Horrific Two Harbors Experience Not Unique (NYSE:TWO)

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Investment in two ports (NYSE: TWO) has seen his actions completely crushed. The sad thing is that the month of September was terrible for the stock market and the sector. It wasn’t unique to Two Harbors. Problems plaguing Two Harbors are common to many other competitors. The company is in a tough industry as a mortgage real estate investment firm, or mREIT. Rising rates have wreaked havoc on mortgage-backed securities and related instruments. The spreads have widened so much that it became a problem as the curve was constantly changing. In our opinion, active portfolio management was guesswork. Many in the sector were put on the defensive, but it was not enough. Like mREITs, the action the Federal Reserve has taken in recent months has weighed heavily on trading. But it’s not just this company, keep that in mind. The sector as a whole has fallen in tandem. Companies like this one that buy and sell mortgages and mortgage packages are struggling. While prepayment risk has subsided, spreads are everywhere and book values ​​have been crushed. It’s just hard when the Federal Reserve has raised its target rate for the fed funds rate 4 times in a row to 75 basis points, after initial hikes in the spring. It is a disaster. In addition, the Federal Reserve is also liquidating its balance sheet, selling its holdings in Treasuries and mortgage-backed securities, or MBS, balance sheet items. The company just reported earnings and we suspect a dividend cut is on the cards sooner rather than later.

Third quarter losses rise

The company was on the brink during the pandemic, but the stock fought back. Now, the actions have been deleted. Over the past six months, with rates going up, mortgage rates moving, housing demand changing and the volatility associated with it, stocks have been crushed. We felt some stabilization was likely in late fall, but unfortunately stocks took an even harder hit here in the fall. Total disaster. The agency RMBS market is tough, but mortgage servicing rights, or MSRs, have done quite well. Combining the two has worked decently for the company, at least to the best of its ability with the rate movement. Spreads have widened to what would be profitable levels, but have been volatile and weighed on book value. This comes as the company reduced its portfolio during the quarter, waiting for a better time to attack.

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Comprehensive losses exploded further to $287 million, huge losses that extended losses of $90.4 million in the second quarter. Oh. Despite reducing portfolio by $1.6 billion, GAAP debt-to-equity ratio expanded to 5.5X from 3.8X, resulting from massive declines in book value that more than offset declines in port holdings . Net interest income fell to $11 million from $14.2 million a year ago. It was painful.

The dividend was not covered

Net interest income is weak. Year-to-date, net interest income is down from $66.6 million to $53.5 million. Also, the best indicator for dividend coverage remains, in our view, core earnings. The sector has moved to reporting distributable income, which is now reported instead of basic earnings. That said, we were looking for $0.68, which would be enough to cover the dividend. Well, distributable earnings came in at $55.2 million, or $0.64 per share, which also fell short of consensus expectations. If this pressure continues, unfortunately the company will have to cut the dividend. Now remembering Q2 was horrible, but at least the dividend was covered, and then some. This may keep the dividend safe, but a few more quarters like this and it will shrink. Secure payday is nice, albeit with an annualized return of a crazy 18.7% right now.

The spread narrowed from the second quarter

The net interest rate spread is a critical indicator and we always look at it. Normally, a wide spread is good, as the ability to earn money can improve. The problem is when there is inversion of the yield curve and extremely volatile rates. It is not that the rates are static and the company can make movements, period. The bottom line here is that the horrible performance reflects one of the most difficult environments for these companies. You want to get a sense of these numbers and how they are trending because they serve as an indicator of an mREIT’s earning potential. To calculate the net interest rate margin, we take the difference in the return on assets and the cost of acquiring those assets. The higher this indicator, the better, in general terms, the interest margin potential. Let’s take a look at the numbers and calculate the spread.

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The company’s annualized return on portfolio assets was 4.61%, up 22 basis points from the sequential quarter. The problem is that the cost of financing has skyrocketed more than the yield. This is investment in game folks. Pretty nasty. Annualized funding cost was 1.69% in the second quarter, but increased 115 basis points in the third quarter to 2.84%.

Because yields didn’t rise nearly as much as the costs to acquire those funds, the net interest rate spread narrowed from the second quarter. This is the reason why the net interest income fell, in addition to fewer assets in the port. The net interest rate spread fell from 2.70% in the second quarter to 1.77%. Painful. We see some good news in the medium term on prepaids.

Constant prepaid rates

In general, high levels of mortgage prepayments are always problematic in the mREIT sector. For a long time, prepayments were a big risk, especially when rates were low and there were a lot of refinances. Obviously, prepayment rates will vary from company to company depending on the type of tenure. Essentially, prepayments mean less interest income when they are made.

But here we are with 30-year rates above 7%. For the most part, the demand for refinancing is about to disappear, because most of today’s mortgages have much more favorable terms. Constant prepaid rates fell from the second quarter once again. Honestly, they’re still a bit high overall at 9.2% for agency RMBS in the company’s portfolio, but they’re well down from 14.2% in the second quarter. It was also down from 17.3% in the first quarter, and much lower than a year ago. That’s one positive thing about all of this. There are many reasons for prepayments, but consumers generally want to sell and refinance at better rates, and we don’t see that happening for many quarters. So when things stabilize and we see the yield curve normalize, better days are ahead. The business model is not broken by any stretch.

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Book value collapses

Obviously, dividend coverage is critical when we bought mREIT stock and the dividend was not covered. Another metric we focus on for an mREIT stock is that we like to buy when the stock is discounted to book value. Book value drives the mREIT stock price along with dividends and of course how the market trades. The problem is that there have been massive drops in book value. The book was reported at $16.42 compared to $20.40 at the end of the second quarter. Big swings in spreads impacted value. It was a 16.2% quarterly decline in economic performance. just horrible. Once rates stabilize and the yield curve relaxes, we will see a real stabilization in book value. We started our call for stabilization, but we did not see that inflation was so entrenched. As such, the shares have been killed.

final thoughts

We want to reiterate. This was a horrible quarter. But the problems facing Two Harbors are common to the mREIT industry as a whole. It’s just a terrible place to invest, but things will get better. However, there will be dividend cuts across the sector, which in our opinion will bring returns more in line with the norms, but as of now, the sector offers massive returns, including 18.7% from Two Harbour. If there are a few more quarters like this, the dividend will be reduced. For now, we think it’s holding until there’s another quarter of data, but keep in mind that a cut is a very real possibility.

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