Two Harbors Investment's (TWO) CEO Tom Siering Presents at KBW Mortgage Finance Conference (Transcript)

Jun. 3.14 | About: Two Harbors (TWO)

Two Harbors Investment Corporation (NYSE:TWO)

KBW Mortgage Finance Conference

June 3, 2014 9:10 AM ET

Executives

Tom Siering - CEO, President and Director

William Roth - CIO

Analysts

Bose George - Keefe, Bruyette & Woods

Bose George - Keefe, Bruyette & Woods

Okay. Good morning. Let's get the next session started. Next up we have Two Harbors. Two Harbors is a mortgage REIT, with a very diversified business model. They’ve invested in a number of different asset classes including MSRs. From Two Harbors we have Tom Siering, President and CEO; Bill Roth, the CIO up on the stage here. Let me kick off the discussion with a question just about the move we have had in rates since quarter end and just to get an update on how that has impacted your portfolio?

Tom Siering

Sure, thanks Bose. I would like to thank KWB and Bose for having us here today. It is always a great event. Thanks to all of you for showing up. As you know Bose historically, we have not taken a lot of rate risk. I guess the exception to that was last year in the second quarter, where we were fairly short of our market which turned out to be a proper decision retrospectively. But historically, we have taken very low rate risk. So rates have moved lower this quarter and this year for a variety of reasons. And so, but we have very low rate exposure. So I would just say in respect of kind of a broad update, and you asked about book value, agencies kind of continue to do their thing. Non-agencies continue to drift higher for, I think a couple of reasons. One the fundamental has been very solid. Secondly, I think there is some market risk premium that can come out of a variety of asset classes. And so we are off to a pretty good start to the quarter, overall. So the rate move is neutral to us, agencies are doing just fine, non-agencies continue to drift higher.

Bose George - Keefe, Bruyette & Woods

And has the change in rates changed your view, just on how you want to be positioned from a duration standpoint at all?

Tom Siering

Well, I will talk a little bit about that and then hand it over to Bill. Rates have moved lower and we think it’s kind of a combination of three things, what’s going on in Europe. If you look at treasuries relative to European rates, market rates are attractive. Secondly the Fed’s comments I think and around their super metrics of inflation and unemployment. And then lastly, I think there was a little technical factor where perhaps people have been caught off sight, but in short strokes in response to your question, it really hasn't changed our approach because we really don’t think of ourselves as interest rate takers one way or the other, rather we are trying to drive all sorts of new portfolio in security selection and hedging.

Bose George - Keefe, Bruyette & Woods

And in terms of investments the returns in the different asset classes you look at, can you discuss that, and just talk about where you see the most value?

Tom Siering

I'll give that one to Bill to answer. Did you hear all that?

Bose George - Keefe, Bruyette & Woods

I actually think my mic is turned way up.

Bill Roth

Yes you have to compensate. Yes, so if you look at our balance sheet, we are obviously invested in agencies as well as legacy non-agency securities. Our agency allocation has continued to drift lower as the returns there we have not found to be as attractive as they were several years ago. We continue to find value in the MSR space, and we also believe that the conduit activities can provide a lot of value for our shareholders as we move forward. So let me spend a minute on each of those.

On the MSR space, what we see there is an asset that on an unlevered basis has a yield in the higher single-digits, but in a portfolio context, because it has negative duration, allows us to reduce some of our other hedges which actually add to the value of the MSR because you’re saving money by not having other negative duration positions such as swaps. Furthermore the integrity of the MSR as a hedge against basis risk is very important in the environment where spreads are tight. Then we are not necessarily sure if or when they will widen, but as I said reduces their buying program. Overtime it’s likely in our opinion that you’ll see wider spreads. MSR will respond to the mortgage rate whereas swaps would not. So we’re excited about the fact that you have an attractively yielding asset, it benefits the portfolio in a number of ways.

On the conduit side what we see is a business that over a long period of time and various cycles typically drives returns in the low to mid-teens. Now today the market is somewhat challenged, as you know many folks in this room are aware our securitization volume has been low. I mean that’s driven by a number of factors, not the least of which are the conforming limits for the GSEs are still relatively high, relative to what housing prices have done. Banks have an insatiable demand for assets of high-quality that have any yield to them. And so as a result the supply-side of the flow of loans available is less than what we would hope.

And then furthermore, the price of AAAs that they trade in the market while they’re certainly tighter than they were at the light of last year are still nowhere close to where they have been when the securitization activity was really very exciting. In our case, we’re less concerned about whether we do one or two or three deals this year or how many next year, but if you look at the folks in Washington clearly want to reduce the government footprint in housing and finance market.

Banks conceivably will not have this insatiable demand for 30-year fixed rate loans forever especially as the rate environment changes. And so we’re looking as this is as a huge upside option to drive value for our shareholders as the securitization market really takes hold as we look forward. So those are the two things we’re most excited about and where we’re spending a lot of time trying to commit capital.

Bose George - Keefe, Bruyette & Woods

And then actually just to close the loop on the returns, is it correct to say that agency and [indiscernible] just for agency and non-agency [indiscernible] kind of high single-digit or [indiscernible]?

Bill Roth

I guess you got to pass the mic. Yes, I mean, there are certain pockets to the agency market on any given day that we find attractive but generally expected ROEs there without jacking up leverage or taking a lot of rate risk are well below 10%. On the non-agency side, from time-to-time we find bonds that we like that will all get us in the double-digits but generally once again without inducing a huge amount of leverage those are sub 10% as well.

Bose George - Keefe, Bruyette & Woods

Then in terms of things that could change the jumbo market view, if it higher rate I mean what’s a big part of it, do you think more of it has to do with banks have anything you know less to do with their capital or do you think more of it has to do with the conforming loan limit issue?

Bill Roth

Weighting which it more or less has to do is kind of challenging, but I think if you look at bank’s balance sheets and the amount of prime jumbo loans that they put on their books, I think it’s safe to say that the incremental add from reducing the loan limits is less than what they have put on their balance sheet. But I mean, they both play a role, but banks have shown that when rate environments change they don’t necessarily want to hold 30-year mortgages. So, if at some point the fed starts to move the front-end of the market whether it’s next year or the year after, it’s very likely that the interest in banks and holdings 30-year loans is going to go down quite a bit, so the pricing probably loosens up there. That’s our expectation.

Bose George - Keefe, Bruyette & Woods

And if you just let me slip in one there just on the home-loan bank funding and where that fits best for your portfolio?

Tom Siering

Sure so the home loan fits nicely in a couple of different areas of trends and in certain pocket of agencies our market is financed very well on that facility and also it is a good funding source for home loans and securitized products. And so it is our anticipation that that’s what we would fund on that facility. And also because this is a Reg FD forum I can announce today that our facility has been increased to $1.5 billion from $1 billion.

Bose George - Keefe, Bruyette & Woods

Actually just a follow-up on the FHLB issue, does this process really starts with FHLB kind of trying to broaden its base with members outside the banks can you kind of discuss how this has broadened to in a pretty meaningful way to you and another non-banks?

Tom Siering

Yes, in respect of home loan’s strategy around that I really wouldn’t be in a position to say. The facility fits very nicely with our business. We’ve spent a lot of time building the conduit and MSR business in respect of the conduit business, we have 30 originators and very forms of development and so the good news around that is that our home loan program has starting to pay off and there is -- our accumulation of home loans has accelerated into the second quarter and we anticipate doing a securitization, but the home loans strategy with respect to us and others I really couldn’t speak directly to Bose.

Bose George - Keefe, Bruyette & Woods

And then just one more on the home-loan bank, can you just talk about the duration that’s available on funding and the funding cost versus other sources of funding?

Tom Siering

Sure, I’ll give that one to Bill.

Bill Roth

Yes, so in terms of available funding there, for most products you can get advance without the five years in some cases longer. And one thing that is nice about FHLB is very transparent, so you can actually go on Google them and who have got the whole list of rates. But to give you an idea on very short borrowing it’s LIBOR plus 10 or so and then it gets out in five years to around LIBOR plus 30. I mean obviously that changes with the market but you can borrow fixed or floating. So those rates aren’t necessarily good for ever but they post them every day. So you could -- but that’s just a general idea.

Bose George - Keefe, Bruyette & Woods

Okay. So let me just check it there is any questions from the audience. Okay so let me just switch to a couple of other areas in term of other asset classes as they have been a few companies that have more actively enterted the non-performing loan market can you just talk about your thoughts on that asset class?

Bill Roth

It’s like who could set back further -- no just kidding. So the NPL market, that space is very interesting, however which we are buying is an asset that obviously is non-performing and so to earn your return you actually have to work the loan to turn it into cash either make it re-performing and then sell it or actually liquidate utilize your cash in that regard, so to make that happen you actually need to control and the servicing and effectively make your return that way. We don’t have the capabilities in-house of the specialty service to actually make that occur, so as a result we opt to not to pursue that because it really -- that would necessitate us partnering new with somebody else to make our returns to shareholders. Anecdotally we’ve heard that expected return there is sort of in the high single-digits but I -- we are not in that market, so can’t really say whether that’s -- how accurate that is.

Tom Siering

Just to add to that too Bose and I surely don’t mean to discourage anyone’s business model because we’re very respectful of competitors. But to me sitting in my chair the NPL trade is a product of the crisis in large volume. And so in my own mind I have a question to run way of that and so really what we’re focused on our businesses that we think have legs into the future and if we look at the mortgage market and if we think about the ultimate fate of the GSE which is difficult to predict. We want to be part of what we see as mortgage market of the future. And so I am sure people are doing quite well in the NPL space but from our perspective we want to be forward looking and I think we’re achieving that.

Bose George - Keefe, Bruyette & Woods

Actually that leads to just a question on GSE risk sharing assets, can you discuss what the returns are like in that market how you see that developing the regulated BBB amount of assets sold this year. How you think about the whole process there?

Bill Roth

Sure, so the GSE risk sharing product has actually been loudly successful by any measures spreads have tightened substantially. The deals that just priced most recently priced at the highest levels that we’ve seen today. And the demand has been extremely high. So that’s great news for demonstrating the amount of capital that’s interested in taking mortgage credit risk. From our perspective the more recent deals have not been priced at levels that we find -- we’ve been able to generate, we think can generate returns for us that would be beneficial to our shareholders.

But more importantly the fact that there has been good traction there, and leads to obviously Mr. Watt has challenged them to triple the amount of volumes. I also think -- so think that’s a good thing, because there is obviously a need for capital to go to mortgage credit, we’re ideally positioned and we think that over time if they go away from the more pristine loan products into loans that have little more character to them if you will. But that will provide more opportunities we think to acquire assets with more attractive spreads.

Tom Siering

In fact to just add a couple of things on that, there is two things going on the mortgage market that we will really hope the Washington is watching. The credit tranches have come out and traded remarkably well as Bill pointed out. The second thing is that we’re seeing jumbo rates lower than forming rates, Bill and I have been in the market collectively and this is very present state, actually 65 years collecting. We have never seen that, and so we’re hopeful that Washington is gaining attention to that because it really speaks to the ability in sales market to effect GSE reform because there is prime capital that’s upon that wants to come into the market. So those two things I think are ordinary and we hope margin and is taking out on that.

Bose George - Keefe, Bruyette & Woods

So let me just check if there are questions from the audience.

Question-and-Answer Session

[Indiscernible]

Tom Siering

The question was around NPLs and reforming loans and so. Yes we did have an investment in what we call credit sensitive loans which are re-performers we’ve liquidated substantially so we said this in our earnings call. We will liquidate that substantially from the portfolio. So it’s something that we always viewed as a trade now today in fact the trade has gone away because there is to a level where we just didn’t think given than the liquidity profile of them which is less than on agencies that they have just risen to a level that we just didn’t think of the risk reward is favourable for our portfolio. So, might we do it again, yes what I really point to that is it’s very likely today it doesn’t feel that way.

Bose George - Keefe, Bruyette & Woods

Okay. Just in terms of the risk sharing market, can you talk about the leverage that’s available there in terms of financing those assets?

Tom Siering

Sure. Bill?

Bill Roth

Yes, the -- so as we look at the just price drive but from the price inside levels of 100 and the back piece priced at LIBOR plus 250. So if you think about these assets in terms of credit quality it’s very hard to almost apply any leverage given the financing levels and generate returns that are available vis-à-vis in other areas that we look at. So, I think the first question is you have an assets that’s take the back piece which is the most credit which already highly leveraged to the credit at the underlying portfolio and to apply three or four more times leverage and still be below 10% yield that’s another challenging notion to us. So, if a dealer is going to provide a lot of leverage that definitely certainly make it a worthwhile transaction for us to look at.

Tom Siering

The -- actually go ahead Danny.

Unidentified Analyst

[Indiscernible]

Tom Siering

Yes, so the question was we have increased our swaption position quite a bit and the statement in question was that that continues to stay low and our -- do we continue to add to our swaption position are we happy with where we are. So, the answer to that is if you look back over the last 20 years we are now consistent with the cheapest levels or we’ve been sitting this in for the cheapest level so we’ve only seen three times in the past and without trying to adjacent value or however you are from the room you have a three times where like before long term capital management was before there are turns go out. And the caper change from that what we saw last summer so we’re not predicting anything but we have observed the volatility still remains very low. And in fact that’s lower cost a number it’s not just interest rate bar.

So we intent to maintain a higher than normal position in swaptions because we think that that make sense, more it’s about by definition is short options. We’ll probably have more than needed but we think that that’s a good position to have for our shareholders because at some point this is normalized we will process from those positions and frankly we’re just extremely cheap. And so I would say that without going into mathematical details and where we are today we do like the profile the net long as many swaptions as protection.

Unidentified Analyst

[Indiscernible]

Tom Siering

The question was, are there any specific tenders that we’re focused on. Well, if you look at Chairman Yellen and her comments and the ball surface you will see that many short data that’s generally one year in last are more cheap, than longer dated. And that kind of provides protection to jokes in the market. So we look at different tenders on a daily basis and that’s to say that the bulk generally going to be is you look at our position from last quarter the reasonably short you know year unit, but we maintain a substantial longer data position as well.

Bose George - Keefe, Bruyette & Woods

Shouldn’t we ask about other asset classes, if there is any other asset classes that we didn’t discuss where you see any value? You’ve spent time with [Heckhams] (ph) in the past, is there anything else that, where you see value?

Tom Siering

Yes, I mean today those were in an environment where rates are low, spreads in many markets are low, there’s a real search for yield and we are obviously, we’re in the market what we expect everyday and when something shows up that we like, sort of regardless of where it is, we’re going to add it to the portfolio, but away from the new initiatives that are very important to us being MSR in our conduit activities. I can’t point the one thing today and say specifically hey that’s a glaring outlier.

Bose George - Keefe, Bruyette & Woods

So let's switch to the MSR -- that market. Actually can you talk about -- because there has clearly been a lot of regulatory headline about you in that area is that in any way impacting the pure prime MSR funding side that you guys are looking at -- just that versus the regular distressed market?

Tom Siering

Well, so the market, just to be clear, and to those who are not certain of the difference here, so the legacy market are typically serving of loans that were made during the crisis or in around that time they require high amount of interaction with the borrower, maybe HARP refinancing but it is high touch servicing. The servicing that we’re focused on is new production, very high quality, primarily influenced by prepaying the interest rates and prepayment rates not credit performance. So there’ve been a lot of headlines about special servicers and interaction with the borrower etc, and some folks in the great state of New York have taken notice and been involved with some of those.

As regards to the new product which with we’re involved and you know, you don’t have the high tech servicing. The borrowers are performing. The credit quality is very good, so that product is not really on the radar screen. You know from that stand point but I will say that that being said, there’s a heightened level of awareness of servicing transfers by different GSEs and Ginnie Mae, just because of the overall landscape as well as the FHFA. So while that hasn’t the specialty servicing situation that’s going on hasn’t really accepted Two Harbors or any of our transactions. But certainly we’re beholden to the GSEs and FHFA and Ginnie Mae for transactions we do and so we’re in regular dialog. On that, you know so far we haven’t seen any impact to transactions that we’re looking at.

Bill Roth

And this is indirectly responsive to your question, but one thing to note is, the systemic landscape is very good for our business model, because if you look at origination lines are down, margins are in and so it can be argued that a smaller to mid size originators need to sell MSR to fund their own businesses. So we think we’re well positioned in today’s environment to continue to acquire MSR.

Bose George - Keefe, Bruyette & Woods

Let me just check if there are any questions from the audience. The follow-up to that would be in terms of the acknowledgment letters from the GSE do you feel like that processes getting easier, are they helping servicing to move?

Bill Roth

I don’t know what I would say is easier necessarily. You know the FHFA has taken notice of this and obviously they’re overseeing some of these transfers and we continue to have a very good working dialogue with the agencies and their regulatory. And we honestly think that we’re part of the solution to the problem. We provide liquidity to the MSR space which we think makes the mortgage market healthy overall, so we have very good relationships in DC and the dialogue has been very healthy.

Bose George - Keefe, Bruyette & Woods

Second question is again. Let me throw in one more on the MSR side. Is there an opportunity in terms of funding MSRs for others, potential buyers of MSRs?

Bill Roth

So, I want to make sure I understand your question.

Bose George - Keefe, Bruyette & Woods

So this basically if someone else is buying the MSR, could you guys provide the effective financing for MSR buyers?

Tom Siering

I don’t really want to help anyone also in the MSR business but, you know there’s been some discussion of financing broadly of MSRs but I don’t anticipate that we would fund the MSRs for anyone else.

Bose George - Keefe, Bruyette & Woods

Any last questions? Okay, great. Thanks very much.

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