Assessing Survival Potential: Two Harbors Investment Corp.
- Most mortgage REITs are 50-100% off their March lows yet remain far below book value.
- The Federal Reserve's direct support of the Agency MBS market eases much of the current '2008-repeat' concerns.
- Two Harbors has very high exposure to agency MBS securities that have appreciated in value YTD.
- The mREIT is currently trading at a third of its book value and at a TTM dividend yield over 20%, creating a strong long-term deep value opportunity.
- While the long-term potential for many mREITs appears strong, another wave of volatility seems likely.
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[Editor's note 5/11/2020: The author has added clarifications regarding the company's book value.]
Without a doubt, this year has been the most volatile year for mortgage REITs since the last recession. During the March crash, most mREITs lost (for a moment) 70% of their value in a matter of weeks. Since then, most are up 50-100% from their lows.
While many investors fear mREITs due to their abysmal performance in the last recession, they are one of the primary benefactors of the Federal Reserve QE policy. More on this in "Assessing Survival Potential: Exantas Capital Corp. Likely To Indirectly Gain From Liquidity Injections" which covered Exantas (XAN). Even more, most pay 20%+ dividend yields today and are trading far below book value, providing extreme value opportunity to investors.
The Value Of Agency MBS mREITs
The risks in mREITs are real. Most have total liabilities to assets of 70-90% meaning it would not take a significant rise in defaults to bankrupt the companies. Given COVID-19 has forced many businesses to close, it is likely there will at least be a significant rise in commercial mortgage defaults. That said, many hold residential MBS assets that are secured by a federal agency which drastically limits their risk. In my opinion, mREITs with high exposure to these protected assets are the best deep-value opportunity today.
During the March crash, liquidity fled financial markets, and fear poured in. This caused a rapid selloff in the agency MBS market that caused companies like Exantas to see margin calls. To illustrate, take a look at the performance of agency MBS ETF (MBB) vs. the mREIT ETF (REM) during and after the crash:
As you can see, the drop in MBB in March occurred while REM fell 50%. Mortgage REITs that own agency MBS securities tend to have higher leverage so a 5-10% drop could jeopardize their equity value. However, as expected, the Federal Reserve stepped in and has been purchasing MBS securities at an extremely rapid pace. This has actually pushed most of these assets to all-time-highs.
The Federal Reserve does not want to see mortgage rates rise back to 4-5% as that would depress home sales. In fact, Jerome Powell has stated that there is no limit to the amount of money it will create to protect the agency MBS market.
Now, a rise in the value of agency MBS is a double-edged sword for mREITs. On one hand, it suppresses mortgage rates which lowers cash flows. On the other, it increases the book value and financial wherewithal of mREITs. Additionally, many mREITs borrow at floating rates so the recent decrease in the discount rate to zero will offset declines in future cash flow.
A Closer Look At Two Harbors
Two Harbors Investment Corp. (NYSE:TWO) is an mREIT that is heavily invested in guaranteed RMBS securities. Its book value is likely to increase due to the Federal Reserve's purchasing of MBS securities. As long as the Federal Reserve acts to back the U.S mortgage market, Two Harbors' balance sheet risk is low as the value of its assets are protected.
As of December 31st, 2019, Two Harbors owned $27.7B in Agency MBS securities and $3.6B in non-agency securities. The company also owned $1.9B in mortgage servicing rights. This put 83% of its portfolio in Agency MBS assets.
The vast majority of its non-agency securities were purchased in distress at heavily discounted prices. These assets carry significantly higher risks than Agency MBS, but with significantly greater potential upside. The company also has increased its exposure to mortgage servicing rights which may add another future cash flow stream. Unlike others, these assets typically benefit from a rise in interest rates since they limit prepayment risk. Since rates have declined, it may seem like losses on this smaller section of its portfolio.
Fortunately, Two Harbors uses derivatives in order to limit its overall exposure to interest rates. According to its interest rate sensitivity table on its 10-K, a 50 bps drop in interest rates is only expected to cause its net interest income to decline 3% and its assets 10 bps. A rise in rates would have an equally positive impact on income, and a marginally worse impact on its asset value at 30 bps. That said, changes in interest are of overall negligible risk to TWO Harbors; credit risk is what matters.
Without a doubt, credit risk is of greater importance today. Its non-agency securities had high credit risk and it is likely those in default will remain so. That said, due to the Federal Reserve's support and Agency guarantees, the credit risk of its agency MBS securities is negligible. Fannie (OTCQB:FNMA) and Freddie (OTCQB:FMCC) remain under conservatorship, so they are essentially guaranteed by the U.S government.
Overall, TWO's portfolio risk is lower than that of most other mREITs, but it does carry higher leverage with total liabilities to assets of 86%. The company also has about a billion in preferred stock, so its $4B book value is only 11.5% of its assets. That said, its market capitalization is only $1.2B and it pays a 26% TTM dividend yield. See below:
Of course, its current book value is unclear. It was $4B before the crash and had declined 55% during the sell-off off RMBS. However, since then most RMBS securities have fully recovered and even made new all-time highs (see (MBB)). Thus, its book value today is likely must closer to the pre-crash figure.
The Bottom Line
Clearly, the market is discounting Two Harbors' risk with the company trading far below its book value and with a high dividend yield. Personally, I believe the company is a solid value opportunity due to the Federal Reserve's support of the mortgage-backed security market. I generally do not believe in a "Powell Put," outside of a few industries that were hit the hardest in 2008.
That said, I am officially neutral on TWO. While I believe it is undervalued, it seems that markets as a whole are not appropriately discounting COVID-19's longer-lasting risks. This means another wave of volatility is possible and it is likely TWO and even perhaps its MBS assets could decline again with it. In other words, I'm short-run cautious but long-run bullish.
In the long run, I believe the company will rise back to near past levels which is likely 10-30% below its pre-crash book value. Again, given the rapid return of RMBS securities, this is likely closer to its book value today. This corresponds to a share price of around $11.
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