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Two Harbors Investment Corp (NYSE:TWO)
Q2 2019 Earnings Call
Aug 7, 2019, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, please continue to stand by. We are experiencing a momentary interruption in today's conference. Thank you for your patience, and please continue to hold. [Technical Issues].

Ladies and gentlemen, apologies for the technical difficulties. Good morning. My name is Garode [Phonetic], and I will be your conference facilitator. At this time, I would like to welcome everyone to Two Harbors' Second Quarter 2019 Financial Results Conference Call. All participants will be in a listen-only mode. After the speakers' remarks, there will be a question-and-answers period. I would now like to turn the conference over to Maggie Field with Investor Relations for Two Harbors. Please go ahead.

Maggie Field -- Investor Relations

Thank you, and good morning, everyone. Thank you for joining our call to discuss Two Harbors' second quarter 2019 financial results. With me on the call this morning are Tom Siering, our President and CEO; Mary Riskey, our CFO; and Bill Roth, our CIO. After my introductory comments, Tom will provide an overview of our quarterly results and long-term strategy; Mary will highlight key items from our financials; and Bill will review our portfolio and investment opportunities. The press release and financial tables associated with today's call were filed yesterday with the SEC. If you do not have a copy, you may find them on our website or on the SEC's website at sec.gov. In our earnings release and slides, which are posted in the Investor Relations section of our website, we have provided a reconciliation of GAAP to non-GAAP financial measures. We urge you to review this information in conjunction with today's call. I would also like to mention that this call is being webcast and may be accessed on our website in the same location.

Before I turn the call over to Tom, I would like to remind you that remarks made by management during this conference call and the supporting slides may include forward-looking statements. Forward-looking statements are based on the current beliefs and expectations of management, and actual results may be materially different because of a variety of risks and other factors. Such statements are typically associated with the words such as anticipate, expect, estimate and believe, or other such words. We caution investors not to rely unduly on forward-looking statements.

Two Harbors describes these risks and uncertainties in its annual report on Form 10-K for the fiscal year ended December 31st 2018 and in other filings it makes or may make with the SEC from time to time, which are available in the Investor Relations section of Two Harbors' website and on the SEC's website at sec.gov. Except as may be required by law, Two Harbors does not update forward-looking statements and expressly disclaims any obligation to do so.

I will now turn the call over to Tom.

Thomas Siering -- Chief Executive Officer, President and Director

Thank you, Maggie, and good morning, everyone. We hope that you had a chance to review our earnings press release and presentation that we issued last night. Please turn to Slide 3 to review our results. This quarter was highlighted by our strong book value growth. We delivered a 5.4% quarterly return on book value and a 14.7% return on book value for the first half of 2019. Our book value performance was a result of both portfolio positioning and active hedging. We're also pleased to have completed our first MSR securitization in the quarter, which has competitive terms compared to our bilateral facilities and gives us more financing flexibility for MSR.

Please turn to Slide 4. In the second quarter, our sector traded under stock price pressure, which we believe was driven by dividend cut concerns, lower interest rates, and a flatter yield curve, as well as an emergence of faster money buyers and sellers, which created more intraday volume and volatility. As you know, our goal is to deliver book value stability through a variety of market environments. We construct our portfolio with this long-term focus in mind, while endeavoring to minimize the impact of short-term changes in rates. In particular, we believe our strategy of pairing MSR with Agency RMBS generate some more stable, risk-adjusted return throughout market cycles compared to hedging agencies with swaps only.

Additionally, our unique portfolio of legacy non-Agency securities is one that can't be easily replicated. And we believe this strategy will continue to generate attractive returns given the strong tailwinds in housing. On this slide, you can see how these differentiating factors have resulted in total stockholder outperformance of 45% since our inception. Recently, we have received some questions on possible GSE reform. We think it is unlikely that anything of substance happens prior to the 2020 election. Obviously, that outcome could greatly influence any reform efforts.

Finally, I would like to congratulate Bill on behalf of Two Harbors on his retirement at the end of the year. Under his leadership, we have built a strong team of investment professionals. I would also like to congratulate Bill Greenberg and Matt Koeppen on their appointment as Co-Chief Investment Officers beginning in 2020. We have a great team at Two Harbors, and we're very excited about the opportunities ahead.

I will now turn the call over to Mary to review our financial results.

Mary Riskey -- Chief Financial Officer

Thank you, Tom. Turning to Slide 5, let's review our financial results for the second quarter. We generated comprehensive income of $201 million or $0.74 per share and our book value was $14.17 per share, compared to $13.83 at March 31st. The increase in book value was primarily driven by the outperformance of higher coupon Agencies and specified pools, with MSR performing as expected and offsetting current coupons spread widening. Credit spreads also improved and contributed to positive book value. Finally, I'd note that through the end of July, our third quarter book value is up between 2% to 3% after accruing for dividends.

Moving to Slide 6, let's review our core earnings results. Core earnings, including dollar roll income, was $0.39 per share in the second quarter, representing a return on average common equity of 11.1%. Core earnings was impacted primarily by the higher prepayment environment. However, we also realized a minor impact from the compression of the LIBOR-repo spread. We avoided much of the effects from spread widening that occurred in the first half of this year by maintaining longer repo maturities. We do expect to see a small impact from this in the third quarter. However, we are actively managing our repo laddering to minimize both costs and exposures.

I'd like to take a brief moment to discuss the change we made this quarter to core earnings. The change involves the modifications approach we used to calculate MSR amortization. Specifically, an adjustment for any gain or loss on the capital used to purchase the MSR. We recognize that core earnings is an important metric to the investment community. We believe that our new approach allows core earnings to better reflect how the carry earned on MSR varies as a function of prepayment rates. As such, we believe it is a much improved and more accurate reflection of the economic returns our portfolio can generate. Further details are provided in the appendix Slide 19.

Finally, I'd note that our other operating expense ratio, excluding non-cash LTIP amortization was 1%, down slightly from 1.2% in the first quarter. As a reminder, we anticipate that our expenses will remain stable in the low 1s in 2019.

Turning to Slide 7, our portfolio yield declined in the quarter to 3.93%. This was primarily driven by lower Agency yields reflective of a lower rate and higher prepayment environment. We also purchased this kind of legacy non-Agencies at lower base yields. However, as we discussed in the past, we anticipate that over time, these kind of bonds will generate double-digit total returns through a combination of both strong yields and price appreciation.

Now, let's review our financing profile as shown on Slide 8. Our economic debt-to-equity ratio, which includes the implied debt on our TBA positions, was 7.8 times at June 30th. Our average economic debt-to-equity was up slightly quarter over quarter at 7.2 times from 7 times. Our diverse financing profile includes a mix of traditional repo, convertible debt, revolving credit facilities, and MSR-secured term loans. We have 25 active Agency repo counterparties, and the market continues to function efficiently for us. As I mentioned earlier, we are focused on managing the laddering of our repo maturities to minimize costs and exposure to repo LIBOR spread changes. The improvement in financing for both MSR and non-Agencies presents an ongoing opportunity for our business. On the MSR front, we closed our first financing securitization this quarter. This $400 million securitization of five-year secured term notes as 12-month prepayment protection and a spread of LIBOR plus 280. The benefits of the structure includes scalability, competitive advance rates and pricing, and the length of the term is greater than bilateral facilities. Across all of our bilateral MSR facilities, we had $300 million outstanding with a total capacity of $790 million as of June 30th. With respect to non-Agencies, our cuts and spreads have continued to be favorable and more consistent quarter over quarter.

With that, I will now turn the call over to Bill for our portfolio update.

William Roth -- Chief Investment Officer and Director

Thank you, Mary. And good morning, everyone. Please turn to Slide 9. In the second quarter, global growth concerns, especially trade issues with China and Mexico, fueled the rally in interest rates and impacted economic growth expectations. This resulted in a flatter yield curve and three-month LIBOR above most longer term rates. This curve shape reflects the market's expectation that the Fed will lower rates, which ended up occurring in July, and the anticipation is that there will be further rate cuts in the latter half of 2019. In the mortgage market, the Agency basis widened, with current coupons widening by about a point while higher coupon mortgages outperformed widening only by about three-eighths of a point.

Specified pools performed quite well in the rally, offsetting much of the basis widening. MSR performed as expected, declining in value in line with its duration and current coupon spread. Residential credit assets continued to perform well. Discounted legacy non-Agencies benefited from lower expected forward LIBOR, which would have the effect of increasing the excess spread available to cover future losses. As a result, prices were modestly higher by about 1 point.

Let's move to Slide 10 to review our portfolio, which at June 30th, was comprised of $32 billion of assets and about $9 billion of net long TBA. From a capital allocation perspective, 76% of capital was allocated to our rate strategy and 24% to credit. In terms of portfolio activity, as the market rallied in the quarter, we added Agency RMBS in part to manage our duration exposure, but also to take advantage of the wider spreads available in the market. Specifically, we added approximately $5.7 billion of 3.5% and 4% coupon lower pay-up specified pools. We think that these bonds have excellent prepayment protection and convexity characteristics at reasonable prices.

We also reduced our 4.5% and 5% coupon higher pay-up specified pool position by approximately $950 million, as we felt these pools were priced at levels that had more risk than reward. Despite the higher Agency balances, however, our exposure to mortgage spread was slightly lower, since our mortgage spread risk declines as interest rates fall. One question we've been getting recently is our outlook for leverage, as it has been drifting higher the past few quarters. We think about leverage in our portfolio from a risk exposure standpoint, similar to the way we think about interest rate exposure. In short, our focus is more on the sensitivity of book value relative to movements in mortgage spread than it is on just the nominal leverage number. Although this quarter we added Agencies which increased our leverage, our mortgage spread risk actually declined.

As we've discussed in the past, and as you will see on the next slide, we continue to believe that pairing Agencies with MSR allows us to have higher Agency leverage but with lower overall risk. We are comfortable with our current level of leverage and do not expect it to change materially from here. On the MSR front, we did not purchase any bulk servicing in the quarter, as we didn't see any packages that met our criteria either collateral wise or price wise. We do expect to see a pickup in transaction volume in the second half of 2019, as there will likely be an increase in supply driven by higher refinance volume. Finally, in our credit strategy, we added approximately $370 million in market value of discounted legacy non-Agency, which, at an average price of $58, we believe have the potential for upside price appreciation.

Turning to Slide 11, let's discuss our risk positioning. As seen on the top of this slide, our exposure to changes in rates remain small. Consistent with our typical practice in the second quarter, we utilized an extensive amount of swaptions and mortgage options to protect our portfolio against big rate moves, either higher or lower. This hedging practice contributed to our strong performance. The bottom cable of this slide shows our spread exposures to rates up and down 25 and 50 basis points. As we've discussed in the past, MSR has negative duration and hedges both interest rate and mortgage spread risk, which you can see in this table.

Please turn to Slide 12. The second quarter presented an interesting rate environment with a flat yield curve LIBOR elevated relative to longer term rates and the potential for increased refinance activity. Nonetheless, we delivered strong returns because of our portfolio positioning. Principally, holding higher coupons, specified pools and MSR; and also because of our dynamic use of options in hedging. Given the current market backdrop, we believe that we've positioned both our rates and credit strategies to deliver strong long-term risk-adjusted returns. In our rate strategy, we view levered returns on Agencies as currently in the low double-digit range. We continue to believe our holdings of specified pools and higher coupons will generate attractive long-term returns.

Returns on Agency paired with MSR are also in the low double digits. But, as we discussed on the last slide, this comes with a lower risk profile. I'd like to spend a moment highlighting the total return opportunity that exists in our credit strategy. We believe that our portfolio of legacy non-Agencies will continue to benefit from the strengthening housing market. Additionally, the lower rate environment is beneficial to our discounted portfolio. Residential credit tailwinds have been strong. And as you can see in the charts on this slide, subprime non-Agency prepayments have increased while loss metrics have come down. Continued reequification over time has resulted in, and can continue to result in, increased prepayments and lower delinquencies, defaults, and severities. We believe these favorable dynamics will persist, driving bond prices higher and generating strong total returns going forward.

Despite the fact that the legacy non-Agency sector is shrinking, we have a substantial and unique portfolio of deeply discounted bond and we continue to find pockets of value and opportunities to add to our holdings.

In conclusion, we believe that we have positioned our portfolio through both security selection and active hedging to drive strong returns over the long term. We are very excited about the opportunities in both our rates and credit strategies in the latter half of 2019 and beyond.

I will now turn the call back to the Operator for Q&A.

Questions and Answers:

Operator

[Operator Instructions] We will take our first question from Doug Harter. Please go ahead, your line is open.

Doug Harter -- Credit Suisse -- Analyst

Thanks. Obviously, the kind of the start to August has been quite volatile. If you could just talk about kind of how your rate positioning is for kind of this -- this kind of magnitude of rate declines we've seen and kind of how how you see the prepay outlook changing with this move?

Thomas Siering -- Chief Executive Officer, President and Director

Sure. Good morning, Doug. How are you?

Doug Harter -- Credit Suisse -- Analyst

I'm [Speech Overlap].

Thomas Siering -- Chief Executive Officer, President and Director

First of all, I'd like to apologize for the technical glitch we had this morning. With that I'll turn your question to Bill.

William Roth -- Chief Investment Officer and Director

Hey, Doug. Thanks for joining us. Yeah, so there were a couple questions in there. I think, Slide 11 is sort of a relatively good depiction of where we were at the end of June. We continue to maintain a slightly long bias and duration. But we have a substantial amount of -- I talked on the call, and one of the things that benefit us through the second quarter is the extensive use of options. Certainly, as markets become more volatile, and with around protecting the mortgage -- the portfolio by use of options is very important and effective. In terms of what we've seen in August, it's a little hard to make sense of what's going on, but we continue to stay close to home. If the primary rate comes down, and it's been pretty sticky so far, but I guess it depends on what rate level we settle at. If the primary rate comes down, then I think you'll see a reasonable pickup in generic prepays or prepays on generic collateral. One of the reasons that we've been active -- continue to be active in adding specified pool, especially off of lower coupons as I discussed on the call, is because that creates more stability in the portfolio, it's easier to hedge and there's less prepay volatility there. So we continue to move in that direction.

Thomas Siering -- Chief Executive Officer, President and Director

Yeah, the team has done a really good job managing this, Doug, and that continues into August as well.

Doug Harter -- Credit Suisse -- Analyst

Great. Just, I guess, on that. The relative -- where do you see relative attractiveness of kind of specified pools today, obviously, given the commentary that generic speed's going to likely continue to increase, but obviously pay-ups have increased substantially?

William Roth -- Chief Investment Officer and Director

Yeah, great question. Yeah, I think, the positioning that we talked about on the call is representative of what where we think value is. We've been trying to buy lower pay-up off of, say, 3.5s. We haven't seen as much off of 3s yet, but we sold pools that had performed very well and pay-ups went up quite a bit off higher coupons. And so by recycling into lower pay-ups of lower coupons, we come up with better convexity, with less premium at risk. And we think those represent good value and we continue to pursue those.

Doug Harter -- Credit Suisse -- Analyst

Great. Thank you, Bill and Tom.

Operator

Thank you. We will now take our next question from Mark DeVries.

Mark DeVries -- Barclays -- Analyst

Yeah, thanks. Let me be the first to congratulate you, Bill, on your retirement and then we may have you for another [Indecipherable]. It's been a pleasure working with you over the years. First question. As you noted in the previous remarks, leverage went up almost more than a half turn on the quarter, although it sounds like part of that was efforts to manage both spread and duration risk. Are there any implications we should think about, though, from the higher leverage in terms of higher earnings power at the end of the quarter versus the average for the quarter?

William Roth -- Chief Investment Officer and Director

Hey, Mark. Well, thanks for the good wishes. I appreciate, enjoyed working with you as well. The average economic leverage for the quarter went from 7 to 7.2, and keep in mind that we think of leverage in terms of including net TBA because that is economic leverage. And I think, as we discussed on the call, we read -- frankly think about really more our risk metrics, which we talked about on Slide 11, which is -- because we have MSR, MSR helps dramatically hedge mortgage spread risk. So even though we have more agencies, we actually have less risk to spread moves. That being said, we do not expect to see leverage change materially from the levels that we've been running recently.

Thomas Siering -- Chief Executive Officer, President and Director

Yeah. Leverage in isolation is sort of a hollow metric, Mark. Really we think in terms of risk over cattlemen headline of leverage metrics. Obviously, that's an important number, but in isolation, it doesn't mean all that much.

Mark DeVries -- Barclays -- Analyst

Okay, fair enough. So, thank you. You also noted that through some of the levering -- I'm sorry, laddering of your maturities on repo, you've at least mitigated some of the impact of the bit of a dislocation we've seen in that kind of repo LIBOR spread. But how much of a drag is that on earnings? And if that normalizes, how much of a lift might we see from kind of core earnings?

William Roth -- Chief Investment Officer and Director

Yeah, that's a great question. Mary is going to answer that one. Thanks.

Mary Riskey -- Chief Financial Officer

Good morning, Mark. So yes, we realize it's a small impact in Q2, about $0.01 per share, due to our maintaining the longer repo maturities. I think repo costs, obviously, haven't come down like the rest of short term rates. And it's not really the availability, but really the pricing. We are keeping our eyes on it and expect it to normalize as time passes.

Mark DeVries -- Barclays -- Analyst

Okay, got it. Thank you.

William Roth -- Chief Investment Officer and Director

Thank you.

Operator

Thank you. We will now take our next question from Bose George. Please go ahead, your line is open.

Bose George -- Keefe Bruyette & Woods -- Analyst

Hey, good morning. Just in terms of incremental returns, you gave us some numbers on that. But I'm just curious how the incremental kind of spreads that you're getting compares to the level you were in the quarter?

William Roth -- Chief Investment Officer and Director

Could you rephrase that, Bose? I'm [Speech Overlap].

Bose George -- Keefe Bruyette & Woods -- Analyst

Sure. Just the spreads on new investments and how that compares to the, I guess, the 138 basis points spread you guys had at quarter end.

William Roth -- Chief Investment Officer and Director

Yeah. Well, I'd say a couple of things. The first thing, as we talked on the call about our expected total returns, that we we think we can realize generally being in the low double digits, and then on the non-Agency, clearly, we've talked about this in the past, sort of the baseline is lower than what we think that is the total return will be. If you think about it, right, we talked about the NIM, the prepays, the repo spreads, and then obviously, some purchases at lower yields of assets. But, as you know, we don't really manage our portfolio, based on a NIM; we really are thinking about it in terms of where we can generate the best total returns, while keeping book value to stable. So I think it's kind of hard to talk about the read these of the -- today versus a historical accounting spread. Rather, we think about the returns that we discussed on the call, low double digits, and then potentially strong total returns on non-Agency being better than that.

Bose George -- Keefe Bruyette & Woods -- Analyst

The -- So then maybe just in terms of the low double -- the returns, from an ROE standpoint -- I mean, just give this a bit of a range. So is that similar to what you have in the portfolio, is it a little lower, or just how would you characterize it versus the ROE you generated this quarter?

William Roth -- Chief Investment Officer and Director

Well, I think it's probably pretty similar to what we saw this quarter. I mean, obviously, one of the things we've been positioned in has been the higher coupons and the specifies which did well last quarter. They continue to do well this quarter. Mary talked about our performance through July and in the -- so far this quarter, and so I think that's relatively consistent with what we saw.

Thomas Siering -- Chief Executive Officer, President and Director

Yeah. Bose, we're the kind of people that [Indecipherable], we have our hat firmly in our hand. For instance, in the fourth quarter, we were very honest about our disappointment on our performance. So this was a great quarter for us. We generated a lot of alpha, and the opportunities for us going forward are abundant. So we're excited.

Bose George -- Keefe Bruyette & Woods -- Analyst

Okay, great. Thanks. And then actually just on the MSR securitization that you guys did, should we think of that more as a -- just a better structure because of the term funding? Or is there a -- any funding benefit as well from that?

Mary Riskey -- Chief Financial Officer

Good morning, Bose. So I think -- We think of it -- a number of benefits from it. The term is definitely beneficial, the scalability, the ability to add additional terminals in the future, and it's not [Indecipherable].

Bose George -- Keefe Bruyette & Woods -- Analyst

Okay, great. Thanks. And then actually one, just on the regulatory side. You noted that GSE reform is unlikely, but just curious what your take is on how the QM patch issue gets resolved.

William Roth -- Chief Investment Officer and Director

Yeah, that's a good one. I think what we saw was sort of an initial shot across the bow, if you will. I think it sounds like FHFA, they would like to get a number of things accomplished and yet at the same time, it seems like Mr. Calabria has -- also aware that there's a lot of this that might need legislation. And so I think by putting something out there on the QM patch expiring, the idea is not necessarily to have it expire but maybe have a discussion and a dialogue as to what should it look like and how can the GSEs continue to support housing but with a modified footprint. So I think that -- I think this is just the beginning of the discussion of how that patch and how that -- the QM -- how that's gonna play out and I think it'll probably take a decent amount of time.

Bose George -- Keefe Bruyette & Woods -- Analyst

Okay. That helps, thanks. And let me add my congratulations to you, Bill, on your retirement and to Bill Greenberg and Matt, on their promotions as well.

William Roth -- Chief Investment Officer and Director

Thank you.

Operator

Thank you. We will now take our next question from Trevor Cranston.

Trevor Cranston -- JMP Securities -- Analyst

Hey, thanks. Good morning, and I'll add my congratulations on your retirement, Bill. Question on the the updated methodology you're using for your core earnings calculation on the MSR amortization. I guess I wanted to make sure I understand the change better. Is the new method that you're using, I guess similar to what we would think of in the Agency MBS market is using like a lifetime-assumed yield on the MSR that you're multiplying by the amortized cost or maybe you can just expand a little bit on exactly what the change was there and how we should think about modeling that going forward?

Mary Riskey -- Chief Financial Officer

[Indecipherable], Trevor. This is Mary. So as I discussed the merits, we did modify the amortization to include an adjustment for the gain or loss on the capital used to purchase the MSR. So this is consistent with the rest of our portfolio where the hedging or the gains and losses on our RMBS portfolio are not included in the core earnings. Appendix Slide 19 provides some more details, but I think you can think about MSR for income as the amortized cost at the beginning of the period times the original pricing yield. And we really believe this is a more accurate reflection of economic return and the carry-on MSR.

Trevor Cranston -- JMP Securities -- Analyst

Okay, so I guess -- So when we think about, for example, this, like third quarter today where rates have dropped significantly, does the new methodology imply that there wouldn't be a significant uptick in amortization because the original pricing yield hasn't changed or am I not thinking about that correctly?

Mary Riskey -- Chief Financial Officer

Yes, that's correct.

Trevor Cranston -- JMP Securities -- Analyst

Okay, great. Thank you. And then second question, I guess more on the macro side. With the volatility we've seen this quarter and expectations for the Fed to likely continue dropping rates pretty significantly, just curious if you guys had any thoughts on the likelihood, if we do continue to see things move lower in the rates market, if you think the Fed would be likely to potentially reinstitute balance sheet growth or the QE programs and whether or not you think that might be focused on the MBS market?

Thomas Siering -- Chief Executive Officer, President and Director

Yes, great question. Matt Koeppen is here. He's going to answer that one for you.

Matthew Koeppen -- Managing Director, Co-Deputy Chief Investment Officer

Hello. That's an interesting question. Maybe some other people in the room want to weigh in. It's a -- We're definitely in the midst of a transitioning market here. Back to the world where we're in a low-rate environment and the Fed is cutting. We definitely [Technical Issues] here, I think you would expect to see, in a higher volatility environment, mortgages continuing to be under pressure. I think in terms of looking forward to QE again, I don't think anybody is really talking about that or discussing that. That seems that's probably lays down the road. But we are continuing to -- like we said earlier, we are continuing to manage the portfolio consistent with how we have in the past. We're certainly glad in an environment like this to be maintaining low risk exposures, low duration, anmd low spread risk. This is the environment that we talked about and prepared for lots of time. So we feel like we're holding it fairly well.

Trevor Cranston -- JMP Securities -- Analyst

Okay, great. Appreciate the comments, thank you.

Operator

Thank you. We will now take our next question from Rick Shane. Please go ahead, your line is open.

Rick Shane -- JPMorgan -- Analyst

Hey, guys. Thanks for taking my question. And, Bill, those looks that everybody's giving you at the table are jealousy; congratulations.

William Roth -- Chief Investment Officer and Director

Thank you, Rick. I appreciate that.

Thomas Siering -- Chief Executive Officer, President and Director

That's a good one, Rick.

Rick Shane -- JPMorgan -- Analyst

I have my moment. Hey, Tom, you talked about the alpha that you guys created in the quarter and it's -- given the challenging quarter, it really stands out and I think we understand a lot of it. I think the call-protected or the prepayment-protected Agency MBS did very well. Obviously, some challenges on the MSR side. But when we look through the details, there are some significant gains, these are realized gains, on swaps. That really make sense to us. There's $97 million of realized gains on other derivatives. What is that and just help us understand when you think about outperformance this quarter, what the puts and takes were?

Thomas Siering -- Chief Executive Officer, President and Director

Yeah. Thanks for that question, Rick. Bill Greenberg is going to take that one.

William Greenberg -- Managing Director, Co-Deputy Chief Investment Officer

Yes. Hi, Rick. Good to talk to you. You mentioned some causes for our outperformance this quarter and i would say that there is a really threefold. One, it was -- [Indecipherable] coolest one is the asset selection that we have are focused on being exclusive higher [Phonetic] coupons is one. The goodness [Indecipherable] our portfolio, which reduces our overall more spread risk is another. And then lastly, as was alluded to on the call, our active hedging strategy and experience. I think all three of those things really contributed a lot. I think, without going -- without delving too much into detail to what exactly we are talking about [Phonetic], I would expect that those we let gains on those reviews result from realizing gains on options that we had, typically when we buy, say, out-of-the-money options in order to hedge for retail risk and the market rallies, those options become in the money or at the money, and rather than keeping them there with reduced convexity benefit, we will roll those options into one-third further out of the money. And I expect that those gains result from that.

Rick Shane -- JPMorgan -- Analyst

Got it. And is now why the notional is on the swaps and the swaptions didn't seem to change much; it was that you took the swaptions and rolled them.?

William Greenberg -- Managing Director, Co-Deputy Chief Investment Officer

Yeah, that's right.

Rick Shane -- JPMorgan -- Analyst

Great. Thank you, guys.

William Greenberg -- Managing Director, Co-Deputy Chief Investment Officer

So things were [Indecipherable] by swaptions at some, again, forget about the portfolio effect [Phonetic] some price market rallies, they go up in value. Their convexity increases for a little while, and then it starts to decrease. And then in order to maintain the convexity benefits of protection that we want, for continued rate rallies, we basically will sell those and buy other ones, oftentimes at equal notionals and will reset the value of the convexity and the portfolio protection characteristics.

Rick Shane -- JPMorgan -- Analyst

Got it. Okay. Perfect. Thank you very much.

Operator

Thank you. We will now take our next question from Matthew Howlett. Please go ahead, Matthew, your line is open.

Matthew Howlett -- Instinet, A Normura Company -- Analyst

Hey, guys. Thanks a lot and Bill, congrats. Just two questions. First, on the MSR. Bill, did I hear you correct that you said the UPB sort of would start to pick up the portfolio on a UP [Phonetic] basis, would start to grow again in the third quarter with flow arrangements? And then what would it take -- You said you're out of the bulk market, but what would it take to get more active? Is that more just where prices come down to, or is it just more of an outlook of where you think speeds are going to ultimately end up?

William Roth -- Chief Investment Officer and Director

Hey, Matt. Thank you, appreciate the good wishes. Yes, so a couple of things. First, we have seen slow volumes pick up, which is not surprising given that we started to see higher refinancings come in. Just to be clear, we are not out of the bulk market. We bought number of packages first quarter, as you know, and we did not buy any -- close any in the second quarter, but that was more function of what was available and the prices and the collateral. So it was more, sort of like saying, well, we didn't see any bonds, we liked the prices that they were trading at.

We do expect to see an increase in our bulk volumes through the remainder of the year. Obviously, there's a lot of volatility lately. So there might be a little bit of a pause from potential sellers until the market settles down a bit, but given that refi volumes are clearly picking up, we would expect the second half of the year, eventually, to see pick up in bulk volumes and we anticipate participating if the prices make sense to us.

Matthew Howlett -- Instinet, A Normura Company -- Analyst

Got it. Okay. And what explains sort of the lack of packages coming out in the second quarter? Was it just the sellers didn't like the prices, or gain on sale margins have improved that they don't need to sell them as ours?

William Roth -- Chief Investment Officer and Director

Well, we don't originate loans and look at whether we should keep the servicing or not, but I can tell you first that volumes earlier in the year were quite substantial. One thing that we did see as the market rallied, was we did see people who wanted to get a certain price hold off because they thought -- well they wanted yesterday's price effectively and so there were a lot of packages that didn't trade, that might have traded. But if somebody makes them and maybe they don't hedge and keep the duration in line with what the market is doing, they might just say-- well, I'll wait. So I think there -- it was a combination of factors. As you know, once the mark -- rates get to a certain point and stabilize and there's more visibility and clarity, what I'll call the bid offer, if you will, will tighten up and you'll see a lot more transaction volume.

Matthew Howlett -- Instinet, A Normura Company -- Analyst

Got it. Okay. By the way, just one question, the FHLB advances. I know you took that; I'm just curious on what -- why you decided to take that down.

Mary Riskey -- Chief Financial Officer

Sure. So we had advances that were rolling off. We still maintained $50 million position with a much longer term. We value that relationship, but we -- with the Agency book, the advances and rates are not better than what we can get in the repo market.

Thomas Siering -- Chief Executive Officer, President and Director

Yeah. We're always [Speech Overlap] most economically, the short answer.

Matthew Howlett -- Instinet, A Normura Company -- Analyst

Right, the wholesale markets had a little bit better finance and a little bit better -- Okay, then the last thing just on the -- I know you guys had sort of low double digit on the Agency -- just the Agency. This is putting aside the MSRs for a second. Is there -- When you look at the spread, the realized spread was 1.1%. When you look at sort of 3Q, you have this dynamic where in the Fed cut and swap ratio going down yet, prepays looked like there were up about 30% in July and the yields are lower. [Indecipherable] Can we expect that spread to be stable, sort of almost -- sort of everything taken together and [Indecipherable] get any sort of color on where that spread could head in 3Q?

William Roth -- Chief Investment Officer and Director

Sure. Yes, I mean, some of the things you say about, obviously, prepays were up, etc, and there's a question of what is the yield on the cheapest to deliver, if you will. When we look at the point capital, whether it's in credit side, or on the Agency side, we're basically surveying across all coupons, all collateral types, all specified pool types, etc, and accessing what we think is the most attractive. That's sort of what we view our jobs as, to drive long-term returns. So as a result, when we cite those kind of returns, we're really looking at what we think is the best of what we can purchase, which is definitely not necessarily the cheapest to deliver or the TBA, which is arguably not going to be nearly as attractive as certain specified pool.

Matthew Howlett -- Instinet, A Normura Company -- Analyst

All right, guys. It's very just really asset selection literally what it all really comes down to, as you look at the portfolio.

William Roth -- Chief Investment Officer and Director

That's exactly correct.

Thomas Siering -- Chief Executive Officer, President and Director

That's the name of the game.

Matthew Howlett -- Instinet, A Normura Company -- Analyst

Yeah, great. Well, congrats on a really solid quarter. Thanks again and congrats, Bill.

William Roth -- Chief Investment Officer and Director

Thanks. Thank you, Matt.

Thomas Siering -- Chief Executive Officer, President and Director

Thank you very much.

Operator

Thank you. As there are no further questions, I will turn the call back to Ms. Field for concluding comments.

Maggie Field -- Investor Relations

Thank you, and thank you for joining our conference call today. We plan to participate in the Barclays Global Financial Services Conference on September 10th, and our presentation will be webcast live on our website under the Events and Presentations link. We look forward to speaking with you then. Have a wonderful day.

Operator

[Operator Closing Remarks].

Duration: 70 minutes

Call participants:

Maggie Field -- Investor Relations

Thomas Siering -- Chief Executive Officer, President and Director

Mary Riskey -- Chief Financial Officer

William Roth -- Chief Investment Officer and Director

Matthew Koeppen -- Managing Director, Co-Deputy Chief Investment Officer

William Greenberg -- Managing Director, Co-Deputy Chief Investment Officer

Doug Harter -- Credit Suisse -- Analyst

Mark DeVries -- Barclays -- Analyst

Bose George -- Keefe Bruyette & Woods -- Analyst

Trevor Cranston -- JMP Securities -- Analyst

Rick Shane -- JPMorgan -- Analyst

Matthew Howlett -- Instinet, A Normura Company -- Analyst

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