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Two Harbors Investment Corp. (NYSE:TWO)

Q4 2013 Earnings Conference Call

February 6, 2014 09:00 ET

Executives

July Hugen - Director, Investor Relations

Brad Farrell - Chief Financial Officer

Bill Roth - Chief Investment Officer

Analysts

Douglas Harter - Credit Suisse

Mark DeVries - Barclays

Bose George - KBW

Trevor Cranston - JMP Securities

Rick Shane – JPMorgan

Dan Altscher - FBR

Joel Houck - Wells Fargo

Eric Beardsley - Goldman Sachs

Operator

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

I would now like to turn today’s conference call to Ms. July Hugen. You may begin, ma’am.

July Hugen

Thank you, Kevin and good morning. Welcome to our Fourth Quarter 2013 Financial Results Conference Call. With me this morning are Bill Roth, Chief Investment Officer and Brad Farrell, Chief Financial Officer. Tom Siering, President and Chief Executive Officer is unable is join us today due to a bad case of the flu, although he looks forward to speaking with all of you again soon. Bill will be giving a brief overview of the full year and fourth quarter. Brad will provide information about our financial results. And Bill will close with a portfolio update. 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 and the SEC's website. This call is being broadcast live over the internet and may be accessed on our webpage in the Investor Relation section under the events and presentation’s link. We would encourage you to reference the accompanying presentation to this call which can also be found on our website. We wish to remind that remarks made by management during this conference and the supporting slide presentation may include forward-looking statements. Forward-looking statements reflect our views regarding feature 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.

Before we discuss fourth quarter and full year results I wanted to mention that we will be hosting an Analyst and Investor Day in New York on February 20th, the event will feature special guest speaker James Grant from Grant's Interest Rate Observer. We will help you connect in the event. There is limited space available so please contact me to RSVP if you’ve not already done so.

I will now turn the call over to Bill who will provide some highlights as summarized on slide 3.

Bill Roth

Thank you July. Good morning everyone and thank you for joining us today. Before I dwell into the quarter I would like to recap 2013 which was an excellent year for us despite a volatile environment with respect to both interest rates and mortgage spend. I’m pleased to report that we generated a return on book value of 10.4% for the year delivering strong results in a challenging year of fixed income in the sector. We also made significant accomplishments on a variety of new investment initiatives during the year which I will discuss more fully later.

Let me touch on our fourth quarter and full year financial results. Our book value was $10.56 per share at December 31 representing a quarterly return on book value of 4.5% when combined with our fourth quarter dividend of $0.26 per share. We recorded comprehensive income of a 171.4 million or $0.47 per weighted average diluted share during the quarter and for the full year we generated 327.3 million in comprehensive income representing a return on average equity of 8.5%.

For the fourth quarter ended December 31, we reported GAAP and core earnings of $0.66 a share and $0.21 per share respectively. And importantly all of these metrics are consistent with our expectations when we set the fourth quarter dividend.

Let’s touch on our stock repurchase program. For the year we repurchased approximately 2.5 million shares. A total authorization is for 25 million shares so we have capacity to continue to repurchase stock. We did not repurchase any stock in the fourth quarter as we believe it was not advisable under securities laws due to the anticipated public announcement of various matters including the Flagstar MSR transaction and our subsidiaries FHLB membership that came later in the quarter. Going forward we will continue to consider share repurchase opportunities available to us in an effort to optimize value for our stockholders.

In the fourth quarter approximately 511,000 of our warrants were exercised before they expired on November 7th. The warrants were delisted from NYSE upon their expiration leaving 3.6 million that were not exercised. No warrants remain outstanding. Turning to slide 4, during 2013 in the fourth quarter we continue to make strides on several initiatives that have allowed us to develop a high quality operational platform that stands multiple components of the mortgage market.

We believe this infrastructure will allow us considerable investment flexibility. I will comment more fully on MSR and the conduit later as part of my portfolio overview and Brad will discuss the implications of our wholly owned subsidiary being granted membership to the Federal Home Loan Bank in Des Moines. We’re excited about this relationship as it will provide us access to long dated financing and to a variety of products and services offered by the FHLB.

Please turn to slide 5, there are a variety of economic and policy related factors important to us, several of which are on this page, of particular interest, our interest rates, unemployment metrics, housing prices and potential changes in policy. We certainly continue to monitor Feds reduced monthly purchasing of agency MBS and U.S. treasuries as this impacts both interest rates and mortgage spreads. We believe this is the first and multiple steps in the tapering process likely to unfold throughout 2014.

Now, I would like to turn the call over to Brad for a discussion of our financial results.

Brad Farrell

Thank you, Bill and good morning everyone. Last evening, we announced comprehensive income of $171 million, or $0.47 per weighted share resulting in a 17.7% return on average equity and an increase in our stockholders’ equity to $10.56 after adjusting for the quarterly dividend of $0.26 per share.

Let’s turn to our book value go forward on Slide 6. Approximately two-thirds of this quarter’s comprehensive income or economic return equivalent was driven by our credit strategy as our non-agency RMBS portfolio recognized realized and unrealized valuation gains. The remainder of the economic return was largely driven by yields were carried on our rate strategy, which includes MSR. Mortgage servicing rights contributed to quarterly returns for the first time in our history due to the recognition of net servicing income in the month of December as a result of the acquisition of the Flagstar MSR.

In Tom’s absence, I would like to step into his shoes for a moment and comment Bill and his team for a strong result in a volatile year. The return outpaced the sector and it illustrated the importance of excellent portfolio management and risk management strategies, well done Bill and his team.

Now, please turn to Slide 7. Core earnings of $0.21 per weighted share represented a 7.9% annualized return on average equity. The $0.21 per share is consistent with our expectations for the quarter as we continue to defensively position our portfolio and managing appropriate amount of excess liquidity in anticipation of the Flagstar MSR settlement. Core earnings increased by $8.7 million on a quarter-over-quarter basis primarily due to investments in MSR and an increase in deployed capital.

Our implied debt-to-equity ratio, which includes our TBA position, was 3.1 times and 3.2 times at December 31 and September 30 respectively. Although our capital is more fully deployed as compared to the prior quarter end, a sizable portion of our capital is now deployed to MSR, which is un-levered. While we continue to believe the low leverage profile is prudent given the risk profile in the market, this profile also freezed up capital for us to allocate to alternative more attractive investment initiatives, including our MSR and conduit activities.

Our other operating expense ratio as a percent of average equity moved to modestly higher on a quarter-over-quarter basis to 1.3%. The increase was largely due to incremental professional expenses and associated transaction costs on MSR activities and the amortization of certain business combination costs. Looking ahead, certain operating expenses will ebb and flow in concept with the evolving contractual and infrastructure needs of our MSR and conduit initiatives.

I would now like to briefly touch upon multiple accounting topics. First, I would like to point out that our MSR assets increased from approximately $16 million as of September 30 to $514 million at year end. It is important to note we have chosen to account for this asset at fair value. Although this decision will potentially generate further volatility in our GAAP income statement, it is consistent with our objective to have stockholders’ equity represent a fair value measurement.

Beginning with our 2013 10-K, we will breakout MSRs separately on the balance sheet as well as provide additional detail around servicing income and the assets collateral attributes. Second, we did not recognize any other than temporary impairments in the quarter, but we did released approximately $62 million of credit reserves on our non-agency RMBS. The release of credit reserves was driven by continued improvement in the performance of our non-agency holdings.

Our taxable income and dividend distributions are highlighted on Slide 8 and 9. For the year, we declared dividends of $772.9 million through the combination of forecast dividends and our special dividend of Silver Bay stock. As previously stated, separate from the Silver Bay dividend, it was our goal to distribute 100% of our taxable income and any prior year carryover through our cash dividends. Excluding the special dividend of Silver Bay stock, we have distributed $427.1 million, which equates to approximately 100.3% of our taxable income at December 31, when combined with a carryover from last year of $10.7 million.

On slide 8 I would like to point out one thing regarding the Silver Bay special dividend and it's 1099 treatments. In accordance with U.S. tax law the Silvery Bay shares cannot be treated separately from our cash distributions. As shown on slide 9, we had taxable income of 425.6 million which represents 55.1% of our total distributions of 772.9 million for the year. As such 55.1% were approximately a $1.17 per share but our total distributions for the year will be treated as dividend income with the remaining $0.95 per share treated as return of capital to Two Harbor stockholders.

Please reference the investor relations section of our website for additional information regarding the dividend and tax treatment. As indicated by these slides taxable income was the largest driver of our dividend distributions in 2013 due to our Silver Bay distribution intentions. However as always we weigh many factors in our dividend declarations. One of the most important factors is our comprehensive income.

As we have previously noted the ability to protect and grow book value is the most meaningful metric as it relates to our long term ability to distribute dividends. Please turn to slide 10; I would next like to spend some time discussing our recently announced membership with the FHLB of Des Moines as well as an update on the repo markets.

After several months of discussions our subsidiary was approved for membership in the FHLB in the fourth quarter. As a member of the FHLB our subsidiary has access to a variety of products and services offered by the FHLB including secured advances. As of December 31, 2013 we requested any secured advances and had $1 billion of available uncommitted credit or borrowings which now maybe adjusted at the sole discretion of the FHLB.

Our ability to borrow from FHLB is specific to our continued credit worthiness, pledging a sufficient eligible collateral to secure advances and compliance for certain agreements between us and FHLB. Each advance will require approval by the FHLB. Eligible collateral securing new advances may include conventional, 1-4 family residential loans, agency mortgage backed securities and non-agency mortgage backed securities with an A rating and above.

We value our new relationship with the FHLB and the additional source of financing as we work towards achieving our objective as a leading capital provider in the mortgage industry. Turning to slide 11, through year end the repo markets generally function in a normal manner and we have not experienced any meaningful shifts in financing haircuts or repo rates. We continue to maintain a lengthy maturing profile with an average of 72 days to maturity at December 31.

One additional point we would like to highlight with regard to the repo market is that it appears the Basel Committee will loosen it's leverage ratio definition. We believe this will ultimately quite any fears of increased volatility in the securities and financing market over the coming year or two.

We will continue to monitor these regulatory activities closely. Given the changes to our balance sheet over the last several quarters we’re always exploring opportunities to further diversify and improve our funding position. Our low leverage cash funding collateral and available capacity with counter parties provides us with both the flexibility to manage through market volatility and the capability to continue to deploy capital to the most attractive investment opportunities.

Now I would like to turn the call over to Bill for our portfolio update.

Bill Roth

Thanks Brad. Please turn to slide 12, as I noted earlier in the fourth quarter we generated a return on book value of 4.5%, bringing our full year return on book value to 10.4%. Our philosophy of maintaining conservative positioning as your interest rate exposure and leverage as well as our use of variety of hedging strategies served us well in 2013 challenging market. These enabled us to have solid returns for the year both on an absolute basis and relative to the performance in the sector.

This year we have meaningful grown our investment in MSR and continue to expand the foundation of our conduit business both of which position our portfolio will continue to performance in the future. I will touch more on these later.

Turning to quarterly results both our rates and credit strategies delivered strong returns in the fourth quarter. On the bottom left of slide 12 you can see that for both the quarter and the year we outperformed the 50-50 benchmark indices without performance of 340 basis points in the quarter and over 600 basis points for the full year. This strong result was driven by our overall positioning and portfolio and risk management strategy. Returns available in the agency space today continues to be tight. As such, we have remained focused on maintaining a low leverage in risk profile and high liquidity to be able to fund additional investments and more attractive opportunities, including MSR where we keep that better returns. We anticipate better office premiums in the agency space later this year as the Fed winds down their purchase program and as Feds normalize.

On the top right of Slide 12, you can see a dramatic improvement in rate strategy yields, which were driven by slower prepays on I/O and I inverse I/O and the contribution from MSR. Our credit strategy also had another good quarter. Continued improvement in housing metrics and job growth led to better performance on many of our holdings. And as a result, the portfolio experienced price depreciation during the quarter. Additionally, due to this better performance, we released over $62 million in credit reserves. Continuing the trend from prior quarters, we also sold some high dollar priced non-agency bonds that had realized the upside optionality we had hoped to achieve. Given the backdrop of expected higher home prices and a continuation of better performance, we continue to maintain a substantial holding of lower dollar priced non-agency bonds, which had an average market price of $66 at December 31.

Please turn to Slide 13. Our portfolio as of December 31 was $13.7 billion, including $10.2 billion in the rate strategy and $3.5 billion in the credit strategy. Our portfolio composition reflects a 57% capital allocation to rates, which was comprised of 44% to agencies and 13% to MSR. MSR have become a larger component of our rate strategy and our aim is to continue increasing our capital allocation to MSR over time.

Turning to Slide 14, our implied debt to equity ratio for RMBS agency derivatives and mortgage loans held for sale, net of TBAs, is 3.1 times largely in line with 3.2 times at the end of the third quarter. This position is reflective of the generally tight agency spreads they were in place for much of 2013 and therefore why we have been carrying low leverage on our agency portfolio. Our non-agency CPR fell somewhat in the quarter to 3.8% due largely to seasonal. As a reminder, we have modeled our non-agencies with fairly draconian assumptions of one to two CPR for life. Higher prepays on this portfolio over time can greatly enhance our performance metrics. For more on our rates and credit holdings please look at appendix Slides 25 through 27.

Moving to the upper right hand side of this slide, let’s discuss interest rate exposure. For most of 2013, we had very limited exposure to both interest rate and mortgage basis risk, but this past spring we were pretty significantly net short interest rates. We covered this short after the big rate backup and today continue to carry a low overall exposure to rates. It is worth noting that this exposure includes duration measures for all of our holdings, including MSR non-agency and loan positions as well as all associated rate hedges. Also given generally tight agency MBS spreads, the improving U.S. economy and the Fed’s tapering actions, we expect to maintain a low basis risk exposure for the near future. You can find additional details on our financing and hedging strategy in the appendix on Slides 23 and 24.

Please turn to Slide 15. In late December, we announced a substantial bulk MSR deal with Flagstar Bank with an unpaid balance, principal balance of $40.7 billion. This bulk deal consisted of Fannie and Ginnie production with largely post 2010 production. Flagstar will provide the ongoing sub-servicing for the mortgages. This raise then represents an exciting step towards building a meaningful MSR portfolio and it aids greatly in our hedging to both interest rate and mortgage basis risk. We also previously disclosed that we have a three-year flow arrangement in place with PHH, where we will purchase 50% or more of PHH’s MSR on new origination production subject to pricing terms and agency approvals with PHH providing the sub-servicing. We believe this will provide a steady stream of MSR investment for us to make high-quality originators. The continued growth of our MSR portfolio is important to our long-term portfolio positioning. MSR are not only attractive from the perspective of offering a yield higher than currently available on agencies or non-agencies but they also offer the opportunity to reduce our hedge cost [ph] as they are negative duration asset.

The yield combined with the reduced cost of swap and swaption could add a 150 to 250 basis points to the agency strategy. We continue to make significant strides towards building the infrastructure necessary to support our operational platform so that we can grow this initiative even further over the next few years.

We have added staff to support both MSR and the conduit including building our technology infrastructure, servicing oversight and underwriting capability which we will continue to develop based on the market opportunities. Importantly the infrastructure necessary for MSR nicely compliments the conduit and vice-versa offering operating efficiencies.

As we turn to slide 16, let’s talk about the conduit. In 2013 we completed two prime jumbo securitizations totaling over 800 million. In the first quarter we participated in the securitization with Credit Suisse and in the third quarter we closed Agate Bay 2013-1 a 434 million securitization which was the first using our own depositor.

Both these deals enabled us to invest an attractive credit and IO bonds. More importantly having a top tier conduit platform going forward allows us to opportunistically create attractive credit assets for our portfolio and also creates the ability for us to source MSR and other loan products in the future.

Continuing to expand our network of high quality originators remains a key focus for 2014. 2013 was an exciting year for Two Harbors. First we’re proud of our ability to have successful navigated the dramatic move in interest rate and volatile spread environment. At the same time we executed several MSR deals completed two prime jumbo securitization including the first using our own depositor and began developing an expansive pipeline of originator partners while building the infrastructure necessary to support these initiatives.

In the process we have created a nimble industry leading operational platform that positions us to take advantage of a variety of opportunity in the housing finance space in the coming years and to increase the value of the Two Harbors franchise. Having the ability to directly source assets for our portfolio combined with our investment teams ability to capitalize on opportunities in the securities market we believe uniquely positions us to best deliver for stockholders. I would now like to turn the call back to Kevin.

Question-and-Answer Session

(Operator Instructions). Our first question comes from Douglas Harter with Credit Suisse.

Douglas Harter - Credit Suisse

You guys have remained sort of with low leverage and more defensively positioned. I guess can you look out as we go through 2014; kind of what would be the opportunities that you’re looking for to move to sort of a more normalized level of leverage?

Bill Roth

First of all the best thing we can do with the dollar today as we said numerous times over the past several months is invest in MSR. That’s I don’t think what you’re referring to I think you’re more alluding to the agency side and if you look at agency spread going back 10 years or longer but gets through all sorts of different environment you will see that generally depending on what you data you look at anywhere between 15 and 30 basis points tighter than sort of average and so it's our belief that the agency spreads to normalize. We would expect to see a widening from where they are today. We’re seeing a limited amount of opportunities in certain parts of the agency space that are sort of low double digit but without taking any duration risk it's very hard to justify putting much, increasing our leverage until we see wider spreads. So if wider spreads come about later in the year as the Fed reduces their program that will be a good opportunity for us to increase our leverage.

Douglas Harter - Credit Suisse

And I guess, how do you view the opportunity to do other large bulk MSR acquisitions where whereby essentially you could essentially take up your leverage on the agency book to fund that?

Bill Roth

So we are in constant dialog with a number of potential partners in that as well as the servicing brokers who show packages to us multiple times a week. So it certainly depends on our ability to source and close deals. As you know, these things can take a number of months, but I mean we are I think we have established that where we are a credible partner, we have two excellent relationships with PHH and Flagstar. And we are certainly working on continuing to expand that, but I don’t have anything specific to say further about specific transactions on today’s call.

Douglas Harter - Credit Suisse

Alright, thanks Bill.

Bill Roth

Thank you.

Operator

Our next question comes from Mark DeVries with Barclays.

Mark DeVries - Barclays

Bill, could you just give us your kind of high level thoughts on what the ROEs are generally available to you right now on your different investment opportunities?

Bill Roth

Sure, Mark. Good morning. Thanks for joining us. Yes. So, on the agency space, as I mentioned just a minute ago, we are seeing a very limited amount of opportunities for low double-digit returns. And you have to remember that we look at these things carrying leverage in the 6 to 7 times with fully hedging out or the duration risk. So clearly, if you use more leverage where you take duration risk, those numbers can obviously be higher, but away from that I would say most agency opportunities are below 10%. On the non-agency side, prices have held really quite nicely despite some of the emerging market appeal that we had. I mean, the U.S. housing has got good tailwinds etcetera. So yields on non-agencies are sort of in the 5% plus or minus. So that gets you on an ROE basis into the high single-digits. And I had mentioned earlier, MSR we said in the past that MSR yields on new production prime are sort of high single expect – these are expected yields. Obviously, it depends on what the prepayments are. The expected yields are high single-digits to low double-digits and that’s un-levered. So you think that we are focusing on that is because if you combine that with being able to buy agency pools that combination gets you on an ROE basis relative to double-digits, in terms of combining the MSR with pools. So that’s what our number one focus is.

Mark DeVries - Barclays

That’s helpful. And Brad, I think you in your prepared comments you referenced that like in front of the Flagstar acquisition, you were kind of running with excess liquidity, is there any way you can scale for us kind of what the drag on core earnings was from that?

Brad Farrell

Thanks Mark. No, I don’t have any comments on that. I think if you think about the size of that capital investment, if you look at our balance sheet at year end, I think you can probably back into a regional estimate. But again, I think I would echo my comments as it was – we are strategically positioning our capital to make that large capital investment. So if you apply that thoughts, take a look at some of our turnover in our RMBS portfolio, I think that’s the best reference I can give you.

Mark DeVries - Barclays

Okay, got it. And then just one last question, can you tell us a little bit about the relative cost if that will be advances to you versus kind of a comparable strategy we see some (indiscernible) and also just how big can you scale that over time they would be available to borrow there?

Brad Farrell

Thanks Mark. I will try to address that and maybe I will make some larger comments on the FHLB relationship. Really, a big thing about this is really our intent around the FHLB. I think we have historically commented that diversification of our counter parties is extremely important to us and so we see the FHLB as an extension of this not only to reduce our liquidity risk but also to kind of optimize our advance rates and funding. So with that we really are focused on the FHLB as not as a replacement for the repo market really as an opportunity that we think aligns well with the (indiscernible) our conduit objective is to provide capital to the residential mortgage market and that’s where it's probably the best synergy. So a lot of these are published on the FHLB site as far as the advance rates and funding cost but the biggest benefits of the FHLB is one, the extension of maturities. So they offer products that extend into five years and in some cases further than that across variety of asset class that we hold.

Lending rates are generally LIBOR or LIBOR plus 30 but that obviously varies based on obviously the asset class is just an extent again the FHLB does publish this on their websites. The other appeal to us is they do offer fixed and floating rates at the various terms. So again that fits really well in how we think about conduit production in prime jumbo as well as any other type of mortgage loan production that we look at. The ROE has start making a lot of sense if we can finance that product at those rates and again I would just stress that we don’t, with the $1 billion of uncommitted capacity we see this as a complement to our overall funding strategy and not a strategic replacement for the repo markets. The repo markets will be and are critical to kind of how we fund our agency RMBS and our overall balance sheet.

Operator

Our next question comes from Bose George with KBW.

Bose George - KBW

If you first just on the MSRs the Flagstar MSR, how much of that came through in 4Q earnings? I just wanted to make sure like the run-rate for that going forward.

Bill Roth

Well obviously that transaction settled in December and I will let Brad talk about sort of the timing and implications of that.

Brad Farrell

So first one clarifying point we noted that it settled in December, we actually took the economics and the kind of the income streams effective in beginning of December. So, one month of income came through in the month of December. So that’s a first important point to make. Secondly, we have disclosed and I believe it's on slide 12 we have kind of expanded our illustration of yield so if you look at the right side of slide 12, we show at the bottom part kind of our legacy illustration of our RMBS only yields and then above you will see the kind of aggregate across the entire portfolio including MSR, mortgage loans as well as kind of finance holdings and our securitizations and so you can kind of look at the delta there and kind of get a sense of the basis point increase this quarter and generally subject to prepayments that’s going to be kind of the exponential increase we potentially will see going forward.

Bose George - KBW

And then just in terms of accounting for that MSR, do you guys get the whole servicing fee and then the sub-servicing expenses go out as an expense to Flagstar?

Bill Roth

Yes I mean from a cash basis it's more of a net settlement but from our income statement it's shown on a gross basis. So we think about our income statement I look at it as kind of three buckets, you’ve a gross servicing income, you’ve your sub-servicing expense which obviously flows through the expense captions and then you’ve our valuation is kind of consists of both kind of the run-off or amortization as well as the market shifts in the value of that MSR.

Bose George - KBW

And then actually one follow-up on the FHLB discussion, assuming you have the right collateral, what are the other constraints on funding through there? I mean, if there is the need to meaningfully increase what you fund through FHLB?

Brad Farrell

No, I can’t really comment on that other than the FHLB as I stressed is the sole has this whole discretion on the capacity that give to us. And they can decrease that capacity or increase that capacity at their own discretion. It’s an early relationship. We believe we are a first REIT that achieved through its captive vehicle, achieve access to the FHLB. And again, I stress if that is the captive vehicle that is the member of FHLB. But I think we are excited about it we think it fits really, really nicely with some of our prime jumbo asset classes. We think there is some opportunity to use in the near-term, but we are more focused on using the capacity we have today. And over time, we will continue to establish that relationship and see if we can extend that capacity.

Bose George - KBW

Okay, great thanks.

Bill Roth

Thanks Bose.

Operator

Our next question comes from Trevor Cranston of JMP Securities.

Trevor Cranston - JMP Securities

Congratulations on a good quarter. I guess to follow-up on the question about the income from the MSR portfolio in the fourth quarter, is there anything that’s not kind of captured in the income you have recognized this quarter, just kind of wondering because I guess if you were to annualize the income from December, it seems like an extremely high yield on the $500 million purchase price?

Bill Roth

Hi, Trevor. Good morning.

Trevor Cranston - JMP Securities

Hi Bill.

Bill Roth

Thanks for joining us. So I think the best way to think about be in this one, I kind of alluded to this earlier. We mentioned that the expected yields and I have to emphasize again expected, because it’s based on our assumption on prepays that could change obviously if the market moves, but we had mentioned sort of high single to low double-digits, right. And then if you think about comparing those with approvals or alternatively taking swaps off. We mentioned that it could be another 150 basis points to 200 basis points. So that gets you sort of into the ROEs of certainly low double-digits, if not higher. And so I think if you want to think about the value of the MSR, you need to think about an ROE that’s consistent with that and compare that to ROEs that I think market asked, which generally are below 10%. So there is a huge benefit there.

Now, obviously there is an expense portion that comes in to play, because we can’t do that without the infrastructure we have built, but that’s the way you offset by the increase in ROE. So I think the way we think about it is capital allocated to what that goes to our ROEs net of the expense compared to the other opportunity. The other thing I think is important to note is that the quality of that ROE is much higher. If you are just long agencies and hedging them with swaps, you have a substantial amount of basis risk. And we have seen what the result of that can look like. If you are hedging with MSR or other I/O products, you have a much, much higher quality hedge, because you are hedging basis risk in addition to interest rate risk.

Trevor Cranston - JMP Securities

Okay, that makes sense. And I…

Bill Roth

Brad, you want to add to that?

Brad Farrell

Because obviously our slides provide us a bit of a new disclosure, I just want to make sure though that you are not – you are kind of, so on the bottom right, we show the agency RMBS yield of 3.1%, which is consistent with our historical presentation. And above you will see that we are at 3.2%, including the MSR. Obviously throwing some rounding and maybe look on the conservative side of that delta, I think you will get back to the, I just mentioned. So, again those are gross yields without sub-servicing expenses. So I think if you work through those I think you will – I think it will make much more sense to you.

Trevor Cranston - JMP Securities

Okay. Yes, I was just looking at the income numbers on Slide 15 we are now annualizing those, but that makes sense.

Brad Farrell

Trevor, one more thing, I just want to caution you and others we said all this thing in December, we had economics for one month and I’m trying to extrapolate one month returns for a year or forever is extremely challenging notion. So I think we will have a lot more clarity as 2014 plays out and we have this asset on our books for a longer period of time. So I just want everyone listening to the call to understand that one month is not indicative of what might happen over the long period of time.

Trevor Cranston - JMP Securities

And I guess to follow-up on the thought about how the ROEs improved by also on running [ph] agency pools. I guess I was a little surprise to see with the addition of the MSRs this quarter. I didn’t see it first glance any real meaningful changes to the hedge growth? Can you comment on if there were any changes maybe in kind of on basis risk hedges or something like that that I might be missing?

Bill Roth

Yeah I think it's challenging, there is a lot of things that go on in the book over the course of the quarter whether it's changing TBA positions and associated hedge, swap hedges or changes in pool position whether going from say different coupon. So I think if you just look at sort of a notional and say, well the notional was about the same why is that? That’s sort of is masked by other things that are going on in the portfolio. I think the best way to think about it is and these are high level number so just take it the way it's worth, 500 million of MSR roughly is $750,000 of negative duration, okay? So and that will move around depending on what coupon you’ve et cetera and I’m talking about the kind of MSR that we bought. So if you said well what is that the equivalent to? That’s the equivalent to about a $1.5 billion of five year swap.

Okay so irrespective of what we you know our notional positions did whether it's swaps or swaptions effectively you can think about by including that MSR we were able to reduce five year swaps by about a $1.5 billion. Now it may not show up because of like I said other things that were going on but that’s the impact.

Operator

Our next question comes from Rick Shane from JPMorgan.

Rick Shane – JPMorgan

I just want to make sure that we’re thinking about the servicing business in the correct way which is that the potential here, I understand it from an economic perspective and from a hedge perspective but from an operating leverage perspective but the opportunity here is more on the financial leverage side it's not really an operating leverage business. Is that the way to scale for you per say? Is that correct?

Bill Roth

Yeah it's a financial asset, we’re not a servicer. So you shouldn’t think about us as a typical servicer whereby if we keep adding we’re getting operating leverage so you’re correct in that. All of our servicing is outsourced to high quality sub-servicers as we mentioned PHH and Flagstar is few of them but you’re correct in that.

Rick Shane – JPMorgan

Got it, okay. We understood the dynamics, we understood the construct of the business I just wanted to make sure if we’re missing something in terms of the dynamics that’s the way we’re thinking about it so. Appreciate the answer guys. Thank you.

Bill Roth

The only thing I would mention obviously is in the infrastructure that we need to support that in the conduit business clearly there is some leverage you gain from that. You need underwriters, you need servicing oversight people et cetera and so if we added $25 million of MSR we wouldn’t necessarily need to have any more people. And obviously if we added another 500 you’re going to require more but there is some benefit there but not to the extent that you would see with an operating company.

Brad Farrell

Yeah it's not a high scale platform.

Rick Shane - JPMorgan

Thank you guys.

Bill Roth

Thanks Rick.

Operator

Our next question comes from Dan Altscher with FBR.

Dan Altscher - FBR

Good morning. Best wishes to Tom, I think it’s over the flu. Bill, just a quick clarification on your comment with Trevor, did you say $750,000 negative duration, did you mean $7.5 billion of negative duration?

Bill Roth

Sorry, I was on mute there, I apologize. It’s the $500 million is – no, it’s about $750,000.

Dan Altscher - FBR

Okay. Just also go through in your comments before of not buying back any stock in the quarter, because of variety of information that was coming out between FHLB and Flagstar. I mean, how does that maybe fit now as a potential use of cash, because I haven’t really heard that mentioned at this point?

Bill Roth

Yes, sure. That’s a great question. And yes, we did buyback stock in 2013. Clearly, the opportunity to buy back stock when the opportunity presents itself that is clearly something that we are very focused on because it obviously drives book value higher, we buy it at a discount. And so that’s something we are always taking under consideration based on where book value is and where our shares are trading at that time. So we still have over 20 million shares available to our purchase and if the opportunities present itself we are not afraid to use it.

Dan Altscher - FBR

Okay. And then as a quick one also on FHLB, I understood it’s not a replacement for repo, it’s more of a complement, but I assume since it’s going to be at the insurance company, which is a captive, it also falls into I guess a TRS. So are there limitations there as to how big this facility can eventually get related to TRS restrictions overall for the REITs?

Bill Roth

Without getting into the menus of the structure, the captive actually is a good vehicle, but regardless of that there is no foreseeable restrictions. The restrictions are going to be limited to our relationship with the FHLB and our eligible collateral that fits nicely with our remit to provide residential mortgage support as well as their remit.

Dan Altscher - FBR

Okay, that’s interesting. And then MSRs are not eligible for advances under FHLB, correct?

Bill Roth

No, they are not.

Dan Altscher - FBR

Okay, great. Thanks so much.

Operator

Thanks Dan. Our next question comes from Joel Houck with Wells Fargo.

Joel Houck - Wells Fargo

Thanks and good morning. I am wondering how should we think about the size of the MSR, I think you mentioned the (indiscernible) a capital allocated and have you guys look there may be comment on the impact, what the impact would have been and that have you had that position the beginning of 2013. Just to get a sense for how the relative value, I guess from that hedging strategy versus kind of the standard 100% swap strategy?

Bill Roth

Hey Joel, good morning. So, let me – it sounds like there are a couple of questions there in one. So we have said in the past in a variety of forms that if you look at the size of our book that we could easily have a billion of market value of MSR to hedge our holdings actually probably more than that, but certainly in terms of our comfort getting to that number is very high. So, obviously if we get to that number, we were constantly revisiting how much capital and it will be dependent on availability, it will depend on the price etcetera. But there is a long way to go from where we are to getting there. So we are comfortable on that for sure.

In terms of – and just to give you further color on that, because we are focused new originations one of the questions that come up with what’s the sort of supply and that’s kind of different for legacy servicing, I mean, there is about a trillion, there is over a trillion a year of new production. So you know it's just really a question of who is making it and who we can partner up with in terms of what we will be able to obtain of that. And then in terms of looking backwards you know the answer is honestly we haven't looked back to see what the impact would be we had at January 1st, and carried it throughout the year. I mean clearly the price at the end of last year when the 10 year was well below 2% the price of MSR of the same coupon was lower than it is today. But we’re more focused on what’s available today owing it hedging it appropriately in earnings and returns going forward. So I unfortunately can’t tell you what things would have looked like, that would I guess it's an interesting exercise to go through.

Joel Houck - Wells Fargo

Yeah I was curious, more amazing. I guess the last one is and you disclosed in the call did you talk about the economics between the on the jumbo securitization how much money you made?

Bill Roth

We did not.

Joel Houck - Wells Fargo

Is it right (indiscernible)?

Bill Roth

I’m sorry so the securitization that we did in August the Q3 securitization?

Joel Houck - Wells Fargo

Yeah just the total economics of the securitization you did in all of 2013.

Bill Roth

We don’t gain on sale, these are assets that we create that go into the book and generate a yield that we earn over the years so that the yields that we earn on the assets the credit bonds, the IOs et cetera that we retain will be part of the portfolios and help that the portfolios yield over the years of these assets are on the books.

Joel Houck - Wells Fargo

Okay so I guess the better way to ask is there expected IRR or kind of a range IRR that you think you get from these transaction?

Bill Roth

Well so you know we didn’t actually talk about specific IRRs related to the transactions that we did. We have estimating time and I’m happy to talk about it today. What we think the IRRs are on securitization at any given point in time so in today’s world the expected IRR using a little bit of leverage on the credit bonds who is sort of in the low double digits but I will tell you that it's a little dangerous to sort of put that in ink because if the loan price changes or the AAA price changes because of the inherent high degree of leverage involved, you know the AAAs are about 93% of the capital structure. So if you change that price by half a point or a point the ROEs can dramatically move higher or lower.

It's our expectation that ROEs over a longer period of time will be anywhere in high single digits to as high as 20% or more because that’s sort of a range that we have seen historically. Frankly our interest in having a conduit as you know securitization of new prime jumbo is being fairly low relative to overall mortgage supply I think in 2013 there is about 12 billion or 13 billion done estimates from this year range from similar to modestly higher. We view this sort of as more of a long term opportunity as the GSEs footprint gets reduced and as rate changes and cycles change you know you need to be there today to be able to capture huge volumes when the market opens up and so that’s sort of what we’re positioning for. I guess we’re more focused on that.

Brad do you want to add anything to that?

Brad Farrell

Yeah and perhaps we talked about FHLB before you joined or maybe I mean obviously the AAA pricing as Bill mentioned has volatility and at points it might not where we like it. One of the benefits of the FHLB is that the prime jumbo collateral does finance generally within their collateral requirements. So that’s another option for us to finance that product on our balance sheets period at the time until or win the AAA pricing as appealing. So I think that’s an important point to make and how we look at that conduit activity.

Joel Houck - Wells Fargo

Thanks guys.

Operator

Ladies and gentlemen, we have time for one last question. And our last question comes from Eric Beardsley with Goldman Sachs.

Eric Beardsley - Goldman Sachs

Just curious if you could comment on what you see the most attractive channel for acquiring MSRs whether it be through relationships like PHH or through the bulk acquisitions? And then secondly if you contemplated any other channels to acquire MSRs like becoming a corresponding lender?

Bill Roth

Yes, hey, Eric. Thanks for joining us. That’s a great question. Yes, I think we are certainly focused primarily on the first two that you mentioned. We have got obviously some solid relationships with two very high quality large originators and that’s obviously those are – those guys are good counterparties for us. There are other midsize and small originators that we are in discussions with as well. In terms of bulk or slow, I think if the partners, right in the package is appealing and price is right. I think we are – I don’t want to say we are in different, the bulk of those are viable sources for us to obtain MSR. In terms of correspondent, we haven’t really spent much time thinking about that. We have been really focused on developing partnerships with the higher quality companies, where we think they will give you decent volumes. So I would say you should think about it more in the first two than the latter.

Eric Beardsley - Goldman Sachs

Okay. Could you use your conduit for that if you want to see a correspondent down the line?

Bill Roth

Well, the conduit basically the way you want to think about it is we have originator partners, but these are originators and so we could get jumbo loans from them, we could get MSR, but it would be more direct one to one with an originator, not sort of correspondent based.

Eric Beardsley - Goldman Sachs

Got it. Great, thank you.

Operator

And I am not showing any further questions at this time I would like to turn the call back over to July for closing remarks.

July Hugen

Thank you for joining our conference call today. We greatly appreciate your interest in Two Harbors. We are attending two conferences early in the year including the 15th Annual Credit Suisse Financial Services Forum in Boca Raton on February 11 and the Goldman Sachs Equity Investor Housing Conference in New York on February 21. We would welcome the chance to speak with you at either event. Until we seek next, be well.

Operator

Ladies and gentlemen that concludes today’s presentation. You may now disconnect and have a wonderful day.

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