Tom Siering - President and CEO
Bill Roth - Chief Investment Officer
Trevor Cranston - JMP Securities
Two Harbors Investment Corp. (TWO) JMP Securities Financial Services and Real Estate Conference October 1, 2013 3:00 PM ET
Okay. It looks like we are on the clock for the next presentation, as we are going to get started. I am Trevor Cranston, and I cover mortgage finance for JMP along with Steve DeLaney. Next presenting company today is Two Harbors Investment Corp. Ticker TWO.
Two Harbors is the largest hybrid REIT in the universe. The company is externally managed by an affiliate of Pine River and have a current market cap of about $3.6 billion. Two Harbors invests in a variety of residential mortgage assets, including agency and non-agency MBS as well as whole loans and recently mortgage servicing rights as well. The company has recently declared a $0.28 dividend, which give the stock about 11.5% current yield. Presenting for the company today we have the CEO Tom Siering, as well as the CIO, Bill Roth.
So with that, I will turn it over to Tom.
Thanks, Trevor. While the government made the shutdown, but this fine conference goes on and it’s always a great conference. I’d like to thank Steve and Trevor for having us again. So some of you are familiar with Two Harbors story and certainly a few probably not as much. But we came to market in October 2009 with the market capitalization of $124 million and today we have a capitalization of about $3.5 billion.
And as Trevor pointed out, we’re the largest hybrid mortgage REIT. What was the thought behind the company, was it really simple one. During the crisis the mortgage market had become really shattered agencies. The agency market was in disarray owning to the disinvestment by the agencies and the non-agency market (inaudible) left for debt.
And so what we thought we could do is bring sort of a fresh and we think sophisticated approach because the mortgage market is really unusual one. Even for an institutional investor it’s difficult to analyze, it’s difficult access, research in the space, it’s quite small. And so we really thought we could add value to the market by bringing Two Harbors into the space.
So our portfolio at the end of the second quarter is about $16 billion, Bill is going to get into more granularity about what is and was in the portfolio. So we’re quite proud of our investment and administrative teams. And so also as Trevor mentioned, we’re part of the Pine River family and we’re quite proud of that, because Pine River is (inaudible) systems. Its structure has really allowed us to bring Two Harbors to where it is today.
We take a very sophisticated approach we feel in respect of interest rate and credit hedging and we use instruments that are rarely if ever seen was in the mortgage REIT space, using things like swaptions, IOs, inverse IOs and other forms of options to hedge interest rate exposure as well as swaps. And on the credit side we use single name and index CDS.
We are very serious about our operational and risk platforms and we think we are best-in-class in the risk department and in middle and back offices. So we are a hybrid REIT and recently we have expanded our platforms, so our legacy portfolio is filled with agency and non-agency securities.
Recently we announced we had bought about $450 million in market cap and credit sensitive loans, so credit sensitive loans are whole loans, were originated during the crisis or meant be securitized but never were and were hung. And so today, these have been modified in one way or another either in principal or coupon and in some cases both.
In the first and second quarter these were very attractive alternative to non-agency investment. We have recently done a couple prime jumbos securitization deals buying whole jumbo loans in the market and then selling of the higher credit components of that, retaining the credit piece and IO.
And lastly, we’ve announced that we bought a small company call Matrix, which allows us to own mortgage servicing rights from the two GSEs and from Gennie. Just as we felt [PAL] was a very elegant solution to the problem, how to do  licenses which is a real problem and the real barrier to entry into the market.
So Matrix had no [rigid made in the loan] 13 or 14 years, and so it was (inaudible) legacy issues and we expect of reps and warranties. And so we announced that we had closed a couple of small Fannie deals and this is important to make sure that our systems and our administrator function operates smoothly as well as build our relationship with the agencies.
So our mission is really simple, but obviously the implementation is complex, which is to say that we want to be the best hybrid mortgage REIT in the space. Obviously, like every other CEO, my job is about optimizing shareholder value. Bill and I spent a lot of time thinking about sharp ratios, information ratios and really one of the exciting things about these new business initiatives are that it has the potential to build substantial franchise value for Two Harbors. In other words, that people won't think of us any longer is simply a portfolio of the securities, but it really a business on top of that.
And also it helps to dampen volatility. And Bill and I are big believer and trying to mute volatility in respect to book value as much as we possibly can. It's a very exciting time for mortgage REITs. Obviously there is an evolving landscape for the agencies. And so whatever their fare, we will be that they will be smaller and offering lower conforming limits and therefore there is going to be an increasing need for private capital within the mortgage space.
So if there any football fans in the room, I know there is at least one. Bill Parcells famously said you are what your record says that you are. And we're pretty proud of our record. And so this shows your returns over 3 year, 2 year, or 1 year and then the last six months in respect of our return. And it's something that we're quite proud of. And so you can see that there has been an awful lot of alpha generation.
And as also represented on this slide, which compares us to the Mortgage REIT Index which is captured on the low and so you can see that the Bill and the team have done a tremendous job through security selection, through the way that they hedge the portfolio, the way they had dynamically allocated money within the portfolio to drive return for our shareholders.
So this is the slide that we think an awful lot about. And so the key takeaways from this are these that if you look at our dividend yield, it's certainly been in line with the competition. In respect of leverage, we traditionally have much less leverage than the typical mortgage REIT. Now we are a hybrid and some of our competitors are agency only. So in fairness, some of that is natural but some of it is the way we think about the world and how we allocate capital.
In respect of interest rates, we're very unusual. I said this with all modesty, we don’t aspire to be anyone other than who we are. And traditionally, mortgage REITs have taken a significant amount of interest rate exposure and the markets has been accepting of that. The second and third quarter were an abject lesson that complacency in that regard is not a healthy thing.
So at the end of the second quarter, we had an aggressively short profile within the bond market as we felt that there was going to be a bit of jail break. And today we've significantly reduced that exposure as we felt that interest rates were approaching an equilibrium point. Bill is going to talk about that more in a second.
And lastly, this slide on the right, is something I think the people aren’t mindful enough of which is this shows our prepayment fees versus the competition. And you can there are much lower and much more consistent than what you typically see, and why is that important? Well, it’s a very difficult, especially in an environment where like we are in, of course there is a lot of interest rate volatility to hedge interest rate exposure if you don’t know what that exposure is. And so I think that 2013 will continue to distinguish Two Harbors from the rest of the space.
With that, I am going to turn it over to Bill.
Thank you. Good afternoon. So during the first day of the third quarter, giving a second quarter update, or sorry fourth quarter, giving a second quarter update seems a little bit odd, so I’m not going to spend much time on this page, except to note a couple of things. Everything on the top right, we can put a little question there, who knows, because some of the things we thought we knew, we definitely don’t know today.
On the bottom left, the fed is still the biggest fire and it’s actually now more of a more, bigger buyer of what's being produced. Unfortunately, mortgages performance after the fed announcement has been quite stellar, which makes investment in agencies today more challenging than it was even before the taper announcement. Probably the only thing on here that really is still in place and we expect to be in places in the bottom right which is that non-agencies continue to performance well not only on a price basis but more importantly on a underlying fundamentals basis.
Our portfolio composition at the end of the second quarter, you can see here on the slide, the most important thing to note is actually on the following slide which is that well our capital was 54% allocated to agencies, we had cut our effective leverage dramatically given the unattractive spread as a result of the fed’s activity in the market. Imply expected ROEs on a fully hedged basis and I want to say that again on a fully hedged basis are well below 10% for almost any fixed rate mortgage agency mortgage pool or coupon. We have been finding value more recently in the longer reset arms, primarily because that is out of the fed’s wheel house and we see ROEs in that sector in and around 10% area on a hedge basis.
So what you can expect to see is that while our ‘capital allocation’ to agencies is still roughly in that 50%, low 50s our effective leverage has dropped dramatically as a result of having sold several billion pools as well as maintain short TBA positions to offset basis risk. We hope that this is not a long-term and we don’t expect it to be a long-term situation. Ultimately the fed is likely to remove their foot from the gas paddle and we’ll have better opportunity.
And at that point, we would intend to be an opportunistic buyer in the agency space. Some good news and I talked about that other slide, the bottom right on the non-agency front the economy does continue to grow, employment does continue to grow albeit not at a pace that obviously the fed is happy with, but nonetheless, borrow performance is getting better, delinquencies are going down, home prices are helping people clearly. And one of the things and one of the reasons that we have liked this strategy is that, if you think about it, everyday that goes by that we’re further away from the crisis and every month that goes by that a borrower has a job and makes another payment their equity in their home continuous to grow and they’re more likely continue to pay. And those borrowers that are struggling or getting their loans modified.
So ultimately this means that you can see borrowers sell their house and move, I mean we’ve all read stories about somebody, somewhere out there that couldn’t move a year and half ago, but they just sold their house and moved somewhere.
Okay, typically you do that when you are not in a lost position. So what does that mean for bonds that we own at deep discounts? On the bottom right, you can see the prepayments, which we have historically modeled and running 0%, 1% or 2% per year for the remaining 25, 30 years on this long life are actually doing substantially better than that.
Typical housing turnover, over cycles runs in the 5%, 6% and 7% per year. So to the extent that as time goes by and the market continuous to heal, we expect that there is the opportunity for more upside in this book. So this is something we are very excited about.
So according to clock we have 8 minutes and 31 seconds and we could use 10 times that much to talk about hedging. But I want to make a couple of things clear. As Tom mentioned on that earlier slide, we don't typically take interest rate risk, we hedge out not only the rate risk, we hedge out to convexity risk through swap options, we're not afraid to short TBAs to protect basis risk.
And what you see on this slide is this that if you look and I mean this is just a little nasty pointer that we were providing with. We typically don't take much exposure here. Now if someone will say, cheese guys at the end of the quarter, if rates went up 100 basis points, you're going to make 10%. While mathematically that's true, keep in mind that assumes a parallel shift meaning fed funds rate, one year rates, two year rates, three year rates, et cetera. I don't think anyone would expect when the fed has a 0% interest rate policy for two year to go up a 100 basis points.
So, while mathematically this is actually correct. In reality what we saw is a bear steepener, meaning the 10 year got smoke and rates went up a bunch and the front end didn’t move much. So what we actually model and expect, but don't disclose are all sorts of different analysis to protect ourselves against curve shapes. The point of that’s being is that when rates were really low, we were concerned about a rise in rates. Since quarter-end we have cut back on this short position dramatically. And although we do maintain a small net short position, we see all that the big moving rates has already occurred from 10 year rate to well below 2%.
I’m going to skip to this, because I know we're running short on time here. I wanted to spend some time on the things that during this conference that we're actually spending the most time on internally. So mortgage servicing, we talked about on our couple of other conferences on our earnings calls, basically as Tom mentioned, we're in that business. We've acquired this past quarter two small servicing packages, both Fannie Mae deals. And that was important because it allowed us to get the Kings out and get on the board with Fannie Mae.
We have also announced that we're in advanced discussions with sellers that could lead to significant investment later on this year. We haven't given any update on that, but understand that anytime you enter into one of these transactions even if we made a deal with somebody today, there is a lot that has to happen before you actually get to the closing table. There is due diligence, there is tapering the transaction, there is passing it through the appropriate GSCs, there is transferring servicing and then there is closing and exchanging the money.
So we hope to have more to say about that as we move through the tail part of this year. Most importantly, we're very excited about it because MSR provides us an IO like cash flow that not only throws off an attractive yield, but also hedges not only interest rate risk but also mortgage basis risk which is as many of you know, can be a [bugaboo] for a mortgage REIT.
And lastly and then I'll abide by the little time clock here. The other thing that is very important for us to focus on and that we're spending a lot of time building out our mortgage loan, condo and securitization business. If you look out there and you say, cheese guys, there is only been $12 billion done this year and the banks are posting jumbo rates that are below confirming rates and Fannie and Freddie and Ginnie are 91% to the market, why are you guys doing this?
Well, it’s very clear to us that the government wants to reduce their footprint. Fannie, Freddie and Ginnie two years, three years, four years from now are going to have a smaller role. We don’t know what that role is going to be, but it will be smaller. It’s also clear to us that it’s very unlikely that the banks will continue to have jumbo rates that are below confirming rate.
Well, why are they doing it today, because it’s good business for them. It’s a 4.25% or 4.5% yielding high quality asset to customers they can sell a credit card to or an auto loan or checking account and that they can fund it effectively zero.
While to the extent that this environment doesn’t last forever, we all know nothing last forever that we expect that this business overtime will give us the ability to create very attractive credit bonds for our portfolio and you need to focus on it today, so that as that markets opens up over the next several years, we can be, that can be a meaningful business for us.
And I think I am going to stop there given we only have a little time left and thanks everyone for coming.
Trevor Cranston – JMP Securities
A couple of questions. I think in the second quarter you bought back a million shares (Inaudible)
Sure. Thanks Lee for that question. I will take the first one. How we look at it is how we look at any investment opportunity. So what is the best use of a dollar today. So I think it’s reasonable to say that in times when ROEs are fantastic as they have been in the past for the assets that populate our portfolio and the share price is trading excess of book value that’s not a good time to be buying back shares. Now today the environment is quite different from that. ROEs especially in the agency space are challenged.
I think you could reasonably assume just given what’s going on in the market agency spreads are touched tighter quarter-over-quarter, non-agencies are out maybe just a [hair] quarter-over-quarter. So you shouldn’t expect that there is a very big change in our book value. Now we haven’t got March and all that and so I want to caution on that, but if you look at broadly what’s happening in the market.
So today it’s certainly is more attractive to buy back shares than it has been historically, but we take a very sober view of this and just say what is the best use of an investor’s dollar today. And on some days that’s going to be buying back shares and on some days it’s not going to be, but it depends upon the opportunity within the stock and the other alternatives that we have.
In respect of how many shares that management owns, I would have to, it’s a substantial number, for instance I own somewhere between 300,000 and 600,000 shares depending upon how you count it. And importantly senior management has never sold a single share. So all of my senior management own shares and management has never sold a single share. Yes?
Just to follow-up on capital question. How much capital would you have for buying additional ancillary?
Sure. Well today capital for us is not a problem, which is to say that the portfolio is very under level relevant to where it could be. And so I have very ample liquidity and tremendous amount of borrowing capacity. So today financing a lot of money is, I mean still buy very nicely and about to finish. But today that’s not gating issue at all. We would not have to raise a single dollar externally to buy a substantial amount of MSR.
Trevor Cranston – JMP Securities
Okay, if there are any more questions, there will be a short break out across the hall in the (Inaudible). Thank you, guys.
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