Tom Siering - President, Chief Financial Officer Brad Farrell - Chief Financial Officer, Treasurer Bill Ross - Chief Investment Officer Maggie Field - Investor Relations.

Douglas Harter - Credit Suisse Bose George - KBW Trevor Cranston - JMP Securities Rick Shane - JP Morgan Jessica Levy-Ribner - B. Riley FBR Robert Brock - West Family Investments.

Good morning. My name is Chelsea and I will be your conference facilitator. At this time, I would like to welcome everyone to Two Harbor’s third quarter 2017 financial results conference call. All participants will be on a listen-only mode. After the speakers’ remarks, there will be a question and answer period.

I would now like to turn the call over to Maggie Field with Investor Relations for Two Harbors..

Thank you, Chelsea, and good morning everyone. Thank you for joining our call to discuss Two Harbors’ third quarter 2017 financial results. With me on the call this morning are Tom Siering, our President and CEO; Brad Farrell, our CFO, and Bill Ross, our CIO.

After my introductory comments, Tom will provide a brief recap of our quarterly results, Brad will highlight key items from our financials, and Bill will review our portfolio performance. The press release and financial tables associated with today’s call were filed yesterday with the SEC.

If you do not have a copy, you may find them on our website or on the SEC’s website at SEC.gov. In our earnings release and slides, which are now posted in the Investor Relations section of our website, we have provided a reconciliation of GAAP to non-GAAP financial measures. We urge you to review this information in conjunction with today’s call.

I would also like to mention that this call is being webcast and may be accessed on our website in the same location. Before I turn the call over to Tom, I would like to remind you that remarks made by management during this conference call and the supporting slides may include forward-looking statements.

Forward-looking statements reflect our views regarding future events and are typically associated with the use of words such as anticipate, expect, estimate, and believe, or other such words. We caution investors not to rely unduly on forward-looking statements.

They imply risks and uncertainties and actually results may differ materially from expectations. We urge you to carefully consider the risks described in our filings with the SEC, which may be obtained on the SEC’s website at SEC.gov.

We do not undertake any obligation to update or correct any forward-looking statements if later events prove them to be inaccurate. I will now turn the call over to Tom..

we intend to be the industry-leading hybrid mortgage REIT. With this in mind, we believe that focusing our business model on our residential rate and credit strategies allows us to run a more focused business.

Through close attention to asset selection, we will opportunistically allocate capital to the most attractive investment opportunities across our strategies. Additionally, we’ll continue to diversify our financing profile and manage our capital structure to optimize earnings and shareholder returns.

Historically, higher interest rates have been the bane of mortgage REITs; however, we believe that our rigorous approach to risk management, of which MSR is a distinguishing factor, will allow us to deliver strong results and book value stability through a variety of interest rate environments.

As the Fed becomes less aggressive with the reinvestments in agency RMBS, we think that this creates a lot of opportunity for our company going forward. I will now turn the call over to Brad for a review of our financial results..

total core earnings, adjusted core earnings, which is core with the removal of the dividend income from Granite Point, and pro forma core earnings, which is indicative of what Two Harbors’ core earnings may look like on a go-forward basis.

As you can see on the right-hand side, while we expect to have numerically lower core earnings due to the lower capital base, we believe that going forward we may have higher core earnings as a percent of book value. Turning to Slide 9, let’s look at a pro forma balance sheet of Two Harbors as of September 30.

Similar to our second quarter disclosure, the intent of this pro forma balance sheet is to illustrate what our balance sheet will look like following the distribution of the Granite Point shares. As you can see on the bottom right, our GAAP book value per share would have been $16.34. I’d like to reiterate a comment I made on the prior earnings call.

With the removal of lower levered commercial real estate, on a pro forma basis our debt to equity would have been around 5.8 times at the end of the third quarter. This is consistent with our expectation that debt to equity on a pro forma basis would nominally increase.

On Slide 10, we continue to maintain a diversified financing profile which includes traditional repurchase agreements, FHLB advances, revolving credit facilities, and convertible senior notes. We had $18.3 billion of outstanding purchase agreements at September 30 with 25 counterparties.

We have not observed any disruptions in the repo markets and they continue to function efficiently for us. Consistent with our historical practice, we extended our repo maturity profile in the third quarter as we have rolled the majority of our repo maturities out past year-end to avoid potential strain around that time.

Our FHLB advances totaled $2 billion at September 30 with a weighted average borrowing rate of 1.56%. The decline in balance is consistent with our expectations as we reduce commercial real estate and agency RMBS, particularly as today’s agency repo rates in terms are more favorable for financing these assets.

Our MSR is financed through both revolving credit facilities and a convertible debt issuance. At quarter end, we had $40 million of short term borrowings under revolving credit facilities with additional available capacity of $50 million.

We continue to make progress on other MSR facility discussions and believe we will have more to say in the near future. We have provided additional details on our borrowings on appendix Slide 27. I will now turn the call over to Bill for a portfolio update..

Thank you, Brad, and good morning everyone. Starting with Slide 11, you will see both our portfolio composition at September 30 and our capital allocation, which was relatively unchanged quarter over quarter and year over year.

If the Granite Point shares had been distributed as of September 30, our capital allocation to rates and credit would have been approximately 66% and 34% respectively. We completed a preferred stock offering early in the third quarter and deployed that capital into our rates and credit strategies in roughly that same proportion.

This included purchasing agency pools at attractive spreads and increasing our legacy non-agency holdings by several hundred million. As we will highlight in more detail shortly, we believe expected ROEs in our rate strategy, which includes agency RMBS paired with MSR, are quite attractive in the low to mid teens.

We believe that baseline ROEs I our credit strategy are currently in the high single digits but with upside opportunity for much higher total returns. Moving to Slide 12, I’d like to discuss some of the drivers of our strong portfolio performance in the quarter. Our net interest spread was 2.1% compared to 2.4% in the second quarter.

This was primarily due to an increase in funding costs and slightly lower yields on an RMBS holding. Also, the addition of agency pools served to lower our overall net interest margin while increasing leverage somewhat.

On a pro forma basis without the consolidation of Granite Point, our net interest spread would have been about 2% in the third quarter. Our higher holdings of agency pools served us nicely from a book value perspective as the mortgage basis tightened and specified pools performed well, outperforming their hedges.

Residential credit also performed well in the quarter as we realized attractive yields on our portfolio, released more credit reserves, and saw some modest price improvement for deeply discounted sub-prime legacy non-agency. Please turn to Slide 13.

We are very excited about the opportunities ahead to deliver strong returns, in particular those related to the Fed’s tapering of its RMBS reinvestments. In our rate strategy, as we’ve highlighted on prior calls, it is our goal to provide returns through a variety of interest rate environments. MSR is a key component of this.

We believe it is possible to construct a portfolio of RMBS and MSR that has higher returns than a portfolio of RMBS hedged only with swaps, yet with much less exposure to mortgage spread risk. Let’s take a look at this with a little more granularity.

With the Fed reducing their reinvestments in mortgages, it is estimated that over $400 billion of net supply of agency RMBS will need to be absorbed by the market in 2018. This will likely cause mortgage spreads to widen, which has the potential to hurt mortgage REIT book values.

In this scenario, MSR is a significant benefit to our portfolio because it increases in value when mortgage spreads widen. The table on this slide shows that using a combination of MSR and agency RMBS leads to reduced book value sensitivity to agency mortgage spreads.

As highlighted on the far right, as of September 30 on a pro forma capital base, our expected overall book value sensitivity to 25 basis points wider spreads is a relatively low 2.9%.

Pairing MSR with agencies positions us to protect book value in this type of spread widening environment, yet at wider spreads we believe there could be tremendous investment opportunity to add agencies.

Turning to our credit strategy on Slide 14, our portfolio continued to realize benefits from fundamental improvement in the housing market and the overall economy. Yields have been strong and bond prices have improved during 2017.

We expect future residential credit performance to remain strong, driven by increasing prepayments, lower delinquencies, defaults and severities.

To take advantage of this, we have kept our portfolio positioned primarily in deeply discounted legacy non-agency assets due to the yield pick-up these assets can realize from these tailwinds and the opportunity to drive increases in book value.

As I noted earlier, current baseline expected ROEs for discounted legacy bonds are in the high single digits. It is important, however, to realize that this masks the total return opportunity over time, which would be driven by higher legacy bond prices.

To highlight this, the legacy non-agencies that we added in the first quarter this year have already delivered strong realized yields as well as price appreciation, positively impacting our book value this year.

Given our expectation for continued improvement in residential credit metrics for legacy assets, including increasing prepayments, we believe that the opportunity still exists for strong total returns going forward. In closing, we delivered a very strong quarter while continuing to execute on our previously articulated plan.

We believe there are tremendous opportunities ahead across our investment strategies to drive returns. We have positioned our rate strategy well by pairing MSR with agency RMBS to generate attractive yields, protect book value, and to be able to capitalize on opportunities arising from potential spread widening in a Fed tapering environment.

Additionally, we believe that strong tailwinds will continue to drive our credit strategy yields and benefit our book value. We are very excited about the future opportunities for Two Harbors and for our stockholders. With that, I will now turn the call back over to Chelsea for Q&A..

[Operator instructions] Thank you, and our first question comes from the line of Douglas Harter with Credit Suisse. Your line is open. .

Thanks. Good morning, Bill.

Can you talk about you see the opportunity from agencies today, kind of given the spread tightening we saw since you kind of grew the balance sheet in the third quarter?.

Well firstly, Doug, I don’t get a good morning?.

Yeah, I’ll say good morning to you, too. Good morning, Tom..

[Indiscernible].

Thanks, Doug. Thanks for joining us.

Yes well, as I mentioned on the call, when we raised the preferred early in the quarter, we thought agency spreads looked attractive just on their own, as well as compared to other fixed income alternatives such as corporate credit, etc, so we thought there was the opportunity for them to perform well, which they did.

In terms of going forward, we haven’t really seen much movement in spreads yet, although it’s only been really one month that the Fed has started tapering their reinvestment, and it’s our opinion that today, to give you an idea, agencies on their own without using MSR are probably high single digit, maybe 10% area, but we particularly liked the MSR and agency combination which, as I mentioned, is in the double digits to the mid-teens, for two reasons.

One, obviously the returns are a lot higher, and second of all, the risk profile is obviously lower, as I pointed out on Slide 13.

So to the extent that agency spreads widen, that would make obviously agencies on their own more attractive, but obviously the combination with MSR even more so, which could potentially add several hundred basis points to the expected return.

So we think it’s really important to have the ability to protect book value into a spread widening environment so you can actually take advantage of the wider spreads when they come about..

Makes sense. Tom, I think since you guys have been public, you’ve always kind of looked at new potential asset classes, whether it was single family or commercial.

Is there anything on the horizon that you’re looking at, at this point?.

No, not really, Doug. I mean, as we’ve said many times and as Bill just stated, MSR is an acute area of focus for us because it protects us, not only as mortgage basis widens but also in a higher interest rate scenario.

The one thing that we really consider to be a strategic imperative for the company is MSR financing, and as Brad said in his comments, we hope to have much more to say about that in the near future. But in regard of new business initiatives, there really is nothing on the drawing board that’s worth discussing..

Great, thank you..

Thank you, and our next question comes from the line of Bose George with KBW. Your line is open. Bose George, your line is now open..

Hey guys, good morning. Sorry - I was on mute. In the area of MSR returns, in your prepared comments you talked about the low to mid-teens return.

The attractive financing opportunities that you mentioned, as those kick in, is that sort of incremental, we could see upside to the numbers you mentioned, or is kind of the mid-teens sort of baking some of that in?.

Yes, thanks Bose for the question, that’s a great question. I would say that the mid-teens is sort of what we would expect when we get financing in place. It’s currently in the, I would say without that, in the low double digits, and so I think it’s fair to think about it that way.

I mean, we do have some financing lines in place, but I think as Brad mentioned, we’re working really hard, and Tom mentioned this is a big priority for us to continue to add to that at attractive financing levels, and that’s what the mid-teens implies..

Okay, great. Thanks.

Then just in terms of the MSR growth over time, is that largely still going to be on a flow basis? Is there room to kind of accelerate that, just given obviously how attractive it is?.

Yes, so let me spend a moment on that. Our flow program, we are expecting roughly $2 billion to $2.5 billion a month in the near term. We have been able to establish some new co-issue relationships during the year, and so that’s obviously a really nice baseline for us. The bulk market has actually been very, very vibrant the last several years.

There was one very, very large trade this year north of $50 billion, but without including that, the last three years have averaged a little bit over $100 billion a year in bulk transactions.

As you know, we’ve already closed on a little over $13 billion this year and we are continuously looking at opportunities to grow that, so I think the vibrancy of the market and our position within the market certainly sets us up well to continue to take advantage.

So I would agree with you to the extent that there are bulk opportunities, we will absolutely be focused on those..

Okay, great. Thanks. Just one more on credit, just on your comments about the potential upside to credit.

If you--the bonds you’re buying now, if you hold them to maturity and the performance is good, do you capture that upside, or is that upside really--you know, should we think about that as a spread tightening upside?.

Well yes, it’s another good question. Thank you for that. When we buy bonds today or have this year, we make assumptions that we think are fairly conservative around prepayments and defaults, etc., and that sets sort of a baseline expected yield.

To the extent that the assumptions that we make are outperformed, which has been the case in the past and we think can very easily be the case in the future if the current trends continue, that would lead to not necessarily spread tightening but changes in scenarios.

So for instance, if you said a bond was $70 and you thought you were going to get $85 as a result of certain scenarios, as prepayments are better and defaults and delinquencies are lower, and you relax those assumptions because of performance, you might recover $90 or $95, so therefore the bonds could go up in price and provide the same, quote, expected yield but based on better performance metrics, which is sort of a long way of saying that if spreads can stay the same but if assumptions change, prices can go higher, and that’s what we’ve seen.

I mean, just to give you an example, there was a dealer research piece out just this past week that had legacy sub-prime returns around 9% for the year through the end of October, so that’s a combination of yield and price gain.

You can see that once you apply some leverage to that, that baseline ROE dramatically understates the value that we can create for shareholders..

Bose, this is Tom - good morning. ROEs are a metric that the market has adopted, but we’ve discussed this before, we really don’t think in respect of agencies or non-agencies what ROE really is - that’s not our super-metric, if you will.

What we really think about is return expectancy, and so in the non-agency space there’s been all sorts of options embedded in those non-agency securities, all of which have been virtuous over time.

One thing, as HPA has kicked in and just the maturation of these securities embeds a lot of positive options in them, so it takes a nominal ROE and then adds those options in, such that we can derive return expectancy. The return expectancy is what we’re so excited about in non-agencies.

They’ve delivered really well in the past and everything that we see in the housing market, etc., makes us very excited for the return expectancy of the sub-prime bonds going forward..

Okay, great. Helpful guys, thank you..

Thank you, and our next question comes from the line of Trevor Cranston with JMP Securities. Your line is open..

Hi, thanks. Good morning. I wanted to follow up on the comment you made, Bill, about the importance of protecting book value in the event that there is a spread widening associated with the taper of the Fed’s balance sheet.

Can you talk about how you guys are thinking about leverage within your rate strategy and how much room you potentially have to increase that, to the extent that we do get a meaningful widening at some point next year? Thanks..

Good morning, Trevor. Thanks for joining us and getting up early. You know, let me spend a minute on the leverage. Our leverage is obviously a function of opportunity, as you pointed out, and I would expect that our rates leverage would sort of be in the range of six to eight times, depending on the attractiveness of agencies.

Obviously pools are higher and MSR is obviously a lot lower, and credit is sort of two times, plus or minus.

As you’ve followed us over the years, you’ll see that we always carry a substantial amount of liquidity on the balance sheet to be able to deploy to the extent we see a dramatic change in the opportunities in our favor, and as I pointed out on 13, if spreads widen, if you lose a lot of money then you’re not going to be in a position to add at the wider spreads.

So the thing that we’re excited about for the portfolio is by having MSR, that sort of dramatically dampens the impact, so I would say that we’re comfortable with where we are today but we certainly have room to increase leverage to agencies overall, to the extent that we see spreads wider..

Got it, okay, that helps. Then one question on the credit portfolio. Looking at the yields on the non-agency book on Page 24, it looked like they ticked down a little bit from last quarter to this quarter. I was just curious if there is--you know, if that was primarily driven by the new assets you added or if there was anything else driving that.

Thanks..

Yes, so that’s a great--that you got to the appendix and looked through all the slides, and it’s a great question. It’s absolutely driven primarily by addition of assets at lower, quote, baseline yields that we talked about.

As Tom mentioned, that’s just the first part of the equation, so a perfect example is if you look at our yields which have come down from--they were, I guess, around 9% or so last year or thereabouts, I don’t have the exact dates, and realized for third quarter was around 8%, but look at what the contribution to our book value has been since the beginning of the year.

It’s been really quite dramatic. The other thing I’d like to point out, which is something that’s particularly exciting for the strategy, is we have seen a tremendous improvement in the financing environment for these assets. There have been a number of new entrants that have come in. Haircuts have come down.

Since the beginning of the year, I would say that haircuts were in the 35 to 40--30 to 45% range, and today they’re probably 10 to 15 points lower than that, sort of in that 25 to 30. Spreads over LIBOR, which a year ago were in the 160 to 175 range, are now in the 125 to 140 range.

So despite the fact that the yields available on the bonds in the market are not what they were in, say, 2011 or ’12 or ’13, we are still very excited about the ability to drive a total return that’s very compelling here..

As you know, Trevor, dealers base haircuts and financing spreads over their perception of price volatility, right, and so there has been a very robust bid in the market for non-agencies because the fundamentals that underlie them are so strong.

So if you look at our opportunities going forward, two areas of acute focus, as I said earlier, are MSR financing and also non-agency financing. Those are real areas of opportunity for our company and pretty recently uniquely so..

Got it, that’s very helpful color. Thank you..

Thank you, and our next question comes from the line of Rick Shane with JP Morgan. Your line is open..

Hey guys, my questions have been asked and answered, but I’ll touch on this just in a slightly different way. During the third quarter, we saw a lot of capital come into the sector primarily targeted at rate strategies, given the opportunity there.

As you guys have pointed to and as most folks are aware, that opportunity--that capital sort of eroded the opportunity fairly quickly. Markets are super efficient, money is rotating.

Are you seeing some of that excess capital that came in flow towards the credit strategies from your peers in the hybrid space, and is that creating any short-term dislocations that you need to be careful of?.

Hey Rick, good morning. Thanks for joining us. Yes, as you pointed out, there was a lot of money raised that moved into the agency space, which was--I mean, we did the same thing, so we think that people benefited from that. In terms of rotation--well, first of all, we can see price action in the markets that we’re involved in.

We obviously don’t necessarily know who’s causing that price action, so it’d be very difficult to say that we’re seeing other REITs do this or do that. What we have seen is agency spreads, they widened a little bit and then they’ve kind of come back in, so they’re hanging in there, actually, reasonably well.

On the credit side, I think we saw a little hiccup in the CRT market with the hurricanes and other natural--you know, the natural disasters, but those seem to have rebounded back to where they were, and legacy assets have held pretty steady as well, so I would say, to be honest with you, I know it’s not headline news, but by and large we’ve seen reasonably stable spreads across the markets that we participate in, in the last month or so..

Rick, it’s Tom. Your question was really kind of focused on the non-agency space. We buy bonds at prices that we like, and we continue to do so. We don’t feel compelled to chase prices, and we’re certainly not doing that.

It’s a fundamental mantra of our company - we don’t do things to do things, we do things that we think are smart for our shareholders, so we continue to buy bonds in the non-agency space that we like for all the reasons that we’ve discussed previously. .

That’s a long mantra. That’s going to be hard to fit on the back of a t-shirt..

Well as you know, I don’t skip a lot of meals, so I have room on the t-shirt..

Okay, I’m done..

Thank you, and our next question comes from the line of Jessica Levy-Ribner with B. Riley FBR. Your line is open..

Good morning guys. Thanks for taking my questions. Most have been asked and answered, but I did want to hear maybe your thoughts around the competition in the MSR market. I know that you don’t participate too much in bulk sales, but what you’re seeing maybe even competition for flow agreements and how we can think about the pricing..

Hey Jessica, thanks for joining us. Yes, I’ll kind of cover a little bit of that. I mentioned a little bit earlier.

This year, there’s been a little over $100 billion in bulk transactions, like I said, excluding this one big headline transaction, and we’ve already closed on over $13 billion, so I’d say--I think it’s fair to say that we’ve participated or purchased about 10% of what’s transacted so far this year.

You have to keep in mind the other thing about bulk is a lot of the bulk transactions may not fit us, so we are focused exclusively on new issue, high quality, performing, conventional collateral.

If you look at our portfolio statistics, you’ll see we have--I don’t want to say zero, but pretty close to zero in terms of delinquencies, very high credit quality.

So of that $100 billion or so, a lot of it could be Ginnie Mae, a lot of it could be non-performing or high-touch servicing, so I would say that our--you know, we see all the deals that come through, and we are happy to participate if it fits us and it comes at a price we like.

I would expect that going forward, we’ll--I mean, we’ve participated in bulk deals in 2016, in 2015 as well, and we’ll have more to say about that as we have transactions that we line up and take advantage of..

Jessica, it’s Tom. In respect of completion, which was the heart of your question, there’s a number of reasons that we could love MSR, and we’ve discussed the benefits it has in a higher interest rate or a wider spread environment.

Also, we think that the fundamentals of the origination business certainly suggest that supply will continue to be abundant going forward. The other thing that we love is the barriers to entry to get into the MSR market are significant, and so in respect of new competition, which was the root of your question, we really aren’t seeing it.

Yes, it’s a competitive market, as it has been, but the environment has not changed in respect of competition significantly at all..

Okay, I appreciate your comments. Thank you..

Thank you, and our next question comes from the line of Robert Brock with West Family Investments. Your line is open..

Good morning Brad, good morning Bill. I just had one question about the agency market.

Could you talk a little bit about the flattening of the yield curve, and with the two to 10 spread being so flat, what the impact is for your agency book?.

Hey Rob. Tom is here with me as well, says hello. Sure. You know, that’s a really important question, and so I’d say there’s a couple things.

In terms of the--you know, what we’ve seen in the yield curve is a function of the fact that the Fed is on this sort of glide path towards higher rates, which is impacting the front end, but at the same time the lack of visibility for higher inflation has kind of kept the longer end pinned at lower rates than you might expect, so we have seen the curve flatten.

I think that’s sort of one of the key dynamics that’s driving that. The second thing I’d like to address about this is our sensitivity to that, to what’s going on. I mean, obviously we like a lot of things about our portfolio.

What we really like with regard to the curve is that our sensitivity of our income to higher--you know, short term rates and a flatter curve, is actually really quite low. There is a couple reasons for that.

First of all, we hedge across all points in the curve, or at least we attempt to, so that helps immunize any curve movements or dampen the impact of curve movements, not only to our book value but also to our income.

The second thing is that our non-agency holdings are almost entirely floating rate, so higher LIBOR obviously benefits our income there.

To give you an example, basically our--if we have some leverage on non-agencies and LIBOR goes up, right, we get more income vis-à-vis our financing cost, so on an overall basis we actually have very little sensitivity to higher shorter term rates and a flatter curve from an income standpoint than you might suspect, and that should be out in the Q when we put that out shortly - I think it’s later today, most likely..

Yes, and Rob, it’s Tom.

Just to add to that a little bit, in respect of our agency exposure and the flattening of the yield curve, I’ll have to make this a qualitative statement because a lot of this has happened post-quarter end, but I will say that the team was really well positioned for what happened in respect of our interest rate hedges, and so the team did a really good job of positioning for a flatter yield curve, so we’ve come through this quite nicely..

Thanks guys, appreciate it..

Thank you. I’m showing no further questions at this time. I will now turn the call back to Mr. Siering for concluding comments..

Thanks a lot, Chelsea, and thank you all for joining our third quarter conference call today. We are pleased with the progress we have made in respect of our plan for 2017, and we are very excited about the opportunities we see emerging for our business. We look forward to speaking with you again soon. Have a wonderful day..

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may all disconnect. Everyone have a great day..