Watch stocks you care about
The single, easiest way to keep track of all the stocks that matter...
Your own personalized stock watchlist!
It's a 100% FREE Motley Fool service...
Two Harbors Investment (NYSE: TWO ) isn't like other mortgage real estate investment trusts. As a hybrid, it has a "go-anywhere" strategy that sends it into far-flung corners of the mortgage universe. It can buy what other pure-agency mREITs like American Capital Agency (NASDAQ: AGNC ) can't.
Two Harbors' silver lining
Two Harbors differs from other mREITs thanks to its position in excess mortgage servicing rights.
For the uninitiated, a mortgage servicing right, or MSR, is the authority to manage mortgages for Fannie Mae and Freddie Mac. A servicer does all the back-end work to collect mortgage payments and make appropriate distributions to Fannie and Freddie in exchange for a small service charge assessed as a percentage of the mortgage balance.
Two Harbors buys the "excess" mortgage servicing cash flows, or the money left over after all costs to actually service the mortgages. It's not building out call centers or hiring staff to do the data entry. Two Harbors is paying for the excess cash flows by buying them from mortgage servicing companies.
Mortgage servicers make money when borrowers make their payments. However, it's quite possible to lose money on MSRs. If, for example, a borrower refinances a mortgage, the MSR on that particular mortgage goes to zero as the balance shifts to a new mortgage, and to a new servicer.
If you think this through to its logical conclusion, you quickly realize that as interest rates go down and mortgages are refinanced, MSR values drop. As rates go up, MSR values go up. Thus, the value of an MSR is directly related to interest rates. The value of a mortgage-backed security is inversely related to interest rates.
Using MSRs as a hedge
Most mortgage REITs have to pay for swaptions, interest rate swaps, and other derivatives to hedge against some of the impact of interest rate volatility. When American Capital Agency reported its second-quarter earnings, it revealed interest rate swaps worth $55.7 billion.
These swaps aren't free. American Capital Agency paid a net weighted average of 1.23% per year in the most recent quarter to maintain this hedge, according to slide 27 of its second-quarter shareholder presentation. That's money that American Capital Agency can't pay out in a dividend or reinvest in new mortgages.
This is where Two Harbors' strategy with MSRs really pays off. Two Harbors acquires MSRs to make money by processing mortgages. Along the way, it also allows Two Harbors to save money on hedges, because its MSRs are positively correlated to interest rate movements.
In effect, Two Harbors gets paid to hedge its portfolio of mortgage-backed securities, whereas it costs American Capital Agency to hedge its portfolio.
MSRs offer double-digit payoffs
Two Harbors Chief Investment Officer William Roth had this to say about MSRs on the last earnings call: "I think we said in the past that we thought yields were in the low double-digits on the excess MSRs. So, that's after extracting all costs." Two Harbors is clearly getting a great return on its MSR purchases.
Of course, Two Harbors can't perfectly hedge its mortgage-backed securities with mortgage servicing rights. And the MSRs it owns are still a relatively small part of its total net asset value. However, investors should commend the company for taking steps to create shareholder value with hedges that provide income along the way.
When Two Harbors reports earnings in November, investors should carefully examine how it has changed its hedging mechanisms. The company reported last quarter that it cut its hedges in July, but that it was still net-short mortgage-backed securities, meaning it would make money as rates rise.
If Two Harbors reports a larger position in MSRs, it should be able to reduce the hedges it has on its books, while adding cash-flowing assets that can support the dividend in a volatile interest rate environment. That's good news for shareholders.
Even More Premium Stock Picks
Dividend stocks can make you rich. It's as simple as that. While they don't garner the notoriety of high-flying growth stocks, they're also less likely to crash and burn. And over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine. With this in mind, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.