Two Harbors Investment Corp. Q3 FY2024 Earnings Call

Please stand by. Good morning. My name is Cynthia, and I will be your conference facilitator. At this time, I would like to welcome everyone to Two’s Third Quarter 2024 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 period. I would now like to turn the call over to Maggie Karr.

Good morning, everyone. And welcome to our call to discuss Two’s third 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 William Dellal, our Interim 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 twoinv.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. Acceptance may be required by law; Two 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 third quarter earnings call. Today, I’ll start by providing an overview of our performance and strategy, followed by a discussion on the markets, and finish with an update on RoundPoint operations. William will cover our financial results in detail, and Nick will discuss our investment portfolio and return outlook. As you may have noticed in our earnings presentation and on our website, we have recently launched a new brand, referring to ourselves simply as Two going forward in all of our Investor Relations and marketing communications, reflective of our evolution as a company into an MSR-focused REIT. While our core competencies have always been the understanding and managing of interest rate and prepayment risks, this new branding marks, in a very visible way, our commitment to MSR as a core part of our investment strategy. Although we intend to grow our origination and operational capabilities within our RoundPoint subsidiary over time, we are intently focused on providing high-quality investment returns, and our combined strategy is designed to extract the most value that we can from our MSR asset for the benefit of our shareholders. I’ll tell you about some of those things in a few moments. Please turn to Slide 3. Our book value at September 30th was $14.93 per common share, which, including the third quarter common stock dividend of $0.45 per share, represented a 1.3% quarterly economic return on book value. For the first nine months of 2024, we generated a 7.0% total economic return on book value, which demonstrates that our strategy is designed to produce strong returns across market environments. Please turn to Slide 4. Figure 1 shows market expectations over the past year for the Fed funds rate. As you can see by looking at the green line, at the end of the second quarter, market expectations were for a total of 50 basis points in cuts in 2024. However, forecasts rapidly changed for the short end of the yield curve following the Fed’s 50-basis-point cut in September, such that by the end of the quarter, the market was pricing in almost 200 basis points of cuts over the next 15 months, bottoming out at around 3%, referenced by the blue line. Recent data, including inflation, jobs, and retail sales, have all come in hotter than expected, and ambiguous statements from several Fed governors have resulted in the market tempering its enthusiasm, so that as of October 21st, two cuts have been taken out of the market and the terminal rate is projected to be around 3.4%, which you can see in the purple line on this chart. Moving to Figure 2, ultimately the 10-year treasury yield finished the quarter 62 basis points lower at 3.78%, while the two-year treasury yield fell by 111 basis points to 3.64%. The curve steepened by 50 basis points, resulting in the first positively sloped yield curve between two-year and 10-year treasury notes since 2022. However, the change in Fed expectations took their toll on the long end of the curve, and rates increased in the month of October. As of October 21st, which is the purple line in this chart, 10-year rates had given back approximately two-thirds of the third quarter’s rate declines, rising 42 basis points to 4.20%, while the two-year rate rose 39 basis points to 4.03% during the same period, steepening the curve by 3 basis points. If we turn to Slide 5, the acquisition of RoundPoint was almost exactly one year ago, and we are on track to achieve the cost savings that we initially set out in improving the economics for our investments in the MSR asset. Additionally, the direct-to-consumer loan origination channel that we started from scratch in December is starting to bear fruit. Once at scale, we imagine this effort to provide significant hedge benefits to our MSR portfolio and to protect our asset from significantly faster-than-expected repayment speeds should interest rates drop precipitously. In our first full quarter of DTC originations, we closed and funded $22.4 million UPB of first mortgages and have approximately another $35 million of UPB in the pipeline. On not a large number, keep in mind that only about 1% of our MSR portfolio is considered in the money, meaning that the customer has 50 basis points or more of rate incentive to refinance. We also kicked off a partnership with a large originator of second liens and we acted as a broker on $7.5 million UPB in a combination of both open-ended and closed-ended loans. We continue to observe a great deal of interest in this product, with mortgage rates hovering in the low 6s. Although these numbers are small, these results show proof-of-concept. It also must be noted that these numbers were achieved by a very small team of only three to five loan officers during the quarter, and by year-end we expect to have about 30 loan officers. As a reminder, we built our DTC originations from scratch with no legacy risk. We spent a minimal amount of money getting it to this stage, and it is now essentially break-even. We are confident that we are building a strong platform and brand for our customers to meet their mortgage and home equity needs. We are thoughtfully augmenting our investment portfolio with additional revenue and hedging opportunities in order to further enhance a strategy that we expect will deliver attractive returns for our shareholders through a variety of market environments. With MSR at our core, we have built an investment portfolio with RMBS that has less exposure to changes in mortgage spreads than portfolios without MSR, while still preserving upside to decreasing volatility and spread tightening. By investing in Two, our shareholders are able to take part in the mortgage market and benefit from our team’s deep expertise in investing in and managing MSR and Agency RMBS. With that, I’d like to hand the call over to William to discuss our financial results.

Thank you, Bill. Please turn to Slide 6. Our book value was $14.93 per share at September 30th, compared to $15.19 on June 30th. Including the $0.45 common stock dividend, this resulted in a 1.3% quarterly economic return, as Bill has already mentioned. Please turn to Slide 7. The company generated comprehensive income of $19.3 million or $0.18 per weighted average common share in the third quarter. Net interest expense of $42 million was higher in the third quarter on higher average borrowing balances that were partially offset by higher RMBS interest income. Net servicing income was $172 million, minus $4 million of third-party subservicing fees and other MSR-related servicing costs. Net servicing income was unfavorable to the second quarter by $4 million due to lower servicing fee collections offset by higher float income and lower third-party servicing costs from servicing our MSR on the RoundPoint platform. Investment securities gain and change in OCI was favorable to the third quarter by about $337 million due to a rally in rates and spread tightening versus a sell-off in rates and slight spread widening in the second quarter. Servicing asset losses were $133 million in the quarter, unfavorable to the second quarter due to declining rates that drove a larger decrease in the servicing asset. Net swap and other derivative gains were lower in the third quarter by $225 million due to hedging losses from the rally in rates. Please turn to Slide 8. RMBS funding markets remained stable and liquid throughout the quarter with ample balance sheet available. At quarter-end, our weighted average days to maturity for our Agency RMBS repo was 78 days. Spreads for repurchase agreements widened with financing for RMBS between SOFR plus 24 basis points and 28 basis points. The widening was primarily due to uncertainty regarding the Fed’s actions in September. At quarter-end, bank balance sheets were temporarily tight owing to a number of factors that included settlements of auction treasury securities, as well as banks managing quarter-end reporting metrics. Post quarter-end, liquidity and balance sheet room quickly returned to easing financial conditions. Similar effects may occur at year-end, and as has been the case in past years, we will seek to minimize our exposure to year-end funding pressures. We financed our MSR activities across four lenders with $1.6 billion of outstanding borrowings under bilateral facilities. We ended the quarter with a total of $610 million in unused MSR asset capacity and $91 million of unused capacity for servicing advances. I will now turn the call over to Nick.

Thank you, William. Please turn to Slide 9. Our portfolio at September 30th was $16.4 billion, including $11.4 billion in settled positions and $4.9 billion in TBAs. Overall, our portfolio benefited from the net performance of mortgages over the quarter, but performance across coupons was uneven. Lower coupons outperformed as investors added duration in the bond rally, while production and higher coupons lagged as negative convexity kicked in and prepayment concerns emerged. We entered the quarter with an up-in-coupon bias, but as interest rates declined, we shifted our TBA exposure lower, mainly tracking the change in current coupon exposure coming from our MSR and also selling some higher coupon TBAs to mitigate prepayment risk. I’ll review spread performance shortly, but given the performance of spreads over the quarter, we steered the portfolio to have less spread exposure by quarter-end even as the economic debt-to-equity rose slightly to 7 times. The increase in leverage naturally results from MSR requiring more current coupon hedging as rates rally. The amount of spread duration is a function of how many and which TBAs or pools we are long after taking into account the effect of the MSR. We continue to manage our exposure to rates across the curve very closely, as you can see in Figure 2 and can be seen in more detail on appendix Slide 17. Please turn to Slide 10 to discuss the market for investing in Agency RMBS. Over the third quarter, against the backdrop of the Fed continuing to have success in guiding the economy to a soft landing, risk assets performed well. The S&P 500 was higher by about 5.5%, and with interest rates falling and the yield curve steepening, demand remained high for fixed income assets. Figure 1, which we have shown over the past several quarters, shows spreads versus volatility from 2019 through present. Our preferred implied volatility gauge, two-year options on tenure rates, decreased from 104 basis points to 94 basis points on an annualized basis, close to its lowest level for 2024. The nominal spread on current coupon RMBS finished 20 basis points tighter at 107 over the treasury curve, while option-adjusted spreads finished 6 basis points tighter at 18 basis points. While nominal spreads remain wider than longer-term averages, by quarter-end option-adjusted spreads moved tighter than a long-term non-QE average of 29 basis points. With OASs at these tight levels, future spread tightening will likely need to be driven by increased demand from depository institutions and/or further declines in volatility. The nominal spread curve flattened a little but remained steep, with peak spreads around the 5.5 coupon at quarter-end, as you can see in Figure 2. On an OAS basis, the belly coupons of 4.5s and 5s were the richest part of the coupon stack, with the higher and lower coupons somewhat cheaper. The move in rates focused a lot of demand on these coupons from convexity hedgers such as originators and servicers. Please turn to Slide 11 to review our Agency RMBS portfolio. Figure 1 shows the performance of TBAs compared to the specified pools we own throughout this quarter. As I mentioned earlier, hedge mortgage performance varied across the coupon stack, which is evident in this chart. Overall specified pools outperformed TBAs, with better performance from higher coupons as prepayment risks increased. We shifted about $3.8 billion in TBA exposure from 5.5s to 6.5s into 4.5s and 5s predominantly to re-hedge the MSR exposure as rates rallied. Overall, we continue to like the relative value of specified pools to TBAs, particularly some of the seasoned pools we own. We added about $300 million in loan balance 6.5s pools in the third quarter. Figure 2 on the bottom right shows our specified pool prepayment speeds by coupon. On aggregate, speeds increased to 7.6% from 7.2% CPR in the quarter. Primary mortgage rates dropped about 75 basis points to just above 6%, which triggered some mild media effect for high coupon originations from the past two years and led to material increases in print prepayment speeds for 6.5 coupons and above. Overall, prepayment rates for 30-year agency RMBS increased 8% quarter-over-quarter to 6.5% CPR in the October report, which reflected September activity. Please turn to Slide 12 as we discuss the market for investing in MSR. MSR performed well in the third quarter, with strong demand for bulk packages. The volume of MSR sales continued to normalize from the record levels of the past few years. This quarter brought approximately $40 billion UPB of supply, bringing the year-to-date total to $305 billion, about 70% of the pace of 2023. Traded prices have held steady, with the supply being easily absorbed by a deep pool of buyers, including both banks and non-banks. The number of banks offering MSR financing has broadened, and the increased competition has led to a compression in financing spreads. Additionally, we saw the first securitization of MSR financing in the past two years, as spreads for the securities returned to sub-300 basis points to SOFR. Let’s look at Figure 1. As mortgage rates have dropped, prepayments have begun to display a bifurcated pattern. They are speeding up for newer higher coupon mortgages, but they continue to be very slow for the locked-in low coupon COVID-era borrowers. This chart compares actual one-month speeds for 30-year 6.5s versus our MSR population for the past 12 months and then shows projections, the dotted lines, for the next several months. As is evident, while the 6.5s have picked up in speed, our MSR portfolio has not noticeably responded to the rally in mortgage rates. The quarterly prepayment speed was unchanged at 5.3% CPR. Figure 2 shows the composition of our MSR and where mortgage rates were at quarter-end. Assuming a 6.25% mortgage rate, on a UPB basis, only 1% of our MSR has a rate refinance incentive of 50 basis points or more. Even if 30-year mortgage rates were to drop to 5%, the number increases to only 7%. Suffice it to say that we have a substantial buffer to further declines in rates before triggering a large-scale refi wave for our MSR. Please turn to Slide 13, where we will discuss our MSR portfolio. With mortgage rates declining, the price multiple of our MSR decreased slightly to 5.6 times from 5.8 times, and 60-plus day delinquencies remained low at under 1%. The portfolio was $203 billion UPB at September 30th, reflecting the net effects of the settlement of the sale of $6.2 billion of higher coupon MSR that we announced last quarter, offset by settled purchases of $3.3 billion UPB from bulk and flow channels. Post-quarter-end, we committed to purchase $2.1 billion UPB through another bulk acquisition. 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 65% of our capital is allocated to servicing with a static return projection of 12% to 16%. The remaining capital is allocated to securities with a static return estimate of 12% to 14%. With our portfolio allocation shown in the top half of the table and after expenses, the static return estimate for our portfolio is between 9.5% to 12.7% 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 10.5% to 15.6%, or a prospective quarterly static return per share of $0.39 to $0.58. As Bill discussed earlier, since quarter-end we have witnessed a large reversal in rates and have been reminded once again how quickly market sentiment can shift and that bouts of high-interest rate volatility are not over. Mortgage spreads have widened, erasing much of the spread performance of the third quarter. In response, we have moved some of our TBA exposure higher and concurrently increased our spread exposure. As noted earlier, we also added $2.1 billion UPB of MSR through a bulk purchase. While periods of high market volatility remain a challenge, we are confident in our strategy as evidenced by the attractiveness of our return potential. We continue to favor the long-run return and stability of having a majority of our capital invested in low mortgage rate MSR while still preserving some upside to tighter mortgage spreads and a decline in volatility. Mortgage spread volatility has declined as the Fed has moved to an accommodative stance, and the market feels generally balanced with regard to supply and demand. Though demand is strong in the MSR market, we have nevertheless continued to find good opportunities to add at attractive levels, leveraging our deep expertise coupled with the benefits of our own in-house servicing and recapture operations. Thank you very much for joining us today, and now we will be happy to take any questions you might have.

The first question comes from Doug Harter with UBS.

Thanks. I was hoping you could talk about the move lower in the static return for the securities portfolio. How much of that was a result of the move lower in coupon that you talked about?

Hey, Doug. This is Nick. Thank you for the question. It was mostly really related to the fact that spreads just got tighter over the quarter. And also, you have to remember that on our return estimate, that fully reflects the composition of our portfolio. And as you can see, the amount of servicing we have as a percentage of capital has gone up a little bit, and its leverage as a total of the portfolio has gone up. And on the other side, the security side leverage goes down a little bit, so that impacts the return potential as well.

Got it. And obviously, this number moves around, but then, I guess, how would you think about how the, one, kind of how quarter-to-date spreads have impacted book value, and two, kind of how that translates to kind of incremental returns today?

Good morning, Doug. Thank you for the question. I can address the book value aspects. As we indicated in our prepared remarks and as Nick mentioned earlier, the market has experienced notable volatility in October, with changes in Fed expectations, rising rates, and a steepening curve. As of October 18th, we estimate that our book value declined between 1.5% and 3%. Additionally, during the last week, mortgage spreads widened further, resulting in a slight additional decrease.

I can respond to your question. As everyone is aware, there has been a significant reversal since the low rates just before the Fed meeting in September. In fact, since the end of the quarter, we've increased by about 50 basis points or so, and mortgage spreads have widened considerably. Many of the events that occurred during the third quarter have now been undone in this brief period of the fourth quarter. If we evaluate our return potential now, it is definitely leaning toward higher leverage. Since the end of the quarter, as I mentioned earlier, we have increased our coupon and TBA exposure a bit, as well as our spread exposure. Consequently, you will notice an uptick in the return potential on the security side compared to what was observed at the end of the quarter.

Great. Thank you both.

Thank you, Doug.

The next question comes from Bose George with KBW.

Hey, guys. Good morning. Just to follow up to Doug’s question, in terms of the new target range, I was curious what drove the much wider range this quarter.

On the return potential, Bose?

Yes. Exactly. On the return potential. Yeah, it’s quite a wide range and maybe just discuss factors that would take it to the high end versus the low end.

I understand your question, and it's a valid one. The variations in returns are primarily influenced by prepayment expectations and funding rates. The assumptions we consider for the high and low ends significantly impact those numbers. If we apply a wider spread on funding rates for securities in repos, it will change those ranges. We've observed some increased volatility in funding rates and the repo side, but for the pools, our funding for MSRs is set for the long term with fixed spreads. Ultimately, the fluctuations are driven by variations in prepayments and funding rates.

Okay. Great. Thanks. And then just based on your earlier comment, it sounds like the return profile distance quarter-end with the movement rates should be somewhat closer to what it was last quarter. Is that kind of a good way to think about that?

Yes, that's correct. I believe it may even be broader than that because mortgage spreads are currently at their highest levels of the year. There are various ways to evaluate spreads, as everyone knows, but almost universally, they are at peak levels for the year. In fact, as of today, mortgage spreads are beginning to look very attractive.

Okay. Great. Thanks a lot.

The next question comes from Jason Stewart with Janney.

Hey. Good morning. Thanks. Could you talk a little bit about your outlooks intermediate-term, maybe near-term and intermediate-term for prepays, how servicing capacity looks for the industry given where current mortgage rates sit?

We have noticed an increase in prepays this month. This can be attributed to day counts and delays related to mortgage rates from the third quarter. These delays are somewhat difficult to assess for various reasons. However, we anticipate that prepays will rise in the next report, reflecting the recent reversal in rates. We estimated that mortgage rates dropped about 75 basis points in the third quarter and have rebounded by at least that much in the fourth quarter. As we move into the winter months, we expect to see prepays decrease overall, which will show slower turnover rates for the lower coupons and reduced sensitivity for the higher coupons. Previously, there was a brief refinancing environment for the higher coupons, which has now shifted. I will let Bill discuss the MSR side.

Yeah. In terms of MSR supply, I think we have said and other people have commented that MSR supply has really reverted back to more historical norms, that the amount of MSR, which has changed hands in 2021 and 2022 were really, and 2023 were record levels, and now the amount is really back to historical levels, which is in the $200 billion kind of range for a year. So, we are continuing to see certain amounts of pools trade and we are participating in those markets. As Nick said, we participate in that market. We bought some at attractive levels. We are finding opportunities to be situational, right? And we sold a little bit in a previous quarter. We bought some here. So, I would say the market is returning to historical norms, but it remains healthy and well-supported.

Got it. Okay. Thank you. And then, just in terms of transaction activity on the MSR valuation, do you think that has an impact on multiples? Maybe if you could just parse out the delta and the move in the multiple, maybe 3Q to where it is going and 4Q in terms of earnings on float income versus prepays and how those two factors are driving MSR transaction multiples? Thanks.

Sure. The prices of mortgage servicing rights depend on various factors, including short-term rates. If the Federal Reserve cuts rates, float earnings may decrease, which would lower transaction multiples, everything else being equal. Long-term prepayments have likely returned to levels seen a quarter ago, which balances out. The pricing of recapture has become a significant focus for participants in the mortgage servicing rights market. We have observed that the price multiples for MSR packages are currently very flat, spanning from low WACC at 3.5% to higher WACC packages around 5% to 6%. This flatness is due to the perceived value of recapture. Overall, while short rate movements are relatively minor compared to our current position, the steepening of the forward curve indicates that future float income projections are higher than they were when the curve was flat. Consequently, we expect only minor changes in MSR multiples.

Yeah. And I’ll just add on to that. So, your question about float income versus prepays, we’ve talked in previous calls about the fact that a lot of our price sensitivity on our MSR is really related to float income, given how far out of the money our MSR is, given its low gross WACC. And although there is always some prepay response, as we’ve gone to some lengths to demonstrate, it’s still pretty small, right? So, most of the price sensitivity that our MSR displays is about float rather than prepays, and I don’t think that’s changed dramatically in this move. Of course, if you had higher gross WACC MSR alone, then it’s prepays and current coupon exposure would have a much bigger impact on the pricing. But most of it is really just interest rate movement related.

Right. So, net neutral on market multiples and bias higher on Two’s MSR multiple. And then, just a quick question. Is the MSR, in your estimate of book value quarter-to-date, is there any change to the MSR valuation embedded in that?

Yeah. Well, when we said we were down between 1.5% and 3% as of October 18th, that incorporates the entire portfolio.

Okay. Thanks.

Thank you.

The next question comes from Rick Shane with JPMorgan.

Thanks, everybody, for taking my question. I’d like to follow up on Jason’s questions related to the MSR. When we look at the sales and bulk purchases, they almost net out. When we look at the gross coupon rate, it ticked down slightly. Can you help us understand a little bit about the characteristics of the purchases you’re making? I’m assuming that some of this is, or a lot of this is seasoned MSR. You’re not buying new production. But help us understand what’s going on here and what the strategy is.

Thank you for your question, Rick. MSRs are complex assets influenced by various factors in their valuation. There's an old saying in the bond market that there are no bad bonds, just bad prices. We evaluate the WACC range of MSRs, and each package has its own characteristics, making it challenging to generalize. We've sold some high gross WACC assets while also purchasing a mix from time to time. We've acquired intermediate WACC assets in the 4% to 5% gross WACC range, but the values can fluctuate based on the specific asset. Just because an asset has a high gross WACC doesn't mean it's not a good value. It's important to note that the intricacies of these assets can significantly impact their worth. Additionally, we have flow MSRs coming into our portfolio, which are typically current coupon. Overall, our strategy encompasses a variety of asset types.

Okay. And, again, when I think a lot, it’s interesting. I’m looking at your slides, looking at the new logo, looking at the new branding and realizing that this is indicative of the strategic shift that you guys are pointing to. And when we think about how you’re approaching the MSR market at this point, we’ve historically thought of it as a pure hedge against the agency book. But I think what you’re, what’s really happening here is that you’re trying to play both sides of the coin, that you really want to be in the recapture business. You’re competing there as much as you are sort of creating the traditional, I’ll call it, Two Harbors book versus the Two book.

I think that’s mostly accurate. In recent years, as interest rates increased, the traditional hedging capability of the MSR asset decreased, leading to a separation between the MBS and MSR portfolios since they didn’t necessarily offset each other. However, we see value and return potential in both. Currently, our MSR portfolio, with a gross WACC of three and a half, is prepaying slowly, generating strong cash flow, and is quite far from being in-the-money. While the MBS and MSR components do not perfectly hedge each other, they do complement one another. When considering ways to enhance potential returns from our MSR asset and benefit both the company and shareholders, there are actions we can take on the MSR side that aren’t applicable to the security side. One such action is acquiring a servicer. As I mentioned earlier, we're on track to achieve the projected cost savings through economies of scale and by controlling our own path, which allows us to operate more efficiently compared to relying on subservicing. The recapture strategy plays a role in this as well. I’ve publicly noted that we can hedge against faster-than-expected prepayment speeds. When rates fluctuate, we have expectations about prepayment behaviors and, consequently, MSR prices, which we can hedge using financial tools. However, we cannot hedge against speeds that exceed our expectations. Our direct-to-consumer channel is set to assist us in this effort. That’s the rationale behind pursuing this strategy. Additionally, now that we're here, we can undertake more initiatives, such as originating or brokering second liens to others. This acknowledges that we are building an ecosystem around the MSR asset aimed at supporting and enhancing the investment portfolio.

Got it. Hey, Nick. Thank you very much, and Bill, that’s very helpful. It’s good to get strategic insight and we appreciate it. Thank you.

Yeah. Thanks, Rick.

The next question comes from Trevor Cranston with Citizens JMP.

Hey. Thanks. Can you talk a little bit about your thoughts on swap spreads relative to treasuries? If there’s a limit to how low you think those can go and how all that plays into your choice of hedging instruments for the portfolio? Thanks.

Hey, Trevor. Thanks for that question. It’s a great question, and I will hesitate to state a limit on where I think swap spreads can go. We’ll say that, we use a combination of swaps and treasury futures to hedge our book overall. And it does appear to us as though a lot of the supply concerns about the market are priced into swap spreads right now. We are at extremely tight levels on swaps relative to treasuries. But as we’ve seen this quarter, that gap continues to grow, and a lot of it has to do with market directionality, and a lot of it has to do with the expectation for budget responsibility of the next and future administrations. But overall, we do think that swap spreads here present a good hedging opportunity and have shifted a little bit or remain reasonably, heavily hedged with swaps. Just thinking that they do offer better carry from a hedge perspective, and that there are reasons to also believe that swap spreads could widen. One of them really would be if the Fed were to really stop the QT side. I mean, and that, there are debates about that in the market. There are arguments on both sides, but there’s a reasonable chance that that happens as well, which would change the dynamic of that market greatly. But it’s a very good question, and it’s one in which a lot of it will just depend on what happens from a budgetary perspective for the U.S. and what supply looks like. But as I said, on balance, we think that there is a lot of the bad news about the budget and treasury supply is priced into spreads right now.

Yeah. Okay. That’s helpful. Thank you.

The next question comes from Eric Hagen with BTIG.

Hey. Thanks. Good morning. When you say that you raised your spread exposure into October, is that a function of taking your financial leverage higher, or is your spread exposure also a function of how much TBA you have relative to pools and such?

Hey, Eric. There are a few factors at play here. It's not about leverage, which we noted in our prepared remarks. Leverage is just one measure of risk we consider, particularly concerning our spread exposure related to the MSR. When interest rates drop at the MSR, we need more mortgages to hedge; when rates rise, we need less. So if we maintain a similar amount of mortgages, our spread exposure will increase as rates rise and decrease as rates fall. Essentially, this is more about allowing that exposure to grow as spreads have widened rather than leveraging more. We haven't actually increased our leverage.

Okay. Got you. I think there is a follow-up question here on leverage, though. I mean, how do you benchmark your leverage relative to the spread environment? Like, does your leverage account for the fact that the Fed is expected to cut rates versus last year when spreads were even wider than they are right now, but the benefit from the borrowing cost wasn’t really reflected in the spread environment? How do you benchmark your leverage against that?

Honestly, I’m not sure I fully understand your question. We assess our portfolio composition and examine the market spreads to determine the potential returns we can achieve. As mentioned in previous calls, we’ve provided a range for our overall economic leverage. I believe that relates to our current view on spreads, but it seems you are inquiring about whether we are forecasting mortgage performance based on the Federal Reserve's actions. However, I'm not entirely certain what you are asking.

Okay. You guys have the convertible debt coming up on a current liability in a couple of months. Do you have a sense for how you’re thinking about potentially refinancing that? It’s your capital structure.

Well, the convertible debt is coming due in early 2026, and so that’s on our radar, and we’ll be addressing it before that. One other point if I could just make about your question about leverage and so forth, and Nick’s answer, I might just elaborate a little bit that leverage is one measure of our risk that we look at, of course. But we have other measures in terms of that we put in the deck also about our mortgage spread exposure and the amount of liquidity we have and so forth. And because the MSR, as out of the money as it is, it does still contribute to offsetting some mortgage spread exposure. We think that’s important to include in our overall risks as well. And so, we don’t just look at leverage as one measure, although we obviously pay attention to it and respect it, but it’s a whole suite of metrics that we look at when we’re managing the portfolio exposures.

Gotcha. All right. That’s really helpful. Thank you, guys.

Thank you.

The next question comes from Harsh Hemnani with Green Street.

Hey. Thanks for taking my question. So, now that RoundPoint is scaled up and operating, I guess, could you remind us the recapture rate on a long-term basis that you’re projecting on the MSRs there?

Yeah. I mean, as I said, we just finished our first quarter of DTC operations, and as I mentioned, we only had a number of loan officers that can be counted on one hand, so we’re not up to scale yet. As I said, I think what we’ve done here is a proof-of-concept, and we’re bringing the thing to scale. And so, I think it’s too soon to talk about what the recapture rates are in our portfolio. But we do expect that we’ll be able to achieve an industry-level recapture rate on the agency portfolio once we’re fully at scale. We are in this weird environment where 1% or less than 1%, especially with the recent movement rates of our portfolio, are at the money. And so, this is a small number of our portfolio that is actually in the money. So, it’s not a great moment to talk about what the recapture rate is, but we’ll have more to say about that in future quarters.

Okay. That’s fair. And then, you’ve touched on this a little bit in the prepared remarks and on a few prior questions, but perhaps in the near-term, call it, next couple of quarters, how are you looking at the relative value across the Two strategies, right? Where are you seeing the opportunity to invest the better in the securities portfolio or MSR?

Thank you for your question, Harsh. Currently, mortgage spreads have shown significant movement this quarter, making the mortgage side quite appealing at this moment. It's difficult to predict how long this will remain the case. Many market participants seem to be waiting for the election to conclude, as we anticipate considerable volatility with several important events coming up in the next few weeks, including non-farm payroll data, the election, and the Fed's upcoming decisions. This uncertainty is likely causing many investors to adopt a wait-and-see approach, which helps explain the recent behavior in mortgage spreads. If I had funds to invest today, I would choose the mortgage side due to its attractive spreads. However, this situation might not endure unless we experience changes in the environment, such as a return to higher rates or uncertainty regarding the Fed's actions. Overall, I believe mortgage spreads could perform better after we navigate these upcoming market events. In the long term, we continue to favor our mortgage servicing rights (MSR), as they are a strong risk-reward investment, easy to hedge, and generate stable cash flows with reliable prepayments.

Got it. Great. Thank you.

Thank you, Harsh.

There are no further questions at this time. Mr. Greenberg, I will turn the conference back to you for any additional or closing remarks.

I’d like to thank everyone for joining us today. Thank you, as always, for your interest in Two Harbors. Go Two.

This concludes today’s call. Thank you for your participation. You may now disconnect.