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Two Harbors Investment Corp. (NYSE:TWO)

Q2 2013 Earnings Conference Call

August 7, 2013 09:00 ET

Executives

July Hugen - Director, Investor Relations

Tom Siering - President and Chief Executive Officer

Brad Farrell - Chief Financial Officer

Bill Roth - Chief Investment Officer

Analysts

Mark DeVries – Barclays

Douglas Harter - Credit Suisse

Trevor Cranston - JMP Securities

Jackie Earle - Compass Point

Dan Altscher - FBR

Joel Houck - Wells Fargo

Bose George - KBW

Ken Bruce - Bank of America Merrill Lynch

Operator

Good day, ladies and gentlemen. And welcome to the Two Harbors’ Second Quarter 2013 Financial Results Conference Call. At this time, all lines are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions) As a reminder, today’s conference call is being recorded.

I would now like to turn the conference over to your host, July Hugen, Director, Investor Relations. Please proceed.

July Hugen

Thank you, Shawn, and good morning everyone. Welcome to Two Harbors’ second 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 brief recap of our second quarter 2013 results and the macro backdrop. Brad will highlight some key items from our financials, and Bill will review our portfolio performance and our 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 would 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 quarterly 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’s 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 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 second quarter earnings call. It was a challenging quarter, but we are happy with measures we took them to mitigate our risk profile and protect book value. This morning, after our comment on the quarterly results and provide some insights related to the current macroeconomic environment, I would like to discuss some developments regarding our new investment opportunities.

As some of you may recall from the updated metrics we have provided as of May 31, early in the second quarter, we positioned the portfolio defensively and put hedges in place to guard against higher interest rates, mortgage basening, widening and a shifting environment. We believe this was prudent and give them what we thought was an asymmetric profile and rates and concerns in the market regarding the fed tapering as a participation in the treasury and mortgage markets, or if you will QE ado. This repositioning was a significant positive contributor for our performance this quarter.

During the quarter, agencies were pressured as interest rates are volatile and ultimately moved substantially higher. Our non-agency strategy also experienced a material quarter and we ultimately reported a small loss on our non-agency portfolio. That said it's worth noting that the non-agency allocation has performed well in 2013 and is up $259 million year-to-date net of hedges. We believe our performance this quarter and our positive return for the first half of 2013 speaks the benefit of our sophisticated approach the hedging in our hybrid model. Now let me briefly recap our financial results. Our book value was $10.47 per share at June 30, representing a quarterly total return of negative 3.7% when combined with our second quarter dividend of $0.31. In the quarter we recorded a comprehensive loss of a $146 million or $0.40 per weighted average diluted share. Year-to-date we have generated a $102 million in comprehensive income representing a return on average equity of positive 5.2%.

We reported GAAP earnings of a $1.06 and core earnings of $0.21 per share which Brad will discuss further. We believe this is remarkable in the context of the sector performance during the same time frame. During the quarter we also repurchased stock under our share repurchase program, 1 million shares of the 25 million shares authorized during this program were acquired during the second quarter as the sector came under pressure. We believe this was a good investment for stockholders as the stock was trading below the value of the time so the repurchase was accretive.

In the second quarter approximately 3.5 million of our warrants were exercised today that leaves just 4.2 million of the original 33 million warrants outstanding. The warrants expire on November 7, 2013 and are currently out of the money as they are strike at $10.25 per share.

Please turn to slide four, next I’ll provide some commentary on the macroeconomic environment that could impact our business and the mortgage and housing sectors. Rising interest rates were challenged as were concerns about the Fed’s announcement that they may begin to reduce RMBS purchases. Unemployment metrics have been showing signs of strength recently with monthly job report demonstrating improvements and employment this spring.

Improving employment metrics are good for our non-agency portfolio if it should reduce, should result in climate delinquencies and defaults, although we believe in (inaudible) in this area may result in higher interest rates overtime. Another metric that has shown improvement is home price performance. On a national level home prices increased 12% as of May 31, on a rolling 12 month basis according to the CoreLogic. Most forecast call for continuation of home price appreciation in the next several years. This creates a nice tail-win for the performance of our non-agency portfolio including credit sensitive loans or CSLs.

Now let’s turn to the policy front, first I would like to touch on the potential for GSE reform. Several bills have been circulated to address the eventual wind-down or diminution of the GSEs. We believe the private sector is necessary to support the U.S. housing market going forward and find it sensible from a policy standpoint to have a private sector rather than the U.S. tax payer banking the mortgage market.

Progress has been made in this regard as witness by Freddie’s recent sale of credit risk into the market. A few other issues that we’re monitoring from a policy and regulatory perspective are on this slide. Next I would like to discuss from our investment opportunities as outlined on slide five, let’s start with mortgage servicing rights or MSRs. We have been working hard on the infrastructure required to support this initiative and continue to make progress on that front. As we have previously reported during the second quarter we closed on the purchase of Matrix Financial Services, a small servicing company with Fannie Mae, Freddie Mac and Ginnie Mae service licenses. This came with a small in servicing portfolio and servicing oversight professionals. Additionally we closed on two small bulk purchases of Freddie Mac MSRs in July and are in negotiations around other bulk and flow arrangements. We also anticipate that we will have the opportunity to make significant additional investments in MSR later this year.

Now let’s turn to the conduit business and securitization, as you may recall in the first quarter we participated in a $400 million securitization with Credit Suisse. In the second quarter, we have continued to aggregate loans and it is our goal to complete a securitization in the future as market conditions allow. We continue to build relationships with originators and grow our middle and back office to support growing our mortgage loan acquisitions. While we view the economics and the risk return profile associated with securitization as attractive today, over the longer term, this business line could be quite fruitful as the government reduces its footprint in financing residential real estate.

Last, let me provide an update on our credit sensitive loan investment initiatives. We closed on some CSLs during the quarter bringing our holdings to approximately $440 million in market value. As a reminder, we view this sector as an alternative to investing in legacy non-agency securities and allocate accordingly based on both absolute and relative value. Bill will discuss all these topics more fully in a bit. A compelling aspect of these new investment opportunities is that they dovetail nicely with our existing strategies and core competencies of credit, interest rate, and prepayment analysis. The event for the second quarter, not only emphasize the importance of effective hedging approach, but also underlying the benefit of having a more diversified business model. We believe that as we expand into these new areas, we can drive higher returns over time, create franchise value, and provide improved book value stability in times of market turbulence.

I will now turn the call over to Brad for a more fulsome discussion of our financial results during the quarter.

Brad Farrell

Thank you, Tom and good morning everyone. I will begin my prepared comments with an overview of our second quarter financial results and discuss certain accounting matters. I will then conclude with an expanded discussion around financing and liquidity.

Please turn to slide six, core earnings of $0.21 per weighted share represented a 7.6% annualized return on average equity. The $0.21 per share earnings roughly aligned with our core earnings expectations for the quarter and what we considered when establishing our second dividend. While we acknowledged this non-GAAP measure underperformance relative to our historical measures of core earnings, it is a direct result of the successful defensive measures our investment team took to protect book value and our overall economic return. Bill will expand upon these measures shortly.

The most direct impacts to core earnings were the lower leverage applied to our capital base and cost of increased levels of industry and mortgage spread protection we utilized through derivatives, namely TBAs, mortgage options, swaps and swaptions. As noted on slide six, our debt to equity ratio to fund cash RMBS through the use of repurchase agreements was 3.6 times and 3.1 times as of June 30th and March 31st respectively. While this would imply our leverage marginally increased, it is important to keep in mind that TBA positions are not part of the debt-to-equity calculation, although they do impact overall exposure. As such, implied leverage can be higher or lower depending on whether we are net long or net short TBAs.

As of March 31, we held a $2.2 billion long TBA position and at June 30, we held a net $2.7 billion short TBA position. This shift during the quarter resulted in a reduction to implied debt to equity from 3.6 times as of March 31 to 2.9 times as of June 30. Similar to other quarters albeit on an exacerbated basis this quarter, core earnings were also pressured as we added considerable hedges to protect our portfolio against rising rates. As we have pointed out before, we focused on total comprehensive income, which includes the health of our book value per share more than core earnings. So, the near term cost of insurance is outweighed by the overall protection of returns.

Our operating expense ratio as a percentage of average equity moved modestly higher on a quarter-over-quarter basis to 0.9%. The rise in operating expense was largely driven by cost incurred in connection with the acquisition of credit sensitive loan packages and the build out of the prime jumbo conduit and MSR programs. As we have discussed previously, the capital reallocation and timing of new business diversification initiatives may impact this metric in future quarters.

As noted in historical earnings discussions, GAAP earnings are not as meaningful as the core earnings and comprehensive income measures when assessing the performance of the quarter. This quarter was a good illustration of that as GAAP earnings were a $1.06 per weighted share. The size of GAAP EPS was due to significant gains on our derivative positions utilized to hedge our portfolio. I would now like to briefly touch upon a few accounting matters. First, other than temporary impairments on our non-agency RMBS we have made fair adjustment of $1.4 million this quarter with only three bond impacted. This fact combined with our release of 29 million for credit reserves to accretable discount demonstrates the continued fundamental soundness in our non-agency holdings.

Second, as Tom mentioned earlier during the quarter one of our wholly owned subsidiaries acquired a company Matrix Financial Services Corporation. This acquisition added approximately $1.5 million in MSRs to our portfolio which is captured in the other assets line-item this quarter due to it's small size. At the time of acquisition the net equity of this subsidiary was only $0.2 million de minimis from the overall balance sheet perspective.

Third, I want to highlight that we recognize tax expense for GAAP purposes of $49 million this quarter associated with the various hedging instruments we hold in our taxable REIT subsidiaries. This tax expense lowered our comprehensive income to that same effect however I want to make clear that the majority of these tax expenses will be offset by deferred tax benefits recognized in prior periods on derivative losses or in other words the TRS corporation do not have a significant tax liability to the IRS as result of these hedging gains.

Now please turn to slide seven which contains a quarterly book-value go (ph) forward, as Tom noted our book value per diluted share was $10.47 this quarter, I would like to take a moment to highlight a few key items from the book value go (ph) forward. First the book value declined this quarter was driven by the comprehensive loss of 146 million. As Tom noted earlier we’re pleased with our performance given the turbulence in the market. To us this is an important note as comprehensive income is the key way we judge our performance over the long term. Second, we announce dividends of $0.31 per share representing a 12.1% dividend yield for the quarter. When thinking about our dividend it is important to understand not only core earnings but the components of our realized gains more specifically this quarter the realized gains from TBAs.

In the quarter we realized $41 million of realized gains from TBAs and TBA options or $0.11 per weighted share. Year-to-date core earnings and realized gains including gains from sales of RMBS have generated approximately $0.61 of weighted EPS which mirrors our cash dividends paid in year-to-date of $0.62 per share.

Please turn to slide eight, I would next like to spend some time discussing the repo markets, our counter party exposure and financing profile both in the second quarter and how we’re positioning ourselves for the long term given our new business initiatives. The first thing I’ll note is that we didn’t experience any disruption in the repo market during the second quarter or thus far in the current quarter. The repo markets are functioning in a normal manner and we have not experienced any sizeable shifts in financing haircuts. Second there were no unexpected or surprising margin calls during the same period, third, to the extent that we do have margin calls we typically maintain a high level of unencumbered cash on hand which was the case during the past quarter and at quarter end.

Lastly regarding funding rates we haven't seen any dramatic changes in terms of the cost of repo funding for agency securities. For now agencies on the other hand funding levels have come in nicely in the first half of this year and liquidity providers are plentiful. Repo rates that were LIBOR plus 175 for LIBOR plus 225 for subprime 6 bonds to 12 months ago typically are now in the LIBOR plus 135 to plus 175 ranges of 40 to 50 basis point improvements. As it relates to our repo financing profile we continue to maintain a lengthy maturity profile with an average on 86 days to maturity at June 30. In line with our profile at the end of the first quarter. Consistent with prior quarters we continue to manage our repo across a variety of counter parties which during the quarter comprised 24 firms. We believe diversity of our counterparty exposure is important should the market undergo a period of stress.

On this slide we’ve highlighted our diverse agency counterparty relationships. As you can see no single counterparty represents a systemic level of risk to our business. We monitor our repo counterparties on a daily basis and track a host of metric that are indicative of the health and solvency of our counterparties. Slide eight indicates the high quality of our non-agency counterparties based on CDS spread which we have found have been important presentation of how the market would use the help of our counterparties. Another metric we monitor is the geographic exposure profile of our counterparties. At quarter end the majority of our repos with counterparties based in North America. Separately from our day-to-day management of the financing profile for our RMBS portfolio, we have been working on a variety of financing arrangements to support our new business initiatives.

During the second quarter, we entered into two new financing facilities totaling over $600 million to finance our mortgage loans. The facilities include a 364-day facility to finance both credit sensitive and prime jumbo mortgage loans and a 90-day facility to finance prime jumbo mortgages. As we increased the side of our credit sensitive loan portfolio and prime jumbo conduit program, we will continue to establish strategic partnerships to finance this asset class prior to our objective of selling the loans into our securitization while holding them in an alternative financing structure.

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

Bill Roth

Thank you, Brad and good morning everyone. Today, I’d like to discuss our second quarter performance and portfolio positioning, our current portfolio positioning and give you an update on our new investment initiatives. Before discussing quarterly results, there have been some recent developments that are good for our business, including pending GSE reform and some exciting progress we have made in advancing our MSR and conduit businesses. Two, competing GSE reform bills have recently been introduced. While neither bill seems likely to be passed anytime soon, both implies the desire to move towards less government involvement in the mortgage market creating opportunities for the private sector in companies like Two Harbors to provide capital to the U.S. mortgage market. We believe this provides good support for our conduit business.

Continued developments around mortgage servicing bodes well for our MSR initiative. Working on the infrastructure to support MSRs has been a key focus this year, and we are pleased to report that we have made significant progress on this front. I will go into more detail later, but we are involved in some very interesting opportunities, which is exciting as we like the available ROE of this asset and MSRs are a natural hedge to our existing portfolio. Given our lower leverage profile today, we have dry powder to put to work as we continue building out this business in the back half of the year. In short, both the potential for GSE reform and the tailwinds that support our MSR initiative are good developments for Two Harbors over the long-term.

Moving into comments about the quarter, please turn to slide nine. The second quarter of 2013 was certainly busy from a portfolio management perspective as we positioned ourselves more defensively early in the quarter given concerns we had around the potential for an increased volatility, rising interest rates, and wider mortgage spreads. Clearly, that panned out well given market events and sector results for the quarter. Despite a modest total comprehensive loss, we were largely able to protect our portfolio from the dramatic move in interest rates and agency spreads as well as the widening in credit spreads, which affected non-agency.

Let’s talk about the agency market. Agency mortgage securities underperformed in the second quarter with increasing concerns around fed tapering, rising interest rates, and improving economic sentiment spreads widened dramatically. Further pay-ups on specified pools were under significant pressure as a result of the higher interest rate environment also underperforming their hedges. As a result, our agency strategy despite our defensive positioning suffered on a total return basis.

The non-agency portfolio fared better down nominally in the second quarter net of hedges. For the first half of the year, our non-agencies and CSLs have performed well with strengthening fundamentals. The improving housing market has led to lower delinquencies and improved prepayment fees. Continued improvement in housing metrics and job growth are good for the future performance of these portfolios.

On the bottom left of this slide, you can see our book value performance relative to a weighted average 50:50 agency, non-agency portfolio. Despite a total return of negative 3.7%, we are pleased to have outperformed by almost 300 basis points. On the bottom right, you will see that our yields and spreads for the quarter were slightly lower than the first quarter. Our annualized portfolio yield fell to 3.7% from 4%. As we have been discussing for some time, we saw lower projected yields on securities acquired in the latter half of 2012 and early 2013 driving a marginally lower net interest margin. Some of this came from the agency side, but some also came from non-agencies. The non-agencies we have bought recently are attractive with loss adjusted yields in the 6% to 7% range but those yields are still less than what we were able to achieve in early 2012 when the sector offered 10% and higher yields. This serves to slowly drag down the overall non-agency yield overtime. Keep in mind that the cost of financing non-agencies has also declined somewhat as Brad noted. The overall cost of financing move slightly higher in the quarter as we increased the size of our swap and swaption hedge by over $2 billion. As Brad mentioned the cost of repo was static quarter-over-quarter. Our total net interest spread was 2.5 versus 2.9% in the first quarter of 2013.

Turning to slide 10, let’s take a look at our portfolio. Our portfolio as of June 30 was 16.1 billion in size including 12.2 billion in agency securities and 2.9 billion in non-agencies as well as other investments. On the top right you will see that our capital allocation is 54% to agency and 46% to non-agency in CSLs. We no longer have an allocation to single family residential property as the distribution of Silver Bay stock has been completed and the bulk of that capital is now allocated to the non-agency in CSL space.

As we turn to slide 11, let’s discuss a few metrics from our portfolio. Our agency prepayment rate for the quarter including inverse IOs kicked higher to 8.7% from 7% previously. This is in-line with our comments the past few quarters about expecting slightly faster speeds as a result of the low rate environment and the continued seasoning of our pools.

More interestingly our non-agency speed increased again to 4%, faster prepays on deeply discounted bonds is a clear win for us especially as we typically model 1 to 2 CPR on our holdings. More details about our agency and non-agency positions can be found in the appendix on slide 19 through 21. Next let’s talk about leverage, as Brad mentioned we reduced our implied leverage during the quarter. While our overall debt to equity ratio is 3.6 times once we take into account our net short TBA position of 2.7 billion at June 30 the metric is actually 2.9 times. As you can see on the slide, we continue to prefer carrying higher leverage for agencies but intend to wait for better ROE opportunities to increase this metric.

Let’s turn to hedging which is a very important part of my commentary on today’s call. Hedging is critical to protecting book value especially during times of market volatility. As you may recall from last quarter at the end of March we have positioned the portfolio with a net short position and by the end of May and June we had a more significant short exposure to rate including a sizeable net short position of 2.7 billion in TBA. This has the effect of greatly reducing our exposure to wider mortgage spreads and a rate sell-off.

Given our concerns about increased volatility and the potential for mortgage base is widening which turned out to be justified, we felt it was appropriate to use a variety of hedges to protect book value. More details on our hedging positions as of June 30 are in the appendix on slide 18 and in our forthcoming 10-Q.

Now let’s take a moment to talk about our current portfolio positioning, while overall volatility today is somewhat new in relative to the month of June it's still elevated. Economic data continues to reflect growth and employment continues to improve. With the likelihood of the Fed tapering this fall and the potential for higher rates and lighter agency spreads we continue to maintain a defensive stance with low leverage and a short interest rate position. However since quarter end we have made a number of adjustments, first although we’re still net short interest rates, in July we reduced our short position to reflect the dramatic rate increase that has already occurred and align our risk position with the current environment.

We’ve also reduced our total agency pool position. We sold several billions specified pools against buying back the associated short TBA positions. This had a neutral effect on both our duration and mortgages spread risk but reduced our balance sheet assets and repo borrowings. The reduction in our pool position will lower our net interest income but it will be more than offset by the reduction in hedging cost from carrying the short TBA positions. In addition we continue to employ low overall leverage today much less than our long-term targets. In general, we don’t think ROEs in the agency market current provide adequate compensation to investors for the increased rate and spread risk in today’s environment. To the extent that agency ROEs become attractive to us again, we have tend to be opportunistic buyers. The good news is that our lower leverage profile frees up capital for future deployment into new investment opportunities, including MSRs and mortgage credits.

Please turn to slide 12 where we had highlighted these initiatives. First, let’s talk about mortgage servicing rights, or MSRs, MSRs are a natural hedge to our agency MBS hedging both interest rate as well as mortgage spreads. As Tom mentioned, our purchase of Matrix Financial Services Corporation allows us to be involved with Fannie, Freddie, and Ginnie MSRs. And as Brad mentioned, this acquisition added a nominal amount of MSR to our balance sheet. Putting together the internal infrastructure to support this endeavor has been our primary focus over the first half of this year. And we are pleased to report that we have made significant progress. We have added expertise in servicing oversight transaction and documentation management as well as underwriting, which benefits not only our MSR effort, but also the CSL and conduit businesses. We also closed on two MSR transactions in July both Fannie Mae deals with midsize originators that could have flow arrangements to follow. These had an initial investment of $13 million.

Looking ahead, we are seeing significant deal flow on a weekly basis from mortgage servicing brokers, primarily on mini-bulk plus flow arrangement. We are also pleased to report that we are involved in advanced discussions with potential sellers that are likely to result in significant investments later this year. Given that MSR transactions are subject to closing conditions and GSE approvals, there is no assurance that these investments will close. We are quite excited about the developments in this business. And while we don’t expect MSRs to contribute significantly to our 2013 financial results, we believe the long-term opportunity set is attractive. Certainly, we will keep you posted as we continue to make progress here.

Second, let’s talk about the prime jumbo conduit and securitization business. As Tom mentioned, we participated in a $400 million securitization in the first quarter. Separately, we currently hold about $520 million in prime jumbo mortgage loans, which we could securitize if market conditions allow. An important development for us this quarter was the creation of our own depositor. So, when the timing is right, we will be able to complete a securitization on our own. As we discussed last quarter, our top priority is developing an originator network to source loans, which will enable us to be an ongoing issuer over time. Today, we have a number of originators that are live in several and some stage of our evaluation process. We are constructive about the long-term opportunity in this market and hope to play a meaningful role as the government reduces its involvement in the mortgage market over time.

Third, let’s discuss credit sensitive loans, or CSLs. As you may recall, we review CSLs as a multi-year, but not long-term opportunity similar to distressed non-agencies. CSLs are a nice complement to our non-agency holdings as they are essentially like the performing loans in non-agency deals. At the end of the second quarter, we have accumulated CSLs with a carrying value of $438 million as compared to $123 million at March 31. Recently, supply has been muted and available yields in the CSL space have contracted relative to non-agencies. So, we intend to take an opportunistic approach going forward in terms of adding to our current holdings.

Finally, as we have discussed before, credit investments from the GSEs are something we have been monitoring given our strength in understanding mortgage credit. As mandated in the FHFA scorecard, the GSEs have been charged with disseminating credit risk in 2013 on at least 60 billion notional of agency RMBS. As you may know in July, Freddie Mac brought to market a $500 million deal covering about 22 billion in notional MBS. This deal offered securities that we viewed is having attractive risk reward characteristics. This was a great first step in the government’s effort to determine private capital, credit risk appetite, and pricing. We’re excited about the potential for similar deals in the latter half of this year and on a longer term basis as this is exactly the type of opportunity that dovetails well with our existing core competency in understanding and managing mortgages credit risk. Before I turn the call over to the operator to begin the Q&A session I would like to note this is a very exciting time for Two Harbors. Our current positioning gives us the ability to be opportunistic going forward as we continue building out our new investment initiatives or when ROEs become more attractive in the secondary markets. For all of the reasons we have highlighted today we believe we can continue to drive value for stockholders over the long term.

We’re most excited about the MSR and conduit opportunities we’ve been highlighting but also expect that in the second half of this year we will likely see renewed market volatility, provide opportunities for us in either or both the agency and non-agency markets. Again thank you for joining us today, I will now turn the call back over to our operator Shawn.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Mark DeVries with Barclays. Please go ahead with your question.

Mark DeVries – Barclays

So Bill it sounds like at least at these levels you don’t find agency MBS that attractive, how much OES (ph) widening would you have to see here before gives you a bigger investor in that space.

Bill Roth

So agency ROEs depending on what sector of the market, range anywhere from mid-single digits on lower coupon to the most attractive when you can find them and it's sort of bond by bond gets your around 10%, so in general I think if you want to categorize agency ROEs to put any real money to work it's probably high single digits on a gross basis. So, if you think about kind of OES (ph) widening that we need to recur it's probably somewhere in the neighborhood of 20 basis points or so. I mean if you look at mortgages on 10 year time horizon even though they have widened since the type (ph) of the earlier this year, they're still fairly average over a long-term basis.

Mark DeVries – Barclays

Okay great. I just wanted to explore some of the implications of any MSR acquisition and also your comment that you wouldn’t expect it to contribute that material in the back half of the year to earnings. So if I think about this, let’s say you go out and you and you buy MSR was about a $1 billion of UPB (ph). Am I right to think that you could then let’s say assuming it's got like a five year average life that you could go out and then terminate roughly a $1 billion worth of swaps and kind of eliminate that negative (inaudible).

Tom Siering

Let me just say a couple of work from there and then I will hand it over to Bill. In respect of what we mean by, not contributing significantly to 2013 it takes a while for these things to close. You need GSE approval and there is a bit of tail to closing these things. So any activity you know would be found within Q4 if it were to close and that’s why we mean it's not from an overall perspective not going to contribute significantly to 2013. So Bill do you want to take the rest of that then?

Bill Roth

Yeah sure, so if you want to think about a $1 billion of notional is really probably about a $10 million investment. Okay, so depends on what the duration of that is, if you look at the duration it's probably depends on the coupon, but it's anywhere from negative 5, 6, 7 to as much as negative 20. So you wouldn't be talking about a $1 billion notional of pools, right? Because you would be talking about something that’s more them more like 50 million or 100 million. We’re talking about a much smaller number depends on the duration of the MSRs, but importantly, the point is, is that MSR has a significant positive yield and negative duration which basically means that we could reduce our swap hedges, for example, which cost us money which would generally increase the ROE on the overall portfolio.

Mark DeVries – Barclays

Okay.

Bill Roth

But volume is kind of it’s hard to predict depends on what the MSR duration is.

Mark DeVries – Barclays

Okay, got it. So, clearly, I guess the swaps that you can close out, you benefit from that negative share going away? And then on the MSR itself, I assume the incremental share from that is not huge right, because we are going to be one you will be sub-servicing and then you will have amortization expense will be modest, very modest positive period on the asset as well?

Bill Roth

Yes. I think we said in the past that we thought yields were in the low double-digits on the excess MSRs. So, that’s after extracting all costs. So, I think we have two small deals we have closed on, some of the things we are looking at, we can’t really talk about what the yields are certainly until they close, but I think it’s not unreasonable to assume that the yield is not similar to those metrics.

Mark DeVries – Barclays

Okay, got it. And then just finally, I think Bill you said your non-agencies have performed well so far quarter-to-date, can you give us an update on broadband on how you think book value is doing kind of mark-to-market from relative to quarter end?

Tom Siering

Yes, Mark, it’s Tom. If you look at there hasn’t been a heck of a lot of movement in either agencies or non-agencies since quarter end. So, there haven’t been dramatic changes in either market.

Mark DeVries – Barclays

Okay, got it.

Tom Siering

I mean, non-agencies are modestly better. Since quarter end, agency spreads haven’t moved very much at all.

Mark DeVries – Barclays

Got it. Alright, thanks for your comments.

Tom Siering

Thanks Mark.

Operator

Our next question comes from Douglas Harter with Credit Suisse. Please go ahead with your question.

Douglas Harter - Credit Suisse

Thanks. Bill, I was hoping you could update us on where you stand of securitizing some of those credit sensitive loans whether you think you have enough size to be able to execute that?

Bill Roth

Hey good morning Doug.

Douglas Harter - Credit Suisse

Good morning Bill.

Bill Roth

Yes. So, the credit sensitive loans, we closed some of those in the first quarter and then some of them in the second quarter. The endeavor that it takes to securitize those actually involves substantially more effort than say a brand new prime jumbo. There is a lot of documentation and data work to get together the pull to produce what’s required to do a securitization. So, it’s something that we are working on. And there are deals that are getting done in the market, but it’s not something that I would say as imminent.

Douglas Harter - Credit Suisse

And then on can you talk would that accomplish better leverage, cheaper financing, or it just give you the comfort of having term financing?

Tom Siering

Hey, Doug its Tom. How are you? Good morning.

Douglas Harter - Credit Suisse

Good morning Tom.

Tom Siering

I would say this given our overall leverage in the portfolio we have a lot of financing flexibility right now. So, we can really pick our spots. And so that would apply to CSLs and certainly it would apply to MSR to the extent that comes on the book. So, right now, we have all the financing flexibility in the world. So, we can really pick our spots. And obviously our goal is always to optimize financing metrics. And as I said, we just have quite a bit of flexibility today and a lot of financing options given our low – very low leverage within the agency portfolio. Bill, is there anything you wanted to add to that?

Bill Roth

No.

Douglas Harter - Credit Suisse

Alright, that’s helpful. Thank you.

Operator

Our next question comes from Trevor Cranston of JMP Securities. Please go ahead with your question.

Tom Siering

Hey, Trevor.

Trevor Cranston - JMP Securities

I guess first I just wanted to make sure I heard correctly the portfolio changes since the end of the quarter, if I understand correctly that you sold several billion of certified (ph) pools bought back the short TBA positions which was net kind of neutral to duration and slight leverage but then on top of that you also reduced the net kind of short exposure to interest rates?

Tom Siering

Yeah that’s exactly right. if you look at there was a slide 11 that showed that up 100 parallel shift would benefit, we would expect that to benefit by 9.9% and by reducing our net short since quarter end you can expect that number to be lower. So everything in that is correct.

Bill Roth

We’re still net short but we’re just less net short than we were at quarter end.

Trevor Cranston - JMP Securities

Okay can give you any color on kind of how you reduce the net short? Was that in the swap or the swaptions?

Bill Roth

Yeah, so, I mean basically it is a combination of things. In addition to selling pools and buying back similar amount of TBA we did cover some more of our TBA short and we did a combination actually without getting into too great of a detail, we covered some of our TBA short and we had some more mortgages options position that we unwound specifically put options.

Trevor Cranston - JMP Securities

And then switching to the prime jumbo securitization slide, can you give any color on what you see in the spreads is kind of on the new issuance AAA this quarter and how far you think that market is away from being kind of functional again for new deals coming out.

Bill Roth

Yeah sure. So let me answer the first question which is spread so we went through a time where AAAs were quoted at some spread over swap to some speed typically 15 CPR and the challenge with that is the market moves either rally to (inaudible) 15 CPRs not necessarily appropriate. So the market has switched to a convention I will put these in quotes “Points Back” so in other words, how many points back of the applicable TBA? So let’s say 3.5 Fannies are or whatever quarter and half the market today is somewhere around 3.5 points back of that, so that would be 97 bucks for a 3.5 pass through.

In that you know it's a lot easier for market participants to digest because then you can make your own speed assumptions. Now in terms of what does that imply for the economics of this, there is obviously there are several input. The input, the first input is where are the loans being produced. So AAAs are wired today and they were at the beginning of the year but so are jumbo number mortgage rates wider. So it's a combination of where the loans are made, what the credit enhancement is and where the AAAs are sold.

I guess the best way to, the way that we think about it is if you look at those metrics you know and you retain the subordinate bonds you're looking at you know yields on the 0% to 7% in other words the bottom 7% as somewhere in the 6% to 7% range unlevered and if you retain the bottom pieces of that you’re going to get ROEs using a little bit of leverage somewhere in the low to mid-teens and as you can tell because there is so much leverage, that number can be very volatile. It's ranged that ROE number is been below 10% and above 20% in the last six months. So I think the market is cheaper on AAA, it's cheaper on the underlying loans and the subordinates are coming out what today seem to be reasonable levels more importantly for us I would say is that as I mentioned the government is going to figure out a way to reduce their involvement whether its reducing Fannie or Freddie footprint, lowering the loan limits, etcetera, which we think ultimately bodes very well for securitization platforms. So, I am not super concerned about today’s metrics per se as much as the overall long-term prospects.

Trevor Cranston - JMP Securities

Got it. Okay, thanks very much for the color. It’s very helpful.

Tom Siering

Thanks Robert. I will appreciate it.

Operator

Our next question comes from Jackie Earle with Compass Point. Please go ahead with your question.

Jackie Earle - Compass Point

Hi, thanks for taking the question.

Tom Siering

Hey, Jackie.

Jackie Earle - Compass Point

Hi. Just two quick ones, what was the discounts of book value in your repurchased shares and how do you look at repurchasing stock versus other capital investments?

Tom Siering

Sure, it’s Tom, Jackie, good morning. We haven’t disclosed what our calculation of book value is at the time. We primarily said that it was accretive. And how we think about repurchasing shares is this. We view it on an absolute and relative basis given other alternatives within the market. Now given our, I would say general lack of well for the agency space right now, you might expect that in times like this repurchasing shares might be relatively more attractive than they were of agency spreads were at very wide levels. So, we view it simply through the lens of what’s best for the shareholders. If we think that repurchasing shares is better than other investment alternatives, that’s what we will do.

Jackie Earle - Compass Point

Okay, thanks. And then secondly on onside panel when you guys reference your targeted capital allocation, can we expect like similar numbers going forward or?

Tom Siering

Yes, I know that Bill tackle that one, Jackie.

Jackie Earle - Compass Point

Okay.

Bill Roth

Yes, hey, so basically our capital allocation is driven as you might expect by what we think the ROE, expected ROE is at a given sector. One thing you will notice is that as the Silver Bay Holdings went out of the portfolio, we pretty much dedicated most of the capital to the credit side of the equation, non-agencies and CSLs; because we think the ROE is there on bonds that we are buying is in the low double-digits. And I mentioned agencies are tighter. If the agencies get much more attractive that would go up, but if the market stays the way it is today, you can expect that the agency will probably go down relative to the others. The other thing I would say is that we mentioned the possibility of significant investment in MSR to the extent that, that comes about you can expect that, that will obviously go up given it’s close to zero and that the others will come down.

Jackie Earle - Compass Point

Okay thanks. I appreciate the color.

Tom Siering

Thanks Jackie.

Operator

Our next question comes from Dan Altscher with FBR. Please go ahead with your question.

Dan Altscher - FBR

Hey, thanks. Good morning. A question on book value moves, I have two part one on the non-agency, Bill I think you referenced – I think Tom referenced that I guess the move is pretty nominal. I guess one, do you think that’s a function of the underlying bonds that you owned that held up pretty well, or was there I guess significant protection in things like CDS that matched pretty well with the basis? And then I have a follow-up question down the book value after that.

Tom Siering

Sure. I will let Bill tackle that. My comment was that non-agencies since quarter end were a tad higher just to be clear on the comment that I made. Bill, do you want to tackle the second quarter commentary?

Bill Roth

Yes, hey, Dan. Good morning. Yes. So, just to give you an idea of the price path in the second quarter, so April was a good month for non-agencies, generally they went higher, May, they were generally unchanged, and in June, with sort of a general widening in credit spreads. Agencies got – our non-agencies got marked down again. And so net of credit hedges, which sort of went in the opposite direction. It was pretty close to a wash for the second quarter to be good in April, flat in May, down in June and then in July we’ve seen a little bit of bounce back both on the non-agency bonds as Tom mentioned and then applicable hedges have also done well as you probably know since quarter end.

Dan Altscher - FBR

And then one other on the book value change for the mortgage loans that are market fair value those I guess that are in the securitization trust and those I guess that are being warehoused for potential securitization. How did those fair I the quarter from a fair value perspective?

Brad Farrell

I will just comment on the technical accounting side and then Bill can kind of give the color. So all those loans including the loans held in the securitization that are on balance sheet are fair valued. So the marks on those loans do move to the P&L and Bill I’ll let you give a bit of color on the shifts.

Bill Roth

Yeah so basically the loans that we own, the prime jumbo loans that we own during the quarter moved as you would have expected them to move basically with TBA price, right? As I mentioned the AAAs, which are 93% of the capital structure trade off the TBA so as TBA went down so did the loans. Now that being said we had hedges in place both short TBAs as well as swap against that. Now that sort of goes into the overall portfolio management but just in terms of direction they went down like similar to Fannie 3.5, the credit sensitive loan. Go ahead Tom.

Tom Siering

Yeah just to be clear net of hedges this is not a significant factor in respect to book value though to be (inaudible) we’re clear on this. So obviously we hedge the interest rate exposure attendant to these and but it's not a big factor in respect to book value for the quarter.

Bill Roth

Yeah I mean just to be clear when the loans come in on to our balance sheet or when we’re locking loans we’re hedging those just like we’re everything else. So the net is de minimis impact as Tom pointed out.

Operator

Our next question comes from Joel Houck of Wells Fargo. Please go ahead with your question.

Joel Houck - Wells Fargo

I’m somewhat confused. I guess it's a more for the July moves; I mean you reduced spec pools and then closed the short TBAs which seems to imply I think rates are going down a whole lot. On the other hand you reduce around that short positioning which means your little less worried about rising rates although from Bill’s comments about the agency it sounds like you're concerned about possibly continued MBS spread widening or basis risk. Can you kind of handicap those three or how kind of organizationally you guys feel about those three scenarios, lower rates say down 50, higher rates up 50 and then continued basis widening? Just where do you think the real risk lies here between now and year-end as we kind of get through this. It seems tapering is on one week, off the next and you got a Fed Chairman coming in here probably at the end of the year.

Tom Siering

But from an overall perspective you’re exactly right. There is a fair amount of uncertainty and the Fed is a very good factor what’s in the mortgage market and so you put all that in the blender and the output is that we are pretty defensive because you know if you look at from a risk reward perspective agency spread simply are not that attractive on an absolute or historic basis and so we want to play defensively that allows us to reserve a lot of capital for the new business initiatives, it allows a lot of capital agency spreads, rewards are widened to more attractive levels. But in the past quarter certainly it has proven that sometimes the best offense is a little bit of a defense. So Bill do you want to add to that please?

Bill Roth

Yes, sure. So, the three things on, firstly, I just want to be clear on some things, selling pools against a short TBA is virtually in different economic position. In fact, it’s actually a net small positive, because the carry on the pools was less than the short the role, buying the role. So, it was actually economically beneficial to our shareholders. They had no impact at all on duration mortgage spread risk, because the long pool short TBA position assuming that these pools have no pay-up, basically not really any position at all. It’s just one balance sheet and one not. So, just in terms of making that come through there is nothing to do with rates, mortgage spreads or anything. That was just as I referred.

In terms of cutting our short duration position, if you saw we were short, you look at that slide, that’s a pretty substantial short position. And given that 10-year rates had gone up almost 100 basis points by sometime in July, we hit 274. The odds are going up another 100 in the very short run we thought were greatly reduced. And so that is why we cut that position back. That doesn’t mean we don’t think that rates could go to 3% or 3.25%, but the odds at 10-year notes hit 4% or something like that in the next six months. It’s pretty low. The Fed is placed to keep the funds rate where it is which would imply a steepness of the curve that I don’t think we have ever seen before. So, what we are aimed to do going up or down frankly is going to depend on the data that comes out. It’s just that simple. The data we believe continues to be supportive of the Fed tapering and modestly higher rates. And so that’s why we are maintaining low overall exposure and a short rate position.

If you look at what happened and what’s likely to happen, higher rates are likely to be accompanied by wider mortgage spreads and lower rates are likely to be accompanied by tighter mortgage spreads. So, by having low leverage and a somewhat short position if rates go up, we might loose on our basis position somewhat, which is greatly reduced. And then we will win on the rate short. So, it’s a very defensive position. If it goes the other way, we will lose on our duration and we will win on our basis. And so the idea is to keep in this time of high uncertainty where we have a lot of new exciting things that are going to basically potentially make a big difference in our profile. We just think that preserving book value is by far and above the most important thing to do.

Tom Siering

Yes. And to be clear, Joe, how we got there, if you look at our swaptions, the position there, it’s hard to pick up Joe as the market sold off, so actually we are getting somewhat shorter as the market sold off, which speaks to the efficacy of our hedging program.

Joel Houck - Wells Fargo

I think most would agree you guys have done the best of any on the hedging, how would you, I don’t know handicap is the right word, but what are your thoughts regarding how much is priced in the mortgage bases with respect to tapering by the end of the year. This is obviously the big topic and you get lots of different answers, but I am just curious as to what you guys think?

Tom Siering

Well, yes, I mean the market is a little schizophrenic right, because the news changes from day-to-day. So, we try very hard not to trade the headlines, I would say, and really just position the book as we think best. I mean, it’s very simple, right. There is a few metrics that Bernanke at all or fix on as they should be. And obviously kind of the super metric is employment and to the extent that lacked some veins, the Fed’s desire to taper or not will be affected. And obviously a change in the leadership of the Fed will have an impact on that. And obviously that’s still uncertain too. So, I think the market, how much of this price has been we would say this that’s not enough is priced at in respect to tapering because ROE is simply aren’t that attractive and we’re going to let that be our guide and how we position the book.

Joel Houck - Wells Fargo

That’s helpful and then if you had to run this defensive position for a while just given uncertain value (ph). So what type of kind of ROE does it generate, obviously it's lower than say a year ago but if you’re going to protect book value and I think that’s the right strategy most people would agree, the trade-off is lower current returns but how should we think about that not that you guys necessarily we’re going to hold you to running this thing to infinity but if we had to think about this for a while what would the ROEs look like?

Tom Siering

I can promise that promise you that we will not run (inaudible) to infinity it will be different in some respect that much I can promise you. We said this lot and perhaps at a point of ad nauseum but Bill and I think about the portfolio in respect from total return and it's a heck a lot easier to generate a dividend when you preserve book value and you have the ability to put money to work in times when it's prudent and one thing that we’re simply not going to get trapped is kind of work backwards to generate dividends in other words unduly increase leverage. So it's very difficult to say, you know, the mortgage market is very ephemeral in nature and conditions that exist today almost certainly won't exist tomorrow. So we really think about it from the standpoint of prudence in respect to total return.

Operator

Our next question comes from Bose George of KBW. Please go ahead with your question.

Bose George - KBW

Actually just wanted to follow-up on the last question just on the potential returns. Just when we think about this quarter versus last quarter what should we think about in terms of the changes that you made that has impact core earnings, I mean the changes to your hedges presumably had upside to core earnings as a result of this. Any comments on that?

Brad Farrell

I’ll start and then Bill you can kind of deep dive into maybe the strategic and more color but I tried to expand my comments around that point. I mean it is a large component of leverage and defensive measures to protect book value. So those are the key drivers, now with this quarter coming out the back of those actions, you know, we will not focus on core earnings and as I noted, realized gains on a specifically TBAs which by definition are not part of core earnings. Those are generating cash flow gains that we look at when we’re declaring our dividend. The other component is we have the intention of treating the value of the Silver Bay stock as return of capital and so to do that for 2013 we will largely target distributing a 100% of our taxable income and so that's another factor in how we think about core earnings, the dividend and really again focusing on Tom’s comments preserving book value. Bill you want to expand on that?

Bill Roth

I think I will be the third person to say that we really don't think that much about core earnings, so if anybody on the phone wants to say the same thing. The bottom line is we can generate a lot of core earnings which require us taking a lot of more leverage and probably a lot of interest rate risk and we already know how to movie ends and so when spreads are narrow you don't want to jack up leverage or take extra risk because when things go the other way, you know, I don't care how much core earnings you produce it's going to be a bad total return and so frankly we’re just not focused on it. We’re focused on what we think we will generate the highest total return and you know I will give you a real simple example, if we had a dollar and that’s all we had and we didn’t invest it for 89 days of the quarter.

And then we bought a bond really cheap on the last day and it went up in price 10%. We would have no core earnings, but yes, we would have had a terrific total return. And I would argue that, that’s a very good result. And so that’s kind of the way we think about it. So, the only thing I can tell you is that you can expect us to have a very high focus on our total return or total comprehensive income, but I can’t tell you what core earnings are going to be.

Bose George – KBW

Thanks. I definitely agree with you guys. Unfortunately, we’ve got (inaudible) trend throughout core earnings that’s why we are trying to fine tune that, but yeah, I definitely agree with your approach to this.

Tom Siering

And to answer your question, I think what you asked at the front end was the changes we have made since quarter end. So, if the changes that we made that Bill discussed, for instance, we do some of the overall balance sheet and taking down the interest rate hedge would have a modest positive impact on core earnings, but again, that’s not the real driver behind that, but I think that was I think that was your question.

Bose George – KBW

Yes, absolutely thanks. That makes sense. And just on the non-agencies, I was just curious where current returns are?

Bill Roth

Yes. Actually, so I mentioned during my comments that bonds we bought recently are in the 6% to 7% range on a loss adjusted basis. And if you sort of apply our typical 1.25 times leverage given its financing has come in to sort of mid-market LIBOR plus 1.50%, you get to low double-digits ROEs. And these are on bonds that we think we have upside optionality. Now, I will tell you that the bulk of the non-agency market does not trade in that 6% to 7% range, it trades lower than that. So, it’s not like we can put substantial amounts of capital work on a daily basis or on a monthly basis, but when we are finding bonds that are in that zone that works for us.

Bose George – KBW

Okay, great. And then actually just a question on that Freddie Mac securitization, did you guys participate and also is there a leverage available for that, I mean, in terms of getting to a double-digit return?

Tom Siering

Yes, Bose, it’s our understanding that there were some confidentiality provisions around that offering, but you might infer that this is something that an area that we would be attracted to. And with respect to financing obviously the most efficient way for us to finance today is through the agency market and we are very under-levered in that respect.

Bose George – KBW

Okay, perfect. Thanks.

Tom Siering

Thanks a lot, Bose.

Operator

Our next question comes from (inaudible) of Deutsche Bank. Please go ahead with your question.

Unidentified Analyst

Hi, good morning. Thanks for taking my question. Actually most have been addressed, but I missed a little bit of revolve around the tax recorded during the quarter, can you may be revisit how to as far as what their capital treatment was because of tax (inaudible) reporting?

Tom Siering

Yes, I am going to let Brad tackle that one.

Brad Farrell

Yes, just I am going to – the connection didn’t come across terribly clear, so I just want to repeat what I think I heard. So, you are asking is you missed the tax that the comment I made and then you are just trying to understand what drove the taxable income?

Unidentified Analyst

The $45 million.

Brad Farrell

Okay, got it, the tax expense, I am sorry. So, that the tax expense, so as a REIT, your mortgage bond exposures are allowable and good asset and good income for our REIT. Certain derivative activities that we participate in specifically swaptions and other more complex synthetic instruments, credit default swaps things like that, TBA mortgage options, are not good assets or good income items for the REIT. And so we create a taxable REIT subsidiary to conduct that activity. So, when certain gains are generated in our taxable REIT subsidiary, it is a corporation that does have tax exposure. My comments specifically with addressing that over time we have actually taken losses in that entity as we made money on our cash bonds. So, this is largely just a flip of the acquisition over our history. So, it’s a tax expense associated with our derivatives, but it doesn’t necessarily correlate to tax payments with IRS.

Operator

Our next question comes from Ken Bruce of Bank of America Merrill Lynch. Please go ahead with your question.

Ken Bruce - Bank of America Merrill Lynch

My question really relate to the new initiatives and firstly thank you for your comments around the capital preservation risk aversion, I think I can understand that certainly in this market back drop but on the new initiatives and some of these questions may seem a bit skeptical that I would just want to kind of understand your commitment to these businesses. How does Two Harbors want to define itself as it looks at the mortgage market either from the servicing perspective or within the conduit activities?

Tom Siering

Sure. Well I hope I can lay some of your skepticism, How we think about it is that our history is steeped in certain competencies which are prepayment risk, interest rate risk, credit risk within the housing and mortgage markets. So it you look at securitization it requires credit analysis just as we go through in our legacy non-agency book. If you look at MSRs we view those through the lens of prepayment and interest rate risk. And historically we’ve participated in the IO market when that’s attractive, today MSRs are much more attractive than IOs and so they provide a natural hedge to our agency book but very importantly they need to stand on their own in respect of their attractiveness. And so today, they are attractive and the reason is because of the capital and regulatory environment that we’re in and secondly given the frantic amount of refinancing that has gone on there, certainly a lot of people who have a lot of MSRs on the books and in some cases that’s fairly large relative to their overall capital and so we provide balance sheet and we’re good partner for certain counterparties because we’re not going to be in the underwriting business and we’re not going to be directly servicing the MSR and therefore we’re quite good partner.

And so today both of those sectors are attractive. Now fully the key is you know to execute on those, today we’re quite enthusiastic that we will be able to within the MSR space but as we cautioned it's subject to diligence, closing, GSE approval et cetera, on the securitization front it's fully going to be tethered to the ultimate profile of GSEs to the extent that they either to the extent they will reduce their footprint within the mortgages space which is immense today as you know that allows private capital such as (inaudible) provided by Two Harbors to participate in the jumbo market and to participate in securitization.

Ken Bruce - Bank of America Merrill Lynch

I guess what I really I’m trying to understand is do you define yourself as an investment company that’s looking for relative value and it just so happens that these areas are interesting today and ultimately you want to allocate capital into them but as you look forward that b can change and so that interest in whether it will be MSR as you’re frankly even in the conduit activities may not be there and how do you think about it in the context of maybe a longer term view?

Tom Siering

Sure, you asked a great question. You know how we think about it is simply this right? We’re going to participate in the mortgage market as a mortgage rate and we want to have all the options that are available to enhance shareholder return. So how Bill and I think about it, the portfolio is in the context of sharp ratios of information ratios. In other words, return measured through volatility metric and so we want to have all the options available to us and our commitment to certain space is going to be driven simply by what we think the risk reward is within those areas. And so we have built out a very lean infrastructure that allows us to efficiently economically, but prudently manage all of the issues associated with these initiatives and we will move capital around depending upon the relative attractiveness of all of these things. And so we don’t want to be narrowly defined, because at times, the agency market is attractive and we have gone through a long period of that in the last few years, not today, plus so. And so on an absolute and relative basis, these new initiatives are much more attractive relative to the legacy agency book and that really is what drives us. I mean, it’s a cliché, but shareholder value is what drives us. And today, these new initiatives are really attractive in that respect. I think Bill is going to add something too.

Bill Roth

Yes, hey, Ken, yes. Let me add something that I think is important to keep in mind. In keeping with what Tom said, you can be very opportunistic and if you want to buy agencies when they are cheap or if they are not so cheap reduce it, one thing about these new initiatives that we are very serious about, because these obviously have a higher operational component is these are things you have to commit to be in for a long period of time. So, given the fact that we are a mortgage REIT, we are going to be invested in mortgages. MSR, almost without exception due to the nature of the asset being a positive yield negative duration has a place in the portfolio for a long period of time. So, you don’t just go in that and say hey, it’s cheap today and then in a year oh, it’s not cheap I don’t – you can’t do that because of the nature of owning mortgage servicing. It’s our intent to be in this business for I guess somebody throughout infinity. So, may be a little less than infinity. If you make a commitment, you make a commitment to that and it’s important for the people that we partner with also, because they need to know that we are going to be here. And our balance sheet can absorb that asset as those prices fluctuate, it still makes sense. And then furthermore on the conduit side, look you can’t sign up dozens and dozens of originators and say you are in that space. And then a year later, just say I am out. Okay, I am really not worried about the longevity of either of these businesses. The mortgage market has and will continue to go through dramatic changes with regards to the players and the capital, and these are two businesses that we are very confident that can be value-added for our shareholders over many years to come. So, understand that we have added staff, we have added expertise. We are very well-positioned and we are committed to both of them. And I think that’s important to understand.

Ken Bruce - Bank of America Merrill Lynch

Yes, and that’s exactly where I was getting after was that these are businesses that have much more operational investments and require consistency over time in terms of being able to aggregate a group of sellers. And so it’s trying to understand your interest in this area and how that will evolve is really what I am getting after you have seen a number of other companies have gotten involved. And I am trying to understand is as the return profile and the business changes around mortgage business is cyclical by it’s very nature that’s going to lead to some ups and downs and understanding how you are thinking about that is really what I am trying achieve. So, thank you for your comments.

Bill Roth

We do understand we have spent a lot of time. We have been very measured on how we have approached this and we built out the infrastructure to support these initiatives. And as I said, we are quite confident, but not only are we a good partner in respect to capital, but we have the competencies at every level to handle these new initiatives. So, we have taken our time, we have built slowly, and we are quite enthusiastic about the future for these new initiatives.

Ken Bruce - Bank of America Merrill Lynch

Great, thank you. That’s all I have.

Operator

I am not showing any other questions in the queue at this time. I would like to turn it back over to management for closing comments.

Tom Siering

Thank you Shawn. And thank you to all our participants for joining our second quarter earnings conference call today. We appreciate your interest in Two Harbors and look forward to speaking again to you soon. Have a great day.

Operator

Thank you. Ladies and gentlemen, thank you for your participation in today’s conference. This does concludes the conference. You may now disconnect. Good day.

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