Two Harbors Investment Corp. And The Changing Business Model

| About: Two Harbors (TWO)

Summary

Two Harbors delivered a reasonable fourth quarter despite weak Core EPS numbers.

Some of their savings from a change in their portfolio won’t show up in Core EPS because of the accounting methods.

Despite the savings not showing up, they are real savings and are positive for shareholders.

Management indicates the dividend should remain solid and the REIT taxable income looks like a positive sign.

TWO is increasing their allocation to MSRs, which is a position that has encouraged different viewpoints.

Two Harbors Investment Corp. (NYSE:TWO) released their fourth-quarter and full-year performance for 2015. The earnings were shy of analyst expectations, but the presentation looked pretty solid. It's important to recognize why earnings were coming in a little low and how management is shifting the portfolio to prepare for their expectations.

Dropping Leverage

TWO invests heavily on assets other than agency MBS. Because of their focus on assets that are credit sensitive, TWO expects substantially higher yields on assets and designs their business to earn returns through credit exposure rather than focusing on the yield curve. One of the interesting things about this decision is that it makes Two Harbors Investment Corp. look more like a regular business and less like an option embedded bond portfolio. They still are an mREIT, but they are materially different from most mREITs.

The "Rates" category includes a few categories, with the most notable being the agency MBS and the MSRs (Mortgage Servicing Rights). TWO decided to substantially reduce their exposure to agency MBS during the fourth quarter and brought their leverage down from 3.1 to 2.5. They also added on some fixed rate "receiver" swaps during the quarter rather than canceling off their fixed rate "payer" swaps. By taking the fixed rate receiver side of the swap, they were effectively reducing their total exposure to the swaps because the positions are offsetting. In a nutshell, this should reduce their quarterly net interest payment on swaps.

They also reduced their position in "Swaptions". A swaption is an option to enter into a swap contract. This was a derivative they were using to hedge the interest rate exposure from agency MBS. Since the agency MBS position is smaller, there is less need for these derivatives.

Due to the way the accounting for swaptions works, the swaption expense almost always completely avoids calculation of Core EPS. The only mREIT I can recall pushing swaption expenses into Core EPS was CYS Investments (NYSE:CYS). It is exceptionally rare for swaption costs to be incorporated into Core EPS.

Putting Those Factors Together

Lower agency MBS means less interest income. An increase in receiver swaps is functionally the same as a reduction in payer swaps. Therefore, there is less interest expense on swaps. However, the reduction in interest income exceeds the reduction in interest expense. However, the reduction in the cost of buying swaptions won't show up in the calculations of Core EPS. As a result, Core EPS doesn't fully capture the reduction in hedging costs and, therefore, the decline in Core EPS is less substantial than it would have otherwise been.

Dividends

When I was looking at Two Harbors Investment Corp. prior to the earnings call, I saw the potential for management to be proactively issuing the share repurchase authorization as a way to prepare for a dividend cut.

I'm not certain that the dividend will be sustained for all of 2016, but I wouldn't be too surprised.

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Management only distributed 92.9% of REIT taxable income for 2015. Despite the Core EPS numbers not covering the dividend, the REIT taxable income indicates that the dividend should be good at least for a while. Management was even proactively indicating that they believed they would be able to issue another $.23 in March and expected to be able to continue throughout the year.

I usually do my analysis on REITs through looking at changes in BV and assessing the quality of Core EPS.

The Two Harbors Technique

I've written previously about the way Two Harbors Investment Corp. is using MSRs. That inspired a very interesting response. I suggest readers check out the response article along with all the comments. The total picture is one of the most interesting pieces I've seen.

TWO has been increasing their relationships to buy MSRs in large amounts and they are treating this as a material part of the portfolio. On the earnings call, management went on to discuss how they felt the MSR segment was attractive in the current situation.

Their total unpaid balance on MSRs was about $51.4 billion at the end of the fourth quarter, up from $48.1 billion at the end of the third quarter and $42.8 billion at the end of the second quarter.

Book Value

Book value was down to $10.11 relative to $10.30 at the start of the quarter. The dividend was $.26, so the company still had a positive total economic return of $.07. It isn't much, but they were actively buying back stock and their repurchasing activities had an average price of $8.37 per share. That is substantially above the current $7.52 which suggests that TWO may be actively repurchasing their shares again since the discount is materially larger than it was for their previous round of repurchasing.

Conclusion

Two Harbors decreased their leverage and decreased their net exposure to interest rate swaps through offsetting positions. The reduction in swaptions is also tied to the reduction in agency MBS, but it won't show up in Core EPS. The move into MSRs is worthy of quite a bit of due diligence because it may be a huge part of determining their future returns.

The overwhelming factor determining results over the long haul is likely to be the performance of their non-agency MBS. If borrowers continue to make payments as agreed, it would indicate strong long-term levels of net interest income.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.