Two Harbors Investment Corp

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.

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 TwoHarborsInvestment.com. 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.

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.