Good morning. My name is Peter, and I will be your conference facilitator. At this time, I would like to welcome everyone to Two Harbors Fourth Quarter 2021 Financial Results Conference Call. . As a reminder, this call is being recorded. I would now like to turn the call over to Paulenier Sims.

Good morning, everyone, and welcome to our call to discuss Two Harbors Fourth 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 earnings press release and presentation associated with today's call have been filed with the SEC and are available on the SEC's website as well as the Investor Relations page of our website at twoharborsinvestment.com. In our earnings release and presentation, we have provided a reconciliation of GAAP to non-GAAP financial measures, and we urge you to review this information in conjunction with today's call. As a reminder, our comments today will include forward-looking statements, which are subject to risks and uncertainties that may cause our results to differ materially from expectations. These are described on Page 2 of the presentation and in our Form 10-K and subsequent reports filed with the SEC. Except as may be required by law, Two Harbors does not update forward-looking statements and disclaims any obligation to do so. I will now turn the call over to Bill.

Thank you, Paulenier. Good morning, everyone, and welcome to our fourth quarter earnings call. Please turn to Slide 3. At quarter end, book value was $5.87 per share, representing a negative 5.6% total economic quarterly return. This underperformance can be attributed in approximately 2 equal parts. Firstly, to spread widening and higher coupon RMBS and IO securities due to slower-than-expected declines in prepayment speeds and higher volatility. And secondly, to a 20 basis-point widening in the spread of the MSR asset, which we see as being within the typical period-over-period variability of MSR spreads and which arise from using the simple average of 3 independent broker marks. The overall environment in 2021 was challenging, as the market wrestled with continued waves of coronavirus infections and uncertainty around the path of economic growth and monetary policy. For the year, we delivered total dividends of $0.68 per share equivalent to an average dividend yield of 10.0%. With the starting book value of $7.63 at the end of 2020, the total economic return on book value equates to minus 14.2%. In many ways, the underperformance in 2021 was a continuation of the market stress of 2020. While the Fed came to the rescue in 2020, buying unlimited amounts of RMBS and stabilizing the market, the Fed's continuing monetary accommodation also had 2 other effects. First, with the Fed having bought almost $3 trillion of RMBS during Q4, spreads collapsed to all-time tight levels, which reduced the tailwind of carry meaningfully. Second, the Fed's asset purchases also reduced mortgage rates to all-time lows, igniting a prepay wave that hasn't been seen since 2003, and creating a very strong headwind for portfolio such as ours with premium and interest-only cash flows. Nevertheless, we took proactive actions during the year, which benefited the company. We issued…

Thank you, Bill, and good morning, everyone. Please turn to Slide 6 to review our financial results for the fourth quarter. Comprehensive income was negative $128.6 million, representing an annualized return on average common equity of negative 24.7%. Our book value was $5.87 per share compared to $6.40 at September 30, including the $0.17 common dividend, resulted in a quarterly economic return of negative 5.6%. As Bill mentioned earlier, the result mostly reflects spread widening in high coupon RMBS, IO securities and MSR. Moving on to Slide 7. Earnings available for distribution was $0.22 per share compared to $0.24 for the third quarter and compared to our fourth quarter dividend of $0.17. Overall, the benefit of our investment in MSR served to partially offset reduced RMBS balances. Net interest income declined by $1.3 million with lower RMBS balances translating into lower interest income and repo funding costs. Interest expense was further reduced by a decline in MSR borrowing costs. Gain and other derivatives was $39.5 million compared to $46.3 million in the prior quarter. The result was driven by a reduction in TBA exposure, which was largely offset by roll specialness, and a lower notional position in U.S. Treasury futures. Turning to MSR. Servicing income rose by more than $4 million to almost $61 million as average UPB balances continued to grow and prepayment speeds slowed. As Bill noted earlier, we expect to settle on $39 billion UPB of MSR in the first quarter and expect to see the economics of that growth come through over the next couple of quarters. Lastly, operating expenses fell by $3 million to $31.4 million due to compensation accrual adjustments, offset by the rescission of the CARES Act employee retention credit that we benefited from in the first 3 quarters of the year. In…

Thank you, Mary. Please turn to Slide 9. As spreads fluctuated during the fourth quarter at tight levels, we became increasingly concerned about the potential for a more aggressive Fed, and in early December, we reduced our overall mortgage exposure to be more defensive, reducing our portfolio leverage to 4.7x. As we did this, we also utilized option structures to replicate the convexity and volatility characteristics of RMBS, which preserved virtually all of the carry, but without the spread risk. Within our specified pool position, we rotated out of our season 3% pools into new production, investor property, loan balance and geography stories. We also added some very low pay-up 2.5% bank service collateral, which we think will outperform TBA as the deliverable worsens. In high coupons, we were not active, and we let that position continue to run off without replacements. Please turn to Slide 10. Figure 1 shows our story and coupon distribution of specified pools and includes the bank service and new production investor stories that I just mentioned. Figure 2 shows the quarterly total return performance by coupon on TBA contracts in our specified pool holdings. Here, we can see that every coupon with the exception of TBA, underperformed their interest rate hedges along the curve and higher coupons suffered more. Finally, Figure 3 compares by coupon TBA speeds to those of our specified portfolio. Overall, prepayment speeds in our specified pools declined 8% to 27.7% CPR and remain much slower than TBA. To the extent that this quarter's underperformance and higher coupons was due to the market being disappointed by the pace of deceleration in prepayment speeds, we are optimistic that, that may be short-lived, as prepayments should begin to slow materially in the coming months. Indeed, the February prepayment report released last Friday showed…

. Our first question is from Trevor Cranston with JMP Securities.

You talked a lot about the widening of current coupons in January and performance somewhat of higher coupons, which kind of reversed what happened in the fourth quarter, I guess. Can you talk about going forward as taper progresses and the Fed embarks on monetary tightening, how you expect the kind of performance of the coupon stack to evolve over the course of the year? And if you could also provide any commentary on sort of what risk scenarios you guys think about that would potentially cause high coupon underperformance going forward?

Yes, sure. Thanks, Trevor. As we've sort of been saying for a while and shown by the chart on Slide 4 of the presentation, we've been saying for a long time, we think spreads on current coupons are going to -- should continue to widen towards long-term averages. And given the environment that we're in, with the Fed still removing accommodation, talking about balance sheet tightening, and all those factors, I think the possibility of an overshoot of long-term averages in spreads is possible. And so we are positioned accordingly for that. As rates continue to rise, what is known as current coupon migrates up also. So looking at the current coupon chart like the 1 that we show here is talking about not a single coupon in the coupon stack. It changes over time a little bit. Currently, right now, they're the high coupons called 3.5 and above, they haven't made any of those for a long time, right? And so as rates rise in the current coupon shifts up there, the current coupon now is probably in the 3% area, right? You should start to see more supply come in those coupons as well. But refinancing speeds across the entire stack, not just the current coupons, will start to fall as the entire machinery of the refinance universe starts to sort of power down. I'm not sure if that answered your question.

Yes. Yes, it does. That's helpful. And then when you were talking about the attribution to the book value performance in 4Q, I think you mentioned about half was underperformance of high coupons and then the other component was widening of MSR. And I think there was a comment that it was partially related to just the pricing variance based on how MSR marks are provided. Could you clarify that a little bit or just elaborate on if the MSR widening was just sort of that pricing variance or if there was anything sort of fundamental related to expected prepay speeds or anything else going on?

Well, I'll start with that, right, and maybe Mary can jump in also. Our fair value marking process is to take the average of 3 independent broker marks, right? And they have their own information and look as to what the -- what their estimates of our portfolio are, and we think the best way to manage that is to take the simple average of those. And within that process, we saw a 20 basis-point widening of that average level.

Got it. Okay. And then the last question for me. I think when you were talking about the refinance ability of the market, I think you gave a number something like 11% after the move in rates in January. Do you have the number offhand for how much of your MSR portfolios remains in the money for refinancing or if that's generally kind of close to what the market level is overall?

Yes. I think that's 1 of the charts, actually. You see it tracks pretty closely on Page 5 of the presentation. We show this percentage in light blue is the Fannie, Freddie universe and the dark blue line in the chart on the upper right is our servicing portfolio. So it's tracking pretty closely with the universe. There was a little bit of divergence in 2020, but it's largely converged now to the universe.

Our next question is from Doug Harter with Crédit Suisse Securities.

Bill, you talked about -- you've talked about for a while that kind of the construct of the portfolio with Agency MBS and MSR is meant to dampen volatility in book value. I would say, for 2021, that didn't work. Can you just talk about lessons learned and how you might -- whether there's any changes to portfolio construction or hedging that you might do to accomplish that lower book value volatility?

Yes, sure. Thanks for the question, Doug. 2021, our performance, you can phrase in 2 different ways, really. One way is, the portfolio construction and the sensitives that we show, as we say on Page 13, right, really reflect parallel changes in spreads across the stack. And what we saw in 2021 with the Fed continuing to buy lots of mortgages that current coupon mortgages didn't really widen at all during 2021. They stayed at very, very tight levels, even through the end of the fourth quarter. At the end of the fourth quarter, they were within 8 basis points or they were about 8 or 9 basis points of the tight levels experienced throughout the year. So we didn't see any current coupon widening during 2021. What we did see was high coupon spread widening during the year, which as rates fell and the Fed started buying more low coupons, they weren't making any more high coupons. It was sort of a static pool of portfolio which you couldn't trade in it particularly, couldn't add to it. I mean, you could sell and we did sell a fair amount of that asset. But what happened was prepay speeds were generally faster than the world expected, right? And as a result of that, those coupons suffered in actual realized cash flow performance as well as forward-looking spread performance on the high coupons alone. And the portfolio was not able to benefit from the offset of the MSR, which benefits from low coupon spread widening. That's what we're seeing today in the early part of the first quarter, a very rapid 20 basis-point move in January, mortgages are under stress again in February, and I'm sure you're aware. And so in that environment, the MSR does provide an offset. And here, we're switching to a turnover environment, out of a refi environment. And so I'm much more confident in the ability of the MSR to provide the offset that is designed to do in this environment.

Our next question is from Eric Hagen with BTIG.

So maybe two questions on my end. Before any offsets from MBS and hedges just by itself, can you say what the total return has been year-to-date for the MSR portfolio? And then separately, what were the unlevered yield -- what was the unlevered yield for the $39 billion that you bought so far this quarter?

I don't think I have the returns broken out on just the MSR of the portfolio without hedges. If I understood your question correctly, that's not something we regularly compute or monitor. We look at the portfolio on a hedge basis and it's not particularly interesting to me what the return of the individual size of that construction are. So that's not something I have at my finger tips for sure. Not sure it seems something we calculate or monitor. In terms of the static yields of the portfolios that we've been buying, we see, in general, static spreads in the very high single digits on an unlevered unhedged basis.

Okay. Got you. And then maybe you can shed some more light on the decision to rotate back into specified pools and really just how you expect the premium there to hold up if the expectation is for wider spreads like you guys did note in your prepared remarks?

Yes. So we talked about this in the past, and there have been many questions about this in past quarters. With the Fed tapering and removing their purchases, we expect the role specialists to decline and that should cause TBA -- that's 1 effect which would cause TBAs to underperform specified pools. In addition, when you talk about TBA investments, that's also a -- refers to what is -- it's the cheapest to deliver concept, right? And so investing in a pool, which is static, which doesn't change over time, unlike the TBA, was implied in the TBA prices, should also benefit the specified pools relative to the TBA. And so over time, as we've discussed, as role specialist declines in that market, we expect to rotate more into specified pools, and this was really the beginning of that shift, and we started by buying very low payup securities which shouldn't -- that pay up should not be particularly at risk as spreads widen.

Got you. And then 1 point of clarity. The book value color quarter-to-date, does that include an accrued dividend? Or is it net of an accrued dividend?

Well, as you know, the dividend is -- I'm sorry, go Mary.

I was just going to say that it would not include a dividend as those aren't set until the Board declares them in March.

Our next question is from Bose George with KBW.

This is actually Mike Smyth on for Bose. Just a couple of questions on the Fed balance sheet. I'm just wondering if you can talk through your expectations for runoff and how that may compare to what we saw last time? And then maybe if you can just talk through where do you think the incremental demand comes from as the Fed moves away?

Thanks very much for the question. Look, I have no particularly better insight into what the Fed is going to do than anybody else. They've said that after liftoff -- after rate hike liftoff, they will start to consider the normalization, right? They said it could be faster than other periods. They've said that they want to get to a treasury-only portfolio. I take them at their word. I think the inflation fears have been internalized by the Fed. I think they will act accordingly. And I think if anything, in this episode compared to the last one, there's probably a higher risk that the Fed acts more quickly and more aggressively to take their mortgage balances down than they did in the past. And I think it results -- that obviously puts higher risk on mortgage spreads.

Great. That's helpful color. And then just 1 more, leverage declined quite a bit again. I'm just wondering if you can kind of discuss what you're looking forward to go on offense and take that up, and then maybe the time line for doing so, given that your targeted returns on assets have improved modestly quarter-over-quarter?

Sure. I mean, the overarching environment here is 1 where the Fed is stepping away and where there's still lots of supply of mortgages and spreads are tighter than they've been in other periods where the Fed has been removing accommodation. And so we're watching spread levels carefully. It's a day-by-day decision about the environment and the relative value. I think that -- in the past, we've said that our leverage could go up to 8 or 9x. And of course, I'll remind you, leverage for us means something different than it does for portfolio without MSR, because we have this MSR offset. And so we really look at the spread exposures that we show on Page 13 more carefully than we do at the nominal leverage, although we're respectful of the number. But given the amount of MSR in our portfolio today, we think that our leverage can go up into the 7s. If spreads overshoot towards the higher end of that range on Slide 5, then it could probably touch in the low 8s or something like that. But we're watching the overall macro environment, the spread environment of the MBS market carefully and we'll make decisions when we think it's attractive to start increasing that over time.

Our next question is from Kenneth Lee with RBC Capital Markets.

Just one on the risk positioning and hedging profile. Just based on the Slide 14, it looks -- it sounds as if Two Harbors is biased towards protection around a bear flattening scenario. Just want to gauge if that's -- that would be a correct reading? Or is there couple of other scenarios that you guys are particularly focused on?

Well, yes, we're most focused on that because that's where all the action has been in the last several weeks, for sure. But as -- and we all knew where this market was heading, which was towards Fed liftoff in rate hikes. And typically, when that happens, the yield curve flattens substantially and so on. And the market is moving very quickly. It shows how quickly the market moves. We actually prepared our remarks last night. I mean, I said there were almost 5.5 hikes priced in the front end and after today's CPI number, right? There's more than 6 hikes priced in 2022. So it just shows how fast the market is moving here. We try to hedge all along the yield curve, right, and to protect against bear flattening as well as bear steepening or bull flattening or bull steepening. We try to not run large interest rate risk positions. We view -- our job, our mandate is to provide mortgage exposure and it's mortgage exposure with MSR and not to make guesses on the direction of interest rates.

Got you. Very helpful. And just 1 follow-up, if I may, in terms of the MSRs. You mentioned there could be a pickup in terms of potential available acquisitions on the bulk side. Just wondering if you could just talk a little bit more about what could be driving the increased availability this year?

Yes. The supply side in 2021, is really the same thing that's driving what we're seeing in 2022, which is that, during the extraordinary refi wave that we saw in 2020, many participants chose not to sell their MSR into the market, because they felt that, that rates were low or that multiples were low. Remember, back in those times, primary secondary spread was very wide. And so price multiples on, what I would call, at the money servicing during those days was probably in the 3 area as opposed to where it more normally is in the 4 to 4.5 area. And market participants saw that and they said, I don't need to -- I'm going to hold on and wait, because I think the price is low. And the primary secondary spread was so wide, so they were making enough money that they didn't need to sell their servicing to monetize it in order to run their operating businesses. And so they just held on to it. And rates rose, the market healed, price multiples improved. And so now those participants are looking to sell those balances into the market. And what we saw in 2021 was not all of that. And of course, 2021 also saw large refinances. So while -- they still have the 2020 backlog. They were still making just as much in 2021 as they made in 2020. And so not all of that pipeline has cleared. And so 2022 should probably see a continuation of that as servicing participants work to monetize their servicing holdings off their balance sheets.

Our next question is from Rick Shane with JPMorgan.

I want to follow up a little bit on the last question. You guys point out sort of the differential in the market in terms of bank service versus nonbank originated lenders. I am curious if you are starting to see any consolidation in the nonbank channels. And I'm also wondering 1 of the things the nonbank originators talked about in terms of their volume opportunity going forward, even as the rate term refi wave ends is the cash out refi opportunity. How are you sort of mitigating that risk within the portfolio? And are you seeing peering in pricing between bank and nonbank originators related to that adverse selection?

Thanks, Rick. I'm not sure I understand your question exactly. So let me just talk for a little bit and see if that helps and answers the question. If not, you can steer me back on course. The addition of some bank service specified pool collateral was really just a relative value trade between TBA, which, as I said, I believe, will worsen as spreads widen, as the deliverable worsens. Bank service collateral prepays a little bit slower than the generic cohort and so forth. But these are low pay-up pools. And it's not a big risk position that we have in general. The cash-out refinances is certainly a thing. We've seen more of that in 2021. That's already known in the market. That's what's keeping turnover speeds higher than it has been in the past over -- in other turnover episodes. I think that's already priced into the market at reasonably fast levels of cash out refis. And so I happen to think that, if anything, the risk of cash out refi speed is probably to the downside, more than to the upside. I guess if it's true of cash out refis, it is true of prepayment models in general as a result of this episode that these were faster-than-expected speeds across the board and models have been -- and expectations, not just modest, models and market expectations have been calibrated to these very fast speeds. And I think it's just as likely that speed can be slower than those expectations. Then -- I think it's just like if not more likely, that there will be slower expectations rather than a higher going forward. Additionally, I'd say in our servicing portfolio, we do have recapture agreements in place with our sub-servicers, and we're able to monetize some of that value as cash out refis happen as well.

Got it. Okay. Yes, that's helpful. I mean, I think 1 of the assumptions that we all often mistakenly make is that normalization is back to normal, but oftentimes normalization episodically overshoots before it returns to normal.

Yes, I agree with that.

Okay. I will say we enjoyed the slide deck. I think every 1 of them, it could be a syllabus for a course on mortgage-backed securities with each slide being 1 daily lecture, and we're going to have to delve into all of them a little bit deeper.

Well, happy to help in that if you need me to. Thanks very much.

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to Bill Greenberg for closing remarks.

Just want to thank everyone for joining us today, and thank you, as always, for your interest in Two Harbors.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.