Description

Two Harbour Preferreds are trading at 15.83 or 63% of face value as of today's close.

TWO just meaningfully derisked their portfolio by selling down all of its credit-sensitive assets at a discount to book value. The Company received approximately $1.7 billion from the sale of about $3.6bn in NPL / RPL loans that it had mostly bought during the last financial crisis.

What remains is roughly the following:

TWO themselves estimate that their book value has fallen by about 55% quarter to date. They are out of their credit assets, their MSRs have fallen in value and the agency mortgages have risen in value. Book value per share should have fallen somewhere into the mid sixes. TWO themselves estimate in a press release that their economic debt to equity currently stands at about 7.5x. Economic debt to equity counts repurchase agreements, FHLB advances, revolving credit facilities, term notes payable and convertible senior notes, plus implied debt on net TBA notional on the debt side and total equity (equity plus preferreds) on the equity side. The above table should be seen as an estimate, and one can argue about how much TBA notional they have and how much they have taken the agency portfolio down by.

I think what matters here is that 1/ 7.5x leverage on agency mortgages is very much on the conservative side for agency mortgage REITs with most players staying well north of 10x in normal times and 2/ there is about $1.8bn in equity subordination below $1bn in prefs with the asset side looking something like $20bn in agencies and MSRs and $4bn in cash and receivables.

Competitors such as MITT, NYMT, MFA, IVR, and RWT have all run into varying degrees of trouble getting margin called during the recent agency mortgage selloff. Some of them may survive, some may not. What is relatively clear at this point is that now that the Federal Reserve has stepped back in to stabilize the market and provide liquidity in agency mortgages, we have returned to a more orderly market. The survivors have survived.

TWO is one of the survivors and now has a very simple balance sheet consisting of Agency mortgages, MSRs and Cash on the asset side and predominantly Repo on the Liabilities side. They also have some swaps to hedge interest rate risk in addition to their MSRs. TWO’s management team are also thought of as being some of the smarter players in the space. This is hard to argue with, as half their competition just blew up. They were also the first management team to update the market when things went south, estimating that book value was down 16% on March 19th.

TWO has decided to suspend paying all dividends on its equity and preferreds, presumably until we have more certainty about the economy. Fortunately the preferreds are cumulative, so any missed dividends will have to be paid once the dividend on the preferreds are turned back on.

In summary, TWO takes no credit risk at this point, is less levered than competitors and have acted in a very shareholder friendly and prudent manner both historically and in this crisis. The main risk is that we have another repo blowup with even bigger margin calls. As the Federal Reserve has already stepped in and shown its willingness to do “whatever it takes” to protect orderly markets in treasuries and agencies, I’m willing to take that risk. Once TWO preferreds turn back on they should trade back to par or higher as they’ll have built up lots of cumulative accrued interest by then. I’d be surprised if we didn’t get there in a year or less (~70% 1-year total return).   

What I like about this is that it represents a return stream that is competitive with equities and relatively independent of the shape of the Covid recovery. Even if we enter a depression agency mortgages bear no credit risk. As long as TWO's management team doesn't do anything reckless (which they are not known for) the TWO preferreds should do well from here.

Catalyst

Dividends turning back on