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I and seemingly all of the people who follow mortgage REITs (of which Two Harbors is one) have worried about the effects of the recent huge run up in interest and mortgage rates. The chart below shows the recent run up in the 30-year US Treasury bond yield.

On March 29, 2013, the yield was 3.10%. On May 2, 2013, the yield was 2.82%. By May 31, 2013, the yield had gone up to 3.28%. On June 28, 2013, the yield was 3.50%. On July 10, 2013, the yield was 3.69%. This is a big move up in a short period of time.

Mortgage REITs expect change. They hedge. They buy and sell MBS, etc. to decrease the amount of extension risk they are exposed to (and for other reasons). Extension risk is the risk that they will be holding too many lower yielding MBS after the mortgage rates and interest rates have risen by a large amount. However, shifting portfolio makeup from lower yielding MBS to higher yielding MBS often involves taking losses along the way. I'm sure Two Harbors (NYSE:TWO) has experienced some of these losses in Q2 2013. It has also experienced simple book value losses in its Agency RMBS portfolio. The market values of the Agency RMBS have fallen as the mortgage rates have risen.

The following chart shows a typical drop - that of the 30-year Fannie Mae 3.5% rate RMBS over the last three months.

(click to enlarge)

As you can easily see the market value of this RMBS has fallen from greater than 106 to below 99 at one point over the last three months. This is a huge drop when you consider the leverage most mortgage REITs use on their Agency RMBS portfolios. TWO targets this leverage to be 6.6x to 7.0x, which is lower than many of its peers. Investors also need to take into account that TWO's Agency portfolio represents only 52% of its capital invested as of the end of Q1 2013. This means it is much less exposed to Agency RMBS losses than some other more highly leveraged mortgage REITs. When you consider that TWO's entire portfolio leverage as of March 31, 2013, was only 3.1x versus an average of 7.1x for its peers, you can see that TWO is really much less exposed to mortgage rate increases than most of its peers. Under the current circumstances that is likely a very good thing.

TWO has yet to announce all of the changes it has made recently. However, the following chart from its most recent investor presentation shows how it believes its book value will be affected by a 100 bps mortgage rate move with a parallel 100 bps interest rate move.

A +6.2% theoretical result sounds good to me and it should sound good to most investors. Yes, there were huge book value changes to the Agency RMBS as the chart farther above demonstrates. However, if TWO is asserting a +6.2% increase in book value for a 100 bps move up in rates, TWO may turn out to have done well with respect to book value for Q2 2013. It may also do well in future quarters.

The following table shows how Freddie Mac mortgage rates have moved up in June 2013.

These are up from an average of 3.55% in March 2013. Actually they are farther up from the lows of May 2013. Still the table shows that the average rate for the week ending June 28, 2013, was at 4.46%. This is 91 bps above the average rate in March 2013. It means that the mortgage rate move up has exceeded the 30-year Treasury bond yield move up of about 40-50 bps by a considerable amount. To me this means that TWO is unlikely to show a book value profit. However, it might break even. Remember it should definitely see book value increases in its non-Agency portfolio. If TWO doesn't break even or better on book value, it could have just a small loss. This should still allow it to outperform its peers in this area.

In addition TWO has provided the following chart about its Agency spreads.

The chart shows that its Agency spreads have been moving up in a good trend. It shows they had moved up from March 31, 2013, to May 31, 2013. It is a certainty that they have moved up further in June 2013. This should mean that the net interest income for Q2 2013 will be significantly higher than that in Q1 2013. This will likely translate into higher dividend payouts in the near future. Perhaps investors will receive higher dividends as soon as Q3 2013.

Keep in mind that TWO's non-Agency portfolio should do well in an improving housing market. Housing prices are up 12.1% year-over-year through April 2013 for the 20-city Case-Shiller index. TWO's non-Agency debt was bought at an average price of $52.25. This means that there is huge potential for gains in an improving market.

Additionally TWO is moving into new areas that it hopes will mean greater profits as the housing market continues to recover. These include:

  • Prime Jumbo Securitization - TWO participated in a prime jumbo securitization in Q1 2013. It intends to continue to build on this capability.
  • Credit Sensitive Loans (CSLs) - This is very similar to performing residential mortgage loans in subprime/Alt-A deals. TWO will control the servicing of the loans. As of April 30, 2013, TWO had purchased or contracted to purchase approximately $600 million CSLs (approximately $450 million in market value). Most of this is new purchases in April 2013.
  • Mortgage Servicing Rights (MSRs) - These are a natural interest rate hedge for TWO's Agency portfolio. It also leverages TWO's strength in prepayment analysis. On May 2, 2013, TWO announced it had acquired Matrix Financial Services Corp. for exactly this purpose. It has approvals from Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC) and Ginnie Mae to hold and manage mortgage servicing rights.

TWO seems to be positioning itself well for the future in what appears to be a very astute way. The management team appears to be performing extremely well. The proof of this will be in the actual results reported for Q2 2013. Still investors should be able to buy TWO now. It is trading at a discount ($10.15 at the close July 12, 2013) to its Q1 2013 end book value of $11.19 per common share. TWO had only a small book value loss in Q1 2013 while many of its peers had large losses. Further TWO says it has positioned itself even better for big mortgage and interest rate moves upward. TWO said this by May 31, 2013, and much of the mortgage rate move up was in June 2013. This should make TWO a good buy at $10.15 per share, especially when investors may see higher dividends soon.

The two-year chart of TWO provides some technical direction for this trade.

(click to enlarge)

The slow stochastic sub chart shows that TWO is currently oversold. The relative strength sub chart shows that TWO is near oversold levels. The main chart shows that TWO is far oversold. It seems to indicate that TWO is in a downtrend. However, the fundamentals are starting to indicate that this should not be the case. Plus technically TWO should be able to find some support at its current level.

I'm impressed with TWO's management. Plus it seems unlikely that Congress will do away with Fannie Mae and Freddie Mac (an investor fear) in the next year or two, even though it is starting to make some noises about doing that. Further TWO is moving into areas less dependent on those two entities. Congress also seems likely to come up with a compromise solution in the end. A replacement for these two entities may well be an improvement for mortgage REIT companies. I think you have to invest in the situation you see. Congressmen (or women) own homes too. They will not want to see prices fall dramatically. TWO is a buy. CAPS agrees with my assessment with a 5 star rating on TWO (a strong buy).

NOTE: Some of the above fundamental financial information is from Yahoo Finance.

Good Luck Trading.

Source: Dividend Payer Two Harbors Says It's Positioned For Interest Rate Rises