Two Harbors Investment Corp

Good morning, my name is Latonya and I will be your conference facilitator. At this time, I would like to welcome everyone to Two Harbors third quarter 2022 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. I would now like to turn the conference over to Paulina Sims. Please go ahead.

Good morning, everyone, and welcome to our call to discuss Two Harbor's third quarter 2022 financial results. With me on the call this morning are Bill Greenberg, our president and chief executive officer, Nick Letica, our 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 third quarter earnings call. I'd like to begin by extending a very warm welcome to Nick Ledica, our new chief investment officer. Nick brings more than three decades of experience in the fixed income and mortgage-backed securities markets, and we are very excited and fortunate to have him on our team. This morning, I will provide some color on the market environment and our performance. Mary will give more detail on our financial results, and Nick will discuss our portfolio activity, risk profile, and outlook. Please turn to slide three. Our book value at September 30th was $16.42 per share, representing a negative 16.2% total economic quarterly return. The portfolio performance reflects one of the most challenging market environments in decades. Risk assets widened against the backdrop of stubbornly high inflation uncertainty surrounding monetary policy, and higher interest rates. The volatility of interest rates and spreads intensified during the third quarter and peaked in the last week of September. As mortgages cheapened and as book value declined in September, we allowed our economic debt to equity ratio to drift higher from 6.4 to 7.5 times. In October, being respectful of market volatility, We thought it prudent to somewhat reduce our leverage. We sold RMBS and used some of the proceeds to repurchase 2.9 million shares of preferred stock at a deep discount to par. At the end of October, our debt-to-equity ratio was right around seven times. We felt this was a good use of capital given that the PREFs have a low-to-mid-teens yield with zero convexity risk, zero prepayment risk, and zero credit or market risk. The accretion to common book value of 26 cents can be thought of as recouping certain RMBS losses over the period that were funded with that capital. In rough terms, a portfolio of 3.5% through 5% coupon RMBS with 8-time leverage would have lost a little over 20% on equity over the last two quarters, while our preferred shares had a total return around negative 25%. It's also possible to think of this trade as selling RMBS at spread levels as they existed two quarters ago. Please turn to slide four. Although headline CPI in December ticked down slightly to 8.2%, core CPI accelerated to 6.6% to reach new multi-decade highs. Nevertheless, the market has confidence that the Fed will be successful in bringing inflation lower, and expectations, as determined by the tradable market in the future CPI fixings, are that year-over-year CPI will have a 3% handle by next summer, as seen in Figure 1. After delivering a fourth straight 75 basis point hike last week, Chairman Powell suggested that even though the Fed may slow its pace of hikes in the near term, the terminal rate is still a long way away, and it is very premature to talk about a pause. Indeed, in the wake of the Fed's meeting, current market pricing implies another 125 basis points of hikes, over the next four meetings, which would bring the implied Fed funds rate to north of 5% by mid-2023, before the Fed pauses, as seen in Figure 2. Fed officials, including the Chairman, have been very outspoken that they are not expecting to pivot and to cut rates in 2023. Mortgage rates reacted in line with the outsized macro volatility, as the depth and liquidity of the mortgage market allowed participants to adjust their exposure to risky assets very quickly. In Figure 3, we show the performance versus rate hedges on the RMBS coupon stack for each of the three months of the third quarter. July saw larger outperformance across coupons, followed by significant underperformance in August and September. Overall, belly coupons of 3.5 and 4s performed the worst, underperforming rate hedges by about 50 ticks. Please turn to Slide 5. The third quarter environment for mortgages was a continuation of what we experienced in the first half of the year. Current coupon static spreads widened another 38 basis points during the quarter, while option adjusted spreads increased 39 basis points, as seen in Figure 1. With this recent repricing, spreads are now at levels that have only been seen in acute phases of previous crisis periods. Indeed, the current spread levels are above the dotted lines in the figure, which represent the 90th percentile spreads over the last 20 years. One side effect of the rapidly rising rate environment and a mortgage index that has a dollar price in the 80s is that the convexity of the index is at all-time highs, as seen in Figure 2. Mortgages are famously negatively convex, which means the changing duration of the securities needs to be constantly rebalanced as rates move. At these rates and dollar prices, however, the mortgage index has essentially zero convexity, and it becomes easier to hedge deep discount securities. Even the so-called higher coupons are below par and benefit from a convexity profile, which is relatively benign. Figure 3 shows static and OAS spread curves across the coupon stack and their changes from last quarter. The astute observer may recognize that these curves are somewhat different from what we showed last quarter. The reason is that we have updated both our expectations around prepayments in this deep discount environment and also moved from showing LIBOR spreads to those relative to Treasuries. From this chart, it's easy to see that rates rose as the curves all shifted to the right and spreads widened as the curves shifted upwards. While interest rates have risen very quickly this year and durations on the lower coupon bonds have fully extended, we have yet to actually see prepay speeds also fully bottom out. Speeds on 1.5s are still slower than 2s, and speeds on 2s are still slower than 2.5s. Many models have put floors on how slow prepayments can be, and many of those models are now starting to over-project speeds. The very low spreads on the lowest coupons are indications that our speed expectations are likely slower than the rest of the market, and despite significant underperformance in these coupons last quarter, we see further downside performance risk. The higher coupons offer significantly more value, with static spreads above 150 basis points and OASs around 50. With the duration of the 5% coupon being only 60% of the duration of the 2% coupon, we see the value of higher coupons to be even greater when the spreads are expressed per unit of risk or duration. Nick will also have a few words to say about the comparison between higher and lower coupons in a special topic in a few moments. Now, I will turn it over to Mary to discuss our financial results in more detail.