Two Harbors' MSR Black Hole

| About: Two Harbors (TWO)


Two Harbors' oft-touted MSR investment strategy is not working.

Runoff in TWO's MSR portfolio is far greater than what is being officially reported.

Management fees are eating up what little income the MSR generates.

I recently read an article titled "Two Harbors: The Only mREIT That Truly 'Gets' MSRs?". That article outlined in some detail how Two Harbors' (NYSE:TWO) investments in MSRs were yielding over a 50% margin. These margins were in such excess to Two Harbors' competition that the author even went so far as to suggest that other mREITs sell their MSR holdings to Two Harbors. Naturally, I was interested in learning how TWO could be so much more efficient at servicing MSRs than its competitors, so I turned to the financials.

At first glance TWO does indeed appear to be earning just over a 50% margin on its MSR investment, but after digging deeper, it soon became apparent that it was earning far less (if it was earning anything at all). The first figure that jumped out to me was TWO's runoff related to its MSR. It was averaging just $2.5m per month, on an asset with a fair market value of $450m. This is far too small to be believable. For starters, during the same period that TWO reported $2.5m in runoff, it also reported a conditional prepayment rate (CPR) of 13, meaning that its MSR asset was decaying 13% annually. Given that TWO's average MSR UPB (Unpaid Principal Balance) over the nine months ended September 30th was $47.5bn and that TWO's average price was 94.8bps, we can infer that TWO's fair value change due to decay was $5.2m per month, or $47.8m for the nine months.

Of course, $5.2m is not close to being $2.5m, so where is the difference coming from? The answer is that the decay related to the MSR asset is typically measured in two forms: the first is the decay related to the collateral that has runoff (illustrated above), the second is time decay. Time decay is essentially the effect of rolling the portfolio forward one month, or in other terms, the realization of one months' worth of cash flows. So in reality, TWO's asset is not decaying at $2.5m per month, but rather $7.75m, or $70m for the nine months ended September 30th.

If we take these new decay figures and run them through Two Harbors' third-quarter financial statements, we can see that the company's margin on its MSR investment is closer to 5% than it is to 50%. But so what, a 5% return on a negative duration asset is still good, right? Especially when you consider that mortgage IO strips typically trade between a 0% and 2% yield. Unfortunately, when Two Harbors reported its expenses related to its servicing asset, it only included the expenses it explicitly pays its sub-servicer and neglected to include its oversight and management expenses related to the servicing asset.

TWO's MSR oversight expense does not explicitly appear anywhere in its 10-Q, so for this exercise I will assume a 50 cent cost to service per unit per month. I believe this figure to be conservative given the highly regulatory environment in which MSRs reside. Which finally brings me to the management expense. As a preface, TWO does not finance any of its MSR with debt as far as I can tell, which means that it pays for its MSR entirely with equity. On its investor relations homepage, the company touts its "Attractive management fee structure"; going on to say that management earns a 1.5% fee on all stockholders' equity. So if we then apply that fee to the average MSR fair value over the nine months ended September 30th and haircut it by TWO's current price to book ratio of .72, we arrive at $404,708 in fees monthly, or $4.9m for the nine months. I have laid out a summary of TWO's MSR below as I have described it above.

The first number that really jumps out here is the servicing margin. After expenses, runoff, and management fees, TWO does not make a dime on its MSR (actually, it makes negative dimes). In reality, TWO's return is even lower, given that I neglected to include the interest expense TWO incurs on MSR-related advances. The second number that jumps out is management's fees. While stockholders are busy losing money, management is raking it in. It makes you wonder whom it is talking about when it mentions things like "Attractive management fee structure." For stockholders, or for management?

TWO should take immediate action to help shore up its MSR. First, the company must change the way it reports decay and accurately report the full impact runoff has on its asset. Second, aligning management's and stockholders' goals is never a bad idea, so tying at least a portion of management's compensation to net income would be a step in the right direction. Finally, to combat the MSRs' negative yield, I would suggest to TWO that it modify its strategy. To push yields up, it must acquire its assets cheaper, possibly putting off purchases altogether until yields make sense for both management and stockholders. At the same time, TWO should strategically sell portions of its portfolio during rate sell offs, thus realizing a positive return on the asset. In the interim, stockholders would be wise to shift their investments to names with less exposure to MSRs, like American Capital Agency Corp. (NASDAQ:AGNC) or Dynex Capital, Inc. (NYSE:DX).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.