Two Harbors Investment (TWO) - 2020 Q1 - Quarterly Report

Part I Financial Statements Q1 2020 unaudited financial statements report a $1.87 billion net loss, primarily from investment and servicing asset losses, and a significant asset reduction Condensed Consolidated Balance Sheets Balance sheet shows total assets decreased from $35.9 billion to $22.2 billion, with corresponding reductions in liabilities and equity - Total assets decreased by approximately 38% from $35.9 billion to $22.2 billion, primarily due to a significant reduction in available-for-sale securities. Total liabilities also decreased, mainly from a reduction in repurchase agreements from $29.1 billion to $17.8 billion[13] Balance Sheet Summary (in thousands) | Balance Sheet Items | March 31, 2020 | December 31, 2019 | | :--- | :--- | :--- | | Total Assets | $22,202,648 | $35,921,622 | | Available-for-sale securities, at fair value | $17,733,059 | $31,406,328 | | Mortgage servicing rights, at fair value | $1,505,163 | $1,909,444 | | Cash and cash equivalents | $1,206,889 | $558,136 | | Total Liabilities | $19,298,515 | $30,951,156 | | Repurchase agreements | $17,795,516 | $29,147,463 | | Total Stockholders' Equity | $2,904,133 | $4,970,466 | Condensed Consolidated Statements of Comprehensive (Loss) Income The statement shows a significant net loss of $1.87 billion, primarily from substantial losses on investment securities and servicing assets - The company reported a staggering net loss of $1.89 billion attributable to common stockholders, or ($6.91) per share, for Q1 2020, compared to a loss of $44.9 million, or ($0.18) per share, in Q1 2019. The loss was driven by over $1.9 billion in 'Total other loss', including a $1.08 billion loss on investment securities and a $587 million loss on servicing assets[14] Statement of Comprehensive (Loss) Income Summary (in thousands, except per share data) | Metric | Q1 2020 | Q1 2019 | | :--- | :--- | :--- | | Net Interest Income | $88,199 | $81,958 | | Total Other Loss | $(1,920,741) | $(70,176) | | Loss on investment securities | $(1,081,607) | $(19,292) | | Loss on servicing asset | $(586,665) | $(188,974) | | Net Loss | $(1,869,656) | $(25,935) | | Net Loss Attributable to Common Stockholders | $(1,888,606) | $(44,885) | | Basic/Diluted Loss Per Share | $(6.91) | $(0.18) | | Comprehensive (Loss) Income | $(2,067,726) | $330,217 | Condensed Consolidated Statements of Cash Flows Cash flow statement shows $10.8 billion cash provided by investing activities, largely offset by $10.6 billion used in financing - Investing activities provided $10.8 billion in cash, primarily from $15.6 billion in proceeds from sales of AFS securities, which was largely offset by $10.6 billion cash used in financing activities, mainly from repaying $46.1 billion in repurchase agreements[20][21] Cash Flow Summary (in thousands) | Cash Flow Activity | Q1 2020 | Q1 2019 | | :--- | :--- | :--- | | Net cash provided by operating activities | $100,206 | $165,814 | | Net cash provided by investing activities | $10,809,889 | $2,654,121 | | Net cash used in financing activities | $(10,639,637) | $(3,138,764) | | Net increase (decrease) in cash | $270,458 | $(318,829) | | Cash, cash equivalents and restricted cash at end of period | $1,887,284 | $778,935 | Notes to the Condensed Consolidated Financial Statements Notes detail COVID-19's impact (asset sales for liquidity), CECL adoption, and the transition to a self-managed structure - In response to unprecedented market conditions from the COVID-19 pandemic, the company sold substantially all of its non-Agency securities and approximately one-third of its Agency RMBS on March 25, 2020, to raise liquidity and de-risk the portfolio[27] - The company adopted the new credit loss accounting standard (CECL, Topic 326) on January 1, 2020, which changed the impairment model for financial assets. An initial allowance for credit losses of $244.9 million was established upon adoption[34][35][39] - On April 13, 2020, the company elected not to renew its Management Agreement with PRCM Advisers, which will terminate on September 19, 2020. The company will become self-managed and expects to retain its current senior management team[217] Management's Discussion and Analysis of Financial Condition and Results of Operations Management discusses Q1 2020 market volatility, strategic shift to rates strategy, a $1.9 billion GAAP net loss, and the transition to self-management Business Overview and Strategy The company responded to COVID-19 market volatility by selling assets for liquidity, shifting capital 100% to its rates strategy - Due to the COVID-19 pandemic and significant spread widening, the company sold substantially all of its non-Agency securities and about one-third of its Agency RMBS on March 25, 2020. This was done to raise liquidity, de-risk the portfolio, and eliminate risks from outsized margin calls[221] - The company's debt-to-equity ratio is correlated with its portfolio mix. Historically ranging from 5.0 to 7.0 times, a higher allocation to Agency RMBS leads to a higher ratio[229] Capital Allocation by Strategy | Strategy | March 31, 2020 | December 31, 2019 | | :--- | :--- | :--- | | Rates strategy | 100% | 78% | | Credit strategy | 0% | 22% | Market Conditions and Outlook Q1 2020 saw extreme market volatility, with Fed rate cuts and QE4, and the CARES Act impacting MSRs - Q1 2020 was extremely volatile. The Fed cut rates by 150 bps to the zero bound and committed to unlimited purchases of U.S. Treasuries and Agency RMBS (QE4)[245] - The CARES Act provides up to 360 days of mortgage forbearance for borrowers with federally backed loans, which could increase delinquencies and require MSR owners like the company to advance payments, potentially impacting liquidity[246] Investment Portfolio Carrying Value (in thousands) | Asset Type | March 31, 2020 | December 31, 2019 | | :--- | :--- | :--- | | Total Agency | $17,706,659 | $27,778,055 | | Total Non-Agency | $26,400 | $3,628,273 | | Mortgage servicing rights | $1,505,163 | $1,909,444 | | Total | $19,311,498 | $33,384,697 | Results of Operations Operations resulted in a $1.9 billion GAAP net loss, a decrease in book value per share, and significant losses on investment securities and servicing assets - GAAP net loss attributable to common stockholders was $1.9 billion, or ($6.91) per share, for Q1 2020, a massive increase from a loss of $44.9 million, or ($0.18) per share, in Q1 2019[260] - Book value per common share decreased to $6.96 at March 31, 2020, from $14.54 at December 31, 2019, driven by a comprehensive loss of $2.1 billion[262] - Loss on investment securities for Q1 2020 was $1.08 billion, primarily from $1.04 billion in realized losses on sales of AFS securities, compared to a loss of only $19.3 million in Q1 2019[285] - Loss on servicing asset increased to $586.7 million in Q1 2020 from $189.0 million in Q1 2019, driven by decreases in interest rates and higher prepayment speed assumptions[290] Key Performance Metrics (Annualized) | Metric | Q1 2020 | Q1 2019 | | :--- | :--- | :--- | | Average annualized portfolio yield | 3.52% | 4.25% | | Cost of financing | 2.39% | 2.47% | | Net portfolio yield | 1.13% | 1.78% | Financial Condition, Liquidity and Capital Resources The company maintains strong liquidity with $1.2 billion cash, manages repurchase agreements, and obtained financial covenant waivers - As of March 31, 2020, the company held $1.2 billion in cash and cash equivalents available to support operations[323] - The debt-to-equity ratio funding AFS securities, MSR, and Agency Derivatives was 6.5:1.0 as of March 31, 2020[255][314] - The company has repurchase agreements with 47 counterparties. As of March 31, 2020, total outstanding repurchase agreements were $17.8 billion[255][326] - Due to the decline in stockholders' equity, the company obtained waivers from certain counterparties for financial covenants based on a percentage decline in total stockholders' equity[335] Quantitative and Qualitative Disclosures About Market Risk The company manages market risks, primarily interest rate risk via derivatives, with sensitivity analysis showing rate change impacts, and manages liquidity - The company uses a variety of derivative and non-derivative instruments (TBAs, swaps, swaptions, futures, MSR) to economically hedge interest rate risk and duration mismatch between its assets and floating-rate borrowings[344] - Liquidity risk is heightened by financing long-maturity assets with shorter-term borrowings. The CARES Act forbearance programs may require the company to advance significant payments for its MSR portfolio, creating a potential liquidity strain, which management believes it is well-positioned to handle[367][369] Interest Rate Sensitivity Analysis (as of March 31, 2020) | Change in Interest Rates | Change in Annualized Net Interest Income (in thousands) | % Change | Change in Total Net Assets (in thousands) | % Change of Common Equity | | :--- | :--- | :--- | :--- | :--- | | +50 bps | $(39,800) | (13.7)% | $(23,869) | (1.3)% | | +25 bps | $(19,900) | (6.9)% | $(6,782) | (0.4)% | | -25 bps | $19,883 | 6.8% | $(9,963) | (0.5)% | | -50 bps | $39,819 | 13.7% | $(19,778) | (1.0)% | Controls and Procedures Management concluded disclosure controls and procedures were effective, with no material changes to internal control over financial reporting - The CEO and CFO concluded that the company's disclosure controls and procedures were effective as of March 31, 2020[372] - No material changes were made to the company's internal control over financial reporting during the first quarter of 2020[373] Part II Legal Proceedings The company reports no material legal proceedings that would adversely affect its financial condition or operations - The company reports no material legal proceedings[376] Risk Factors New risks include management agreement termination (self-management transition) and COVID-19 impacts on asset values, delinquencies, and MSR liquidity - A new risk factor is the termination of the management agreement with PRCM Advisers. The transition to a self-managed company involves risks such as failing to retain key personnel, the adverse impact of a ~$144 million termination fee on liquidity, and unforeseen operational disruptions[378][379] - The COVID-19 pandemic poses a material risk, potentially causing further declines in asset values, increased borrower delinquencies, and higher MSR servicing costs[382] - The CARES Act requires the company to make servicing advances for MSR assets on loans in forbearance, which could have material adverse consequences on liquidity and financial condition despite some mitigating actions by the FHFA[383] Share Repurchases and Use of Proceeds The company repurchased 105,300 shares in Q1 2020 under its program, with 25.3 million shares remaining for repurchase - As of March 31, 2020, the company had authorization to repurchase an additional 25,325,700 shares under its existing program[387] Share Repurchases in Q1 2020 | Period | Total Shares Purchased | Average Price Paid per Share | | :--- | :--- | :--- | | Jan 2020 | — | $— | | Feb 2020 | — | $— | | Mar 2020 | 105,300 | $10.09 | | Total | 105,300 | $10.09 |