Two Harbors' CEO Discusses Q1 2013 Results - Earnings Call Transcript

May. 8.13 | About: Two Harbors (TWO)

Two Harbors Investment Corp. (NYSE:TWO)

Q1 2013 Results Earnings Call

May 8, 2013 9:00 AM ET


July Hugen - Director, IR

Tom Siering - President and CEO

Brad Farrell - CFO and Treasurer

Bill Roth - Chief Investment Officer


Douglas Harter - Credit Suisse

Mark DeVries - Barclays

Trevor Cranston - JMP Securities

Jason Stewart - Compass Point

Dan Altscher - FBR

Joel Houck - Wells Fargo


Good day, ladies and gentlemen. And welcome to the Two Harbors’ First Quarter 2013 Financial Results. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer, instructions following at that time. (Operator Instructions)

As a reminder, this conference is being recorded. Now, I’ll turn the conference over to your host, July Hugen, Director of Investor Relations. Please begin.

July Hugen

Thank you, Kairon, and good morning. Welcome to Two Harbors’ first quarter 2013 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 2013 results. Brad will highlight some key items from our financials, and Bill will review our portfolio performance and new investment opportunities.

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 the discussion of its first 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 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 fourth webinar in our ongoing series titled Mortgage REIT Primer. The webinar provides general information about REITs, mortgage REITs and Two Harbors model and can be found on our website under the webinar link. 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

Thank you, July. Good morning everyone and thank you for joining our first quarter earnings call. It has certainly been a busy start to the year and we are pleased to provide with updates regarding our business. After I comment on the quarterly results and provide some insights related to the macro-economic environment, I would like to discuss some of our new investment opportunities. Brad and Bill will cover these in greater detail later.

In the quarter we recorded $$248 million of comprehensive income or $0.81 per weight average diluted share. This is remarkable in the context of the sector’s first quarter performance as agencies put pressure to interest rate the slight volatility. Our comprehensive income was driven by non-agency performance. There was also a minor impact from the depreciation of our Silver Bay common stock as Brad will discuss later.

Our performance this quarter speaks to the benefit of our hybrid model, our rigorous acuity selection and our sophisticated approach to hedging. Non-agencies have continued to rally into the second quarter while agencies have staged a modest rebound.

Our book value was $11.19 per share on March 31 representing the total return of 8.5% when combined with our first quarter cash dividend of $0.32 and special dividend of Silver Bay stock which amounted to $1 per share. We reported GAAP earnings of $0.47 and core earnings of $0.29 per share which Brad will discuss further.

The distribution on Silver Bay common stock to Two Harbors shareholder which was completed on or about April 24 was an important accomplishment this quarter. As you may recall, in late 2012 we announced that concurrent with Silver Bay’s IPO we would contribute our portfolio a single family homes in exchange for 17.8 million shares of Silver Bay common stock. At the same time we announced that subject to the approval of the board and following the expiry of the 90-day lockup it’s our intention to distribute the Silver Bay stock to our shareholders by means of a special dividend. We were pleased to have met this goal. Silver Bay went from nascent bids for public market investment years time. It hopes to capitalize on America’s improving housing markets.

Next, I would like to talk about the capital we recently raised. Late in the quarter, we completed an accretive public offering raising approximately $763 million in net proceeds. We expect to use the proceeds to purchase agency and non-agency bonds and Credit Sensitive Loans or CSLs. We also intend to deploy capital into mortgage servicing rights and prime jumbo securitization as market conditions allowed.

We think the timing of this raise is good for investors given available yields in the market and would note that agencies spreads became more interesting late in the quarter, Bill will comment further on the capital deployment shortly.

During the first quarter we also reported progress related to several of the new business initiatives that we have discussed in prior quarters, which we will expand on later. In the first quarter, approximately 6 million of our warrants were exercised with an additional 3 million since quarter end. Today that leaves just about 4.5 million of the original 33 million warrants outstanding. As previously announced, the declaration of the Silver Bay stock dividend triggered certain adjustments the warrants under the terms of the warrant agreement.

As a result they are now struck with an exercise price of $10.25 and each warrant can be converted into 1.0727 shares of common stock. The warrants expire in November 2013 and they are currently in the money. You should note the impact of this adjustment for the company was the minimum.

Please turn to slide four, next I will provide some brief commentary on a few developments that could impact our business in the mortgage and housing sectors. National home price performance is improving, which is important to our non-agency portfolio and CSLs.

According to CoreLogic, home prices increased 10% as of February 28 on a rolling 12-month basis. Most forecast call for continuation of home price appreciation in the next several years as well.

Unemployment metrics continue to languish. However, signs of strengthening GDP and other economic indicators led to a modest increase in interest rates during the first quarter. We continue to hedge against the potential rise in interest rates by using swaps, swaps options, and interest-only securities, as we believe this is the prudent way to manage our exposure at different points on the yield curve. Preservation of book value risk mitigation is a paramount objective.

From a policy perspective one thing I’d like to touch on is the extension in the Home Affordability Refinance Program or HARP through 2015, which was announced in mid-April. We were not surprise by this extension. We have been expecting an announcement of this nature for quite some time.

It is important to note that we have variable exposure to HARP pools in our portfolio and therefore we do not view this is meaningful development in terms of managing our existing portfolio. Of course, we are mindful of other potential development regarding policy and regulatory changes, a field which are noted on the slide.

Another item that as form recent media headlines is the financial stability oversight committee councils annual report and its potential commentary on mortgage REITs. The publish report came out last week was benign in its remarks regarding mortgage REIT. Although, it did discussed interest rate risk and liquidity risk associated with leverage. As many of you know, we hedge our interest rate exposure quite closely. We are also prudent regarding the leverage we employ and have a historically low amount of leverage currently.

Next, I’d like to discuss some of our new investment opportunities as noted on slide five. On May 2nd we announced the one of our wholly owned subsidiaries has acquired a company, Matrix Financial Services Corporation that has approvals from Fannie Mae, Freddie Mac and Ginnie Mae to hold and manage mortgage servicing rights.

Importantly, Matrix with less than 10 employees has little in the way of operations are potential legacy liabilities that has all the necessary agency approvals that will position us to own and acquire MSRs.

Additionally, we recently receive a private letter ruling from the IRS advising that we can treat the beneficial ownership of excess servicing spread as good income for recompliance purposes.

Let’s discuss securitization, in the first quarter we participated in a $400 million prime jumbo securitization. We are pleased with our progress giving the attractive economics and risk return profile. We continue to build out our originated platform for aggregating norms. Bill will elaborate on this.

Next, let me provide and update on our CSL investment initiative. During the quarter we continued to make progress on purchasing CSLs and we anticipate securitizing them at some point. These are portfolios of whole loans that often have been modified and commonly have high LTVs.

As many of you know, a compelling aspect of these new investment opportunities is they dovetail nicely with our existing strategies and our core competency of credit and prepayment analysis. These are exciting times in the housing mortgage markets and for our company. I will now turn the call over to Brad for a deeper dive into our financial results.

Brad Farrell

Thank you, Tom and good morning everyone. I’ll begin my prepared comments with an overview of our first quarter financial results and few pertinent accounting insights, discuss quarterly changes to book value including the impacts of our weekly capital raise, and finally provide a brief update to our financing profile.

Please turn to slide six. Core earnings of $0.29 per weighted share represented a 9.7% annualized return on average equity while GAAP earnings albeit a less meaningful metric due to mark to-market accounting vagaries was $0.47 per weighted share. Core earnings were driven by a number of things which I would detail shortly. But before that, I would also note that we define core earnings to exclude the deal costs related to securitization we completed in the first quarter, which we believe stays through the run rate measurement objectives of core earnings within the industry. That’s how we think about the economics for securitization, I will expand on this in a moment.

Core earnings were largely in line with the fourth quarter of 2012 and our internal expectations for this quarter. As we have been discussing for some months we saw lower projected yields on securities acquired in the latter half of 2012 and into early 2013, driving a marginally lower net interest margin. Importantly, the CTR on our current portfolio has remained low and stable despite low interest rates.

Similar to the prior quarters, core earnings were also pressured by a robust financing and hedging strategy. In addition, the core earnings measurement was diluted by approximately $0.03 per share as a result of the capital allocation with Silver Bay common stock. While the investment in Silver Bay common stock resulted in unrealized fair value appreciation within the quarter, it did not generate meaningful core earnings.

Our operating expense ratio as a percent of average equity was static quarter over quarter at 0.7%. As we look forward, we expect the size of our investment portfolio and new business diversification initiatives may impact it in future quarters.

I would like to briefly touch upon a few accounting matters that provide further color into our portfolio performance and financials. First, other than temporary impairments on our non-Agency RMBS were an immaterial adjustment of $0.2 million this quarter with only one bond impacted. Again this illustrates continued fundamental soundness in our non-agency holding.

The next accounting topic I would like to discuss is the accounting for the prime jumbo securitization Tom noted. Due to management’s inclusion, we are deemed the primary beneficiary of the securitization due to certain loss mitigation and servicer control lies we hold within our subordinate securities. The securitization is accounted for as an on-balance sheet transaction. Consistent with our accounting for our own portfolio of mortgage loans, we are accounting for the mortgage loans held within the trust and the associated collateralized borrowings under the fair value option election. Under this election the changes in fair value of this item will run through the income statement and deal costs which are typically capitalized into the basis of the securities were will immediately expensed.

In summary, this fair value election creates a few accounting nuances but ultimately management feels this accounting most accurately reflects the real economic of the securitization in the financial statements relative to alternative accounting options under GAAP. We will continue to provide investors transparency related to this and other accounting topics in the future.

The final accounting topic concerns the Silver Bay common stock and associated earnings. On April 24, 2013 we recognized a taxable related gain for approximately $16 million which is roughly the difference between the closing share price of Silver Bay on that date from $19.40 and on top basis of $18.50 and the approximate 17.8 million shares withheld in our portfolio. A portion of this gain was included within our first quarter GAAP income statement as we recognized 7.8 million in mark-to-market gains, representing the difference in the December 31 market price of 18.83 per common share and the value of the shares on March 18 which was the day on we announced our stock dividend. Due to the accounting requirements surrounding the special dividend, the fair market value appreciation between March 18th and the distribution date April 24th were captured as an adjustment to dividend payable rather than through the income statement.

Finally, we recognized $1.4 million of installment sale gains in Silver Bay that we classified it discontinued operation and as previously disclosed reduction to the management fee of circa $4.3 million in accordance with the contribution agreement.

Now, please turn to slide seven which contains a quarterly book value go forward. As Tom noted, our book value per diluted share was $11.19 this quarter. I’d like to take a moment to highlight a few key items from the book value go forward.

First, on March 22nd, we completed an accretive public offering of 57.5 million shares for net proceeds of approximately $763 million. Due to the timing within the quarter, this capital raise impacted our overall leverage at quarter end. Similar to other raises, we anticipated deployment cost that will take a few months which will impact core earnings and average leverage in the current quarter as well.

Second, book value increased to strong comprehensive income for the quarter of $248 million. This is an important note as comprehensive income is a key way we judge our performance over the long-term.

Third, we announced dividend to our shareholders in the form of a cash dividend of $0.32 per share and the distribution of the 17.8 million shares of Silver Bay stock to our shareholders which amounted to $1.01 per share.

As a reminder, for every 100 shares of Two Harbors stock, a stockholder received approximately 4.9 shares of Silver Bay stock. We are pleased to be able to complete the cash dividend, as well as a special dividend during the first quarter while growing the underlying book value.

As of quarter end, you will note that the remaining warrants have a slight negative impact on a fully diluted basis for the fully diluted book value per share of $11.19 versus $11.23 on a basic basis.

Please turn to slide eight. As it relates to our financing profile, we continue to maintain a lengthy repo maturity profile with an average of 82 days to maturity at March 31st, in line with our profile at the end of the fourth quarter.

Consistent with prior quarters, we also continue to manage our repo across a variety of counterparties, which during the quarter comprised 24 different firms. On this slide, we have highlighted our diverse agency counterparty relationships, as well as the high quality of our non-agency counterparties based on CDS spread.

Finally, I will point our listeners to slide 17 in the appendix. Outlined on this slide is additional information, a stockholder might find useful when understanding the Silver Bay stock dividend.

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

Bill Roth

Thank you, Brad, and good morning everyone. This morning I’d like to discuss first quarter performance, our current portfolio, the recent capital raise and give you an update on the progress we’ve made in respect to the new investment opportunities we have highlighted in the past.

Before diving into quarterly results, there are a couple of policy-related topics I would like to mention. Recently, President Obama has nominated Mel Watt to be the Director of the FHFA. While there has been a lot of press around his nomination and qualification, his appointment is still uncertain.

Additionally, last week the Congressional Budget Office released a report noting the principal forgiveness could potentially save taxpayers money. Mr. Watt’s nomination has raised concerns in the market about potential changes to HARP and the CBO report implies a possibility of principal forgiveness being introduced for delinquent agency loans.

Both of these possibilities could lead to higher uncertainty within the mortgage market which would likely be expressed through higher mortgage rates. While these possible changes may benefit some stakeholders, overall higher mortgage rates are clearly uneconomical. Importantly, our portfolio is not at significant risk if either of these possibilities takes form.

Please turn to slide nine. The first quarter of 2013 was a great start to the year. The benefit of our hybrid model was demonstrated this quarter as we had strong overall return despite mix performance within our portfolio segment.

To start, agency securities underperformed in the first quarter. With improving economic sentiment and interest rates moving modestly higher, there was some concern in the market regarding how long the fed will continue to be a buyer of agency mortgages which cause spreads to widen.

Further, pay ups and specified pools were under pressure as a result of the interest rate environment. As a result, our agency strategies suffered slightly on a total return basis losing a small amount.

The non-agency portfolio on the other hand had wonderful quarter generating an economic return of approximately $274 million. This was generally due to improving data around house Prices, declines in severe delinquencies and better overall borrower performance similar to the trends experienced in recent quarters.

We also realized a gain on our CSL which reflects the same type of exposure as non-agency. We believe these trends are likely to continue given the tremendous affordability of housing and as the economic backdrop borrower performance and the housing market improves. Similar to prior quarters, the supply of non-agency remains muted today although we do continue to find securities at attractive valuations from time to time.

On the bottom left side of the slide, you can see our return on book value versus some familiar indices for the first quarter. We are pleased that our return on book value of 8.5% greatly outperforms a simple 50:50 agency, non-agency capital allocation strategy. We believe this demonstrates the importance of having the ability to dynamically allocate capital. On the bottom right, you will see that our yield and spreads for the first quarter were in line with results from the fourth quarter.

Turning to slide 10, let’s take a look at the portfolio. Our portfolio as of March 31st is $15.5 billion in total size, including 12.3 billion in agency securities and 3 billion in non-agency as well as other investments. On the top right, you will see that our capital allocation is roughly in line with last quarter with a little over 50% to agency, almost 40% to non-agency and CSL and the rest to home via our holdings in Silver Bay common stock.

Going forward our allocation to residential properties through Silver Bay will be zero given the distribution of the shares with stockholders. It is important to note that we are under-deployed as of quarter end as a result of our most recent study capital raise. As we complete the deployments we expect to put capital to work across the agency and non-agency portfolio as well as the CSLs and MSRs which I will discuss later.

As of April 30, we were approximately 75% deployed although we expect it to take a few months to complete the deployment process. This is similar to the deployment lag experienced during prior years. On the agency side, we have been focusing on prepay protected tools and certain third-year coupons at much lower pay-up than in past months. And we've also been able to take advantage of attractive implied funding rates available in the TBA market.

These TBAs are not reflected in our pool holding but represent exposure to agency to RMBS. At quarter end, we had 2.2 billion in TBA exposure, up from 1.9 billion at 12/31. TBA exposure can be converted to specified pool opportunistically over time depending on how long the TBA funding advantage persists and the attractiveness of pools that become available.

On the credit side, we've been able to pick up the non-agency bonds as well, as well as several hundred million in credit sensitive loan pools. As we noted at the time of the capital raise, we are expecting returns in the low double digits from this rate as agency spreads at the time of the raise were attractive and we see good opportunity in CSL and MSRs. We will provide full detail on our updated portfolio after deployment is completed.

As we turn to slide 11, let’s discuss a few metrics from the portfolio. The overall profile of our portfolio remains fairly consistent with prior quarters. Our agency prepayment rates for the quarter, including inverse buyout ticked somewhat higher to 7 and 6.6 previously. While prepayment speed generally remains fast across the overall market due to the low interest rate environment and the continued success in our program. We believe that our agency prepayment rate relative to the fastest prepayment experienced in the broader market as a result of our dedication to stringent securities selection approach when purchasing assets, 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 holdings can be found in the appendix on slides 20 and 22.

Consistent with past quarters are non-agency holdings are predominately weighted towards lower dollar price subprime bond. More information on our non-agency portfolio is available on the appendix on slide 21.

Next, let’s talk about leverage. Our overall debt-to-equity ratio is 3.1 times. Lower than 3.4 times at the end of the fourth quarter due largely to our recent capital rate. While we have increased the leverage on our agency strategy recently due to more attractive spread, overall leverage at quarter end remains impacted by the timing of the capital rates.

It is also important to note that our stated leverage does not include implied leverage from being long TBAs. Broadly speaking, we continue to target a debt-to-equity ratio of six to seven times for the agency portfolio, including our TBAs and 1 to 1.5 times for the non-agency portfolio. We expect overall debt-to-equity to be around four times, once our capital is fully deployed.

Let’s discuss hedging next, which is another important element in protecting book value. Although interest rates moved a touch higher in the quarter, in historic context, they remain low. Further, they have moved back to roughly year-end level since quarter end. If the macroeconomic backdrop continues to improve, we think rates could move higher. So protecting our portfolio against higher rates makes a lot of sense to us and you can see our duration portfolio on the right-hand side of this slide.

Note that while, we typically carry little rated exposure as of March 31 we were actually slightly net short. That means if rates rise, we would expect our book value to increase. Also as you will see in our 10-Q, our portfolio is currently positioned such that a parallel increase in rate, including LIBOR would have a beneficial impact to our interest income.

Although from an overall portfolio management perspective, we continue to enjoy the low-rate environment from a funding perspective and do expect these conditions to persist. More details on our hedging positions as of March 31st are in the appendix on slide 19. We are very pleased with our financial performance in the first quarter of 2013 but we are even more excited about the progress we’ve made in some of our new initiative.

On slide 12, we have highlighted as we did last quarter a variety of potential opportunity that dove tail with our core competencies of credit and prepayment risk management. I’d like to spend a few minutes updating you on the progress we've made in these areas.

Let’s talk about securitization first. Last quarter, we noted that the math around creating subordinate bonds in IOs by a securitization have become more attractive recently. We are pleased to note that we participate in a prime jumbo securitization in the first quarter through Credit Suisse. This produced attractive residential mortgage credit in IO bonds for our portfolio.

More importantly, we continue to work on building our own originator network to source loans which will enable us to be in ongoing issuer over time. We anticipate adding several originators in the second quarter who will originate and sell loans directly to Two Harbors with the aim of growing our originator partners throughout the remainder of 2013.

We are very constructive regarding the future of non-agency originations and securitization as the government reduces its footprint over the years to come. We hope to plan meaningful role in this market and will continue to keep you posted as we build out its initiatives.

Credit sensitive loans or CSLs as we’ve spoken about before are nice complement to our non-agency holdings as they contain similar credit exposure. In short, they are essentially like the performing loans in non-agency deal. We have had good success adding CSL so far this year and have purchased or contracted to purchase in total about $600 million in loan or about $450 million in market value as compared to $123 million in market value as of March 31.

Importantly, these loans are potentially securitizable and we intend to consider securitization if the math allows us to create credit bonds of attractive yields. It is worth noting that while this endeavor capitalizes on our credit expertise and we have been successful on purchasing packages at prices we like, supplies typically limited to what the banks decide to sell. And as such we less control over how much we can purchase at any point in time. That said, we are excited about CSL providing attractive credit opportunities for our portfolio and we keep you posted on the continued development in this initiative.

Another opportunity we’re pursuing is MSRs, our mortgage servicing rights. MSRs are a nice fit in our portfolio as they provide a natural hedge to our agency MBS. As Tom mentioned, we recently closed on the purchase of a company which allows us to be involved with Fannie, Freddie and Ginnie MSRs. We have been in discussions with a number of potential sellers of MRSs and we will keep you posted as we progress towards adding these to our portfolio.

Finally, as we have discussed before, credit investments from the GSE are still on our radar screen. As mandated in the FHFA score card this past quarter the GSEs are charged with disseminating credit risk on at least 60 billion notional of agency RMBS in 2013. We think this could be very interesting opportunity given our strengths and understanding mortgage credits.

Before wrapping up, I would highlight that we are excited about 2013 for a variety. Funding rates are low, we like what we own in our securities and CSL portfolios and believe that the new initiatives we just discussed will lead to excellent additions to our holdings over time. Our goal is to continue driving value for our shareholders over the long-term and we look forward to keeping you informed on the opportunities we see across all facets of our business.

Thank you again for joining us today. I will now turn the call back over to our operator, Kairon.

Question-and-Answer Session


(Operator Instructions) First question is from Douglas Harter of Credit Suisse.

Douglas Harter - Credit Suisse

I was just hopeful to touch a little bit more on the MSR acquisition, the company that you acquired, first I guess was there any MSRs that actually came with that or little legacy risk, can you just go expand on that a little bit?

Tom Siering

A very small amount came with it, but so small, it’s really -- out of any real note. The thing that we did like about the company was that it had no originated loans in many, many years and therefore we think the legacy liabilities should not be an issue. It came with a small handful of employees, but came with all the licenses. So it was a very clean acquisition in our mind and something that fits really well within our business model.

Douglas Harter - Credit Suisse

Just on that, coming with the license, can you now -- as you look at the larger MSR packages, can you talk about what the approval process would be if you can agree to price with the seller?

Bill Roth

Yes, so as you know we just closed on this we are in a position now to entertain working with sellers or partners. And our best understanding of the approval process in terms of the conversations we’ve had with the agency is that -- and I think this is true across the board is that you need to show up with whoever you are partnering with or purchasing from, there is an application that’s put in, the GSEs have to review it, understand whether it’s a bulk purchase or a slow purchase and then approve it. So it’s a lot different than buying securities that it can take a month or two to go through that process.

Douglas Harter - Credit Suisse

And I guess just finally on this, the GSEs have to approve your purchase?

Tom Siering

Yeah, they have to approve the transfer of all the licenses, and so that’s what we have -- so we closed the acquisition and we received all the records of approval from the GSEs and from Ginnie.


Our next question is from Mark DeVries of Barclays.

Mark DeVries - Barclays

Bill, did you talk about what the loss adjusted deals that you expect on your tenured securitization?

Bill Roth

Yeah, it’s -- hey good morning, thanks for joining us, Mark. Because these are very leveraged structures, if you’re retaining the bottom 3% or 5%, a very small move in either the price of loans or the price of the AAAs or AAs et cetera that you sell, actually is very impactful. So we’ve said in the past that we think the ROE from this kind of strategy is in the double digits.

But I’m a little bit reluctant to give you a number to hang your hat on because you can imagine if you have that much implied leverage, which is 20 to 1, 20 or more. Small move in anyone of the components can actually make a big change. So we expected to bounce around as the inputs change but we’re only going to focus on doing securitizations for what we’ve attained is attracted to us.

Mark DeVries - Barclays

Okay. Got it. And from an accounting perspective, I think you guys mentioned you guys have fair value. Will this contribute much to the core earnings in the near term or there has to be cash flows initially or what have a bigger impact just on fair value market?

Tom Siering

Hey, Mark, it’s Tom. I’m going to hand that one over to Brad.

Brad Farrell

Yeah. Thank you. So obviously, these loans are the entire loan structure and AAA debt structure is on our balance sheet. This was to generate both yield and cash flow. And so that will be an impact on core earnings. The objective of the fair value and just how we think about a lot of things is core earnings. It’s obviously a metric that’s used in the industry. But we look at economic return in total.

So there is only the market fee to fair value which is largely going to mirror the actual economic, which is really just a subordinate and IOs we hold. So it’s really kind of the objective of what we’re trying to do there. So core earnings, yes, an impact but we’re looking at this more around a fair value of these instruments and the impacts of the economic return.

Mark DeVries - Barclays

Okay. Great. And then, Bill, how much of a pickup would you expect to generate on returns from the strategy once you’re able to move the loans you’ve kind of directly source through these originated partners?

Brad Farrell

You’re talking about the prime jumbo securitization?

Mark DeVries - Barclays

Yeah. Exactly.

Brad Farrell

I mean, the originating -- working with originators yourself generates the inputs at a better valuation and buying them in bulk as you can imagine. And that also varies over time. But more importantly, we feel it’s more important to control the process, have loans underwritten guidelines and basically, create a sustainable business model as oppose to just relying on purchasing in bulk. While the economics are better, it’s really more about creating a sustainable business model than it is just the math.

Mark DeVries - Barclays

Okay. That is helpful. And just one last house cleaning thing, Brad, I think you mentioned there is at least $1 million, $1.4 million kind of cost expense that reduce the management fee related to the Silver Bay’s thing? Was there anything else that brought back that number down on a Q-over-Q basis?

Tom Siering

The direct impact of management fee was $4.3 million, that’s a contractual discount that was negotiated with the contribution agreement. The $1.4 million came to the separate line, the discontinued op and largely that’s the allocation we received from Silver Bay and the management fees they paid to the managers. So there is nothing else other than those two items I noted.

Mark DeVries - Barclays

Okay. Great. Thanks.


Thank you. Our next question is from Trevor Cranston of JMP Securities. Your line is open.

Trevor Cranston - JMP Securities

On the credit sensitive loan portfolio, you talked a little bit about potentially securitizing some of that retaining to subordinate pieces. I think there have been a few other securitizations that’s kind of reperforming loans that we’ve seen over the last few months. Can you maybe just comment on whether or not, you think the economics are securitizing those was attractive kind of where we sit today or is it something that’s likely to be more far out in the future for you guys?

Bill Roth

Good morning, Trevor. Look forward to seeing you out on the West Coast in a few weeks.

Bill Roth

So to answer your question, there have been a number of deals done and it really depends on the collateral. So we’ve seen deals done that have been unrated private deals, that had, what I would call higher LTV loans in it and then we’ve seen rated deals with even some of the tranches getting AAA from better quality collateral. So the answer to your question is that it is likely that the economics will be attractive but how attractive they are really depends on what kind of pool you put together. So as I mentioned we’ve repurchased about 600 million in face amount and once those all closed, and we settled those, what we are going to do is stratify that and see if we can optimize the math regarding the securitization. So that’s really where it will come down to.

So it’s not something that you could expect to see out of us immediately because some of these things have to settle and we have to go through that process. But I think that market is -- there have been a number of deals done, I think there is more and more investor interest as more deals have come to market. And so I think that sort of developing asset class and like any developing asset class typically the more step-in suggests the better pricing you get as an issuer.

Trevor Cranston - JMP Securities

And then just one more thing on the MSRs, as you start adding assets in that bucket, would you envision taking out some of your swap inflection, or can you maybe just talk about how you are thinking about hedging your portfolio as you start adding MSRs to your portfolio.

Bill Roth

That’s a great question. And I’d say first because we don't really run much interest rate exposure at all, I mentioned that as of the end of the quarter we were slightly in that short. The addition of new -- particularly new issue low coupon MSR obviously adds negative duration which would make us more short. And so unless we decided that we wanted to be even more short we would therefore be able to either add positive duration by buying more pools or by unwinding swap. And so one of the benefits to adding MSR is we expanded underlying swap because obviously not only it produces an asset on our books with positive yield but also save us money on unwinding our swap position.

In a bigger picture sense we would look at adding MSR, likely we’re adding I/O and we would have that hedge in the portfolio as we would hedge IO.

Trevor Cranston - JMP Securities

If you look at kind of some indications, some of that would be in excess, looks like prices of that, or actually more so far in the second quarter than they were in the first quarter, can you just comment on what you are seeing in the market and the general trends in book value at quarter end?

Tom Siering

Hey Trevor, it’s Tom. So I said in my prepared remarks the non-agencies continuing to rally into the second quarter. So I want to caution that a month doesn’t make a quarter, right, but the company did have a nice April.


Our next question is from Jason Stewart of Compass Point.

Jason Stewart - Compass Point

It’s actually Jackie for Jason. A quick question on MSRs, I know historically you haven’t -- the expected return, with the acquisition and the GSE approval, it seems more relevant today. So I was just wondering if you could provide more color on what range you expect to see IRRs on new productions --

Tom Siering

Well, yeah I mean very attractive, otherwise we wouldn’t have gone through this -- but we are in the game now which is -- this has been a difficult process to get to this point and our team did a great job to effect this acquisition. We would feel more comfortable talking about MSR yield when they become a meaningful part of the portfolio. Today they are attractive, they are honestly a little less attractive that may have been, but still nonetheless very attractive relative to in absolute and relative expected returns. But we are very excited about being in a position to acquire MSR.

Jason Stewart - Compass Point

And do you see this attractive versus IOs or versus lowered MBS investing?

Tom Siering

The short answer is yeah.

Jason Stewart - Compass Point

Okay. Thank you.


Thank you. And next question is from Dan Altscher of FBR. Your line is open.

Dan Altscher - FBR

Thanks. Good morning. I’m wondering if could give us kind of the relative breakouts, the book value contribution between the agency book and non-Agency book and then the swaps and swaptions kind of thing on a either per share basis dollar amounts, how much that individually contributed since the other types of Silver Bay and dividends are pretty clear?

Tom Siering

Sure. We are going to let, Brad tackle that.

Brad Farrell

Yeah. I think you’ve got us kind of feed a couple points that we mentioned in our prepared comments. Bill noted that the return on the non-Agency book portfolio is $274 million in quarter. I also noted that we had a small gain on Silver Bay of $8 million. And so you largely can take the delta, just kind of back in to where the agency fell out in rough numbers is how we look at it.

We don’t provide necessarily the breakdown between kind of the hedging instruments and the cash funds. We looked at that at kind of total return perspective. But that kind of gives you the three buckets that I think might address your question.

Dan Altscher - FBR

Okay. That’s fair. And then, I had a one more question on the MSRs. How big I guess do you envision this book getting I guess maybe in the near-term or longer-term in terms of maybe an unpaid principal balance or an actually this MSR value? And then also since the press release stated that you could not manage the MSRs. You are actually kind of servicing them or showing them or bringing out to a sub-servicer.

Tom Siering

Yeah. It’s Tom. We do not anticipate servicing ourselves. So we are in discussions with the number of servicers. Obviously, we are concentrating on ones that would be agencies like the best because that speeds, the comfort that they would have around those servicers speeds the path to actually requiring the MSR and receiving the necessary approval from the agencies. And I’m sorry, you got another question. What was your first question?

Dan Altscher - FBR

It’s just I guess relative sizes, how much you envision the MSR book becoming on, whether it’s going to pay principal balance or the actual value of the MSR?

Tom Siering

Yeah. That’s difficult for us to say. I mean, frankly it’s going to be a function of two things, supply and their relative attractiveness to other options within the portfolio. So it could be significant but we love all our children equally. So it’s going to have to compete with our alternative investment opportunities.

Dan Altscher - FBR

That’s a great line, loving the children. That’s great. Thanks so much.


Thank you. And next question is from Joel Houck of Wells Fargo. Your line is open.

Joel Houck - Wells Fargo

Thanks. Just hoping to get back to the disclosure on page 11 regarding the sensitivity changes and rates and I guess you provided some color. I’m more interested in I guess in how you guys think about the tradeoff and kind of current yield versus protecting book value because we normally, at least in recent history haven’t seen reach. Everyone seems to take a little bit of exposure to rising rates.

Now, this is -- it could be a fundamental shift, I’m just interested in management stocks in terms of how you are going to manage with your stock prices around that is going forward. We are going to continue to see it get kind of net short on balance given where rates are now or is this more of a transitory thing in Q1?

Tom Siering

Hey, Joel. Just a one remark and I will hand it over to Bill. In respect of comparing us with other REITs, we really don’t aspire and I say this with all humility, we don’t aspire to be anyone other than ourselves. And all we think about managing our shareholders money. Bill, do you want to opine upon that?

Bill Roth

Yeah. I mean I think, Joel, we said in the past, we are not --we don’t view ourselves as in a business of producing a dividend because if we want to do that, we could use a lot more leverage, we will take a lot more interest rate risk. We are really frankly thinking about total shareholder value, which is obviously a combination of the dividend and then book value change, so the way -- as you know we rarely at least in the last few years have taken much interest rate risk primarily just because rates are so darn low and while they might go lower, if they could go they could go a lot higher. So we view it’s our job to protect our shareholders investment by being very cautious when rates are at this point in time.

Additionally if you see what’s going on in the economy, yeah some numbers are bad, some numbers are a little better but we see consistent slow growth, we've seen the US become more competitive, the private sectors adding more jobs at the expense of the government. So to the extent that changes and if they decide they want to be less involved, let’s just say that, we could see a reasonable move in rates and we just think that it's a very prudent time to be very cautious. So we’re not as concerned with eking out the last penny or two of dividend vis-à-vis having an issue with book value.

Tom Siering

Yeah I think it’s important to note, how we think about this in the global context. The economy is improving, right. Housing revamping, unemployment falling, that’s going to lead at some point to a reduction of QE and where would rates be with out QE, I don’t know, but definitely higher than they are today and we want to be prepared for that.


Thank you. There are no further questions at this time. I would like to turn the call over to management for any closing remarks.

Tom Siering

Well, great. Lot of good questions today. Thank you for joining our call and thanks for your interest and in support of Two Harbors. Gave a great day. We look forward to speaking to you again soon.


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

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