuff that's still out there. There are a lot of bonds that are still at deep discounts. And frankly, we've been buying monthly a decent amount of -- over the last year, in fact, recently, in the last few weeks, we've added a reasonable amount as well. And these are assets that are still deep discounts with the upside that we talked about. So I'd say that we're pretty confident that we're going to be able to add enough assets to get back to where we are today and, potentially, further. And the other comment I made on the call is we haven't really seen any big credit dislocations recently. And to the extent that, that happens and these things widen out, that would be really a great opportunity to add in decent size, and we did that both in 2017 and 2016 in two different periods where that occurred. Hopefully, that's helpful.

That is, thank you. And Brad, can you just talk about the expectations for the nonmanagement fee expenses? So those remain elevated or will that likely come back down to kind of where it has been trending?

I'm sorry, can you repeat the question? I'm not quite sure if I understand about the management fees.

The non-management fee expenses.

Oh, the non-management fees. Okay, I misheard you. I think we've said previously that if you exclude the LTIP, we anticipate to run between 1.1% and 1.4%. I think Q4 was a little bit on the low end for various reasons, kind of, year-end is a little bit light on transactions, et cetera. If we anticipate being active in our volatility and hedging practices, which we would expect as well as active in the MSR bulk and pursuing opportunities such as that, it would likely be on the higher end of that range, possibly not as high as this quarter. So I would, kind of, steer you toward the higher end of that. But obviously, a lot of uncertainty as we navigate to protect book value and grow the portfolio. And then, as we commented the post-close, we would anticipate taking those numbers and reducing about 30 to 40 basis points, which is also consistent with that philosophy I just mentioned. Hopefully, that answers your question.

And ladies and gentlemen, I'm not showing any questions in the queue. I will turn the call back to Mr. Siering for concluding comments.

Thank you, Carmen, and thank all of you for joining our first quarter conference call today. We are very excited about the opportunities that help Two Harbors and the potential to drive enhanced value for our stockholders. We look forward to keeping you updated. Have a wonderful day.

And with that, ladies and gentlemen, we thank you for participating in today's conference. This concludes the program, and you may all disconnect. Have a wonderful day.