Two Harbors (TWO) had a rough first quarter. Share prices plunged dramatically. Book value declined substantially. Dividends were paused. The bears were having a party. That party just got destroyed.
We're going to start talking about TWO, but these lessons apply to the whole sector.
Bears are in for punishment:
Last night (4/6/2020), Two Harbors issued another press release:
That's a big deal. Two Harbors has done a great job of providing updates to investors over the last two weeks, and this latest one is a huge hit to the bears. With recent estimates for book value running around $6.20 (a bit lower than their latest statement, which implied a value closer to $6.54, shares are already back to trading around 66% of book value. That is based on shares close today at $4.12.
We covered the argument for mortgage REIT common shares in a public article yesterday. Common shares of TWO are doing pretty well. They are up 47% today. That's pretty well, right?
The dividend was brought back on 4/06/2020.
On 4/03/2020, they provided this gem:
We placed green boxes to highlight positive statements.
Going back a little further, on 3/25/2020, they announced the sale of most non-agency assets:
Let's talk about those preferred shares.
How much of a hit did their dividends take? Well, the ex-dividend date is slightly later than in prior quarters. That doesn't seem all that terrible.
The Two Harbors' preferred shares are still trading in the general range of $17.50 to $18.50.
We've been investing in them for a while. We swapped some shares of TWO-B for shares of TWO-A a few weeks ago:
You'll notice those two orders executed in the same minute. We have a net increase in cash of $48.927. That's not much to write home about. So, why make the trade?
So, what happens when you upgrade from a 7.625% coupon rate to an 8.125% coupon rate? You get paid more. We still own preferred shares from the same REIT. So, this isn't a major change.
The market has corrected this disparity at least somewhat, with shares of TWO-A now trading around $18.29 and shares of TWO-B trading around $17.82.
We find it a bit interesting that the common shares are trading near 75% of projected book value (lower if we use the company's last update instead of our more recent projection). Preferred shares are trading around 70% of call value. Normally, we would expect the preferred shares to trade closer to call value than the common shares do to book value. We also appreciate that the preferred shares are cumulative and have already been restarted.
The spread between agency RMBS yields and hedging rates shrank. That is part of how TWO recovered some book value relative to 3/20/2020. That was around the lowest point for most book values. With spreads shrinking, the mortgage REITs have less incentive to maximize leverage. That makes restarting dividends more reasonable. By delaying their dividends slightly, TWO kept more liquidity available for managing the portfolio. That was a good decision, though it created immense amounts of panic.
No, they are not dead. Neither are most of their peers. The rumors of their demise were greatly exaggerated. Bears are getting whacked hard over the last few days. Since their lowest close of the year, on 4/3/2020 (yeah, Friday), common shares have rallied about 89%.
The preferred shares are up quite a bit as well. It would be nice if we had called them last weekend. Fortunately, we did:
We'll include the index cards for each of the preferred shares from TWO. However, we need to highlight that the projected ex-dividend dates are not yet updated for the company's new dates established last night:
TWO's announcement isn't just big for TWO, it is a sign for the sector. It reflects the first of the mortgage REITs with a dividend suspension bringing back their dividend. The common share dividend is small for now, but that's a wise choice as well. The company could use the capital they save to repurchase common shares or preferred shares. Either activity would drive book value per share higher.
There are quite a few common shares and preferred shares that are still trading at lower valuations, so investors still have a great deal of opportunity throughout the sector.
We don't expect TWO's common shares to recover to the prices they had in late February. That's fine with us. We had a bearish rating. On 2/18/2020, when shares were at $15.29, we estimated a price-to-book of 1.07. We believed that was too high. Here is the table we published:
We were right.
We weren't loving the value on TWO's preferred shares in late February either. From Preferred Shares Week 192 (subscription required), we had 3 "Overpriced" ratings and 2 "Hold" (neutral) ratings for the preferred shares:
The decision should reverberate throughout the other mortgage REITs:
|(AGNC)||American Capital Agency Corp.|
|(AI)||Arlington Asset Investment Corporation|
|(ANH)||Anworth Mortgage Asset Corporation|
|(ARR)||ARMOUR Residential REIT|
|(CHMI)||Cherry Hill Mortgage Investment|
|(CMO)||Capstead Mortgage Corporation|
|(NLY)||Annaly Capital Management|
|(ORC)||Orchid Island Capital|
|(CIM)||Chimera Investment Corporation|
|(IVR)||Invesco Mortgage Capital|
|(MITT)||AG Mortgage Investment Trust, Inc.|
|TWO||Two Harbors Investment Corp.|
|(WMC)||Western Asset Mortgage Capital Corp.|
|(NYMT)||New York Mortgage Trust|
|(NRZ)||New Residential Investment Corp.|
|(PMT)||PennyMac Mortgage Investment Trust|
About half of the mortgage REITs had either significantly reduced their common dividend or suspended it. A slightly smaller portion had suspended their preferred dividends.
Suspended common dividends: AI, ANH (pending announcement), MITT, TWO (reinstated), WMC, NYMT, IVR (retroactively), MFA (retroactively)
Reduced or paying part in stock: CHMI (at least 50% in stock), NRZ, PMT, TWO (reinstated dividend is lower)
The agency mortgage REITs without MSRs appear to be under the least pressure right now. However, we want to get a feel for the industry behind originating loans. This should give us some insight into how experts within the sector are thinking about loan origination. That's a huge part of the equation because if mortgages servicing dies, it would wreck loan origination.
We'll start with looking at a recent interview on Housingwire.com:
There is yet another expert who sees the sector getting through this turmoil. Yes, it is rough. Yes, share prices plunged. Yes, the more widely circulated stories are telling a tale of doom and gloom. However, mortgage servicing remains a critical part of the process. If the mortgage servicers go under, who will service the mortgage? That's a serious question, and it is one most people can't answer. Most of them don't understand the role of a servicer. Is it any wonder they are terrified of the sector? They saw a black box that paid dividends and had something to do with mortgages. Many of them bought the box because they liked the dividends.
When those investors heard about margin calls and dividend suspensions, they assumed the sector had died. That simply isn't the case. It is possible that some mortgage REITs might not survive. That is within the realm of possibility. On the other hand, it is extremely unlikely that all mortgage REITs would go under.
Like many other experts on the sector, we've argued in favor of a temporary pause on mark-to-market. Banks could still refuse to renew repo lines, but it would give the mortgage REITs more time to arrange asset sales if needed. Like every expert on mortgage servicing, we've argued for the government to provide a liquidity facility. We still believe that it is more likely than not that we will see some form of facility arranged. Some politicians won't want to be "bailing out the banks", but failing to act would be ignorantly crashing the entire economy.
Since so many investors are unfamiliar with the concept, we're going to provide a very brief overview. Some troll is going to cry because the overview isn't long enough. We accept that and ask them to kindly step away from the keyboard.
A mortgage servicer bills the homeowner for their payment. The payment covers principal, interest, taxes, and insurance. The servicer proceeds to forward those cash amounts to the relevant parties. The servicer is paid a moderate fee for this activity.
The difficult part is that the servicer is required to forward those payments, even if the homeowner never sent the payment. That is a source of risk for servicers, but they understand it. The servicers project potential default scenarios and keep cash on hand to deal with it.
If you've been living under a rock lately, you should probably hear about the CARES act. The act, intended to help the economy recover, was severely rushed. It contains a mix of legislation that is good and legislation that is stupid. In that manner, it is similar to most acts.
As senators rushed the bill, they allowed all borrowers on federally-backed loans to request forbearance. The forbearance is not "forgiveness". It is a pause in making payments. The senators failed to include the other part of that process, a source of liquidity for the servicers. As homeowners request forbearance (currently no evidence of hardship is required), the servicer ends up in a bad situation. The government just stepped in to say the homeowner gets forbearance, and therefore, the servicer can't foreclose for missed payments. That's an understandable response, but they are expecting the servicer to continue sending out cash.
Think about that for a bit. Would you expect Costco to continue stocking their shelves if they were prohibited from requiring customers to pay? Where would they get the cash?
Some investors think that by forcing the mortgage REIT to cover these advances, they could bankrupt the mortgage REIT. They believe that the cumulative portfolio of MSRs could end up with a negative value. Seems like a stretch. Companies have a tendency to use subsidiaries for these assets. Those subsidiaries tend to be LLC (limited-liability companies). I'm not a lawyer. I won't try to get into nuances. I'll simply suggest that one reason to have a structure of LLCs would be to protect the parent company.
For investors who want to know more about liquidity facilities, I suggest reading: A federal liquidity solution for the mortgage servicing industry.
One area we find interesting is that mortgage servicing rights may run through subsidiaries. Investors believed that requirements to pay out on mortgage servicing rights would bankrupt the company. That may not be the case when the assets are held in subsidiary LLCs. Regardless, we think things will get better rather than worse.
On the day, bears took a ferocious beating:
Source: Seeking Alpha
That's a rough wake-up call for the investors who were betting against the sector.
It's about to get even worse for those bears. The following two announcements could fuel the rally even further.
NYMT provided an update that will leave the nonbelievers quaking in fear:
If you think they aren't terrified, you might not know how to interpret that announcement. I put together a very quick spreadsheet to handle the estimates. I'm using the values from the green boxes:
Based on some quick rough math, it looks like BV per share rallied a bit since their latest update. Further, leverage is down significantly. Betting against those NYMT preferred shares? Shame on you!
Think we should've called this out before NYMT announced it? We did:
Source: The REIT Forum's Portfolio Update on 4/5/2020.
Annaly Capital Management has been silent for so long. They decided to get in on the fun with their own press release:
Note: Our book value estimates come from Scott Kennedy, who is also an analyst at The REIT Forum. He nailed these valuations yet again.
That's a tough pill for bears to swallow. Too bad. Analysis based on finding book value per share still works. It still gives us the confidence to keep buying even when the market is in a panic.
We expect to see several mortgage REITs moving to trade at higher price-to-book ratios. We also expect to see many of the preferred shares rallying significantly higher. Bears may try to dismiss this announcement as one single positive event. However, we see it marking the start of a trend. The incentive for keeping dividends suspended is dramatically reduced as spreads tighten.
Paying the preferred dividends while keeping the common dividend low is a very reasonable technique for mortgage REITs. If share prices remain low, they will have the opportunity to repurchase shares driving book value per share higher. Book value per share matters a great deal because it is one of the critical factors for determining how much a mortgage REIT can earn. With more book value per share, the mortgage REIT can either increase earnings or increase liquidity (which also boosts earnings a little).
The damage from book value lost from late February through about 3/20/2020 will still sting. It still reduces the long-term value of common shares. Surely, some bears will try to focus on that element. It will be a weak argument since we already demonstrated that we correctly had bearish ratings in place. Nonetheless, they will make it.
We'll grab some bullish ratings on TWO, NLY, and NYMT since we talked about them, and each is within our bullish range.
We will also call for a huge rally in the NYMT preferred shares. They've roughly doubled since our Portfolio Update was published over the weekend, but NYMT just threw the bears off a cliff with that update.
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Disclosure: I am/we are long IVR-C, MFA-B, TWO-D, NLY-F, NLY-I, CMO-E, AGNCO, MFO, NYMTM, ANH-C, NYMTN, TWO-B, MITT-C, MFA-C, MITT-B, NYMTO, TWO-A, EFC, CMO, NRZ. 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.