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Executives

July Hugen – Director, IR

Tom Siering – President and CEO

Brad Farrell – CFO and Treasurer

Bill Roth – Chief Investment Officer

Analysts

Douglas Harter – Credit Suisse

Mark DeVries – Barclays

Bose George – KBW

Trevor Cranston – JMP Securities

Ken Bruce – Bank of America

Joel Houck – Wells Fargo

Stephen Laws – Deutsche Bank

Boris Pialloux – National Securities

Two Harbors Investment Corporation (TWO) Q4 2012 Earnings Call February 7, 2013 9:00 AM ET

Operator

Good day, ladies and gentlemen and welcome to the Two Harbors’ Fourth Quarter 2012 Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer and instructions will be given at that time. (Operator Instructions). As a reminder, this conference call is being recorded.

I would now like to hand the conference over to your host, Ms. July Hugen, Director-Investor Relations. Ma’am, you may begin.

July Hugen

Thank you, Sei, and good morning. Welcome to Two Harbors’ fourth quarter 2012 financial results conference call. With me this morning are Tom Siering, President and Chief Executive Officer; Brad Farrell, Chief Financial Officer; and Bill Roth, Chief Investment Officer. After my introductory comments, Tom will provide a recap of our 2012 results. Brad, will highlight some key items from our financials, and Bill will review our portfolio performance.

The press release and financial tables associated with today’s conference call were filed yesterday with the SEC. If you do not have a copy, you may find them on our website. This call is also being broadcast live over the Internet and may be accessed on our webpage in the Investor Relations section under the Events & Presentations link. In addition, we’d like to encourage you to reference the accompanying presentation to this call, which can also be found on our website. Before management begins its discussion of fourth quarter results, we wish to remind you that remarks made by Two Harbors’ management during this conference call and the supporting slide presentation may include forward-looking statements.

Forward-looking statements reflect our views regarding future events and are typically associated with the use of words such as anticipate, target, expect, estimate, believe, assume, project and should or other similar words. We caution investors not to rely unduly on forward-looking statements. They imply risks and uncertainties and actual results may differ materially from expectations. We urge you to carefully consider the risks described in our filings with the SEC, which may be obtained on the SEC website at www.sec.gov. We do not undertake any obligation to update or correct any forward-looking statements if later events prove them to be inaccurate.

I would like to draw your attention to the third webinar in our ongoing series titled prepayments part two concepts and agency valuation. The webinar can be found on our webpage under Events and Presentation. We intend to post additional webinars in the future to provide investors and analysts with management insights regarding the market and our business.

I will now turn the call over to Tom, who will provide some highlights as summarized on slide three.

Tom Siering

Thanks July. Good morning, everyone. Thank you for joining our fourth quarter earnings call. Before I comment on the quarterly results, I would like to discuss the full-year. This 2012 was truly a remarkable year for our shareholders. We are delighted to report that for full-year we delivered total return on book value of 47% with dividends of $1.71 per share. We believe this is a testament to our rigorous security selection and the talent of our investment team. It’s important to note that we were able to accomplish us a way that is consistent with our mission of protecting book value through thoughtful hedging.

Our total shareholder per return for 2012 was 40% as measured by change in share price which compares to a return of 19% for the sector in 2012 as measured by the Pine River Mortgage REIT Index. As you know, delivering shareholder value is our primary goal.

Our economic returns during the year were outsized. Our investment team generated $1.05 billion in total comprehensive income during 2012 and we give all credit to them for that remarkable result. Approximately 16% of the attribution return in 2012 was derived from our non-agency strategy with the remaining from the agency portfolio.

Over the last year, we’ve grown our business threefold as measured by market capitalization. At the start of 2012 our market capitalization was approximately $1.3 billion. Through the completion of three capital raises and portfolio appreciation, our current market capitalization is nearly $3.7 billion.

Today, we are the largest public hybrid mortgage REIT. However, it has never been our ambition to be the largest hybrid mortgage REIT, but rather to be the best. We believe the growth in our business over the past year can be attributed to our Alfa generation and Two Harbors best practice policy in respected governments and disclosure.

Of course the key to our perused of excellence is obtained. This year it was transformative for both our investment and administrative teams on the investment side of our business Will Roth become the sole CIO after serving his Co-CIO with Steve Kuhn since our inception of the company in 2009. We would again like to thanks Steve for his service and we look-forward for our continued alliances with him.

As you may recall from the third call, we’ve also expanded on our invest – senior investment management team with a hiring of Nick Smith, Dan Cook, and Bill Greenberg. These key additions expand our investment expertise and enhance our ability to diversify our business model and drive shareholder value overtime.

Today, we have a dedicated administrative team, which we believe is tremendously important to the long-term success for our business and accomplishments as we position ourselves to explore new business initiatives. Effective as of beginning 2012 with Brad Farrell, CFO and most recently Rebecca Sandberg was named General Council effective March 1, 2013.

Brad has previously served as Two Harbor’s controller, and Rebecca was previously our Deputy General Counsel. So, these transitions have been seamless and natural.

Another important accomplishment in 2012 was the contribution of our portfolio, a single-family homes to Silver Bay in exchange for 17 spot 8 million shares of common stock confirmed with Silver Bay’s IPO in December. Since the IPO, the shares have appreciated approximately 10%. These shares are subject to a 90-day lockup, which expires in mid March. As we discussed previously subject to the approval of our board, it is our intention to distribute the Silver Bay shares to our shareholders by means of a special dividend at some point following the expiry of the 90-day lockup on those shares. We will continue to keep you advised if and when the board should make such a determination.

Now moving to fourth quarter results, we recorded a $185 million of comprehensive income. Our book value increased to a $11.54 per share during the fourth quarter, representing the total return of 6% combined with our fourth quarter dividend of $0.55. We reported GAAP earnings of $0.64 and core earnings of $0.28 per share, which Brad will discuss further.

Let’s take a moment to discuss the fourth quarter dividend. As you may recall, this dividend include taxable income from the contribution of our single-family homes to Silver Bay, as well as from realized gains from our Agency portfolio reposition, which Bill comment on later. The $0.55 dividend was also, we believe, in terms of timing for our shareholders given changes to tax policy in 2013. It should not be taken that this dividend level is representative of our ongoing earnings power.

In the fourth quarter, approximately 3.5 million of our warrants were exercised leaving just over 13.5 million of the original 33 million warrants outstanding. This resulted in proceeds of approximately $38 million to Two Harbors. As a reminder, the warrants are stuck at $11 with an expiry date of November 7, 2013, so the warrants are currently in the hedge. As of December 31, 2012, we had approximately 299 million shares outstanding.

Please turn to slide four, I’ll next provide some brief commentary on some developments that could impact our business in the mortgage and housing sector. On a macro level, home price performance, which is important to our non-agency portfolio has been a bright spot recently in a murky macroeconomic environment. Home prices continue to improve across much of the United States. According to CoreLogic, home prices increased 7.5% as of January 1 on a 12-month rolling basis. This forecast call for a continuation of HBA in the next several years, albeit at a slower pace in 2012.

Unemployment metrics have continued to languish at a level higher than we would like to see, although generally seem to be improving. But importantly supply of distressed homes and shadow inventory have been diminishing. Interest rates which are still low by historic levels have moved a bit higher lately on the back of improving economic data and market sentiment. Despite the Fed’s stated intentions, we continue to prudently hedge in spiking interest rates as Bill will discuss further. We also continue to monitor developments regarding policy and regulatory changes a few of which are noted on the bottom of the slide. We always manage our business with these and other potential changes in mind.

Please turn to slide five, you may recall the last quarter we outlined a variety of opportunities that we are evaluating, some of which we may ultimately pursue. I would note that several of the opportunities we are evaluating have the potential to diversify our business, provide returns on co-related to our existing agency and non-agency portfolios and may evolve for more attractive returns in our currently available in our legacy portfolios. Also, they may be even more compelling if and when the interest rate environment changes.

When we evaluate investment opportunities in mortgage market, there are several factors we consider. New opportunities must be grounded in our core competencies such as understanding and managing pre-payment and mortgage credit risk. They must also enhance the overall risk reward profile of our business. Lastly, we must have confidence that we have the proper infrastructure in place to support them. So, with all this in mind, we anticipate a measured move into new opportunities over time. Silver Bay, is a great example of this. Based on our analysis of the distressed non agency market, we found an emerging asset class with an attractive return profile for our shareholders. Bill will comment more fully on some of these nascent investment initiatives.

The fourth quarter and the entire of the year were remarkable periods for our investment strategies, and we believe our performance speaks not only to the quality of our team, our analytics, and infrastructure, but also to the advantage of our structure as a hybrid mortgage REIT. We are very excited about the ongoing opportunity set in the mortgage market and we look forward to 2013.

I will now turn the call over to Brad.

Brad Farrell

Thank you, Tom and good morning. I’ll begin my prepared comments with an overview of our financials and few pertinent accounting topics, discuss quarterly changes to book value, provide an overview of our financing profile and conclude with comments on our 2012 dividend distributions relative to our 2012 taxable income.

Please turn to slide six, core earnings of $0.28 per share represented a 9.8% annualized return on average equity. While GAAP earnings albeit often a less meaningful metric due to mark to-market accounting was $0.64 per share. Strong GAAP earnings were principally driven by realized gain in our RMBS portfolio as we saw surge in agency securities to adjust our risk profile and take advantage of their high relative market valuation.

Core earnings will impact by a number of things, which I will detail shortly. But before that I would also note that we define the core earnings to exclude the revenue and expenses associated with our real estate investment portfolio, which is now presented as discontinued operations in our financial statement. This refinement of the core earnings definition increased our core earnings by $0.01 per share. Core earnings were largely impacted by leverage in the quarter. Total leverage ticked modestly lower to 3.4 times from 3.8 times as of September 30 through the sale of the aforementioned RMBS and also reflecting slightly lower leverage on our agency portfolio, which Bill will expand up on.

We would be remised to now also mention the approximate $336 million invested in Silver Bay common stock. During the quarter, the average capital of $295 million associated with the single family homes due to its ramp stage cause a drag on EPS and ROE metrics. Similar to prior quarters, core earnings were also pressured by our hedging strategy as well as lower projected yields on securities recently acquired.

While we acknowledge it some of the mortgage reinvestors and analyst monitor core earnings to provide a dividend benchmark, it is not the principal metric we focused on when managing our portfolio and as its associate risks. Our primary goal is to deliver total return for our shareholders overtime and it is not our intention to deliver short-term results such as core earnings at the expense of the long-term protection of book value. Our expense ratio as a percent of average equity modestly increased quarter-over-quarter at 0.7%, excluding expenses related to discontinued operations. As we’ve talked about in the past the size of our investment portfolio and new business diversification initiatives will likely impact this metric in current and future quarters.

I would like to briefly touch upon a few accounting matters that are relatively immaterial on a quantitative basis, but provides further color into our portfolio performance and financials. Other than temporary impairments on our non-Agency RMBS were an adjustment of $1.6 million this quarter. This adjustment continues to represent an immaterial amount relative to our overall holdings. I would also note that we re-classified $65 million of our credit reserves to accretable discount during the fourth quarter across 22 bonds.

This is our first sizeable release to credit reserves. The release of credit reserves was driven by fundamental credit improvement in the bonds cash flows. But I would note that the amount represents less than 5% of our credit reserves. This release of credit reserves will respectively adjust the yield recognized on these bonds over their remaining life. Even with lower projected credit losses on these bonds, the yield impact is hugely marginal, due to offsetting extension of these bonds lies and the timing of the principal and interest cash flows.

While we are prudent when it comes to releasing credit reserves due to ongoing uncertainties in fundamental cash flow drivers, we thought it was appropriate for these bonds, but cannot be considered indicative of future releases. The other accounting topic we’re discussing concerns the realized gain accounting for our contribution to Silver Bay. As of December 31, 2012 we recognized $10.6 million of realized gains, which represents the difference in the cost basis of our properties relative to the value of the 17.8 million shares of common stock received in the IPO. Not included in this figure, but which will be recognized in 2013. Our installment sale gains of approximately $4 million. Reduction in future Two Harbors management fees are exactly $4.3 million in the second quarter of 2013, and additional working capital adjustments which were anticipated to be immaterial, but subject to final determination in accordance with the contribution agreement we entered into with Silver Bay.

Now, please turn to slide 7 which contains a quarterly book value report. As Tom noted, our book value per diluted share was $11.54 this quarter, up from $11.44 last quarter. More importantly, this is a significant increase from book value a year ago of $9.03, a 28% increase.

We’re also distributing $1.71 in dividends. As the quarter ends, you will note that the remaining warrants have a slight negative impact on a fully diluted basis as of December 31 due to the closing share price of $11.08.

Please turn to slide A. As it relates to our financing profile, our total number of counterparties remained unchanged at 23. We continue to have a lengthy repo maturity profile with days to maturity, an average of 85 days at December 31.

We continue to focus on high-quality counterparties as represented by the low overall credit scores. As noted in our Analyst Day presentation in October, credit scores are one indicator of the health of our financing profile. As this slide illustrates, we focused on both diversification in our Agency counterparties and strong credit stability in our non-agency counterparties due to the less liquid nature of the investments.

I’d like to next discuss the dividends from accounting perspective. Please turn to slide 9. As many of you know, our dividend distribution requirements are based on cash full income, although GAAP net income for the REIT was $374 million, it’s total taxable income was $440 million in 2012 consisting primarily of core earnings of approximately $315 million, realized gains on RMBS and hedges of $106 million and gains from the Silver Bay contribution were approximately $11 million. This taxable income combined with the amount carried forward from 2011 of $13.7 million supported our dividends paid during 2012 resolving in the distribution of approximately 98% of our 2012 taxable income. We will have a minimum taxable income carryover of $11 million in 2013 which you can see on the bottom right hand corner of the slide.

As it relates to turnover in our RMBS portfolio during the quarter, sales of securities generated capital gains of $103 million. As part of any repositioning in the agency portfolio, we generally realigned our swap and swaption hedges to align hedge duration with that of our assets. Importantly, in unwinding and resetting new swaps, we decided to realize the losses on unwinds in January 2013 rather than in the fourth quarter. This benefited our taxable income in the fourth quarter and our ability to make tax advantageous distribution to our shareholders while lowering our taxable income profile in early 2013 by approximately $58 million. Bill will discuss the positive impacts of the net interest margin as of January 31 for modeling purposes. We do not expect this timing difference to materially impact our 2013 taxable income due to the offsetting reduction in hedging costs and anticipated taxable gains in our RMBS portfolio and potential distribution of Silver Bay common stock to our shareholders.

Now, I’d like to turn the call over to Bill for our portfolio update.

Bill Roth

Thank you, Brad, and good morning everyone. The investment team had another busy quarter both managing our current portfolio and working on potential new opportunities, which I will discuss later.

Please turn to slide 10. 2012 was a great year for investors who have enjoyed a total return on book value of 47%. Both our agency and non-agency portfolios had an excellent year with non-agencies driving performance in the fourth quarter. As some of your may remember, we raised capital early in the year to deploy into the non-agency market as prices were low and yields were in the 9% to 11% range.

These investments have performed exceptionally well. Last summer, the investment ROE on the agency strategy was attractive, so we completed another capital raise which also proved fortuitous to both earnings and book value. We focused on securities with key prepayment protection which was important given the low rate environment and the propensity of borrowers to revise.

On the bottom left to this slide, you can see our return on book value versus some indices for the year. We are very proud of this accomplishment. This also demonstrates why we believe it is important to dynamically allocate capital to different sectors of the market as opportunities change. In terms of yields and spreads, on the bottom right you will see that our yields and NIM for the fourth quarter came in better than we had expected as of September 30.

Please turn to slide 11. As you can see our RMBS portfolio is $14 billion in size including $11.3 billion in agency security and $2.7 billion in non-agencies. You can see on the right that our allocation to agencies has dropped and the allocation to non-agencies and single family homes ticked higher. This reflects our reducing capital and overall leverage to the agency strategy as spreads were generally tight much of the quarter. That is a good segue to discussion about our agency portfolio repositioning.

The markets appetite for prepayment protection continuing to favorably impact the pay-ups of our Agency prepaid protected pools during the quarter and due to appreciation to what we believe was full value, we sold a significant amount of our higher dollar priced agencies. In aggregate, we sold over $3 billion of high pay-up loan balance in MHA, 4% and 4.5% coupon security and subsequently purchased $2.5 billion of prepaid protected 3% coupon security at lower dollar prices and much lower pay-ups over TBA.

This portfolio repositioning reduced both our prepayment risk and pay-up risk. Generally, the bonds we bought with lower coupons and lower pay-ups are much easier to hedge than the bonds we sold, which were higher coupons securities with high pay-ups over TBA. These transactions generated substantial realized gains and were impactful to our $0.55 in the quarter as was mentioned earlier.

For our non-Agency portfolio, declines in severe delinquencies improving home prices and better overall borrower performance have been continuing trends. As a reminder, our non-Agency portfolio was purchased at around $0.50 on the dollar. These bonds have performed well so far and our mark at December 31, was around $0.60 on the dollar. As such, we believe there is further room for upside as borrowed performance in housing continues to improve.

Unfortunately, with a very strong technical in place and limited availability of bond, the ability to upsize our non-Agency position as yields we find attractive is much more challenging today than it was a year ago when there was abundant supply and not many bidders. Although we generally do not comment on book value into a quarter and obviously a month is not a quarter make, we did want to note that non-agency performance has been strong thus far in the New Year. This has been a positive for book value. Agency spread widening in January was a small offset to this. But on a combined basis, our book value for the month moved markedly higher.

As I turn to slide 12, I would like to highlight a few key metrics of our portfolio. The overall profile of our portfolio remained fairly consistent with prior quarters. Our Agency prepayment rate for the quarter including inverse IOs was 6.6%. We believe that this prepayment rate is a result of our dedication to a stringent, security selection approach when purchasing asset. Given the lower NIMs generally available today and the low rate environment, we believe security selection is of paramount importance to our portfolio. About 98% of our Agency portfolio has some type of prepayment protection and we find these assets much easier to hedge as their cash flows are generally more stable than those of generic pools. More details about our Agency holding can be found in the appendix on slides 20 and 22.

Next, let’s talk about leverage. Our overall debt-to-equity ratio is 3.4 times, somewhat lower than 3.8 times at the end of the third quarter. It is important to point out that we have not taken our leverage up on the Agency portfolio to try to generate additional yield in this period of tighter RMBS spread. In fact, our leverage on the Agency strategy dipped to about 5.7 times this quarter. Our top priority is generating shareholder returns over the long-term, which makes book value protection critical to the way we think about portfolio management.

Carrying lower leverage at certain times to protect book value is worth the short-term sacrifice in core earnings. Broadly speaking we continue to target a leverage ratio of six to seven times for the agency portfolio and 1 to 1.5 time for the non-agency portfolio. And we anticipate increasing our leverage on the agency strategy from 5.7 times should valuations look more compelling to us. On the non-agency side, our leverage remains low and within the 1 to 1.5 times range we have historically carried.

Let’s discuss hedging next, which is another important element in protecting book value. Although interest rates remain low, protecting our portfolio again higher interest rates makes a lot of sense to us, especially given that the cost of hedging remains cheap. As a reminder, we swap, hedges and IO bonds to protect our book value. We aim to keep the portfolios interest rate exposure low and we continue to have little duration exposure as you can see on the top right. We had over $17 billion notional and hedges comprised of over $12 billion in swaps and approximately $5 billion in shares as of December 31.

As Brad mentioned, our hedge profile changed from the end of December to the end of January as we unwind swaps related to the portfolio repositioning in December. Because of these changes to our portfolio, at the end of January we had $13.7 billion in swaps with an average pay rate of 66 basis point, and average maturity of about three years, which will be helpful if you are modeling our hedge portfolio.

More details on our hedging positions as of December 31 are in the appendix on slide 19. As a result of higher asset prices lower yields and tighter spread, the current environment for investing today is more challenging than in the past few years. While we are pleased with our performance in 2012, it is our goal to continue delivering attractive returns to shareholders. Our hybrid model provides us an ideal platform to take an opportunistic approach to the residential sector, which includes all real estate asset classes including unsecuritized asset.

On slide 13, we have highlighted as we did last quarter, a variety of potential opportunities that dovetail with our core competencies of credit and prepayment risk management. For the benefit of our shareholders, it is worthwhile to spend time exploring different avenues to add value. But as you might expect, some opportunities may make sense to pursue and some will not. As Tom noted, we continue to build our team with high-quality talent both on the investment and administrative side to give us the ability to expand into areas that will deliver value to shareholders.

Let’s talk about securitization first. Last quarter we noted that the math around creating subordinate bonds and IOs via a securitization have become more attractive recently. Over the past quarter, we’ve continued to make progress on the securitization front. Recently, there has been some media attention concerning a deal that mentions two harbors. We are currently not at liberty to comment on any specific transaction, but we’ll keep you posted when and if we close on a securitization.

Importantly, we continue to build our originator network to source loans, which will enable us to be an ongoing issuer over time. We’re pleased with our progress to-date on developing securitization as one of our tools to drive shareholder value and we’re excited about the future of this initiative.

Credit sensitive loans or CSLs fit nicely with our skill set in analyzing legacy non-agency securities, as these loans are very similar to those in sub-primer Alt A deals. These loans are currently performing where the borrower has either had some payment troubles in the past is underwater on his mortgage or both. It is also not unusual for a loan to have been modified at some point in the past and in many cases, the borrower is in a better position to make the monthly payment now than when the loan was originated.

Like loans in non-agency deals, these loans although currently paying have a reasonable probability of default and possible loss. The advantage CSLs have over legacy non-agency securities is that with CSLs we own the servicing rights for the loans and oversee and direct the work that the sub-servicer does to maximize value.

At this point, we have some small pools that we expect to close on this month. As we accumulate more size, there is the potential to securitize these assets to generate attractive credit investments for our portfolio. While this endeavor is exciting, and capitalizes on our credit expertise, supply is limited typically to what the banks decide to sell and as such, we have little control over how much we can purchase at any point in time.

Finally, keep in mind that our current position is quite small relative to our overall portfolio. Another opportunity we’re evaluating is MSRs, our mortgage servicing rights which we have discussed in the past. We believe MSRs are a good fit for our business as they provide a good hedge to our agency MBS portfolio and leverage our expertise on prepayment.

As I’ve noted before the barriers to entry are quite high but we feel we have been making progress evaluating this opportunity and we will keep you posted when and if we enter this market. Finally as we’ve also discussed before credit investments from the GSE fall into the when and if category.

Before wrapping up, I would highlight that we are excited about 2013 for a variety of reasons including the new initiatives I just mentioned. But while at this point they are quite small relative to our portfolio or in the investigation stage, we believe there is substantial value to our shareholders in seriously considering these opportunities. We aim to continue driving value for our shareholders over the long-term and look forward to keeping you informed on opportunities we see across all facets of our business.

Thank you again for joining us today. I would like to turn this back to the operator at this point.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Douglas Harter from Credit Suisse.

Douglas Harter – Credit Suisse

Thanks. I guess if you could just talk a little bit about the new opportunities on the loan side. Can you talk about the returns there relative to securitizations and what makes that attractive today versus a year ago?

Tom Siering

Sure. Good morning Doug.

Douglas Harter – Credit Suisse

Good morning.

Tom Siering

Thanks for joining us.

Douglas Harter – Credit Suisse

Yeah.

Tom Siering

So on the – I think there were two questions in there. On the credit sensitive loans, yields in that market are very competitive with yields that we see in the non-Agency side, although I will tell you that the value of owning and controlling the servicing is actually fairly substantial. In terms of securitization of credit sensitive loans, there have been some deals done in the past, not very many, but we’ll have to wait and see certainly if we get enough size to securitize.

And then see what the math around securitization is, but in terms of just a raw product, we find them very competitive with their counterparts in the security side. In terms of securitization, as I mentioned, we’re not at liberty to comment on any deals there are currently in the market, but we know what we’ve said before is that securitization math looks a lot more interesting than it did a year ago and that’s due primarily to the triple A part of the capital structure trading at tighter levels than it had back then. And also the fact that the credit enhancement from the rating agencies seems to have found its footing and come down a little bit. Certainly, if and when we complete the securitization, we’ll be happy to talk about what the math looks like.

Douglas Harter – Credit Suisse

Great, I appreciate that. Thanks, Bill.

Bill Roth

Thanks, Doug.

Operator

Thank you. Our next question comes from Mark DeVries from Barclays.

Mark DeVries – Barclays

I have a follow-up question on securitization, at the end of third quarter, you had about 15 million of mortgages held for sale and purchase commitments of 320, but ended the fourth quarter at about $59 million, did you sell any mortgages to another investor during the quarter?

Tom Siering

No, we, there is always the fallout element in our pipeline process, so until they’re funded, they’re either subject to fallout, or subject any sort of bulk transaction that is not complete.

Mark DeVries – Barclays

Okay, got it. Next question is for Tom and I think Brad questioned this a little bit but how do you think about the dividend here with the core earnings obviously kind of below the run rate of the kind of the quarterly value you guys are generating, particularly through the depreciation of your non-agency book. How do you think about kind of using that appreciation through other realized gains to support the dividend going forward?

Tom Siering

I think there is a couple of elements to that question, as you know we do not provide dividend projections, but maybe I can answer that in a couple of steps. One, if you look at our core earnings for the quarter, coming in at $0.28, that will always be driven by a number of things that we think are important, leverage being one which is most depended on our hedging strategy which with the use of swaps and other instruments.

But also, we don’t want to lose sight of the fact that we have Silver Bay capital on our balance sheet, which due to the ramp stage we estimate had a dilution impact about $0.03. So that’s kind of one element is, removing that capital, that average capital that we had, we’ll be close to probably around the $0.31 mark based on our current management of our portfolio. And then going forward, it’s always a balancing act between our book value and dividend, but it really gets back to risk management, that Bill feels, as the team feels that there are opportunities to derisk our profile by harvesting gains that would drive those decisions, and might or might not impact the dividend.

Mark DeVries – Barclays

Okay. And, then finally for Bill, what type of yields do you expect on the CSLs and what kind of leverage do you think you could put against us?

Tom Siering

Yeah, I think I alluded to this just a bit ago. With – the yields on credit sensitive loans are very competitive with non-agency subprime bonds, and the leverage that you can get in the securitization frankly depends on what the best pool looks like. There have been handful – small handful of deals that have been done. We obviously haven’t done one, so I can’t tell you what ours might look like; but on an unlevered basis, we find the yields to be attractive, and on a levered basis through a securitization, we would be very pleased if we could get something like that done, we think it’ll be very worthwhile.

Mark DeVries – Barclays

Okay. Thanks.

Tom Siering

Thanks Mark.

Operator

Thank you. Our next question comes from Bose George form KBW.

Bose George – KBW

Just want to ask about incremental spreads on agencies and non-agencies just given the changes in book value since quarter end?

Brad Farrell

Sure, so, I mean, just to give an idea on non-agencies have a couple of remarks. First of all that market today, a lot of bonds that we typically look at that would be in the 5% to 6% range. Now, one bright spot I’ll mention is which is something that we haven’t seen in a long time is as we started to see the repo funding spread come in on non-agencies which I think is very worthwhile, certainly from the funding standpoint, funding is very plentiful, but we’ve seen some spreads coming about 25 basis points from certain dealers, not everyone, but I think that’s obviously bodes well. So, if you kind of put that together you will see using the kind of leverage that we use, expected ROE, somewhere in the 10% area on a growth basis.

On the Agency side, what we’ve seen so far in January is actually the mortgage we’ve seen as a curve – is deeper on the curve and mortgages have underperformed quite a bit. One of the reasons actually we took our leverage down was because mortgages appear to be fully priced to us at certain times during the quarter and certainly that has helped, help this out in January as the Agency strategy would have suffered. But that being said today, I think that ROEs are also roughly 10% on the Agency strategy using leverage sort of in that 6 and 6.5 times that we typically carry.

Bose George – KBW

Okay, great. Thanks. And then actually on the leverage, I guess you guys said on the Agencies, no plans to change leverage, but just curious on the non-agencies. If things – if the world continues to improve, could there be a change in leverage over there?

Tom Siering

Yeah, Bose. Good morning and it’s Tom, how are you? You shouldn’t expect that our leverage is going to change significantly and either our agency or non-agency portfolios. As you know Bill and I’ve been around a while and we don’t want to treat leverage as a mechanism to create a certain dividend yield but rather we will manage to book prudently from total return perspective. So in short don’t expect much change in our leverage levels.

Bose George – KBW

Okay. Great. Make sense. Thanks. And just one last one, just the GSE prepaid numbers that were out last night. Any surprises there?

Tom Siering

I mean they were pretty much – they were generally flat some were up or some down a little bit, but generally mix. Next month is expected to be down 10% to 15% that’s generally due to day count. But no, there were not any terrific surprises there.

Bose George – KBW

Okay. Great. Thanks a lot.

Tom Siering

Thanks a lot Bose.

Operator

Thank you. And our next question comes from Trevor Cranston form JMP Securities.

Trevor Cranston – JMP Securities

Thanks. Most of my questions have been asked. But I guess one more maybe on the securitization platform. Are you able give us any sense about the piece that which you are able to acquire loan currently and maybe can you talk about if you have any sort of goal or target for the year in terms of kind of getting up to a rate and maybe a deal for quarter or is it just still too early to comment on that? Thanks.

Tom Siering

Hi, Trevor. Good morning. It’s Tom.

Trevor Cranston – JMP Securities

Hi.

Tom Siering

With respect to that it’s just – the very honest answer is that we’re just not sure. It’s going to be dictated by supply and is going to be dictated by the economics and the economics relative to our other alternatives. As we’ve said before, we don’t want to do things to do things, we just want to do things that are smart and optimize shareholder value. So, available supply is obviously going to be driven by a lot of things and putting the market of the real estate market, which seems to be improving, and so, just have to say. but, we’re going to do things, our commitment is only to do things that are smart for our shareholders.

Trevor Cranston – JMP Securities

Okay, that’s helpful. Congratulations on a good year. Thanks.

Tom Siering

Thank you Robert.

July Hugen

Thank you Robert.

Operator

Thank you. Our next question comes from Ken Bruce from Bank of America.

Ken Bruce – Bank of America

Thank you. Good morning.

Tom Siering

Good morning Ken.

Brad Farrell

Good morning.

Ken Bruce – Bank of America

Good morning. My question is a bit more philosophical. You pointed out on a number of occasions that you like the flexibility of the hybrid model and clearly you’re starting to demonstrate that now. It sounds like you’re going to see similar changes just as the year kinds of comes to pass. I guess I would like to maybe understand where you see the boundaries of any strategy shift away from agencies. What might be a gating factor to that? Whether it be tests and things of that nature or just how to think about how far you may evolve the strategy?

Tom Siering

Sure. Yeah, Ken. First thanks, this is Tom. In respect to that, obviously the retest, the whole little test is a gating factor certainly. Not agencies don’t confirm to that particularly as well if at all. But really how we think about it is this, that we want to have new initiatives that are grounded in our core competencies and we are not going to divert very far from that. So, the things that Bill talked about, be it MSRs or securitization or CSLs. Obviously are all very close to our legacy portfolio. They are just new wrinkles, if you will. And the other thing is, so it’s got to be rely upon core competencies and you should think anything to be incremental such as with these new initiatives are.

Ken Bruce – Bank of America

Okay and just as you look at potentially harvesting effectively gains, where there has been relative value has effectively been express your market prices already and rotate out. How much of that would you look to do on any given period. I mean, there is obviously some school of thought that you can effectively pull forward earnings through gain recognition. You see some of that from time to time this past quarter is part of that, and how should we think about how quickly you may move a strategy around, understand you just had incremental, but I guess I’m trying to gauge exactly that what that might mean?

Brad Farrell

Sure. It’s very tough to say. We’re just going to do things that are smart. Value is growing out of the sector, we’ll rotate our developments team that did a marvelous job in the fourth quarter repositioning the agency portfolio by rolling down coupon to enhance prepayment protection. Obviously that resulted in some capital gains in the fourth quarter and it’s very difficult to say. Obviously we have considerations of being a reed, and so we can’t be a high velocity trading vehicle, but we just want to do things that are smart. I was delighted at the reposition in the fourth quarter in building the team constantly and look at ways to enhance value.

Ken Bruce – Bank of America

Okay. And lastly, can you see the number of REIT in one form or another begin to develop operating platforms that have in the sense kind of positioned those companies for doing different things. Is that something that Two Harbors wouldn’t envision as it relates to some of the conduit activities or how should we thinking about your involvement in the loan side of the equation understanding again you’ve made some comments to that, but I’m trying to get a sense as to what scale of that might look like?

Bill Roth

These new initiatives it’s tough to say. All of these things attract mathematically, some of them have operating here on them or some complicated issues around that. But we’re just going to do things again that are smart for our shareholders and things that later on the core competencies where we have the infrastructure to support it, where we have staff to support it, et cetera, but we’re very excited about these new things. We don’t want to oversell them today because they are not a significant part of our portfolio, but it’s just our commitment to enhance shareholder value.

Ken Bruce – Bank of America

Okay. Thank you for your comments. Congratulations on the good quarter and good year, and look forward to seeing in 2013.

Bill Roth

Thanks for those kind words Ken.

Tom Siering

Thanks Ken.

Operator

Thank you. Our next question comes from Joel Houck from Wells Fargo.

Joel Houck – Wells Fargo

Thank you, and good morning.

Tom Siering

Good morning Joel.

Joel Houck – Wells Fargo

Wondering if you can – may be if the crystal ball look out through 2013 and give us may be a range of what you think the net ROEs are for the agency business assuming six to seven times leverage obviously you guys are running a bit below that. And then what margin ROEs look like on the non-agency side again assuming your target leverage ratio of 1 to 1.5?

Brad Farrell

Well, I’ll tell you Joe, if I had a crystal ball, I’ve been on a warmer place than Minnesota right now. Bill commented on the ROEs that exist in the market today and that’s really all that we can say. Mortgage spreads are pretty manageable, we’ve seen a lot of volatility in the past few years, and so it’s very difficult for us predict and certainly we would be reluctant to give any guidance. Market conditions just change too rapidly. Today there is some lowers in the past few years. We’re trying to enhance our ROEs through new initiatives, but outside that we really can’t say a lot.

Joel Houck – Wells Fargo

Okay. So Tom, I guess are the best assessment I guess at this point in terms of modeling this after balance of 2013 is that fair?

Tom Siering

Yeah, that’s difficult to say. I mean ROEs move around a lot. So what they are today is some indication, but they’re changing awful lot. So we’ll just have to see. We’re optimistic, but market changes, conditions change daily.

Joel Houck – Wells Fargo

And I guess in terms of the new initiatives what is the – obviously this is small right now, but as you kind of look out I mean how do you think about these businesses particularly our understanding is that purchased MSRs can be restructured to read eligible assets. So would you guys envision any potential changes, maintain a REIT status with respect to the asset and the income tax or is that really kind of dependent upon the opportunities that you kind of put in as the company going forward or.....

Tom Siering

Yeah, thanks for the question. We’re not going to do anything to jeopardize our REIT status. So, and how big the initiatives are just it depends. These things are mathematically attractive today. They have operating complexities, and – but anything that we do, we’re going to do well. That’s our commitment.

Joel Houck – Wells Fargo

Okay and then last, I guess it’s safe to say that anything you guys are currently looking at, you already have the existing infrastructure expertise with your affiliation of Pine River. Is that a fair statement?

Tom Siering

I’m not going to spend one money of shareholder value that I don’t feel confident that I can manage prudently and demonstrate best-in-class in everything, investment, controls, accounting, audit, the whole thing. So, when we say we want to be the best, we mean it. We want to be the best.

Joel Houck – Wells Fargo

Okay.

Brad Farrell

And I could maybe expand upon that, as each of those initiatives have their own unique characteristics, they also overlap with each other. So, areas of underwriting, due diligence, operational components. Those will continue to be expanded upon as each of those grow. And really try to understand each of the – the opportunities in each of those three buckets, you can actually get to the underwriting stage early in the phase. And so, you can really understand the credit components, or the prepayment components. And so, we obviously will build out the appropriate team to kind of maximize the value in those areas. Silver Bay is probably a good example of that. There was appropriate hiring to support that initiative, make sure that we’re managing the risks, those are operational risks, those are even asset class risk. We will be approaching at the same way on each of those initiatives. Fortunately, they overlap a lot. So, it can be fairly streamlined in what we do.

Tom Siering

And finally, I would say to your point, yes, without a doubt that the external manager being part of the Pine River family gives us a lot of support in a variety of areas and we rely upon that relationship and benefit from it certainly. We are very proud to be part of the Pine River family.

Joel Houck – Wells Fargo

All right. Thank you very much.

Operator

Thank you. Our next question comes from Stephen Laws from Deutsche Bank.

Tom Siering

Good morning.

Stephen Laws – Deutsche Bank

I have specific stuff has been covered in the deck or the Q&A. I just wondered if you guys could take a minute, maybe talk about the competitive landscape particularly with respect to non-regulated mortgage REITs versus regulated financial institutions and their unknown balance sheet requirements and other issues that they may or may not have addressed for them any time soon, and kind of how that positions you guys to target more of these credit sensitive investments?

Tom Siering

Good morning. Thanks for the question. Yeah, that’s -I’ll try and be brief because that sounds like it could be a lengthy discussion, we could have or beer some time.

Stephen Laws – Deutsche Bank

Sure.

Brad Farrell

The banking industry obviously has had – they have had their headaches with regards to whole host of issues in the mortgage arena. There is a hangover that exists certainly for certain institutions and obviously they are being highly regulated in terms of our participation as well as capital rules. On the other hand, the banks enjoy the tremendous benefit of being able to collect deposits which is certainly tremendous from this funding standpoint.

In our case, we’re basically focused on a very small part of what banks do in general. We’re focused on the residential market with an extremely high emphasis on securities, and we also fund ourselves using this tree, and that’s not something that enjoys the benefit of federal deposit insurance certainly.

So, the business models are very different. What I would say is that in terms of taking a look at mortgage credit, I think the remodel is very, very well set up, ourselves particularly since that’s one of our core competencies to be a long-term provider of mortgage credit. And, as the government goes through and figures out what they’re going to do with housing, finance, the GSEs, the new definitions of what qualifies, we’re very excited about our ability to put capital to work at what we think are going to be attractive returns that don’t have any necessarily regulatory burden due to the deposit insurance that the banks enjoy.

Stephen Laws – Deutsche Bank

Great. Well, thanks for the color. The brief color on that and I definitely look forward to catching up on that in more detail in person sometime.

Tom Siering

Sounds great. Thank you.

Operator

Thank you. Our next question comes from Boris Pialloux from National Securities.

Boris Pialloux – National Securities

For taking my questions, just a quick question. The first one is, until March are you hedging your exposure to Silver Bay? And second question is, you were mentioning in the press release that you have $56.9 million of purchase commitment, does that include CSL?

Tom Siering

Good morning, Morris, this is Tom. I’ll answer the first question, and then hand it over to Bill for the second question. In respect of hedging our exposure to Silver Bay, the answer is no. It is of unhedged position. So, in respect to our overall portfolio, it’s not that impactful, but there is a correlation obviously mathematically between our holdings and Silver Bay and book value for Two Harbors, so it’s relatively de minimis, but it’s an unhedged position.

Brad Farrell

And, this is Brad, I can take the second. The answer is no. There was small CSL trades that Bill mentioned are not part of the pipeline as noted in our 1231 position.

Boris Pialloux – National Securities

Okay. Thank you.

Tom Siering

Thanks, Morris.

Operator

Thank you. Our next question comes from (inaudible) Point.

Unidentified Analyst

Question, just one quick one. Given the investments in the platform, what could we expect for the run rate operating expenses on go-forward basis?

Tom Siering

That’s – I think that’s a question just like the – just look at all these strategies, we can say fairly limited amount, it all related to drives on which one and what size, and how fast. I think in the near term, it’s a fairly small amount in correlation to the size of the balance sheet position, and we’re really unable to provide much more color than that.

As we go through each quarter and generate a focus on our balance sheet and showing the assets that we’re building, we’re going to give a lot more color on how the basis points might change. Now, all these strategies is important to realize that a large part will have operational cost to them that are really embedded in the investment themselves. Due diligence of loans, underwriting for example, which are we match from an accounting perspective show an increase in the operating expense ratio, but really it just embedded in the ROEs of that strategy. So, those are some things to think about. At this time, I can’t really provide much more color.

Unidentified Analyst

All right. Thank you.

Tom Siering

Sure. And I’ll just add on to that too, importantly when we – as we might spend money on these new initiatives, we’re making sure that we’re getting value for that. So, we go through what it costs to create and operate these new strategies and we want to make sure that they are incrementally accretive to earnings. So, that’s how we think about it.

Unidentified Analyst

Got it.

Tom Siering

Thank you.

Operator

Thank you. I’d like to hand the conference over to Tom Siering for any closing remarks.

Tom Siering

Well, thank you for joining our call. As we discussed, we’re greatly pleased with the returns we generated for the shareholders in 2012 and are optimistic about the opportunities that we see over the coming year. Thanks for listening. Have a great day.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This concludes our program for today. You may all disconnect and have a wonderful day.

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