Executive Summary / Key Takeaways

• Two Harbors Investment Corp. (TWO), through its MSR-centric strategy and integrated RoundPoint platform, aims to deliver stable, attractive risk-adjusted returns across varied market environments, leveraging operational efficiencies and expanded opportunities beyond a traditional RMBS-only model.
• The acquisition and integration of RoundPoint Mortgage Servicing LLC are on track to generate significant cost savings by bringing servicing in-house and provide greater control over the MSR portfolio's cash flows, enhancing the value proposition of the core MSR asset.
• The nascent direct-to-consumer (DTC) originations platform and expansion into second lien offerings, enabled by the RoundPoint infrastructure, serve as strategic hedges against prepayment risk for the MSR portfolio while also providing supplementary revenue streams.
• Despite recent market choppiness and volatility, particularly influenced by macroeconomic uncertainty and policy developments, the company maintains a strong liquidity position and anticipates attractive levered returns, supported by the low prepayment risk of its deeply out-of-the-money MSR portfolio and normalizing financing spreads.
• Key risks include interest rate volatility, liquidity management in stress scenarios, and the outcome of ongoing litigation, but management is actively managing exposures and focusing on operational execution to mitigate these challenges and drive sustainable stockholder value.

The Evolution of an MSR-Centric Strategy

Two Harbors Investment Corp., known simply as "Two," has strategically evolved since its founding in 2009. Initially focused on investing in, financing, and managing mortgage servicing rights (MSR) and Agency residential mortgage-backed securities (Agency RMBS), the company has consistently sought to leverage its deep expertise in understanding and managing interest rate and prepayment risk. This foundational approach aimed to deliver more stable performance compared to portfolios solely invested in RMBS.

A pivotal moment in this evolution was the acquisition of RoundPoint Mortgage Servicing LLC, which became effective on September 30, 2023. This move was not merely an expansion but a fundamental shift towards becoming an integrated mortgage finance company. The strategic rationale was clear: bringing servicing operations in-house promised significant cost savings through economies of scale, provided greater control over the MSR portfolio's valuable cash flows, and opened the door to a more expansive set of opportunities within the mortgage finance ecosystem. Management has indicated that the integration of RoundPoint has largely proceeded according to plan, already yielding improved economics.

This integrated model positions Two uniquely within the mortgage REIT landscape. While competitors like Annaly Capital Management (NLY) and AGNC Investment Corp. (AGNC) are dominant players primarily focused on large-scale Agency MBS portfolios with sophisticated hedging strategies, and PennyMac Mortgage Investment Trust (PMT) operates a vertically integrated mortgage banking model including origination and servicing, Two's strategy centers its investment portfolio around the MSR asset, complemented by Agency RMBS, and underpinned by its wholly-owned servicing and origination platform. This structure is designed to provide a differentiated risk-adjusted return profile.

Operational and Technological Edge

The RoundPoint platform is central to Two's operational strategy and provides a key differentiator. By handling substantially all servicing functions for its own MSR portfolio, Two gains direct control over the servicing process, aiming to reduce costs and enhance efficiency. Management has explicitly stated a focus on implementing operational efficiencies to achieve a low cost of service per loan, noting progress on this front.

The company is also leveraging technology and process improvements within RoundPoint to drive these cost efficiencies, including exploring the use of AI applications. While specific quantitative metrics on the impact of these technologies were not detailed, the strategic intent is to enhance profitability by lowering operational expenses associated with servicing the large portfolio, which stood at over 900,000 loans or about $225 billion of UPB serviced by RoundPoint as of June 2024.

Beyond servicing, RoundPoint enables strategic expansion into related business lines. The direct-to-consumer (DTC) originations platform, launched in the second quarter of 2024, is a prime example. Built from scratch with minimal legacy risk and de minimis initial cost, this platform is strategically designed to benefit the MSR portfolio through the retention or recapture of existing borrowers who refinance. This serves as a crucial hedge against faster-than-expected prepayment speeds, particularly valuable in a declining interest rate environment. While still in its nascent stages, the platform funded $42 million UPB of first mortgages in Q4 2024 and $22.4 million UPB in Q3 2024, with pipelines of $21 million and $35 million, respectively, demonstrating proof-of-concept. The goal for 2025 is to bring this platform fully to scale.

Furthermore, the company is expanding its offerings to include second lien loans, brokering $33 million UPB in Q4 2024 and $7.5 million UPB in Q3 2024, with intentions to originate these loans directly. This initiative capitalizes on the current market environment where many borrowers with low first mortgage rates seek to extract equity without refinancing their primary loan. The exploration of participating in the Ginnie Mae market and growing third-party subservicing are additional strategic pillars aimed at diversifying and expanding the platform's revenue-generating capabilities.

Compared to competitors, this integrated model provides Two with levers to impact its results through direct operational actions, a capability not available to traditional securities-only REITs like AGNC. While PMT also has an integrated model, Two's specific focus on leveraging its low-coupon MSR portfolio through recapture provides a targeted hedge that complements its investment strategy.

Financial Performance and Portfolio Dynamics

Two's financial performance reflects the interplay of its investment portfolio and the operational results of RoundPoint, all reported within a single segment. For the three months ended March 31, 2025, the company reported a net interest expense of $20.3 million, an improvement from $42.2 million in the same period of 2024. This was primarily driven by lower interest rates in Q1 2025 and reduced borrowing balances on AFS securities and MSR.

Net servicing income, a significant contributor, was $153.7 million in Q1 2025, down from $159.2 million in Q1 2024. This decrease was mainly attributed to lower servicing fee income on a smaller MSR portfolio (due to runoff and sales) and lower float income resulting from declining interest rates. However, higher ancillary and other fee income from subservicing and lower third-party subservicing costs partially offset this decline, highlighting the benefits of the RoundPoint integration.

The fair value changes in the portfolio and hedges significantly impact comprehensive income. In Q1 2025, the company recognized a loss on investment securities of $32.7 million and a loss on servicing asset of $36.2 million. Losses on interest rate swaps and swaptions amounted to $98.8 million, while gains on other derivative instruments (like TBAs and futures) were $1.4 million. Importantly, unrealized gains on AFS securities recorded in other comprehensive income were $157.2 million, driving comprehensive income attributable to common stockholders to $64.9 million, or $0.62 per weighted average common share. This contributed to an increase in book value per common share to $14.66 at March 31, 2025, up from $14.47 at December 31, 2024.

The MSR portfolio remains a core asset, valued at $2.96 billion at March 31, 2025, with a weighted average gross coupon rate of 3.5%. The low coupon profile means a substantial portion of the portfolio is deeply out-of-the-money for refinancing, contributing to low prepayment speeds (4.2% CPR in Q1 2025) and stable cash flows. The price multiple of the MSR was 5.9 times at the end of Q1 2025. The Agency RMBS portfolio stood at $8.61 billion, primarily consisting of fixed-rate securities.

Liquidity and Risk Management

Managing liquidity and risk is paramount for a leveraged REIT. Two actively monitors and forecasts its liquidity daily to ensure it can meet potential margin calls. As of March 31, 2025, the company held $573.9 million in cash and cash equivalents. It also maintained significant unused borrowing capacity across its financing facilities: approximately $6.5 million on unpledged securities, $950.1 million on MSR financing facilities (including $170.1 million committed and $780.0 million uncommitted), and $46.7 million on servicing advance facilities.

The company's debt-to-equity ratio funding its investment securities and related assets was 5.0:1 at March 31, 2025, and it remained in compliance with all financial covenants, including maintaining cash liquidity above $200 million and net worth above specified thresholds.

The primary risks faced by Two include interest rate risk, prepayment risk, liquidity risk (particularly margin calls), credit risk (limited on Agency assets but present on non-Agency and originated loans), and operational/legal risks. The company utilizes derivative instruments (swaps, swaptions, futures, TBAs) and the negative duration characteristics of MSR to economically hedge interest rate and prepayment risks. However, hedging is complex and may not fully mitigate volatility, especially during periods of high realized volatility, which can increase convexity costs.

The ongoing litigation related to the termination of the Management Agreement with PRCM Advisers LLC in 2020 remains a potential risk. While the company's board believes the complaint is without merit and no contingency liability has been recognized as of March 31, 2025, due to the uncertain outcome, an adverse result could materially affect the company.

Outlook and Return Potential

Management anticipates that markets will continue to be choppy in the near term, influenced by macroeconomic uncertainty and policy implementation. In response, the company plans to maintain portfolio leverage and risk at muted levels until there is greater clarity on the economic path.

Despite the volatility, the company continues to see attractive levered returns on its portfolio. The static return potential on common equity, based on the portfolio and spreads at March 31, 2025, was estimated to be in the range of 9.1% to 14.7%, or $0.33 to $0.54 per prospective quarterly static return per share. Management noted that wider spreads observed post-quarter end would translate to a higher return potential. The low prepayment rates on the company's low-coupon MSR are expected to remain a tailwind.

The strategic focus for 2025 is centered on operational execution: scaling the DTC originations platform, expanding second lien offerings, growing third-party subservicing, exploring new markets like Ginnie Mae, and continuing to drive cost efficiencies through technology and process improvements within RoundPoint. These initiatives are expected to enhance profitability and further support the value of the MSR asset.

The MSR market is expected to remain well-supported, although bulk acquisition opportunities may be limited. Two remains active in both bulk and flow markets, committing to purchase $1.7 billion UPB of MSR post-Q1 2025, demonstrating its ability to find opportunities.

Conclusion

Two Harbors Investment Corp. has strategically positioned itself as an MSR-centric REIT with an integrated operational platform. The core investment thesis revolves around leveraging the stability and cash flow generation of its deeply out-of-the-money MSR portfolio, complemented by actively managed Agency RMBS, while the RoundPoint platform drives operational efficiencies, hedges prepayment risk through recapture, and expands revenue opportunities. Although the company operates in a volatile market environment and faces risks inherent to mortgage finance and its specific litigation, its strong liquidity position, disciplined risk management, and focus on executing its integrated strategy provide a foundation for delivering attractive risk-adjusted returns. The successful scaling of the RoundPoint platform's capabilities, particularly in DTC originations and cost reduction, will be key indicators of the company's ability to enhance profitability and create sustainable stockholder value in the periods ahead.