Two Harbors (TWO)

At just over $200 million market cap and less than year in business, I toyed with the idea that TWO didn’t rate its own blog post.

As noted yesterday, it also hasn’t been doing so well, losing book value while everybody else was gaining, at least according to the analysts at one Wall Street shop.

When I took a closer look at the company, I saw that they had laid out their philosophy, and that it differed from the rest of the group in one significant way, so they’re getting the full treatment.

To put the Two Harbors mREIT into a single sentence, they intend to buy whatever is cheap, and structure their portfolio so it self-hedges.

I know this sounds like the first ten years of Annaly, but here we have one big difference.  These guys actually bought negative duration mortgage securities — IO strips issued by Fannie and Freddie.

For years, Annaly said their short duration paper together with their long duration paper would suffice as a risk management technique.  They called it their proprietary “barbell” strategy.  In 2004 through 2006, they cut their dividends (and earnings) by nearly half in what was in retrospect a minor correction in the greatest mortgage bull market in history.

Today Annaly uses swaps to lock in some of their future financing costs, as do most of the other amREITs.  Two Harbors is not doing that, trusting the better-than-expected future cash flows from IOs to make up for the extra financing costs in a rising rate environment.  I don’t know of any levered portfolio that has succeeded with that strategy through an entire interest rates/economic cycle.

On a portfolio basis, the negative duration of the IO’s draws the whole portfolio down to an average duration less than a quarter year longer than the duration of the liabilities.  They are, however, very exposed to a surge of prepayments followed by a slowdown in a higher rate environment.  That could blow out the IOs, but leave 20+ years of underwater MBS needing financing that costs more than the yield of the MBS.  The markdowns would be horrendous if that were to happen.

That’s not to say the “cash flow hedging” I see in TWO’s portfolio profile doesn’t have some attractive features, most striking of which is financing at 40 basis points today vs. the effective cost of funds the others suffer — ranging from 1.5% to nearly 2.5%.

The other big difference in Two Harbors (a nice place in Minnesota, by the way) is that they started out with a team of more than 80 people so they could do the diligence and investment management work on non-Agency MBS.

I wonder how many of the staff did a stint at Cargill, as did the CEO and several key players on the team.  Some day maybe I’ll tell my Cargill/Kidder story from the early days of CMO trading (1986).  That was before the time of any of the TWO folks, so I won’t tell it here.

They’ve bought bonds ranging from seasoned subprime MBS to alt-A’s, and not just the most senior tranches.  Those came with some pretty steamy yields even in today’s market, so the ROE at under 4x leverage can still hit the high teens bogey the mREITs seem to need to deliver.

Basically, I see a big bet on rising rates with lower prepayments but also an end to the deflationary spiral in house prices.  If all that comes together, this portfolio will be a home run.

If it doesn’t, they may turn in more quarters like the last one, where at least one Street analyst thinks they lost equity for their shareholders while everybody else was enjoying gains.

hh

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