Two Harbors Investment Corp. (NYSE:TWO) Barclays 2020 Global Financial Services Conference September 14, 2020 8:15 AM ET
Company Participants
Bill Greenberg – President & Chief Executive Officer
Matt Koeppen – Chief Investment Officer
Conference Call Participants
Mark DeVries – Barclays Capital
Mark DeVries
Okay, good morning and thank you for joining us to help kick off the 18th Annual Barclays Global Financial Services Conference. I am Barclays Consumer Finance Analyst, Mark DeVries and I’m pleased to be joined by Two Harbors CEO, Bill Greenberg and CIO Matt Koeppen. We will be conducting a fireside chat, but we’ll break it up with some polling of the audience and we will also leave time for any questions that come in from the audience during this session.
If you’d like to ask a question you should have an option to enter it on the upper left hand side of your screen or you can try to email it directly to me and we’ll do our best to address your questions in the time we have today.
Before my first for management, I’d like to lead off with a question for the audience. To participate, please click through to the poles on the left hand side of your screen. After you respond you should be able to toggle back to the video of the discussion.
Turning to the first question for the audience, what do you view as the biggest driver of total returns for Two Harbors over the next year, higher leverage, lower funding costs, lower spread volatility, stable interest rate environment, or other?
So as you respond we’re going to move to some questions. First question for management, can you provide an update on book value quarter-to-date if there are any worth mentioning?
Matt Koeppen
Yes, I’ll take that one, good morning and thank you for hosting. We are estimating a total return of about up 2% for the quarter through the end of August. So far it hasn’t been a particularly volatile period with the summer months and mortgage spreads have generally been on slow grind [ph] tighter.
Mark DeVries
Okay great. Can you talk through how you think about the dividend level in this environment?
Bill Greenberg
Yes, I’ll take that one and again thanks for having us very much Mark, it’s a pleasure to be here. The way we do think about it in this environment isn’t particularly different from the way we think about it in any other environment. We always sit down and try to align our dividend with the earnings, with the economic earnings power of the portfolio.
And we try to set a dividend with more than one quarter in mind and its potential sustainability going forward. Due to the COVID virus this year we gave a little bit more guidance on a forward-looking basis than we have in the past indicating that we think $0.14 dividend is achievable here and that’s still true. One thing I would note is that for the remainder of 2020 we do expect our dividends to be characterized as a return of capital based on the activity that occurred during the first and the second quarters.
Mark DeVries
Okay great. Moving to the next question for the audience if you could, but what is the biggest risk to the shares that you see as investors, low asset yields, rising funding costs, spread volatility, or interest rate volatility? Please register your answers if you can. Moving back to questions for management, can you provide an update on forbearance and delinquencies in your portfolio? How has your liquidity position changed quarter-to-date and what level of defaults could you support with the current capital?
Bill Greenberg
Sure, I’ll take that. I think one of the biggest surprises and in 2020 in our portfolio and may be in many others has been the level of forbearance and delinquencies for these assets. As of the end of August, in our servicing portfolio of $16 billion or so, we were experiencing at the end of August we had 5.1% of our portfolio was in active forbearance, but of those 27% had made their August payments. So that’s a net rates, those are both in forbearance and delinquent of about 3.7% and we’ve seen the gross forbearance rate decline even further I mean the last, even though it is summer going from 5.1% down to 4.8%.
So we feel very good about what that means for our liquidity for our advancing obligations they are very manageable. We are working on some facilities as we’ve talked about in the past. We have as we’ll talk about in a little bit I think we have increased risk a little bit, so that’s drawn a little bit into our excess capital, but overall we still think these numbers are very, very manageable and we are very confident with our liquidity position.
Mark DeVries
Okay, and could you remind us how high you think those delinquency rates will go and still be manageable?
Bill Greenberg
Well, so number one, that’s initial question, we have many factors that could go into that, whether there is a second wave, whether some of the things that we saw with like the PPP expiring in July, whether that puts additional stress on borrowers. So it’s hard to say how high it could go. We feel that we’re very well protected and very well able to manage if those numbers were to quadruple, that seems like a very unlikely scenario.
When we started this thing in March and April people were talking about scenarios that could have been 30% or 40% delinquent and obviously it is a 10th of that. So our philosophy has always been to hope for the best and prepare for the worst. We have scaled down our expeditions a little bit from what they were at the beginning, but we still feel confident that we could handle many multiples of where we are.
Mark DeVries
Okay, great. Do you have an update you can provide on the service advance [ph] facilities that you mentioned in the 2Q earnings call?
Matt Koeppen
I’ll take that one. We have actually made good credits on that front and while it’s not close we expect to close our first sourcing advance facility this month. It does take a high degree of customization, so it does take some time. For example the — any facility needs to have connectivity built specifically to a specific subsourcer [ph], but everything has been moving according to plan and as Bill was just describing our forbearance experience has been pretty favorable, so the timing for all this is working out just fine. It will be up and running in plenty of time for any advances to fall through for us.
Mark DeVries
Okay, got it. Moving to another audience question, what do you think is Two Harbors best use of capital at this time, main dry powder, invest into agent CMBS, invest in the MSRs, increase the dividend, buyback stock or other? Turning back to management, what’s your current outlook for returns on agency mortgages in this environment?
Matt Koeppen
Sure, we see agency mortgages hedged with swaps generally to be I would call it in the high single digit area, maybe into the double-digits given the spread tightening that we’ve seen in the last couple of quarters. We do still see industry mortgages paired with servicing to be in this sort of low mid double-digit gross return area which we still see is attractive and as I know we sort of indicated after the second quarter expect it to be adding some risks in the RMBS market and we did, we have managed to add about $3 billion in compound mortgages this quarter so far.
Mark DeVries
Okay, what coupons do you currently find attractive for your agent CMBS and when you are looking at a particular spec pools to help manage prepays in his low rate environment?
Matt Koeppen
Sure, we still continue to like the Fed’s targeted coupons in the current compound part of things. So that ends up being 30-year TBA 2 and 2.5 coupons. The continued spend purchases they’ve been buying call it a third of the new production which is, you know production has been high but the take outs have been very high too. That’s led to an attractive dynamic where those coupons are supported in spread terms and there is also a significant role advantage in funding insurance specified pools. I think you’re aware that not all of our specified pools are our high-quality call protected stories. So in the higher coupon part of this sector we do still continue to favor specified pools.
Mark DeVries
Got it. How are you thinking about leverage there?
Bill Greenberg
So, I’ll take that one Mark. For us leverage means a little bit something different than it does for many people, mostly due to the presence of MSR in our portfolio right? So we like to think more in terms of what we call a drawdown risk measure. I like to say that when people ask about leverage what they are really asking about is how much money can we lose due to spread movements, right?
And because of the presence of MSR in our portfolio and when mortgages widen or tighten there is a corresponding offsetting impact in the MSR performance. We are able to run a higher leverage with lower spread risk, mortgage spread risk than a portfolio that does not contain MSR. And so that’s the way we look at it.
We focus more on risk than on a nominal leverage number although we are respectful of that and with that, we can translate our leverage numbers to that risk measure and so we think that we’re comfortable running as we indicated I think in our second quarter call running a leverage number that translates into an eight or nine times number, but the way we think about it is really in terms of the spread risk part of the portfolio.
Mark DeVries
And but, you know, having said that, how should have appetite for leverage today versus what it might be, what it might have been six months ago or kind of what you anticipate on a going forward basis?
Bill Greenberg
So I think, if you were to look back six months ago, I think it is roughly similar to where we were than, as you know our portfolio has undergone some changes. We’ve simplified our portfolio with not having any non-agencies in the portfolio and being an agency only Re at the moment with the agency RMBS and agency MSR, and so that will result in again a nominal leverage that looks higher than it did six months ago because non-agency is usually more low a level, but if we think about the agency part of the portfolio only, I’d say that’s about the same as where we imagined it before.
Mark DeVries
Okay, got it. One last question for the audience. Over the next year, would you expect your position in Two Harbors to increase, decrease or remain the same? And thanks for participating. Turning back to now other remainder of the questions for management, can you comment on any additional MSR portfolio activity outside of the 4.5 billion of MSR full time in July that you called out on your 2Q call?
Bill Greenberg
Yes sure. I’ll take this one Mark. So, as I think everyone knows, mortgage origination volumes have been at record highs. As a result we have been able to achieve what for us is record high servicing flow production in our portfolio for both July and August we were able to lock commitments for more than $5 million each month and more than $10 million so far for the quarter and September is on a similar pace. So that, so we’re very happy with that. On the bulk side we have seen the bulk market coming to life a little bit. We’ve unfortunately not won any of those packages yet. We haven’t bid on the bunch. We have bid on several that unfortunately have not traded, but that market is slowly coming back to life. We expect there to be more volume in the future as participants ultimately decide to sell in the future.
Mark DeVries
Okay. Is that bulk market still being impacted by too wide of a spread between what buyers are willing to pay and what sellers are wanting to, willing to part within that?
Matt Koeppen
Yes, I think that’s one way to say it. Another way to say it is that to my eye the origination gains are so large, the spread between primary and secondary spreads are so large that there’s not as much of a need, a cash need for originators to sell servicing in order to monetize the asset in order to help run their business and so I think many people when they see par mults being three today instead of four which there is a reason for that and mainly because of primary and secondary spreads are so wide that they think that it is better for them just to wait and home for a mean reversion [ph] and prices to go up rather than what the market prices are today. So yes, I think that’s one reason why the bulk market is and the flow market too is not being able to take out much origination as there is actually being produced.
Mark DeVries
Okay, great. How is prepay speeds performs in the quarter and how does the prepay speeds in your portfolio compare with the broader TBA universe?
Matt Koeppen
Yes, I can take that one. Well, you know the sort of cheapest to deliver collateral out there being the most finances are all major pools have been pretty fast. We’ve seen that refi machine has been efficient and effective. I think that surprised people early on as we got into this environment, but people have adapted referred that mortgage originators have actually been adding capacity. They have been hiring in that sector and refi capacity has been increasing. So the most refinanceable collaterals has been paying pretty fast now in specified collaterals like I said, that’s where most of our specified holdings are and those feeds I would say have been more prepaying in line with expectations, those stories holding up well and not really showing us any particular surprises.
Mark DeVries
Okay. Well one of the things Bill you just alluded to is the kind of the unusually wide primary and secondary spread, I’m kind of wondering what your thoughts are on how much that can compress and how much more prepay speeds could accelerate even if the kind of underlying interest rates don’t move there in and how do you think about that in terms of what you’re willing to pay for servicing?
Bill Greenberg
Yes, so I think as always happens, most always happen in refinancing environments that the primary and secondary spreads usually widens out until the origination machine can work through the near-term capacity, and then assuming rates haven’t moved up since then, then it can tighten and get a lower risk to borrowers and then the thing starts all over again. And so I think it is unlikely that prepayment speeds increase a lot from here.
Capacity is already running at what its — at its maximum and so I don’t anticipate that, but I do anticipate is fast speeds will stay fast for longer here. If we’re making $300 billion a month in origination and that’s $3.5 trillion a year, the size the more universes is more than $5 trillion that’s more than a year’s worth of refinancing assuming if your mortgages and versus refinance will but it basically is. It’s more than a year’s worth of activity that we can sustain here at the level. So I think that is the more likely path here assuming rates don’t ultimately backup.
Mark DeVries
Okay. What’s your general estimate for the percentage of warrants out there that are in the money at this point to refinance?
Bill Greenberg
So it’s almost all of them, it’s 80%, 85% something like that. I’m sorry, you also asked a question about servicing which is something which I alluded to in one of my previous answers which I can explain on more here, which is all else equal, when we think about when you value servicing for pricing or hedging, we look at what we think the long-term speeds might be on such a thing. And so as a result, we have to project forward what we think is going to happen in not just for us in ours where interest rates change, but when interest rates stay the same. And when interest rates stay the same as you pointed out, the primary secondary spreads will compress over some period of time. Right? And that is the reason why par mults [ph] today are more like three as opposed to what they were six months ago when they were more like four.
And so, to someone who isn’t looking at that carefully or building that in, it might seem like the nominal price is lower today, three versus four. But for us it’s really the same and we look at the values and the projected returns of the servicing assets being roughly the same as it was six months ago, even though the nominal price is three times as opposed to four times because we’re projecting the primary and secondary spread to come in, in some way.
Mark DeVries
Okay. Is there an absolute kind of the lower bound and where more interest can go that could actually program that primary and secondary spreads from compressing the more normal globalized level?
Bill Greenberg
I don’t think so.
Mark DeVries
So we could go back to either 1 and 1.10 primary and secondary spreads I guess closer to this or get worse?
Bill Greenberg
I’m sorry, I mean I’m not understanding your question.
Mark DeVries
Yes, I guess, I’m trying to understand, is there a coupon level that which Fannie and Freddie maybe just more look to try and sell at that would prevent, you know when you’ve got a 70 basis point tenure, that creates an upper bound or a lower bound on how on what mortgage rates can go that could keep that primary or secondary spread from reverting back to kind of its long-term historic average? I guess does that make sense?
Matt Koeppen
I’d like to take that. I think they are making one and a half coupons, they are pooling one and half couple mortgages out there make, so I would like to believe that is some flow around coupon or something, but I’m not sure there is.
Bill Greenberg
I think if tenure rates were to rally 50 basis points, then over time right, I mean I think if that would happen tomorrow I think primary secondary would widen up so mortgage rates would not go down that much, you would still be in the 2.75 to 3 area. But I would expect if tenure rates were to be 50 lower and 25 basis points then over time we would see mortgage rates shift 50 basis points lower.
Mark DeVries
Okay, very helpful. Let’s see, how do you think about the balance between generic and spec pools just given the current level of elevated prepays how they pay offs on spec pool has really treaded since quarter end?
Bill Greenberg
I’ll take that one, I’ll the second part of that first. It is pay ups have basically I would say broadly traded in line to maybe slightly stronger, just generally speaking. There’s differences among various coupons and stories, but broadly they are in line to tough stronger in this quarter I would say. And in terms of how we think about it, you know I think the sort of the generic versus specified I think it is really how we think about that is, again back to thinking about the TBA flow in current coupons and how the sort of cheapest to deliver on the worst collaterals getting delivered to the Fed is that making our purchases.
So it is less thinking about the speeds and more about the TBA float in the current coupon. And like we alluded to earlier, we do think that there’s a favorable dynamic that’s being created in the current coupon part of things, we do think that’s attractive. And also, like we said, specified pools, we do continue to think that those are providing attractive returns in the higher coupon part of the sector.
Mark DeVries
Great. How have prepayment projections trended during the quarter? Do you see a scenario where elevated prepays become the norm given the Fed’s announcement to keep rates lower for longer?
Bill Greenberg
So I think they are the norm. I think we’re living in a fast prepay world. I’m not sure how much it is key to the Fed’s commitment to keep short-term rates longer. I mean, fast speeds are really more a consequence of, as we just discussed is to where long-term rates are, and so forth. I think market participants in general have adjusted already. I think prepayment projections have reacted to this environment and some of the reduced frictions that we see in the world, like increased PIW waivers and so forth, which are and other effects, which are causing speeds to be faster than one would have expected six months ago for this level of rates and so forth. So I think it’s until something changes until rates were to rise for whatever reason. As I discussed sort of moment ago, we’re living in a fast prepay world.
Mark DeVries
Great, how – in this environment if at all, has your hedging strategy changed?
Matt Koeppen
Yes, I don’t think we’re broadly thinking about our hedging strategy differently, whether it’s, whether you’re in a low rate environment or a high rate environment. I think the way the way that we approach our hedging, with respect to rate and curve exposure, I think we always think about it the same way.
We keep those exposures small. We try not to drive returns to alpha through that’s on curve rate. So, I think our strategy really applies to all environments, including this one. The one thing that’s a little different than as normal as we aren’t using a lot of options today, given where we are in low rates, our portfolio isn’t as negatively convex as it might be in higher rate environment when you’re a little more custom in terms of your underlying wax [ph]. So since we’re sort of through that level, and generally prepayment speeds are already fast, it doesn’t require a lot of options and those mortgage options or rate options in our strategy.
Mark DeVries
Got it? Turning to capital allocation with, stocks still trading below book here, how do you view the attractiveness of buybacks compared to investing in agency RMBS?
Bill Greenberg
Yes, I’ll take that one. So we always think about it really as just what is the best use of the capital and so when we compare the potential benefit of buying stock back below book and capturing that immediate discount, we compare that with the alternative of taking that capital and investing it in our target assets, agency RMBS and agency MSR, which lasts for a long time.
And so if you talk about, capturing a 20 point discount in book compared to let’s say in round numbers, say that you can earn 10% yield on your capital, on a levered basis, while that’s a two-year breakeven, that doesn’t sound very good to us. And so, there could be ranges of discounts and ranges of opportunity sets that could change that, but that’s the framework in which we look at it.
Mark DeVries
Okay, got it. What types of challenges and opportunities do you see on the horizon with the Fed’s current no hike approach to rates?
Matt Koeppen
Yes, I’ll take that one. I think we’ve touched on these in earlier questions, but I think in terms of challenges I guess, one of those challenges that we think about, low [indiscernible] low for a long period of time is probably back to the primary, secondary spread compression which you noted is historically wide. If that continues to tighten like we talked about, we think that will keep speeds fast for a longer period of time, keep speeds fast for a longer period of time.
I guess on the opportunity side of things we also talked about, as long as this environment persists and we stay here with, sort of, slower to low economic growth and the Fed keeps its pedal on the gas with purchases, that’s going to continue to support current coupon RMBS and all the dynamics that lead to tighter spreads and special roles. Those are two that, that come to mind.
Mark DeVries
Got it. Is there anything on the horizon that stands out as potential risk to interrupt the current favorable environment?
Bill Greenberg
No, risk is all. All I can see is blue skies ahead. It’s totally fine sailing. No, I think there are a couple things that we’re paying attention to. I mean, one thing we can say is certainly, what is it not so far? Obviously, as Matt just said, and as I think everyone probably knows, the Fed supports of the sector has taken a lot of the tail risk of widening spreads off the table.
The funding markets have healed substantially since earlier in the year. Term markets are developing in those markets at very low rates and which certainly help create a tailwind for ours and similar strategies. So there’s lots of things that it’s not. When we do think about things that it could be, and we touched on it a little bit earlier could expiration of PPP or other things cause increased forbearances or delinquencies.
A second wave of virus could increase potential lockdowns and cause some of those things too, because it used to be continued social unrest, election unrest, things of that nature that could create just more volatility in the market, we’re paying attention to some of those things as well. Not today’s business, but obviously one day, the Fed will decide to start buying less mortgages than they have been which could, which will, at some point, create a taper tantrum like scenario and we want to be aware of that. And also, the ability of us to source MSR, I think is something that we’ve been successful at so far. But with that, we’re watching that carefully and trying really hard to make sure that we can maintain that.
Mark DeVries
Yes, that’s an interesting point about an inevitable taper tantrum. What did you learn from the last one, and that will help you kind of position for that potential outcome at some point in the future?
A – Matt Koeppen
I would say one thing, that one thing that benefits us and the way we manage the portfolio is we’re pretty aggressive hedgers I would say, so we’re pretty quick to react. So if, – if there’s an environment change or dramatic rate environment change or something like that, we’ve historically felt to be quick reactors to changing environments. So, whatever that requires in terms of position changes and rate hedging we stay on top of that pretty closely and are quick to react. So I think that helped us in 2013 during that environment, and I would expect us to use this same mindset in the future like those I don’t think this is a near term problem, but it certainly on some horizon, we’ll have to think about that, of course.
Mark DeVries
Yes, does the larger servicing portfolio position you a little bit better in this environment, at least I guess you’re a little bit more fully hedged for the spread widening than I guess you would have been in 2013?
Bill Greenberg
So, sure, as Matt alluded to earlier, one of the reasons why we don’t — are not using so many options at the moment is because our servicing portfolio is positively convex here that as rates are low and prepayments are fast, the servicing acts more like a put option on rates, which has positive convexity, and so that’s the reason why we’re not using so many options.
The same thing sort of applies a little bit to your question about how to manage through a taper tantrum. And that I would say is really about, not about duration, management, but it’s about convexity management. Right? And so, in 2013, our service as big as what today and we used a lot more options. I mean today we have servicing and so we don’t have that, but some combination of managing the convexity through options and monitoring where the servicing convexity is, will help us to do that.
Matt Koeppen
The other thing I would say about that Mark is the portfolio’s construct of pairing, servicing with mortgages in a taper tantrum, which you would expect mortgage spreads to be widening up, that’s really when we think that our portfolio construct will shine and will show it’s worth. We generally have much less, broader overall exposure, mortgage spreads with the construct, so it’s in that kind of environment that lower mortgage spread exposure can really be beneficial.
Mark DeVries
Okay, great. Just one last question from me then. Is there anything you’re monitoring around GSE reform, whether it’s enhanced capital requirements is the potential for a recap release that you’re concerned about in terms of the potential impact to your markets?
Bill Greenberg
We’re obviously monitoring closely. I don’t think anything that is on the horizon is very impactful to us. I think these are second order effects. Whether the footprint widens further is depending on the change of administration, or tightens further, I think these are marginal impacts in terms of right, but they would impact the availability of securities, potential supply, demand, the size of the credit box, things of that nature. We’re not involved in the CRT markets at the moment. So, so all those impacts I do think that affects those things, affect us very little at the moment, but we’re obviously keeping track of everything.
Mark DeVries
Okay, great. Well, it looks like we don’t have any questions from the audience and nor do mine, so let me thank you very much for your time and for joining us.
Bill Greenberg
Thank you very much. It’s my pleasure to be here.
Matt Koeppen
Thank you, Mark.
Question-and-Answer Session
Q –
