Maggie Field - IR Thomas Siering - President, CEO & Director Brad Farrell - CFO and Treasurer William Roth - CIO & Director.

Bose George - KBW Rick Shane - JPMorgan Chase & Co. Fred Small - Compass Point Doug Harter - Credit Suisse.

Good morning. My name is Carmen, and I'll be your conference facilitator. At this time, I would like to welcome everyone to Two Harbors' First Quarter 2018 Financial Results Conference Call. All participants will be on a listen-only mode. After the speakers' remarks there'll be a question-and-answer period.

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

Thank you, and good morning, everyone. Thank you for joining our call to discuss Two Harbors' first quarter 2018 financial results. With me on the call this morning are Tom Siering, our President and CEO; Brad Farrell, our CFO; and Bill Roth, our CIO.

After my introductory comments, Tom will provide an overview 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 are based on the current beliefs and expectations of management and actual results may be materially different because of a variety risks and other factors. Such statements are typically associated with the words such as anticipate, expect, estimate and believe or other such words.

We caution the investors not to rely unduly on forward-looking statements.

Two Harbors describe these risks and uncertainties in its annual report on Form 10-K for the fiscal year ended December 31, 2017, and in other filings that may or may be made with the SEC from time to time, which are available in the Investor Relations section of Two Harbors website and on the SEC's website at sec.gov.

Except as may be required by law Two Harbors does not update forward looking statements and expressly disclaims any obligation to do so.

I'd also like to inform you that in connection with the proposed merger between Two Harbors and CYS Investment, Inc., Two Harbors and CYS will file with the SEC a registration statement for the transaction which will include a joint proxy statement relating to the shareholder meetings of Two Harbors and CYS Investment.

This registration statement and joint proxy statement will contain important information about the transaction. Investors are urged to read these materials when they become available. I will now turn the call over to Tom..

Thank you, Maggie, and good morning, everyone. We hope that you had a chance to review our earnings press release and presentation that we issued last night. Please turn to Slide 3, as we take a moment to review our results.

At March 31st, our book value was $15.63 per share which represents a negative 1.3% total return on book value inclusive of our $0.47 quarterly dividend. Our book value declined quarter-over-quarter primarily due to the spread widening in the latter half of March and higher coupons especially specified pools.

Bill, will detail this further in his remarks. Beginning this quarter we will report core earnings including TBA dollar role income as Brad will discuss shortly. We believe this metric is a better representation of our underlying earnings power and provides our stockholders with greater transparency.

Core earnings including dollar role income was $0.48 per basic share in the first quarter in line with our projections when we declared our quarterly dividend. On April 26th, we announced our proposed acquisition of CYS Investments Inc.

As we turn to Slide 4, I'd like to highlight some of the details of this transactions and why we believe this will be beneficial to our stockholders. As we stated on the joint conference call with CYS, we expect this transaction to close in the third quarter.

After the transaction closes, we expect to reallocate the capital and CYS' portfolio into our target asset classes. In 2019, we anticipate that the combined company's capital allocation to Agency's MSR and credit will look substantially similar to how Two Harbors looks today. Bill will highlight this in further details in his remarks.

Furthermore, the combination of Two Harbors and CYS should create operating cost efficiencies, [lowering] our other operating expense ratio by approximately 30 basis points to 40 basis points. This transaction represents a unique opportunity to create value for our stockholders.

We believe our stockholders will benefit from the enhanced scale and liquidity of the combined companies including a larger capital base that supports continued growth in our target investments.

As we anticipate improved Agency spreads in 2018, we believe this deal could be accretive to our earnings and endorses the capital raising attendant to this transaction.

Importantly, as we stated on our joint conference call with CYS, we expect to maintain our quarterly dividend of $0.47 per share through 2018 subject to market conditions and discretion and approval of our Board of Directors. Please turn to Slide 5.

The foundation of our success in 2018 and beyond is routed in our key areas of focus each of which supports our overall goal to provide book value stability through a variety of interest rate environments. Following the close of the proposed merger, we believe the larger combined company will enhance our ability to deliver strong stockholder returns.

I will now turn the call over to Brad for a review of our financial results..

Thank you, Tom. Turning to Slide 6, let's review our quarterly results. We incurred a comprehensive loss of $23.7 million or $0.14 per basic share which represented a return on average common equity of negative 3.3%. Our book value at March 31st, was $15.63 per share as compared to $16.31 in the fourth quarter.

After accounting for our first quarter dividend of $0.47, we incurred a negative return on book value of 1.3%. As we turn to Slide 7, let's review our core earnings results. As Tom mentioned, beginning this quarter we will report core earnings, including dollar role income.

In the first quarter our investment team shows to take a net long position in TBAs rather than Agency calls for various liquidity, hedging and leverage benefits. Historically, we did not view our TBA investment activities as meaningful enough to include.

Additionally, our ability to invest in more significant TBA exposure over time benefits from our recent receipt of a tax opinion that allows us to hold these investments in the REIT and avoid any tax friction.

As result of these factors, and our view that TBAs will continue to be a part of our investment strategy over time, we believe the net TBA dollar role income, combined with our core earnings is a meaningful indicator of our underlying earnings in 2018 and going forward.

Core earnings of $0.46 per basic common share plus dollar role income of $0.02 combined with $0.48 in the first quarter, representing a return on average common equity of 11.8%. Our earnings were driven by MSR portfolio growth and additional servicing income, combined with slower prepayment speeds.

Additionally our earnings benefited from favorable spread income on our swaps due to increases in LIBOR. This was offset by increased financing expenses on Agencies, as well as higher servicing expenses due to some seasonal adjustments and higher other operating expenses.

Our other operating expense ratio, excluding non-cash LTIP amortization was 1.4%, up from 1.1% in the fourth quarter. These higher expenses were driven primarily by brokerage and trading fees due to the active management of our hedging position to protect book value in a changing rate environment.

As we turn to Slide 8, I'd like to highlight some of our accomplishments in the first quarter with respect to how we've optimized our financing profile to benefit future earnings performance. Our debt to equity ratio was 5.9 times at March 31st, unchanged from December 31st.

We are comfortable with this level of debt to equity and maintain plenty of liquidity to take advantage of market opportunities as they arise in 2018. The repo markets have continued to function efficiently for RMBS with new counterparties entering the market.

We believe that our diversified financing profile, and more specifically recent positive changes in the non-Agency and MSR financing space, will be positive to our future earnings performance.

As we noted on our fourth quarter earnings call we've seen the repo market for non-Agencies become more competitive recently, resulting in improvements and advance rates and spreads. We've consistently seen spreads offered between 100 to 125 basis points over LIBOR or as a year ago these spreads were approximately 150 to 175 basis points.

We expect this positive trend to continue in 2018. In the first quarter we increased the capacity of one of our MSR financing facilities that we announced in the fourth quarter by $100 million, bringing the facility's total capacity to $400 million. As of March 31st, we had $203 million outstanding on this facility.

As a reminder this facility finances Fannie Mae MSR collateral, and offers three distinct competitive advantages. First, MSR financing allows us to generate incremental MSR returns on a levered basis. Second, the multiyear financing term is at a favorable spread to LIBOR of 225 basis points. Third, and, importantly, the facility features AA margining.

The AA margin feature allows us to better manage our liquidity in a changing interest rate environment, such as the first quarter and we experienced increases in the value of our MSR collateral. We continue to advance other MSR financing discussions focused at substantially similar terms. I will now turn the call over to Bill for a portfolio update..

Thank you, Brad, and good morning everyone. Please turn to Slide 9, as of March 31st, our investment portfolio was $22.4 billion with substantially similar capital allocation as last quarter, 69% of capital was allocated to our REIT strategy and 31% to credit. Let's turn to slide 10.

As Tom noted in his remarks, we are excited about the investment opportunity presented by our proposed acquisition of CYS. We believe that the additional capital will support continued growth in our target assets and allow us to take advantage of market opportunities as they arise.

I would like to highlight two key strategic portfolio considerations related to this acquisition. First, we intend to reallocate the capital from CYS' current portfolio into Two Harbors target assets.

As we execute on this plan, we anticipate that approximately 50% of our capital will be allocated to MSR and credit, which leads to roughly the same capital allocation that we have today. We expect to reach this target allocation in 2019.

Second, upon closing we intend to have a similar hedging strategy that is in line with our current low level of exposure. As we have emphasize frequently over the years, one distinguishing factor about Two Harbors is our acute focus on protecting book value and part of this involves not taking undue interest rate risk.

Moving to Slide 11, I'd like to switch gears to discuss some of the drivers of our portfolio performance in the first quarter. Our net interest spread was 1.93% down slightly quarter-over-quarter. In our REIT strategy, our hedges and MSR performed as we expected them to in a rising rate environment.

However, in the latter half of the quarter, as Agency spreads widened higher coupons Agencies particularly specified pools underperformed lower coupon Agencies.

While the impact of interest rate and mortgage spread moves on our book value was consistent with our estimations from the fourth quarter, the underperformance of higher coupon Agencies and specified pools which is the majority of what we own led to a further diminishing of book value.

On the other hand, residential credit continued to perform well with spreads generally stable. As to performance so far this quarter, we have seen a modest reversal of the underperformance of both higher coupons and specified pools.

In that light, despite interest rates being up over 25 basis points in April, our book value after accruing for the dividend is roughly flat since quarter end. As we move to Slide 12, let's discuss our rate strategy.

Our Agency position didn't change substantially and we ended the quarter with approximately $18 billion of Agency pools and $450 million net long TBAs. As Brad mentioned in his remarks, we use TBAs as both a pool substitute and to manage our overall portfolio positioning.

Going forward, we don't expect our TBA position to be a material part of our investment strategy unless the roles become very special. With respect to MSR investment activity, we added $13.6 billion [UPB] through both a bulk purchase and our monthly flow sale arrangements.

MSR is now about 20% of our equity capital allocation and we expect that this allocation will remain similar as we redeploy capital following the closing of the merger with CYS. Over the long term we expect the amount of capital allocated to MSR will continue to grow.

MSR is a key component of our hedging strategy driving strong returns while mitigating both interest rate and spread risk. This segues into our discussion about our current risk positioning highlighted on Slide 13.

We continue to maintain a prudent approach to interest rate and spread exposure, by actively managing our hedge positioning, utilizing a variety of tools including swaps, swaptions and MSR, we believe that we will be able to continue to minimize book value volatility.

Looking at the left-hand side of this slide you can see that in the rate of 25 basis points scenario we expect that our book value would increase by 0.7%. On the top right hand side of this slide you can see that our net interest income would decline by 1.6%.

We anticipate that both of these exposures will continue to be in a relatively neutral position. And as I mentioned earlier we intend to maintain similar positioning after we close the CYS transaction. Turning to net income exposure, a key contributor to our net income stability is MSR float income, which increases in value when rates rise.

Consistent with the rise in short term rates in the first quarter, our float income increased to $4.4 million compared to $1.1 million for the first quarter of 2017.

We expect that for every 25 basis points increase in short term rates we would make an additional $3.2 million of income annually, which helps stabilize our income as short term rates move higher.

Finally, from a spread widening perspective you can see on the bottom of this slide that if Agency spreads widen 25 basis points we would expect our book value to be down about -- down by a relatively small 3.8%. Moving to Slide 14, let's discuss our credit strategy.

Residential credit performed well, generating a positive return each month of the quarter. On prior earnings calls we've highlighted the benefits of our credit strategy to book value, and often get asked the question if there are opportunities to add more of these deeply discounted legacy assets at attractive levels. The answer to that is yes.

We continue to find and add to our portfolio non-Agency bonds that we think generate low to mid double digit total returns. Importantly, this is in the absence of any real dislocation in the credit markets when we believe there would be an even greater opportunity to add legacy non-Agencies.

Additionally, as Brad mentioned in his remarks improvements in financing for legacy non-Agencies has allowed us to allocate capital to our credit strategy in a much more efficient way.

At a higher level residential credit continues to benefit from fundamental improvement in the housing market, including re-equification by borrowers, resulting in increased prepayment, lower loan to value ratios and fewer delinquencies, defaults and severities.

As an illustration of how that helps drive strong returns let's take a look at the bottom left of the slide. Our current portfolio LTV is around 70%. If we apply assumptions of 3% HPA per year in the base case and 6% per year in an upside scenario, you can see that our LTV can drop substantially over the next three years. In the upside scenario to 53%.

This would lead to lower fall and losses. As you can see on the bottom right of this slide, subprime non-Agency CPRs also continue to increase. This clearly benefits our deeply discounted bonds.

We believe these positive tailwinds can benefit our credit strategy by driving bond prices higher and generating strong total returns benefiting our book value going forward. I would now like to turn the call back to the operator for Q&A..

Thank you. [Operator Instructions] And our first question is from the line of Bose George with KBW..

Hi, guys. Good morning. In terms of the timing for reaching the allocation post deal getting the allocation back to where it was pre-deal.

I'm just curious in terms of asset class is like MSRs where it might be harder to ramp up, I mean could we see more sort of bulk purchases? And also just in terms of timing the 2019 is that like beginning of the year and end of the year or is that just any sort of timeline -- a little more sort of a timeline would be great?.

Good morning and thanks for joining us. This is Bill. .

Hi, Bill..

Yeah. So, we said on our call last month that we estimated around six months to get back to our current -- roughly our current allocations and that six months from closing. So, it's a little hard to tell exactly when 2019, but obviously we'll know more as we get closer to that.

In terms of servicing, we've been continuing to grow our servicing bulk both through flow and bulk. The bulk opportunities this year have been running very strong at over a $100 billion on an annualized basis. As you know we closed a decent sized deal in the first quarter and we continue to look at those opportunities as they come about.

So, I would say that we're pretty excited about that. I think the main point as I mentioned earlier is that we expect to look substantially the same as we view now roughly six months after closing..

Okay. Great. Makes sense. Thanks.

And then actually one clarification on Slide 13, when you show the spread impact, you show the Agency and the MSRs, it doesn't mention credit, is credit sort of expected to be neutral in this scenario?.

Yes, we're just trying to –that's correct, we're trying to just isolate the sensitivity to Agency spread. And what we see in the last six months to 12 months -- two years is as Agency spreads have widened and tightened non-Agency especially the legacy don't seem to have moved when Agencies move. So, we're just trying to just isolate that..

Okay. Thanks. And actually one more just back on the deal.

The pro forma book value for the deal is that roughly stable?.

Sure. So, good morning Bose this is Tom. So, Bill made a comment -- Bill made on comment on our book value in respect of what the ultimate consideration is would be function of the book values of the respective company, the time the exchange consideration is set..

Yeah. And one comment we noted in our kick off on the announcement that we would expect it to be less than 2% dilution, was noted in the public domain. We've given the relative benefits, we wanted to comment on that..

Thank you. Our next question comes from Rick Shane with JPMorgan..

Your presentation answered a lot, and the timeline to deploying or redeploying the capital after the acquisition is helpful.

I am curious about one thing, presumably given liquidity and the need to or desire to be fully deployed following the acquisition I am assuming it would be relatively over concentrated in rate strategy as you redeploy the capital.

I wanted to understand how we should think about the hedging strategy during that period because presumably you'll need to add some relatively long duration swaps, and then you'll be in a position once you redeploy where those swaps are still in place? I hope to understand sort of the implications of that or how do you mitigate during that six month window, the risk from the rate shock?.

So, I think there's a couple of different parts to that, I think the first thing is CYS they're managing their book right up until the deal closes. And I think the -- so that's their thing. And then, one of the things is that -- one of the considerations is what the exposure is when the deal closes, which obviously we don't know what that is today.

But let me talk about the -- our philosophy is basically that we don't as you know, tend to take as much interest rate risk and our intended rate exposure will be similarly low both before the deal closes and after the deal closes. So, right now we're seeing Agencies hedged with interest rates products roughly around the 10% area.

So we'll have to see what the CYS book looks like when the deal closes and we'll have to just adjust from there, but basically we've been growing our MSR and credit book all along and we intend to continue to do that right up until close.

So you can expect those allocations to move higher, then you'll see things drop down and then they'll move back up higher over time. So I think the main thing is that whatever the combined position is at close, we will be making sure that we're maintaining the same low level of rate exposure that we have -- do have today as well as historically..

And actually it probably suggests how correctly and incorrectly I am looking at this, which is I was thinking about this almost exclusively from the acquisition of capital.

But I -- I think ignoring the fact that you are in fact acquiring assets that are coming on hedged and so the differential between how you might hedge those assets and how the CYS team might hedge them is probably not as -- is a narrower gap than I'm giving you credit for?.

Okay, I think that's right. So but the -- and this is Tom, good morning. The punch line is you shouldn't expect our interest rate exposure to look measurably different at post closing than it looks today..

Thank you. Our next question is from Fred Small with Compass Point..

Hi, good morning. Thanks for taking my questions.

Just following up on Bose's question, the 2% or under 2% dilution following the deal is that you are confirming or is that still the case that's how you're currently thinking?.

Yeah. It will be very close to that, we believe yes..

Okay. And then on the -- you mentioned that the financing costs or the repo market for non-Agency has become more favorable over the past few months or the past year.

What's driving that?.

I'm sorry. Go ahead, Brad..

Yeah. I think it's a combination of factors. One it's to a certain degree the focus of lenders moving towards kind of higher spread products combined with more comfort in those asset classes as prices improved credit has stabilized in [indiscernible] metrics.

So, I think it's a combination of the meaningful lenders moving towards that because of various regulatory requirements as well as getting comfortable as the asset classes.

And then other more competition coming into the space as well .So, with all things combined we're seeing -- and to certainly rightfully so, the spreads have not really come in for quite some time as we saw the growth in the valuation of those products, the market is kind of adjusting and catching up for that kind of the past six months..

Yeah. To add to what Brad said, Fred, one of the chief determinants of spread and financing has to do with the volatility of the assets.

Non-Agencies have gone through quite a evolution last four or five years towards a much more stable from a price standpoint and with good reason, because the underlying fundamentals have been rock solid and to the extent that there have been surprises -- there have been surprises to the upside.

So, it's all the things that Brad said, but the price volatility of non-Agencies has become very muted over time..

One thing further I wanted to clear up. You would rather note in respect of the merger the [indiscernible] as Kevin said on our joint call, CYS assets received an unsolicited inquiry from a third party but that third party was not us.

We were brought into the process to expose that and -- but, the details of this will be outlined much more -- in a much more fulsome line in the proxy statement..

Okay. Awesome, that's helpful. And thank you for the clarification. Then just I think its Slide 13, where you go through the sensitivities. I guess just in terms of the sensitivity of the book and to net income.

How do you anticipate those will shift following at the time of the acquisition or shortly following?.

Yes. So I think we mentioned it, our primary focus is to maintain not just now but post acquisition, very low exposure to both metrics. Now obviously those will move around as the market changes and our hedge positions change, but you can expect that these numbers will remain fairly low, not only now until the closing but post closing as well..

Is there any sort of minimum that you're trying to keep them to or trying to manage them through the process versus where they are now?.

No, not necessarily I mean, obviously, a lot depends on the market and what's going on in the economy and our general overall views. I mean I think you followed us for a long time as some of the others on the call have, we generally are not inclined to take a lot of interest rate exposure.

But sometimes those numbers are a little bit bigger than you see on the page today.

It's just so happens we're an environment where the Fed is raising rates, the economy is doing well, and there could be different continued upward pressure on rates, so we feel particularly compelled to make sure that these numbers are pretty darn small for the time being..

Thank you. Our next question is from Doug Harter with Credit Suisse..

Bill can you talk about your comfort and the ability to find enough attractive credit assets post the merger close to get to your target allocation?.

Yes, sure.

Look we're primarily focused on the deep discount legacy assets and if you look in the presentation at slide -- I think it's 14, if you think about how long these assets have been out there? You're talking about 10, 12, 15-year-old loans, housing -- between all the tailwinds we discussed if you think about on a forward basis what -- what's the scenarios are going to look like? We're still very bullish on this sector.

Now in terms of supply, this is still a -- I think it's north of 500 billion of the stuff is still out there, there're a lot of bonds that are still at deep discounts and frankly we've been buying monthly a decent amount over the last year.

In fact recently in the last few weeks we've added a reasonable amount as well, and these are assets that are still deep discounts with the upside that we talk about, so I'd say that we're pretty confident that we're going to be able to add enough assets to get back to where we are today and potentially further and the other comment I made on the call is we haven't really seen anything credit dislocations recently and to the extent that that happens and these things widen out, that would be really a great opportunity to add in decent size, and we did that both in 2017 and 2016 and two different periods where that occurred.

So, hopefully that's helpful..

And Brad can you just talk about the expectations for the non-management fee expenses, should those remain elevated or will that likely come back down to kind where they've been trending?.

I'm sorry, I guess can you repeat the question, I'm not quite sure if I understand about on the management fees?.

The non=management fee expenses?.

The non-management fees okay, I may have misheard you. Yeah, I think we've said previously that if you exclude the [LTIP] we anticipate to run between 1.1% and 1.4%. I think Q4 was a little bit on the low end for various reasons kind of year-end, year-end a little bit light on transactions, et cetera.

If we anticipate being active in our volatility and hedging practices which we would expect as well as active in the MSR book and pursuing opportunities such as that. It would likely to be on the higher end of that range, possibly not as high as this quarter. So, kind of steering towards however the higher end of that.

But obviously a lot of uncertainty as we navigate to protect book value and grow the portfolio. And then as we commented that post close we would anticipate taking those numbers and reducing by 30 to 40 basis points, which is also consistent with that philosophy I just mentioned. Hope for that, does that answer -- hopefully answers your question..

It does. Thank you Brad..

Thank you. And ladies and gentlemen, I'm not showing any questions in the queue. I will turn the call back to Mr. Siering for concluding comments..

Thank you, Carmen and thanks all of you for joining us our first quarter conference call today. We are very excited about the opportunities ahead for Two Harbors and the potential to drive enhanced value for our stockholders. We look forward to keeping you updated. Have a wonderful day..

And with ladies and gentlemen, we thank you for participating in today's conference. This concludes the program and you may all disconnect. Have a wonderful day..