Two Harbors Investment Corp (TWO) 2024 Q1 法說會逐字稿

Good morning. My name is Jennifer, and I will be your conference facilitator. At this time, I'd like to welcome everyone to Two Harbors first-quarter 2024 financial results conference call. (Operator Instructions) I would now like to turn the call over to Ms. Maggie Karr.

Good morning, everyone, and welcome to our call to discuss Two Harbors' first-quarter 2024 financial results. With me on the call this morning are Bill Greenberg, our President and Chief Executive Officer; Nick Letica, our Chief Investment Officer; and Mary Riskey, our Chief Financial Officer.

The earnings press release and presentation associated with today's call have been filed with the SEC and are available on the SEC's website as well as the Investor Relations page of our website at twoharborsinvestment.com. In our earnings release and presentation, we have provided reconciliations of GAAP to non-GAAP financial measures, and we urge you to review this information in conjunction with today's call.

As a reminder, our comments today will include forward-looking statements, which are subject to risks and uncertainties that may cause our results to differ materially from expectations. These are described on page 2 of the presentation and in our Form 10-K and subsequent reports filed with the SEC. Except as may be required by law, Two Harbors does not update forward-looking statements and disclaims any obligation to do so. I will now turn the call over to Bill.

Thank you, Maggie. Good morning, everyone, and welcome to our first quarter earnings call. Today, I'll provide an overview of our quarterly performance, then I will spend a few moments discussing the markets and finish with an update on round point operations. Mary will cover our financial results in detail, and Nick will discuss our investment portfolio and return outlook.

Let's begin with slide 3. Our book value at March 31, increased to $15.64 per share, representing a positive 5.8% total economic return for the quarter. Our results were driven by the performance of our RMBS portfolio in a declining volatility environment and MSR, which experienced slower than expected prepayment speeds. MSR continues to benefit our portfolio with a very attractive yield combined with limited prepayment risk and low interest rate sensitivities. As we have previously emphasized, our high capital allocation to MSR acts as a balance to our portfolio when agency spreads fluctuates. I'm confident that our portfolio design and current allocation between MSR and agency RMBS positions us well for what we expect to be a higher for longer interest rate environments.

Please turn to slide 4 for a brief discussion of the markets. Stronger than expected economic data and sticky inflation readings pushed interest rates higher in the quarter and led the market to the realization that higher for longer rates is the most likely path. Employment report came in stronger than expected in each month of the quarter, averaging gains of 281,000 new jobs per month. Similarly, both consumer and producer price indices surprised higher with three-month annualized core CPI and metric closely watched by the market and the Fed, reaching 4.5%, its highest level since June 2023, as seen in figure 1. At the start of the year, Fed funds futures implied more than six interest rate cuts in 2024. So by quarter end, that number had fallen to just under three, as you can see in figure 2. Sentiment continues to evolve and following the Fed's mid-April meeting, those expectations had fallen to about 1.3 interest rate cuts for 2024.

Please turn to slide 5 for a brief discussion on RoundPoint's operations. We completed the 10th transfer of our servicing to RoundPoint's platform on February 1, and we have one final transfer of approximately $52,000 loans in early June, as shown in figure 1. We are still in the early stages of building our subservicing platform. And in the quarter, we added one new subservicing clients. We expect to transfer in approximately $17,000 loans from this client in the near term. We are continuing to build out the team and supporting infrastructure for our direct-to-consumer recapture originations channel, and we still expect to begin taking locks in the second quarter.

This direct-to-consumer portfolio retention business should be thought of as a way to hedge faster than expected prepayment speeds in a refinance environments. Though that may seem distant, we intend to offer ancillary products, including second-lien loans to our customers in the meantime. The ability to build this critical piece of our servicing business from scratch without any legacy issues or risks is exciting and something that few companies have the opportunity to do.

Institutional demand remains high for investors who are looking to participate in the MSR market, given the never-before-seen risk profile of the current servicing universe, with the majority of outstanding MSR being hundreds of basis points away from an economic incentive to refinance. Given our deep expertise as an MSR investor, we believe that we are the ideal partner to service MSR for this new capital, and we are actively working on the ability to support various structures.

With over 60% of our capital allocated to servicing and the remaining 40% to securities, we believe that we are positioned to benefit in the current market environment and beyond. Our high allocation to MSR means that our portfolio is less exposed to fluctuations in mortgage spreads than portfolios without MSR. And we believe that this is an attractive position, particularly amid uncertainty over the future paths of Fed actions or inactions, interest rate volatility, and mortgage spread performance.

In addition, owning an operating company allows us to significantly impact our results through our own actions in a way that's not possible and only owning a portfolio of securities. Our future success will be determined by remaining discipline and sticking to our areas of expertise, managing interest rate and prepayment risk. With that, I'd like to hand the call over to Mary to discuss our financial results.

Thank you, Bill, and good morning. Please turn to slide 6. Our book value increased to $15.64 per share at March 31 compared to $15.21 at December 31, including the $0.45 common dividend results in a quarterly economic return of positive 5.8%. As a reminder, total economic return is the primary metric we consider as an indicator of our performance. We repurchased approximately 485,000 shares of preferred stock in the quarter, lowering the ratio of preferred stock to total equity.

Please turn to slide 7. The company generated a comprehensive income of $89.4 million or $0.85 per weighted average common share in the first quarter. MSR values increased during the quarter on higher rates and spread tightening, offset somewhat by the RMBS allocated as a hedge. RMBS values decreased as a result of rate movement, more than offset by gains on swaps and futures, which is consistent with the mortgage spread tightening that we've observed in the quarter.

Net interest expense of $42 million was favorable $3 million to Q4 from lower average borrowing balances and lower cost of funds, partially offset by lower RMBS interest income from net sales. Net servicing income of $159 million included $134 million of servicing fee income and $32 million of float and ancillary income, offset by $7 million of third-party subservicing fees and other MSR related servicing costs. Overall, net servicing income was unfavorable to Q4 by $7 million on lower float income due to seasonality of escrow balances and lower servicing fee collections, partially offset by lower third-party servicing and other MSR related costs as we continue transferring loans to the RoundPoint platform.

Please turn to slide 8. RMBS funding markets remained stable and liquid throughout the quarter with ample balance sheet available. Spreads on repurchase agreements tightened slightly with financing for RMBS between SOFR plus 18 basis points to 24 basis points. At quarter end, our weighted average days to maturity for our agency repo was 88 days. We financed our MSR across five lenders with $1.6 billion of outstanding borrowings under bilateral facilities and $296 million of outstanding five-year term notes. We ended the quarter with a total of $602 million of unused MSR financing capacity and $135 million of unused capacity for servicing advances. I will now turn the call over to Nick.

Thank you, Mary. Please turn to slide 9. Our portfolio at March 31 was $14.7 billion, including $11.3 billion in settled positions and $3.4 billion in TBAs. We maintain the belief that now is not the time to go out on a limb in terms of risk or leverage, given the current market conditions and level of spreads. And as a result, we kept a neutral risk profile with ending economic debt to equity of 6 times. Over the quarter, we shifted our mortgage exposure up in coupon, which we will detail in our agency portfolio commentary. This benefitted the portfolio and resulted in lower spread sensitivity, as you can see in the spread exposure summary chart on this page.

Please turn to slide 10. In the first quarter, despite a 30-basis point rise in rates on the 10-year treasury and less optimism about the Fed cutting rates this year, volatility declined, driving positive performance for RMBS. Though still high by historical standards, realized volatility across the yield curve fell from the prior quarter, as did implied volatility. Our preferred gauge implied volatility on 2-year options on 10-year swap rates decline to about a 98 basis points annually, close to the bottom end of its range since the beginning of 2023. The nominal spreads to treasuries for the current coupon finished at 119 basis points, essentially unchanged over the quarter. As you can see from figure 1, the spread continues to closely track implied volatility and remained well above the 50th percentile of long-term history. Spreads for current coupons were aided by lower-than-expected supply, strong fixed income fund inflows, and tame prepayment rates.

Although the overall performance of RMBS was positive in the first quarter, performance varied widely. Mainly in higher coupons outperformed lower coupons and specified pools outperformed TBAs. Specified pools broadly outperformed the same coupon TBA owing to elevated demand typical of the beginning of the year. And for higher coupons, investors seeking to protect performance against potential fast prepayment speeds. Lower coupons like 30-year 2s and 2.5s widened by around 5 basis points to 10 basis points on concerns of bank portfolio reallocation. As is evident in figure 2, spread curves flattened over the quarter with higher coupons tighter versus lower coupons wider.

Please turn to slide 11 to review our agency portfolio. Figure 1 shows the composition of our specified pool holdings by coupon and [story]. And then figure 2, you can see the performance of TBAs and the specified pools we own throughout this quarter. We replaced approximately $2.4 billion notional of 2.5% through 5% TBA, with an equal amount of higher coupon, 5.5% through 6.5% TBA, reversing a down in coupon trade from the fourth quarter and more defensively positioning our portfolio from a spread perspective. We also rotated approximately $350 million notional of lower coupon specified pools into 6% specified pools to capture positive pay-up performance. We continue to favor pools over TBAs, with pools accounting for about 70% of our exposure. Figure 3 on the bottom right shows our specified pool prepayment speeds decreased slightly to 5.1 CPR in the first quarter from 5.4 CPR in the fourth quarter.

Please turn to Slide 12. As we discuss market environment for investments in MSR. Activity in the MSR market remained brisk with bid wanted activity totaling $160 billion. Although a sizable number, as is shown in figure 1, this is down slightly from the first quarters of the prior two years. We expect MSR supply to be lower compared to prior years, given low origination volume and the large amount of low coupon servicing that has already traded hands. This lower supply combined with a growing investor base should keep MSR values well-supported, as evidenced by the strong traded levels of servicing so far this year.

Mortgage rates drifted higher over the quarter with 30-year rates averaging around 6.75%, still hundreds of basis points above the gross coupon of our MSR. Being so deeply out of the money, prepayments on our servicing are predominantly from housing turnover rather than a homeowner refinancing their loan to a better rate. In prior quarters, we have discussed the disincentive or so-called lock-in effect that a very low-rate mortgage has on a homeowner to move or sell their home. This is the primary reason for today's historically low turnover rates.

A direct proxy for turnover is existing home sales. And in figure 2, you can see on a monthly basis how closely prepayment speeds on our MSR tracked this time series. Existing home sales so far in 2024 have been in line with last spring and remain at a pace far below recent years. Something you can see on appendix slide 19, along with a few other market data charts we added this quarter. Though there are signs that the housing market is beginning to normalize to the high level of mortgage rates, it is our expectation that turnover on low-rate mortgages will continue to run at historically low levels.

Please turn to slide 13 to review our MSR portfolio. The portfolio was $215 billion UPB at March 31, which include the addition of $3.1 billion UPB through bulk and flow purchases in the quarter. Note that post quarter end, we committed to purchase a $2 billion UPB bulk package. The price multiple of our MSR increased slightly to 5.7 times from 5.6 times. For the entire quarter, speeds paid 3.8% CPR slower than our projections. Assuming unchanged mortgage rates, we expect prepayment rates to rise modestly in the second quarter, reflecting turnover seasonality. Even so, less than 1% of the mortgage loans that back our MSR are likely to refinance at current rates, and over 80% of balances are at least 250 basis points below current mortgage rates.

Finally, please turn to slide 14, our return potential and outlook slide. The top half of this table is meant to show what returns we believe are available on the assets in our portfolio. We estimate that about 63% of our capital is allocated to servicing with a static return projection of 12% to 15%. The remaining capital is allocated to securities with a static return estimate of 12% to 13%. With our portfolio allocation shown in the top half of the table and after expenses, the static return estimate for our portfolio is between 9.1% to 11.7% before applying any capital structure leverage to the portfolio. After giving effect to our outstanding convertible notes and preferred stock, we believe that the potential static return on common equity falls in the range of 10.1% to 14.1% or a prospective quarterly static return per share of $0.39 to $0.55.

Though fixed income markets remained subject to periods of high realized rate volatility and the near-term likelihood of significant tightening of RMBS spreads remote, nominal spreads for agency RMBS are wide on a historical basis and the return potential of our portfolio is strong. We are content to let spreads sit here at their current levels, while our low duration and low convexity MSR portfolio continues to generate attractive cash flows with low spread volatility. Thank you very much for joining us today. And now we will be happy to take any questions you might have.

(Operator Instructions) Doug Harter, UBS.

Thanks. First, hoping you could give us an update on how book has performed so far in April and then sort of in that context, given spread widening, is that enough to kind of change your year kind of look on the market and moving off a neutral stance?

Good morning, Doug. Thanks for joining us today. So far in April, as of last Friday, we estimate our book value to be down between 1.5% and 2%. I'll let Nick answer the question of how you think that's changed, our outlook and positioning.

Hey Doug, thanks for the questions, Nick. So no, it really has not changed our outlook or positioning. It is -- spreads have widened out a little bit. They continue to be within the range that they've been for the year. And as we've as we've talked about, we still -- we believe that the construction of our portfolio, our capital allocation as it stands between MSR, and securities is where we would like it to be.

And I wouldn't say that there has not been a sufficient amount of disturbance or widening in the mortgage market to really change our outlook on spreads. We remain somewhat defensive about spreads relative to others. I would say we continue to believe that while mortgages from a longer-term value -- longer-term perspective do have value, in the near term the market is subject to these bouts of volatility, as we've seen for this quarter already.

And although things have changed to some degree, with regard to the range of spreads, the range of spreads do seem to be tighter than they were at some periods in the last two years. The market is still subject to the shifts in sentiment about the Fed and mortgages definitely react to it. So we would -- we continue to have, as you see from our numbers, we continue to have exposure to, positive exposure to spreads tightening, which again, is likely the long-term trend. But in the near term, we prefer to keep our mortgage exposure in a neutral range.

Just as a follow-up on that, I guess how willing are you to be opportunistic and more tactical during those bouts of volatility, sort of trading the range, if you will, versus holding a longer term neutral defensive position?

Look, we respond to markets as they develop every day. So every day is a new day in the markets, as we know. So we're absolutely positioned to take advantage of spreads. If we believe they're opportunistically wide, we will do so. But at this -- in the current market, as said, if you look at the spread range and how it's done over the last couple of years. We still believe we're well within that range. And like the portfolio construction as it is right now.

Great. Thank you, Nick.

Thanks, Doug.

Trevor Cranston, JMP Securities.

Hey, thanks. Following up on the question about your performance in April. Can you comment on whether or not there's been any significant changes to the portfolio in April in terms of coupon composition in particular. Thanks.

No, there has not been or the portfolio from quarter end has changed very little to date.

Got it. Okay. And then, given the outperformance of spec pools relative to TBAs over the last few months. Can you give us an update on how you sort of think about the relative value between specs and TBAs right now? Thanks.

Sure. spec pools, a lot of that is just governed by how those are in the TBA market, frankly, I mean, we're always of course, comparing where pools are trading to TBAs and making relative value judgments. And as you guys know, we do tend to move our position in the coupon stack around, not infrequently.

Right now, I would say to elaborate on your first question a little bit, we don't see a compelling reason to move our exposure right now. The value proposition across the stack is pretty flat. We do like the higher coupons right now.

Just the lower coupon market seems to be fairly well priced and there have been these -- as we noted in our commentary, there has been some amount of selling related to some bank portfolio reallocations, we think that could persistent lower coupons. So we have not moved our performance over the quarter or we have not moved our positioning materially over the quarter from where we were at the end.

Okay. Appreciate the comments. Thank you.

Thanks, Trevor.

Bose George, KBW.

Hey, good morning. Can you remind us what are the drivers that sort of push you to the high end or the low end of the target range or the range you've provided?

The drivers are primarily -- Hey, Bose, our drivers (technical difficulty) excuse me, are prepayment and funding rates.

Okay, great. And then actually in terms -- given, just can you talk about the comfort level with your dividend is, I guess it's slightly below the midpoint of the range. So is that -- presumably, that suggests levels of comfort there.

Yeah. The dividend, as you can see from our return projection is squarely within the range of those outcomes. And yes, we feel good about being able to support the dividend on a go-forward basis.

Okay, great. Thanks.

Jason Weaver, JonesTrading.

Hi, good morning. Noting your comment, expected lower supply, where do you see incremental returns on new MSR today and where the relative value looks like between, say, production coupons and season deal?

Yeah, good morning. Thanks for the question. We see the value proposition being low coupons and high coupon to be pretty flat. The range of returns is probably at an unlevered unhedged basis in the low teens. Levered in hedge, we think it's mid-teens probably.

One of the things that we've observed in the market and there's been lots of demand in the market. The service has been very well bid this quarter. Is that the recapture assumptions that are embedded in some of the higher coupons can be pretty high, pretty efficient. And so this is something to keep in mind as we look at the relative values between high coupons and low coupons.

But every pool is different. Every situation is specific. And we're willing and able to participate across the, right across the sector in terms of coupons. As we noted in our prepared remarks, we bought a small pool post-quarter end. We continue to be active in the market and active bidders. And we're being very disciplined on the price that we pay in order so that we can get returns that we think are worthwhile in the market.

Okay. Thank you. That's helpful. And then I'm just curious, outside of the interplay between MSR and agency RMBS are you making any additional changes to your hedging approach, given that we we're coming to a consensus view of a higher longer-term -- higher for longer environment with potential volatility ahead?

No, I don't think so. We've always had an approach or -- of keeping our interest rate exposures low generally. And so embedded in that is the full range of the portfolio and whether the MSR has more or less interest rate risk, which hedges the MBS that just gets put into the mix and the calculations that we do in order to figure out how much other hedges we need in our portfolio.

But we're generally trying to keep our interest exposures low. We don't feel that we have, particularly an edge in knowing which direction interest rates are going. So we keep our exposures pretty flat. As you can see from our disclosures, the kinds of sensitivities that we show.

All right, thank you. And just one more and I'll jump back in the queue. Are you seeing any changes in the willingness of counterparties to extend additional MSR financing?

No. In fact, the opposite. We're seeing lots of demand for new balances. On the MSR side, we're seeing new participants enter the markets regularly. There's lots of MSR financing supply out there in the market.

All right. Thank you again for taking my questions.

Thank you.

Rick Shane, JPMorgan.

Hey, guys. Thanks for taking my questions. (multiple speakers) how are you? Look, most of my questions have been asked and answered. I do have a housekeeping question, simply because you guys have tweaked the way you report line items, and we need to reconstruct our model a little bit. You historically broke out other interest income from securities income. Can you break that out for us? And also, what was the converts expense on the quarter?

Sure. Good morning, Rick. So I will -- just note that the details of the interest income and interest expense will be included in our Q, which will be filed today. You can also find the breakdown on page 21 of the deck on our portfolio yields and financing costs. So specific to your question, convertible senior notes quarterly expense was $4.6 million. And what was your other question?

What was the other interest income line?

Let's see, I believe that was $17 million. Yeah, so on 21, you can see RMBS interest expense of $100,600. So the remainder would be other.

Okay, terrific. Thank you very much. Sorry to do that, but it just seems there's a lot of hassle with the model. Thank you.

Thanks, Rick.

Eric Hagen, BTIG.

Hey, good morning, guys. Following up on the MSR financing, do you see that maybe leading to improve economics or terms that you get in the market? And do you think your counterparties are giving you guys credit for having brought in the subservicing function?

Good morning, Eric, thanks for the question. In terms of I think, whether spreads will evolve, so that's a definite maybe. We haven't seen that yet, but these things typically have a way of doing that when there's lots of competition and so forth. Tighter spreads is often one byproduct of that.

The one thing to keep in mind however though, is that our financing facilities generally are, these are not overnight repos kind of thing, these are generally longer-term facilities. And so it takes a little bit longer for these things to reset and so forth. But as these things come up, we do renegotiate rates as they occur.

And in fact, the last couple of facilities which have recently come up for renewal, we did actually renegotiate to lower rates. So that is beginning to happen. Then could it happen more? That remains to be seen.

And your other question in terms of whether our lenders are giving us credit for the subservice, for the subservicing operations. I'm not sure what you mean by that and how it affects our lending profile or how lenders view us. But all our lenders are aware that we run our servicing in house and that's incorporated into their analysis and the rates they give us and then the credit analysis that they do. So, yes.

Okay. That's helpful. Hey, I mean, you guys are always very thoughtful on the mortgage market just generally. Do you feel like there's a lot of risk at this point that the Fed could actually sell agency MBS from its portfolio? That was a conversation at one point. Do you see that being a risk on the table at this point? And then like adjacent to that, how much risk do you think is priced into the mortgage basis that the Fed actually hikes rates at some point this year?

Eric, this is Nick. No, we do not think that there's a risk that there's any sales of mortgages of the Fed. As far as whether things are priced in, the market is very efficient. So it's yeah, it's extremely hard thing to say. I would say that the -- overall in the first quarter until today, we've seen a little bit more of a muted response out of the mortgage market than we had in period -- in prior periods of volatility or kind of surprise volatility in higher rates.

So I think that's a function of the fact that the market still does believe that the -- I think the market does overall, believe that the Fed will still cut at some point this year. But I do think that the spreads have been reasonably well calibrated to Fed expectations. But like we've said that things have stayed in a range, and we like the long-term exposure of being long mortgage spreads. But you have to balance that against this near-term volatility that can seemingly pop up at any time. We're not done with the volatility in the market, that's for sure.

Yeah, that's helpful. Thanks for the perspective. Appreciate it.

Thanks, Eric.

And at this time, I'll turn the call back to Bill Greenberg for closing remarks.

I'd like to thank you everyone for joining us today. As always, thanks for your support.

This does conclude today's conference. We thank you for your participation.