Two Harbors Investment Corp.
Q3 2013 Earnings Call Transcript

Published: 6 Nov 2013

[Operator:]

Good day, ladies and gentlemen and welcome to the Two Harbors’ Third Quarter 2013 Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer with instructions to be given at that time. (Operator Instructions) As a reminder, this conference is being recorded. I’d now like to turn the call over to your host for today, Ms. July Hugen, Director of Investor Relations. Please go ahead.

[July Hugen:]

Thank you, Ben, and good morning. Welcome to our Third Quarter 2013 Financial Results Conference Call. With me this morning are Tom Siering, President and Chief Executive Officer; Brad Farrell, Chief Financial Officer; and Bill Roth, Chief Investment Officer who will discuss our third quarter results. The press release and financial tables associated with today’s conference were filed yesterday with the SEC. If you do not have a copy, you may find them on our website and the SEC’s website. This call is being broadcast live over the Internet and maybe accessed on our webpage in the Investor Relations section under the Events and Presentations link. We’d encourage you to reference the accompanying presentation to this call, which can also be found on our website. We wish to remind you that remarks made by management during this conference call and the supporting slide presentation may include forward-looking statements. Forward-looking statements reflect our views regarding future events and are typically associated with the use of words such as anticipate, target, expect, estimate, believe, assume, project and should or other similar words. We caution investors not to rely unduly on forward-looking statements. They imply risks and uncertainties and actual results may differ materially from expectations. We urge you to carefully consider the risks described in our filings with the SEC, which maybe obtained on the SEC’s website at www.sec.gov. We do not undertake any obligation to update or correct any forward-looking statement if later events prove them to be inaccurate. I would like to draw attention to our recently released webinar titled Fundamental Concepts and Hedging. The webinar is focused on hedging for mortgage REIT with the focus on interest rate hedging and can be found on our website in the Investors section. I will now turn the call over to Tom who will provide some highlights as summarized on slide three.

[Thomas Siering:]

Thanks, July. Good morning. And thank you for joining our third quarter earnings conference call. During the quarter due to uncertain around interest rates, Fed actions and budget sealing issues, our portfolio positioning remained defensive in respect to spread and interest rate risks. The time seems to want this. We also have been -- has been in liquidity to fund some of our new investment initiatives, both agencies and non-agencies move slightly higher in the quarter following the Fed’s announcement to forgo tapering their RMBS purchases, which came as a surprise to the market. As a result, both our rates and credit portfolios were up normally, although as we were positioned with the low leverage profile, we didn’t see dramatic movement in our portfolio. Let me recap our third quarter and year-to-date financial results. Our book value was $10.35 per share as of September 30th, representing a quarterly total return of 1.5% when combined with our third quarter dividend of $0.28. In the quarter, we recorded comprehensive income of $54 million or $0.15 per weighted average diluted share. During the first nine months of the year we generated $156 million in comprehensive income, representing a return on average equity of 5.4%. We are happy with this performance in the context of the macro back drop and sector performance through September 30th. On a book value basis, Two Harbors have a total return of 6.3% through September 30th, while 10-year treasuries had a negative 5.1% total return in the same period. We incurred a GAAP loss of $0.53 per share for the quarter ended September 30th and core earnings of $0.19 per share. All of these metrics are consistent with our expectations when we set the third quarter dividend. We continue to repurchase stock under our share repurchase program during the third quarter. As you may recall, in the second quarter we repurchased 1 million shares and during the third quarter, we repurchased an additional 1.45 million shares at an average price of $9.23 per share, bringing our purchases year-to-date to approximately 2.5 million shares. As a reminder, our total authorization is for 25 million shares, so we have capacity to continue to repurchase stock. As always, we evaluate this program to the lens of investment opportunities available to us in an effort to optimize value for our shareholders, because of the stock was trading below book value, the repurchases were accretive. Next, let’s touch upon our warrants. In the third quarter, approximately 65,000 of our warrants were exercised. We recently announced we intend to de-list the warrants from the New York Stock Exchange upon their expiration tomorrow. Now, I would like to provide a brief update regarding MSRs and our mortgage loan conduit and securitization program as outlined on Slide 4. MSRs remain the best use of capital in the current investment environment and we’re very excited about the progress we’ve made related to our MSR initiative. We announced Monday, that we’ve been put in a two year flow agreement PHH Mortgage corporation subject to agency approvals and pricing terms. Additionally, we’re in advanced negotiations with other MSR sellers that are likely to result in substantial additional investments in the near term. Importantly, we’re making progress in our Mortgage Loan Conduit and Securitization program because we’re on our securitization using our own depositor Agate Bay Mortgage. We believe this business represented an excellent long term opportunity for Two Harbors. Our goal is to develop an industry relating prime jumbo mortgage conduit and Walmart Material to our financial performance in 2013. The equation of this securitization represents progress toward that goal. Please turn to Slide 5. Interest rates seems significant volatility during the quarter, but we’re ultimately, relatively unchanged on a quarter-over-quarter basis. Mortgage rates are higher than earlier this year, which may damp and revise in mortgage origination. Unemployment metrics have generally shown signs for improvement over the course of the year, although some reasonable reports have been more mixed. Improving employment data has largely been reflected of demographic degrees rather than robust job creation. On a national level home prices increased 12.4% as of August, 31 on a rolling format basis according to CoreLogic. [indiscernible] forecast predict a continuation of home price appreciation during the next several years creating a nice tailwind for our credit strategies. From a policy standpoint, there was no shortage of headlines during the quarter. Janet Yellen was nominated as Federal Reserve Chairperson while send an approval is still needed, the market is generally expecting that our nomination will be confirmed and then she will follow retiring Chairman Bernanke’s policies rather consistently. This is a good Segway into a discussion about such apron. Uncertainty reigns around the future of the Federal Reserve’s RMBS purchases, another topic that dominated the headlines in the third quarter. However assuming Miss. Yellen is installed as new Fed Chair, she won’t take over till January, 2014, which may mean tapering this hold off until the new year. Now I’ll turn the call over to Brad for a discussion of our financial results.

[Brad Farrell:]

Thank you, Tom and good morning everyone. Please turn to Slide 6. Core earnings of $0.19 per weighted share represented a 7.1% annualized return on average equity. The $0.19 per share earnings aligned with our core earnings expectations for the quarter as we defensively positioned our portfolio and what we considered when establishing our third quarter dividend of $0.28 per share. Our debt-to-equity ratio was 3.0 times and 3.6 times at September, 30 and June, 30 respectively. While this appears to be a reduction in leverage, our employed debt-to-equity was 2.9 times at June, 30th, after accounting for a short TBA position. As Bill discussed on our second quarter call, we believe a reduced leveraged profile was prudent given the risk profile in the market and it also frees up capital for us to allocate to our new investment initiatives. Today, it is most important for us to have capital available to work in our MSR strategy. Our operating expense ratio as a percent of average equity moved modestly higher on quarter-over-quarter basis to 1.0%. Similar to last quarter the rise in operating expense was largely driven by MSR and loan activities and a lower equity base. I would note that our operating expense does exclude the deal cost associated with the Agate Bay transaction, as it is non-recurring and the cost that we view as part of our target yield in creating the subordinate securities we hold. As noted in other past earnings discussion, GAAP earnings are not as meaningful as core earnings and comprehensive income when assessing the performance of the quarter. Similar to the second quarter this quarter was a good illustration of that, as we incurred a GAAP loss of $0.33 per weighted share. I would note that we did choose to realize $262 million of capital losses as we sort about $3 billion agency pools. I would now like to briefly touch upon a few accounting topics. First we did complete a securitization in the quarter, which is now consolidated on our balance sheet. Consistent with our overall accounting philosophy, we elected fair value option for the accounting of the mortgage loans held for investment and collateralized debt to best reflect the economics of our retained interest. Second, while I would note our MSR assets increased to $16 million as of September 30th due to a few small pools settled early in the quarter, the forward purchase commitment of any bulk or flow MSR is not recognized in the financials under GAAP until settled. And last, our ability to briefly note that we did not recognize any other than -- any other than temporary impairments in the quarter nor did we release a meaningful amount of credit reserves. Now please turn to Slide 7, which contains our quarterly book value go forward. Our book value per diluted share was $10.35 this quarter. I’ll discuss a couple of highlights. First, we are pleased with our comprehensive income this quarter and the year given the ongoing turbulence in the mortgage market. Comprehensive income is one of the key ways we judge our performance over the long-term. Year-to-date, we have declared dividends of $676 million to the combination of free cash dividend and our special dividend of Silver Bay stock. As it is, our previously stated intention for Silver Bay dividend distribution to be treated as a return of capital to our stockholders, it is our goal to distribute 100% of our taxable income and any prior year carryover through our cash dividends. Excluding the special dividend of Silver Bay stock, we have distributed $332 million which equates to approximately 97% of our taxable income as of September 30th when combined with the carryover from last year of $10.7 million. We are pleased with this metric as we are well-positioned moving into year-end from a dividend distribution standpoint. Please turn to Slide 8. I would next like to spend some time discussing the repo markets and financing profile, both in the third quarter and how we're positioning ourselves for the long-term given our new business initiatives. The repo markets are generally continuing to function in a normal manner and we have not experienced any sizable shifts in financing haircuts or repo rates. We continue to maintain a lengthy maturity profile with an average of 76 days to maturity at September 30th. As we approach year end, we have extended our repo terms consistent with our past practice in order to avoid any choppy trading around that time. Importantly, as of today we have a de minimis amount of repo maturing prior to year-end. Slide 8 provides an update to our counterparty exposure at September 30th. We spent a significant amount of time analyzing our balance sheet and liquidity profile. Our lower leverage cash funding collateral and available capacity with counterparties provide us with both the flexibility to manage the market volatility as in the second quarter and also the opportunity to deploy capital to investment opportunities such as MSR as we anticipate doing in the near-term. Now, I’d like to turn the call over to Bill for portfolio update.

[William Roth:]

Thank you, Brad, and good morning everyone. Please turn to Slide 9. In the third quarter, we generated a total return on book value of 1.5%. For the first nine months of the year, our total return is 6.3%. This is a result we are pleased with given our overall defensive position and low leverage. Both our REIT strategy and our credit strategy posted positive results for the quarter. Please note that we are now including agencies and MSRs in the REIT strategy and non-agency securitization and loans in the credit strategy. As we have communicated in a few recent conferences, we find the returns for our new initiatives particularly MSR to be superior to the returns available in the securities market, especially in the agency stay. As such, we are focused on maintaining a low leverage and risk profile and high liquidity to be able to fund increased investment in these new opportunities. Agency securities sold off hard early in the third quarter with rising rates as the tenure hit 3% then rallied late in the quarter when the Fed announced it was delaying its tapering of MBS purchases. With our lower risk profile in place since early in the second quarter, we neither suffered much in July nor profited that much in September. As a result of this defensive posture, our agency returns this quarter while positive were generally modest. The credit strategy was also abnormally in the third quarter net of hedges as fundamental can generally continue to improve. The improving housing market has led to lower delinquencies and improved prepayment speed. Continued improvement in housing metrics and job growth are good for the future performance of these portfolio. During the quarter, we sold some high dollar priced non-agency bonds that have largely realized their upside potential and replace these with lower priced bonds with more upside optionality. Regarding CFL, supply has been somewhat sporadic and yield levels uninspiring. We neither increased nor decreased our position in CSL this quarter. So far in the fourth quarter rates in agency MBS are roughly unchanged. If you look at the non-agency market you’d see the prices are modestly higher. Our book value is generally reflective of these trends. On the bottom left of this slide you can see our book value performance relative to weighted average is 50

[Operator:]

Thank you, sir. (Operator Instructions) Our first question today comes from the line of Mark DeVries of Barclays. Your line is open. Please go ahead.

[Mark DeVries:]

Yeah. Thanks. Good morning. Could you give us a little bit of color on, given the size of your current MBS portfolio, ideally how you would look to size your servicing book against supply is not really an issue?

[Thomas Siering:]

Sure. Thanks, Mark. I will give that to Bill.

[William Roth:]

Hey, Mark. Good morning. Thanks for joining us. Yeah, I mean I said a couple times in some of these conferences that if you look at our total capital base and our holdings in the securities space that we could have easily a billion of MSR market value, without really too much trouble. And obviously we’re kind of a long way from that. But I think that if you think about capital allocation you could see the rates allocation stay in the 60% range plus or minus with the substantial amount of that going to MSR. So I think before we even think about moving things around, we have plenty of runway to go.

[Mark DeVries:]

Okay. And how should we think about you kind of -- as you build up that MSR, how much your kind of swaps portfolio might shrink over time?

[Unidentified Speaker:]

Yeah, I mean I think the best way to think about it if you -- if you want a know what the number is, current production MSR and it depends, you know what kind of product it is whether it’s Ginnie Mae, GSE or [indiscernible], you now roughly has a duration that's about somewhere around three to four times that of a five year. Okay, so for five years -- call it a five year duration that MSR be 15 or 20 negative, so you can -- I think you can do the math and figure out what our hedges could go down. The way we like to think about it is if you think about what that does, it probably adds anywhere from 150 to 250 basis points in ROE by adding MSR and reducing hedges.

[Mark DeVries:]

Okay, great. And the finally, Tom could you just comment a little on how aggressively you might look to buyback more stock if the shares continue to trade around this level of 0.9 times plus or below it?

[Thomas Siering:]

Yeah, thanks Mark. It’s a great question. You know in the current context given where the shares are trading, and given the relative, you know opportunity set within our legacy portfolios, you know I mean we view through the lines of what's best for the shareholders. And in the current paradigm, you know that -- that's an interesting opportunity. So I can't obviously speak to numbers, but I will assure you that will go all the way to what we think is right for our shareholders.

[Mark DeVries:]

Got it. All right, thanks for the comment.

[Thomas Siering:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Douglas Harter of Credit Suisse. Your line is open. Please go ahead.

[Douglas Harter:]

Thanks and good morning. I was wondering if you could talk about the capacity given your low leverage to add whether it be the MSR opportunity or other assets just by increasing leverage to a more normalized level?

[Thomas Siering:]

Thanks Dough. How are you? Good morning.

[Douglas Harter:]

Good morning, Tom.

[Thomas Siering:]

Bill, do you want to handle that one?

[William Roth:]

Yeah, sure. So you know, I think the way we think about it is we look at what we think the expected ROE is on any given product using what we think is an appropriate amount of leverage there. So agencies today as we said or not have interesting we think when the Fed gets out of the way if you will that that would be potentially more interesting. In the mean time, you know MSRs -- the best dollar we can spend in terms of acquiring assets and that we would not intend to use any leverage on. So if the agencies become interesting again, you can expect that we would increase our leverage there. But in the mean time, what happens is we have the excess liquidity deployed in the MSR. And the same goes with non-agencies as well. I mean right now our leverage reflects the back that we don’t see great value except in as I mentioned MSR. But that takes some time to put to work.

[Douglas Harter:]

All right, I guess just to sort of understand that, so let’s -- if the larger MSR opportunity that you referenced came to fruition, now is that something where you would look to sell agencies to fund that or you could use the extra leverage against that book to fund that?

[Thomas Siering:]

One of the great things, Doug is that we can use the portfolio to effectively leverage MSRs. So our liquidity position is great right now. So there’s no issues around that.

[Brad Farrell:]

This is Brad. I’ll comment on one thing and it obviously become more transparent in the 10-Q which we intend to file later today and especially the September 30th we are cash funding a reasonable amount of our balance sheet, specifically non-agency and some of our loan products, which we do have available financing if we choose and so that’s a very illustrative example of being about put those out, seek capital from that and then apply those to MSRs, that’s could be a good example for your question.

[Doug Harter:]

Thanks Brad. And then, you have referenced a couple of times, the best dollar is a return available would be in the MSRs? Could you just kind of frame what you see the return opportunity today?

[William Roth:]

Yeah. Sure. So, yeah, just to give you an idea and like I said it depends on the product, but new issue MSRs anywhere from very high single digits into the low double digits on an unhedged basis, just outright with no leverage. Once you, as I said before, once you either add a long position to offset the negative duration or remove swap and swaptions that actually become additive to that. I would say that securitization is very interesting from an ROE perspective, as you probably know the securitization map, today is very challenging based on the where the big banks are posting rates for jumbos. So we think that is not a long term issue, but rather just function of the current market and if you look back at the -- earlier this year, there have been a decent amount of securitization has done and the map on the subs and IOs, there is also attractive. So, those are kind of the two best in terms of buying assets. But I think the latter will hopefully revert back to the opportunities we saw earlier this year.

[Doug Harter:]

Great. Thank you, Bill and Brad.

[Brad Farrell:]

Thanks, Doug.

[Operator:]

Thank you. Our next question comes from the line of Trevor Cranston from JMP Securities. Your line is open. Please go ahead.

[Trevor Cranston:]

Hi. Thanks. Just to follow up a little bit on the last question on the MSR investment opportunities. Can you comment at all if you are seeing much in the way of bulk purchase opportunities, I mean, you’ve made some comment about kind of keeping your liquidity level high for investments and it seems like core purchases wouldn’t require that -- a very large amount of capital at least in the near-term. So could you maybe comment on how you attract from this any bulk opportunities you are seeing versus flow, if you would include that near-term opportunities that you mentioned?

[Thomas Siering:]

Good morning, Trevor. It’s early where you are. Bill, would you take that one please?

[William Roth:]

Sure. Yeah. I mean the nice thing about the flow deals are -- you are getting current coupon and from a cash standpoint, it’s very easy to deploy once at a time. On the other hand, we are involved in pretty much every discussion that we can be, now that we have announced this initiative we are in the deal flow and so we absolutely are seeing opportunities and hearing of opportunities, and we are certainly open to bulk purchases and will evaluate those just as we would any other investment alternative.

[Trevor Cranston:]

Okay. That’s helpful. And one kind of detail thing, I saw on slide nine, its looks like you were allocating some interest rate swap and swaptions to the non-agency books this quarter. Is that kind of something you expect to meeting going forward that you need a rate hedge on the non-agency book, given the correlation we’ve seen over the last couple of quarters?

[William Roth:]

I’m taking a look at slide nine, where are you referring to, Trevor?

[Trevor Cranston:]

The bottom right table for the September 30 side, the 0.6% swap and swaption cost on the non-agency column?

[William Roth:]

Yeah. So, yeah, we do think that some of the non-agencies, look when your bonds that were at 50 bucks or 40 bucks or 30 bucks and they are all credit, it’s hard to see how there is any real rate component, but as the market has rallied substantially and some of these bonds have -- we mentioned on a call, right, that we sold some of these higher dollar priced bonds, has it kind of run out of room to the extent that we still have some of those, we do believe that they have accumulated some duration not very much, but we think the purest way to think about it is bonds and have duration you said, appropriately either hedge or decide not to hedge, so that’s where that comes from.

[Trevor Cranston:]

Okay, understood.

[Thomas Siering:]

And just a reminder to that non-agency is a wider view as well, we offset prime jumbo loans -- we had a larger bucket of prime jumbo loans prior to the securitization, so some of that is also mixed into that number.

[Trevor Cranston:]

Okay, got it. And then last…

[William Roth:]

Trevor, one thing I wanted to add. Given -- we don’t want to be too cute here, I mean given that we’ve said, we’ve been [indiscernible] liquidity, you might reasonably expect that we’re anticipating some bulk purchases in the near term. Now that’s subject to a lot of yes including not in significantly QC approval, but -- yeah, we’re not trying to be cute around our language here, that’s where we’re anticipating -- am I not coming to fruition, but that’s how we position ourselves.

[Trevor Cranston:]

Okay. I appreciate that priority. And then last thing I guess on the dividend, you made the comment that the kind of results this quarter were in line with what you’re expecting when you set the dividend level, can you comment at along if there was a meaningful gap between where core EPS and tax, core EPS was just sort of a third quarter in kind of how you’re thinking about the dividend level for the fourth quarter, if taxable EPS was somewhat closer to where core EPS was in the third quarter?

[Thomas Siering:]

Yeah, thanks, Trevor. I will say that Brad and the team have done a marvelous job of doing financial projections for the year and as we’ve said, our results in respect to both core EPS and book value were almost spot on where they end of that and with that I’ll give it to Brad to talk about the dividend a bit.

[Brad Farrell:]

Yeah, there’s a lot to this and I’ll try to hit a few key points. First, we obviously don’t provide projections on -- and where Q4 or even 2014 might land, that’s just in our current views of -- we just don’t give forward looking statements. But a couple of things to note there, first, given the Silver Bay stock distribution and our intents which we’ve noted several times to distribute a 100% of our taxable income that is a large driver of our dividend and any dividend this year that we projected. And so conveying the 97% mark where we are as of September, 30 is an important message both from a comfort -- that we’re very comfort -- where we've forecasted ourselves and two it gives you a sense of the taxable income measure. Second, again we’ve commented a lot on comprehensive income and book value protection is our Number 1, Number 2, Number 3 focus internally. Core earnings, while I do understand it presents some sort of run rate estimate that the market can digest. It’s just not how we manage the portfolio or how Bill and Tom and team manage the portfolio. [indiscernible] has a lot of weakness in measure and an example of that is where we took our [indiscernible] position on agency pools, really we de-risked our mortgage exposure and 3 billion of our mortgage pools. So really whether we held those mortgage pools or sell those mortgage pools, it really did not have an impact on our overall return, but if we held those pools obviously it would generate a higher core earnings. But that inflation would not have really done the best decision for us to hold those positions, so again there is a gap between taxable income and core earnings, it’s made up of a lot of factors, but we’re looking at taxable income first, book value and comprehensive income second and then third we obviously are reinvesting capital as principle and interest comes in, and obviously if we’re investing in lower yields over time. That will cause pressure or downward pressure on the dividend naturally, but taxable income and book value preservation are are kind of the first two drivers that we’ve focused on this year.

[Trevor Cranston:]

Okay. Thanks. I appreciate all the comments.

[Thomas Siering:]

Thanks, Trevor.

[Operator:]

Thank you. Our next question comes from the line of Bose George of KBW. Your line is open. Please go ahead.

[Bose George:]

Hey guys. Good morning.

[Thomas Siering:]

Hey Bose.

[Bose George:]

Going back to the MSRs, is distressed MSRs part of the opportunity or is it really going to be more on the prime side?

[Thomas Siering:]

Yeah. Great question, Bose. I will give it to Bill.

[William Roth:]

Hey, Bose. Good morning. We, obviously, as you know, we have kind of an opportunistic approach to investing, but the reality is that the distressed MSRs really relies on having a servicing operations that can more efficiently capture and process those loans. So we think that our competitive advantages in managing IO risk, which relates to sort of newer issue prime, part of the market. We are certainly not averse to considering the other, but we don’t think that we have a comparative advantage there. So, I think from your standpoint you should assume that most if not all of what we do we will be related to new issue.

[Bose George:]

Okay. Great. Thanks. And then, actually just in terms of the mechanics of the agreement, how is the price determined, is it market price at that time, just curious how the structure is going to work?

[William Roth:]

Yeah. Sure. So, what we do is we agree on our pricing metrics for all products means adjust to all different -- all the different products once a quarter and on a multiple basis. And then action effects for the three months, and then at the end of three months, we re-price if necessary and then that would be good for the next three months.

[Bose George:]

Okay. Great. That makes sense. And actually then switching over to the jumbo securitization side, I guess the -- I am serious what the ROEs, sort of the implied ROEs are right now, if you securitize just based on where banks are pricing their product, et cetera? I mean tell us where the economic stand and what has to happen to get back to where it makes more sense?

[Thomas Siering:]

Yeah. Today, Bose, they aren’t inspiring I would say. But there is lot on that horizon that we are quite excited about. GSE reform is at the top of that list. So, we believe over the longterm that this is going to be a very interesting, very compelling, very accretive business. But today ROEs where the big banks are because of their lack of opportunities that are waved from mortgages, it's just not good and it's not our focus. Our focus right now, today is on MSRs.

[Bose George:]

But it’s like we had to think about what needs to happen. If I look at the Wells Fargo's pricing, if they take their jumbos kind of in line with conforming, is that enough or does it have to go above conforming, because right now it looks like they are -- whatever 30 basis points inside of conforming, does that have to kind of fully go the other way to make the economics work?

[Thomas Siering:]

Yeah. Well, that’s obviously abnormal but I will let Bill to give you some more color.

[William Roth:]

Yeah. I mean I think if you look the 25 roughly deals that we’ve done this year. When you look at the math, the bonds, the retain bonds, with a small bit of leverage gets you into the 10% to 15% ROE range. And that’s obviously worthwhile for us to be involved. And if you price the jumbo loans a point higher or a point and a half or two points higher whatever the math is on a given day, right, you can see how that numbers fall apart pretty quickly. So, I think from a long-term perspective, you have to think about the government reducing its footprint, right. Rates not necessarily being -- the rate market being where it is today and banks, not necessarily taking their quantity or the percentage of production that’s out there and if you do that we think that that becomes very worthwhile. But, I mean look, it’s the mortgage market right. Things change very quickly and without necessarily noticed. So we are trying to do is having an originator network in place, so that we can take advantage of the opportunity and it may not be in prime jumbo in the short-run. But there is MSR that we can source from this network and presumably at some point there will other products, although that’s where we are focused on today.

[Bose George:]

Yeah, thanks a lot.

[Thomas Siering:]

Yeah, the originator network is really important both in respect of prime jumbo and MSRs. So those things go hand and glove pretty nicely for our business.

[Operator:]

Thank you. Our next question comes from the line of Rick Shane of J.P. Morgan. Your line is open. Please go ahead. Rick Shane - J.P. Morgan Hey, guys. Thanks for taking my questions. First on the MSR business, I’m assuming that this is going to be a strategic business that you’re going to retain permanently. But there is President in the market for standalone servicing businesses and there’s President within your history of incubating businesses and then spinning them out. Am I correct in seeing this as a long term strategic business or is it something you would contemplate as ultimately a separate vehicle?

[Thomas Siering:]

That's a very good question. We’re always going to do what's right for our shareholders. Today we’re just interested in building up this platform, this business. It’s very compelling. And we really can't speak to the future. Today we contemplate that this would be all housed within Two Harbors. But we don’t know what the future brings. But today our focus is on building out this platform. It’s a very compelling opportunity for us today and that's really our only thought. Bill, I don’t know. Is there anything you want to add to that?

[William Roth:]

So I mean the one thing is it’s right. It’s very complementary to our core business. So we think it made sense within our structure and we’re not really thinking about any other solution at this point except for executing of what we have.

[Thomas Siering:]

Yeah, I mean there president with some market wide speak, this is a standalone business. But we’re not that far down the road yet. Rick Shane - J.P. Morgan Got it. Second question; obviously there was this pretty significant shift during the quarter in terms of your hedging strategy. And explain that a little bit. I’d love to understand two things. One is the timing of the shift and maybe that will help us understand the second part of the question which is really the outlook because I think the consensus view is still that rates are going higher is just that that has been pushed out in terms of when it will occur and maybe over the next 12 months, the expectations for examples, where the 10 year will move – has been dampened, but the expectation is that that it still will be higher. Why given, just the sort of temporal shift make a pretty significant strategic shift on that?

[Thomas Siering:]

Yeah, sure. I’ll give it to Bill in a second. But we felt in the spring there was going to be a jailbreak in respect to interest rates and not to be self-congratulatory. But Bill and the team got that about right. Rates moved a lot higher. And then we became worried about some of the shenanigans in Washington about very muted job creation and that sort of thing. So we’ve brought up much closer to home. So from a rates perspective, we got it about right. And as we look forward, there’s a lot of uncertainty out there. We really think the Feds’ [indiscernible] is employment data and as I said in my earlier comments, if you look at employment data it’s not really job creation that's going on. It’s really vagaries, it’s the demographics. In other words people falling out of the workforce, America is getting older, people just retiring and that sort of thing. So while the administration may pound their chest that the nominal unemployment rate is lower, that's really a tickle misleading. Bill, would you add something there?

[William Roth:]

Yeah, sure. I mean the thing is Rick, right when the tenure was at 160 or 190 or 210, it just seemed to us that as Tom mentioned there was this greater asymmetry. In the third quarter when you see – the Feds pretty insistent that the short rates are going to be very low for a long period of time in the 10 years 3% or 2.75%. The risk -- the parameters change. And so we just felt that it made a lot more sense to be closer to home. Now the other thing is, there is two other things that are sort of extenuating circumstances. First of all with the PHH range, I mean we’re going to be buying negative duration MSR every month, right. So we’re going to add a negative duration every month which we may or may not choose to hedge. Second of all as Tom mentioned, some of these discussions that we’re involved in mainly to decent size MSR coming our way in the near term, which also has negative duration. So we’re not afraid as you can tell -- we’re not afraid to change our positioning. If we believe that that’s appropriate, but we just thought that the market was in a much more balanced situation with the tenure in 2.60% to 3% range than it was in the 1.60 to 2%. Rick Shane - J.P. Morgan Great. That asymmetry characterization really helps me get there right. Thank you.

[Thomas Siering:]

Sure. Thanks for joining us.

[Operator:]

Thank you. Our next question comes from the line of Dan Altscher of FBR. Your line is open, please go ahead.

[Dan Altscher:]

Hey good morning and thanks for taking my question here. I was wondering if you can, maybe, give us a little bit of sense in terms of the progression of the PHH flow that’s going to come in, how much in size of any UPB or related MSR do you think, we’re going to see on a monthly or quarterly basis on a go forward basis?

[Thomas Siering:]

Hey, Dan, good morning. I will give that to Bill.

[William Roth:]

Hey, Dan. Thanks for joining us. So as you may have seen and maybe for those who didn’t, under our agreement with PHH, we would be looking to purchase 50% or more of their newly originated mortgage loan MSR where the MSR is eligible for sale. So I think what I would point you to is if you look at PHH volumes in terms of their production, you can make some reasonable assumptions about quantity. I mean a lot of it obviously it depends on, how much is produced going forward but we think it over the two year term this will be pretty decent size for us.

[Dan Altscher:]

Okay. And maybe just sticking with the MSR also, I mean I think it’s pretty clear while a lot of the large banks are looking to offload MSR portfolios with Basel III in capital treatment. But I guess, you’ve seen a little bit more of move for the non-banks to do this as well. So can you maybe talk conceptionally why you think the non-banks are now looking to offload, as well here?

[Thomas Siering:]

Sure, yes, great question Dan. And by the way thanks for the kind words last night in your note in your research report. What happened is, right, there has just been -- there are torrents of refinancings within the mortgage space. So a lot of these standalone guys, have wind up. Business has been great for them and they wind up with a lot of MSR on their balance sheet. And I think they’re just looking to de-risk a little bit. And I think we’re a great capital partner forum. We’re not going to compete with them in origination or not going to compete with them in the ultimate servicing. And so it’s a great marriage and we’re quite excited about PHH. We think that will be a great financial partner. They are great people and so we’re very excited about that. So it’s really a very natural marriage, I think for us.

[Dan Altscher:]

That’s really interesting point until you don’t compete with loan origination and it’s kind of leading to my third question of as you’re building up it’s origination network, although it looks like 30 folks already. Can we talk a little bit about or describe who those originators might be not names of the sellers but geographies and products or how we want to think about it that way?

[Thomas Siering:]

Sure, I will give that one to Bill.

[William Roth:]

Yes. So as we mentioned, we have about 30 originators in some part of the approval process. And so our view is if we want to align ourselves with high-quality organizations, that have demonstrated good performance in the past and are involved in the kind of products they were looking at. So there are lot of entities out there, some are national and larger, some are regional. If you can imagine -- if you look at any of these securitizations, you need to have a good diversification of geographies and so we’re obviously mindful of that, but it’s a mix. But the biggest thing is if we want to be aligned with what we think are high quality organizations that produce a high quality product.

[Dan Altscher:]

Okay.

[Thomas Siering:]

Yeah and intentionally, we do a lot of diligence on our current parties. They do a lot of diligence on us. It’s a whole new world out there where people want good counter parties and that’s what we are working toward and we’re very confident that we’ll get there.

[Dan Altscher:]

Okay. Thanks for the time everyone.

[Operator:]

Thank you. Our next question comes from the line of Joel Houck of Wells Fargo Securities. Your line is open, please go ahead.

[Joel Houck:]

Good morning and thanks for taking my questions. I guess couple of technical questions on the PHH transaction, are all these MSRs read eligible assets, I’m assuming the bulk purchases are, just if you could confirm that.

[Thomas Siering:]

Sure Joel, I’ll give that to Brad.

[Brad Farrell:]

Yes. So we just got at a high level in the past. So Matrix Financial Services is the seller servicer that we acquired few quarters ago. That is the entity that acquires the MSR, we also noted that we received a private letter ruling from the IRS that allows us to structure what we call an excess servicing strip and taken a portion of that asset and put it into the REIT and that excess piece is structured as we’ve outlined with the IRS, a good read asset, so that’s kind of the probably the technical answer to your kind of more technical question. Hopefully that addresses.

[Thomas Siering:]

Yeah, bottom line, it's a good read asset.

[Joel Houck:]

Yeah, I just wanted to confirm that because that obviously given the size that you talked about earlier that has huge implications for learning the basics risk into high risk. Second technical --

[Thomas Siering:]

That’s a perfect --- yeah, that’s a perfect summary.

[Joel Houck:]

So second technical question, there’s been a PHH itself is kind of been in the news with respect to possible sale, who know what’s true what’s not, but I’m wondering just in terms of your agreement, if you have protection and I’m assuming you do with respect to any change of control with PHH?

[Thomas Siering:]

Well we really can’t comment on PHH's businesses. So I think that’s probably best directed to them rather than us. But we’re quite comfortable on our arrangement with them, but we really can’t comment on their business and frankly we have little or zero insight into those initiatives. So I think its best directed to them.

[Joel Houck:]

Yeah, okay. I mean I was just wondering more in what if as opposed to having you guys predict what they were going to do. Anyway I’ll take it offline I guess, so more I guess on the last point here, the more strategic development here which I think the market investors are perhaps not fully appreciating is the -- this notion of adding negatively [indiscernible] MSR in replacing Swaps, I think Bill made a comment that its 250 basis points of ROE added. I’m assuming that's more current income from the reduction of having viewed Swaps, but more importantly Swap has hedges still --- they didn’t do nothing really to mitigate the basis whereas its inherent in any mortgage REIT. So if you guy look out in terms of to build out a strategy in a couple of years, what does it do or -- and at least how are you guys thinking about this in terms of how much basis risk will be eliminated once this kind of strategy is fully up and running?

[Thomas Siering:]

Bob, I wanted to congratulate you. That’s a very nuance question and I can see that Bill’s [indiscernible] right now, so I’ll give it to Bill to answer that.

[William Roth:]

Yeah, I mean basically -- yeah, one of the key benefits of owning MSR is -- I mean there’s three key benefits frankly, right. First of all has an attractive yield, but it’s not just yield because there’s a number of things that have yield in them. It’s got negative duration and as you noted it hedges mortgage basis rate, which is to say that, if the mortgage rate goes up and the swap rate doesn’t i.e. mortgage has widen, like we saw in the third quarter, that can be very, very damaging to a portfolio is just swap -- mortgages and swap. So, if you have mortgages and MSR, as the mortgage rate changes the MSR obviously changes and value as well, so it’s a much, much better hedge and I would, July, is going to be happy that I am going to refer you to the webinar that we just did to, because we have a discussion on and we actually have a little discussions on slide on the impact of that. So, going forward, I think, I mean, I think, if I could predict that several years, I might be throwing on or beat somewhere already by now. But I would say that generally having mortgage assets such as agency securities or loans that have positive duration and having MSR, which is an IO product that has negative duration and hedges basis risk that can be a core component of our strategy. Now that doesn’t mean you don’t include swaption or swap, it just we can replace the substantial amount of those hedges and have a much better risk profile. We have higher ROE, we have less basis risk. Now there are still other risks that are involve and is probably beyond the scope of this conversation, but we think that’s a very, very powerful combination. So you can expect to see that becoming more preeminent part of our portfolio going forward.

[Joel Houck:]

And does it also, I think, correctly, does it minimize -- not minimize, does it lower the need to delta hedge because your duration wouldn’t move as much for given rate increases.

[Thomas Siering:]

Well, it depends on the construction of the portfolio, right. So, you shouldn’t anticipate the swaps and swaptions, well never be absent within our portfolio because we need to mitigate interest rate risk along the curve. And so there’re never be a perfect coupling likely of our agency book versus our MSR book. But it’s a very elegant and a very accretive hedge to our book. So they will have to be kind of a union of MSRs swaps and swaptions as we look forward. But we’re quite excited about it because it has a very positive OAS and it mitigates spread risk. And so your question is -- questions are really great ones, something that obviously we’re quite excited about.

[Joel Houck:]

Okay. Again congratulations on the deal as well as the progress you’ve made in getting at this point in a quick time frame. Thank you very much.

[Thomas Siering:]

Thanks for your questions. All great ones.

[Operator:]

Thank you. Our next question comes from the line of Jason Stewart of Compass Point. Your line is open. Please go ahead.

[Jason Stewart:]

Hi. Good morning.

[Thomas Siering:]

Good morning.

[Jason Stewart:]

Maybe you could give us generically an idea of where MSRs for this type of products are trading relative to say perhaps, trust IOs and if that’s a good benchmark to gauge relative movements?

[Thomas Siering:]

Sure Jason. Good morning. I’ll give it to Bill.

[William Roth:]

Yes. Hey Jason. Good morning. So new issue MSR, you’re buying brand new [Zero Wawa] current production. That is not necessarily a perfect comparable in the trust market. Most of these are fairly season. So they might be a year season, two-year season. And so there is not really a direct comparable. I think if you want to take a stab at it, I mean, you go back to my remarks about the high, very high single digit into the low double digits for yields. So if you run, you can, I guess, run a variety of different trust that you think might be comparable. But if you look on -- if you look on Bloomberg and try and find something that is perfect and comparable, there is nothing really that lines up exactly. So it does make it a little challenging. But I will say that they two traded a substantial OAS and yield pickup as you would imagine. And so obviously that’s very worthwhile from our standpoint.

[Thomas Siering:]

Yeah, I mean if you look at the market share early, Jason, there’s been really a few changes in the relative evaluation between IO and MSR. And MSR historically have been relative to IO. Today the market is completely different than that. And that's why we’re so excited about this opportunity.

[Jason Stewart:]

Okay. And it's fair to say that there’s a significant barrier to investing in excess MSRs or MSRs relative to buy and trust IO just through – as a security? I mean there is a significant difference in the operations and access to that market, that's fair.

[Thomas Siering:]

Absolutely and it took us a long time to develop this platform. The GSE rightfully are very concerned about who the counter parties are in this space because what they’re really concerned about is the person that has the mortgage or they being properly serviced and then served and therefore and they’re quite mindful of who can get into the space. So while a lot of people want to get into this space it’s very difficult and it took us a long time to get here. The progress has been as great as we would have liked internally, but we finally feel like we’re there. We have all the approvals, we have the platform, we have the counter parties, we have the opportunity. That's why we’re excited.

[Jason Stewart:]

I would know what – and I think you kind of merged two different elements and there’s a significant distinction between buying the MSR and buying the excess. The various entries to buy the excess are lower to buy the MSR and have all the right to terminate and to manage server reserves and to make different decisions around the MSR and the performance of the MSR provides greater value to us. And there is a lot higher barriers to entries to achieve that.

[Thomas Siering:]

Yeah we could have the bought the excess, Brad's point is a great one, we could have bought the excess a long time ago but we didn’t feel that served our shareholders particularly well and the reasons for that are long and nuanced and we'd be glad to have a discussion around that if you chose to. But essentially the rights to the excess although are not the same as a who directly owns the servicing rights and we think in the interest of our shareholders the route we’ve taken is absolutely the proper one and is good for a long term business initiative .

[Jason Stewart:]

And I think you just said some of those before and down the road at some point you will get credit for managing your counterparty relationships the right way. But when you think about your counter parties and who’s originating this. Are there products I’m assuming their products maybe hybrid under ARMs if you would exclude from the agreement to buy the MSR.

[Thomas Siering:]

I’ll give that one to Bill

[Bill Roth:]

Okay hey Phil you know there’s an old saying, old bond traders saying, there’s no such thing as a bad bond just a bad bond price and I think that would hold true for MSR as well. Obviously, I just take a simple example of 51 [ph] ARM. It's a lot shorter. Seeds are typically much faster that’s going to trade at a different price. That’s something that you need to do work on and model it but we spend substantial amount of time analysing the pricing the potential pre-payment path for all these products and so we build the differences into our model. So I would say certainly at the wrong price, we don’t really want anything and at the right price we are happy to take any of the products that make sense for us.

[Jason Stewart:]

Okay. Thanks for taking the questions I appreciate it.

[Thomas Siering:]

Thank you for joining us.

[Operator:]

Thank you, our next question comes from the line of Jim Young of West Family Investments. Your line is open. Please go ahead.

[Jim Young:]

Yeah. Hi! Could you talk about your typical non-agency portfolio in which you have or would you recognize the discount accretion of $37.2 million for the quarter, yet you still have a net discount remaining $2.5 billion with $1.4 billion credit reserves, still has a September 30th. How do you see this developing over the next couple of quarters given the underlying improvements in the housing fundamentals? Thank you.

[Thomas Siering:]

Hey! Jim good morning I’ll give that one to Brad.

[Brad Farrell:]

Yeah I think I’ll answer it more of an accounting and I think Bill probably can give more of the future of the view pre-payment speed and other things. We look at our credit reserves on a quarterly basis. There are signs of improvement. Prepayments speed is -- even though a small chain of prepayments speed is very valuable to us, but there has been a lot of mixed results in the market, unemployment has been a little bit inconsistent as we mentioned. So we have not taken an aggressive stance under rating credit reserves today. That will -- if the path continues that will likely occur over time and Bill, maybe you can kind of comment more on your view of how that portfolio performance might play out?

[William Roth:]

Yeah. Sure. I mean, mathematically it’s fairly simple, right. If every loan in every deal were prepaid tomorrow, right at par then we would -- the credit reserve would just go into income. Now we know that’s not going to happen. But as Brad mentioned, we’ve been fortunate to be able to release reserves because performance has been good and we do look at that every quarter. Certainly if performance exceeds our expectations, there is the opportunity to see more of that. Going forward, we are very pleased with the way the performances has been, prepays have picked up, part of that has been because rates are low and some of the guys can refi. Part of it is frankly, because housing prices are higher. For guy who is under water and he couldn’t refi and now he got some equity in the house that’s driving prepay. So we are certainly optimistic that that could happen in the future where we see more releases, but we can’t make any promises obviously.

[Thomas Siering:]

Yeah. And Jim, I will just tell you how we feel about that philosophically, right. We don’t want to get into the business of taking OTTI one quarter and then releasing credit reserves and vice versa quarter-over-quarter. So we take a very conservative approach to that and we release credit reserves where it is abundantly clear, where it just hits us over the head that our assumptions were too conservative. But we want to take a very level approach to that. Obviously the fact that OTTI in our book has been de minimis over time speaks to the fact that the portfolio is really performing well and frankly in excess of our original assumptions. But we just want to take a very level approach, the accounting treatment around that.

[Jim Young:]

Thank you.

[Thomas Siering:]

Thanks, Jim.

[Operator:]

Thank you. And this does conclude our Q&A session. I would like to turn the conference back over to Mr. Tom Siering for any closing remarks.

[Thomas Siering:]

Thanks, Ben. I would like to thank everyone for joining our third quarter conference call. We had a lot of great questions. We really like that and we appreciate your interest in Two Harbors and we look forward to genuinely to speaking to you again soon. Have a great day everyone.

[Operator:]

Ladies and gentlemen, thank you for your participation in today’s conference. This does conclude the program. You may all disconnect. Have a great rest of your day.