Good morning. My name is John. And I will be your conference facilitator. At this time, I would like to welcome everyone to Two Harbors Third Quarter 2021 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 Paulina Sims, Head of Investor Relations. You may begin..

Good morning, everyone. And welcome to our call to discuss Two Harbors, Third Quarter 2021 financial results. With me on the call this morning are Bill Greenberg, our President, Chief Executive Officer, and Chief Investment Officer. And Mary Riskey, our Chief Financial Officer.

The press release and financial tables associated with today's call were filed yesterday with the SEC and are available on both the Two Harbors and SEC website. In our earnings release and slides, 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 in the Investor Relation section of our website. As a reminder, remarks made by management during this conference call and the supporting slides may include forward-looking statements.

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. We caution investors not to rely unduly on forward-looking statements except as may be required by law.

Two Harbors does not update forward-looking statements and expressly disclaims any obligation to do so. I will now turn the call over to Bill..

Thank you, Paulina. Good morning, everyone, and welcome to our Third Quarter Earnings Call. Please turn to Slide 3. At quarter-end book value was $6.40 per share representing a 2.3% total economic quarterly return.

The performance, which was largely in line with the dividend, reflected the partial retracement tighter of high-coupon spreads as recent data pointed to early signs of burnouts and slower prepayment speeds. Earnings available for distribution, formerly known as core earnings, were $0.24 per share.

Elevated activity in the MSR market continued in the third quarter and into the fourth. We saw $120 billion UPB in bulk deals come to market in Q3, and another $100 billion in October bringing the year-to-date volumes to approximately $400 billion.

This is more than double the volume that we might typically see for a full year and we expect this heightened activity to continue for the rest of the Fourth Quarter. In the Third Quarter, we acquired 15 billion UPB through bulk transactions and have committed to add another 21 billion over the next 2 quarters.

Additionally, we settled on 14 billion through our flow program. Lastly, post-quarter end, we issued common equity for net proceeds of approximately $194 million in a transaction that was accretive to book value. We are seeing attractive opportunities in the MSR market and have already committed additional capital in that area.

Furthermore, with the Fed taper upon us, we expect we will be able to increase leverage and deploy more capital in RMBS at attractive spreads in the near to intermediate term. Please turn to slide 4 and I will briefly discuss the overall market environment.

The 10-year swap rate fell from 1.44% on June 30th to a low of 1.16% in the middle of July, and then subsequently rose 40 basis points to end the quarter at 1.55% as the market considered increased inflationary pressures and more precise communication on tapering from the Federal Reserve.

Indeed, as announced last Wednesday, the Federal Reserve will reduce its monthly purchases of U.S. Treasury Securities by $10 billion, and agency RMBS by $5 billion beginning this month and expects to complete the process by mid-2022.

Although the last taper in 2013 resulted in a tantrum of high market volatility, we expect the market reaction to be more orderly this time, all else being equal. Firstly, the Fed is expected to continue to be a source of demand for some time as paydowns from its RMBS portfolio are reinvested, as shown by the blue bars in figure 1.

Secondly, the Fed has clearly communicated the timing and pace of its tapering and its clearly dissociated the decision to taper from the decision to raise rates.

Lastly, even while banks have significantly reduced their purchases of agency RMBS, as long as loan growth is tepid and deposit balances remain high, banks will also likely be a source of demand when spreads become more attractive.

Current coupon spreads have widened out somewhat as shown in Figure 2, but remain at very tight levels with current coupon OAS currently sitting at minus 7.6 basis points as of October 29th.

This spread is more than 15 basis points rich to past periods of quantitative easing where the Fed was buying mortgages, and about 35 basis points lower compared to periods where the Fed was not actively buying mortgages.

While we don't expect these spreads to normalize immediately, we do expect spreads to gradually widen over the course of the tapering process. Turning to figure 3, we show the effect of the refinancing wave has had on the distribution of conventional mortgages by rates.

By comparing the gray bars, which show the coupon distribution at the end of March, and the blue bars, which show the coupon distribution at the end of September, we can see that the distribution has shifted significantly to the left, indicating that a meaningful number of mortgages have already refinanced into lower coupons.

The gray and blue lines show the cumulative distributions of mortgages from March and September, respectively. At the end of March, the percentage of mortgages that were with at least 25 basis points of incentive had declined from about 85 % at the end of 2020 to about 64 % as shown by the light gray circle.

At the end of September, although mortgage rates were 8 basis points lower than in March, there were actually fewer refinance able mortgages, 56 %, as shown by the dark gray circle as a result of this restriking of the mortgage universe.

With the current mortgage rate at 3.14, the amount of refinance able mortgages falls further to 54 % as shown by the green circle. Taken all together, this chart points to overall slower prepayment speeds, which should be beneficial to our agency POS MSR strategy. Now, I will turn it over to Mary to discuss our financial results in more detail..

Thank you, Bill and good morning, everyone. Please turn to Slide 5 to review our financial results for the Third Quarter. Comprehensive income was $45.2 million, representing an annualized return on average common equity of 9.1%.

Our book value was $6.40 per share compared to $6.42 at June 30th, including the $0.17 common dividend results in the quarterly economic return of 2.3%. As Bill mentioned earlier, the result reflects spread tightening and high-coupon specified pools, which offset spread widening and lower coupon RMBS.

Moving on to slide 6, as we note at the top of the page, core earnings will now be referred to as earnings available for distribution or EAD in line with the evolving industry practice. Earnings available for distribution increased to $0.24 per share, compared to $0.19 in the second quarter. Beginning in the third quarter, EAD includes U.S.

Treasury futures income, which is the economic equivalent to holding and financing irrelevant, cheapest to deliver US treasury note or bond using short-term repurchase rates. As a hedging instruments. We use futures interchangeably with swaps. And we think the treatment of hedging instruments in EAD should be consistent.

Futures income in EAD was approximately $0.03 per share for Q3. Had futures income ban included for Q2, it would've increased EAD by $0.02 for a total of $0.21 per share. Interest income decreased from $43.4 million to $36 million as our RMBS position continued to decline through a combination of sales and paydowns.

Interest expense declined by $2.5 million reflecting lower RMBS and MSR borrowings. Turning to MSR, net servicing income increased by $9 million to $56.7 million as a result of higher balances and collections and slower prepayment.

Gain on other derivatives rose by almost $20 million as we benefited from a larger position and continued drill specialness in TDA, as well as the inclusion of futures income.

Expenses increased by $3.2 million to $34.2 million driven largely by one-time non-recurring credits and servicing expenses in the Second Quarter, as we mentioned on our last earnings call. In the table on the lower right, we show our portfolio yield. Our realized net spread in the quarter rose by 62 basis points to 2.55%.

This net increase was attributable to the combination of higher yields on newly-purchased MSR and a greater proportionate of MSR in the portfolio. Net spread as of September 30th, which reflects our estimate for the near term, increased further to 2.77%, but will be dependent on our portfolio mix. Please turn to Slide 7.

We continue to maintain a strong liquidity position with unrestricted cash of $1.1 billion at quarter-end, which includes net proceeds from our July common stock offering of $256 million. Funding for agency RMBS to the repo market remained attractive and continues to remain attractive despite the recent increase in rate.

We maintained access to diverse funding sources for MSR and our unfunded and committed MSR financing capacity stands at $413 million. Finally, leverage declined from the prior quarter in conjunction with the lower RMBS balance.

Average and quarter-end economic debt-to-equity in the third quarter were 6.0 times and 6.1 times respectively, compared to the second quarter average and ending of 6.5 times. We expect are leverage to increase in coming quarters as we add MSR and RMBS. I will now turn the call back to Bill for our portfolio update..

Thank you, Mary. Let's turn to Slide 8 to discuss our quarterly portfolio activity and composition. During the quarter, our portfolio grew to $17.9 billion as we deployed some of the capital that was raised in July into MSR and RMBS.

We adjusted our allocation in RMBS by selling some higher coupon pools that had tightened to unattractive spreads and reinvested into TBA, which continued to benefit for role's specialness.

We also added to our hedging mix by increasing our options positions, utilizing both interest rates and mortgage options, which are expected to benefit from volatility in a sharp breakout to higher rates should that occur. Please turn to Slide 9 as we discuss our specified pool positioning, prepayments, and performance.

As you can see in figure 1, we remain positioned in loan balance and geography stories. Although prepayment speeds have generally been very fast, the New York collateral has performed particularly well with speeds in the 4 % and 4.5% coupons, coming in around 30 CPR during the third quarter compared with generics, which came in higher than 50 CPR.

Figure 2 shows the quarterly total return performance by coupon on TBA contracts shown by the gray bars and on our specified pool holdings shown by the blue bars. You can see that our coupon pools outperformed TBA s as the market reacted to data published during the quarter, plenty to nascent but clear evidence of burnouts.

Finally, Figure 3 compares by coupon, observe prepayment speeds from pools delivered into TBA contracts to observe prepayment speeds on our specified portfolio.

Overall, prepayment speeds in our specified pools declined 8 % to 30 CPR and remained significantly slower than pools delivered into TBA, showing the value of the prepayment characteristics of that collateral.

Please turn to Slide 10, our MSR portfolio is currently valued at $2.2 billion as of September 30th, based on $200 billion UPB, and with a gross coupon of 3.4%. that translates into a price of about a $0.111 or right around a 4.2 multiple. The percentage of MSR in forbearance continued to decline and ended the quarter at 1.7% by loan counts.

Forbearance rates have continued to decline even further in October to 1.2% by loan counts. During the quarter, we settled on $14 billion UPB of MSR through our flow program and $15 billion in bulk purchases offsetting the runoff and growing the UPB by $9 billion.

Additionally, we have executed term sheets to acquire a further $21 billion in bulk transactions in future quarters. Year-to-date, we have committed to purchasing $44 billion through the bulk channel alone. In Figure 2, we show the trend of our settled UPB for the flow and bulk channels over the last 4 quarters.

Flow channel settlements have continued to decline mirroring the drop-in overall refinancing activity. A bulk market, on the other hand has been very active, and that trend has accelerated throughout the year.

Although bulk supply has been robust, pricing has held steady with demand rising to meet the increased supply as some large participants re-entered the market and some new participants expand their interest in the asset class. In Figure 3, we compare our servicing prepayment speeds in blue bars versus TBA speeds in grey bars.

Since more than half of our portfolio has some kind of specified characteristic, such as low loan balance or high LTV, or has some significant seasoning to it that makes it more prone to burnouts, our prepayment speeds are significantly slower than generic. Overall, prepay speeds of our MSR portfolio declined by 7 % to 27 CPR. Please turn to Slide 11.

In place of the charts that we have historically shown, we thought it would be helpful to show a slightly different risk view of our agency plus MSR portfolio. On this page, you can see a snapshot view of our effective coupon exposure and spread risk for agency RMBS paired with MSR and agency RMBS hedged with rates.

Because the MSR asset has negative interest rate duration and negative current coupon spread duration, the MSR asset looks and act in many ways like a short position in RMBS.

This effective short position, which is shown in the top left chart by the gray bars, can be hedged perfectly for both rates and spreads by adding TBA as indicated by the blue bars. The chart in the top middle shows our portfolio's remaining RMBS exposure after setting aside the exposure already accounted for in the top left chart.

These RMBS assets are hedged with interest rates and are largely distributed in the 3 % through 5 % coupons. Lastly, the top-right chart shows our aggregate position. Because the RMBS plus MSR chart in the top-left nets to 0 by design, the combined chart showing the current coupon risk position is identical to that expressed in the top middle charts.

In the second row, we show book value exposure to changes in current coupon mortgage spread. In the left chart, book value declines about 0.5% in both spread widening and spread tightening scenarios. The fact that these numbers are not exactly 0, despite a perfect hedge, is just the result of negative spread convexity.

The remaining current coupon spread exposure shown in the bottom middle chart is 3 times higher than in the bottom left chart because it doesn't have any MSR to act as a spread offset. In a hypothetical portfolio consisting of only RMBS with no MSR. the current coupon spread exposure would be expected to be 5 % to 10 % for 25 basis points shift.

The fact that this exposure in the bottom middle chart is only 1.5% is the result of dividing the sensitivity by the book value of our entire portfolio, where a significant amount of capital is allocated to the paired construction shown in the charts on the left.

The chart on the bottom right sums of these risk exposures together for a total of 2 % exposure or 25 basis points widening in the current coupon mortgage spread, which we consider ed to be very low.

Of course, this exposure assumes a parallel shock across the coupon stack and is not a relevant estimate for the book value sensitivity to spreads on higher coupons moving in isolation, or on MSR. Please turn to Slide 12, where we show our interest rates and curve exposures.

Figure 1, we show our exposure to an instantaneous parallel shift in interest rates, with a total exposure of -0.7%, or a 25-basis-point shock. We can see the total interest rate exposure for MSR, shown gray, is roughly hedged with our RMBS portfolio, shown in blue, with relatively little impact from swaps in futures.

In figure 2, we show our exposure to changes in the long end of the yield curve, keeping the front-end constants. With rising rates more of a concern today, we see that our portfolio exposure to a bare steepening shift of 25 basis points results in the +0.1% gain in book value. Figure 3 is a new addition this quarter.

With Fed hikes on the horizon, it is interesting to look at our portfolio exposure to changes in the front end of the yield curve while leaving the longer end unchanged. With inflation fears in the foreground, the obvious concern is to a shock upward in the front-end in a bear flattening move.

In this scenario, our portfolio has low sensitivity with only a minus 0.8% impact to book value. Taken together, these three charts demonstrate our commitment to hedging the full yield curve exposure, and our desire to have little book value volatility, no matter the rate environment.

Finally, I'd like to discuss our outlook for Two Harbors and our return expectations for new investments on Slide 13. Spreads and returns on target assets largely remained constant over the quarter, with the exception of high coupon specified pools.

With the tightening we experienced in the quarter, we now seen return expectations in the mid to high single-digit down from the high single to low double-digits at the end of Q2. Current coupon specified pools remain unattractive with expected returns in the mid-single-digits.

Current coupon TBA rolls remained around 50 basis points special, and they continue to carry well so that TBAs hedged with swaps offer low double-digit returns assuming this role last forever. Spreads however, continue to be tight and returns with decreased to mid to high single-digits, depending on how fast specialist goes away.

Moving to the lower half of the chart, we continue to be excited about our investment opportunities in the parent agency plus MSR construction, and we are focused on investing here.

Expected returns on new investments in the parent MSR and pools construction can be in the high single-digits to low teens, while MSR paired with current coupon TBAs can offer returns in the low to mid-teens.

As I mentioned previously, large supply in the MSR market is creating currently attractive opportunities to deploy more capital in the parent agency plus MSR construction, and that's where we're spending most of our effort and capital.

Additionally, we expect to see more opportunities in the RMBS hedge with rates in the coming quarters, as we expect the weight of robust mortgage origination and the absence of offsetting Fed purchases to push spreads gradually wider.

With the Fed finally, removing accommodation and prepayment speeds beginning to slow materially, we're very constructive and optimistic about the forward outlook for Two Harbors and our paired agency plus MSR strategy. Thank you very much for joining us today. And we will now be happy to take any questions you might have..

Thank you. At this time, we will be conducting a question-and-answer session. A confirmation tone will indicate that your line is in the question queue. .

One moment, please, while we poll for questions. Our first question comes from the line of Trevor Cranston with JMP Securities. You may proceed with your question..

All right, thanks and thanks for all the new turnkey and data you couldn't deck this quarter. It's very helpful. Just curious, you talked about the level of current coupon spreads today versus historical levels and why they are liquid wide and over the next few quarters.

I was curious if you could share your thoughts on the role specialness, where -- where that is today versus maybe an average historical level and how you think that evolves as that taper starts to get implemented? Thanks..

Sure, thanks very much, Trevor. And thanks for joining us. I think that the role specialist in the reason for the role specialists at about 50 basis points special is -- we've certainly seen it slightly more special over in certain period than it is today. We've certainly seen it less special.

And in a normal environment, it's typically the case that roles are not very special at all. And in fact, one of the main sources, probably the main source of role specialists today, is the activity of the Fed and large banks buying and creating this supply-demand imbalance between front with contracts.

I do fully expect that role will follow mortgage spreads and that as the market returns to normalize, the Fed reduces its involvement spreads will, in all likelihood, normalized. And role specialists will probably also be normalized along with it in roughly the same kinds of time periods.

So, I would think by the time that the Fed has done tapering, spreads will be somewhat more normalized, and role mostly be gone. That's my expectation..

Okay. That makes sense. Then you also commented that the floor MSR purchase volume was declining a bit as originations come down and the bulk activities picked up.

Do you guys see any opportunities to add more flow partners that are more originators were looking for partners to provide that capital, just given the lower profitability of the origination business today?.

Sure. We have a group of flow seller partners that have been among the larger participants in that market over time.

The reason that people choose to be in the flow market is because they don't want to accumulate the interest rate risk and the prepayment risk and they don't want to bother hedging, either because they don't want to or it cost too much to implement the program.

As the market -- as interest rates fell off, as refinancing volumes go down, there's less of that to do, right? And so that's why we expect flow volumes to continue to decline.

It's possible, I guess that some people have kept servicing because they thought that rates were low and we are going to rise and that markets were low and they wanted to hold. That's been one of the sources of bulk supply over the last year as those participants have chosen to monetize their holdings.

It's possible that maybe some of those guys with compressed margins could want to restart flow relationships. Some of those guys have been in and out of the flow market over time. So, we may see some of that. We're well-positioned and already in touch with those guys in order to be able to reengage with them, should they desire..

I appreciate the comment. Thank you..

Thank you..

Our next question comes from the line of Eric Hagen with BTIG. You may proceed with your question..

Hey, thanks. Good morning. Seems like you're -- you're active and growing the MSR portfolio and you've identified an opportunity with all the bulk paper coming to market.

On the $21 billion in bulk that you've bought since quarter end, can you clarify when those are expected to settle? And then the $413 million in funding capacity for MSR that you noted, I assume that's before the bulk settles that you've bought since quarter end, but maybe you can clarify that too. Thank you..

Yes. Thanks for the question Eric.

Mary, can you take that one? Do you do you have that information handy?.

Sure. The bulk settlements are expected in the December and January time frame. Your other question was related to unused committed capacity and you're correct, that is -- that capacity is before the bulk transactions that have not yet closed..

Got it.

Can you say how you expect to finance the $21 billion that you're closing on in December and January? Is it from the breakdown of capital and funding capacity that is going to be absorbed?.

Yeah, we actually took down financing and MSR a bit in the third quarter, just due to our excess cash position. So, I think the answer is it's going to depend on opportunities to deploy capital. And we have plenty of options to finance that should we need to from a cash perspective..

Thank you..

Thanks, Eric..

Our next question comes from the line of Bose George with KBW. You may proceed with your question..

Hey, everyone. This is actually Mike Smith on for Bose.

Just a few related to the equity rates, can you just talk about your pro - forma leverage? How much of the capital is deployed, and then whether or not there's any expectations for a drag on earnings in the fourth quarter?.

Yeah. Thanks for the question. I'll start with that and then maybe Mary can add with the pro - forma numbers. We've already started to deploy some of that capital as we indicated previously, with some of the MSR purchases that we've settled on as well as committed to. We continue to see attractive opportunities in the MSR market.

And when we do that, we often pair it with RMBS, so that capital is already in the process of being deployed. Of course, we're cognizant of the overall level of mortgage spreads, which are still very tight. So, to the extent that we are deploying capital, it's in the MSR assets right now or in the paired construction.

We're not adding outright RMBS versus rate investments here yet, because spreads are still unattractive, as we said, 15 basis points reached to periods where the Fed is buying and 35 basis points reached to other periods. We expect that to occur in coming quarters. and we're prepared to deploy more capital there as well.

But when you look at how much capital is being deployed here, looking at the overall leverage number is not necessarily a good indication of that rather than looking at the assets that we're buying and how we're funding it. Mary, do you want to speak to the proforma numbers..

Okay.

Can you repeat the proforma part the question, please?.

Yeah.

I was just wondering if you could talk about how leverage has trended since quarter end and then if there's any expectations for a drag on earnings in the fourth quarter?.

I don't -- there has not been a material change in leverage since quarter end, more about where we were..

Is there any expectation for --.

-- go ahead..

I was going to say, on the earnings part of the question, is there any expectations for a drag in the fourth quarter with capital deployment?.

And I would say no, not directly. We're expecting the taper to start and to be able to see more opportunities. And we've got MSR in the pipeline. So, no expectations for that..

Great. And then just one more.

Could you just provide any updates on how book value has trended since quarter-end and what are the drivers of this?.

Yes, since quarter-end, as of last Friday, we're down around 2 %. And that's been driven by some slight widening in both MSR to around 20 basis points in spreads and some slides widening in high-coupon specs as well..

Great, thanks a lot for taking the questions..

Thank you..

As a reminder, we are in the question-and-answer session. Our next question comes from the line of Rick Shane with JPMorgan. You may proceed with your question..

Hey, guys. Thanks for taking my questions this morning. And thank you for the additional disclosure. It's certainly very helpful. Bill, when we look at Slide 13, it's obviously really interesting in terms of how it differentiates both assets and hedging from a performance perspective.

What is interesting to me is that the -- at this point that this positive factor driving your performance is the hedging strategy more than the asset gathering strategy. When we look at hedging swaps and MSR, you're certainly growing MSR much faster than , but you've grown swaps a bit as well.

But when we compare TBA versus pools, you're growing TBA a lot faster than pools. I'm just trying to think about what that means.

Are you creating in the short term less durable assets with the idea that that way when spreads widen as we move through taper, that you'll move back in the pools?.

Thanks, Rick. Thanks for joining us today. Those are good questions. I'm not sure I totally understand the model. Let me talk for a little bit and see if I answer them, and if not, you can ask more explicitly.

Recently, as we point out on the presentation, we've let our high coupons pools pay down and we've sold some and replace them with low coupon TBAs because the role specialness is adding incremental attorney.

If you look at the charts on page 13, TBAs hedged with swaps, the higher end of that range in the low teens is assuming that real specialness last for a long time and the lower end of that range, is assuming that real specialness disappears tomorrow, right? And so, given the Fed's posture and the statements they've made, we think that real specialist will continue for a little bit.

It should follow spreads so that as spreads begin to widen from reduced asset purchases and continued mortgage supply, we expect the role specialist to also decline in that way.

When role specialist declines, that will also come with it in all likelihood a more attractive spread not just in the TBA but also in the specified pools that are associated with those coupons.

Because as role specialist goes down, those specified pools become more attractive and I think it is fair to expect that during a period like that that we would be rotating out of TBA into specified pools in the lower coupons as that happens..

Got it. Okay, that's exactly what I was looking for. Yes. And then so when we think about it, clearly the strategy you are going to lean different directions, but you're also clearly not putting all of your eggs in any one basket either from an asset or a hedging perspective.

As you look forward and see the scenario that would create an opportunity to migrate back into pools, I'm curious what -- and I really just don't know the answer here, looking forward, what would be the implication for the swap market, would that become a more compelling element of the strategy as well in that same environment?.

So, first thing I would say is that one of the great things about our MSR plus MBS strategy is that we don't care very much about what's the -- what this current coupon spread does. And so, the fact that we're able to add investments in that paired construction is independent of our view as to whether spreads widened or not.

And the fact that that can still be in the low teens is a very good fact and we're continuing to add capital in that strategy. To the extent that we have additional capital to invest in an RMBS plus rates strip part of the portfolio. Then, as we said, we're going to be looking for some widening there.

The hedge -- or that exposure, whether it exists in current coupon TBAs or in specified pools, will depend on the relative attractiveness of those asset classes, which in turn will depend on Fed involvement, role specialists, and those dynamics. Not sure if I got your question there..

You did. That's exactly it. Perfect. Thank you so much..

Thank you..

At this time, we have reached the end of the question-and-answer session. And I would like to turn the call back over to Bill for any closing remarks..

I'd like to thank you everyone for joining us today. And as always, thank you for your interest in Two Harbors..

This concludes today's conference. You may disconnect your line at this time. Thank you for your participation and have a great day..