Two Harbors Investment Corp

Got it. And again, we're obviously very early in the tightening cycle, but as we think about, again, way, way down the road, how things will evolve, is the strategy that because you will have ultimately less liquidity on the MSR portfolio in a time when that will become a headwind, is the strategy just ultimately to use the TBA market and the MBS market to lever up and basically use that as your flex and keep the MSR portfolio relatively static inside.

Well, I mean, you're right. There's no question. RMBS and TBAs are more liquid than MSR, but MSRs are not completely illiquid. There are trades that take place and people do move around portfolios. And so when we think about our liquidity needs in short time periods, yes, it's a liquid part of our portfolio that we're primarily relying on. But when you think about longer time scales and how portfolios evolve through time, I think it's fair to also consider that there can be movements in the MSR portfolio if necessary or desired from a portfolio strategy perspective.

Great. Thank you, Bill. Thank you.

Thank you. Our next question comes from the line of Kenneth Lee with RBC Capital Markets. Please proceed with your question.

Hi. Thanks for taking my question. You talked about the spec pools underperforming relative to TVAs in the quarter. Just wondering if you could just share with us what's your expectations going forward? Do you expect that to reverse? Thanks.

Thanks, Ken, very much. I think it depends a little bit on the coupons and the stories. On page 11 of our presentation, we showed this a little bit where the specified pools in 2.5s through 3.5s underperformed TBAs and 4s and above outperformed TBAs. And I tried to make a comment about that in my prepared remarks about for the lower coupons, it was a longer spread duration. that was mostly the cause of that or the catalyst for that. And then the higher coupons, you have this effect of that's where the production is going to occur and the deliverables are going to be changing there, making the TBA worse than specified pools. So it depends a little bit. We're starting to find attractive valuations in the... what I used to call high coupons, but maybe now I'll call current coupons in terms of specified pools where the production is. And so while there is continued role specialness in those coupons, fours, four and a halves, fives, where we have some TBA exposure, we have been increasing our allocation to specified pools there. We think that is attractive. And as production catches up with the rate market, and you start seeing those new bonds being created, the role specials, those high coupons, I do expect to dissipate and diminish. And when that happens, I think, or as that happens, I think you can expect to see our allocation to specified pools probably increase relative to TBA over time.

Gotcha. Very helpful there. And for my follow-up, I wonder if you could just share your thoughts on where mortgage spreads stand now and how you think about the potential for any kind of further widening driven by the RMBS runoff as the Fed starts their action. Thanks.

Okay. Well, yeah, that's the key question. As I said in my prepared remarks, I think, and the chart that we showed on slides, slide four, no, slide five, where OASs are back to long-term averages, maybe the cheap side of fair, but interest rate volatility has been high, and so static spreads, Z spreads, are certainly in a quite attractive range. There is concern both as I said from interest rate volatility as well as the runoff from the Fed as well as potential Fed sales that could make them widen somewhat and we'll have to see how those dynamics unfold a little bit I would say the risk to wider spreads is probably greater than the risk to tighter spreads but they are looking attractive on a fundamental basis and we as we said during the prepared remarks We've increased our leverage somewhat from quarter end, and we've done a little bit more since quarter end. Our current leverage is probably now in the 5-4 area, right, to express our interest in these attractive valuations. But we want to be cautious given the supply-demand dynamics that you just said, and so we're trying to balance those two effects.

Gotcha. Very helpful. Thanks again. Thank you.

Thank you. Our next question comes from the line of Trevor Cranston with J&P Securities. Please proceed with your question.

Hey, thanks. Bill, you mentioned the sort of marginal increase in net spread exposure because of the low coupon of the MSR relative to kind of where current mortgage rates are. Can you talk about sort of how how quickly the hedge effectiveness of the MSR would be expected to change if rates continue to move up, and if there's a level of rates at which you'd actually expect the duration of the MSR asset to turn positive, and sort of how you'd manage the overall hedging of the portfolio through that. Thanks. Yeah, sure. Thanks, Trevor.

Yeah, so as you know, in April, alone, or since quarter end, rates are another, especially the long end, are another 65 basis points higher. And with the gross coupon of our servicing remaining fixed at 3.2%, the hedging effectiveness or the duration of the MSR asset has become even less negative. Rates have to go up an awful lot for them to be positive, probably another couple hundred. But the duration of the MSR asset is pretty low here, and in order to get that back up, some amount of new mortgage servicing that's at the money needs to be created, and the portfolio needs to be recycled a little bit in order for that to happen. So that's something that's going to happen organically over time, and is just part of the life cycle of a servicing portfolio.

Okay, sure. That makes sense. And in terms of supply of MSR, you know, you guys bought some bulk this quarter. Can you talk about what you expect to see on the bulk side of the market going forward? And, you know, if the bulk stuff coming out tends towards the lower coupon, you know, how much appetite you guys would have to add more of that to the portfolio? Yeah.

Yeah, thanks. So as we said in the prepared remarks, the MSR market has been very active, very robust. We've seen more than a full year of typical bulk activity already in 2022. Again, this rate movement has been so fast that there hasn't really been time to adjust. So all of the portfolios that we saw and that we are continuing to see in the market are generally of the lower WAC variety. Right. And as, as you pointed out, you know, our appetite for that stuff is probably less than it was given that we're, we're probably more on the, on the lookout for things that are going to hedge our portfolio more. And so we're, we're going to be focused more on trying to find, um, the new at the money stuff rather than focused on, on the lower coupon, um, um, high multiple high price stuff.

Okay. Got it. Um, and then last thing, um, do you guys have an estimate as to, um, how much book values change since the end of the quarter?

Yeah, thanks very much. As I said, it's been a very, very volatile April into May. Rates are up another 65 basis points. Since then, mortgage spreads have continued to widen, especially down in the low coupons. With that said, and the way that we've been able to position our portfolio, and we've been relentless in keeping our mortgage exposure with current coupons, we've been able to to maintain a positive 0.5% book value change since the end of the quarter.

Okay, perfect. Thanks very much.

Thank you. Our next question comes from the line of Eric Hagan with BTIG. Please proceed with your question.

Hey, thanks. Good morning. Hope you guys are well. I think I have three questions. First is just how do you see the prepayment profile for spec bulls developing here? Like how sensitive do you think some of the low-balance borrowers are to home price appreciation and cash-out refi? I'm not sure I've heard anyone ask you guys your perspective on how much value is left for upside in the MSR. It would be good to get your thoughts there and maybe just an approximate DVO1 in dollar terms for the MSR if you have that. And then in the past, the company has been short some TBAs within the coupon stack. I'm curious how – what the value is, if any, in running that strategy now. Thanks.

Sure. So your first question was on what I think prepay speeds or how I think HPA or things like that will affect low loan balance. Is that right? The conventional wisdom I think of low loan balance pools is that not only do they provide refi protection, but they also generally have have higher turnover speeds, discount speeds from lower lock-in. I think that's probably borne out in the data. We are to a very large degree in uncharted waters here. I don't think that we've ever had an environment where we've had so many mortgages so deep out of the money to be able to see how these things will behave. you know, discount environments in general, let alone one as sort of deep as this one, are few and far between, and every economic environment is different and so forth. HPA has obviously been very high. That has been the cause behind some pretty fast cash-out refinance activity in the last year and two years. But we have a significant number of mortgages today that are 200 basis points out of the money right and um and to be able you know if you if people want to take cash out um at that stage that's you know if you talk about taking 10 of your mortgage balance 20 of your mortgage balance out you know the the the implied um uh rate on that marginal amount is very very high and you know if the market starts to to start producing you know some helix or some second liens that would almost surely be a more attractive option for borrowers to do. So I don't know how big that effect will be. My intuition is that with the Fed raising rates and the overall intent to cool things down a little bit, that the cash-out activity will generally slow. And I think that turnover speeds, as I said during my prepared remarks, which have historically ranged between 5 and 10 CPR, I think many people are thinking that they're probably at the higher end of the range now because of the cash out activity that we've said. I actually think have a possibility to surprise to the slow side, but we'll see how that unfolds, of course. Your second question was about, remind me, I'm sorry.

Yeah, sure. It was about the value upside left in the MSR.

In MSR, sure. So again, you can look back at historical periods to see how high servicing prices have been. The floating rate components are one value that sort of increase quickly when rates rise, especially short-term rates rise and in a steep curve especially. If you look back to other periods of higher rates, it's easy to see periods where the floating rate components alone can add a full multiple or more to the value of servicing. The highest I've seen servicing malts be in the world, and I've been doing this since the late 90s, is probably mid-sixes, is about as high as I've ever seen them go, depending on shape of the curve, level of short-term rates, amount of floats, servicing costs, all of those things. And those days, people didn't even build in, well, never mind about that. I was going to say people didn't even build in recapture, but in a discounted environment, With high multi, that's not going to be a very big effect. And your last comment is, what is our duration of our servicing at the moment? You know, it's pretty low. You know, I would say that for the entire servicing portfolio right now, for a 100 basis point move, right, on a model basis, of course, it depends on all market environments and shape of curve and all of those things, right, is probably around 50 million bucks. for a parallel shift up 100 basis points.

Gotcha.

I'm just the MSRS, to be clear.

Yeah, that's really helpful. And then in the past, you guys have done the coupon swap strategy a little bit within the coupon stack. Can you talk about the attractiveness there? Appreciate it.

Yeah. Right now, we have... I don't know what we had at the end of the quarter, but certainly we had no net short positions, as you see from the chart on page 13, I think, right? There was no net positions. We've been diligent and quick in moving our exposure up in coupon. So we don't have, as you see on the chart on page 13, we have very little exposure below three and a half at all, right? And, you know, We have no exposure in short positions in any TBAs, in low coupons in particular. Obviously, the market changes all the time. Should the valuations warrant such a thing, we could consider that, but we're not particularly taking a strong view about the price or the valuations of low coupons at the moment relative to the turnover speeds that are priced into the market there. So we're happy being flat down there at the moment, and all our exposure is up in the current coupons.

That's really helpful, Collier. Thanks a lot. Thank you.

Thank you. Our next question comes from Lyon of Bowes George with KBW. Please proceed with your question.

Hey, good morning. Actually, first, in that slide 10 where you give the, you know, the return expectations, is that based on your current leverage?

Slide 15, you mean?

Slide 15, sorry. Yep.

No, those would be based on more market standard leverage numbers.

And so you said you were at 5.4. What would be sort of a market and more normal leverage, sort of a couple of turns higher?

Yeah, I think that... You know, we've said in the past that we can operate with leverages in the eight to nine times. That depends, of course, on the amount of servicing that we have in the portfolio. We have more servicing today than we did when we said that number in the past. So, you know, a natural resting place for us is probably, you know, in the seven handle, eight handle areas.

Okay, great. That's helpful. Thanks. And then can you just talk about your expectation for specialness into the back half of the year?

Sure. So as I said in the prepared remarks, role specialists on the formerly fed coupons has all but disappeared, right? We're seeing reasonable role specialists, maybe let's call it 50 basis points in the production coupon. here. In the higher coupons, four and a halves and fives, it's even more pronounced, more than 100 basis points of specialists. But that, as I've said sometimes, is optical. By that I mean that the role mechanics back into an implied financing spread by looking at the difference between the price in the front month and the price in the back month And today, again, because the rate market has moved so far so fast and the production mortgage market hasn't really had time to catch up, the collateral characteristics of bonds in the front month are pretty different than the collateral characteristics for bonds in the back month. And so those are really two different bonds, and so it's a little bit unfair to imply a financing spread from those two different bonds. Nevertheless, you can do that, and that's in there, and those are big numbers here. But as the market catches up, as the production in the current coupons and the slight premiums begins to normalize in the back half of this year, I also expect that to diminish. I would expect by the end of the year, things should be pretty normal.

Okay, great. Thanks.

Thank you. Ladies and gentlemen, as a reminder, if you'd like to join the question queue, please press star 1 on your telephone keypad. Our next question comes from the line of Doug Harder with Credit Suisse. Please proceed with your question.

Thanks. Just another question on leverage. Can you just talk about how you think about or remind us how you think about leverage on agency paired with MSR versus agency paired with rates?

Sure, yeah. Thanks for bringing that up, Doug. So in a portfolio without MSR, there's really a very direct and straight line correspondence between, between leverage and risk and drawdown risk. How much money can you lose, right? For, for spread widening with a portfolio with MSR as current coupon mortgage spreads widen, the MSR will, will benefit from that. We'll, we'll have a natural increase in price from that. And so we always look at leverage in through the lens of, of, what that drawdown risk number is. We obviously want to be respectful of nominal leverage numbers, but another important number for us is what you see on the bottom right slide of page 13, which is what is the portfolio exposure for a 25 base point widening in mortgage spreads. And that number, which currently at the end of the quarter was minus 2.8%, is a lower number than you would get for a portfolio without MSR for the same leverage. And so we look at both of those things, obviously, and account for both those things when we say, when we determine how much risk we're comfortable with and what we think the appropriate amount in our portfolio is.

Great. Thank you, Bill.

Thank you. Our next question comes from the line of Aaron Saganovic with Citi. Please proceed with your question.

Hi. Thanks. I was interested in kind of your return profiles. Obviously, your slide 15 shows a much better environment for investing, but you talked about being still a little bit cautious with the potential Fed sales coming on board, when do you think you might feel comfortable really expanding your leverage? Is it just seeing how the initial roll-off does, or are you waiting until they actually start to sell their portfolio?

Thanks. That's a good question. Look, that's a hard one, right? It's obviously very market dependent and will depend exactly on how things unfold. As I said before, the things that are giving us pause here are potential Fed sales, potential appetite of the private market in general of who's going to buy all the bonds that are going to be running off, and interest rate volatility. I think we need to see some progress, some clarity here. on at least some of that before we start to meaningfully be adding. But as I said, from a valuation perspective, fundamentally, they actually look pretty good. I think Chairman Powell's comments yesterday took some of the tail risks off the table a little bit. Pretty firm commitment to not go 75, to not keep hiking until something breaks, to be looking at the trends of of the economy and watching it as, as the hiking process is underway. So I think those, those were pretty friendly comments, which have been interpreted as such by the market in general. So that, that was helpful, but I think I'd like to see just, you know, a little bit more progress in, in at least some of those three dimensions. Okay.

And it, it did look like you took up the portfolio a little bit. Do you, do you expect that you're,

roe might expand a little bit um from here just from from the portfolio changes that you've made thus far well you know you know i mean i mean give it given the the the static expected returns on on page 15 right increasing leverage will increase increase the carry of the portfolio and and and can increase expected returns right but of course spread movements do and will always dominate those sorts of things. So it's, of course, impossible to predict what the returns will be, but certainly on a static basis, increasing leverage will do that.

Okay. And then just lastly, I think Mary had referenced that repo prices were rising a little bit, but I'm assuming that takes that into account in slide 15. So there is the, you know, financing readily available to create the types of returns that you're highlighting there?

Yeah, so one thing I'll say is, you know, rising financing costs in and of themselves don't particularly change returns, right? Because on the fixed rate mortgage side, we are hedging our interest rate risk, which Some people like to explicitly say that that hedge hedges the funding. You pay fixed on swaps, you pay fixed at some fixed rate, and you receive some floating rate, some SOFR rate or OAS rate that generally offsets the increase in funding that you would have from rising Fed rates, rising repo rates, and so forth. Hedges it exactly. On the MSR side, the floating rate components that we generally receive right, the float on taxes and insurance on principal interest, this is a little less intuitive to understand, but nevertheless is true, also offsets the increase in funding on the short-term rates from our MSR facilities. And so in and of themselves, rising short-term rates, rising funding rates don't change the economics of our portfolio very much. In fact, they increase it, right, because there's the equity piece and all these things that matters. The thing that matters most is the spread to a risk-free rate that you would get on a fixed rate swap or something like that of SOFR or OIS or something like that relative to repo rates and relative to swaps. And so far we have seen repo rates being very stable as a spread to, say, SOFR. That's a chart that we have in our portfolio on page nine. and we've seen that spread in both three-month and six-month tenors to be stable at right around 10 basis points for quite a long time. Okay. Thank you. Thank you.

Thank you. Ladies and gentlemen, that concludes our question and answer session. I'll turn the floor back to Mr. Greenberg for any final comments.

I just want to thank everyone for joining us very much today, and as always, thank you for your interest in Two Harbors.

Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.