Good day, and welcome to the Two Harbors Investment Corp. Third Quarter 2020 Financial Results Conference Call. Today's conference is being recorded. And at this time, I would like to turn the conference over to Corey Stolhammer. Please go ahead, sir.

Good morning, everyone. Thank you for joining our call to Two Harbors Third Quarter 2020 Financial Results. With me on the call this morning are Bill Greenberg, our President and CEO; Mary Riskey, our Chief Financial Officer; and Matt Koeppen, our Chief Investment Officer. 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, 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 Relations section of our website. 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 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, Corey, and good morning, everyone. I'd like to welcome you all to our third quarter 2020 earnings call. The call will be as follows. I will go over quarterly results at a high level; and Mary Riskey, our Chief Finance Officer, will give more details on our financial results; and then Matt Koeppen, our Chief Investment Officer, will discuss our portfolio composition, activity and risk profile. And then I will make some comments about our forward outlook. Finally, we will be happy to take any questions. Summary of our results is shown on Page 3. Our book value at September 30 was $7.37 compared to $6.70 per share on June 30. This represents a 12.1% return on book value for the quarter. Included in these results, reversal of the previously accrued termination fee of $0.51 per share attributable to the nonrenewal of the management agreement, which reflects the fact that there is no longer any payment due as a result of the for cause termination. On a purely economic basis, excluding that reversal, our total return on book value would have been 4.5%. The favorable return is generally due to strong performance in lower coupon RMBS, tempered somewhat by the volatility reducing presence of MSR in the portfolio. This result validates our agency plus MSR strategy in which MSR is intended to meet the effects of mortgage spread widening and tightening in RMBS and produce more stable risk-adjusted results over the long term in a variety of economic cycles. Our core income for the quarter was $0.28 per share, which is far in excess of the declared dividend for the quarter of $0.14 per share. As we have discussed many times past, we believe that core earnings is not necessarily the best measure of the expected economic returns…

Thank you, Bill. Turning to Slide 5. Let's review our financial results for the third quarter. As Bill mentioned, our book value at September 30 was $7.37 compared to $6.70 per share on June 30, [Technical Difficulty] of 12.1%. Excluding the result of the previously accrued management agreement termination fee, the quarterly return on book value would have been 4.5%. Book value growth was driven by positive performance from our RMBS portfolio and was offset by lower MSR pricing from fast speeds and mortgage spread compression. As you can see in the middle of the page, the reversal of the management agreement termination fee was $139.8 million or $0.51 per share. When the Board of Directors announced its plan to not renew the management contract with Pine River on April 13, the nonrenewal payment as well as the associated legal and advisory costs were to be recorded in Q2. As announced on July '21, the Board of Directors subsequently terminated the management agreement for cause, which carries with it no associated termination payment. Following GAAP principles, we reversed the termination fee in the third quarter. Moving to Slide 6, let's discuss our core earnings results. Core earnings were $0.28 per share in the third quarter compared to $0.05 in Q2. Our favorable core earnings were primarily driven by 3 factors. First, net interest income was higher, moving from $45.2 to $60.5 million due to favorable repo rolls on lower LIBOR offset by rotation into coupon agencies and fast speeds. Second, restriking our entire swap portfolio at current rates at the end of Q2 resulted in favorable swap interest spread changing from $56.3 million to income of $0.8 million. Finally, expenses were lower in the quarter, declining from $46.8 million to $43.5 million due to termination of the management agreement on…

Thank you, Mary, and good morning, everyone. Turning to Slide 9. Let's review quarterly portfolio activity and composition. As previously noted, the third quarter economic return on book value was 4.5%, excluding the reversal of the termination fee associated with nonrenewal of the management agreement. This performance was driven by a general spread tightening in MBS across most TBA and specified pool coupons as the Federal Reserve continued its balance sheet expansion by purchasing more than $300 billion mortgages this quarter. Mortgages will also benefit in the backdrop of relatively low implied and realized volatility during the quarter, which minimized delta hedging costs and muted embedded option costs within the assets. With interest rates stable, the market prices servicing was steady and behaved largely as expected. I would point out that third quarter returns are lower in our portfolio construction than in a mortgage portfolio without MSR. At Agency plus MSR REIT, this is by design. We've discussed in the past that MSR acts as a short positioning in the current coupon, which outperformed this quarter, and results in overall lower mortgage spread exposure. We estimate that the presence of MSR reduced returns relative to a portfolio with MSR by around 3% to 4%. On the other hand, we anticipate that our portfolio returns will likely outperform in periods of mortgage spread widening for the same reason. We did increase our RMBS portfolio, mostly through adding exposure to current coupon TBA as we find them relatively attractive. The continuation of the Fed's large-scale purchase activity should cause roll specialness to persist in the near future. Our net TBA balance increased by about $3 billion, and our specified pool position is lower by approximately $1 billion due largely to runoff. Additionally, as Bill mentioned, we've been able to source substantial volumes…

Thanks for that discussion, Matt. Finally, I'd like to take a look at our outlook for Two Harbors and our return expectations on Slide 15. After the significant spread tightening we have seen in the last 2 quarters, we see gross returns for specified RMBS paired with swaps are less attractive than they were, and we see them to be in the range of mid- to high single digits depending on coupon and story. Current coupon TBA returns are enhanced by roll specialness, which is likely to continue for the near future. This could increase near-term returns to the mid-teens area depending on assumptions about how long specialness lasts. New investments in flow MSR paired with RMBS today can also drive returns in the low mid-teens. And if you assume rural specialists on the RMBS component, it can be even higher. Investments in the flow channel are generally more attractive than bulk. We can still at times be 200 to 400 basis points tighter. However, it is very deal-specific and some recent bulk transactions have occurred at attractive levels, too. As Mary discussed, our liquidity profile remained not only stable but strong. As we look forward, our expectations are to increase the size of the servicing portfolio and manage the RMBS portfolio accordingly, which would likely include the use of TBAs to enhance portfolio returns with attractive implied funding. New investments in specified pools are less compelling today with spreads nearer to the tight end of recent ranges. From a risk perspective, we are comfortable increasing our leverage to the 8 to 9 area, in today's environment, with current spread levels, we would broadly expect to maintain overall risk and leverage that is consistent with current levels. Thank you very much for joining us today, and we will now be happy to take any questions you might have.

[Operator Instructions] And your first question is from Doug Harter.

Just one, just wanted to clarify kind of the last comment you made about leverage. Since you said you're comfortable with higher leverage, I guess, do you expect kind of increase to those levels in the near term, assuming kind of returns kind of stay with where you just kind of highlighted?

Doug, thanks for joining. I'll start with that one. I can see us I could see us increasing slightly. I think we're perfectly comfortable, as we've guided before, with nominal leverage numbers in the 8 to 9x. I would note Mary pointed out that had we not had the change due to the management fee, we would have been -- our nominal leverage numbers would have been about 8.3x. So I think we're operating sort of in a comfortable zone and we can see ourselves continuing here. I would -- the last thing I would say is I would -- I would point out that nominal leverage isn't the whole story with our portfolio construction. As we've said before, the paired construction gives you lower mortgage spread risk despite what could potentially be higher nominal leverage numbers.

Yes. I would just add a couple of things. Doug, thanks for the question. Sort of what we said on the last slide is that there's been some pretty significant spread tightening here in mortgages, the relative attractiveness of specified pools isn't what it was even a quarter ago. And as we came out of the spring, we sort of said we were going to add risk and leverage slowly and prudently over time, there's potentially -- we thought there was potentially some so much starting to hear some spread volatility may be attributable to the election, which is, again, thankfully so far, proceeding orderly. And so I would say, should market conditions warrant. We're totally comfortable increasing our leverage further into those levels. But given where things are right now, where market conditions are now, we expect things to be in the area that they are in currently.

And then just if we could touch on the last slide. If you could help explain kind of why would the -- if you're pairing TBAs with either MSRs or swaps, you're kind of getting a similar kind of return outlook, why -- kind of why the TBAs, there isn't kind of an advantage to pairing them with MSR versus swaps?

Yes. Well, one way to think about it is purely from a mathematical standpoint. But if you have 2 things, and one is yielding, right, or if you look at TBAs versus swaps as being, call it, low mid-teens, and in order for the combination of something else to be higher than that, the other thing has to be higher than that also, right? And so what this is saying is that that because the MSR by itself is sort of in that zone, it doesn't add anything that's already starting from a pretty high number. So when you're averaging numbers, so to speak, right, the average ends up being a combination of 2 things. And so in order for it to be higher, the other thing would have to be higher itself.

[Operator Instructions] The next question is from Bose George.

Actually, can I get an update on book value quarter-to-date?

Bose, thanks for joining. Yes. So far, we are pretty flat here in the fourth quarter. We've seen interest rates, again, pretty stable and steady during October performance in -- across coupons and MBS is a little mixed, with current coupons are touch tighter, some coupons, like the 2.5% and the 3% were a little bit wider. We've seen prices in the servicing market have also been pretty steady. So overall, that nets to something pretty close to unchanged through October.

Okay. Great. That's helpful. And then actually, you talked about the economic return earlier in the call, I guess, being a little higher than where the dividend is now. And it's -- but it's still obviously quite a bit lower than when you think about MSR paired with Agency MBS or which you're generating now with the portfolio with the TBA specialness. But when you think about the longer-term return, is it because you want to exclude sort of the unusual income from the TBAs, just help us kind of think about where that longer-term return is and what's driving that?

Yes, I'll start with that, Bose, and thanks for joining. As the charts on Page 15 indicate, some of those things and why we have fairly wide ranges shown there is especially on the TBA side, in large part, due to how long you think roll specialness on TBAs will last, right? And we happen to think it will persist in the near to intermediate term, at least. Obviously, it depends a little bit on the Fed buying. Those numbers often will reflect where we think on the MSR side, right, new purchases are more attractive than existing holdings, especially in the flow markets, we're able to buy things several hundred basis points cheaper than bulk or where our current portfolio is priced. And so putting all that together, we think that the prospective returns in the portfolio going forward are what we said in the low mid-teens. We did indicate that we expect to modestly increase our dividend next quarter. We normally don't give dividend guidance in general, but given the unusual circumstances of 2020, we felt it was appropriate to give a little bit more visibility. And so that's what we expect there, which will bring -- which should bring the dividend more in line with what we think the portfolio is economically expected to earn.

Okay. So the -- thinking about the economic return, it is kind of more of a double-digit number in that range. Is that a fair statement?

Yes. Yes. I say once you put all that stuff together, it's probably low doubles, yes.

And your next question is from Stephen Laws.

I guess, first, want to start with the question about the adverse market fee that goes into effect with refinances on December 1. Can you talk about, I guess, bigger picture, how you think that's going to be handled by the market? And how much of that fee is passed on to borrowers through higher refinance mortgage rates? And along from there, the impact on your portfolio, if it dramatically slows refi, this income statement benefit from lower amortization expenses and a positive mark on servicing valuations? Does it impact the balance sheet from book value or pace of MSR growth? Can you maybe take a couple of minutes and talk about how you expect that change on December 1 to impact the market in your portfolio?

Sure. Thanks for the question. It's a good one. I have a couple of thoughts about it. So first, obviously, an upfront fee amortized over the average life of the asset really only translates into maybe a 10 to 12 basis point elbow shift, if you will, in the refinancing curve. And so if you felt that, that was entirely going to be passed through by the [indiscernible] consumers that's what would be in it. It would nominally reduce refinancing speeds by some amount. Now it's true the primary secondary spread is very wide. Originators could absorb all of that themselves if they wanted to and only have their profitability go down a little bit. I guess different participants will do different things, right? If you ask me, I'd probably say it's going to be split 50-50, and so it will be something smaller than the 10 to 12 basis points or maybe 5% to 6% or 7%. Look, speeds have been really fast here. And the adverse market delivery fee was meant to go into effect earlier. It's been postponed until the end of the year. That certainly had the effect of pulling through some refinancings sooner in the market rather than later. Maybe that's one reason why speeds have been more elevated than maybe some people thought here. And so looking forward, I think it certainly -- it's a complicated picture from everything that I just said. I think it certainly has the effect directionally of slowing speeds in some way, whether it's a small effect or a medium effect, it remains to be seen, I think, that should generally help our servicing portfolio more than a specified pool position. Our specified pool position is very well protected, very high quality, mostly loan balance and geography. It will have a marginal impact there. It will have a bigger effect on servicing should improve valuations there. When we've been bidding on servicing, we've not included that particularly in our valuations in our flow grids or in our book prices. So potentially, there's some tailwind there.

Great. Can you touch base on outlook for the operating expense line or noninterest expense now that you're internally managed, maybe next year, I think you guys have provided a little bit of color previously, but now that you've moved to an internal structure, can you update us on kind of your outlook for G&A and comp and benefits for, say, full year '21?

Sure. Steve, it's Mary. So we would expect our operating expense ratio, excluding out of amortization and nonrecurring expenses to be in the low 2% range. I would note that included in our operating expenses are certain transaction expenses associated with MSR. So the expense ratio will move around a bit depending on our acquisition activity and the size of our MSR portfolio, but we generally believe it will be in the low 2%.

Great. And lastly, Bill, can you talk about how you view potential stock repurchase that, I guess, where we're today, about 25% discount to the new book value number relative to the low to mid-teens ROE you talked about as far as new investments there and all, do you think you guys should look at doing both? Does there -- one seems to outweigh the other? Can you talk a little bit about your considerations there as you reinvest capital either in new investments or possibly your own stock?

Sure. I appreciate the question. I think we talked about this last quarter, perhaps. The lens through which we look at this question is really about obviously uses of capital, right? And if I think about just trading 25% below book here compared to, again, just statistic round numbers, 12% returns on investable assets. That's a 2 year breakeven, right, that the investors would earn the same amount of money in 2 years as they would by realizing that benefit today and is 2 years a short time or a long time is that worth it or not worth it. It obviously depends on the on the relative spreads in the market and the investment opportunities and the relative discount to book. At those prices, it seems to me, 2 years is a pretty low number. Obviously, we haven't made any decisions yet about those things. We did not buy any stock back in the third quarter, mostly for that reason that we felt that 2 was a low number, right? And so we'll continue to monitor that as the world unfolds and develops, but that's the lens through which we're looking at this.

And we'll take the next question from Trevor Cranston.

Most of my questions have been asked. I was curious, you mentioned being able to begin growing the MSR portfolio again in 4Q. Yes. As you look at your portfolio today, can you talk about sort of how much you would like to be able to grow the MSR book over time, assuming that you're able to find product to buy related to -- relative to the size and the composition of the current agency book?

Yes, Trevor. I'll start with that one. I don't think we have a particular target in mind. We certainly have room to grow the servicing asset. We do find it attractive. It's one of the most attractive things that we see today. I think it would be -- I think there's certainly -- I think we have a lot of room to adverse sort of amount close to levels where I think we would say that we have too much. And we have -- like we said, we have been seeing volumes pick up. It's been pretty exciting, actually. So the bulk markets are -- have become much more active. Full volumes, like we said, have been higher. I think we've seen volumes increasing even further in the fourth quarter so far. So that's been really good. I can see just where we are in the cycle, I can see there being a period here where maybe the bulk market is a little less active just because we're getting into year-end. But they -- whatever it's a fast refi environment, and people are certainly making new loans, they're making servicing. And I do think that will make its way into the market eventually. So I do feel like we're in a place where we can grow the portfolio in coming quarters.

I would just add a couple of things to that, Matt, if I could. Really, if I look at the combination of stories, which are being told on Page 15 of the presentation and on Page 13 of the presentation, right? So as Matt said, pairing agencies plus MSR is one of the most attractive things we can do. We think that the advantage of our portfolio is really is to lower mortgage spread risk and adding more MSR certainly lowers that risk as you see on Slide 13 there. And netting those numbers of -- we're contributing 2.5% in lower mortgage spread risk from existence of MSR, that could be bigger, right, to make the total net smaller, which we think is really the main advantage of our portfolio. So yes, we want to grow the MSR portfolio, and we think the market is allowing us that opportunity to do so in the near term here.

Right. Okay. That's helpful. And then just one question on the cost of funds side. Do you guys have any meaningful amount of repo outstanding that hasn't yet rolled down to current market rates? And if so, could you maybe share when you expect that to roll?

This is Mary. I can start with that. The bulk of the repo had rolled to market rates in Q3. I think we had a little bit left to do in the fourth quarter, but the most part, the repo balances are at current market rates.

We'll take the next question from Rick Shane.

I wanted to talk about Slide 6 for 1 second, which was -- and you show on there the gain on other derivatives being $32.9 million for the third quarter on a core basis. And when we look at the P&L, I'm going to go back to it, the gain on a GAAP basis was $65.6 million, and then you make the adjustment in the core to get to that net number. I'm curious what is driving those marks and how we think about what should be in core and what should be backed out of core?

Sure. So the gain and other derivatives line for core earnings is exclusively TBA dollar roll income.

Got it. And what are the other -- and so what are the other derivatives that are going through there on a GAAP basis?

Well, any realized and unrealized on the TBAs would be in -- on the GAAP income statement versus in core. So primarily, it's TBA and maybe a few options. But I think the difference between what you see in core and what you on the GAAP income statement is realized and unrealized?

Got it. So we should think of what shows up as core on a net basis is actually the roll income and everything else is just marks on both sides?

That's correct.

And your next question is from Kenneth Lee.

You mentioned that when you look at some of the MSR valuations, a few were relatively situational. I guess just stepping back more broadly, wondering if you could just share with us your thoughts on how would you characterize the overall MSR markets in terms of just activity and trading and whether things have truly recovered at this point?

Yes, I'll start with that, Ken. Thanks for the question. I'd say it's continuing to improve from its earlier trauma we have seen a fair amount of bulk packages out there. I think as Matt said in his comments, there's some amount of price discovery happening. There's more as we've indicated, we're acquiring more flow volume here. And I'd think prices are starting to return to more normal levels. You still have this dynamic where the gain on sale is very high. And so there are still many servicers that aren't particularly interested in selling servicing into that market, maybe they think rates are going to rise in the future with more stimulus or maybe they think that that molds at 3 are supposed to go to 4 or for whatever reason, they don't need to sell. And so I'd say the volumes of expected MSR sales is still lower than then I would say, than the natural level is supposed to be. But the pricing is returning to more normal, and there is, I would call it, an increasing degree of visibility into the market. I think people understand where market prices are. Bid offer spreads are lower than they were, again, several months ago. And so I would reiterate what I said. I think it's beginning to heal. In addition, I think I said this. If I didn't, I'll say now. On the flow market, while there are -- well, those dynamics are still true and many participants are still retaining, we are seeing more sellers be interested in selling flow MSR to us going forward. Again, maybe for the same reasons that that hedging concerns might be coming up or maybe there's some cash needed and so forth. So the market is overall starting to improve and to heal, but already, it's in a pretty good place right now.

Got you. Very helpful color there. And one follow-up, if I may. When you just combine together all the dynamics of the agency markets, the roll specialness as well as the funding cause wondering whether if you could just give us a sense of where net interest spreads could potentially trend over the near term?

Sure. I can take that question. So if you look on Page 7, we have shown you our as of yield as of September 30, which is a near-term outlook. I think over time, we would expect those yields to decline as we rotate our asset portfolio into lower coupons. We would expect that to be in the 1% to 1.25% range for a net yield, that's going to occur over time.

Got you. Got you. Very helpful.

And I would -- I should add that our yield on Page 7 does not include TBA dollar roll income.

[Operator Instructions] The next question is from Mark DeVries.

Yes. Just wanted to clarify some of the comments around the dividend. I think you indicated, Bill, that I think at least intermediate return expectations are kind of, let's call it, mid-teens, which presumably is benefiting from the higher returns on TBAs. But it looks like just on pools, it's kind of the low double digits. Should we expect the dividend to kind of move more towards those immediate returns or more towards the kind of the long-term sustainable if the specialness disappears?

So that's good question. Thanks for joining us. I'd say the answer is probably somewhere in the middle, right? When we look at the graph on Page 15, if we look at the returns attributable to pools, I'd say some of the low coupon pools -- lower coupon pools, again, we don't have any in 2s, as we said, are probably towards the tighter end of that range. And the higher coupon specified pools that we have are more towards the higher end of that range, right? As I said, certainly, new MSR purchases, combined with TBA are sort of in the low mid-teens. Putting all that together, we think it's in the low double digits, right, altogether. As we said, we expect to increase our dividend modestly in the next quarter. And then -- and we set our dividend policy, as you know, as have said, with more than one quarter in mind with some look to sustainability and those sorts of issues as well as issues like taxable income and so forth. And so we'll have to see how things unfold. We're going to look at all of those factors. As we said, we expect increases modestly, keeping all those things accountable. And I just have to see how things unfold from there.

Okay. That's helpful. And just wanted to get your view of how long you think specialness persists? Is it as long as the Fed is an active buyer? And if so, how long do you think that will be?

I think that's exactly right. I think the graphs on page whatever, Page 10, show that, right? And so that's what we expect. I don't know. One man's opinion. Matt can give you a bit. Look, I think low rates and the refi volumes that we have here in terms of origination volumes and the coupon distribution in the world probably indicates that fast speeds will persist, assuming rates don't rise for another year or so, right? The Fed involvement is probably going to be dependent on what their view of the economy is, right? I don't know what -- the presidential election is going to come out. But if we're looking at potentially a divided government with the ability to -- for lack of stimulus or this kind of thing, maybe the Fed will need to keep their foot on the gas a little bit longer than they would have if it came out a different way. So I think this is going to be here for a little while.

And it appears there are no further questions at this time. Bill Greenberg, I'd like to turn the conference back to you for any additional or closing remarks.

Well, I'd like to thank everyone for joining us today for our third quarter earnings call. And thank you very much for your interest in Two Harbors. Right, we'll see you next time.

This concludes today's call. Thank you for your participation. You may now disconnect.