A bit more than a year ago, I went long on Two Harbors Investment Corp. (TWO) one of a group of mortgage REITs that are popular at this moment because of their high dividend yields.
As everybody needs to do periodically, it is time to evaluate the investment in light of the fact that the share price has declined about 10% since the time of my original investment. Specifically, I need to know whether the conditions that caused me to make the investment in the first place are still valid. I have collected a year's worth of dividends, so I am ahead on the deal, but there may be a chance to put that money to work elsewhere.
For the purposes of this analysis I will compare TWO with Annaly Capital Management (NLY) which is a widely held mREIT which might be considered an alternate investment. The Two Harbors 10Q is linked here, and the Annaly Capital Management 10Q is linked here.
Share Price Chart
TWO has had the slightly better time of it over the past year, and currently has a dividend yield of 15.6% vs. Annaly's 13.4%,
TWO has been the more consistent of the two for the last two years.
|Portfolio Growth (MRQ)||41.20%||5.20%|
Obviously we are talking about two completely different types of investments here. TWO is only 1/10 the size of NLY, and as a result, the task of growing 41% in the last quarter is much easier for TWO, which is one reason why "small" might very well be "better" in this industry.
NLY is the more highly leveraged, as computed by taking portfolio size divided by stockholders' equity. I have included interest rate spread and CPR (Constant Prepayment Rate) for reference but these two companies are completely different in this regard.
NLY invests only in agency-backed mortgage backed securities. The current portfolio for TWO is about 80% agency backed, and 20% non-agency backed, which is explained in detail on page 45 of the company's most recent 10Q. I did an article a few months ago on what the value of agency backing actually is, if any, for further reference.
The Non-Agency RMBS is an interesting business, and is discussed on Page 46 of the TWO 10Q. The average coupon rate of these loans is over 9%, and the average FICO score of the mortgagees is 640, so these are higher risk borrowers, paying a premium for their money. The drawback? The delinquency rate on these loans is around 40%.
We can do a grossly oversimplified calculation to see what kind of a business this is:
|Non-agency RMBS Portfolio:||$1,500,000,000|
|Theo Interest Income||$135,000,000||$52,500,000|
|heo Net Interest Income||$ 81,000,000||$52,500,000|
TWO's non-agency portfolio is actually around $1.5B. TWO would still be much better off participating in the high yield business than in the agency-backed business, with an effective zero delinquency rate, because the premium charged more than compensates for the delinquencies. This is reflected in the aggregate spread of 3.9% that they have claimed in the table on Page 34 of the quarterly report, compared with the NLY spread of 2.45%.
If you hold some mortgages in the high-yield, high delinquency space, and end up with a lot of foreclosures, you eventually have a lot of real estate on your hands. TWO has started a trial program to keep some of these properties, and rent them out. As of the most recent 10Q their portfolio of these is relatively small, at $6M but you could envision this growing into a bit of an empire if the program is successful.
All of these REITs participate in hedging, trading the securities, and participating in derivatives to either reduce risk or make some additional income. Here is a summary of these activities for TWO and NLY:
|TWO ($M)||NLY ($M)|
|Net Interest Income||74||721|
|Gain on Sale of Securities||9.9||80|
|Gain (loss) on Derivative Instruments and Other Securities (net)||-8.8|
|Unrealized Gain(Loss) on AFS Securities Net||195||-162|
|Unrealized Gain(Loss) on Derivative Instruments (net)|
|Net Unrealized Gaines (losses) on Interest Only ABS||30.8|
|Realized Gains (losses) on Interest Rate Swaps||-16.1||-219|
|Unrealized Gains (losses) on Interest Rate Swaps||341|
|Reclassification Adjustment for net gains/losses||-80|
|Effects of Hedging Program||180||-9.2|
As of the most recent quarter, TWO had an "unrealized gain on Available for Sale Securities" of $195M, which is not quite three times the company's annual interest income. The net impact of this on comprehensive income is a positive $180M. The positive contribution of the TWO hedging program gives it an advantage in borrowing costs. According to the table on Page 34, TWO had a 1.0% borrowing cost this quarter, compared with 1.52% for Annaly (page 25 of the NLY 10Q).
In previous articles we've analyzed the "discussion of quantitative and qualitative risk" that the managements of these funds use to disclose their risk reduction strategy. In this case, the actions of TWO over the past two quarters is interesting:
TWO's risk reduction strategy shifted between the third quarter of 2011 and the first quarter of 2012: The company has rotated the curve clockwise: It is hedged against an interest rate decrease, but stands to gain in the event of an interest rate increase. This is nearly the opposite of what the curve looked like in September.
Here is the graph for NLY:
NLY's management has slightly reduced the risk associated with an increase in interest rates. It is still biased toward an interest rate decrease.
The Bottom Line
Things being what they are, is there any compelling reason to unload my investment in TWO? I have to say "no." The dividend, the main driver of being in this investment in the first place, is intact. The company is engaged in an interesting business that allows it to have lower costs and higher income on its mortgage products than its competitors. TWO is hedged to benefit from an increase in interest rates, and not be hurt if they decline.
So, on the basis of all of this, I will either happily sit on this investment or increase my position because the fundamental reasons I got into it in the first place are still intact.
As we are so fond of saying, and as was so vividly demonstrated over the last few days, the world is full of chaos, and there are no guarantees on anything.