End Of Quarter Surge In MBS Values Makes Two Harbors A Buy

Oct. 3.13 | About: Two Harbors (TWO)

Two Harbors Investment Corp. (NYSE:TWO) is a mortgage REIT, which focuses on investing in, financing, and managing RMBS and related investments. Its main target assets in the past have been Agency RMBS, non-Agency RMBS, and other financial assets (about 5% to 10% of the portfolio). It is externally managed and advised by PRCM Advisers LLC, a wholly owned subsidiary of Pine River Capital Management LP.

Mortgage REITs in general and TWO in particular saw big falls in their stock prices when book values fell dramatically in Q2 2013 as mortgage rates and interest rates rose rapidly. TWO itself saw its book value decrease from $11.19 per share as of March 31, 2013 to $10.47 as of June 30, 2013. This was a loss of -$0.72 per share or -6.43%. If you offset by the Q2 dividend payout of $0.31 per share, then the economic loss was only -3.7%. This was better performance than most of the mortgage REITs.

TWO's non-Agency performance for 1H 2013 was up. However, TWO recorded a comprehensive loss of -$146 million or -$0.40 per diluted share due to its Agency RMBS holdings for Q2 2013. Still due primarily to its non-Agency holdings, it generated $102 million in comprehensive income for 1H 2013. This represented a return on average equity of +5.2%. It far outperformed most other mortgage REITs.

After the big Agency RMBS losses of Q2 2013 by TWO, investors were worried that the book value losses would continue. Indeed the mortgage rates and interest rates continued upward for the first two months of Q3 2013. This caused Agency RMBS values to fall even more; and it worried investors even more. Partly this worry was because TWO was trading relatively close to its book value at the end of Q2 2013. The stock price was $9.71 per share at the close on September 30, 2013; and the book value was $10.47 as of June 30, 2013. Since TWO had lost book value in Q1 2013 (-$0.35 per share), investors were doubly worried about TWO's Q3 performance. This is a legitimate worry given its considerable Agency securities holdings (see table below).

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The substantial amount of Agency securities holdings is why the rapid rise of Agency RMBS values in September 2013 was so cheering to TWO stockholders (or prospective investors). The chart below shows the movement of the 30-year FNMA 3.5% MBS during Q3 2013.

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The chart shows that the 30-year FNMA 3.5% RMBS is about 1% higher at the end of Q3 2013 than at the beginning of Q3 2013. In other words, the book value of this MBS has gone up in Q3 2013. The charts of other Agency fixed rate RMBS show a similar pattern. Overall TWO has leverage of 3.6x; but the non-Agency leverage is very low. The Agency leverage was lately in the 5.5-6.0 range. This means that the roughly 1% gain in Agency RMBS value was multiplied roughly 6 times. The Agency portfolio comprises approximately 50% of TWO's equity. A ballpark book value gain figure for this might be in the neighborhood of +3% for TWO for Q3 2013.

On top of this, TWO is hedged against interest rate increases. The 10-year US Treasury note yield closed at 2.61% on September 30, 2013. It closed at 2.49% on June 28, 2013 (the last trading day in June 2013). This rise of +12 bps for Q3 2013 should ensure that TWO's hedges should at worse be book value neutral. They might even provide a small book value gain.

For non-Agency securities, the repo rates saw improvements in Q2 2013 of 40 to 50 bps. I do not have the figures for Q3 2013. However, the improvement in Q2 was surely due to the improvement in the credit quality of the non-Agency MBS due to the recent improvement in housing prices and the housing market. This means TWO should again post good results for its non-Agency portfolio in Q3 2013. The decrease in the repo rates should add to net interest spreads. Plus the value of the non-Agency RMBS themselves has likely increased again in Q3 2013 as it did in both Q1 and Q2 2013. At worst, this is again roughly flat. The average discounted weighted cost basis of the non-Agency MBS is $52.16 (out of $100), so there is a lot of potential for book value gains. Essentially as long as the housing market continues to improve, which it has recently, these holdings should continue to appreciate. Further CPRs (constant prepayment rates), which were up in Q2 2013 for TWO, have likely settled down considerably in Q3 2013. By itself, this should have added to both the net interest spread and the book value of these entities in Q3 2013.

In addition to the main investments of TWO (Agency and non-Agency MBS), TWO completed its acquisition of Matrix Financial Services. This now allows TWO to own mortgage servicing rights from Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC), and Ginnie Mae. TWO also closed on two small bulk purchases of Freddie Mac MSRs in July, and it is in negotiations about other bulk arrangements. Such investments should provide a natural interest rate hedge for portfolio and mortgage basis. TWO expects such investments to become a bigger part of its portfolio as the year goes on. If management's record is any indication, these investments should prove to be fruitful for TWO.

TWO has also expanded into Prime Jumbo Securitizations and Credit Sensitive Loans (CSLS). It is early on in these areas to try to predict profits or losses for Q3 2013. However, TWO's management has a record of success; and it has given investors no reason to believe that this will change. The following chart shows TWO's total stockholder return since its IPO date in October 2009. An 82% total return (as of August 30, 2013) in about four years should be attractive to most investors.

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Investors should take into account that this chart does not reflect the virtually assured book value gains in Q3 2013. Note the 82% figure is through August 30, 2013. The gain in book value of the Agency MBS since then has been much more than that for the entire quarter. It also does not take into account TWO's Q3 2013 dividend of $0.28 (an annualized 11.44% dividend). These may push the total return into approximately the 90% range for a four-year period. This would make most investors happy, especially since TWO has been paying great dividends to income-oriented investors. Plus the lowered, but still good dividend will also be easier to cover out of Core EPS. These were only $0.21 per share in Q2 2013, while the dividend was $0.31 per share. Since the Core EPS should be significantly higher in Q3 2013, a further lowering of the dividend seems unlikely in the near term.

All told, TWO should have had what most investors would consider a great performance in Q3 2013. Its outlook is good to great. It is entering a number of areas which should be much more resistant to interest rate and mortgage rate increases. Investors will have to monitor the performance of these new areas over the next year; but they should perform well. This makes TWO a buy, especially with its likely 3%+ increase in book value in Q3 2013.

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

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The slow stochastic sub chart shows that TWO is nearer oversold levels than overbought levels. The main chart shows that TWO appears to have bottomed from its recent downtrend. It now appears to be trending sideways to upward. The fundamentals agree with this direction. With a Beta of 0.68, the fundamentals may be the more important indicator. It is trading at about a 6.5% discount to its Q2 2013 ending book value. With the book value likely having risen further in Q3 2013, it is trading approximately at a 10% discount to its book value. Plus, TWO did not suffer the huge book value losses that other mortgage REITs did in 1H 2013. TWO's CAPS rating is four stars (a buy). There is one caveat. Investors may wish to average in as the overall direction of the market has been trending downward recently.

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

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TWO over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.