Two Harbors Investment's (TWO) CEO Thomas Siering on Q1 2014 Results - Earnings Call Transcript

May. 9.14 | About: Two Harbors (TWO)

Two Harbors Investment Corp. (NYSE:TWO)

Q1 2014 Earnings Conference Call

May 8, 2014 9:00 AM ET

Executives

July Hugen – Director-Investor Relations

Thomas Siering – Chief Executive Officer and President

Brad Farrell – Chief Financial Officer and Treasurer

William Roth – Chief Investment Officer

Analysts

Mark C. DeVries – Barclays Capital, Inc.

Trevor Cranston – JMP Securities

Stephen A. Laws – Deutsche Bank Securities, Inc.

Eric Beardsley – Goldman Sachs & Co.

Joel J. Houck – Wells Fargo Securities LLC

Daniel K. Altscher – FBR Capital Markets & Co.

Kenneth M. Bruce – Bank of America Merrill Lynch

Operator

Good day, ladies and gentlemen, and welcome to the Two Harbors First Quarter 2014 Financial Results. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, with instructions following at that time. (Operator Instructions) As a reminder, today’s conference is being recorded.

And, now, I’ll turn the conference over to your host for today’s conference, July Hugen, Director of Investor Relations. Please begin.

July Hugen

Thank you, Tyrone, and good morning. Welcome to our first quarter 2014 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.

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 website in the Investor Relations section under the Events and Presentations link. We encourage you to reference the accompanying presentation to this call, which can also be found on our website. Reconciliation of non-GAAP financial measures to GAAP can also be found in the presentation.

We wish to remind you that remarks made by 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 future looking statements, if later events prove them to be inaccurate.

Before we move into first quarter results, we would draw your attention to our Introduction to Non-Agency Securities Webinar, the latest in our ongoing series. You can find this and other webinars on the Investors tab of our web website under the Events and Presentations link.

I will now turn the call over to Tom.

Thomas Siering

Thanks, July. Good morning to everyone and thank you for joining in our first quarter earnings call. Let me start with a summary of our financial results.

Please turn to Slide 3. We had a solid start to the year, generating a total return on book value of 3.9%. In the quarter, Two Harbors delivered comprehensive income of $152.6 million or $0.42 per weighted average diluted share, representing a return on average equity of 15.7%.

For the quarter, we also reported core earnings of $0.24 per share, and a GAAP loss of $0.08 per share. While GAAP earnings are an important and necessary accounting standard, this metric is not instructed as to our financial performance.

The interest rate curve flattened during the quarter as longer-term rates fell, while shorter-term rates rose modestly, due to perceived Fed intentions. Mortgage rates remain elevated from early 2013 levels, but fell slightly in the quarter.

Over the last two quarters, we have delivered a total return on book value of 8.5%, which we are proud of considering the volatility in interest rate environment. Interest rates rose in Q4 2013 and fell in this quarter. To frame this result, the 10-year treasury has returned only 1.5% over the last two quarters. This is a testament to our ability to generate alpha in a variety of interest rate environments.

I’d like to provide a brief update on the MSR and mortgage loan conduit initiatives. We continue to work with a variety of partners to further develop our investments in MSR. We have been adding MSR to our portfolio from the previously-announced flow arrangement with PHH, and subsequent to quarter end, we closed an additional bulk portfolio sale from Flagstar.

MSR continues to be an excellent asset for our portfolio. We have made considerable progress on our mortgage loan conduit initiative as well. We have been adding loans to the portfolio and continue to advance relationship with originators. From a financing perspective, we expect to utilize the FHLB to support our conduit activities in the future, which is an important way for us to optimize our overall funding mix.

Bill will cover more details on the MSR and conduit initiatives later in this presentation. Let’s discuss the macro environment, as outlined on Slide 4. Unemployment figures were stable throughout the first quarter with unemployment at 6.7% at the end of March. Subsequent to quarter end, unemployment fell to 6.3% on April. This coupled with home price appreciation, which coin core logic was up 12.2% on a rolling 12-month basis as of February 28, creates a good environment for the performance of our credit strategy.

Late last year, the Fed announced its intention to begin tapering its purchases of U.S. Treasuries and Agency MBS. The Fed has cut its monthly purchases of U.S. Treasuries and Agency MBS to $25 billion and $20 billion, respectively down from $45 billion, $40 respectively at the peak. The Fed remains focused on what they view as the economic super metrics of unemployment and inflation.

We believe the winding down of asset purchases will continue through 2014, although questions regarding the end date to the Fed accommodate a policy will most likely continue to impact the MBS market this year. Chairman Yellen has made it clear that until the target figures of 2% inflation and 5.5% unemployment are achieved, the Fed will continue to tweak as they say, their accommodation to the markets.

There are a number of legislative proposals that could significantly impact our sector. So let’s spend a moment discussing what we are monitoring in Washington. With the introduction of the Johnson-Crapo bill and HOME Forward Act in March, GSE reform remains a hot topic on Capitol Hill. Other legislation we are monitoring include The PATH Act and Corker-Warner, both of which would also phase out the GSEs. While it is uncertain if any of the proposals will ultimately become legislation, it does appear that significant change to the U.S. mortgage market is likely in the coming years. That being said, we have doubt as to how much will be accomplished in 2014, as it is a contentious election year.

Over the longer-term, however, mortgage rate by Two Harbors will be part of the solution to the quandary of how to reduce the government footprint in the mortgage markets. Another topic of interest is the implementation of the QM guidelines that went into effect in January. These essentially delineate very high quality loans from those with weaker credit scores. Thus creating a bifurcated market for residential credit. Bill, will touch on the potential opportunity created by this legislation – by this regulation.

Now, I'll turn the call over to Brad for discussion of our financial results.

Brad Farrell

Thank you, Tom. Good morning everyone. Let's turn to Slide 5. Book value increased to $10.71 after adjusting for the quarterly dividend of $0.26 per share and our comprehensive income was $152.6 million or $0.42 per weighted share. Our comprehensive income was driven by solid performance across both our rates and credit strategies.

Please turn to Slide 6, for an overview of our financial results. Core earnings of $0.24 per weighted share represent a 9.1% annualized return on average equity. This is in line with our expectations when we set the dividends. Although we remained defensively positioned and are managing liquidity prudently, core earnings increased by $11.8 million quarter-over-quarter, primarily due to the full quarter investment in MSR, approximately, $500 million and generally higher yield across our portfolio.

In the first quarter, our implied debt-to-equity ratio, including our TBA position was 2.7 times. This was a decrease from 3.1 times at December 31, as we eliminated some of our long TBA positions in the quarter, and at March 31, our net short about $1 billion in TBA’s.

Our other expense ratio increased to 1.5% this quarter, up from 1.3% in the previous quarter. As a reminder, our operating expenses will vary depending on the needs of our MSR and conduit businesses.

On the bottom right-hand side of this slide, we have noted a variety of accounting topics. We released, approximately, $23 million of credit reserves on our non-Agency mortgage-backed securities. This quarter, some of our holdings outperformed our original recovery assumptions. This caused us to release reserves.

However, our general view of fundamentals remains unchanged. As our prime jumbo pipeline gains momentum, I would like to highlight one accounting topic that I believe is important. In accordance with ASC 815, we recognized interest rate lock commitments on mortgage loans held for sale as derivatives and account for them at fair value on the balance sheet.

At March 31, the loss on the derivative was immaterial, but the financial impacts may become more relevant as our pipeline grows. Our MSR assets decreased from, approximately, $514 million, as of December 31, to $477 million at March 31. As a reminder, we have chosen to account for this asset at fair value.

During the quarter, we recognized $30 million of servicing income, $5 million of subservicing expense, and a $33 million decrease in the fair value of our MSR, which includes implied amortization of $12.5 million. Unlike the mortgage loan interest rate lock commitments I previously discussed, in accordance with GAAP standards, any MSR pipeline we might have as of March 31, that is MSR we have committed to purchase, but not yet funded is not recognized on our balance sheet as a derivative.

Please turn to Slide 7. I would, next, like to spend some time discussing our financing profile, including the Federal Home Loan Bank of Des Moines, as well as an update on the repo markets. As we discussed on our fourth quarter call, our subsidiary TH Insurance Holdings, was granted membership on the Federal Home Loan Bank of Des Moines in December.

As of March 31st, we have secured advances of approximately $465 million with the weighted average maturity of approximately 2.8 years. While today our advances are primarily collateralized by agency securities, we continue to believe over time the most efficient and constructive use of our FHW financing availability is with our prime jumbo conduit initiative.

As a reminder, our total capacity is $1 billion so our available funding capacity with FHLB is approximately, $535 million, as of March 31. We’re pleased with this continued diversification of our financing profile as it allows us to optimize our funding mix.

Moving to repo, the repo markets are functioning in a normal manner and we have not experienced any meaningful shifts and financing haircuts or repo rates. We have a lengthy maturity profile, with an average of 84 days to maturity at March 31, a slight extension from the 72 days at December 31.

With that, let me turn the call over to Bill who will provide an update on the portfolio.

William Roth

Thanks, Brad, and good morning. We're pleased with our total return on book value of 3.9% given our conservative positioning.

Let’s turn to Slide 8 for an overview and take a look at the performance drivers in our rates and credit strategies. Our rate strategy did well. With yields increasing 50 basis points quarter-over-quarter to 3.7%. The rates performance was driven by higher realized yields on our Agency assets, primarily due to slower prepays on I/O, inverse I/O, MSR and HECMs.

For example, our MSR yield this quarter was 10.6%. Yields in the future for MSR and other I/O products will be determined by the amount of prepayments. Tighter spreads on higher coupon Agency MBS and ARMs, also contributed to overall performance.

Our credit strategy had another good quarter and non-Agency yields increased 20 basis points to 9%. Non-Agency bond prices also appreciated during the quarter, as the market's viewpoint regarding macroeconomic conditions and borrower performance improved. We're pleased that our higher aggregate portfolio yields generated any annualized net interest spread of 3.5% up 30 basis points from the fourth quarter.

Please turn to Slide 9. Our portfolio as of March 31 was $13.6 billion, including $10.5 billion in rates, and $3.1 billion in credit. Our portfolio composition reflects a 58% capital allocation to rate, which is comprised of 45% Agency and 13% MSR in line with last quarter. With regards to opportunities on the rate side, yields and spreads on most Agency RMBS still aren’t very appealing.

As such, we continue to maintain low leverage in the rate strategy, as well as a low-risk profile. We still prefer assets higher in coupon, as well as other short duration products, such as ARMs and HECMs. This positioning keeps our basis risk exposure fairly low and aims to minimize any book value impact resulting from wider spreads that could be a consequence of the Fed ending it asset purchases later this year.

With respect to MSR, we expect to increase our allocation over time, which I will cover later. Within our credit portfolio, we continue to emphasize discounted non-Agency, particularly subprime, and have been adding to our holdings as they become available at levels we like. We typically prefer bonds that are priced between $0.40 and $0.65 on the dollar, offering an attractive expected yield and with upside to better prepay and credit performance.

Also, during the quarter, we closed on the sale of substantially all of our CFL portfolio. As we have previously discussed, we viewed our investment in CSLs as more of a trade than a long-term strategy.

Turning to Slide 10, you will see that our overall portfolio metrics are very similar to last quarter. Leverage remains low with our implied debt-to-equity ratio for RMBS, Agency derivatives, and mortgage loans held for sale, net of TBA, at 2.7 times. Prepays on our Agency and non-Agency portfolios fell in the quarter, due to the traditional, seasonal slowdown and an especially harsh winter across much of the U.S.

As discussed in prior quarters, we have modeled our non-Agencies with a fairly draconian prepayment assumptions of one to two CPR for life. On these deeply discounted bonds, higher prepay, such as we have been experiencing in recent quarters greatly enhance our performance metrics.

Moving to the top right of the slide, we continue to carry very little exposure to interest rate risk. Also, as you can see on the bottom right, we added significantly to our swaption position this quarter. Given that the price of volatility has been near historic lows, we added out of money swaptions to help immunize our portfolio from a dramatic move in rates.

So, to summarize, we continue to be positioned conservatively with low leverage and rate risk. For more on our rates and credit holdings, please look at the appendix slides 18 through 22, and see slides 24 and 25 for more information on our hedging.

Please turn to Slide 11. We continue to make progress adding MSR. During the first quarter, we added $121 million unpaid principal balance, or UPB, from our flow arrangement with PHH. This was, largely, from production late in 2013, just after this program started. Subsequent to the end of the quarter, we closed on a bulk portfolio of, approximately, $5 billion UPB of MSR from Flagstar, with economics having transferred on April 1.

Consistent with our prior transaction in December, Flagstar will continue as servicer under our subservicing arrangement with them. The underlying pool mortgages is compromised, primarily of recent production Fannie Mae loans, and the purchase price is approximately, $50 million. We continue to make great enhancements to our MSR platform, adding to our oversight, investor reporting, underwriting and technology and capabilities. There is still a robust pipeline for MSR sales, particularly of new originations.

The combination of tight origination spreads, reduced volumes, and more onerous capital requirements have led many originators to look to MSR sales to rationalize their business economics. To provide some insight about the MSR pipeline, in the last 12 months, we have evaluated over $400 billion UPB of servicing that was for sale, bid on a subset of that amount; and one enclosed on $42 billion UPB. This enabled us to invest about $500 million of capital in MSR.

Going forward, we expect to see opportunity to add MSR via bulk purchases, flow sale arrangements, and through our originator relationships. As we had said before, we're focused primarily on new production MSR, given its attractive yields and benefits to our portfolio.

Turning to Slide 12, let's talk about our mortgage loan conduit. We have seen an increase in loan production this quarter and our pipeline for prime jumbo loans at March 31 has increased to $154 million, which are subject to customary closing conditions. Combined with our holdings of $141 million, we expect to have $300 million or more sometime this quarter, which we would intend to securitize should market conditions warrant. During the quarter, we added multiple new originators and we continued to identify additional candidates for inclusion to our already robust new originator pipeline.

One benefit of our conduit initiative is the ability to use our originator relationships to generate attractive assets for our portfolio. While so far, this has been restricted to prime jumbo loans and MSR, we are currently evaluating the benefits of offering a non-QM loan product. For those not familiar with, it the term non-QM, or non-qualifying mortgage refers to loans that do not meet the CFPBs qualified mortgage rules.

We believe this segment of the market to be very large, as it generally encompasses borrowers that do not have pristine credit and fall outside of the stringent lending standards outlined by the CFPB.

In broad strokes, this could present an opportunity to acquire prime and nonprime loans that do not meet the definition of a qualified mortgage, while still representing an attractive yield and good credit risk for our business. Similar to other initiatives, we will allocate resources and capital, if we think this will drive increased shareholder value over the long term.

In closing, we are pleased with our strong return on book value in the quarter. We remain conservatively positioned with low leverage and interest rate risk, while we continue to evaluate opportunities we believe are beneficial to our stockholders.

In terms of the second quarter, we are off to a decent start with respect to portfolio performance, although we caution that we are only a month into the second quarter. The areas we're most excited about remain MSR and our conduit activity, which we view as a way to drive increased franchise value while serving our goal of being a permanent capital provider to the U.S. mortgage market.

I will, now, turn the call back to our operator, Tyrone.

Question-And-Answer Session

Operator

(Operator Instructions) First question is from Mark DeVries of The Barclays. Your line is open.

Mark C. DeVries – Barclays Capital, Inc.

Bill, could you just walk us through where you see the levered ROE opportunities in each of your different investment categories?

Thomas Siering

Yes, sure. Good morning, Mark. Thanks for joining us. Yes, so generally on an ROE basis, on the Agency side, most buckets, we see fully-hedged as below 10%. On the non-Agency side, in terms of securities, there are, also, generally below 10%. And but as I mentioned, we're adding some from time to time that we find attractive. And so, those we hope would drive returns that are higher than that.

In terms of the MSR, MSR today, just on the asset alone, we see as in the high single-digits, expected yield. But, keep in mind that when you add the benefits of reducing hedges, or getting long duration to offset that, it adds several hundred basis points. So that would take that into the low double-digits.

And then, securitization, securitization today is, generally north of 10% not by a whole lot. But I will tell you that we expect to see AAA spreads normalize over time and that would drive those numbers higher. So, today, I would call it low double-digits, but we think there's upside to those over time.

Mark C. DeVries – Barclays Capital, Inc.

Okay, that’s helpful. And then I think you mentioned some of you guys in the Agency side focused assets with what spread duration out of concern that spread OAS could widen. Was that are you guys getting a less – little less certain about an eventual widening? Or is that just going to cautious the way you've cashed it in the past?

William Roth

I mean, I think that's consistent with what we've said before. I mean, the Fed has continued to taper, yet, mortgage spreads have hung in very nicely. So, as we go through the remainder of the year, if they continue on that path, and they stop their buying new investments every month, it, certainly, is possible that spreads could widen. I mean, I think you've seen the data. They’re very narrow. So, we're just being cautious from that standpoint. I mean, we're not suggesting they will or they won't. We're just aware of where spreads are and think that they're not attractive enough to be very aggressive adding in Agency space.

Mark C. DeVries – Barclays Capital, Inc.

Okay, got it. And…

Tom Siering

Yes, Mark. Mark it’s Tom, good morning. Yeah, Bill I just still feel there is asymmetry to that market today. And so, we really haven't changed – to answer your question directly, we really haven't changed our point of view very much at all, with regard to agency spread.

Mark C. DeVries – Barclays Capital, Inc.

Okay, got it. And then on the same lines, I guess, you increased interest rate exposure a little bit on a Q-over-Q basis, is that a reflection of the fact that we just saw rates rally a little bit here, or that you're a little bit less convinced that rates could be headed higher?

William Roth

Well, if you – on Slide 10, we show that, fourth quarter and keep in mind, this is only one measurement. This is a parallel shift of 100 basis points, which as we said many times before, it’s extremely unlikely to happen. But in the fourth quarter, we would have actually expected to lose a little money. And as of the end of the first quarter, we actually would have expected to make a little money.

So, you can determine from that, that, as of the end of the quarter, we were slightly net short. But I think the bigger point is that if you look at that chart, with the exception of second quarter last year, we're pretty much keeping very little exposure to rates on a general basis. Rates they are very low. Funding rate is low. I mean, as Tom mentioned, there is asymmetry. We think it is prudent to keep a very low, overall position with respect to rates.

Mark C. DeVries – Barclays Capital, Inc.

Got it. Sorry. And, then, just one last question. What needs to happen before you guys jump into the non-QM market?

William Roth

Well, jump in is an interesting way to phrase it. As I mentioned during my remarks, I mean, we're certainly evaluating it. And there is a number of factors that go into that; right? The first is, is there demand for loan product at a certain rate and level of underwriting that is non-QM? And what do those terms look like and who are the borrowers?

And in additionally, the other thing is, as you can imagine, there is a substantial amount of stringency we need to have on the underwriting side, on the legal side, on the compliance side, because if you are in that non-QM, you’re not exempt from what the CFPB has set as the standard. So it’s not just setting a rate and a LTV and a FICO. There’s a lot of things, which we are investigating. And if we decide to offer a product, it will be because we feel like the return opportunities are attractive and that we’ve covered all of those basis. So, we’ll keep you posted on that.

Mark C. DeVries – Barclays Capital, Inc.

Okay. Is that something you think, realistically, could happen in 2014?

William Roth

Well, I can just tell you that we’re certainly evaluating it. I can’t give you a dead set timeframe. As I said, there’s a lot to consider. And so, I can’t really give you an exact timeframe.

Tom Siering

Yeah, I’d just say stay tune, Mark.

Mark C. DeVries – Barclays Capital, Inc.

Okay, all right. I appreciate your time.

William Roth

Thank you.

Operator

Thank you. Our next question is from Trevor Cranston from JMP Securities. Your line is open.

Trevor Cranston – JMP Securities

Hi, thanks. I guess on the conduit side, you know when you went through the ROEs, it sounded like the returns on the jumbo loans were reasonably attractive versus kind of the other alternatives you guys look at. Can you give some more details kind of how is the build out of the conduits progressing? I mean it looks like the pipeline of loans is starting to increase a little bit. And just kind of give us a little bit of color on how to think about the run rate size of the pipeline going forward.

William Roth

Yes, sure. Well, as I mentioned, we’ve added a number of originators in the second quarter. We have more that we’re evaluating. We’ve come out of this deep freeze that we had in the winter. We’ve continued to see on into the second quarter an increase in volume that we’re pleased with. And as I would say, without getting into hard numbers, because there’s fallout and rates could change, et cetera, that could change what our holdings look like, I mean the bottom line is that we’re still adding originators and our volumes are picking up. So I would say that if market conditions warrant, we would intend to conclude some securitizations as we move through the year.

Trevor Cranston – JMP Securities

Got it. That’s helpful. And the one quick follow-up on the non-QM opportunity. As far as you’re aware, would those be financeable with the FHLB borrowing lines, or would be something that would more have to be done in the private repo market?

William Roth

I think Brad’s going to take that one, Trevor.

Brad Farrell

Hey, Tervor.

Trevor Cranston – JMP Securities

Hey.

Brad Farrell

FHLB, and they do publish a lot of their guidance. Obviously this would be one thing we would be look at as well as part of our assessment. But they don’t necessary look at kind of non-QM, QM. They are looking at the underlying collateral and the structure of the loan. So assuming those loans meet the standards of LTV, and FICO, and underwriting protocols they would be accepted. So that is an option of financing depending on the product we issue.

Trevor Cranston – JMP Securities

Got it, okay. One last thing, the size of the swaption portfolio increased quite a bit this quarter. I was just curious if you guys have any general thoughts on – it seems to make sense to add given how low volatility, I was curious do you guys have any general thoughts on why volatility has remained so low given the shape, the curve and kind of how you expect that to play out over the next few quarters?

William Roth

Hey, Trevor. That’s a great question. I’m not sure that we’re the best at explaining why certain things exist, but with the Fed having anchored the front end, that obviously plays into a part. I think that forward guidance et cetera explains it. But the bottom line is, if you look at we are in the bottom decile in terms of cost for short-dated ball meaning like say three-month tenure, six-month tenure et cetera.

And if you look back, we haven’t seen levels like this persist since 2007 and before that, 1998. So, we’re not predicting the kind of volatility that occurred in 2007 and 1998, but we do think it’s prudent to add volatility when it’s very cheap. And, then, we’re protected against violent moves.

Thomas Siering

Trevor, it’s Tom. Chairman Yellen has been forthcoming about how should she view the world, right, unemployment and inflation, or as I said earlier, her super metrics. I think that the market has taken comfort that she’s going to continue to provide QE support to the market as needed until those things are met. In respect to the inflation, we’re somewhat distant from that, from unemployment.

We’re also distant from that. So, I think the market has taken solace on what she’s said publicly, which is fine, but the risk is that the world changes and the market is caught offside. And given how cheap volatility is right now, it just seems prudent to us to take advantage of that to immunize from shock risk or immunize shock risk within the portfolio.

Trevor Cranston – JMP Securities

Okay. Great. I appreciate the comments. And thanks everybody.

Operator

Thank you. Our next question is from Bose George of KBW. Your line is open.

Unidentified Analyst

Yes, guys. This is [Chas Dyson] (ph) in for Bose today. Just going back to Slide 10 there. The debt-to-equity implied debt-to-equity ticked down a little bit. How are you guys thinking about that going forward? Any opportunity you can take that out and lever up a little bit.

William Roth

Hey, this is Bill. Thanks for joining us. As Brad mentioned in his section, a lot of that was driven by changes in our TBA position. And so, that TBA position actually can move around somewhat given opportunities we see there. If you look back the last several quarters, though, our overall implied debt -to-equity has been in this same general area. I mean I would say if we see opportunities to put capital to work at expected ROEs we think are attractive, then, absolutely, you should see that go up. That would be what would drive that.

Unidentified Analyst

Okay. Thanks. And then, on the credit sensitive loans, I know you talked about kind of seeing that more as a trade as opposed to a long-term opportunity. But are you guys kind of out of that market now or is there opportunity to jump back at some point or where do you see that going?

Brad Farrell

Well. We’re never out of any market. So, Bill…

William Roth

Yes, I mean basically the situation was, when we bought and we thought they were really very attractive and then they got to the point were frankly the market had replace quite a bit and we didn’t think that they were attractive to hold. We sold them. So, obviously, we still pay attention to the market, but for us to fill that position back up we need to think that they were, once again, very attractive. So would leave it. It’s like any other asset and so it would have to cheapen up quite about there for us to get interested again.

Unidentified Analyst

Okay. And then on the $5 billion bulk MSR transaction, what are you guys seeing in transaction? I feel like in the bulk market, you guys are evaluating different partners and kind of making progress there.

William Roth

So, as I mentioned on the call in the last 12 months we’ve looked at over $400 billion of UPB that was in for data available-for-sale. So that’s whatever, $30 billion, $40 billion a month, if you want to just break it down that way. So without getting into details about particular sellers or sizes, it’s our view that the market going forward will still be very robust. I mean if you look at it, new production, just new monthly loans when you add them up for the year, it’s about $1 trillion. And it’s our belief that there will be a reasonable amount of that new production servicing the debt sold, because as I mentioned on the call, the dynamics are taking place in that market. So we continue to work with both bulk, slow and our originators to look at opportunities there.

Unidentified Analyst

Okay, thanks guys. Thanks for the time. I appreciate it.

William Roth

Thank you.

Operator

Our next question is from Steven Laws with Deutsche Bank. Your line is open.

Stephen A. Laws – Deutsche Bank Securities, Inc.

Thank you. Good morning. A couple of questions, two on the financing side. It looks like there is $3 billion of swaps maturing over the balance of 2014. I guess about $900 million matured in the first quarter and it looks like you rolled that into, mainly, three-year swaps. There is going to be a little bit of longer dated swaps as well. Can you talk about how you’re going to roll the swap book, as it matures this year, so we can think about the blended financing cost impact there?

William Roth

Hey, good morning, Steven. Thanks for joining us. Unfortunately I’m not going to have a great answer for you in terms of from a modeling standing point. The way we think about our swap and swaption position is from a total duration standpoint. So what we would do is we would look at any amount in any given bucket and that would contribute to our overall hedge profile and we look at that on a daily basis.

So, I mean, it’s entirely possible that those go – obviously they’re very short. So they don’t contribute that much to our overall duration profile. So I can’t tell you what we might do or not do with regards to that particular bucket. Just that if you look at our overall duration profile, we tend to keep it fairly closely-huddled around no exposure.

Thomas Siering

And this is Tom. And as you know, hedging is a living, breathing thing. The portfolio changes on a daily basis. Interest rates change on a daily basis. And so, hedging needs to be fluent and dynamic. And while no hedging strategy is perfect, one thing that we’ve tried to use, as I said earlier, expansion of chief volatility to try to mitigate shock risk and today, to us, that seems like a smart thing to be doing. But we really can't give forward guidance on that because we don't know what the portfolio will look like a month from now. But our hedging strategy will accommodate whatever the portfolio does look like at that time.

Stephen A. Laws – Deutsche Bank Securities, Inc.

Great. I appreciate the color. I guess what's the average maturity for the bucket of about seven months, it’s going to be later in the second half before we really get a great idea of that. I guess, to follow up a little bit, whole loan questions earlier, and just the commentary in your prepared remarks regarding, potentially, financing those through the FHLB, I appreciate the color, but availability financing is really more due to the underlying characteristics of the loan. Do you have any guidance, I’m trying to work with financing cost is and how FHLB financing for whole loans compares and contrasts with Wall Street's financings available.

Thomas Siering

Yes, Stephen. I can take part of that. And to a certain degree point you to – we had an analyst day presentation in kind of late February and we had a pretty robust discussion about the benefits, the comparatives of the repo market, why the FHLB is appealing to us. So I’d point you there. But, obviously, I can answer some of the question right now.

The appeal to FHLB is twofold. One, it gives us some optionallity on Agency securities. Especially, if we want to take out more lengthy maturity profiles. So, on a short-term rate, it is relatively comparable to finance, say, three to six months. If we were looking to extend out, as you can see, our average extension now is 2.8 years. The rates really don't increase that much relative to the street financing.

So, it is very appealing in that regards. And then for loans, the advance rates and the cost of financing really don't change, whether it's whole loans, or whether it's Agency securities. So, again, our average funding cost is say 40 basis points, that's relatively what we would be financing with whole loans. And so, obviously that’s a pretty big advantage versus kind of street financing, which is typically a LIBOR plus 200.

Now, having said that the advanced rates aren't quite as strong, but you can see that there is an appeal to finance our conduit activities with FHLB.

Stephen A. Laws – Deutsche Bank Securities, Inc.

Great. I appreciate the color there. And thank you for taking my questions.

Thomas Siering

Thank you.

Operator

Thank you. Our next question is from Eric Beardsley of Goldman Sachs. Your line is open.

Eric Beardsley – Goldman Sachs & Co.

Hi, thank you. Just back to the MSR acquisition opportunity, just wondering, if you could comment how the competitive environments for those assets has developed, if you've seen any shift in what types of institutions are selling MSRs?

Brad Farrell

Hi, Eric. Good morning. Like any market, the market in MSRs is competitive. There are, obviously, banks and servicers that compete. There's some new entrants as you know that that have come in, but, I mean, bottom line is, in a given transaction, you'll see anywhere from a handful to a dozen people – companies show up. And the bottom line is, right, you have to have a market bid to be competitive. We feel like we're competitive. We, obviously, have been successful so far. But it’s a competitive market and if you’re on the market you have a chance to win.

Eric Beardsley – Goldman Sachs & Co.

Have there been any changes in terms of what your expected yields are based upon the competition, or it’s pretty similar to when you guys last spoke at the Investor Day?

William Roth

Yes, I mean, I think the market is probably is a little bit tighter. We have been talking about high-single to low double-digits. That’s probably a little bit. I mentioned high single-digits and have granted. The MSR that we have was in excess of 10% yield in the first quarter. So that obviously is a low double-digits number, but I would say it’s probably a little bit firmer today than it was when it was a quarter ago.

Eric Beardsley – Goldman Sachs & Co.

Got it. And then, just on the prime jumbo conduit. What’s your ideal deal size in terms of you waiting to do securitization and is it you’re really just waiting to gather enough assets or would you like to see spreads come in before you do another deal as well?

William Roth

From a deal size standpoint, it doesn’t become really cost effective until you’re at least $250 million or $300 million, just because of the cost you pay for legal and rating agency et cetera. So, I think, if you look at the deals that have been done that’s sort of at the low-end. In terms of the timing, for us do a deal and sell AAAs, we would be monitoring that market continuously. I mean, that market has bounced around quite a bit. Certainly last year was fairly volatile. So, kind of hard to predict timing because you get a little movement there and it really makes a big impact.

Thomas Siering

This is Tom. The benefit of the home loan facility, obviously, affords us patience to let AAA spreads get to where we think they should be. And so, AAA spreads aren’t where we like them. There’s no reason to sell into a market that we don’t like and respect the AAAs for that.

Eric Beardsley – Goldman Sachs & Co.

Okay, great. Thank you.

Thomas Siering

Thank you.

William Roth

Thank you.

Operator

Thank you. Our next question is from Joel Houck of Wells Fargo. Your line is open.

Joel J. Houck – Wells Fargo Securities LLC

Good morning. Thanks for taking my question. Just wonder if you could talk about given kind of the concern over basis or spread widening as the year plays out, you do have $6 billion and 30-year fixed, of which five being the 4% and 4.5% coupon. Can you remind us, again, what specifically those securities represent in terms of mitigating basis risk? Obviously, you can’t completely eliminate it, but if you could kind of go over that would be helpful.

William Roth

Yes, sure. I mean, look, it’s fairly simple. If the basis widening is driven by excess supply that the Fed isn’t buying, that’s going to be reflected primarily in current coupon, right, and current coupon has longer spread duration. They’re longer assets. Presumably that would filter through to the higher coupons of which the Fed is not in their targets today.

But because those are shorter assets, we expect those to perform better than current coupons. It may not help us through, but if it does you would lose less money owning notes than you would lower coupons. So one of the reasons is you see that – and I think on Analyst Day we showed what our overall exposure was. It’s extremely low.

HECMs are sort of unrelated to Fed activities. Those are very short assets that’s our ARMs issue now, but the higher coupons, they could get impacted if current coupons widen. Maybe just be impacted less.

Joel J. Houck – Wells Fargo Securities LLC

Okay, that’s helpful. The other I guess thing you kind of alluded to is what is your assessment, Bill, I have to risk of kind of not just spreading into other higher coupons, and also spilling over into the non-Agency market if we start to see kind of people get really nervous in the second half of the year as it taper plays out?

William Roth

Well, yes, presumably right the tapering our credit combination ends because the economy is better, right. Unemployment as well our inflation is at the target rate and so forth, which means economy will be pulling a lot, that’s pretty good for the non-Agency market.

Joel J. Houck – Wells Fargo Securities LLC

Yes, I know I agree that – I agree with the comment I guess my concern is that it seems like the Fed and Yellen are going down a path of eliminating this QE, because they don’t think it’s effective, and the underlying economy really isn’t that strong that include the housing market has been, but as we’ve all seen those numbers are starting to weaken here, into the first four months, I kind of wondering how you view, do you play more defensive in the non-Agency side of if the data doesn’t pick real soon. Or is it just hey, we’ve got confidence if the Fed not going to taper all the way if this is not supported by the data.

William Roth

Well, obviously we’re looking at what we actually owned right. What are the performance of the underlying pools? What does the outlook look like? Obviously that’s impacted by general economic activity. We want to look at the actual holdings within the pools that drove our portfolio and to the extend that we’re comfortable with the outlook for those we’ll continue to hold them. To the extend that we are not, start to trim.

Thomas Siering

The other thing is Joe, implicit in your remarks there is that rates presumably will go up and spreads would lighten, and so any drivers or returns they are going to driven by how interest rate exposure you have, how much leverage you have.

Joel J. Houck – Wells Fargo Securities LLC

Yes.

Thomas Siering

Obviously you can see where even since slightly short the market, which we think would help us, and we have low leverage. So look, very possible that we or anybody else could lose money as a result of widening spreads and changing rates. It’s just a question of managing your overall and that’s why we are concerned the reposition right now.

Joel J. Houck – Wells Fargo Securities LLC

Okay, fair enough.

William Roth

It continues to be right, Rosetta Stone and non-Agency is that prepayments are so low at current levels and we modeled them the very low levels. To the extend the economy picks up and people are able to move for refinance half of those very muted levels, then that’s good for our non-Agency portfolio. But like anything else we think conditions are shifting on us. We are going to shift the portfolio to refect that in your point of view.

Joel J. Houck – Wells Fargo Securities LLC

Okay, great, thank you for the color.

William Roth

You bet.

Operator

Thank you. Next question is from Dan Altscher of FBR. Your line is open.

Daniel K. Altscher – FBR Capital Markets & Co.

Thanks good morning. I appreciate you taking my call. It’s good to see some of the PHH flow come on this quarter. Can you maybe just help us – give a little walk through from I guess there maybe like $7.5 billion or UPB, you did this quarter to I guess $121 million that you actually took on?

Thomas Siering

Hey, good morning. Well, there is a couple of comments I’ll make there. First, what we took on was, what we closed during the quarter, which was primarily fourth quarter activity and only a very small portion of the fourth quarter, because we put that in place. By the time we put it in place we were pretty much at the end of the year.

So it doesn’t reflect any activity from the first quarter. That’s the first think I would say, and then, the other thing I would say is under the agreement. The agreement is for at least 50% of their production, of eligible production. And so then, if you want to project forward you have to determine what you thought eligible production was that would come through to us. But the bigger answer is that this is really from a tail end of fourth quarter.

Daniel K. Altscher – FBR Capital Markets & Co.

Okay. That makes sense. So I guess, we’ll see in next quarter, what maybe a more full quarter looks like. That's fine we’ll pay attention and watch there. Question on the FHLB advances understood the rates are kind of similar on Agency repo and FHLB. But as the term makes sense, I think, probably, what I would have thought is the more clear advantage would have been trying to finance on the non-Agency side obviously, for terming and cost. Even though, maybe the haircuts maybe larger there. So why only focus on agency for this go around and not non-Agency, where you go beyond maybe more attractive borrowing rates?

Brad Farrell

Yes, this is Brad. You’ll see that, we do have some non-Agencies, but the key thing is absolutely key is, that the FHLB only finances single A rated and above, and if we think about the majority of our non-Agency holdings they would not meet that standard.

So, really the target for FHLB financing for us is again kind of three fold Agency securities that fit our maturity profile that’s appealing to us. Most importantly the conduit and being able to aggregate whole loans, prior to securitization. And, then, if we do retain any bonds our deals are the deals that are obviously rated above A, but you think about our legacy portfolio it doesn’t really apply.

Daniel K. Altscher – FBR Capital Markets & Co.

Okay. That’s really helpful. Thanks Brad. And then maybe build us a, maybe hopefully a quick one. It seems like there has definitely been a market trend moving more towards swaptions, and I understand your point that while it’s been really low and attractive on the pricing, but do think fundamentally or anything there’s that’s maybe an advantage that a swaption has ever using a traditional swap, because obviously swaption need to be rolled maybe a little bit single than the actually swap. So beyond the price what is the incentive for using a swaption?

Brad Farrell

Well. A swap and a swaption are very different instruments right? A swap is basically just, basically, a flat-out, either short or long position, if you’re paying at the short position in the market right? So rates go up, you win, rates go down you lose. And that’s fine because on your assets its’ going the other way.

Swaption like any other option is optional protection. So if your longer payer swaption in the market rally as you win and you just lose your little premium that you paid. And you can keep winning as long as the market rally. The vice versa you’re covered in the [indiscernible]. So they are very different profiles. The reason it’s important to use Swaptions with mortgages because the mortgages short convexity i.e. mortgages shorten and then expand in different environments and so you need that optional protection. So the reason that we like swaptions more today is just a function of price.

Daniel K. Altscher – FBR Capital Markets & Co.

Okay. Thanks so much for the comments.

Thomas Siering

Yes. Thanks for joining us.

Operator

Our next question is from Ken Bruce of Bank of America Merrill Lynch. Your line is open.

Kenneth M. Bruce – Bank of America Merrill Lynch

Thank you. Good morning, gentlemen. Thank you. Good morning, gentlemen. Your comments have been very helpful this morning. As usual, I'm going to pull back a bit and go a little bit more strategic on you. One of the aspects and characteristics of Two Harbors, which I find quite interesting, in addition to the unique portfolio construction and very close risk management, is the blend of investment businesses and what is, effectively, operating businesses. I really want to get your understanding or get your thoughts around, strategically, what do you see Two Harbors being when it grows up? Effectively, you've been a little bit of a chameleon, in terms of an investment portfolio, getting into areas that have strong relative value; some are trades, and you get out of those businesses. You are, obviously, investing in platform businesses, so I really would like to understand how you think this business over time, if it’s shifting more into operating companies and or do you think that will be just this unique blend that we see in the market today?

Thomas Siering

Sure, thanks for the – on the question, and thanks for the kind remarks as well. This is Tom, so on respect to where we are in the future, I don’t have a great answer for you, because it’s going to depend upon a lot of different things. I mean, for instance, the ultimate fate of the GSC is going to be very impactful for our business. And what we –what we are here to do is to drive shareholder value. We want to do the things that are – that is reward the lease risk and with dampened volatility. And one of the benefits, we think of the existing model as that really does reduce volatility within our portfolio.

And importantly, the market describes value of the operating businesses. So in respect to the MSR and the conduit, not only are they the most attractive use of an investment dollar today. It’s early the market covers the long-term benefits of the operating businesses that does initiatives represent. And so, it’s really difficult to say what the future will hold for us.

Bill and I am a team and Brad we spent a lot of time thinking about these things. And our only thought is what’s the best outcome for our shareholders. And so no doubt that there is going to be the need for private capital within – with the mortgage and housing markets going forward.

The banks are very present within the market today, but traditionally they’ve sort of had an ephemeral love affair with the mortgage market. And if you look at mortgage REITs by Two Harbors were really sort of a penultimate, permanent capital vehicles, look like that liquidity, and so it’s going to depend where is capital needed, where our investors pay most handsomely to provide capital and that is where we will dedicate our time and resources.

Brad Farrell

I can add this one, maybe I can add just one comment. I mean having a very robust middle office around people, so, strong underwriting; IT surround systems that can analyze different types of assets, you can onboard different types of assets; and then, obviously, the licenses, themselves. So being able to acquire loans; being able to acquire MSR, not only is it operational in nature, it’s very – it gives it a lot of optionality.

And so, as the future kind of unfolds, it affords us the ability to, if we were look at CSLs in the future, we have function that can underwrite those loans, and we can be nimble. So non-QM or any other optionalities – we have the front-end that can assess the risk around those assets, we have the middle office and back office that can, actually, support those decisions in a manner that is going to really kind of reduced the risk of the company to execute. So I’ll just add that.

Kenneth M. Bruce – Bank of America Merrill Lynch

Yes, I guess, this is a part comment and trying to tease out a little bit more, how you're thinking about this, and I share your views around the opportunities that are unfolding in the mortgage market. And I do think that mortgage rates are very uniquely position to fairly capitalize on those changes. I guess, in addition to building the core competencies that are necessary to be in these aggregation business, whether it be on the loan side or on the servicing side, it also, over a superior amount of time, requires investment, in terms of brand recognition in the market, in terms of being able to develop these businesses more wholly.

And I guess I would be interested if you have been thinking about it in that context as you look at your early involvement in these businesses? They're, clearly, very deep markets and you can grow into something quite a bit different, or quite a bit larger than you are today, and how you're thinking about that?

Thomas Siering

Yes, this is Tom again. So in respect to that, I mean, one of the benefits of our business and also, frankly having the imprimatur of Prime River Capital Management, which is the parent company to the manager of Two Harbors. We see a lot of things coming over the transom, I don’t think I will shock anyone. We’ve built out a very robust infrastructure in respect to being to due diligence opportunities to investigate opportunities to think about the future.

So I really don’t have anything to say and respective today. Where we maybe in the future, which is the confident what we think about all things within my housing and mortgage market. And we think about them with one thought what’s that’s for our shareholders. And so it can the business transform from where it is today? Sure. Will it? I do not know. I don't know because if the existing business model, we think, is best for our shareholders, then, we'll conduct business as it is today. But, there will be a lot of opportunities. I mean there is going to be some alteration, ultimately, to the GSEs. There is going to be the need for more private capital. And we are well positioned to provide that capital. And we think that our shareholders will be paid well to participate in the market going forward.

So, please stay tuned. And you know, we, obviously, will have more to say about emerging opportunities in future.

Kenneth M. Bruce – Bank of America Merrill Lynch

Thank you very much for your comments and color this morning.

Thomas Siering

Okay, thank you for your questions and comments.

Operator

Thank you. This is the Q&A portion of today’s conference. So I’ll turn the call over to Mr. Siering for any closing remarks.

Thomas Siering

Thanks, Tyrone. Again, thank you all for joining us today. On May 20, we will be hosting our Annual Stockholders’ Meeting at the Pierre Hotel in New York. On June 3, we will be attending the KBW Mortgage Finance Conference in New York and we would be pleased to have the opportunity to speak to you at either of these or both of these events. As always, we greatly appreciate your interest in Two Harbors. Have a great day.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program. You may now disconnect. Have a wonderful day.

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