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Two Harbors Investment (NYSE:TWO) has seen its stock absolutely get crushed. The sad thing is, the month of September was horrific for the stock and the sector. It was not unique to Two Harbors. The issues plaguing Two Harbors are common to many other competitors. The company is in a tough sector, as a mortgage real estate investment, or mREIT, company. Rates rising have wreaked havoc on mortgage-backed securities and related instruments. Spreads have widened so much it became a problem as the curve was constantly in flux. Actively managing the portfolio was guesswork in our opinion. Many in the sector got defensive, but it was not enough. As an mREIT, the action the Federal Reserve has taken the last few months has weighed heavily on operations. But it is not only this company, keep it in mind. The sector as a whole has fallen in tandem. Companies like this that buy and sell mortgages and bundles of mortgages are struggling. While prepayment risk has declined, spreads are all over the place, and book values have been crushed. It just is tough when the Federal Reserve has increased its target rate for the federal funds rate 4 times in a row at 75 basis points, following the initial hikes in the spring. It is a mess. Further, the Federal Reserve is also running off 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 in the cards sooner than later.
Q3 losses mount
The company was on the brink during the pandemic but the stock battled back. Now, shares have been obliterated. For the last six months with the rate hikes, mortgage rates moving, housing demand changing, and the volatility associated with it, the stock has been crushed. We felt some stabilization was likely in late fall, but alas, shares got hit even harder here in the fall. Total mess. The Agency RMBS market is tough but mortgage servicing rights, or MSRs, have performed somewhat well. Pairing them both has worked decently for the company, at least as best it can with the movement in the rates. Spreads have widened to what would be profitable levels, but it have been volatile and weighed on book value. This comes as the company shrunk its portfolio during the quarter, waiting for a better time to pounce
Comprehensive losses exploded wider to $287 million, big time losses that extended losses of $90.4 million in the second quarter. Ouch. Despite reducing the portfolio by $1.6 billion, the GAAP debt-to-equity expanded to 5.5X from 3.8X, which was a result of massive declines in book value that more than offset the decline in the port holdings. Net interest income was down to $11 million, from 14.2 million a year ago. It was just painful.
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. Further, the best gauge for dividend coverage remains, in our opinion, core earnings. The sector has moved to reporting distributable income, which is now reported in place of core earnings. That said, we were looking for $0.68, which would be just enough to cover the dividend. Well, distributable earnings came in at $55.2 million, or $0.64 per share, which also missed consensus expectations. If this pressure continues, the company will have to cut the dividend unfortunately. Now, recall Q2 was horrible, but at least the dividend was covered, and then some. This may keep the dividend secure, but a few more quarters like this and it will be cut. The pay day sure is nice though with annualized yield a crazy 18.7% right now.
The spread narrowed from Q2
The net interest rate spread is a critical indicator and we always look at it. Normally, the spread being wide is a good thing as the ability to make money can improve. The problem is when there is yield curve inversion and extremely volatile rates. It is not like the rates are static and the company can make moves and that is it. The bottom line here is the horrific performance reflects one of the hardest environments for these companies. You want to have a sense of these figures and the way it is trending because it serves as a gauge for potential earnings power of an mREIT. To calculate the net interest rate spread, we take the difference of the yield on assets and the cost to acquire those assets. The higher this indicator, the better, generally speaking, for the potential for net interest income. Let us take a look at the numbers and calculate the spread.
The annualized yield on the company’s portfolio assets was 4.61%, up 22 basis points from the sequential quarter. The problem is the cost of financing has skyrocketed more than the yield. This is the inversion at play folks. Quite nasty. The annualized cost of financing was 1.69% in Q2, but ballooned 115 basis points in Q3 to 2.84%.
Because the yields did not rise anywhere near how much the costs to acquire those funds rose, the net interest rate spread narrowed from Q2. This is a reason net interest income fell, in addition to less assets in the port. The net interest rate spread fell from 2.70% in Q2 to 1.77%. Painful. We do see some medium-term good news on prepayments.
Constant prepayment rates
Overall high levels of mortgage prepayments are always problematic in the mREIT sector. For a long time, prepayments were a huge risk, especially when rates were low and refinancing happened a lot. Obviously, the rates of prepayment will vary company to company depending on the type of holdings. Essentially, prepayments mean less interest income when they are made.
But here we are with the 30-year rates above 7%. For the most part, the demand to refinance is about gone, because most current mortgages are at much more favorable terms. The constant prepayment rates dipped from Q2 once again. Honestly, they are still kind of high overall at 9.2% for the Agency RMBS in the company portfolio, but they are way down from Q2’s 14.2%. It was also down from 17.3% in Q1, and much lower than a year ago. That is one positive from all of this. There are many reasons for prepayments, but usually consumers want to sell and refinance at better rates, and we do not see that happening for many quarters. So when things do stabilize and we see the yield curve normalize, better days will be ahead. The business model is not broken by any stretch.
Book value collapses
Obviously, dividend coverage is critical when we buy an mREIT stock, and the dividend was not covered. Another metric we focus on for an mREIT stock is that we like to purchase when the stock is at a discount-to-book value. Book value drives the share price of mREITs in conjunction with the dividends, and of course, how the market is trading. The problem is there have been massive declines in book value. Book was reported at $16.42 compared to $20.40 at the end of the second quarter. The big changes in spreads impacted the value. It was a 16.2% quarterly decline in economic return. Just horrific. Once rates settle down, and the yield curve relaxes, we will see real stabilization in book value. We were early on our call for stabilization but we did not see inflation being so entrenched. As such, shares have been murdered.
Final thoughts
We want to reiterate. This was a horrendous quarter. But the issues facing Two Harbors are common to the mREIT sector as a whole. It is just a terrible place to be invested, but things will get better. However, dividend cuts will happen across the sector, bringing yields more in line with norms in our opinion, but as of right now, the sector is offering massive yields, including Two Harbor’s 18.7%. If there are a few more quarters like this, the dividend will be cut. For now, we think it is maintained until there is another quarter of data but be warned a cut is a very real possibility.
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