Two Harbors Investment Corp

Good morning. My name is Peter and I will be your conference facilitator. At this time, I would like to welcome everyone to Two Harbors fourth quarter 2021 financial results conference call. All participants will be in a listen-only mode. After the speaker's remarks, there will be a question and answer period. If anyone should require assistance during the call, please press star zero on your keypad. As a reminder, this call is being recorded. I would now like to turn the call over to Paulina Sims.

Good morning, everyone, and welcome to our call to discuss Two Harbors' fourth quarter 2021 financial results. With me on the call this morning are Bill Greenberg, our President, Chief Executive Officer, and Chief Investment Officer, and Mary Riske, our Chief Financial Officer. The earnings, press release, and presentation associated with today's call have been filed with the SEC and are available on the SEC's website, as well as the investor relations page of our website at TwoHarborsInvestment.com. In our earnings release and presentation, we have provided a reconciliation of GAAP to non-GAAP financial measures, and we urge you to review this information in conjunction with today's call. As a reminder, our comments today will include forward-looking statements, which are subject to risks and uncertainties that may cause our results to differ materially from expectations. These are described on page two of the presentation and in our form 10-K and subsequent reports filed with the SEC. Except as may be required by law, Two Harbors does not update forward-looking statements and 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 fourth quarter earnings call. We turn to slide three. At quarter end, book value was $5.87 per share, representing a negative 5.6% total economic quarterly return. This underperformance can be attributed in approximately two equal parts. Firstly, to spread widening in higher coupon RMBS and IO securities due to slower than expected declines in prepayment speeds and higher volatility. And secondly, to a 20 basis point widening in the spread of the MSR asset which we see as being within the typical period over period variability of MSR spreads and which arise from using the simple average of three independent broker marks. The overall environment in 2021 was challenging as the market wrestled with continued waves of coronavirus infections and uncertainty around the path of economic growth and monetary policy. For the year, we delivered total dividends of 68 cents per share equivalent to an average dividend yield of 10.0%. With a starting book value of $7.63 at the end of 2020, the total economic return on book value equates to minus 14.2%. In many ways, the underperformance in 2021 was a continuation of the market stress of 2020. While the Fed came to the rescue in 2020, buying unlimited amounts of RMBS and stabilizing the market, The Fed's continuing monetary accommodation also had two other effects. First, with the Fed having bought almost $3 trillion of RMBS during QE4, spreads collapsed to all-time tight levels, which reduced the tailwind of carry meaningfully. Second, the Fed's asset purchases also reduced mortgage rates to all-time lows, igniting a prepay wave that hasn't been seen since 2003 and creating a very strong headwind for portfolios such as ours. with premium and interest-only cash flows. Nevertheless, we took proactive actions during the year which benefited the company. We issued and repurchased convertible notes last February, redeemed our Series D and E preferred shares, and we raised common stock through two public offerings. On the asset side, we grew our MSR portfolio, acquiring over $88 billion of UPB at very attractive levels. In expectation of spread widening, we reduced leverage, increasing the amount of dry powder to be deployed in a more attractive investing environment. Indeed, over the past few weeks, it has become clear that the Fed has shifted to a much more hawkish stance and mortgage spreads have reacted by widening about 20 basis points during the month of January. Despite the rapid and large spread movement, we think there is more to go and expect more volatility in the near term, as the timing and pace of rate hikes, balance sheet normalization, and other supply-demand dynamics are sorted out. It is in precisely these kind of environments that our agency plus MSR construction should benefit, and indeed, our best estimate of book value through the end of January is approximately positive 2%. Looking ahead, we see a path towards normalization in RMBS spread levels. The refi wave appears to be over, and the prospect of higher rates and slower prepayments points to a more constructive environment for both RMBS and MSR. We are well positioned to capitalize on the improved investment opportunities as they present themselves in the coming year. Please turn to slide four. During the fourth quarter, economic data, Federal Reserve commentary, and market expectations converged on an accelerated timeline to higher rates and the removal of monetary accommodation. As we see in figure one, The 10-year rate fluctuated between 1.4% and 1.6% during the quarter, before breaking out in January to the 1.9% range where it sat pre-pandemic. The prospect of more rate hikes pushed short-term rates higher, flattening the yield curve by 53 basis points during the quarter. The market has continued to reprice, and expectations have become more front-loaded, with almost 5.5 hikes now expected in 2022, with a total of 7 by the end of 2023. The Federal Reserve has announced it will complete its monthly purchases of Treasury and agency RMBS by March, as seen in Figure 2. More recently, while the Fed has said that interest rates will be their primary tool in implementing monetary policy, they do recognize that the balance sheet is bigger than it needs to be and have expressed a desire for the balance sheet to return to a Treasury-only portfolio. Chairman Powell has also said that the pace of balance sheet normalization could be faster than it had been in past episodes. The timing and pace of any runoff or outright sales should also affect mortgage spreads. We have consistently said that mortgages at historically tight spreads would need to widen eventually. In our view, the question was not if they would widen, but how quickly and by how much. With the Fed removing its accommodation and banks likely having less appetite for securities as a function of lower reserves and increased loan demand, some mortgage analysts are projecting the private sector may need to absorb to 700 billion dollars of mortgages in 2022. current coupon spreads remain near historical tights throughout the fourth quarter although as i mentioned have swiftly widened out by roughly 20 basis points since year end as shown in figure three however spreads still remain approximately 15 basis points tighter than other periods where the fed had not been buying mortgages let alone periods where the fed is net shrinking indeed Relative to the last period of quantitative tightening, in 2017 through 2019, spreads were at current levels or tighter only 8% of the time. 92% of the time, they were wider than they are now. In the shaded area in Figure 3, we show how wide mortgage spreads might be able to go. We don't expect spreads to widen and stay at levels much beyond historical averages, but it's instructive to note that during the last period of quantitative tightening, mortgage spreads overshot the long-term average by an additional 20 basis points. Please turn to slide five. Since the beginning of the pandemic, the average coupon of the mortgage universe has declined by approximately 75 basis points, from 4.25% to 3.5%. As a result of this restriking of the mortgage universe and the upward trajectory in mortgage rates, the percentage of mortgages in the Fannie-Freddie universe with at least 50 basis points of refinance incentive has fallen to around 30% at year-end 2021 compared with roughly 80% at year-end 2020. With the jump in mortgage rates in 2022 to north of 3.5%, that percentage is projected to fall further to roughly 11%. With such a small percentage of the market eligible to refinance, we are looking at an environment of sharply lower prepayment speeds. How much slower is shown in Figure 2? The dark gray bars indicate the realized prepayment speeds for our current specified pool coupons over the course of 2021. Yes, these speeds were much faster than what was expected at the beginning of the year as a result of high HPA and GSE policies to make refinancing easier. But higher rates will necessarily lead to slower speeds, and we show our projections for those TBA and specified coupons in the light gray bars, assuming current interest rates stay unchanged throughout the year. With prepayment rates projected to come down sharply and quickly, the economic carry and cash flows of our paired MSR strategy are expected to dramatically improve. In Figure 3, we show the components of economic carry of our MSR portfolio for 2021 and the projected amounts for our current portfolio over the next year, assuming rates are unchanged and we do not replace or add any MSR. In 2021, the value lost from prepayments labeled runoff in the chart, overwhelmed the MSR cash flows despite contributions from our recapture agreements, resulting in total net economic carry of close to negative $200 million. Our static projections for 2022 change this picture dramatically. Runoff is forecast to drop by over 50%, and we project the net economic carry of our MSR to be close to positive $200 million, nearly the inverse of last year. Of course, these projections are model-based and reflect a single point in time with a number of assumptions. But the idea is that the fast prepay headwind that we experienced in 2021 has shifted, and our base case expectation is for a much more favorable environment in 2022. Now I will turn it over to Mary to discuss our financial results in more detail.