Two Harbors Investment Corp. Price & Performance (TWO)

Except as may be required by law Two does not update forward looking statements and disclaims any obligation to do so. I will now turn the call over to Bill.

Thank you, Maggie.

Good morning, everyone. Welcome to our earnings call. Before turning to our results, I'd like to take a moment to remember our Board member, Reed Sanders, who passed away this month. Reed served as a member of our Board of Directors since our company's inception in October 2009 Two. He was a trusted advisor and partner to 2 and our management team. And to me personally, and we will miss him greatly. Please turn to Slide 3. Our book value at December '31 was $14,.47 per common share, which including the common stock dividend of $0,.45 per share, represented a 0% quarterly economic return on book value. For the full year of 2024, we generated a 7% total economic return on book value. Please turn to Slide 4. Figure 1 shows the evolution of the market's expectations for the Fed's interest rate policy over the past year. While the Fed delivered two twenty five basis point cuts over the quarter, robust jobs and inflation data along with hawkish comments from Chairman Powell at the Fed's Dec. 0 meeting, tempered rate expectations for 2025. Indeed, the beginning of the the market was pricing in more than 100 basis points worth of additional Fed cuts shown by the blue line, but by the end of the quarter, the market had reconsidered only pricing in roughly 35 basis points.

As seen by the purple line. Over the quarter, the ten year treasury yield went up by 79 basis points to finish at 4.57% while the two year increased by 60 basis points to 4.24% deepening the yield curve by 19 basis points. As seen in Figure 2 Two. While short term rates may yet decline in 2025, the Fed remains very data dependent. Further, a decline in short term rates did not necessarily correlate decline in longer term treasury rates. Or mortgage rates. Rather it's our expectation that mortgage rates are likely to remain above 6% in the intermediate term. At that level, the so called lock in effect should keep housing activity muted and incidentally we'll also help prepayments [indiscernible] Which is a benefit to the value of MSR portfolios like ours. Interest rate volatility is likely to remain high for the foreseeable future with the biggest risk being that inflation reemerges the Fed pauses or reverses the rate cutting cycle. We continue to keep our interest rate exposure low believe that our MSR centric strategy will generate favorable returns independent of any short term fluctuations in Fed driven funding rates. Please turn to Slide 5. At year end, we serviced $2.12,000,000,000 dollars UPB of MSR across 861000 loans. 58,000 or 1,120,000,000,0.0 UPB of which are serviced for third party clients.

Looking back, 2024 concludes our first full year owning and operating mortgage company. I'm pleased to say that the integration of Roundpoint into Two is largely gone according to the plan that we laid out. In particular, we are already reaping the improved economics that we estimated due to lower costs and servicing the loans from our own MSR portfolio. Specifically, have benefited from increased economies of scale and additional cash flows from the SERVE [indiscernible] Had previously benefited our sub servicers and not us. In 2024, we also launched a direct Two consumer origination platform with the intent of maintaining our current servicing portfolio through recapture of the underlying mortgage loans, the borrower refinances or moves into a new loan product. We think of this effort primarily as being a hedge to our MSR portfolio, serves to protect our assets from faster than expected prepayment speeds should interest rates drop precipitously. Taken altogether, the value of Two MSR portfolio benefits from the success of servicing which directly affects the success of originations, which circles back to a positive value contribution to the MSR portfolio. With a weighted average note rate of 3.46% in our MSR portfolio, and mortgage rates currently around 7%, roughly only 0.2% of our customers would benefit from a rate and term refinance.

With that as background, we funded $42,000,000 UPB of first mortgages in the quarter. There's approximately another $21,000,000 UPB currently in the pipeline. We recognize that these are small numbers, but we are very pleased with the proof of concepts and progress thus far. In less than one year, we stood up a brand new platform entirely from scratch with no legacy risks and for a de minimis cost. The challenge and opportunity in 2025 Two. Is to bring this platform fully to scale. Despite the small number of refinanceable loans in our portfolio, we are utilizing the platform to bring incremental revenue and returns to our shareholders. With mortgage rates north of 7%, of our customers are looking for ways to extract equity not giving up their ultra low mortgage rates. And so in the latter half of the year, we began to offer second lien loans to our borrowers. In the quarter, we acted as a broker on $33,000,000 UPB in a combination of both open ended and closed end loans. We intend to expand this effort which will likely include originating the loans in our own name. With mortgage rates expected to remain above 6% in 2025, our focus at Roundpoint is on generating additional cost efficiencies in servicing, especially through the use of technology and AI applications.

From a customer experience perspective, are dedicated to creating a strong platform and brand for our customers. To turn to for all their mortgage and home equity needs. Our results in 2024 demonstrated the benefits of our portfolio its core focus on hedged MSR. With roughly 2 thirds of our capital allocated to MSR that is almost 400 basis points out of the money, that asset should generate relatively stable cash flows going forward. Regardless of the path of short term interest rates. RMBS spreads remain wide on a nominal basis reflective of continued elevated levels of implied interest rate volatility. While 2024 saw RMBS spreads meaningfully tighten, the outlook for RMBS in 2025 is still attractive. But the risks are more balanced. The efforts we have made and continue to make regarding process improvements and product offerings at Roundpoint allow us to shape our return profile in a way that owning only a portfolio of securities cannot. We're very proud of what we have accomplished in the past year I'm tremendously excited about where we are going. With that, I'd like to hand the call over to William discuss our financial results. Thank you, Bill. Please turn to Two 6.

Our book value was $14,.47 per share at December '31, compared to $14,.93 on September '30, Including the $0,.45 common stock dividend, this resulted in a flat quarterly economic return as Bill has already mentioned. For the year, we generated an economic return of 7%. Please turn to Two 7. The company incurred a comprehensive loss of $160,000,0.0 or $0,.03 per weighted average common share, in the Net interest expense of $35,000,000 was lower in the by $740,000,0.0 due to lower RMBS borrowing balances as a result of sales of RMBS, Additionally, we shifted a portion of our MSR financing from credit facilities to VFN repurchase agreements.

Which on average carry lower floating rate spreads. This was slightly offset by higher overall average MSR borrowing Net servicing income was $168,000,000 minus $5,000,000 of non operating MSR related servicing costs. This is now slightly from the due to lower float income result from lower average outstanding balances and lower rates earned on the balances given the decline in short term rates. The lower float was offset partially by higher servicing fee collections and higher sub servicing related income earned. As expected, due to higher yields, investment securities gains and changes in OCI swung from a gain of $2.70,000,000 dollars in the to a loss of $2.67,000,000 dollars in the Additionally, net swap and other derivative gains in our RMBS hedge portfolio were $145,000,000 in the compared to losses of $2.00 $5,000,000 in the resulting from market movements in swaps and futures offset by market movement in TBAs and slightly lower swap interest spread income. The servicing assets showed a gain of $8,250,000,0.0 in the after a loss of $13,340,000,0.0 in the Higher rates lower projected prepayments resulted in a positive $13,940,000,0.0 change in the valuation of MSR. As opposed to a negative $9,380,000,0.0 change in the to $57,000,000 from $2,000,000 in the The decline in runoff was a result of lower UPB, due to the sale of MSR in the as well as a decline in realized prepayment rates.

It is important to look at changes in values for the assets and the hedges together. Rather than in isolation.

In that change, in the sum of investment securities gain and changes in OCI net swap and other derivative gains, as the servicing asset gains shows a loss of $4,750,000,0.0 in the compared to a loss of $6,730,000,0.0 in the Please turn to Slide 8. Our MBS funding markets remained stable and available throughout the quarter. With spreads for repurchase agreements at so far plus 35 basis points. Concerns about anticipated year end funding pressures, and uncertainty around Fed actions anticipated and rates have reverted back to more normal ranges around SOFR plus 15 to 20 basis points. In retrospect, U. S. Was uneventful of the funding markets and early indications in 2025 are that spreads are normalizing into a tighter historical context. At quarter end, our weighted average days to maturity for our agency RMBS repo was forty nine days compared to seventy eight days at the Our days to maturity are typically lower at December '31 as we intentionally roll repos of the 5 lenders with $180,000,000,0.0 of outstanding borrowings on the bilateral facilities. We ended the quarter with a total of $8.65,000,000 dollars in unused MSR asset financing capacity and $60,000,000 in unused capacity for servicing at FASA.

I will now turn the call over to Nick Two. Thank you, William. Before I launch into the slides and provide more detail, let's talk a little bit about the performance at a high level. This was an interesting quarter, particularly for mortgage performance, as mortgage spreads didn't exactly follow usual playbook.

In total, we started the quarter with less mortgage spread risk than any recent quarter, with most of our exposure in 5.5% and up. As rates rose and spreads widened, we let our spread exposure increase, which contributed positively to our performance. Our MSR was aided by slower than expected prepayment speeds, though the quick rise in rates in Oct. 0, which triggered a fair amount of re hedging. Impacted our MSR performance. As we discussed in last quarter's earnings call, the risk of our MSR varies as rates move both in terms of duration and coupon As rates increase, the duration exposure declines and shifts into higher coupons. In practice, that means having to sell some of our RMBS at lower prices, due to higher rates and in a month like Oct. 0 at wider spreads. Higher rates have typically spelled trouble for mortgage performance. And it did again in Oct. 0 as interest rates increased involved which negatively affected many mortgage REIT book values. However, in Nov. 0, following the decisive election results, investors aggressively returned to the market leading to a recovery in spreads that would not have been predicted based on the move in rates.

Over that two month time period, the ten year treasury yield increased by 39 basis points.

And the slope of the two year Two year treasury curve flattened by 12 basis points. Yet the index turned in a net positive excess return of plus 5 basis points.

Though hawkish comments from the Fed in Dec. 0 drove rates higher yet again, and pushed the quarterly index excess return to minus 11 basis points. The muted reaction of mortgage spreads compared to prior periods was notable. Of course, the index is heavily weighted to lower coupons. And performance across the stack varied widely. Higher coupons, especially in pool form, outperformed turning in a positive hedge return performance. Jumping into the deck, please turn to Slide 9. Our portfolio at December '31 was 1,480,000,000,0.0 including $1,040,000,000,0.0 in settled positions and $440,000,000,0.0 in TBAs.

Our economic debt to equity decreased slightly to 6.5 times Though as you can see in Figure 3, our mortgage spread exposure increased into a more normal range as spreads became more attractive in the quarter. As we have said in the past, leverage exposure is but 1 of many risks we manage. And it can't be taken by itself to assess our overall risk. We continue to manage our exposure to rates across the curve closely. You can see more detail on our risk exposures on appendix slide 17. Please turn to slide 10. As you can see in Figure 1, our preferred implied volatility gauge two year options on tenure rates, increased from 94 to 101 basis points on an annualized basis right in the middle of its range for 2024. Implied volatility and nominal spreads remained higher than longer term averages while option adjusted spreads are close to longer term averages. The level of mortgage spread volatility has materially declined from earlier parts of this The nominal spread on TBA current coupon finished 11 basis points wider at 117 basis points of the treasury curve. While the option adjusted spread finished 6 basis points wider at plus 23.

Note that some of the spread widening reflects the shift from about a 5% current coupon at the start of the quarter to something in between 5.56% by quarter end. As you can see in Figure 2 Two, the nominal spread curve steepened with peak spreads around the 6% coupon at quarter end.

The OAS curve flattened with higher coupons picking up spread as prepayment risk diminished.

Please turn to Slide 11 to review our Agency RMBS portfolio.

Figure 1 shows the performance of TBAs compared to the specified pools we own throughout Two [indiscernible] As I mentioned earlier, given that the interest rate curve bear steepened and implied volatility ticked up, lower coupons underperformed higher coupons. Higher coupon specified pools were the best performer. As you can see in Figure 1, outperforming TBAs by at least a quarter point and rate hedges by about a half point. In terms of activity, we shifted TBA exposure up in coupon and replaced some specified pools with TBAs.

We also bought some higher coupon pools to improve carry as dollar rolls weaken. Incorporating the effect that our MSR has on our net notional mortgage our position increased by about $150,000,000,0.0 over the quarter. Though primary mortgage rates increased by about 75 basis points [indiscernible] Overall prepayment rates for thirty year agency RMBS rose by 0.4 percentage to 6.9% CPR as higher coupon speeds reflected the lagged effect of the refi wave triggered by the fall in rates in Borrowers with the refinance incentive responded to the lower rates in Sept. 0, with a propensity similar to borrower behavior in 2019.

Figure 2 on the bottom right shows our specified pool prepayments speeds by coupon.

On aggregate, speeds increased to 8.1% from 7.6% in the led by an increase in speeds from 5.5, six and six point five.

Please turn to Slide 12 Two we discuss the market for investing in [indiscernible] The MSR market remains stable and well supported with bulk deals consistently receiving double digit competitive bids Some large scale bids and acquisitions in lifted 2024 transfers to $6.62,000,000,000 UPB approximately the same amount in 2023, So the number of bulk bid opportunities dropped by about 25% year over year as you see on Figure 1. While demand for MSR continues to be strong, from both bank and non bank portfolios, we expect there to be ample opportunities in 2025 to add MSR at attractive spread. Please turn to Slide 13, where we will discuss our MSR portfolio. Figure 1 is an overview of our portfolio at quarter end the details of which can be found on Appendix Slide 23. The portfolio was $2.00 $2,000,000,000 UPD at December '31, reflecting the settlement of $250,000,000,0.0 UPB through bulk and flow channels, and portfolio recapture. With mortgage rates increasing in the quarter, the price multiple of our MSR increased slightly to 5.9 times from 5.6 times, and 60 plus day delinquencies remained low at under 1%. Our MSR portfolio with a low gross mortgage rate of 3.46% experienced a 4.9% CPR in down 0.4 percentage points compared to as slower seasonal factors kicked in.

In order to facilitate comparison of our MSR prepayment with a larger universe, we map our portfolio into cohorts by mortgage rate, so that they resemble RMBS. Figure 2 compares CPRs across those implied security coupons in our portfolio of MSR versus TBAs. You can see that prepays remain low and steady for the majority of our portfolio with 5.5% and above slightly increasing.

Finally, please turn to Slide 14, our return potential outlook slide.

The top half of this table is meant to show what returns we believe are available on the assets in our portfolio.

We estimate that about 61% of our capital is allocated to Two. With a static return projection of 11% to 14%.

The remaining capital is allocated to securities with a static return With our portfolio allocation shown in the top half of the table, and after expenses, the static return estimate for our portfolio is between 9.8% to 12.1% before applying any capital structure leverage to the portfolio. After giving effect to our outstanding convertible notes and preferred stock, we believe that the potential static return on common equity falls in the range of 10.8% to 14.4% or a prospective quarterly static return per share of $0,.39 to $0,.52 We like that our current capital allocation is focused on MSR, and believe it will result in strong returns for our stockholders. Flow prepayments are a positive tailwind for our servicing portfolio. But even if prepayments pick up, we believe that the significant progress we have made at Roundpoint on our direct to consumer origination platform will serve as a hedge to our MSR portfolio. Additionally, our focus on generating additional cost efficiencies and servicing especially through technology and process improvements at Roundpoint, will contribute positively to the value of MSR.

We continue to actively manage our RMBS position [indiscernible] and aim to extract additional returns from historically wide nominal current coupon spreads. We believe that our unique hedged MSR centric strategy will continue to generate attractive levered returns in 2025 and beyond. Thank you very much for joining us today. And now we will be happy to take any questions. You might have.

We will take our first question from Doug Harter with UBS. Thanks and good morning. It's Marissa Lobo on for Doug.

I was hoping you could give us an update on how book has performed so far in the quarter?

Yes. Good morning, Marissa. Thanks for the question.

It's been a reasonably quiet quarter, although I'll stress that it's early in the quarter. It's only been 1 of course. But, our total return is estimated to be up between about 1.5% and 2% as of last night.

Got it. Thank you. And second, how does the lower leverage level impact your view on earnings power? And what was the normalized range for earnings be? Thank you for the question. This is Nick.

As I mentioned in my prepared remarks, the overall debt to economic ratio is really but 1 measure that we look at in terms of our return potential and our earnings power. And as you can see, our from our return potential slide that overall, we Two central tendency of our returns and the range of our returns is still supportive of our dividend and very much in the range of what it was in prior quarters.

So [indiscernible] The leverage itself is it determines some of the components of our of the debt to equity. But if you look at other components of our risks such as our the amount of mortgage spread risk we have, as a again, as I said in my prepared remarks, quarter over quarter that increased into a more normal range. And that was really that's really reflective of where how we feel about spreads. And how they look right now. And beyond that, the overall mix of our assets of having over 60% of our of our capital in MSR is very supportive of stable and in our opinion predictable returns for future periods. 1 thing I might add, Marissa, also is is that the way that we hedge your MSR and we're hedging the current coupon risk. But as rates rise, we need less MBS to hedge the current coupon risk of the portfolio. Right? And as rates go down, we need more And so that has a direct impact in when we're keeping everything unchanged, our risk unchanged as rates move has an impact on the overall leverage, which is why Nick stresses that the leverage is just 1 component of of the risk that we manage and measure.

Thanks for that. And finally, does this your earnings power outlook, does that reflect the cost of volatility? No, as it says, those are static spreads. [indiscernible] Thank you. That's it for me.

Thank you.

We will take our next question from Mikhail Goberman with Citizens JMP.

Hey, good morning, guys. Could you maybe expand a bit on your outlook for agency MBS spreads for this year? And also, how do you guys see the allocation to MSL MSRs versus MBS evolving throughout the year? Thank you.

Hey, Mikael, thanks for the question. What I would say is the we have seen and we've made note of it and about that there has been a much more controlled response of mortgage spreads I would say really notably since Nov. 0 when we got through the presidential election and slightly before that when we when the Fed first cut. And I think that that's really a reflection of the fact that there is a more predictable fed path than there had than there was in the earlier parts of the cycle. I still think this is still a very data dependent Fed. It's still quarter to quarter. There's a lot of other things that are being factored into the risk equation out there in the world. But the overall amount of spread risk has declined and there are there are good reasons to be positive about mortgages mortgage spread this year. I mean, net supply and supply demand seems to be pretty much imbalanced. We have something like a net net amount of supply in the low $200,000,000,000 which has been reasonably absorbed by the market. There's been better uptake by banks and I think the general consensus is there's the uptick by banks has has been more than what the market was generally assuming kind of a consistent amount of demand from money managers and flows Two funds that buy mortgages.

Two RVO mortgages looks quite good relative to other spread assets in the world. Funding rates, they were they they spiked a little bit towards the end of last year, but now they've come right back Two the zone they've been in, which is good. Of course, if the Fed does cut more this year, the steeper yield curve is usually usually constructive for mortgage spreads because it encourages it encourages Two, mostly banks Two go further out on the curve and buy mortgages. So all of those things are good points. So our overall feeling is and we're keeping it down the fairway here is that mortgages should be should continue to be constructive for us from a return perspective And where spreads are right now, we don't really need spreads. We say this in our recorder, but it's true. We really don't need really do not need spreads to tighten to get performance. I think what the part of it that can be that is difficult is when you have a tremendous amount of volatility and that really has kind of down So overall, I'd say we are positive on mortgage spreads, but as we know from the volatility that this market has given us that there is that there's always something that can change that.

However, 1 of the key parts of our strategy, which we can't really overemphasize is the core of our MSR MSR. That really does provide a lot of stability Two our our return profile. And if you look at our many quarters. You can see we've had a lot of stability of book value and good economic returns and we think that will bode us well for the [indiscernible] Great. So given that, I'm guessing that the MSR allocation versus MBS is kind of going to be steady as she goes similar to what it's been in the recent Two Correct. Sorry, I didn't mean to not answer that question. Yes, we do we don't expect to see a material change in our MSR allocation. We're always looking at the very at the asset allocation that we can Two move asset allocation as we get cash flows to invest or new capital. But we don't see a material change in our in the allocation to our MSR.

Great. Thank you. And if I can squeeze in 1 more. Any thoughts on potential GSE reform in the nomination of this new FHFA person?

Thanks. Hi, this is William.

I don't think we have more information than what the market has regarding GSE reform, but I think we can break the the GSE reform question into 2 questions actually. What is the status of privatization? And what is the status of the guarantee? And the guarantee itself breaks into 2 sub questions. What is going to happen to existing securities that have the guarantee and what is going to happen to [indiscernible] that will whether they will carry the guarantee or not. Once we have more detail about the about potential plans, we can look at the implications through the lens of those 2 questions. We really don't have any more information at current about don't want to speculate about what's going on.

Got you. Well, thank you very much and best of luck going forward. Thanks very much, Mikhail. Thank you.

We will take our next question from Bas George George with KBW. [indiscernible] Morning. This is actually Frank Gilobetti on for Bose. Just to start, can you discuss the main difference [indiscernible] the EAD and the static return range you provide on Slide 14?

Sure.

Thank you, Frank, for the question.

I'll get started. [indiscernible] return potential that we show on on Slide 14 is our is our actual portfolio at quarter end. It is projected out it uses it is a mark to market It's a mark to market basis where everything in the portfolio is marked contemporaneously at that date and valued at that date. So in our our opinion, I mean, it's a good assessment of where the return potential of the static yields are to the forward curve when you take ARC our entire portfolio marked on the same day. And generate a yield or a return potential. EAD is is the word that we use, the up about it is that it's asynchronous. So that the EAD is something where if you have assets that are like many of our mortgage pools we bought long ago, and the EAD reflects the purchase price or the the return at that time, whereas other components of our of our overall business structure such as our our funding, our repo or more contemporaneous So that you can have a real difference in timing between those things and it can create distortions to what how we see the portfolio The way I'd like to think about it Bose is that is that if you were to buy and sell the portfolio every day, you would the EAD would look something more like what we have on Slide 14.

Great. That's very helpful.

And then just stay on that slide.

The return of your MSR fell to like 11% to 14% from 12% to 16% last quarter?

Given the higher rate environment, is a driver of the lower returns, the increase in the mark to Two on MSRs this quarter?

It's a very good question. And it's a it's a combination of things. The biggest thing that it is, is that and this is again, this is a slice and time It is 1 day and we manage our portfolio through time. But a component of the return of our MSR portfolio is its hedge in that hedge is our RMBS securities or current coupon securities typically. Which add to which also add to the return of the strategy, right? It's It's a paired strategy of MSR plus MBS and the MBS add return when rates go up as I mentioned in my comments the amount of of MBS that we need to hedge that MSR declines. So overall, if you think about it that way, Two leverage of that part of the portfolio goes down, right? There's less there are less securities that are attached to the MSR. Consequently, the return potential will all else being equal will tend to go down as that hedge as that hedge becomes a smaller part of the overall pair.

Great. You very much. Appreciate it.

Thank you.

We will take our next question from Eric Heik with BTIG.

Good morning. This is Jake Katzicus on for Eric.

Thanks for taking my questions. Are you guys seeing any new financing counterparties or sources of leverage to support the MSR portfolio?

Go ahead, [indiscernible] there are some new entrants that are trying to gain traction in the market. We've seen a few requests inbound calls for people who want to expand into MSR financing.

Yes. In general, I would just add to what William just said there. I think that continues to grow and expand. As William said, there's more counterparties entering the market all the time. And so it's a very healthy healthy market for that product right now. Great. Thank you. And then can you also just share how much the cost have changed in response to the first 100 bps of rate cuts that we've seen? Which costs are you thinking specifically? The in the MSR portfolio.

Are you talking about our financing costs? And yes, I can just back it up to maybe just kind of costs in general, how they've shaped in response to the 100 bps of cuts that we saw?

Right.

So Two things like that. So our financing costs on the MSR assets our floating rates and our index to short term funding rates so far right? So as the Fed has cut our funding costs have gone down right? Just like they have on the RMBS side of the portfolio. Right? Lower sulfur rates also impact the float income that we have in our portfolio that we have generated by the MSR asset as well, which offsets some of that. In general, I would say that we hedge the entire yield curve right? And so changes in rates in 1 part of the curve or another generally have a very small effect.

On our portfolio.

I'm not fully understanding what you're getting at, so maybe we can follow-up more fully later. But I hope that I hope that answers some of your question. Yes, it does, definitely. Thank you guys very much.

Okay.

We do not have any further questions. I would like to turn the call back to Bill Greenberg for closing remarks.

Two hours Two.

This concludes today's call. Thank you for your participation. You may now disconnect.