Why Two Harbors Investment Corp Isn't Scared of Higher Interest Rates

Janet Yellen, the Federal Reserve’s first ever Chairwoman is subtly altering the face of US credit markets by managing interest rate expectations, and the only way to decipher its impact on Two Harbors Investments (NYSE: TWO) is through the “dismal science”.

Jul 28, 2014 at 4:23PM
Two

Source: Company.

I believe in pulling the band aid off quickly, so here goes. There's going to be economics in this article.

Buying a home is far from simple, but often people misunderstand it simply as a relationship between you and your mortgage lender. Circa 1950 this may have been an accurate picture of owning a piece of the American Dream, but financing homes is far more complex in today's economy. 

For instance, Janet Yellen, the Federal Reserve's first ever Chairwoman, is subtly altering the face of US credit markets by managing interest rate expectations, and the "dismal science" is our only way to decipher its impact on Two Harbors Investments (NYSE:TWO).

What Two Harbors does
Two Harbors is a niche player. If we're looking at the total market for real estate income trusts (REITs), we see two subcategories: equity REITs and mortgage REITs. They key division here is that equity REITs engage in owning and managing property, whereas mortgage REITs invest in real estate debt.

All mortgage REITs pick between three ways of classifying themselves so we can get a broad sense of what assets they invest in. Agency REITs only buy government backed securities, non-agency REITs stick to the commercial variety, and hybrid REITs are a mixed bag.

Two Harbors is a hybrid REIT with a portfolio of about $3.8 billion.

Two Harbors

What assets they own
An overwhelming portion of Two Harbors portfolio is in residential mortgage backed securities (RMBSes). Here's how they work.

Groups of mortgages are taken -- either by a commercial bank, or a government sponsored enterprise like Fannie Mae or Freddie Mac -- and bundled up as a financial asset to be bought and sold.

Think of an RMBS as a cargo ship sailing from individuals who just paid their mortgage bills to the investors who currently own the asset. The ship may stop at a few ports on the way -- the original lender -- where it can shed a little cargo -- fees -- but the bulk of the revenue is simply passed on to investors.

Since all REITs are mandated to pay out at least 90% of their dividend/interest revenue, both the REIT and the RMBSes are essentially pass-through entities. It's a way for investors who are feeling bullish on housing to see upside without straining their cash flow in search of physical property.

Where the Federal Reserve comes in  
Janet Yellen is in a tricky spot. The Fed rationalized historically low interest rates -- courtesy of their monthly bond purchases -- as fuel necessary to keep the economy going. True to their word, the Fed's Open Market Committee voted to scale back the stimulus early last year when the economy began showing signs of life. 

Now they're hinting at raising interest rates, but they still have to be cautious. These days, just one wrong word from the Fed can spook Wall Street into starting a sell off.  

Regardless, I'm not worried about it. Here's two reasons why:

  1. Any rate increase is going to come in thinly sliced increments. A little downward pressure to house prices is ok, since they already rose 11% in the 12 months preceding March 31, 2014.
  2. Think about the cash flow. A bump in the prime rate hurts borrowers, but it's Christmas for lenders.

Fight the fear
Two Harbors originally came into being as a response to actions undertaken by Fannie Mae and Freddie Mac. In light of the housing collapse, both government controlled lenders had been federalized and forced to rework their balance sheets.

The same fear and groupthink that drove markets toward subprime RMBSes, now kept investors far, far away. No one wanted assets that wreaked havoc on global financial markets, so the subprime debt sold at huge discounts

We know that an asset's price moves in the opposite direction of its yield, meaning that by picking up the cheaply priced securities, Two Harbors was also buying the rights to fat returns. It's amazing how much panic blinds us to the wisdom of buy-low-sell-high!

Luckily, the management team at Two Harbors realized that subprimes weren't destructive by nature; they'd just been misused. Under-regulated and over-leveraged, financial markets had allowed too much of a good thing.

Conclusion
Of course, there're plenty of risk associated with RMBSes. People could pay off their mortgages early -- forestalling a predicted stream of income -- or worse, not pay their mortgages at all. If enough homeowners default on their loans, the REIT could collapse under the weight of its own debt. 

But its important to remember that Yellen is a proven forecaster. So between her, and the clever folks at Two Harbors, we're in good hands.      

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Gaurav Seetharam has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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