Two Harbors Investment Corp. (NYSE: TWO-PB) is a Maryland-based real estate investment trust (REIT) that invests in, finances, and manages mortgage servicing rights (MSR) and Agency residential mortgage-backed securities (Agency RMBS). The company's strategy of pairing Agency RMBS with MSR, with a focus on managing various associated risks, including interest rate, basis, prepayment, and credit and financing risk, is intended to generate more stable performance relative to RMBS portfolios without MSR, across changing market environments.

In the first quarter of 2024, Two Harbors reported a net loss of $176.8 million, with annual revenue of $556.75 million, annual operating cash flow of $343.5 million, and annual free cash flow of $30.9 million. The company's book value per common share increased to $15.64 at March 31, 2024, up from $15.21 at the end of 2023, representing a positive 5.8% total economic return for the quarter.

Business Overview

Two Harbors' investment portfolio is primarily composed of MSR and Agency RMBS. The company's MSR portfolio had a fair market value of $3.1 billion as of March 31, 2024, representing the right to control the servicing of residential mortgage loans. Two Harbors acquires MSR from third-party originators through flow and bulk purchases, as well as through the recapture of MSR on loans in its portfolio that refinance.

The company's Agency RMBS portfolio is comprised primarily of fixed-rate mortgage-backed securities backed by single-family and multi-family mortgage loans, with the majority of the portfolio consisting of whole pool certificates. Two Harbors seeks to deploy moderate leverage as part of its investment strategy, generally financing its Agency RMBS through short- and long-term borrowings structured as repurchase agreements.

In September 2023, Two Harbors completed the acquisition of RoundPoint Mortgage Servicing LLC, a leading servicer of conventional loans in the country. This acquisition is expected to add value for Two Harbors' stakeholders through cost savings achieved by bringing the servicing of its MSR portfolio in-house, greater control over the company's MSR portfolio and the associated cash flows, and the ability to participate more fully in the mortgage finance space as opportunities arise.

Financials

For the first quarter of 2024, Two Harbors reported a net loss of $176.8 million, compared to net income of $203.6 million in the same period of 2023. The company's quarterly revenue increased from $22.8 million in Q1 2023 to $430.3 million in Q1 2024. The increase in revenue was primarily driven by higher gains on investment securities and other derivative instruments.

Two Harbors' operating cash flow for the first quarter of 2024 was $115,000, compared to $343.5 million in the same period of 2023. The decrease in operating cash flow was mainly due to changes in working capital and other operating assets and liabilities. Free cash flow for the quarter was $30.9 million, up from a negative $1.1 billion in Q1 2023, reflecting the company's focus on managing its liquidity and capital resources.

Liquidity

As of March 31, 2024, Two Harbors had $666.2 million in cash and cash equivalents and $72.2 million in restricted cash. The company's borrowings consisted primarily of $8.4 billion in repurchase agreements, $1.4 billion in revolving credit facilities, $295.5 million in term notes payable, and $269.0 million in convertible senior notes.

The company's debt-to-equity ratio, which includes unsecured borrowings under convertible senior notes, was 4.6:1.0 as of March 31, 2024. Two Harbors had approximately $3.0 million in unused borrowing capacity on its unpledged securities and $135.4 million in unused committed and $466.3 million in unused uncommitted borrowing capacity on its MSR financing facilities.

Risks and Challenges

Two Harbors' business is subject to various risks and challenges, including interest rate risk, prepayment risk, credit risk, and liquidity risk. The company's performance is heavily influenced by changes in market interest rates, which can impact the value of its AFS securities and MSR portfolio. Prepayment risk, or the risk that the principal amount of a mortgage loan will be repaid at a different rate than anticipated, can also affect the company's results.

Additionally, Two Harbors is exposed to credit risk on its non-Agency securities and the potential for counterparty defaults on its derivative instruments and repurchase agreements. Liquidity risk is another key concern, as the company relies on short-term borrowings to finance its long-maturity assets, which could be impacted by lender margin calls or the inability to roll over its repurchase agreements.

Outlook

In its latest guidance, Two Harbors stated that it expects prepayment rates on its MSR portfolio to rise modestly in the second quarter of 2024, reflecting seasonal turnover patterns. However, the company noted that less than 1% of the mortgage loans underlying its MSR are likely to refinance at current rates, and over 80% of the balances are at least 250 basis points below current mortgage rates.

The company also expressed confidence in its portfolio construction, with a high allocation to MSR acting as a ballast to its Agency RMBS portfolio when mortgage spreads fluctuate. Two Harbors believes it is well-positioned to benefit in the current market environment and beyond, given its expertise in managing interest rate and prepayment risks.

Conclusion

Two Harbors Investment Corp. is a mortgage REIT that has demonstrated its ability to navigate challenging market conditions through its strategic focus on MSR and Agency RMBS. The company's recent acquisition of RoundPoint Mortgage Servicing LLC is expected to enhance its operational capabilities and provide greater control over its MSR portfolio.

While Two Harbors faces various risks, including interest rate, prepayment, and liquidity risks, the company's conservative leverage, disciplined investment approach, and expertise in managing these risks position it well to deliver stable performance over the long term. Investors should closely monitor the company's ability to execute on its strategic initiatives and manage the evolving market environment.