Two Harbors Investment Corp

and welcome to the Two Harbors Investment Corporation's first quarter 2021 financial results conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Paulina Sims, Senior Director of Investor Relations. Please go ahead.

Good morning, everyone, and welcome to our call to discuss Two Harbors first quarter 2021 financial results. With me on the call this morning are Bill Greenberg, our president and CEO, Mary Riske, our chief financial officer, and Matt Kepin, our chief investment officer. The press release and financial tables associated with today's call were filed yesterday with the SEC. If you do not have a copy, you may find them on our website or on the SEC's website at sec.gov. In our earnings release and slides, we have provided a reconciliation of GAAP to non-GAAP financial measures. We urge you to review this information in conjunction with today's call. I'd like to mention that this call is being webcast and may be accessed in the investor relations section of our website. I'd also like to remind you that remarks made by management during this conference call and the supporting slides may include forward-looking statements. These statements are based on the current beliefs and expectations of management, and actual results may be materially different because of a variety of risks and other factors. We caution investors not to rely unduly on forward-looking statements. Except as may be required by law, Two Harbors does not update forward-looking statements and expressly disclaims any obligation to do so. I will now turn the call over to Bill.

Thank you, Paulina. Good morning, everyone, and welcome to our first quarter earnings call. Today, I will go over our quarterly results at a high level and share some thoughts on the market environment, including the meaningful shift in interest rates during the quarter. Mary will give more details on our financial results, as well as our capital structure and financing activities. And finally, Matt will discuss our portfolio composition, activity, and risk profile, as well as our outlook. Please turn to slide three. At quarter end, book value was $7.29 per share, representing a negative 2.2% total economic quarterly return. First quarter performance was largely driven by roughly flat portfolio returns, with a significant increase in MSR values hedging the decrease in RMBS prices. Lower coupons underperformed higher coupons. Specified pool performance was mixed as our high coupon securities, where we are mostly positioned, outperformed their hedges. This quarterly performance also includes the impact of the actions we took to optimize our liability and capital structure as we execute on our long-term strategy. During the quarter, with spreads tightening beyond historic levels and volatility increasing, we reduced our RMBS position somewhat. primarily in 2% and 2.5% coupons, given the unattractive risk-reward proposition. Given these conditions, we would expect to maintain a low exposure to mortgage spread risk. Ultimately, we believe the rapid pace of economic recovery will lead to a moderation of Fed support and spread normalization, at which time we expect to increase leverage and deploy excess cash into investments at more attractive levels than what are available today. As we mentioned last quarter, the MSR market is healthy with pricing and activity at pre-crisis levels. We continue to benefit from the strong relationships with our originator partners, settling on 21.3 billion UPB in our flow sale program and adding another 1.1 billion UPB through bulk purchases. I would reemphasize our view that MSR provides strategic value both as a hedge to mortgage spread risk and as an asset that, on its own, delivers a low double-digit levered return, and this is where we expect to continue to deploy capital while keeping spread risk low. In this environment, where the short-term direction of mortgage spreads remain highly uncertain, we are confident that the agency plus MSR strategy can continue to deliver attractive risk-adjusted returns over time. So, with more than a single quarter in mind, we declared a common stock dividend this quarter of 17 cents per share. As always, we will continue to evaluate the dividend within the context of market conditions and return expectations. On slide four, we highlight some of the noteworthy market dynamics and rate movements during the quarter. A substantially improved market outlook for the U.S. economy drove interest rates sharply higher, with 10-year swap rates rising from 93 basis points to 178 basis points, and five-year forward 10-year rates climbing all the way to 2.5%. During this period, the mortgage current coupon rose 66 basis points from 1.38% to 2.04%. Looking at the bottom left chart, the spread between primary and secondary mortgage rates continued to compress to more historical levels, especially over the last two quarters, meaning that the gain on sale profit for originators has also come down to more normalized levels, and any further increase in interest rates will likely be passed on to borrowers as higher mortgage rates. The chart on the top right shows the distribution by mortgage rate of fanning mortgages in the blue bars, which we believe is a good proxy for the agency universe as a whole. At the end of December, roughly 85% of all mortgages had at least 25 basis points of refinance incentive, as shown by the gray circle. With the rise in interest rates and mortgage rates now hovering around 3.17%, the percentage of mortgages that are refinanceable with at least 25 basis points of incentive has declined to about 64%, as shown by the green circle in the chart. Additionally, those 64% of borrowers have for some reason not taken advantage of refinancing when rates have been lower, so their sensitivity to refinancing is not precisely known. Nevertheless, higher interest rates, higher mortgage rates, tighter primary-secondary spreads, and lower numbers of mortgages being refinanceable will inevitably lead to slower prepayment speeds, which should be beneficial to our agency plus MSR strategy. Although rates have shifted higher and prepayment expectations have moderated, RMBS valuations continue to be very rich. We acknowledge that there are powerful technical factors at play, such as continued role specialness in the 2.5% coupon and, not unrelatedly, large-scale purchase demand from the Federal Reserve as well as large banks, as those entities added $380 billion and $180 billion of RMBS, respectively, in the first quarter alone. Looking at the chart on the bottom right of slide four, the option adjusted spread on an index of agency RMBS currently sits at six basis points as of the end of the quarter. Although you cannot see from the chart, current spread levels are the types they have been since 2006. However, we do not expect these favorable technical forces to last forever. With the virus receding and the economy gaining strength, the Federal Reserve will one day begin to moderate their asset purchases. Most market participants expect that the Fed taper will occur sometime in early 2022, and Chairman Powell has said that he will be careful to telegraph those intentions to the market well in advance, and so that communication could come this year. Given the pace of economic rebound, it is our view that the risk to that conventional forecast is to shorter timelines, not longer. Furthermore, while the Fed has been clear that they will wait until they see the results of quickening economic growth, the large banks will in all likelihood act sooner to divert capital from investment to making loans, and so a bank taper could occur even sooner. As we discussed on our fourth quarter earnings call, data analysis of historical spreads suggest that spreads are typically mean reverting once they reach extreme levels. As a result, we view the risk of spread widening to be significantly higher than the likelihood of spread tightening. With a long-term mean of 35 basis points over the last 10 years, spreads have room to materially widen. Without the benefit of role specialness, the fundamentals of owning RMBS are not very attractive today. With spreads being where they are, the hedge-adjusted carry on the asset only leads to mid-to-high single-digit gross returns. Given these rich valuations and higher price volatility that we have seen recently, the investment thesis of buying a rich asset and expecting that the Fed and the banks will keep buying at higher prices does not seem sustainable to us. Indeed, as Matt will discuss later, the total quarterly performance on the TVA coupons that the Fed and banks have been buying was essentially zero. meaning that we did not give up any economic performance by being underweighted those coupons. We intend to be patient and deliberate in executing our strategy. We are continuing to add MSR at attractive levels, which, when paired with RMBS, keeps our exposure to mortgage spreads low. One benefit of the agency plus MSR strategy is that it allows us to keep exposure to spreads low when spreads are tight and to increase exposure when spreads are attractive. This is what we intend to do over time. I'll now turn the call over to Mary to discuss the details of our financial results.