lerbank
investment work
Two Harbors Investment Corp. (NYSE: TWO) reported upbeat fourth-quarter results compared to their less than strong third-quarter results. Despite this positive news, its book value per share has been declining for years and its portfolio is under pressure from external factors Market forces like RMBS market issuance and still rising interest rates. Furthermore, the latest inflation report suggests that the Fed may not cut interest rates at the end of 2023, but rather keep them at elevated levels, which will prolong the difficulties TWO is facing. The stock is fairly valued, but if the book value continues to fall, the current price could be slightly overvalued within a year.
RMBS market for 2023
The last quarter of 2022 and the beginning of 2023 were quite turbulent in the mortgage markets. Mortgage rates hit a more than 10-year high last October 7% due to the Federal Reserve’s rapid rate hikes in 2022. The housing sector was hit the hardest, with mortgage rates almost doubling the year before. As top mortgage rates have fallen slightly. Mortgage rates have been falling slowly but steadily since last November (but we saw a small rise in February) and are enjoying a somewhat positive impact on the housing market. The average interest rate on a fixed rate mortgage rose in February after the 10-year Treasury bond rose to 3.86% this week from 3.39% earlier in the month. Freddie Mac reported that the 30-year fixed-rate mortgage rose to an average of 6.32% yesterday, compared to 6.09% in early February.
freddiemac.com
In the fourth quarter of 2022, an average of 13.3 billion RMBS per month was issued in the US. I expect the first quarter of 2023 to be similar, we are already seeing the issuance of 11.9 billion RMBS in January. However, these emissions are down 60-65% year-on-year. Both CMBS and RMBS issuance have declined significantly, and the vast majority of TWO’s portfolio consists of mortgage-backed residential securities.
sifma.org
Property prices have risen about 20% since the pandemic began, and despite recession fears, prices have not (yet) fallen significantly. Therefore, buying a home remains difficult for many potential buyers. This is further complicated by the current owners who are reluctant to sell due to the extremely low mortgage rates they have received in recent years. I expect this trend to continue in the coming months, possibly into the end of 2023. The number of completed single-family home, townhouse, condominium and co-op transactions is down 38% by the end of 2022 compared to early 2022, and the current figure is about 25% below the average pre-pandemic home sales figure.
Additionally, for the past several months, investors had been expecting the US Federal Reserve to cut interest rates in late 2023. However, the latest US inflation figure, which came in higher than expected, has caused analysts and investors to reconsider their earlier forecasts. Futures markets initially forecast that the US Federal Reserve would cut rates twice before the end of 2023, but as the January inflation report came out this week, futures markets are suggesting there may be no rate cuts at all at Fed meetings later this year will be 2023. This will prolong the pressure on TWO’s portfolio for this year.
Q4 results
Two Harbors Investment Corp. reported fair fourth-quarter earnings following the third-quarter disaster. Book value at the end of the third quarter was $16.42 per share for a quarterly economic total return of -16.2%. In the fourth quarter, the economic return was +11.6%. Portfolio performance in the third quarter reflected one of the most challenging market environments in decades, and the positive sentiment in the fourth quarter is more of a temporary good performance. While interest income was up 5.2% compared to Q3 due to the rise in cash rates, the decrease in RMBS portfolio size somewhat offset this. MSR borrowing costs increased significantly (by 38%) due to higher funding rates and larger average balances, while RMBS costs decreased due to lower average balances. Book value has been steadily declining for years, in the last quarter of 2020 the book value per share was $30.52 (adjusted for the reverse stock split) and by the end of 2022 it was even down 7.9% at $17.72. Increase compared to Q3 2022.
Presentation fourth quarter 2022
During the third quarter, the Company sold RMBS and used a portion of the proceeds to repurchase 2.9 million shares of preferred stock. This continued in the fourth quarter with an additional 2.9 million open market preference repurchases. That gave me a signal that the company believes in the value of these stocks. I realize that TWO’s management sees their preferred stock as a good investment. I can’t say the same about its common stock. Additionally, the company conducted a one-for-four reverse stock split in November 2022, which could also be a red flag for investors.
Evaluation
In my opinion, TWO is trading at a fair price right now, but with book value falling, a year from now that price could appear overvalued. It’s trading at 1.04 times book value, which is in the upper part of the last 12 months, the average would be around 0.92-0.94 times. There were times when TWO was trading at 0.8x book value a few months ago due to the price drop in September and October, so the current price and book value appear fair. However, if book value per share continues to decline in line with the current trend (which is about 16-20% per year), book value could be around $14 per share by the end of 2023. In this case, the current share price of $17 could appear overvalued. That’s why I’m neutral on TWO.
Final Thoughts
Two Harbors Investment Corp. has been struggling to maintain its book value per share for years, and given the difficult economic environment, it’s likely to remain so in 2023. The longer than expected high interest rate environment will also negatively impact their portfolio and I’m not sure they can generate significant shareholder value over the long term. Two Harbors Investment Corp. stock is fairly valued, but if the book value per share continues to fall, the current price is quite overvalued. The reverse stock split is also a red flag for me, hence my rating of Hold on TWO.
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