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Text: I'm excited to join the Two Harbors' team and look forward to working with all of you.
We urge you to review this information in conjunction with today's call.
These statements are based on the current beliefs and expectations of management and actual results may be materially different because of a variety of risks and other factors.
Paulenier brings with her more than a decade of financial services and Investor Relations experience, and we are very excited to have her here with us.
Mary will give more details on our financial results, and Matt will discuss our portfolio composition, activity and risk profile.
Turning to Slide 3.
We are very pleased with our fourth-quarter performance and book value of $7.63, which represents a 5.8% quarterly return on book value.
The results were driven primarily by continued outperformance of lower coupon TBAs, some improvement in specified pool pay-ups and some marginal tightening in MSR spreads.
We have spent a significant amount of resources over the years building out our MSR acquisition and oversight platform, and we reaped some benefits this quarter as we added over $40 billion of unpaid principal balance of MSR through both our flow sale channel and bulk purchases.
Finally, as a reflection of all of these trends and with the confidence in our forward outlook, we also raised the common stock dividend this quarter by 21% to $0.17 per share.
We have also been very focused on our liability structure.
Subsequent to quarter end, we issued $287 million of a new convertible note maturing in 2026 and whose proceeds were primarily used to refinance the existing convertible note that is maturing in January 2022.
We felt it was important to execute this exchange sooner rather than later as it provides uncertainty for us of our capital structure for the intermediate future without having this maturity looming for the next year.
Additionally, we wanted to have as many potential opportunities as possible to execute, and this window was available and so we were pleased to access it.
With the certainty provided by the exchange and maturity extension of the convertible notes, we also felt it was the right time to call our Series D and E preferred stock.
As a consequence of the events of the first quarter, our ratio of preferred stock to total equity had increased from 20% to about 32%.
While we have stated that we felt this amount was manageable, we did recognize that this was not only high compared to our peers, but more importantly, it is not what we would write down on a blank piece of paper for our capital structure.
During 2020, we built up a very sizable liquidity position to protect us against further market stress.
As time has passed and as the markets have stabilized, we have come to recognize this amount of available liquidity as overly conservative.
Furthermore, the primary measure by which we manage our portfolio is potential loss to stockholder equity and not nominal leverage, and we have stated many times that we are comfortable with our portfolio risk profile.
Further deploying all of this excess liquidity into our target assets would increase our risk to uncomfortable levels.
Those two ideas together led us to the conclusion that we had a certain amount of capital that was essentially fallow and that its best use was to call the Series D and E preferred stock.
After the call was completed on March 15, our new ratio of preferred stock to total equity will be about 26%, which we think is appropriate for our Agency plus MSR portfolio.
The convertible note exchange and the call of the preferred stock will result in a mix of common, preferred and unsecured debt that is rightsized for our portfolio composition and risk appetite for the foreseeable future.
It is also accretive to earnings, as Mary will discuss in a few moments.
We continue to see good momentum in our MSR purchase program, which has helped to offset the impact of high prepayment speeds we have been seeing.
Purchases in our MSR flow program grew by over 136% year over year, reflecting the strength of the platform and relationships we've built to source and manage the asset.
On the RMBS side, there are still several tailwinds, the most important of which are very low funding rates and continued Fed involvement which they have indicated will persist for some time.
However, spreads on RMBS are at very tight levels, as Matt will discuss later, and we think some caution is warranted.
While unsure of the timing of any potential spread widening, we believe that in an environment with uncertainty in the direction of RMBS spreads is one where our portfolio with its lower exposure to those spreads because of the MSR offset is especially attractive.
Turning now to some comments about the full-year performance.
Results for 2020 as a whole were disappointing to be sure as book value declined to $7.63 from $14.54, a result of the market volatility and dislocation induced by the pandemic.
The decisive and proactive actions we took in the first quarter to sell our non-Agency portfolio, derisked the balance sheet and generated a strong liquidity position.
We took control of our own destiny, and we met every single market call during the period.
Apart from portfolio returns, 2020 has been a transformational year for Two Harbors as we transitioned to self-management.
Our stakeholders continue to benefit from the collective investment, risk management, governance and operations expertise from those who have been supporting the company for many years.
At the same time, we have the opportunity to deliver additional value through significant annual cost savings and enhanced returns on any future capital growth.
Importantly, the internalized management structure enhances transparency and further aligns our goals with that and our stakeholders.
In many ways, we think of our newly internalized company as Two Harbors 2.0, and we are really excited for 2021 and the years ahead.
We generated comprehensive income of $113.5 million or $0.41 per common share, representing an annualized return on average common equity of 22.1%.
As Bill mentioned, our book value rose to $7.63 from $7.37 per share on September 30, resulting in a total economic return of 5.8%.
Book value growth was driven by favorable MSR pricing due to marginal tightening in MSR spreads, TBA dollar roll specialness and lower expenses due to transition to self-management.
Moving on to Slide 5.
Core earnings increased to $0.30 per share from $0.28 in Q3.
Interest income decreased this quarter from $89.7 million to $72.5 million due to lower average balances and coupons as well as higher Agency amortization due to prepayments.
This decrease was partially offset by lower interest expense of $22.6 million, reflecting lower borrowing rates and average balances.
Gain on other derivatives increased from $32.9 million to $43.5 million due to higher TBA dollar roll income on higher average balances and continued roll specialness.
Roll specialness contributed $0.06 to core earnings versus $0.04 in Q3.
Expenses declined by $6.2 million, primarily due to transition to self-management and lower servicing costs.
Turning to Slide 6.
Our portfolio yield in the quarter was 2.26%, and our net spread decreased two basis points to 1.76%.
Portfolio yield decreased by 16 basis points from 2.42% to 2.26%, primarily due to higher Agency RMBS prepayments.
Our cost of funds decreased 14 basis points from 0.64% to 0.50%, driven primarily by favorable repo rolls.
This quarter, we are providing additional disclosure to reflect the impact of net TBA dollar roll income in our portfolio yield.
Inclusive of this impact, the annualized net spread for the aggregate portfolio was 1.96% with the benefit of 36 basis points in cost of funds.
I'd like to reiterate that since our RMBS position continues to reflect some accounting yields from the higher rate environment in which they were purchased, both core earnings and portfolio yields are anticipated to exceed our expected economic returns in the coming quarters.
We expect our asset yields to decline over time to market rates and the net portfolio spread should converge to market levels that are more consistent with our return expectations.
Slide 7 highlights our strong liquidity and capital position with ample liquidity with $1.4 billion in unrestricted cash as well as $215 million in unused committed capacity on our MSR asset financing facilities.
Late in the third quarter, we also added a $200 million servicing advanced facility to provide committed capacity in the event of increased forbearances or defaults.
As a reminder, forbearance rates have been to date benign and lower than expected.
Our economic debt to equity at quarter end declined to 6.8 times from 7.7 times at September 30, as we decreased risk late in the quarter.
And our quarterly average economic debt to equity was 7.5 times in Q4 compared to 7.6 times in the third quarter.
On Slide 8, we have outlined the pro forma impact of the liability and capital actions we have taken post-quarter end.
As Bill mentioned, the issuance of new convertible debt in February provided certainty around the maturity and refinancing of our existing convertible debt, which matures in January of next year.
With that certainty in hand and our plans to optimize the financing of our MSR asset over the coming year, we elected to redeem $275 million of preferred stock, effectively reducing our cost of capital as well as our preferred ratio to 26%.
Taken together, these actions are expected to deliver an annual net benefit to earnings of approximately $0.04 per share beginning in 2022, from the reduction in preferred dividends, offset by costs associated with the convertible debt and incremental MSR financing.
As a final note, we have included information on REIT taxable income and the tax characterization of our dividend distributions on appendix Slide 27.
For additional information, regarding the distributions and the tax treatment, please reference the dividend information found in the investor relations section of our website.
Turning to Slide 9, let's review our quarterly portfolio activity and composition.
As previously noted, the fourth-quarter economic performance was primarily driven by a general spread tightening in MBS as the Federal Reserve continued its balance sheet expansion, having purchased almost 1.5 trillion MBS during Q4 so far.
Not surprisingly, the strongest move was seen in the current coupon mortgages that have been the Fed's focus with a more modest but positive performance in higher coupons.
With interest rates modestly better steepening, but generally stable, we also saw some modest improvement in MSR spreads.
As Mary noted, we did decrease risk somewhat during the quarter, reflected by lower economic debt to equity of 6.8 times.
This is in part from sales and paydowns in our specified pool portfolio, where valuations in some stories and coupons have become less attractive.
In addition, after having increased our position size in TBA 2s to $7 billion, a significant spread tightening and resulting valuations in the quarter led us to reduce that exposure.
On net, we took our overall notional TBA exposure down by $1 billion to end the quarter at $5.2 billion.
Another factor behind the decision to reduce our exposure was that the Fed began to focus its purchase activity in forward months, which aligns more closely with origination sales and has the effect of decreasing roll specialness.
The result has been that roll specialness in the 2% coupon has decreased significantly between mid-December and the end of January.
We continue to have good success in sourcing substantial volumes of new servicing through our flow channel at attractive levels and have largely been able to maintain the size of our portfolio in this fast prepay environment.
Additionally, we opportunistically added almost $200 million market value of interest-only securities, or IO, during the quarter.
The market is seeing very strong demand from banks for structured mortgage-backed securities near to par dollar price, which can only be created today by stripping IO off of premium securities.
That demand has led the spreads on the strip down security that are tighter than that on the underlying securities.
We consider those spreads quite aggressive with some structures actually having negative option adjusted spreads, which means that the result in IO that we retain is very attractive.
Additionally, these positions provide portfolio benefits that are similar to MSR when paired with RMBS in reducing mortgage spread exposure even further.
In the lower left-hand chart, you can see that specified pool performance was mixed with a 3%, 3.5% and 4% coupon specified outperforming TBA, but flat or underperforming in both lower and higher coupons.
While we don't own any specified pools in the 2% coupon, as I mentioned earlier, we do own TBA, which outperformed by more than one point during the quarter, supported by strong Fed demand and attractive roll dynamics.
Today, with regards to specified pools, we remain positioned largely in loan balance and geography stories.
In the lower right-hand chart, we show a comparison of generic speeds to our specified portfolio speeds by coupon.
The slower prepayment speeds of specified compared to generic highlights the reason that specified pools command a significant price premium over TBA.
Moving to Slide 11.
You can see that our MSR portfolio was valued at $1.6 billion as of December 31, based on $186 billion of UPB and with a gross coupon of 3.7%.
That translates into a price of about $0.86 or right around a 3.2 multiple on our existing portfolio.
The balances from the end of 2019 are also shown here, and I would highlight two things: first, our UPB is up modestly in a fast prepay environment, which is a testament to our ability to source new MSR investment; second, the weighted average coupon fell from 4.1% to 3.7%, consistent again with what you would expect in a refi environment.
As we reinvest into new production collateral, it will benefit our portfolio prepayment speeds should rates stabilize.
We settled $23 billion UPB of new MSR through our flow program during the quarter, which represents record volume for us as we experienced our biggest three months ever.
Activity in the bulk market continues to increase as well, and we continue to find valuation situational with some packages trading at precrisis yields, while some are clearing at wider spreads.
We had some success in the bulk market and settled on $20.4 billion UPB in four separate transactions.
Low pricing during the quarter was fairly constant at a three multiple.
In the lower right-hand chart, we compare our servicing prepayment speeds in blue versus generic collateral in gray.
Currently, a majority of the underlying loans in our servicing portfolio have some form of seasoning or prepayment protection, which is why our speeds are somewhat slower than the implied TBA speeds.
Nevertheless, we do have expectations for speeds to remain high going forward.
Primary mortgage rates have continued to grind lower with 30-year rates generally below 3% in national surveys, even with the spread between primary and secondary rates at wide levels.
The longer the interest rates stay at these levels, the greater our expectation that primary mortgage rates will decrease further.
As a result, unless interest rates sell off and provide prepayment relief, these faster prepayment speeds will certainly continue to impact returns.
Over the next two slides, we display our effective coupon positioning and risk profile.
In the chart on the top of Slide 12, we show the combined exposures of Agency P&I bonds and MSR at year end compared to our positioning at the end of Q3, as indicated by the diamond bullets.
The main change in our effective positioning was a decrease in the 2.5% and 4% coupons, a result of the specified pool activity I mentioned earlier.
The lower left-hand chart shows our common book value exposure to 25 basis point spread widening or tightening, and it indicates that book value would decrease by only 2.7% in an instantaneous 25 basis point spread winding.
I would note that we are combining the effect of structured IO with MSR regulation today, which we have not done in prior periods due to smaller position sizes.
In aggregate, this 2.7% exposure is lower than in recent quarters due to the reduction in specified pools and TBA positioning.
Moving to Slide 13.
Here, we see our interest rate and curve exposure, both are low and in line with our historical positioning.
I would call it again that the Agency plus MSR portfolio provides significant interest rate offsets, which you can see by comparing the gray bars to the blue bars in both charts.
Let's look at some data that highlights the attractiveness of the Agency plus MSR portfolio construction.
As we've discussed, Q4 has impacted mortgage spreads significantly, which today are at the tight end of the range.
To illustrate, let's go over the first chart.
What we have here is 10 years of daily option adjusted spread data on the JPMorgan mortgage index with the x-axis being the OAS.
It's important to also point out that this data includes previous periods of quantitative deep when the federal reserve were also active buyers of mortgages.
The scatter plot shows the change in OAS spread over a one-year time horizon for any given starting spread.
Dots that are above the x-axis indicate that spreads were wider one year later from where they began, and dots below the x-axis indicate that spreads were tighter one year later.
You can see a clear pattern, which is quite intuitive that when spreads are tight, they tend to widen.
And when spreads are wide, they tend to retrace tighter.
Mortgage spreads typically mean reverting.
As of January 4, the OAS was 16 basis points and as highlighted by the vertical blue line.
This data shows that it's quite common for spreads to widen 20 or 30 basis points in the year that follows.
In fact, in the past 10 years, there are exactly 0 instances when spreads were unchanged, let alone tighter one year later.
The lower chart quantifies our preference for the Agency plus MSR portfolio construction.
Again, the x-axis is the starting OAS, same as the other chart.
The y-axis in this case shows the expected returns on the same one-year time horizon, using the average of the one-year spread change data as just described.
In particular, we assume that the spread change occurs immediately and the portfolio earns a higher yield for the next one year.
We have plotted an Agency-Only portfolio, which represents Agency MBS hedge swaps, which is the light blue line.
The Agency plus MSR portfolio is represented by the black line.
You can see that at the OAS level of 16 basis points, historically, we've observed spreads move around 20 basis points wider over the next year.
And in that case, the one-year return would be expected to be negative around down 1% in the Agency-Only example.
But because of the mortgage spread widening protection embedded into the Agency plus MSR construction, the expected return for the paired strategy is much better and gets you into the mid-high single digits.
The flat slope of the Agency plus MSR line relative to the Agency-Only portfolio is what we mean when we talk about our stable expected return and book value profile and it's particularly powerful in tight mortgage spread environments like today.
We're not saying spreads are necessarily going to widen, and they're certainly strong supporting technical factors, but valuations are rich and history suggests limited further upside.
Finally, I'd like to take a look at our outlook for Two Harbors and our return expectations on Slide 15.
After the significant spread tightening we've seen in the last two quarters, we see gross returns for specified RMBS paired with swaps as being less attractive than they were, see them to be in the range of mid- to high single digits depending on coupon and story.
Current coupon TBA returns are enhanced by roll specialness, which is likely to continue for the near future albeit at less attractive levels.
New investments in flow MSR paired with RMBS today can also drive returns in the high single digits to low teens.
And if you assume roll specialness on the RMBS component can be higher.
We continue to focus on our strong partnerships with MSR sellers and internal platform, which gives us the ability to source significant volumes, especially in today's prepaid environment.
To conclude, we feel very good about our Agency plus MSR portfolio and the forward outlook.
As Mary highlighted, our capital and liquidity position remains very strong, and we took steps subsequent to quarter end to further optimize our capital structure with the benefits accruing over time to our common shareholders.
And as Matt said, new investments in specified pools are less compelling today with spreads near the tight end of the long-term ranges, and we have reduced risk and leverage somewhat given the environment.
However, as we discussed, we still see returns for our strategy to be supportive of current dividend levels, and this tight spread environment is one where our Agency plus MSR strategy is especially attractive.

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two harbors investment corp - qtrly reported core earnings of $82.0 million, or $0.30 per weighted average basic common share.
two harbors investment corp - qtrly reported book value of $7.63 per common share.

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