Greetings, and welcome to the Two Harbors Investment Corp., First Quarter 2022 Financial Results Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this call is being recorded. I would now like to turn the conference over to your host, Paulina Sims, Head of Investor Relations for Two Harbors Investment Corp. Thank you. You may begin.

Good morning, everyone, and welcome to our call to discuss Two Harbors First Quarter 2022 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 harbors investment.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, Paulina. Good morning, everyone, and welcome to our first quarter earnings call. Please turn to Slide 3. At quarter end, book value was $5.53 per share, representing a negative 2.9% total economic quarterly return. The speed and magnitude with which the bond market repriced this quarter was historic by many measures as the market rapidly adjusted its expectations that the Federal Reserve will move aggressively to contain rising inflation. The steps taken last quarter to meaningfully reduce leverage and the significant reallocation of capital from MBS to MSR helped to insulate our portfolio from the large widening in MBS spreads. Although the portfolio was not completely immunized from the move in spreads, this quarter's performance demonstrates the benefits of the paired agency plus MSR construction as well as active management of the portfolio. Please turn to Slide 4. During the quarter, inflation continued to trend higher as the Warren Ukraine and Russian sanctions contributed to the upward pressure. With CPI rising by 8.5% year-over-year, its fastest acceleration since 1981, the Fed vowed to do whatever it takes to combat increasing prices and re-anchor inflation expectations. The market received this message clearly and swiftly incorporated 9 to 10 rate hikes through the end of 2022 after pricing in only three hikes for the same period at the beginning of the quarter. With only five Fed meetings left in 2022 after yesterday's meeting, the market is pricing in at least several more 50 basis point increases, which hasn't been done in more than 20 years. Further, as seen in figure 1, the market is clearly expecting short-term rates to rise above the so-called neutral rates before coming back down, implying an interest rate cut as early as the end of 2023. To put the magnitude of this quarter's rate movements…

Thank you, Bill, and good morning, everyone. Please turn to Slide 6. For the first quarter, the Company reported a comprehensive loss of $60.3 million, representing an annualized return on average common equity of negative 12%. Our book value was $5.53 per share compared to $5.87 at December 31, including the $0.17 common dividend results in a quarterly economic return of negative 2.9%. Results were mainly driven by the substantial spread widening in RMBS and higher hedging costs, which were largely offset by spread tightening in MSR. Furthermore, our decision to reduce our RMBS position in the fourth quarter, and keep leverage low through February, also muted the impact of the spread widening in the quarter. Moving on to Slide 7, earnings available for distribution was $0.18 per share compared to $0.22 for the fourth quarter. Interest income, which grew by $12 million, benefited from lower amortization as prepayment speeds slowed as well as incremental investment in Agency RMBS. Interest expense rose by $2 million to $22 million due to a combination of rate increases and higher average RMBS and MSR borrowing balances. This was partially offset by reduction from the January maturity of our 2022 convertible senior notes, which should result in annual savings of approximately $9 million. TBA dollar roll income decreased to $22 million on a lower average notional position during the quarter. U.S. Treasury futures income was also lower as we moved to a net short position. Turning to MSR. Servicing income grew by more than $11 million to almost $137 million on higher UPB from the settlement of bulk purchases in the quarter, while servicing expense increased by $2.5 million. Lastly, operating expenses rose to $13.9 million, a level which is more in line with our expected run rate. The increase reflects the impact of…

Thank you, Mary. With origination no longer adding supply and lower coupons and much of the past production locked up in the Fed and bank balance sheets, lower coupon spreads stayed tight relative to higher coupons. To take advantage of the additional spread offered by higher coupon specified pools, we sold our 2.5% bank service collateral and added loan balance and geography stories in 3% through 3.5% coupons. We also adjusted our TBA positions up in coupon as current coupon rates increased from around 2.5% to 4%. Besides improving the hedging correlation to our MSR, moving up in coupon in TBA also allowed us to take advantage of the very strong dollar rolls and higher coupons as roll specialists and lower coupons has largely disappeared. In particular, we added $4.7 billion of 3.5% and 4% TBA while selling $4.3 billion of 2% through 3% TBA. Please turn to Slide 11. Our specified pool position, as seen in figure 1, remains mostly allocated to high-quality loan balance, geography and investor collateral in 3% and higher coupons. With the main story of the quarter is late in figure 2, was a massive underperformance of specified pools and TBA contracts all across the coupon stack. Aside from 5% specified pools, mortgages underperformed their interest rate hedges by 1.25% to 2.5% and on an asset basis before applying any leverage. 3% and 3.5% specified pools underperformed TBA, as they have longer cash flows and longer spread duration by 4%, 4.5% and 5% specified outperformed TBA, as the TBA deliverable worsened on a relative basis in those coupons. With the sharp selloff in rates and mortgage spreads, mortgage rates spiked higher and prepayment speeds dropped precipitously as shown in figure 3. Our specified pool speeds dropped 38% during the quarter, from 27.7 CPR to 17.3…

Thank you. At this time, we will be conducting a question-and-answer session. Our first question comes from the line of Rick Shane with JPMorgan. Please proceed with your question.

Look, the MSR strategy is really being validated by what we've seen over the last quarter and, frankly, over the last several quarters. But I am curious when you think about the strategy long term, I think the one consideration is that you are hedging a highly liquid product with a much less liquid product, and as we sort of move through the cycle, can you talk about how you manage that balance?

Sure, Rick. Thanks for the question. We consider the liquidity profile of the portfolio in the Company across various different scenarios and cycles. And when we think about how much excess liquidity we need to protect us in different rate movements and spread movements. That is built into our portfolio management, right, and our strategy and our expected returns and all of that. And I think if ever there was a test of such a thing this last quarter with its very large rate movements of 150 basis points or more shows that we manage that very well and incorporate into our strategy.

Got it. And as -- and again, we're obviously very early in the tightening cycle. But as we think about again, way, way down the road, how things will evolve? Is the strategy that because you will have ultimately less liquidity on the MSR portfolio in a time when that will become a headwind. Is the strategy just ultimately to use the TBA market and the MBS market to lever up and basically use that as your flex and keep the MSR portfolio relatively static inside?

Well, I mean you're right, there's no question RMBS and TBAs are more liquid than MSR, but MSRs are not completely illiquid, right? There are trades that take place, right, and people do move around portfolios, right? And so when we think about our liquidity needs in short time periods, yes, it is a liquid part of our portfolio that we're primarily relying on, right? But what you think about longer time scales and how portfolios evolve through time, right? I think it's fair to also consider that there can be movements in the MSR portfolio, if necessary or desired from a portfolio strategy perspective.

Thank you. Our next question comes from the line Kenneth Lee with RBC Capital Markets. Please proceed with your question.

You talked about the spec pools underperforming relative to TBAs in the quarter. Just wondering if you could just share with us what's your expectations going forward? Do you expect that to reverse?

Thanks, Ken, very much. I think it depends a little bit on the coupons and the stories. I mean, on Page 11 of our presentation, we showed this a little bit where the specified pools and 2.5 through 3.5 underperformed TBAs and 4s and above outperformed TBAs, and I tried to make a comment about that in my prepared remarks, but for the lower coupons, it was a longer spread duration, mostly that was mostly the cause of that or the catalyst for that and then the higher coupons, you have this effect of that's where the production is going to occur and the deliverables are going to be changing there, making the TBA worse than specified pools. So it depends a little bit. We're starting to find attractive valuations in the -- what I used to call high coupons, but maybe now I'll call current coupons in terms of specified pools where the production is. And so while there is continued roll specialness in those coupons, 4.5s where we have some TBA exposure, we have been increasing our allocation to specified pools there. We think that is attractive. And as production catches up with the rate market and you start seeing those new bonds being created, the role special high coupons, I do expect to dissipate and diminish. And when that happens, I think as that happens, I think you can expect to see our allocation to specified pools probably increase relative to TBA over time.

Got you. Very helpful there. And for my follow-up, I wonder if you could just share your thoughts on where spreads and now and how you think about the potential for any kind of further widening driven by the RMBS runoff as the Feds starts their actions?

Thanks, Ken. Well, yes, that's the key question. As I said in my prepared remarks, I think -- and the chart that we showed on Slide 4 -- no, Slide 5 where OASs are back to long-term averages, maybe the cheap side of fair. But interest rate volatility has been high and so static spreads, these spreads are certainly in a quite attractive range. There is concern, both, as I said, from interest rate volatility as well as the runoff from the Fed as well as potential Fed sales that could make them widen somewhat. And we'll have to see how those dynamics unfold a little bit. I would say the risk to wider spreads is probably greater than the risk to tier spreads. But they are looking attractive on a fundamental basis. And we -- as we said during the prepared remarks, we've increased our leverage somewhat from quarter end, and we've done a little bit more since quarter end. Our current leverage is probably now in the 5-4 area, right, to express our interest in these attractive valuations. But we want to be cautious given the supply/demand dynamics that you just said. And so we're trying to balance those two effects.

Thank you. Our next question comes from the line of Trevor Cranston with JMP Securities. Please proceed with your question.

Bill, you mentioned the sort of marginal increase in net spread exposure because of the low coupon of the MSR relative to kind of where current mortgage rates are. Can you talk about sort of how quickly the hedge effectiveness of the MSR would be expected to change if rates continue to move up? And if there's a level of rates at which you'd actually expect the duration of the MSR asset to turn positive and sort of how you'd manage the overall hedging of the portfolio through that?

Yes, sure. Thanks, Trevor. Yes. So as you know, in April alone or since quarter end, rates are another especially the long end run are 65 basis points higher. And with the gross coupon of our servicing remaining fixed at 3.2%, the hedging effectiveness or the duration of the MSR asset has become even less negative, right? Rates have to go up an awful lot for them to be positive probably another couple of hundred, but the duration of the MSR asset is pretty low here. And in order to get that back up, some amount of new mortgage servicing that the money needs to be created and the portfolio need to be recycled a little bit in order for that to happen. So, that's something that's going to happen organically over time and it's just part of the life cycle of a servicing portfolio.

Okay. Sure. That makes sense. And in terms of supply of MSR, you guys bought some bulk this quarter. Can you talk about what you expect to see on the bulk side of the market going forward? And if the bulk stuff coming out tends towards the lower coupon, how much appetite you guys would have to add more of that to the portfolio?

Yes. So, as we said in the prepared remarks, the MSR market has been very active, very robust. We've seen more than a full year of typical bulk activity already in 2022. This rate movement has been so fast that there hasn't really been time to adjust. So, all of the portfolios that we saw and that we are continuing to see in the market are generally of the lower WACC variety, right. And as you pointed out, our appetite for that stuff is probably less than it was given that we're probably more on the lookout for things that are going to hedge our portfolio more. And so, we're going to be focused more on trying to find the new anti-money stuff rather than focused on the lower coupon high multiple, high priced stuff.

Okay. Got it. And then last thing, do you guys have an estimate as to how much book values changed since the end of the quarter?

Yes. As I said, it's been a very, very volatile April into May. Rates are up another 65 basis points. Since then, mortgage spreads have continued to widen especially down in the low coupon. But with that said and the way that we've been able to position our portfolio. And we've been relentless in keeping our mortgage exposure with print coupons. We've been able to maintain a positive 0.5% book value change since the end of the quarter.

Thank you. Our next question comes from the line of Eric Hagen with BTIG. Please proceed with your question.

I think I have three questions. First is just how do you see the prepayment profile for spec pools developing here? Like how sensitive do you think some of the low balance borrowers are to home price appreciation and cash out refi. I'm not sure I've heard anyone ask you guys your perspective on how much value is left for upside in the MSR. I think it would be good to get your thoughts there. And maybe just an approximate DV01 in dollar terms for the MSR, if you have that. And then in the past, the Company has been short some TBAs within the coupon stack. I'm curious how what the value is, if any, in running that strategy now?

Sure. So your first question was on what, I think, prepay speeds or how I think HPA or think that will affect a little on balance? So that's -- is that right?

Right.

The conventional wisdom, I think, of low loan balance pools is that not only do they provide refi protection, but they also generally have higher turnover speeds, discount speeds from lower lock-in. I think that's probably borne out in the data. We are, to a very large degree, in unchartered waters here. I don't think that we've ever had an environment where we've had so many mortgages so deep out of the money to be able to see how these things will behave. And of course, discount environments in general, let alone on a sort of deep as this one are few and far between. And so -- and every one of economic environment is different and so forth. HPA has obviously been very high. That has been the cause behind some pretty fast cash out refinance activity in the last year and two years, but we have a significant number of mortgages today that are 200 basis points out of the money right? And to be -- if people want to take cash out, at that stage, that's if you about taking 10% of your mortgage balance 20% of your mortgage balance out, the implied rate on that marginal amount is very, very high. And if the market starts to start producing some HELOCs or some second liens that would almost surely be a more attractive option for borrowers to do. So I don't know how big that effect will be. My intuition is that with the Fed raising rates and the overall intent to cool things down a little bit that the cash at activity will generally slow and I think that turnover speed, as I said in my prepared remarks, which have historically ranged between 5 CPR and 10 CPR. I think many people are thinking that they're probably at the higher end of the range now because of the cash out activity that we said. I actually think have a possibility to surprise to the slow side, but we'll see how that unfolds, of course. Your second question was about -- remind me, I'm sorry.

Yes, sure. It was about the value upside left in the MSR.

In MSR, sure. So again, you can look back at historical periods to see how high servicing prices have been. The floating-rate components are one value that sort of increase quickly when rates rise, especially short-term rates rise and in the steep curve, especially, if you look back to other periods of higher rates, it's easy to see periods where the floating rate components alone can add a full multiple or more to the value of servicing. The highest I've seen servicing malts be in the world, and I've been doing this since the late '90s is probably mid-6s is about as high as I've ever seen them go depending on that the curve level of short-term rates, amount of float, servicing costs all of those things. And those days, people didn't even build in -- never mind about that. I was going to say people didn't even build and recapture, but in the discount environment with high multiple, that's not going to be a very big effect. And your last comment is, what is our duration of our servicing at the moment? It's pretty low. I would say that for the entire servicing portfolio right now for a 100 basis point move, right. On a model basis, of course, it depends on all market environments and shape of curve and all of those things, right, is probably around $50 million for parallel shift up 100 basis points -- and just the MSR assets to be clear.

Yes, that's very helpful. And then in the past, you guys have done the coupon swap strategy a little bit with on the coupon stack. Can you talk about the attractiveness there?

Yes. Right now, we have -- I don't know what we had at the end of the quarter, but certainly had no net short positions as you see from the chart on Page 13, I think, right? There was no net positions. We've been diligent and quick in moving our exposure up in coupon. So, we don't have -- as you see on the Page 13, we have very little exposure below 3.5% at all, right? And we have no exposure in short positions in any TBAs in low coupons in particular. Obviously, the market changes all the time, should the valuations warrant such a thing, we could consider that. But we're not particularly taking a strong view about the price or the valuations of low coupons at the moment relative to the turnover speeds that are priced into the market there. So, we're happy being flat down there at the moment. And our exposure is up in the current coupons.

Thank you. Our next question comes from the line of Bose George with KBW. Please proceed with your question.

Actually, first, in that Slide 10, where you give the return expectations, is that based on your current leverage?

Slide 15, you mean?

Sorry 15, sorry, yes.

No, those would be based on more market standard leverage numbers.

And so your -- you said you were at 5-4, what would be sort of a market at more normal leverage or a couple of times higher or...?

Yes. I think that -- we've said in the past that we can operate with leverages in the 8 to 9x. That depends, of course, on the amount of servicing that we have in the portfolio. We have more servicing today than we did when we said that number in the past. So a natural resting place for us is probably in the seven handle, eight handle areas.

Okay. Great. That's helpful. And then can you just talk about your expectation for specialists into the back half of the year?

Sure. So as I said in the prepared remarks, rule specialists on the formerly Fed coupons is all but disappeared, right? We're seeing reasonable rule specialist babies call it, 50 basis points in the production coupon here. In the higher coupons, 4.5s and 5s, it's even more pronounced, more than 100 basis points of specialists. But that is, as I've said sometimes, is optical, by that, I mean that the role mechanics back into an implied financing spread by looking at the difference between the price in the front month and the price in the back month. And today, again, because the rate market has moved so far so fast and the production mortgage market hasn't really had time to catch up. The collateral characteristics of bonds in the front month are pretty different than the collateral characteristics for bonds in the back months, right? And so there's really two different bonds and so it's a little bit unfair to imply a financing spread from those two different bonds. Nevertheless, you can do that, and that's in there, and those are big numbers here. But as the market catches up as the production in the current coupons and the slight premiums begins to normalize in the back half of this year. I also expect that to diminish. I would expect by the end of the year, things should be pretty normal.

Thank you. Our next question comes from the line of Doug Harter with Credit Suisse. Please proceed with your question.

Just another question on leverage. Can you just talk about how you think about -- or remind us how you think about leverage on agency paired with MSR versus agent paired with rates?

Sure. Yes. Thanks for bringing that up, Doug. So in a portfolio without MSR, there's really a very direct and straight line correspondence between leverage and risk and drawdown risk, how much money can you lose, right, for spread widening. With the portfolio with MSR, as current coupon mortgage spreads widen, the MSR will benefit from that, will have a natural increase in price from that. And so, we always look at leverage through the lens of what that drawdown risk number is, right? I mean we obviously want to be respectful of nominal leverage numbers. But another important number for us is what you see on the bottom right side of Page 13, which is, what is the portfolio exposure for a 25 basis point widening in mortgage spreads? And that number, which is -- which currently at the end of the quarter was minus 2.8%, right, is a lower number than you would get for a portfolio without MSR for the same leverage, right? And so, we look at both of those things, obviously, and account for both those things when we say when we determine how much risk we're comfortable with and what we think the appropriate amount of our portfolio is.

Thank you. Our next question comes from the line of Arren Cyganovich with Citi. Please proced with your question.

I was interested in kind of your return profile Obviously, your Slide 15 shows a much better environment for investing, but you talked about being still a little bit cautious with the potential Fed sales coming on board. When do you think you might feel comfortable really kind of expanding your leverage? Is it just kind of seeing how the initial roll-off does? Or are you waiting until they actually start to sell their portfolio?

It's good question. Look, that's a hard one, right? It's obviously very market dependent and will depend exactly on how things unfold. As I said before, the things that are giving us pause here are potential Fed sales potential appetite of the private market in general of who's going to buy all the bonds that are going to be running off and interest rate volatility, right? I think we need to see some progress some clarity on at least some of that before we start to meaningfully be adding. But as I said, from a valuation perspective, fundamentally, they actually look pretty good. I think Chairman Powell's comments yesterday took some of the tail risks off the table a little bit, right? Pre-affirm commitment to not go 75 to not keep hiking until something breaks to be looking at the trends of the economy and watching it as the hiking process is underway. So I think those were pretty friendly comments, which have been interpreted as such by the market in general. So that was helpful. But I think I'd like to see just a little bit more progress in at least some of those three dimensions.

Okay. And it did look like you took up the portfolio a little bit. Do you expect that your ROE might expand a little bit from here just from the portfolio changes that you've made thus far?

Well, I mean, given the static expected returns on Page 15, right, increasing leverage will increase the carry of the portfolio and can increase expected returns, right? But of course, red movements do and will always dominate those sorts of things. So it's, of course, impossible to predict what the returns will be. But certainly on a static basis, increasing leverage, we'll do that.

Okay. And then just lastly, I think Mary had referenced that repo prices were rising a little bit, but I'm assuming that takes that into account in Slide 15. So, there is the financing readily available to create the types of returns that you're highlighting?

Yes. So one thing I'll say is, rising financing costs in and of themselves don't particularly change returns, right? Because on the fixed rate mortgage side, we are hedging our interest rate risk, which some people like to explicitly say that, that hedge has the funding, right? You pay fixed on swaps, you pay fixed up right at some fixed rate and you receive some floating rate, some SOFR rate or OS rate that generally offsets the increase in funding that you would have right, from rising Fed rates rising, repo rates and so forth. In you said exactly. On the MSR side, the floating rate components that we generally receive, right, the float on taxes, insurance on principal interest. This is a little less intuitive to understand, but nevertheless, it's true also offsets the increase in funding on the structure rates from our MSR facilities. And so in and of themselves rising short-term rates, rising funding rates don't change the economics of our portfolio very much. In fact, they increase it, right, because there's the equity piece and all these things that matters. The thing that matters most is the spread to a risk-free rate that you would get on a fixed rate swap or something like that of SOFR or OS or something like that relative to repo rates and relative swaps. And so far, we have seen repo rates being very stable as a spread to say, SOFR. That's a chart that we have in our portfolio on Page 9, right? And we've seen that spread in both three-month and six-month tenors to be stable at right around 10 basis points for quite a long time.

Thank you. Ladies And gentlemen, that concludes our question-and-answer session. I'll turn the floor back to Mr. Greenberg for any final comments.

I just want to thank you, everyone, for joining us very much today. And as always, thank you for your interest in Two Harbors.

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