Two Harbors Investment Corp. Q1 FY2023 Earnings Call

Good morning. My name is Diego and I will be your conference facilitator. At this time, I would like to welcome everyone to Two Harbors' First Quarter 2023 Financial Results Conference Call. All participants will be in a listen-only mode. After the speaker's remarks, there will be a question-and-answer session. I would now like to turn over the call to Maggie Karr.

Good morning, everyone, and welcome to our call to discuss Two Harbors' first quarter 2023 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 a reconciliation 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. This morning, I will provide color on our quarterly performance and the market environments. Mary will provide information around our financial results and Nick will discuss our portfolio activity and positioning. Please turn to Slide 3 for an overview of our quarterly results. Our book value at March 31 was $16.48 per share, representing a negative 3.6% total economic quarterly return. Our book value was impacted by the violent move lower in rates arising from the banking crisis, as our portfolio had a slight short duration bias heading into March, consistent with what we disclosed in our fourth quarter earnings call. As more regional bank headlines hit the news, rate volatility continued to be elevated, which caused increased hedging costs and mortgage spread widening. Our earnings available for distribution or EAD was $0.09 per share. As we've discussed on prior earnings calls, EAD does not necessarily reflect the earnings potential of our portfolio. For this reason, last quarter, we introduced the metric income excluding market-driven value changes or IXM, which we believe should better assist our investors and analysts when thinking about our earnings potential. IXM was $0.59 per share for the first quarter, representing a 13.3% annualized return on average common equity. This compares to $0.73 per share in the fourth quarter. The change in IXM quarter-over-quarter is mainly the result of timing differences in realized MSR cash flows. This backward-looking metric of realized return is meant to be viewed in conjunction with Slide 15, which is our forward-looking return potential slide. Please turn to Slide 4. After beginning 2023 with two months of relative calm, the financial markets were roiled in early March by the seizure of two regional banks, Silicon Valley Bank and Signature Bank, by banking regulators, which sent tremors throughout the banking system. The undercurrent of the Fed's campaign of raising rates was called into question, and the market, which was already extremely sensitive, quickly reacted to the new information. Interest rates on the front end of the yield curve plunged, with the two-year treasury yield declining by 109 basis points over a three-day period, culminating in the largest one-day move ever on March 13. Just a few days prior, the two-year yield had hit a cycle high of 5.07%, its highest level since 2007. These effects can be seen clearly in figure 1. At the beginning of the year, the market was pricing in just one more interest rate hike, with a peak fed funds rate of just over 5% and a terminal rate of 4.5%, as shown by the light blue line. By early March, the market became more bearish, pricing in three rate hikes, only to snap back after the SVB news broke and all rate hike expectations were replaced with rate cuts. Despite the market's expectations, the Fed raised its benchmark rate by 25 basis points on March 22, in a continued effort to slow down the economy and drive inflation down towards their long term annual target of 2%. Interestingly, however, by late April, the market was again predicting a forward path of Fed activity almost exactly as it had been on December 31. If an investor had slept through it, they wouldn't have known that a 300 basis point round trip in fed expectations had even occurred. This kind of interest rate volatility, especially for maturities inside of one year, is breathtaking and is a good reminder of why we keep our interest rate exposures low across the curve. Moving to figure 2, I’d like to change gears and expand upon a subject that may be underappreciated in the market, which is the float income component of MSR. Float income refers to the interest that is earned on principal, interest, and taxes and insurance before those monies need to be remitted to the relevant investors. While MSR and fixed coupon interest-only or IO bonds share many similarities and risks, MSR is not a bond. It has important additional cash flows that include cost to service and compensating interest, which detract from the overall cash flow, as well as additive cash flows like float income, late fees, and ancillary income and recapture. In different interest rate environments, these components will add more or less to the value of servicing. Looking at the chart in figure 2, you can see in the light blue line that in a rising rate environment, an IO extends as prepayment speeds slow, which causes the price to increase. At very high rates, the prepayment speeds can't go any slower, which ultimately results in an IO acquiring positive duration and decreasing in price as rates increase. In contrast, the float component of MSR behaves differently. You can see this in the navy blue line on the charts in figure 2. The price goes up for two reasons as rates rise. First, like an IO, MSR extends as rates rise and prepayment slows, causing the price to rise. Second, as rates rise, the effective coupon of float income also increases since the cash flow is based on the short-term earnings rate on those custodial balances. At very high rates, even when the prepayment speeds can't slow anymore, the effective coupon in this component continues to rise, which causes the price of this component to continue to increase. In figure 2, as you can see, in higher rate environments, these additional cash flows caused the value of MSR to outperform the IO. While in a normal rate environment, the float components of MSR can contribute about 50% of the duration of the MSR asset, when rates are higher and the MSR is deeply out of the money, the float components can contribute closer to 80% of the duration of the entire MSR asset. The main point here is that float income, which is essentially uncapped, adds materially to the negative duration of out-of-the-money MSR and is now the primary reason why MSR multiples could continue to rise somewhat in a further sell-off. Moving forward, we are cautiously optimistic about the investing environment. With high interest rate volatility and with the FDIC selling larger amounts of bonds, spreads on RMBS are at historically attractive levels. Nevertheless, there remain uncertainties in the market from potential follow-on effects from the banking crisis to political uncertainty related to the debt ceiling debate. As a result, fundamentally, we might expect that an overweight position in mortgages is justified. We think a more neutral posture is prudent, given the technical backdrop. Furthermore, with banks likely on the sidelines of the MBS market for the time being and with the Fed and GSEs out of the market, we think that wide spreads available in the market can persist for some time. Wider for longer suits us just fine, as we believe those spreads are attractive for our portfolio and should be supportive of our ongoing earnings generation. With all of that said, we are committed to and confident in our portfolio construction of Agency RMBS paired with MSR, and we believe that our portfolio with less mortgage spread duration than portfolios without MSR is very well-positioned to benefit from the current environment. Now, I will turn it over to Mary to discuss our financial results in more detail.

Thank you, Bill, and good morning, everyone. Please turn to Slide 5. For the first quarter, the company incurred a comprehensive loss of $63.2 million or negative $0.69 per weighted average share. Our book value was $16.48 per share at March 31 compared to $17.72 at December 31, including the $0.60 common dividend, resulting in a quarterly economic return of negative 3.6%, which primarily reflects mortgage spread widening in March and increased hedging costs. Moving to Slide 6, I'd like to add some detail around IXM. In the first quarter, IXM was $0.59 per share, representing an annualized return of 13.3%. This quarter, we refined the calculation of IXM for determining expected price changes to use the realized forwards methodology, which is a change from Q4 when we used the unchanged term structure methodology. Standing on that, the methodology for determining expected price changes may be computed based on either of two commonly assumed scenarios, realized forwards and unchanged term structure. The unchanged term structure methodology assumes that the term structure of the yield curve is unchanged day over day. The realized forwards methodology assumes that rates follow the one-day forwards. Q4 IXM under both methods was a return per weighted average share of $0.73. Quarter-over-quarter, IXM decreased to $0.59 from $0.73, which can almost entirely be attributed to timing differences in the realization of certain MSR cash flows. The service fee that is collected depends on the precise day of the month that borrowers make their mortgage payments. There's also a seasonality component to float income as some of the custodial balances like taxes and insurance are due to be remitted once, twice, or four times per year. Finally, certain servicing costs also fluctuate from period to period, such as non-recoverable advances and interest on escrows. IXM takes into account these natural cash flow timing variations. As a result, the difference between Q1 and Q4 does not reflect significant degradation in the earnings power of the portfolio, but rather a reflection of the realization of MSR cash flows. Slide 15, our return outlook slide is the forward-looking version of IXM, and those prospective return ranges are consistent albeit wider with the prior quarter. Please turn to Slide 7. We thought that it would be helpful to provide investors and analysts a comparison of GAAP and non-GAAP measures. GAAP comprehensive income excluding realized and unrealized gains and losses and non-recurring expenses as compared to EAD and IXM. In future quarters, this comparison will be included in the appendix slide, but we would like to highlight a few things this quarter. As you see on this page, the actual cash flows for income and expense are the same in all three measures with a few minor exceptions. For example, if you look at the RMBS section, coupon income and funding expense are the same across all three. This is also generally true for MSR servicing income, float and ancillary servicing expenses, and funding expenses. The primary differences in the measures result from the amortization lines, which we refer to as price changes. IXM for RMBS and MSR is based on market value and expected return, which is different from GAAP and EAD amortization. For RMBS, GAAP and EAD amortization is based on amortized cost and yield to maturity at purchase. For MSR, GAAP amortization is based on the percentage of principal paid multiplied by the beginning market value. And for EAD, amortization is based on amortized cost and the original pricing yield. We hope that this disclosure helps reconcile the differences between our GAAP and non-GAAP measures. Please turn to Slide 8. Earnings available for distribution was $0.09 per share compared to $0.26 for the fourth quarter. As a reminder, we expect EAD to continue to diverge from expected ongoing earnings power. The decline in EAD this quarter was primarily driven by changes in interest income and expense. Interest income increased by $17.3 million, primarily due to four things: higher rates on cash holdings and reverse repo balances, an increase in the size of our RMBS portfolio, rotation to higher net yielding RMBS, and slower prepayment speeds. Likewise, interest expense increased by $26.9 million on higher financing rates and higher borrowing balances on RMBS, partly offset by lower borrowing balances on MSR financing. Turning to Slide 9. The portfolio yield increased 17 basis points to 5.09% due to the rotation to higher net yielding RMBS, lower agency CPR and a higher proportion of the portfolio invested in higher yielding assets. Our net realized spread in the quarter narrowed by 45 basis points to 0.52% from 0.97%, primarily due to higher rates on financing. As a reminder, the portfolio yields in this table are EAD-based calculations and not market-based measures. Please turn to Slide 10. Let's spend a moment talking about financing and what we are seeing in the repo markets. Despite the extreme volatility and news about the banking crisis, funding in the repo market remains liquid and well supported. Spreads on repurchase agreement financing for RMBS improved in January and February from year-end, but increased in March following the news of bank failures. At the end of the quarter, spreads on repurchase agreements were coming back in, and we were so far plus 15 basis points to 20 basis points with no signs of balance sheet stress. We finance MSR across four lenders with $1.5 billion of outstanding borrowings under bilateral MSR asset financing facilities and $400 million of outstanding five-year MSR term notes. We maintained access to diverse funding sources for MSR with a total of approximately $606 million in unused MSR financing capacity at the quarter end. I will now turn the call over to Nick.

Thank you, Mary. Please turn to Slide 11. I'd like to focus my opening comments on the supply and demand dynamics for mortgage-backed securities, which in our minds is the primary narrative in our market. The chart shows current coupon spreads since the beginning of last year. Spreads are unquestionably wide, with nominal and OAS spreads respectively in the 92nd and 82nd percentiles of the long-term history, generating attractive levered returns in the low to mid-teens, as shown in our return potential a few slides forward. Despite these positive signals and a strong belief that over a longer horizon, this time period will be viewed as a great entry point. Our enthusiasm is tempered by the belief that over the short to medium-term, supply is likely to keep mortgage spreads wider than long-term averages and could potentially push them wider than their already generous levels. In fact, we have seen spreads widen into the beginning of this quarter. In addition to $200 million of projected net organic supply for 2023, the FDIC through BlackRock has commenced the auction of the asset sales from Silicon Valley Bank and Signature Bank, which will likely persist for the next six months. Sales of the lower coupon, deep discount, Agency RMBS, and CMO positions totaled approximately $85 billion. Inclusive of these sales, other bank selling, and Fed paydowns, which are effectively another form of supply, the total net supply for Agency RMBS is projected to be $500 million for 2023, with the bulk of the supply ahead of us. In an environment where many banks are either on the sidelines or perhaps selling, it will be up to relative value accounts like money managers, REITs, and hedge funds to absorb the bulk of the supply. This group of investors typically demands a higher risk premium than depository institutions. As such, it is reasonable to assume that spreads will remain wider than long-term averages. Figure 2 provides some historical context of the relationship between option-adjusted spreads and who is buying and who is selling. The blue bars are institutional accounts like banks, the Fed, or the GSEs, while the gray bars are relative value accounts like money managers and REITs. The line is the option-adjusted spread of the MBS index as measured by Bloomberg at the end of each year, and for 2023 at the end of the first quarter. In periods in which institutional demand dominates, spreads tend to tighten. Conversely, in periods when relative value accounts are the buyers and institutional accounts are the sellers, spreads widen. There are several periods that we could point to, but the most recent experience of tightening was the 2020 to 2021 period, with strong bank and Fed buying. Then into 2022 to 2023, the Fed and banks stepped back from buying, which drove the spreads wider by over 30 basis points to what now aren't historically attractive levels. To sum this up, spreads have already reacted to the shift in the buyer base and the anticipation of excess supply, and at present levels are supportive of our strategy. That said, it remains to be seen whether these effects are fully priced into the market as the thick of the supply is still ahead. The FDIC bank-related selling has made lower coupon MBS valuation more attractive. Post quarter-end, we have moved some of our mortgage exposure down in coupon but have plenty of dry powder to do more of that trade and/or increase our spread exposure as opportunities present themselves in the coming months. Now let's turn to Slide 12 and discuss our portfolio in the first quarter. At March 31, our portfolio was $15.8 billion, up from $14.7 billion at the end of the fourth quarter. On the top right of the slide, you can see a few bullet points about our risk positioning and leverage. From a risk perspective, we opportunistically moved about 30% of our hedges from treasury futures to swaps to take advantage of deeply negative swap spreads in the quarter. Given the macroeconomic uncertainty, we are keeping exposures low across a wide range of interest rate and current scenarios. You can see more detail on our risk positioning by looking at Slides 17, 18, 28, and 29 in the appendix. Our debt-to-equity ratio increased slightly to 6.5 times, maintaining a neutral leverage position as we were balancing the wide nominal spreads available in the market versus historically high volatility and the supply-demand dynamics that we just discussed. In terms of portfolio activity, in February, we completed a common stock capital raise for net proceeds of $176 million. In line with our stated objective at that time, we settled $11 billion UPB of MSR through a bulk purchase paired with an additional $1 billion of current coupon TBA. We have committed to acquire an additional $15 billion UPB of MSR to settle in the second quarter. Given the subsequent widening of mortgage spreads, this capital allocation proved to be the right one. In the quarter, we were active in moving positions between TBA and specified pools as highlighted in the bullets under portfolio activity. We moved $2 billion of higher coupon TBAs into loan balance, credit, and geographic pools to capture relative spread pickup and mitigate future prepayment risk. We then moved some 4 and 4.5 specified pools, which we believe were fully valued into TBA. Finally, we covered a short position of Fannie Mae 2 TBAs after the sharp underperformance of the lower coupons in March. Moving to Slide 13, our specified pool portfolio was predominantly positioned in higher coupon, loan balance, and geographic pools at quarter end. Mortgages had mixed performance across the coupon stack in the quarter with low coupon 2 and 2.5 widening about 0.5 points driven primarily by supply concerns from FDIC-related sales. Current coupon RMBS widened by a similar magnitude given their persistent supply. The belly coupons of 3 to 4.5 remain roughly unchanged without the supply pressures felt by the lower and higher coupons. In the quarter, specified pools modestly outperformed TBAs as you can see in figure 2. Specified pool prepayment speeds also declined, landing at 5.3% CPR, as you can see in figure 3. Please turn to Slide 14. Our MSR portfolio was $3.1 billion at March 31, comprised entirely of Agency MSR. We saw a 35% increase in supply of MSR in the quarter for the reasons we discussed on our last earnings call, as rates have risen, originations have slowed, and mortgage companies are selling MSR to fund their ongoing businesses. This is occurring at the same time as several large MSR holders announced their intentions to step back from the MSR market. As previously discussed, we added four bulk purchases opportunistically to take advantage of the selling in the market. Our price multiple modestly decreased to 5.4 times, which incorporates the effect of the settled bulk purchase. As anticipated and providing a tailwind for our MSR, prepayments continued to slow, coming in at 4.1% CPR in the first quarter. Finally, please turn to Slide 15, our return potential and outlook slide. The top half of this table is meant to show what returns we believe are available in the market. We estimate that about 61% of our capital is allocated to hedged MSR, with a market static return projection of 14% to 17%. The remaining capital is allocated to hedged RMBS with a static return estimate of 12% to 14%. The lower section of this slide is specific to our portfolio with a focus on common equity and estimated returns per common share. With our portfolio allocation shown in the top half of the table and after expenses, the static return estimate for our portfolio is between 10.4% to 13.1% before applying any capital structure leverage to the portfolio. After giving effect to our standing convertible notes and preferred stock, we believe that the potential static return on common equity falls in the range of 12.3% to 16.6%, with a prospective quarterly static return per share of $0.50 to $0.69. Thank you very much for joining us today, and now, we will be happy to take any questions you might have.

Thank you. Ladies and gentlemen, we will now begin our question-and-answer session. Our first question comes from Doug Harter with Credit Suisse. Please go ahead with your question.

Thanks and good morning. Hoping you could talk a little bit about how you're thinking about when the time might be to want to increase your mortgage basis exposure kind of given your comments that spreads are towards the wider side and kind of what are the factors you'd be looking at?

Good morning, Doug. Thanks very much for the question. As Nick said in his prepared remarks, on a fundamental basis, the spreads are certainly attractive there. They are at historical wide levels, but there's just so much out there that we see that tempers our enthusiasm, the banking crisis issues are still ongoing, even with the resolution of First Republic. So there's a lot of uncertainty there and of course, we have some debt ceiling discussions coming up this month that need to be resolved, and there's a whole bunch of factors in the market that doesn't seem to give the all-clear sign, and so we're going to wait a little bit to see how that unfolds. As I said, with or as Nick said, with the banks out and with the GSEs absent, we think it's more likely than not that spreads can stay at these levels for quite some time here. And so that's sort of our outlook and that's what we're looking for, and we think that suits us fine.

I guess just given that uncertainty, how would you characterize the risk for further widening versus how much of those risks are kind of priced into the market?

Hey, Doug. This is Nick. Yeah, very good question. Something that honestly we grapple with day in and day out these days. It's not as though, as we said in the comments where spreads are right now and when you see our return potential it is very supportive of our strategy to generate a high level of return on income. So, as Bill said, we don't feel pressed to increase leverage or exposure given all the uncertainties ahead of us. And as I said in my comments, we have seen spreads widen since quarter-end and that's amidst some technicals that have not moved in the same direction. For example, longer-term volatility has pretty much moved sideways. We had a strong correlation between those things prior to the event in March with the banks, but since then, given the supply concerns, we have seen spreads widen in a fairly flat volatility environment. So we're just watching it. We'll see where things go, but it's a very hard thing to predict right now.

Okay. Thank you.

Our next question comes from Kenneth Lee with RBC Capital Markets. Please state your question.

Good morning. Thanks for taking my question. Just one on the static returns prospectively, just wondering if I could get a little bit more thoughts around potential volatility there and what could be sort of the key drivers that you think over the near term could drive some of that volatility in terms of the static returns? Thanks.

Hi, Ken. That's a great question. As you can see, if you compare our the range of our assumption range of our results compared to this quarter versus last, you can see that we actually have a wider range than we did last time, and that is reflective of the volatility we're seeing in the market and the assumptions that go into this analysis. And of course, a big component of it is just the spread level in the market, right. So as, to the extent that spreads are wider and more volatile, you're going to see a wider variation in these numbers, but it takes into account all the assumptions that you would expect in a leveraged mortgage return. Obviously, prepayments are a big part of it, funding levels are a factor, and all of those things, and we feel like this range that we have this quarter, that we're giving a $0.50 to $0.69 range does incorporate a wide variation in the underlying assumptions that could drive these numbers.

Got you. Very helpful there. And then just one on the hedging strategy, there were some changes in the book value sensitivity to rates, but just wanted to get a higher level, what's the best way to think about your current hedging strategy? What kind of scenarios are you positioning yourself for? Thanks.

We're really trying to be very balanced right now. We are not – we are trying to be pretty agnostic with regard to the direction of rates or curve shape. Just given all the variability in the market right now, the path ahead of the banking crisis we had in March was probably a little bit more predictable than it is right now. The effects of what the bank crisis will do to the economy and how much work that's actually going to do for the Fed are all very hard to judge. So we're trying to stay pretty neutral across the curve. I think if you look at our exposures, they are pretty balanced, as I said, across the curve and in various curve scenarios. We're trying not to take a strong view one way or the other.

Gotcha. Very helpful. Thanks again.

Thank you.

Our next question comes from Bose George with KBW. Please state your question.

Hey guys. Good morning. Actually just on sticking to Slide 15, as your allocation to MSR increases, does the prospective range of that return go up just as that hedged MSR percentage increases?

Yeah. Well, I think just from – thanks for the question, Bose. Good morning. Yeah. I think if you look at the top of Slide 15, the higher the percentage of MSR, given the fact that the static return estimates for MSR are higher than that from RMBS right now, that would increase those results, the more that we did that.

And how high could that percentage, the hedged MSR percentage potentially go this year?

We don't have a set number in mind. It depends on market opportunities and such. We do see value even aside from it being, as we show here, a higher static return potential than RMBS. We do think there's value in having some RMBS as a balance here, and so it can go higher, but you're unlikely to see it be 100%.

Okay. Great. And then actually switching, just wanted to ask about book value. Can you just give us an update on book value quarter-to-date?

Yeah. You bet, Bose. So as Nick said during his comments as well as in the Q&A here, spreads have been volatile. They've been wider in the month of April. For the first half of the month through the 21, we were rolling down between 1% and 2%, but in the last week of the month with FDIC sales and First Republic news, spreads have been pretty rocky here, and as of Friday, we were down about 4%.

Okay. Great. Thanks for the update.

Thank you.

Our next question comes from Trevor Cranston with JMP Securities. Please state your question.

Hey. Thanks. The question on the float income, you guys talked about earlier in the presentation, a couple of things there I guess. Number one, do you have the average balance of custodial funds was in the first quarter? And also, I was wondering if you could, Mary talked about the seasonal impact of tax payments on float income. I was wondering if you could provide any sort of numbers around the estimated seasonal impact for the first quarter? Thanks.

So, thank you for the question and good morning. We don't have those numbers handy as to what the average balances were; we can circle back on that. In terms of the seasonality that Mary mentioned, some states require interest and escrows, some states don’t; some states require the remittances to be done annually, some are done semi-annually, some do it monthly and so forth, and so that provides a natural seasonality among the states. And the balances that exist between the states, between when things need to be remitted and how long you can hold onto it for, so that's a very detailed question; it's not as simple as seasonality like we haven't prepayments that were slower in winter and faster in summer; it's a more complex shape than that, if you were to analyze it.

Okay. Got it. Thank you.

Yeah. Thank you.

Our next question comes from Arren Cyganovich with Citi. Please state your question.

Thanks. Just kind of following up on Doug's earlier question about spreads and when they could potentially tighten. What are the kind of scenarios that would likely lead to tighter spreads? Would it be, would we have to enter into a recession and see generally lower rates and slower kind of growth overall to bring folks back to wanting to get, I guess, more demand for RMBS assets?

Thank you for that question, Arren. The typical factors that lead to tighter mortgage spreads are decreased volatility and a generally steeper yield curve during a rally. Right now, we find ourselves in a fascinating market, characterized by reduced bank purchasing and a potentially different reaction from the banking sector than in the past, influenced by their focus on bank portfolios and their duration. This situation leads us to believe that spreads will be wider than long-term averages for an extended period. However, to address your question, more predictability regarding the direction of interest rates and the Federal Reserve’s actions should help tighten mortgage spreads. Additionally, as time progresses and we work through the current supply challenges—particularly due to some higher coupon production numbers that, while significant, are manageable in today’s market without bank participation, and the upcoming influx of lower coupon supply—the dynamics of the market will evolve. The reason we were optimistic about mortgage spreads earlier this year has been the substantial retail flow into fixed income, which has provided support for all fixed income sectors, including mortgages, facilitated through the money manager channel. Therefore, the current state of spreads largely depends on how much the money management community can absorb of the incoming supply.

Okay. And do you think that whenever the Fed does pivot and provide kind of, instead of a tightening guide path to a kind of loosening guide path with lower short-term rates, would that be enough to likely lead to tighter spreads as you kind of get away from this inverted yield curve?

I mean, it should be helpful. The one thing that's been said in the market, which I think is an interesting point is that with these sales coming from the FDIC and through BlackRock, there is potentially some market sensitivity to those sale levels, and that if rates rallied and prices go up, it could potentially cause an acceleration of those sales that might temper mortgage performance in that kind of scenario. But overall, I would agree with your assertion that if we see a turnaround and a little bit more predictability in the Fed, that should be positive for mortgage spreads.

My last question is regarding Slide 7, where you have listed various GAAP and non-GAAP earnings. Which of these is influencing your dividend policy? I understand that IXM is more indicative of your earnings potential, but we are having difficulty determining how the dividend might relate to both the potential earnings power and the actual earnings you are generating.

Hi, Arren. This is Mary. So we obviously consider several measures and I think that what I would point you to is Slide 15, that is probably the most significant factor in determining where we think return potential is and where we set the dividend.

But in terms of the actual earnings that you have or are you going to be end up like if you produce a quarter like you did this quarter, are you going to be returning capital relative to or versus actual earnings relative to that distribution?

While the characterization of the dividend depends on taxable income, which is different from all these measures, but I think I would point you to the cash flow information on Page 7, and again, we believe the dividend is reflective of the return potential of the portfolio.

Okay. Thank you.

Our next question comes from Eric Hagen with BTIG. Please state your question.

Hey. Thanks. Good morning. Hope all is going well. I think just one from me, when you think about your stock valuation and where you could trade on a near and longer-term basis, how does that drive the amount of leverage that you're comfortable running, like how much more risk do you think you can take at your current valuation, and what scenarios do you think you could maybe trade at a higher valuation with higher leverage?

Well, thanks for the question, Eric. Good morning. I would say that we don't really think of the stock price has having an input into the amount of leverage that we run; that's really a risk question. We're always trying to have performance so that the returns are high-quality returns with an acceptable level of risk, and so we're making those decisions based on the existing portfolio and the existing assets and existing book value, rather than looking at what the stock price is. We're not trying to link the two in any way. That answers your question.

Thank you. And our next question comes from Rick Shane with JP Morgan. Please state your question.

Thanks, everybody, and good morning. Hey, Nick. I have some questions on Slide 29, which is the interest rate swaps and swaptions. You had talked a little bit about the hedging strategy during your comments, but can you help me understand what's going on the slide? It looks like a lot of netting trades, but again, I think there's something much more sophisticated going on there than I understand. If you can just help us understand both the interest rate swaps and the swaptions because the notional seems to largely net out?

Thank you for your question. I don't think it's as complicated as it may seem from the slide. As mentioned in our prepared remarks, we've shifted some of our hedges this quarter from futures to swaps. This decision was influenced by several opportunities presented by negative swap spreads, allowing us to execute that trade at favorable levels and enhance our spot carry on our hedges efficiently. About 30% of our hedged book has transitioned from futures. We prefer maintaining a mix of these hedging instruments because as market volatility increases and potential liquidity challenges arise, having access to both types can be beneficial in a fast-moving environment. The netting you're observing reflects the portfolio activity associated with the re-hedging we carried out. As the quarter progressed and rates fluctuated significantly in March, we had to reverse some hedges we implemented earlier in the quarter as the market improved and our portfolio became shorter. Adjustments to our hedges were necessary, which is what you're seeing in those numbers. The interest rate swaps represent a small trade we made for protection against certain rate scenarios, and that's what you're viewing on that page.

Got it. Okay. So I heard the initial comment as you saw an opportunity, and I assume that opportunity is persistent, and what you're saying is that there was an opportunity in terms of the curve that you saw benefited from it and then largely netted that trade out as you move through the quarter.

Well, I wouldn't say we netted it out. We're ending the quarter with us. We ended the quarter with some of our hedging in swaps. It's just that as we re-hedged through the quarter, some of the initial trades we did, we had to pare down along with other trades because our hedge book has to move with the duration of our underlying securities.

Okay. Got it. Thank you very much.

Of course. Thank you.

Thank you. There are no further questions at this time. I'll hand the floor back to management for closing remarks.

I want to thank you all for those good questions. I want to thank you all for taking the time to join us today, and thank you as always for your interest in Two Harbors.

Thank you. And with that, we conclude today's conference. All parties may disconnect.