Earnings Call Transcript - TWO Q2 2022

Operator, Operator

Greetings, and welcome to the Two Harbors Investment Corp. Reports Second Quarter 2022 Financial Results Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this call is being recorded. I would now like to turn the call over to Paulina Sims, Head of Investor Relations. Thank you. You may begin.

Paulina Sims, Head of Investor Relations

Good morning, everyone, and welcome to our call to discuss Two Harbors Second Quarter 2022 Financial Results. With me on the call this morning are Bill Greenberg, our President, Chief Executive Officer, and 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 two 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.

Bill Greenberg, President and CEO

Thank you, Paulina. Good morning, everyone, and welcome to our second quarter earnings call. At quarter-end, book value was $5.10 per share, reflecting a negative 4.7% total economic quarterly return. After the significant bond market adjustments in the first quarter, volatility persisted into the second quarter. Inflation remained higher than anticipated, prompting the Federal Reserve to speed up monetary tightening, which raises the likelihood of a recession. Many asset classes, including mortgages, experienced increased risk aversion during the quarter, resulting in mortgage performance in the first half of 2022 being among the worst in decades. We commenced the year with mortgage spreads at nearly record tight levels, adding substantially to our mortgage servicing rights (MSR) portfolio while decreasing residential mortgage-backed securities (RMBS) balances and overall leverage to counteract spread widening. These actions helped mitigate losses over the past two quarters, but we are now in a significantly different position, with current mortgage spreads at historically wide levels. Despite the economic uncertainties and the future direction of interest rates and monetary policy, we see considerable opportunities in both RMBS and MSR, and we've adjusted our portfolio to leverage the current market by increasing RMBS exposure and leverage. We're also poised to further enhance our MSR assets. We are pleased to announce our agreement to acquire RoundPoint Mortgage Servicing Corporation from Freedom Mortgage Corporation. This move represents a strategic pivot as we shift to an in-house servicing model. Given the growth of our MSR portfolio, managing servicing operations internally will boost efficiencies and returns on our MSR assets, allowing us to enhance recapture and portfolio defense strategies, expand our third-party subservicing business, and explore additional opportunities within the mortgage finance sector. We will purchase RoundPoint for a preliminary price that includes its tangible net book value plus a premium of $10.5 million, subject to post-closing adjustments. This transaction will exclude an MSR servicing exchange known as RPX and a retail origination platform, both of which RoundPoint will sell before closing. Founded in 2007, RoundPoint is led by a team with extensive industry experience. By merging their established practices with the scale of the Two Harbors portfolio, we believe we can make this transition from our subservicing model efficiently. Although the deal is anticipated to close in 2023, we aim to start transitioning loans to RoundPoint as a subservicer later this year. As we scale RoundPoint, we expect to realize approximately $20 million in incremental annual pre-tax earnings. Beyond improving MSR servicing efficiency, this acquisition will create additional and diverse revenue opportunities. As an experienced subservicer, RoundPoint will allow us to seek ways to grow that business and exploit the economies of scale in servicing operations. Furthermore, we believe this will enable us to collaborate more closely with our MSR flow sellers and develop stronger industry partnerships. Overall, we are very enthusiastic about integrating RoundPoint and enhancing our MSR strategy. During the quarter, inflation continued to rise, with the May and June CPI readings at 8.6% and 9.1%, the highest annual inflation rates since 1981. Inflation expectations have consistently fallen short, resulting in the Fed accelerating monetary tightening, having raised its benchmark rate by 225 basis points this year, including two significant hikes of 75 basis points. Many in the market now suspect a hard landing for the economy is increasingly possible due to these aggressive measures to control price growth. Consequently, uncertainty around interest rates sent bond market volatility to multi-decade highs. For instance, the two-year treasury rate rose and fell significantly within the quarter. Realized volatility in mortgage rates similarly surged as the market adjusted to new economic data. In this quarter filled with volatility and uncertainty, mortgage performance understandably suffered. The Bloomberg US MBS Index had negative excess returns for the second quarter, making it one of the weakest quarters in two decades. Given the mortgage underperformance, we now see significant upside potential in owning RMBS at these levels, with current coupon ZV spreads widening considerably. Low nominal spreads have rarely remained at such elevated levels for extensive periods. Despite the ongoing volatility, mortgages remain attractively priced, offering above-average positive returns if further spread widening does not occur. Additionally, the range of available RMBS coupons has greatly increased, providing lucrative relative value investing opportunities. Unusually large liquid tradable coupons are now available. We think it is more relevant to compare spreads of bonds of similar durations than to keep the coupon fixed. The changes in interest rates have affected coupon levels and mortgage durations. Notably, although low coupons face risks from prepayments, they are easier to hedge than higher coupons, which require more frequent rebalancing. The similarity of the OASs to low coupons suggests that projected high coupon returns remain favorable even under sustained high volatility. We believe higher coupons present more value in this environment, as recent trends indicate that low coupons have limited upside. Thus, we find the higher coupons to offer considerable relative value. Now, I will turn it over to Mary to discuss our financial results in more detail.

Mary Riskey, CFO

Thank you, Bill, and good morning, everyone. Please turn to slide seven. For the second quarter, the Company reported a comprehensive loss of $90.4 million, representing an annualized return on average common equity of -19.1%. Our book value was $5.10 per share compared to $5.53 at March 31. Including the $0.17 common dividend results in a quarterly economic return of -4.7%. The results primarily reflect the mortgage spread widening Bill discussed earlier and, to a lesser degree, higher hedging costs as a result of the elevated volatility we saw during the quarter. Moving on to slide eight, earnings available for distribution was $0.22 per share compared to $0.18 for the first quarter. Interest income increased by $12.2 million as we grew the RMBS portfolio and rotated into higher coupon securities. Interest income also benefited from lower amortization as prepayment speeds declined. Interest expense rose by $14.8 million to $37.1 million due to the combination of growth in MSR borrowing balances as well as an overall rise in rates. TBA dollar roll income increased to $57.7 million on a higher average notional position in a shift to higher coupon TBA which benefited from roll specialness. As we noted earlier in the year, we expected roll specialness to fade in the second half as supply catches up to demand in the production coupons. Currently, we aren’t seeing TBA persistently special in any coupon. Finally, our U.S. Treasury futures income was also lower reflecting a larger short position which was used to hedge lengthening mortgage duration. Turning to MSR, net servicing revenue grew by roughly $6.7 million to approximately $76.1 million in conjunction with a larger average MSR portfolio. Turning to page nine, the portfolio yield increased 94 basis points to 4.39% driven by our investment in higher coupon RMBS and higher yield on a larger average MSR portfolio. Our realized net spread in the quarter was 3.26% compared to 2.75% in the prior quarter as the higher portfolio yield more than offset an increase in the cost of funds. Net spread as of June 30 is estimated at 3.18%. As noted on the bottom of the slide, beginning with the second quarter, we have incorporated the implied asset yield and financing of TBA. First quarter comparative data has been updated to reflect the change. Please turn to slide 10. Funding in the repo market remains liquid and well supported. Similar to the first quarter, funding costs for Agency RMBS rose on an absolute basis. However, as shown in the chart in the upper right, the spread itself remains low, currently right around 10 to 13 basis points for both three-month and six-month maturities. We maintained access to diverse funding sources for MSR. Our unfunded and committed MSR asset financing capacity stood at $218.8 million at quarter-end with additional capacity available on an uncommitted basis. Please turn to slide 11. As I mentioned earlier, we grew our mortgage exposure during the second quarter deploying capital into RMBS and adding TBA which brought our portfolio leverage to what we would consider to be a neutral position at 6.4 times. Average economic debt to equity in the second quarter was 5.6 times compared to the first quarter average of 4.8 times. I will now turn the call back to Bill for our portfolio update.

Bill Greenberg, President and CEO

Thank you, Mary. With large re-pricing and mortgage spread since the beginning of the year, we felt that the historically cheap valuations currently available in the mortgage market no longer justified the underweight we had been carrying, even despite continued market uncertainties. Overall, our specified pool and TBA positions both grew by $1.7 billion respectively as we increased portfolio leverage. We aggressively moved our position up in coupon where we saw the best value with ZV spreads in the 125 to 150 basis point area. During the quarter, we increased our total spec pool and TBA position in 4.5 and 5s coupons by over $7 billion while decreasing our position in 3 through 4 coupons by over $4 billion. Furthermore, after the material widening of lower coupons within the quarter, we increased our position in 2.5s by nearly $0.5 billion. With roll specialness largely a thing of the past, we have added specified pools when we find ones that meet our criteria. Within specified pools, we have focused our purchases within higher loan balance 200k to 250k max pools in Florida geographies. We view Florida geography as a particularly compelling story as it trades to a sizeable discount to loan balance collateral with similar prepayment profiles. Overall, we view these stories as providing cheap prepayment options with low absolute pay-ups and trade at spreads that are wider than TBA. Please turn to slide 12. While all mortgages widened during the quarter, lower coupon suffered the most. As tenure rates rose towards 3.5% and mortgage rates approached 6%, a market-wide rotation from lower coupons to current coupons caused that part of the stack to underperform 30 to 60 ticks. In contrast, the 3.5 through 5 coupons where our portfolio was positioned for the majority of the quarter fared much better using between 5 and 25 ticks. Lastly, prepayment speeds shown in Figure 3 dropped as expected in commensurate with the rate move. With most mortgage-backed securities now trading at a discount, there is a point to remember that faster speeds are actually a cash flow advantage as more principal is returned at par more quickly. In contrast, slower speeds are a cash flow disadvantage for the opposite reason. In furtherance of this fact, prepay speeds on TBA collateral are now below 5 CPR in most cases as those coupons reflect newly originated loans whose borrowers are just settling in and are very unlikely to prepay. As TBA, those slow-paying bonds are the cheapest to deliver. We have constructed our portfolio such that many of our specified pools have seasoning and borrower characteristics which result in faster speeds than the TBA. Please turn to slide 13. Activity in the MSR market remained very robust with approximately $144 billion of UPB offered during the second quarter and another $56 billion coming through in July. As seen in Figure 1, our MSR portfolio declined by $3 billion UPB to $229 billion reflecting net portfolio runoff. Our MSR price multiple expanded marginally to 5.4 times as a result of higher interest rates and wider mortgage spreads. During the quarter, we entered into agreements to sell roughly $21 billion UPB in the third quarter and intend to deploy the proceeds into historically attractive RMBS. Our 60-day delinquency rate continues to fall towards pre-COVID levels and in the quarter at 0.8%. In Figure 2, we show the trend of our settled UPB for our flow and bulk channels over the last four quarters. Slow volumes continue to decline in conjunction with lower refinancing activity. In figure three, we compare our servicing prepayment speeds versus TBA. Overall, prepayment speeds on our MSR portfolio declined by 30%, from 14.2 to 10.0 CPR. A moment ago, I told you about how faster speeds are a benefit for mortgage-backed securities, and slower speeds are a detriment. But that is only true for principal-bearing securities. For interest-only instruments like MSR, slower speeds are always better than faster speeds. Although our MSR prepayment speeds are faster than newly-originated TBA collateral, that is just a consequence of having acquired our portfolio over time. The slow TBA speeds, as I mentioned, reflect newly-originated loans, and there just hasn’t been enough time at these new rate levels to generate MSR off of those loans in any real size. Over time, as those loans move up to so-called seasoning ramp, those speeds should increase as well. Also, over time, we will be able to purchase that newer at-the-money MSR, which will also increase our weighted average coupon. However, we view 10 CPR as already quite slow, and we expect it to move slower still. We project our portfolio speeds to decline another 20 plus percent to 6.9 CPR, and expect further slowing throughout the third quarter. Please turn to slide 14. Through a combination of our RMBS activity and the effect of the large sell-off in rates on our MSR, our exposure to mortgage spreads has increased significantly from where it stood for last quarter, and at the beginning of the year. As seen in the lower right panel, a 25 basis point widening in RMBS spreads would have an impact of negative 7.6%, up in magnitude from negative 2.8% in Q1, and negative 0.8% at the beginning of the year. With no rates on the MSR portfolio being so low, our portfolio coupon is 3.2%, while primary mortgage rates are around 5%. Any change in mortgage rates has little effect on our prepay speeds or current cash flows. Importantly, when RMBS spreads are normal or tight levels, the offsetting risk of at-the-money MSR is a huge advantage, by reducing volatility with high yielding assets. In this unique period, with RMBS spreads so wide, you see the low sensitivity of the MSR asset as an advantage. We capture the upside if mortgage spreads tighten, while the MSR maintains a steady cash flow with low prepays. Over time, as we add new current coupon MSR, the duration and hedging effects of the MSR will return to normal. Please turn to slide 15, where we show our interest rate and yield curve exposures. Interest rate sensitivity of the portfolio has little changed from the prior quarter, and is very low. With the MSR almost fully extended, it has very little duration, and so, the duration gap between our RMBS and repo must be hedged primarily with interest rate products. A 25 basis point parallel shock up would have an effect of plus 1.1% on book value attributed to the MSR asset, as seen in figure one. The RMBS position, on the other hand, had its sensitivity increased to minus 9.5%, and so, the rate hedge offset of 8.5% brings the total rate exposure in an up 25 basis point parallel move to a net positive 0.1%. In today's environment, with the Fed in motion, we have been particularly focused on the very front-end of the curve, and we have been very careful to keep exposure in that part of the yield curve as low as possible. I often like to say that we are mortgage investors, and not Fed interest rate guessers. In figure three, we show that our sensitivity changes in short-term rates are calculated to be 0.0%, impacting the book value in an up 25 basis point there flattening shock. Lastly, I would like to discuss our outlook for Two Harbors, and our return expectations for new investments on slide 16. Static return expectations are as interesting as they have been in a very long time. Lower coupon pools and TBA offer high single-digit returns with relatively low convexity risks. Projected returns on current coupon pools and TBA are in the mid-teens, having very wide spreads, and stand to benefit the most if and when rate volatility subsides. The MSR paired strategy also continues to have low to mid-teens returns and lower RMBS spread risk. All of these pairings currently offer very attractive returns with different risk profiles. Despite the uncertainty and near-term drag from volatility seen during the quarter, the longer-term outlook for Two Harbors is very positive. Historically, wide mortgage spreads present an excellent opportunity for investment, while the variety of tradable coupons within the space allows us to take advantage of relative value opportunities. We expect interest rate volatility to eventually subside, and both the MSR and RMBS should benefit when that occurs. Additionally, we're very excited for the evolution of our MSR strategy through the acquisition of RoundPoint. The increased operational efficiencies and the revenue opportunities it presents will add value for shareholders while deepening our involvement in the industry. Thank you very much for joining us today. And we'll now be happy to take any questions you might have.

Operator, Operator

Thank you. We will now be conducting a question-and-answer session. Our first question comes from the line of Doug Harter with Credit Suisse. Please proceed with your question.

Doug Harter, Analyst

Thanks. Bill, since the Fed meeting mortgage spreads have tightened quite nicely. I guess just one, can you talk about what that has done to book value quarter-to-date, and two, how that has impacted returns and whether that changes any of the attractiveness of assets today?

Bill Greenberg, President and CEO

Thank you for the question, Doug. Good morning, it's great to have you here. The volatility in interest rates and mortgage spreads has persisted since the Fed meeting. Throughout July, price performances have fluctuated. As you mentioned, mortgage spreads can vary significantly from day to day, being a quarter-point or half-a-point wider one day and then the same number tighter the next. Consequently, our performance has also reflected these changes. I’m hesitant to provide a specific figure because it has varied, but by the end of July, our book value had increased by approximately 1.5%.

Doug Harter, Analyst

Great. And then so I guess based on that, do you still see the return environment as relatively consistent with kind of what that outlook slide has?

Bill Greenberg, President and CEO

Yes, generally, given the volatility we experience daily, I do. In certain ways, I believe the higher coupons are evident in both the ZV and the OAS graph presented earlier, as well as in the returns shown on page 16. The low coupons have tightened significantly, as you may have observed, and they appear closer to where they were at the end of March.

Doug Harter, Analyst

Great, that makes sense. Thank you.

Operator, Operator

Thank you. Our next questions come from the line of Arren Cyganovich with Citi. Please proceed with your questions.

Arren Cyganovich, Analyst

Thanks. I just wanted to dig into the acquisition a little bit more. Can you talk about the rationale; is it more of a cost savings or a revenue opportunity that you see there? And maybe dig into some of the benefits of having your own servicer versus using a subservicer?

Bill Greenberg, President and CEO

Yes, there are many benefits, which is one reason we are excited about it. As our portfolio has grown, we have reached a scale that makes it sensible to bring this in-house. The cost savings from doing so, rather than paying subservicers, are substantial; it provides us with greater control over portfolio servicing. Additionally, it enables us to explore ancillary businesses, such as subservicing, and to engage more meaningfully with our existing seller network and other partnerships. Therefore, we believe there are many advantages across our servicing and mortgage activities. Perhaps the most significant aspect is the additional revenue and cost savings we expect to generate.

Arren Cyganovich, Analyst

Okay, I understand. You mentioned a $10.5 million premium to tangible book. Can you share the total sale price and let me know if you will need to raise any equity capital related to the acquisition?

Mary Riskey, CFO

Hi, Arren, this is Mary. So, we can't disclose their book value; they're not a public company. However, we are acquiring their servicing platform, which is a capitalized business, so we're not acquiring any MSR. And they're divesting certain businesses that would have capital. So, we don't expect the book value to be a material number.

Arren Cyganovich, Analyst

Okay, thank you.

Operator, Operator

Thank you. Our next questions come from the line of Trevor Cranston with JMP Securities. Please proceed with your questions.

Trevor Cranston, Analyst

Great, thanks. Good morning. You mentioned the benefit of MSR being less rate-sensitive and spread-sensitive in the prepared remarks in terms of increasing your portfolio's spread exposure. I guess where you stand today, does it make or would it make sense, potentially, to sell more of the MSR portfolio in order to reallocate capital to MBS or given the lower sensitivities, that's not going to be as meaningful of a benefit where we are today?

Bill Greenberg, President and CEO

Thank you for the question. We continuously evaluate relative value, and while RMBS is appealing, MSR is also attractive for different reasons due to its minimal spread and interest rate exposure, alongside strong cash flow. As mentioned earlier, prepayment speeds have decreased significantly, and we anticipate them to be about 7 CPR in July, with expectations for further slowdowns in August. In my opinion, there is a greater chance for speeds to trend slower than faster. We appreciate having a strong servicing portfolio with low coupons and significant discounts, which is sensitive to turnover speeds. Thus, our analysis revolves around relative value and risk profiles. Our strategy may involve selling more assets or purchasing additional ones depending on market prices.

Trevor Cranston, Analyst

Okay, got it. And then on leverage, I think the current leverage level was characterized as a neutral position in the opening remarks. Can you talk about how high you'd be willing to take leverage if you were to get more aggressive, and can you be kind of more outright positive on the market?

Bill Greenberg, President and CEO

Yes, thanks. So, when we talk about overall portfolio leverage, it's important to incorporate the amount of MSR that we have in our portfolio at any given time, right? So, more MSR because the leverage in that asset is lower than the leverage in the MBS asset will generally generate a lower overall portfolio leverage, right? And we have more MSR today than we've had in the past, if you compare our portfolio to what it was pre-COVID. What I would say, as I said, neutral is right around here, mid-high sixes. I would say full overweight is probably in the high sevens, low eights kind of area. But that would be like max overweight kind of thing, which, that's why I say, if you say that's one-and-a-half to two turns higher, go back one-and-a-half to two turns lower, that's what we were when we thought we were maximum underweight, right? So, that's why we say we're sort of in the midpoint here.

Trevor Cranston, Analyst

Okay, that makes sense. Thank you.

Bill Greenberg, President and CEO

With today's portfolio, of course, right.

Operator, Operator

Thank you. Our next questions come from the line of Bose George with KBW. Please proceed with your questions.

Bose George, Analyst

Good morning, everyone. Regarding RoundPoint, now that you'll have a service there, I assume recapturing will become an increasing component of the mix, among other things. Will you also consider origination capacity as another method to acquire MSR?

Bill Greenberg, President and CEO

Yes, so it's not particularly our intention to compete in the origination space with retail participants or wholesale participants. As you point out, we are interested in recapturing other portfolio defense strategies, right, and other ways in which to partner in a complimentary way with our existing servicing seller network and other counterparties. And so, we will be doing some things along that line, but we don't intend, at this time, to really compete in any meaningful way in the retail or wholesale origination space.

Bose George, Analyst

Okay, great, thanks. And than actually just in terms of servicing technology, is there a decision to be made in terms of that? Is RoundPoint, on MSB, is there any sort of cost saves that could be from a servicing technology standpoint?

Bill Greenberg, President and CEO

That's something we are always going to be looking at over time as these things unfold and as it develops.

Bose George, Analyst

Okay, great. Thanks.

Bill Greenberg, President and CEO

Thank you.

Operator, Operator

Thank you. Our next question is coming from the line of Rick Shane with J.P. Morgan. Please proceed with your questions.

Rick Shane, Analyst

Thank you for taking my questions. I have a couple of inquiries regarding the acquisition. There was a question about the size of the acquisition, and it appears to have a minimal book value plus the 10.5 million. Should we expect that the consideration will be entirely in cash? Additionally, when considering the EPS impact, you mentioned $20 million of net income accretion. Should we interpret that as being accretive to EPS as well?

Mary Riskey, CFO

Good morning, Rick. Thanks for joining. So, on an EPS basis, we did disclose we expect incremental pre-tax income to be approximately 20 million once our portfolio has fully transferred, which on a per share after-tax basis will be $0.45 accretive. And I'm sorry, what was the first part of your question?

Rick Shane, Analyst

Consideration, and again, the EPS accretion makes a lot of sense, and it sounds like the book value de minimis, so it's relatively small acquisition price for $20 million of pre-tax?

Mary Riskey, CFO

Yes, you can expect that will be cash.

Rick Shane, Analyst

Got it. And then, when we think about the P&L on a go-forward basis, a servicing platform certainly brings on some additional operating expenses. So, is there anything we need to consider there in terms of how much of an impact it will have on your OpEx side?

Mary Riskey, CFO

I believe we will see some integration savings over time, which should lead to an improvement in our operating expense ratio as we combine common functions.

Rick Shane, Analyst

Got it, okay.

Mary Riskey, CFO

These expenses are what they are, but we do expect some integration savings on the OpEx side.

Rick Shane, Analyst

Got it. And then, look, historically the plus and minus of being a servicer is that it is a business that doesn’t scale particularly well, but it is a business that at the same time has a very predictable stream of revenues. And as a business that has historically relied upon outside servicing, you have been able to bulk up very quickly opportunistically. Do you lose that by taking on the scalability issues of owning your own servicing platform?

Bill Greenberg, President and CEO

Yes and no. I would say that servicing is a core part of our strategy and will continue to be. Given that, the best way to maximize the value from our assets and platform is to have our own servicer. Our history shows that we haven't frequently moved our capital or MSR balances drastically; they have remained steady or grown. We anticipate this trend to continue, and as long as that holds true, owning our own servicer will be more efficient and better positioned to extract value from our platform for borrowers and the additional opportunities we identify.

Rick Shane, Analyst

Got it. And then, last question, and this is for Mary, is there any reason, so you used their value counting for your MSR, many of the servicers use lower cost per market, is there any reason if you internalize your servicing that you need to change that accounting? I just don't remember all the rules associated with us.

Mary Riskey, CFO

No, we will not change our accounting methodology for MSR. It will continue to be valued at accounted for value.

Rick Shane, Analyst

Okay. Thank you, guys.

Bill Greenberg, President and CEO

Thanks, Rick.

Operator, Operator

Thank you. There are no further questions at this time. I would now like to turn the call back over to Bill Greenberg for any closing comments.

Bill Greenberg, President and CEO

I just want to thank everyone for joining us again today, and as always, thanks for your interest in Two Harbors.

Operator, Operator

Thank you. This does conclude today's teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of your day.