After reading the new article on the Annaly Capital (NLY) dividend by Regarded Solutions, I started to think about how the mortgage REITs are earnings their dividends in the current low interest rate environment. My own recent article on Annaly dissected the company cash flow, showing that 88% of the dividend payout came from net interest earnings after expenses and the balance was from profits on the sale of mortgage securities. So I started to dig into the most recent income statements of the mortgage REITS to see where the dividend cash was coming from.
Some companies make it easy. American Capital Agency (AGNC) very plainly stated that in the second quarter the company generated net interest income after expenses of 94 cents per share. Since the dividend paid was $1.25, AGNC earned 75% of its dividend in the form of interest on its portfolio. Then, moving down the mREIT list in order of descending market cap, I came to Two Harbors Investment (TWO). My quest to do a comprehensive list of mREIT payouts came to an end as I attempted to figure out the Two Harbors income statement. I decided it would be better to hash out the numbers here and get some discussion feedback.
The Confusing - to me - Financials
I will start with the easy number. For the second quarter, Two Harbors paid a 40 cent dividend. The earnings report listed 214.8 million shares outstanding, so total distributions were $85.9 million.
Now on to the different ways Two Harbors reported income:
- The company reported $90.4 million in net interest income. Posted 66.7 million of adjustments - primarily rate swap and swaption losses - and $11.8 million of operating expenses against the interest income for an income before taxes of $7.4 million. On the subject of taxes, the income statement shows a $16.6 million benefit, bringing net income up to an even $24 million. So on the interest earnings side, Two Harbors was a little short of covering the dividend!
- Next on the income statement, $117.6 million of unrealized gains on securities-available-for-sale and BAM!, the "comprehensive" for the quarter is $141.6 million. That's better!
- Finally, Two Harbors reports what it calls "Core Earnings". This calculation starts with the $24 million of net income and adds and subtracts the realized and unrealized gains and losses from the different parts of the company's business. The biggest chunk is the addition of $$36.3 million for "Unrealized loss, net of tax, on interest rate swap and swaptions economically hedging repurchase agreements and available-for-sale securities" This number appears to match the unrealized gains against the costs of interest rate hedges. Makes sense and brings the core earnings total to $76.1 million - just $10 million short of covering the dividend.
What This All Means
By aggressively issuing equity to fund the purchase of more mortgage securities, Two Harbors has tripled the number of outstanding shares in the last year. It is understandable that cash flow has not quite kept up with the dividend payments as the new money has been put to work. My biggest question concerns the fact that at most 50% of the distributions come from net gains on investment positions and one could argue that the bulk of the dividend was from unrealized gains in the portfolio. What happens if MBS prices stop rising and flatten or decline?
18% of the Two Harbors MBS portfolio is non-agency securities and the unrealized gains may be coming from this portion of the holdings. It is hard to get a read on the gains expectations since Two Harbors keeps growing so rapidly. Nationally, mortgage rates have stabilized in the third quarter, even ticking up a little. It will be very interesting to go over the Two Harbors income statements when the third quarter results are released.