Business Context and Reporting Period
Company: Two Harbors Investment Corp. (TWO)
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2010
Business Overview: Two Harbors is an externally managed Real Estate Investment Trust (REIT) focused on investing in, financing, and managing residential mortgage-backed securities (RMBS). The company targets Agency RMBS (guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac) and Non-Agency RMBS. It is managed by PRCM Advisers LLC, a subsidiary of Pine River Capital Management L.P.
Key Financial Metrics
| Metric | 2010 | 2009 |
|---|---|---|
| Total Assets | $1,797.4 million | $538.4 million |
| RMBS Portfolio (Carrying Value) | $1,354.4 million | $494.5 million |
| Net Interest Income | $35.7 million | $2.7 million |
| Net Income (GAAP) | $35.8 million | ($8.7 million) loss |
| Net Income Attributable to Common Stockholders | $35.8 million | ($8.8 million) loss |
| Earnings Per Share (Diluted) | $1.60 | ($0.39) |
| Dividends Declared Per Share | $1.48 | $0.26 |
| Stockholders' Equity | $382.4 million | $121.7 million |
| Book Value Per Share (Diluted) | $9.44 | $9.08 |
| Repurchase Agreements (Debt) | $1,169.8 million | $411.9 million |
| Debt-to-Equity Ratio | 3.1:1 | 3.4:1 (approx.) |
| Cash and Cash Equivalents | $163.9 million | $26.1 million |
Material Changes vs. Prior Period
- Portfolio Expansion: Total assets increased by approximately 234% from 2009 to 2010, driven by the deployment of capital raised in two follow-on public offerings totaling $235.3 million in net proceeds.
- Profitability Turnaround: The company reported a net income of $35.8 million in 2010, reversing a net loss of $8.8 million in 2009. This improvement was driven by a larger asset base and favorable net interest spreads.
- Yield Performance: The consolidated net yield on the RMBS portfolio was approximately 5.3% for the year ended December 31, 2010. Non-Agency RMBS yielded approximately 10.9%, while Agency RMBS yielded 3.4%.
- Cost of Funds: The average cost of funds on repurchase agreements was 0.66% for 2010, benefiting from low LIBOR rates.
- Dividend Growth: Quarterly dividends increased throughout 2010, culminating in a $0.40 per share declaration in December, compared to $0.26 in December 2009.
Guidance, Outlook, and Risks
Management Commentary & Outlook: Management highlighted a strategy of managing a balanced portfolio with low interest rate exposure and positive prepayment upside. The company successfully transitioned its common stock to the NYSE in February 2011. Capital raised in late 2010 was fully invested by January 2011. Management expects to continue navigating regulatory developments, including potential GSE reforms, while maintaining a diversified portfolio to balance risks associated with interest rates, prepayments, and credit.
Key Risks and Contingencies:
- Interest Rate Risk: Rising rates could increase borrowing costs faster than asset yields adjust, compressing net interest margins. The company uses interest rate swaps and swaptions to hedge this risk.
- Prepayment Risk: Faster-than-expected prepayments on Agency RMBS could accelerate premium amortization, reducing yields. Slower prepayments could extend duration.
- Credit Risk: Non-Agency RMBS are exposed to credit losses from underlying mortgage defaults. The company mitigates this by purchasing at significant discounts and maintaining credit reserves.
- Liquidity and Financing: The company relies heavily on short-term repurchase agreements. A disruption in funding markets or margin calls could force asset sales at depressed prices.
- Regulatory Risk: Changes to the structure of Fannie Mae and Freddie Mac or new regulations under the Dodd-Frank Act could impact the availability and pricing of target assets.
- REIT Qualification: Failure to meet REIT distribution or asset tests could subject the company to corporate income taxes.
Investor Verification Checklist
- Portfolio Composition: Verify the current split between Agency (approx. 75%) and Non-Agency (approx. 25%) RMBS and the specific vintage/credit quality of the Non-Agency holdings.
- Leverage Metrics: Confirm the current debt-to-equity ratio and the weighted average cost of funds, as profitability is highly sensitive to the spread between asset yields and borrowing costs.
- Prepayment Speeds: Monitor Constant Prepayment Rates (CPR) on the Agency portfolio, as deviations from assumptions significantly impact net yields.
- Counterparty Exposure: Review the concentration of repurchase agreement counterparties to assess counterparty risk.
- Dividend Sustainability: Compare GAAP net income and taxable income to ensure the company can maintain its 90% distribution requirement without eroding book value.
- Management Fee Structure: Note that the 1.5% management fee is based on stockholders' equity, which may incentivize capital raising regardless of investment returns.