Good day, and welcome to the Two Harbors Investment Corp. Fourth Quarter 2020 Financial Results Conference Call. Today’s conference is being recorded. And at this time, I would like to turn the conference over to Paulina Sims. Please go ahead.

Good morning, everyone. I’m excited to join the Two Harbors team and look forward to working with all of you. I’d like to welcome you to our call to discuss Two Harbors’ fourth quarter 2020 financial results. With me on the call this morning are Bill Greenburg, our President and CEO; Mary Riskey, our Chief Financial Officer; and Matt Koeppen, our Chief Investment Officer.

Thank you, Paulina. Good morning, everyone, and welcome to our fourth quarter earnings call. Before I begin, I’d like to publicly welcome Paulina to our team on this, her first earnings call with Two Harbors. Paulina brings with her more than a decade of financial services and Investor Relations experience, and we are very excited to have her here with us. This morning, I will go over our quarterly results at a high level and share some thoughts on our forward outlook. Mary will give more details on our financial results, and Matt will discuss our portfolio composition, activity, and risk profile. Turning to Slide 3. We are very pleased with our fourth quarter performance and book value of $7.63, which represents a 5.8% quarterly return on book value. The results were driven primarily by continued outperformance of lower coupon TBAs, some improvement in specified pool payouts, and some marginal tightening in MSR spreads. We have spent a significant amount of resources over the years building out our MSR acquisition and oversight platform, and we reaped some benefits this quarter as we added over $40 billion of unpaid principal balance of MSR through both our flow sale channel and bulk purchases. Finally, as a reflection of all of these trends and with the confidence in our forward outlook, we also raised the common stock dividend this quarter by 21% to $0.17 per share.

Thank you, Bill, and good morning, everyone. Please turn to Slide 4 to review our financial results for the fourth quarter. We generated comprehensive income of $113.5 million, or $0.41 per common share, representing an annualized return on average common equity of 22.1%. As Bill mentioned, our book value rose to $7.63 from $7.37 per share on September 30, resulting in a total economic return of 5.8%. Book value growth was driven by favorable MSR pricing due to marginal tightening in MSR spreads, TBA dollar roll specialness, and lower expenses due to the transition to self-management. Moving onto Slide 5, core earnings increased to $0.30 per share from $0.28 in Q3. Interest income decreased this quarter from $89.7 million to $72.5 million due to lower average balances and coupons as well as higher agency amortization due to prepayments. This decrease was partially offset by lower interest expense of $22.6 million, reflecting lower borrowing rates and average balances.

Thank you, Mary, and thank you all for joining today. Turning to Slide 9, let’s review our quarterly portfolio activity and composition. As previously noted, the fourth quarter economic performance was primarily driven by a general spread tightening in MBS as the Federal Reserve continues its balance sheet expansion, having purchased almost $1.5 trillion MBS during QE4 so far. Not surprisingly, the strongest move was seen in the current coupon mortgages that have been the Fed’s focus, with a more modest but positive performance in higher coupons. With interest rates modestly steepening but generally stable, we also saw some modest improvement in MSR spreads. As Mary noted, we did decrease risk somewhat during the quarter, reflected by lower economic debt to equity of 6.8 times. This was in part from sales and paydowns in our specified pool portfolio where valuations in some stories and coupons had become less attractive. In addition, after having increased our position size in TBA2s to $7 billion, significant spread tightening and resulting valuations in the quarter led us to reduce that exposure. On net, we took our overall notional TBA exposure down by $1 billion to end the quarter at $5.2 billion. Another factor behind the decision to reduce our exposure was that the Fed began to focus its purchase activity in forward months, which aligns more closely with origination sales and has the effect of decreasing roll specialness. The result has been that roll specialness in the 2% coupon has decreased significantly between mid-December and the end of January. We continue to have good success in sourcing substantial volumes of new servicing through our flow channel at attractive levels and have largely been able to maintain the size of our portfolio in this fast prepay environment. Additionally, we opportunistically added almost $200 million market value of interest-only securities, or IO, during the quarter. The market is seeing very strong demand from banks for structured mortgage-backed securities near a par dollar price, which can only be created today by stripping IO off of premium securities. That demand has led to spreads on the stripped-down security that are tighter than that on the underlying securities. We consider those spreads quite aggressive, with some structures actually having negative option-adjusted spreads, which means that the resulting IO that we retain is very attractive. Additionally, these positions provide portfolio benefits that are similar to MSR when paired with RMBS in reducing mortgage spread exposure even further.

Thanks for that discussion, Matt. To conclude, we feel very good about our agency plus MSR portfolio and the forward outlook. As Mary highlighted, our capital and liquidity position remains very strong and we took steps subsequent to quarter end to further optimize our capital structure, with the benefits accruing over time to our common shareholders. As Matt said, new investments in specified pools are less compelling today with spreads near the tight end of the long-term ranges, and we have reduced risk and leverage somewhat given the environment. However, as we discussed, we still see returns for our strategy to be supportive of current dividend levels, and this tight spread environment is one where our agency plus MSR strategy is especially attractive. Thank you very much for joining us today, and we will now be happy to take any questions you might have.

And our first question will come from Doug Harter. Please go ahead.

Thanks, and good morning. Can you talk about the relative sizing of your MSR and agency portfolio today? If I look at Slide 13, it looks like the interest rate sensitivity from both is relatively matched up. Can you just talk about your expectations and willingness to continue to grow the relative size of each?

Sure. Good morning, Doug, and thanks for joining us. That’s a good question. So as you point out on Slide 13, right, on the left-hand chart, you do see the interest rate sensitivity of the agency RMBS and the MSRs being roughly equal and offsetting. But if you go to Slide 12, you see that there’s a little bit of a difference between the mortgage spread exposure between the MSR and the RMBS, so it’s not something exactly interest rate hedge; it’s not exactly the same as mortgage spread hedged exactly. The relative sizing amount of the MSR depends on level of interest rates as well as relative pricing. We don’t particularly have a target of what the right – of what the terminal size of MSR is, that’s a dynamical thing and we manage it actively.

Got it. How do you view the current size of the flow program in relation to the expected run-off? Is it set up for growth, or is it intended to replace run-off at this stage?

I’d say, again, it’s market dependent. We’re very pleased with the amount of flow servicing that we’re acquiring, which as Matt said, is largely offsetting the run-off. We do, as we’ve noted in the past, have recapture programs with our existing sub-servicers as well, and that’s part of what we’re doing also. The amount of relative size that we acquire in any period is a function of the price, right, that we are showing to our seller partners, right? If we were to increase our price substantially, we would get substantially more MSR volumes. And so it’s a balance between the attractiveness of the price that we’re looking to see and the volumes that we’re getting.

Hey everybody, good morning. One quick housekeeping question and then a couple of other questions. I didn’t hear - have you guys provided a book value quarter-to-date?

Good morning, Rick. Thanks for joining. We did not provide it. But through the end of last week—it’s early in the quarter, but through the end of last week, we were up a little north of 2% so far in the quarter, so that’s coming again from spread tightening - we’ve seen some spread tightening in healthy coupon, so that’s where we are so far.

Okay, thank you. And thank you for all the technical stuff. It’s a really interesting call and the materials are helpful. I’d love to understand Slide 11 a little bit better in terms of MSR pricing. It’s consistent with what we’ve heard anecdotally, which is that with the big supply of MSR available due to production, that pricing remains benign. How do we think about what we’re seeing on Slide 11 in context of the marginal tightening of MSR spreads that you guys referred to as well? I just need to understand the dynamic between that slide and that comment.

Sure. Good morning, Rick. Nice to have you here, I’ll take that one. Well, I mean, as you see in the chart in the lower left, the price multiple of new flow that we’re acquiring is a little north of a three multiple. We did say that the MSR spread has tightened marginally, maybe only 50 basis points; that doesn’t have a big impact on the price. And so maybe the price went up from 3 to 3.1 multiple or something like that, so it’s a pretty small effect, but noticeable in the returns.

Got it, okay. And then last question for me. And as you increase modestly the allocation to IO, can you help us, and again, just putting this in context of what we saw last year, think about liquidity and funding for those assets, and does this create a risk that we should be considering?

Sure, I’ll take that one. I guess we’re looking at it on an opportunistic basis here. It’s atypical for us to be able to source significant quantities of IO. It’s coming sort of as a function of the huge demand for strip down bonds that’s happening today. The spreads on the asset are a little bit tighter than what we’re seeing on servicing by maybe a couple of hundred basis points, but there’s an advantage in CUSIP dial in the funding aspect of things, where the haircuts are lower and the funding rates are significantly lower. In terms of the liquidity of them, I mean, they’re certainly far more liquid than servicing, right? So they’re—like I said, they’re CUSIPs. They trade on a T-plus-2, if you want to sell servicing, that’s a long drawn-out process, so it’s an improvement in liquidity. And I think, overall, the thing to keep in mind is the addition of the CUSIP dial really is just an extension of the portfolio construction that really provides the same exposure as servicing does when we’re looking at that.

Terrific. Thank you, guys, for all of the detail, and hope you’re all well.

Thanks, Rick. Thanks for joining us.

And our next question will come from Eric Hagen. Please go ahead.

Hey, good morning, guys. Good to hear from you. A couple of questions here. Can you talk about where sub-servicing costs are right now and how they may have changed over the last, call it, few months? And then on the funding and hedging side, are you seeing opportunities to take advantage of a flatter term structure by adding longer-term repo? And then on the hedging, where along the yield curve, do you think it makes the most sense to add hedges right now?

Sure, good morning, Eric. Good to hear from you, too, and thanks for joining us. I’ll take the first question and then I’ll let Matt talk about the repo question. Sub-servicing costs have been stable. When we enter into our sub-servicing agreements, we have a predetermined cost to service schedule that sets out what the costs are for performing loans and non-performing loans and so forth, and so that really hasn’t changed at all in recent months. Our cost to service for performing loans is still in, call it, $6 to $7 per loan per month area, and there was some activity around the cost in terms of the CARES Act and the forbearances as that came online, but as we discussed before, that’s been very benign and lower than expected. I’ll let Matt talk about the term structure of repo rates now.

Thanks Bill. Morning, Eric. The repo market’s been terrific, like you noted. It is very flat, the term structure is very flat with rates in the 20 to 25 basis points, at the higher end for longer-term. I think we typically have a pretty termed-out repo book. I think it was down around 60 days weighted average at the end of Q4. I think you’d expect to see that stretch out to more typical ranges for us, which is more like in the 70 to 80 days weighted average. I think we’ve seen—since last year, I think we’ve seen term markets fully redevelop. We’re seeing one-year repo at attractive rates from multiple car parties, so I think we’ll continue to ladder our maturities as we typically do.

Great, that was really helpful color. Then on the four bulk transactions over the quarter, can you give some sense or some market color, if you will, around the competition in the market for those transactions, and really what in your opinion would catalyze potential additional bulk sales to take place going forward?

Yes, thanks Eric. I think as we’ve said in the past, we find the pricing in bulk transactions to be situational. There are some packages that we think are pretty tight and some that are attractive. The competition for bulk packages is pretty good right now - I mean, it’s competitive. I would say that market has healed. In a way, there’s probably as many market participants trading in the bulk market as there was pre-crisis. Competition probably is, if anything, continuing to increase a little bit - that’s one reason why we prefer the flow market. These are relationships that we have built over time and have in place with approximately two dozen sellers that sell to us on a daily basis, and in environments like this that can be a more stable and constant stream of flow products. Throughout this whole episode, what we’ve seen is with primary and secondary spreads being so wide, the need to sell in bulk for servicers has been diminished in general, and so I think you won’t see more packages come to market until you see a significant rate rise, is my belief.

Really interesting, thank you very much. Appreciate it.

Yes, thank you.

Our next question will come from Bose George. Please go ahead.

Hey, good morning. I just wanted to go back to the IO versus the MSR. It seems like one benefit to the IO would just be less operational risk, like you don’t have to do the servicing advances, obviously, so is that the preferred place to expose versus MSR?

Morning Bose, thanks for asking that question. I think it’s certainly true - you don’t need the operations in order to manage the IO position, but the financial risks are certainly similar to the MSR position in terms of managing the interest rate, the prepay risk, and the risk that we have. As Matt said, we view this as really an opportunistic sort of environment, where the demand from banks and other participants for more stripped-down coupons leaves behind an attractive looking IO. This doesn’t always happen. There’s normally not this much IO in the market. The amount of stripped down CMOs being created is historically very high, and so they’re attractive today, they give us the portfolio characteristics that we like, they have good financing characteristics, they’re pretty liquid, so for those reasons we like them, but I wouldn’t call it a strategic change in what we’re doing at all.

Okay, great. Helpful, thanks. Then just on the roll specialness, you guys noted it’s down in January. Can you just talk about where it stands now relative to year-end, and then would you expect now to continue to be active, etc.? Do you think you could see improvement in specialness in the near term?

Sure, good morning Bose, it’s Matt. I’ll take that one. It has come off significantly. I think the main thing that’s caused that is that the Fed has really changed their purchasing activity. They’ve pushed their purchases out into the back months, which more matches origination sales. For example, I think we talked about this in Q3 earnings, but at the time we were seeing, for example, the advantage for TBA2s, for example, as being about 100 basis points through repo rates at the time, and I think that where the roll rates for that coupon today are indicating something only like 20 or 25 basis points through, so it’s off dramatically. That level will certainly be a function of the Fed’s activity and their buying, right - they’ve modified their activity a little bit. I guess I would expect a continuation of the levels that we’re seeing today in the near term unless they change something, but it’s probably reasonable to expect something similar to what we’re seeing today.

Okay, great. Thanks. Then just one last one, the issue with Pine River, the litigation, is there any timeline for when there’s resolution on that?

I’m sorry, I was on mute there. As you know, the situation is active. As I’m sure you can appreciate, I can’t really say much more than that. The board continues to believe the suit is without merit and we’re in the early stages of this process, and again I’m sure, as you can appreciate, I can’t really say much more than that.

Yes, definitely understand. Thanks a lot.

Thank you.

Our next question will come from Trevor Cranston. Please go ahead.

Hey, thanks. Good morning. You guys briefly talked about primary secondary spreads in the opening remarks. I was curious about a couple things. First, with respect to where MSR valuations are today, do you think that significant compression of primary secondary spreads is already reflected in those valuations, and just more generally how we should think about the overall impact to the portfolio if that spread does continue to compress over the course of the year? Thanks.

Sure, Trevor, thanks very much for that question, and thanks for joining us. Yes, certainly a compression in primary secondary spreads is baked into current MSR pricing - that’s one reason why we’ve said in the past that while optically servicing prices might seem lower today than they did pre-crisis, most of that reason is because the primary secondary is so wide and valuations are building in that compression. If you look at yields or spreads or things of that nature, that incorporate that mean reverting of that spread, you would find that the pricing is similar to what it was pre-crisis.

Okay, got it. Then one more question, looking at Slides 13 and 14 on spread exposure and the level of spreads today versus historical levels. I think generally they’ve continued to tighten in January. If you guys continue to find opportunities to add more, either through MSR or IO in light of where spreads are today, would you consider taking the net spread exposure to an overall short position, or is that something you guys try keeping a pretty tight band around - you know, zero-ish? Thanks.

Yes, that’s a good question. Again, we don’t have a target for that number. We think—like, when we talk about our other interest rate exposures, we think the net exposure to mortgage spreads is already low. We are finding the ability to sell these stripped down CMOs at low to negative option adjusted spreads, which allows us to retain the attractive IOs. The MSR that, as you point out, that we’re creating especially on a flow basis is very attractive, which serves to reduce that more so. Again, we don’t have a target for that number, but it’s driven entirely by the opportunities; but I think the idea, and as you know, the whole thesis of our strategy is to maintain a portfolio where that exposure is low, and that’s what we’re trying to do.

Okay, appreciate the comments. Thank you.

Thank you.

That will conclude today’s question and answer session. I would now like to turn the call back to Mr. Bill Greenburg for any additional or closing remarks.

Thank you very much everyone for joining us today, and thank you for your interest in Two Harbors.

This will conclude today’s conference. Thank you for your participation, and you may now disconnect.