- Summary

I’m pitching Two Harbors (ticker TWO), as  a long.   

TWO is a hybrid mortgage REIT, and is one of the more dynamic and innovative of mortgage REITs around.

For instance in 2012, they started buying single family homes and subsequently sold those assets into a single family housing REIT IPO - Silver Bay (SBY), they have since distributed those shares that they received in return for contributing their properties;  and now they are looking to invest in new stuff: credit sensitive loans, MSRs, and securitizations,  in addition to their bread and butter agency & non-agencyRMBSinvestments. 

I think TWO offers attractive risk / reward with a 10-11% dividend yield, trades at 1.05x P/B (which in my opinion is cheap given the quality of the manager and how proactive / value-creating they are), and there is further upside as they slowly become the next operational mortgage REIT (like PennyMac [PMT] and/or Redwood [RWT]), which would drive multiple and earnings expansion.

Also, for those trying to get long housing, TWO (and guys like it - e.g.MFA, CIM) offer some of the purest and cheapest ways to get long housing as they still trade near book value and hold a significant chunk of low dollar price non-agency MBS that is benefiting from rising home prices and borrower healing.

Assets that they invest in

- Credit Sensitive Loans (CSLs)

Basically they're starting to buy performing loans where the borrower may have had payment delinquencies or are maybe underwater.  

ROEs are attractive  in the low/mid double digit % – which is a better yield than non-agency bonds (yielding around 10%), which most other non-agency / hybrid mortgage REITs are buying, and value of owning and controlling the servicing is substantial.

Also, somewhat uniquely, by investing in credit sensitive loans, they can get past that 55% whole loan limitation that hybrid REITs face and still qualify as a REIT. So theoretically, they could get to 100% non-agency exposure, which at the moment I think the market would like just given the uncertainties around agency mortgages and pure agency mortgage  REITs like AGNC andNLY.   Zais Financial Corp (ZFC) is a new mortgage REIT that is designed & touted specifically to pursue the just this strategy.  Competition remains low in this asset class as it is a bit less transparent and more difficult to source and buy these loans (as opposed to securities)

As they've said in recent investor presentations,  CSLs are  "Very similar to loans in sub-prime/Alt-A deals"  and  "We will control servicing rights on the loans"   and  "Potential to securitize and create attractive credit investments"

- Securitizations

They recently did a $425mm jumbo securitization through Credit Suisse, with similar execution to the Redwood deals.  They contributed loans to the deal and retained the subordinate pieces.

TWO is targeting low/mid ROEs for these investments;  this segment could be an interesting launching pad into other business lines. 

They are currently building out their originator network in order to source loans as well

As private labelRMBSsecuritization execution improves, they will benefit as that only improves the "arb" that they get between buying loans and then securitizing them - with the drivers being the price of the loans, execution,  enhancement, liability pricing, etc.

They are on their way to becoming like Redwood with a conduit.  Given their track record and backing byPineRiver, I think they could have the cachet and certainly the expertise to develop something like Redwood Trust and be a provider of capital (particularly in the alt-a side)

- Mortgage Servicing Rights (MSRs)

TWO harbors recently received approval to be a servicer under (“Freddie Mac”) home mortgage (1-4 unit) program. This approval allows the company to invest in Mortgage Servicing Rights (MSRs) on Freddie Mac loans and it allows them to own & control the servicing (rather than guys like HLSS who are just providing the capital).  It's a nice complement to their agency exposure since it provides a natural interest rate hedge, plus they should be able to earn a high-single-digit to low-double-digit return on it

I think that they will likely target prime MSRs.  Part of their angle is buying MSRs off banks who may need the regulatory relief.  They will sub-service these loans (perhaps to the likes of a PHH or PennyMac Mortgage Services - PMS), unless they get large enough in them and it makes sense for them to bring it in-house

- Non-agency - bread and butter

~10% ROEs right now.

Their current portfolio is 80% senior subprime bonds; bought at 51 cents on the dollar,  currently marked at 60 cents on the dollar

Mostly 2006+ vintages, and primarily floating/hybrid

30-40% of the portfolio is 60+ day delinquent. Original fico of 638 

They lever this portfolio about 1.7x.

So overall, this portfolio provides significant exposure and upside to an improving housing market, plus a nice current yield.   This is currently about 50% of the portfolio, but over time they will also add CSLs to the mix, getting their exposure to housing to above 50%-70% of the portfolio, and theoretically up to 100% if they wanted to

- Agency MBS investments

Agency MBS spreads are attractive once again after the post QE3 spread collapse and fear that arose as people thought the Fed would squeeze all the juice out and spike prepayments through the roof.  Agency REIT stocks have been all over the place (the recent Q4 volatility was driven much by panicked retail [and surely some non-retail] selling in my opinion).  For the past few years, it used to be pretty clear that book values determined where the stocks would go.  As of late, the stocks are trading more on dividend & yields.   Although longer term, they should stay closer to book values. 

At the current low/mid teens ROEs that you can achieve by buying MBS and getting financing through repo, plus the opportunities the TBA market affords you,  it's again a pretty attractive area.

This part of the portfolio also provides a nice hedge to the market as well.  When their cyclical holdings sell off, the agency MBS stuff they hold should rally (they usually hedge most the rate risk,  but not all of it completely).  Plus given where rates are, hedging interest rate risk is quite cheap (outright short rates trades are better than options and provide better payoffs & risk/rewards in my opinion).  Also as they invest in more MSRs, that will provide a natural interest rate hedge and reduce the costs of hedging their book.

They were  5.7x levered in these assets and will bring probably that back up to 6.5x ish as the opportunities have come back

On the agency side, they generally invest in pre-pay protected  agency MBS,  mostly highLTVand/or low loan balance. Their CPRs have been around 6-7% over the last year (which quite ridiculously low), but they have been reducing the amount of payups and switching into lower dollar price MBS in order to reduce price risk

They've said that they will look to reduce their agency MBS exposure to roughly 30% of their capital (maybe more)

- Operational costs

They are not spending a lot more to go into all these different areas.  From conversations I've had with them, it’s more like hiring a few people / teams as a lot of the products and skill sets overlap.

When they started buying single family homes (which is much more operationally intensive), they did a great job managing expenses. SilverBayhired the appropriate people and operations were smooth.   Being externally managed also helps in situations like this

- Upside

Stock is currently at $12.00,   $4.3bn market cap ,  348mm shares

it's roughly at 1.06x Q1 2013 pro forma book value (after adjusting for theSilverBayshare distribution, cash dividend, and capital raise). 

Clearly, this stock is mostly a broad bet on housing, and home prices (which I'm sure most reading are bullish on), but with their agency exposure, there’s a bit of a hedge as well (agency mortgage REITs have done relatively well in the recent early April 2013 market swoon).   

if book value rises 10% over the rest of this year, and then TWO trades back to 1.2x (i.e. the higher end of the range for the better mortgage REITs, which this one is),  the stock could get to $15,  or about 25% upside from here in price appreciation,  plus a 10-11% dividend,  for a ~35% total return.   

Also, I think that they'll potentially end the year at a 11-12% dividend yield (if the stock price doesn't change).

For reference, in 2012, they grew book value by $2.51 and also paid $1.71 in dividends for a total of  $4.22 in economic value created & distributed,  with the stock starting at $9 in BV (and trading at the same level) at the end of 2011 for about 47% economic return

For comparison -MFA(another hybrid mortgage REIT) - trades around 1x P/B and a 10% dividend yield, but they are much more boring and will just stick with agency and non-agency MBS.  I'd rather pay up a little forTWOHarbor's effective active management, operational upside, and innovation.

- Downside scenario

If they trade at 1x P/B and book values fall around 10% due to a pullback in the housing market (offset by a rise in the book value in their agency MBS holdings), offset by a 10% dividend, your total return is around -5%.  

- Further upside case

There's added upside if they build out an operational business to complement what they are doing now and become the next Redwood or PennyMac.   Given that they basically developing a conduit channel obtaining more servicing approvals, and building out originator relationships,  who knows what they may do next.   But it would provide the potential for earnings and multiple expansion.  In PennyMac's and Redwood's case, their operational correspondent sides are roughly half the business now, while their REIT investment side is the other half. 

Management is well aware of the opportunities, but has played it cool for now 

Like last year, who would have thought that they'd create value by buying single family houses and spin those into an IPO and then distribute it.

For comparison,   PMT trades at 1.3x book value & a 9% dividend yield. I also like PMT (given its exposure to pure distressed housing and its rapidly growing correspondent lending platform)

RWTis at 1.5x book value and 12.5x 2013 EPS, and 5% dividend yield.  I also likeRWTas it is nicely positioned to ramp up its mortgage conduit (given it is one of 2 issuers to have continuously been able to issue private labelRMBSover the past few years).  It's conduit platform and correspondent lending should also just start to grow rapidly this year.

AGNC - arguably the best managed pure agency REIT trades around 1.08x P/B, and a 15% dividend.  However, their pure agency exposure is highly volatile and uncertain right now given what's going on in rates and the Fed.   This is dominated by retail investors who are looking for yield

- Dividend

They announced at $0.32 dividend for Q1,  which should be sustainable for them over the year; there is upside to that number as they move from lower yielding assets like non-agency MBS and deploy more capital into higher yielding credit sensitive loans and securitizations

Consensus is basically around $0.32 / quarter

On the Q4 call, they said that $0.31 / quarter dividend is sustainable (and that was during a tougher yield / spread environment)

So currently it's at a 10-11% dividend yield,  with upside as they shift into higher yielding and more attractive areas, I think overall ROEs / dividends could rise to 12-13%  for the company as a whole

- Timing - opportune

Also, they just did a recently capital raise (which was accretive to book value), distributed theSilverBayshares, and announced their dividend.  Usually, that’s a good time to buy these REIT stocks due to the short term technical pressures on the stock when any of these events happens.  Plus it gets a short term headwind out of the way.

Mortgage REITs frequently can trade a bit sloppy after any one of those events.  Having all 3 has made the shares rather slack

- Silver Bay (brief tangent)

For those who are curious, I'm not a fan ofSilverBay:  like most new REIT IPOs, it will take more than a year to truly ramp up.   And given the operational complexities of the single-family REIT model, it isn't clear how their targeted yields and returns will turn out.

Perhaps there will be high demand for single family rentals, and maybe the maintenance costs won't turn out too be too high; or maybe it just won't be possible to do this on the scale that BX and SBY and Colony hope.

- Secular Themes

There are a few secular themes behind TWO Harbors as well (in addition to the likes of Redwood).  Namely: 1) the GSEs slowly stepping away from being virtually the sole provider of residential capital through guarantee fee increases and loan limit decreases; 2) BaselIIIand how that will change the role of banks in mortgage finance.

Regarding 1), as the GSEs step away, they will naturally need private capital, securitizations, conduits.  These are things that TWO can and potentially will provide in the future

Regarding 2), as we've seen with the recently turned battleground Mortgage Servicer space, banks are looking to shed Mortgage Servicing Rights (MSRs).   It's likely that TWO will look to be a provider of capital and team up with a servicer for prime MSRs as the likes of Sun Trust, Regions, and maybe even Wells Fargo unloads some of it for capital relief.

Given the tax and regulatory advantages of being a REIT (vs. a bank), mortgage REITs have and will continue to be a beneficiary of the changes going on in mortgage finance.

TWO could become a partner for banks who need true sale treatment