Two Harbors Investment Corp

Q1 2023 Earnings Conference Call


spk12: Good morning. My name is Diego, and I will be your conference facilitator. At this time, I would like to welcome everyone to Two Harbors First Quarter 2023 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 session. I would now like to turn over the call to Maggie Carr.
spk00: Good morning, everyone, and welcome to our call to discuss Two Harbors' first quarter 2023 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 has been filed with the SEC and are available on the SEC's website, as well as the Investor Relations of our website at In our earnings release and presentation, we have provided reconciliations 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.
spk02: Thank you, Maggie. Good morning, everyone, and welcome to our first quarter earnings call. This morning, I will provide color on our quarterly performance and the market environment. Mary will provide information around our financial results, and Nick will discuss our portfolio activity and positioning. Please turn to slide three for an overview of our quarterly results. Our book value at March 31st was $16.48 per share, representing a negative 3.6% total economic quarterly return. Our book value was impacted by the violent move lower in rates arising from the banking crisis as our portfolio had a slight short duration bias heading into March consistent with what we disclosed in our fourth quarter earnings call. As more regional bank headlines hit the tapes, rate volatility continued to be elevated, which caused increased hedging costs and mortgage spread widening. Our earnings available for distribution, or EAD, was $0.09 per share. As we've discussed on prior earnings calls, EAD does not necessarily reflect the earnings potential of our portfolio. For this reason, last quarter we introduced the metric Income Excluding Market-Driven Value Changes, or IXM, which we believe should better assist our investors and analysts when thinking about our earnings potential. IXM was 59 cents per share for the first quarter, representing a 13.3 annualized return on average common equity. This compares to 73 cents per share in the fourth quarter. The change in IXM quarter-over-quarter is mainly the result of timing differences of realized MSR cash flows. This backward-looking metric of realized return is meant to be viewed in conjunction with slide 15, which is our forward-looking return potential slide. Let's turn to slide 4. After beginning 2023 with two months of relative calm, the financial markets were roiled in early March by the seizure of two regional banks, Silicon Valley Bank and Signature Bank, by banking regulators, which sent tremors throughout the banking system. The undercurrent of the Fed's campaign of raising rates was called into question, and the market, which was already extremely sensitive, quickly reacted to the new information. Interest rates on the front end of the yield curve plunged, with the two-year Treasury yield declining by 109 basis points over a three-day period, culminating in the largest one-day move ever on March 13th. Just a few days prior, the two-year yield had hit a cycle high of 5.07%, its highest level since 2007. These effects can be seen clearly in Figure 1. At the beginning of the year, the market was pricing in just one more interest rate hike with a peak Fed funds rate of just over 5% and a terminal rate of 4.5%, as shown by the light blue line. By early March, the market became more bearish, pricing in three rate hikes, only to snap back after the SVB news broke and all rate height expectations were replaced with rate cuts. Despite the market's expectations, the Fed raised its benchmark rate by 25 basis points on March 22nd in a continued effort to slow down the economy and drive inflation down towards their long-term annual target of 2%. Interestingly, however, by late April, the market was again predicting a forward path of Fed activity almost exactly as it had been on December 31st. If an investor had slept through it, they wouldn't have known that a 300 basis point round trip in Fed expectations had even occurred. This kind of interest rate volatility, especially for maturities inside of one year, are breathtaking and are good reminders of why we keep our interest rate exposures low across the curve. Moving to Figure 2, I'd like to change gears and expand upon a subject that may be underappreciated in the market, which is the float income component of MSR. Float income refers to the interest that is earned on principal and interest and taxes and insurance before those monies need to be remitted to the relevant investors. While MSR and fixed coupon interest only or IO bonds share many similarities and risks, MSR is not a bond. It has important additional cash flows that include cost-to-service and compensating interest, which detract from the overall cash flow, as well as additive cash flows, like float income, late fees and ancillary income, and recapture. In different interest rate environments, these components will add more or less to the value of servicing. Looking at the chart in Figure 2, you can see in the light blue line that in a rising rate environment, an I.O. extends as prepayment speeds slow, which causes the price to increase. At very high rates, the prepayment speeds can't go any slower, which ultimately results in an I.O. acquiring positive duration and decreasing in price as rates increase. In contrast, the float component of MSR behaves differently. You can see this in the navy blue line on the chart in Figure 2. The price goes up for two reasons as rates rise. First, like an I.O., MSR extends as rates rise and prepayments slow. causing the price to rise. Second, as rates rise, the effective coupon of float income also increases, since the cash flow is based on the short-term earnings rate on those custodial balances. At very high rates, even when the prepayment speeds can't flow anymore, the effective coupon on this component continues to rise, which causes the price of this component to continue to increase. In Figure 2, as you can see, In higher rate environments, these additional cash flows cause the value of MSR to outperform the I.O. While in a normal rate environment, the float components of MSR can contribute about 50% of the duration of the MSR asset, when rates are higher and the MSR is deeply out of the money, the float components can contribute closer to 80% of the duration of the entire MSR asset. The main point here is that float income, which is essentially uncapped, adds materially to the negative duration of out-of-the-money MSR and is now the primary reason why MSR multiples could continue to rise somewhat in a further sell-off. Looking forward, we are cautiously optimistic about the investing environment. With high interest rate volatility and with the FDIC selling large amounts of bonds, spreads on RMBS are at historically attractive levels. Nevertheless, there remain uncertainties in the markets from potential follow-on effects from the banking crisis to political uncertainty related to the debt ceiling debate. As a result, while fundamentally we might expect that an overweight position in mortgages is justified, we think a more neutral posture is prudent, given the technical backdrop. Furthermore, with banks likely on the sidelines of the MBS market for the time being, and with the Fed and GSEs out of the market, we think that widespreads available in the market can persist for some time. Wider for longer suits us just fine, as we believe those spreads are attractive for our portfolio and should be supportive of our ongoing earnings generation. With all of that said, we are committed to and confident in our portfolio construction of agency RMBS paired with MSR, and we believe that our portfolio, with less mortgage spread duration than portfolios without MSR, is very well positioned to benefit from the current environment. Now, I will turn it over to Mary to discuss our financial results in more detail.
spk03: Thank you, Bill, and good morning, everyone. Please turn to slide five. For the first quarter, the company incurred a comprehensive loss of $63.2 million, or negative 69 cents per weighted average share. Our book value was $16.48 per share at March 31st, compared to $17.72 at December 31st. Including the 60-cent common dividend results in a quarterly economic return of negative 3.6%. The results primarily reflect mortgage spread widening in March and increased hedging costs. Moving to slide six, I'd like to add some detail around IXM. In the first quarter, IXM was 59 cents per share, representing an annualized return of 13.3%. This quarter, we refined the calculation of IXM for determining expected price changes to use the realized forwards methodology, which is a change from Q4 when we use the unchanged term structure methodology. Standing on that, the methodology for determining expected price changes may be computed based on either of two commonly assumed scenarios, realized forwards and unchanged term structure. The unchanged term structure methodology assumes that the term structure of the yield curve is unchanged day over day. The realized forwards methodology assumes that rates follow the one-day forwards, Q4 IXM under both methods was a return per weighted average share of 73 cents. Quarter over quarter, IXM decreased to 59 cents from 73 cents, which can almost entirely be attributed to timing differences in the realization of certain MSR cash flows. The service fee that is collected depends on the precise day of the month that borrowers make their mortgage payments. There's also a seasonality component to float income. as some of the custodial balances, like taxes and insurance, are due to be remitted once, twice, or four times per year. Finally, certain servicing costs also fluctuate from period to period, such as non-recoverable advances and interest on escrows. IXM takes into account these natural cash flow timing variations. As a result, the difference between Q1 and Q4 does not reflect significant degradation in the earnings power of the portfolio, but rather a reflection of the realization of MSR cash flows. Slide 15, our return outlook slide, is the forward-looking version of IXM, and those prospective return ranges are consistent, albeit wider, with the prior quarter. Please turn to slide seven. We thought that it would be helpful to provide investors and analysts a comparison of GAAP and non-GAAP measures. GAAP comprehensive income excluding realized and unrealized gains and losses and non-recurring expenses as compared to EAD and IXM. In future quarters, this comparison will be included in the appendix slide, but we would like to highlight a few things this quarter. As you see on this page, the actual cash flows for income and expense are the same in all three measures, with a few minor exceptions. For example, if you look at the RMBS section, coupon income and funding expense are the same across all three. This is also generally true for MSR servicing income float and ancillary, servicing expenses, and funding expenses. The primary differences in the measures result from the amortization lines, or what we refer to as price changes. IXM for RMBS and MSR is based on market value and expected return, which is different from GAAP and EAD amortization. For RMBS, GAAP and EAD amortization is based on amortized cost and yield to maturity at purchase. For MSR, GAAP amortization is based on the percentage of principal paid multiplied by the beginning market value. And for EAD, amortization is based on amortized costs and the original pricing yield. We hope that this disclosure helps reconcile the differences between our GAAP and non-GAAP measures. Please turn to slide eight. Earnings available for distribution was $0.09 per share compared to $0.26 for the fourth quarter. As a reminder, we expect EAD to continue to diverge from expected ongoing earnings power. The decline in EAD this quarter was primarily driven by changes in interest income and expense. Interest income increased by $17.3 million, primarily due to four things. Higher rates on cash holdings and reverse repo balances, an increase in the size of our RMBS portfolio, rotation to higher net yielding RMBS, and slower prepayment speeds. Likewise, interest expense increased by $26.9 million on higher financing rates and higher borrowing balances on RMBS, partly offset by lower borrowing balances on MSR financing. Turning to slide nine, the portfolio yield increased 17 basis points to 5.09% due to the rotation to higher net yielding RMBS, lower agency CPR, and a higher proportion of the portfolio invested in higher-yielding assets. Our net realized spread in the quarter narrowed by 45 basis points to 0.52 percent from 0.97 percent, primarily due to higher rates on financing. As a reminder, the portfolio yields in this table are EAD-based calculations and not market-based measures. Please turn to slide 10. Let's spend a moment talking about financing and what we are seeing in the repo markets. Despite the extreme volatility and news about the banking crisis, funding in the repo market remains liquid and well supported. Spreads on repurchase agreement financing for RMBS improved in January and February from year end, but increased in March following the news of bank failures. At the end of the quarter, spreads on repurchase agreements were coming back in and were so far plus 15 to 20 basis points. with no signs of balance sheet stress. We financed our MSR across four lenders with $1.5 billion of outstanding borrowings under bilateral MSR asset financing facilities and $400 million of outstanding five-year MSR term notes. We maintained access to diverse funding sources for MSR with a total of approximately $606 million unused MSR financing capacity at quarter end. I will now turn the call over to Nick.
spk09: Thank you, Mary. Please turn to slide 11. I'd like to focus my opening comments on the supply and demand dynamics for mortgage-backed securities, which in our minds is the primary narrative in our market. Figure 1 shows current coupon spreads since the beginning of last year. Spreads are unquestionably wide with nominal and OAS spreads respectively in the 92nd and 82nd percentiles of long-term history, generating attractive levered returns in the low to mid-teens as shown in our return potential a few slides forward. Despite these positive signals and a strong belief that over a longer horizon, this time period will be viewed as a great entry point, our enthusiasm is tempered by the belief that over the short to medium term, supply is likely to keep mortgage spreads wider than long-term averages and could potentially push them wider than their already generous levels. In fact, we have seen spreads widen into the beginning of this quarter. In addition to $200 billion of projected net organic supply for 2023, the FDIC, through BlackRock, has commenced auctions of the assets seized from Silicon Valley Bank and Signature Bank, which will likely persist for the next six months. The sales of the lower coupon, deep discount agency RMBS and CMO positions total approximately $85 billion. Inclusive of these sales, other banks selling and Fed paydowns, which are effectively another form of supply, The total net supply for agency RMBS is projected to top $500 billion for 2023 with the bulk of the supply ahead of us. In an environment where many banks are either on the sidelines or perhaps selling, it will be up to relative value accounts like money managers, REITs, and hedge funds to absorb the bulk of the supply. This group of investors typically demands a higher risk premium than depository institutions. As such, it is reasonable to assume that spreads will remain wider than long-term averages. Figure 2 provides some historical context of the relationship between option-adjusted spreads and who is buying and who is selling. The blue bars are institutional accounts, like banks, the Fed, or the GFCs, while the gray bars are relative value accounts, like money managers and REITs. The line is the option-adjusted spread of the MBS index as measured by Bloomberg at the end of each year and for 2023 at the end of the first quarter. In periods in which institutional demand dominates, spreads tend to be tighter or tightened. Conversely, in periods when relative value accounts are the buyers and institutional accounts are the sellers, spreads widen. There are several periods that we could point to, but the most recent experience of tightening was the 2020 to 2021 period with strong bank and Fed buying. Then into 2022 to 2023, the Fed and banks stepped back from buying, which drove spreads wider by over 30 basis points to what now are historically attractive levels. To sum this up, spreads have already reacted to the shift in the buyer base and the anticipation of excess supply, and at present levels are supportive of our strategy. That said, It remains to be seen whether these effects are fully priced into the market, as the thick of the supply is still ahead. The FDIC bank-related selling has made lower coupon MBS valuation more attractive. Post-quarter end, we have moved some of our mortgage exposure down in coupon, but have plenty of dry powder to do more of that trade and or increase our spread exposure as opportunities present themselves in the coming months. Now let's turn to slide 12 and discuss our portfolio in the first quarter. At March 31st, our portfolio was 15.8 billion up from 14.7 billion at the end of the fourth quarter. On the top right of the slide, you can see a few bullet points about our risk positioning and leverage. From a risk perspective, we opportunistically moved about 30% of our hedges from treasury futures to swaps to take advantage of deeply negative swap spreads in the quarter. Given the macroeconomic uncertainty, we are keeping exposures low across a wide range of interest rate and curve scenarios. You can see more detail on our risk positioning by looking at slides 17, 18, 28, and 29 in the appendix. Our debt-to-equity ratio increased slightly to 6.5 times, maintaining a neutral leverage position as we were balancing the wide nominal spreads available in the market versus historically high volatility and the supply-demand dynamics that we just discussed. In terms of portfolio activity, in February we completed a common stock capital raise for net proceeds of $176 million. In line with our stated objective at that time, we settled 11 billion UPB of MSR through a bulk purchase paired with an additional billion of current coupon TBA. We have committed to acquire an additional 15 billion UPB of MSR to settle in the second quarter. Given the subsequent widening of mortgage spreads, this capital allocation proved to be the right one. In the quarter, we were active in moving positions between TBA and specified pools, as highlighted in the bullets under portfolio activity. We moved $2 billion of higher coupon TBAs into loan balance, credit, and geo pools to capture relative spread pickup and mitigate future prepayment risk. We then moved some four and four and a half specified pools, which we believe were fully valued, into TBAs. Finally, we covered a short position of Fannie Mae 2 TBAs after the sharp underperformance of the lower coupons in March. Moving to slide 13, our specified pool portfolio was predominantly positioned in higher coupon, loan balance, and geo pools at quarter end. Mortgages had mixed performance across the coupon stack in the quarter, with low coupon 2 and 2.5s widening about a half a point, driven primarily by supply concerns from FDIC-related sales. Current coupon RMBS widened by a similar magnitude given their persistent supply. The belly coupons of threes through four and a half remains roughly unchanged without the supply pressures felt by the lower and higher coupons. In the quarter, specified pools modestly outperformed TBAs, as you can see in Figure 2. Specified pool prepayment speeds also declined to 5.3% CPR, as you can see in Figure 3. Please turn to slide 14. Our MSR portfolio was $3.1 billion at March 31st, comprised entirely of agency MSR. We saw a 35% increase in supply of MSR on the quarter for the reasons we discussed on our last earnings call. As rates have risen, originations have slowed, and mortgage companies are selling MSR to fund their ongoing businesses. This is occurring at the same time as several large MSR holders announced their intentions to step back from the MSR market. As previously discussed, we added four bulk purchases, opportunistically taking advantage of the selling in the market. Our price multiple modestly decreased to 5.4 times, which incorporates the effect of the settled bulk purchase. As anticipated and providing a tailwind for our MSR, repayments continued to slow, coming in at 4.1% CPR in the first quarter. Finally, please turn to slide 15, our return potential and outlook slides. The top half of this table is meant to show what returns we believe are available in the market. We estimate that about 61% of our capital is allocated to hedged MSR, with a market static return projection of 14% to 17%. The remaining capital is allocated to hedged RMBS, with a static return estimate of 12% to 14%. The lower section of this slide is specific to our portfolio, with a focus on common equity and estimated returns per common share. With our portfolio allocation shown in the top half of the table and after expenses, the static return estimate for our portfolio is between 10.4 to 13.1% before applying any capital structure leverage to the portfolio. After giving effect to our outstanding convertible notes and preferred stock, we believe that the potential static return on common equity falls in the range of 12.3 to 16.6% or a prospective quarterly static return per share of 50 to 69 cents. Thank you very much for joining us today. And now we will be happy to take any questions you might have.
spk12: Thank you. And ladies and gentlemen, at this time, we will be conducting our question and answer session. If you would like to ask a question, please press star one on your telephone keypad. Confirmation tone will indicate that your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Our first question comes from Doug Harder with Credit Suisse. Please state your question.
spk10: Thanks and good morning. I'm hoping you could talk a little bit about how you're thinking about when the time might be to want to increase Your mortgage basis exposure, you know, kind of given your comments that spreads are towards the wider side and, you know, kind of what are the factors you'd be looking at?
spk02: Good morning, Doug. Thanks very much for the question. You know, as Nick said in his prepared remarks, you know, on a fundamental basis, the spreads are certainly attractive. They're at, you know, historical wide levels. But there's just so much out there that we see that tempers our enthusiasm, you know, the banking crisis stuff out there is still ongoing, even with the resolution of First Republic. So there's a lot of uncertainty there. And of course, we have some debt ceiling stuff coming up this month to be resolved. And there's a whole bunch of stuff in the market that seems like it's not giving the all clear sign. And so we're going to wait a little bit to see how that unfolds. As I said, or as Nick said, with With the banks out and with the GSEs out, we think that it's more likely than not that spreads can stay at these levels for quite some time here. And so that's sort of our outlook, and that's what we're looking for, and we think that suits us fine.
spk10: I guess just given that uncertainty, I guess how would you characterize the risk for further widening versus how much of those risks are kind of priced into the markets?
spk09: Hey, Doug, this is Nick. Yeah, very good question. Something that honestly we grapple with day in and day out these days. It's not as though, as we said in the comments, where spreads are right now. And when you see our return potential, they are very supportive of our strategy to generate a high level of return and income. So, as Bill said, we don't feel pressed to increase leverage or exposure, given all the uncertainties that are ahead of us. And as I said in my comments, we have seen spreads widen since quarter end, and that's amidst some technicals that have not moved in the same direction. For example, longer-term volatility has increased. pretty much moved sideways. You know, we had a strong correlation between those things prior to the event in March with the banks. And, you know, but since then, given these supply concerns, we've seen, you know, spreads kind of widen out in a fairly flat volatility environment. So, you know, we're watching it. You know, we'll see where things go. But, you know, it's a very hard thing to predict right now.
spk12: Okay. Thank you. Our next question comes from Kenneth Lee with RBC Capital Markets. Please state your question.
spk05: Good morning. Thanks for taking my question. Just one on the static returns prospectively. Just wondering if I could just get a little bit more thoughts around potential volatility there and what could be sort of like the key drivers that you think over the near term that could drive some of that volatility in terms of the static returns there. Thanks.
spk09: Hey, Ken, that's a great question. And as you can see, you know, if you compare the range of our results compared to this quarter versus last, you can see that we actually have a wider range than we did last time. And that is reflective of the volatility we're seeing in the market and the assumptions that go into this analysis. And of course, you know, a big component of it is just the spread level in the market, right? So to the extent that spreads are wider or more volatile, you're going to see a wider variation in these numbers. But it takes into account all the assumptions that you would expect in a levered mortgage return. Obviously, prepayments are a big part of it. Funding levels are a part of it, all those things. And we feel like this range that we have this quarter that we're giving a 50 to 69 cent range does incorporate a wider variation in the underlying assumptions that could drive these numbers.
spk05: Gotcha. Very helpful there. And then just one on the hedging strategy. There were some changes in the book value sensitivities to rates, but just wanted to get a higher level. What's the best way to think about your current hedging strategy? What kind of scenarios are you positioning yourself for? Thanks.
spk09: We're really trying to be very balanced right now. We are trying to be pretty agnostic with regard to direction of rates or curve shape, just given all the variabilities that are in the market right now. And the path, I think, ahead of the banking crisis we had in March was Probably a little bit more predictable than it is right now. The effects of what the bank crisis will do to the economy and how much work that's actually going to do for the Fed are all things that are, I think, very, very hard to judge. So we're trying to stay pretty neutral across the curve. I think if you look at our exposures, they are pretty balanced in, as I said, across the curve and in various curve scenarios where we're trying not to take a strong view in one way or the other.
spk05: Gotcha. Very helpful. Thanks again. Thank you. Thank you.
spk12: Our next question comes from Bose George with KBW. Please state your question.
spk06: Hey, guys. Good morning. Actually, just on sticking to slide 15, as your allocation to MSR, you know, increases, does the prospective range of that return go up just as that hedged MSR percentage, you know, increases?
spk02: Yeah, well, I think just from a, thanks for the question, good morning. Yeah, I think if you look at the top of slide 15, you know, the higher the percentage to MSR, given the fact that the static return estimates for MSR is higher than that from the RMS right now, that would increase that results the more that we did that.
spk06: And how high could that percentage, the hedge MSR percentage, potentially go this year?
spk02: Well, we don't have a set number in mind. It depends on market opportunities and such things. We do see value, even aside from it being, as we show here, a higher static return potential than RMBS. We do think there's value in having some RMBS in an RMBS portfolio as a balance here. And so it can go higher, but you're unlikely to see it be 100%.
spk06: Yep. Okay. Great. And actually, switching, just wanted to ask about book value. Can you just give us an update on book value according to date?
spk02: Yeah, you bet, Bose. So, you know, as Nick said during his comments as well as in the Q&A here, spreads have been volatile. They've been wider in the month of April. You know, for the first half of the month, you know, through the 21st, we were rolling down, you know, between 1% and 2%. But in the last week of the month with FDIC sales and First Republic noise, spreads have been pretty rocky here. And as of Friday, we were down about 4%.
spk06: Okay, great. Thanks for the update.
spk02: Thank you.
spk12: Our next question comes from Trevor Cranston with JMP Securities. Please state your question.
spk08: Hey, thanks. The question on the float income you guys talked about earlier in the presentation, a couple things there. Number one, do you have what the average balance of custodial funds was in the first quarter? And also, I was wondering if you could, you know, Mary talked about the seasonal impact of tax payments on float income. I was wondering if you could, you know, provide any sort of numbers around the estimated seasonal impact for the first quarter. Thanks.
spk02: So thank you for the question. Um, and good morning. Um, we don't have those numbers handy as to what, what the average balance is. We can, um, we can circle back on that. Um, you know, in terms of the seasonality that, that, that Mary mentioned, you know, some States, some States require interest on escrow. Some States don't, some States require the remittances to be done annually. Some are drive semi-annually, some do it monthly and so forth. And so, um, that provides a natural seasonality among the states and the balances that exist between the states between when things need to be remitted and how long you can hold on to it for. So that's a very detailed question. It's not a simple seasonality like you have in prepayments where it's slower in winter and faster in summer. It's a more complex shape than that if you were to graph it out. Okay.
spk08: Got it. Thank you.
spk02: Yep.
spk08: Thank you.
spk12: Our next question comes from Aaron Saganovich with Citi. Please state your question.
spk11: Thanks. Just kind of following up on Doug's earlier question about spreads and when they could potentially tighten, what are the kind of scenarios that would likely lead to tighter spreads? Would it be, would we have to enter into a recession and see you know, generally lower rates, you know, and slower kind of growth overall to bring folks back to wanting to get, you know, I guess more demand for RMBS assets.
spk09: Hey, Aaron. Yeah, thank you for that question. The traditional drivers for tighter mortgage spreads are lower volatility and generally speaking, steeper yield curve and a rally. I mean, those are the historically have been the elements to drive spreads tighter. Very interesting, the market that we're in right now with this lack of bank buying and potentially a little bit different response from the banking community than we've seen in the past, given the, uh, focus on, uh, you know, bank portfolios and duration of bank portfolios and what that means. And, you know, really that's, that's, what's driving our comments and belief that we're going to see spreads wider than long-term averages for a long period of time. But I think, you know, to, to answer your question, uh, as usual, I think more predictability on the path of, of rates, the movement of the fed should, should, uh, drive mortgage spreads tighter and just a passage of time a little bit here as we get through the supply that is in front of us, both from an organic nature of some of the higher coupon production numbers, which are not overwhelmingly large, but large enough in the current market, especially without banks buying, and then the dual effect of the slug of lower coupon supply that's coming into the market. What I would say is, you know, what has held mortgage spreads in, and one of the reasons that we were very optimistic about mortgage spreads early in the year has been just the amount of retail flow that's come into fixed income that has been supportive of all of fixed income and mortgages. And, you know, that's flowing through the money manager channel. So, you know, the fate of spreads here in many ways is sitting with the money management community and how much they can absorb of the supply that's coming into the market.
spk11: Okay, and do you think that whenever the Fed does pivot and provide, you know, kind of a, instead of a tightening, you know, guide path to a, you know, a kind of loosening guide path with lower short-term rates, would that be enough on its own to likely lead to tighter spreads as you kind of get away from this inverted yield curve?
spk09: I mean, it should be helpful. One thing that's been said in the market, which I think is an interesting point, is that with these sales coming from the FDIC and through BlackRock, there is potentially some market sensitivity to those sale levels in that if rates rally and prices go up, it could cause potentially an acceleration of those sales. that might temper mortgage performance in that kind of scenario. But overall, I would agree with your, I would agree with your assertion that if we see a turnaround and a little bit more predictability out of the Fed, that should be positive for mortgage spreads.
spk11: And then my last question is, slide seven, you have kind of the listed, you know, various gap and non-gap earnings. Which one of these is setting your dividend policy? I fully understand like the, The IXM is kind of more illustrative of what your earnings power can be. But we're struggling a little bit with trying to figure out where dividend might go relative to the potential earnings power and the actual earnings that you're producing.
spk03: Hi, Aaron. This is Mary. So we obviously consider several measures, and I think the what I would point you to is slide 15. That is probably the most significant factor in determining where we think return potential is and where we set the dividend.
spk11: But in terms of the actual earnings that you have, I mean, are you going to end up, like if you produce a quarter like you did this quarter, are you going to be returning capital relative versus actual earnings relative to that distribution?
spk03: Well, the characterization of the dividend depends on taxable income, which is different than all these measures. But I think I would point you to the cash flow information on page seven. And, again, we believe the dividend is reflective of the return potential of the portfolio.
spk12: Okay. Thank you. Our next question comes from Eric Hagan with BTIG. Please state your question.
spk01: Hey, thanks. Good morning. Hope all is going well. I think just one from me. When you think about your stock valuation and where you could trade on a near and longer term basis, how does that drive the amount of leverage that you're comfortable running? Like how much more risk do you think you can take at your current valuation? And what scenarios do you think you could maybe trade at a higher valuation with higher leverage?
spk02: Well, thanks for the question, Eric. Good morning. I would say that we don't really think of the stock prices having an input into the amount of leverage that we run. That's really a risk question. We're always trying to have performance so that the returns are high quality returns with an acceptable level of risk. And so we're making those decisions you know, based on the existing portfolio and the existing assets and the existing book value rather than looking at what the stock price is. We're not trying to link the two in any way. I don't know if that answers your question or not.
spk01: Okay. That's helpful. Thanks.
spk12: Thank you. And our next question comes from Rick Shane with J.P. Morgan. Please state your question.
spk07: Thanks, everybody, and good morning. Hey, Nick, I have some questions on slide 29, which is the interest rate swaps and swaptions. You had talked a little bit about the hedging strategy during your comments, but can you help me understand what's going on on this slide? It looks like a lot of netting trades, but again, I think there's something much more sophisticated going on there than I understand. If you can just help us understand both the interest rate swaps and the swaptions because the notional seems to largely net out.
spk09: Yeah. Hey, Rick. How are you doing? Thank you for that question. So I don't think it's actually as complicated as you may be inferring from that slide. As we noted in our prepared remarks, we did move some of our hedges this quarter from futures to swaps, and that was really driven by the fact that There were some opportunities with some fairly deeply negative swap spreads to put that trade on at levels we thought were effective and to boost our spot carry on our hedges in what we thought was an efficient way. And as I said, it's about 30% of our hedge book that moved away from futures. We like to have a mix of those. hedging instruments because as markets have moved around with the volatility in the markets and you run into potential bouts of illiquidity, having both of those instruments at our disposal can be helpful when things are moving around as fast as they are. I think what you're seeing in terms of some of that netting is just you're seeing the portfolio activity and the re-hedging that we did as the quarter progressed. Rates, as you know and we discussed, rates moved an epic amount in March and, you know, we had put some hedges on earlier on the quarter that we needed to reverse as, you know, as the market rallied and, you know, our portfolio would get shorter, we obviously have to adjust our hedges. So I think that's what you're seeing in those numbers. The interest rates options is, you know, was a small trade we put on to, for, you know, some protection and some rate scenarios. And that's, that's what you're looking at on that page.
spk07: Got it. Okay. So I heard the initial comment as you saw an opportunity and I had assumed that that opportunity had persisted. And what you're saying is that there was an opportunity in terms of the curve that you saw benefited from it and then largely netted that trade out as you moved through the quarter.
spk09: Well, I wouldn't say we netted it out. We're ending the quarter with some of our hedging and swaps. It's just that as we re-hedged through the quarter, some of the initial trades we did, we had to pare down along with other trades because our hedge book has to move with the duration of our underlying securities. Okay. Got it.
spk12: Thank you very much.
spk09: Of course. Thank you.
spk12: Thank you. There are no further questions at this time. I'll hand the floor back to management for closing remarks.
spk02: I want to thank you all for those good questions. I want to thank you all for taking the time to join us today. And thank you, as always, for your interest in Two Harbors.
spk12: Thank you. And with that, we conclude today's conference. All parties may disconnect. Have a great day.

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