For just about every mortgage REIT, the COVID-19 crisis has been devastating financially. No strategy was safe during this period, as even REITs with government guaranteed assets saw book values take dramatic hits.

In particular, the volatility in the month of March was unprecedented, as bonds traded like tech stocks. While nearly every major mortgage REIT reacted by deleveraging, they made different choices as to which securities to sell and which to retain. Here is how one handled it. 

Blocks balanced on top of stacks of coins, spelling COVID-19

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A rough quarter

Two Harbors (NYSE:TWO) is a mortgage REIT that invests in government-guaranteed mortgage backed securities, non-government-guaranteed mortgages, and mortgage servicing rights. The first quarter hit the company particularly hard, with book value per share falling over 50% from $14.54 per share to $6.96. Total assets fell from $41 billion to $21 billion and the dividend was dramatically cut. Year to date, the stock is down 70%. Two Harbors' Co-Chief Investment Officer Mark Koeppen had this to say about what happened: 

In March, the COVID-19 pandemic had a swift and dramatic effect on volatility, leading to unprecedented spread widening across many asset classes. In response to this crisis, we de-levered, reduced risk and raised excess cash. We sold Agency RMBS, both specified pools and TBAs. We also sold substantially all of our non-Agency portfolio, eliminating the risks of continued outsized margin calls and ongoing funding concerns associated with the significant spread widening on these assets. As a result of these decisive actions, we are strongly positioned from a liquidity perspective to manage upcoming cash requirements.

Two Harbors sells its credit portfolio

Unlike Chimera, which unloaded its government-guaranteed assets to focus on credit assets, Two Harbors chose the exact opposite strategy, selling its credit portfolio and retaining its government-guaranteed assets. Margin calls were the most immediate issue facing mortgage REITs, since the typical REIT uses its own assets as collateral for loans. As the value of the collateral falls, the REIT must come up with additional cash in accordance with the repurchase agreement. If the REIT doesn't have the cash, then it must sell assets.

Two Harbors started the quarter with $3.6 billion in non-government-guaranteed assets, but by the end of the period, it had almost nothing left. The company also went from $27.8 billion in agency mortgage backed securities to $17.8 billion. 

Servicing will be challenged going forward

Two Harbors still has its mortgage servicing portfolio and will be challenged with forbearance issues going forward. Mortgage servicing is a business that involves handling the day-to-day administration of a portfolio of mortgages. Servicers send out the monthly bills, collect the monthly payments, ensure property taxes and insurance are paid, handle address changes, and deal with the borrowers when they miss payments. As compensation for this service, the servicer usually gets 0.25% of the outstanding mortgage balance.

In normal environments, this is a pedestrian business; however, these are not normal times. When a borrower fails to make a payment, the servicer is required to reach into its own pocket and pay the missing payment to the ultimate owner of the mortgage. When defaults are low, this requirement can be handled easily, but if 15% of the mortgage book stops paying, it can ruin a non-bank servicer. On the conference call, Two Harbors mentioned it is in discussions for a credit line to fund these payments, and the company has the liquidity to survive even higher delinquency amounts. 

With Two Harbors stock trading at a 36% discount to book value, it is certainly interesting, given its mainly agency exposure. It is probably too risky until we get an announcement that the company has secured an advance line and we have a better idea of what the forbearance numbers are going to look like. The dividend of $0.05 per share each quarter (down from $0.40) works out to be a 4.3% dividend yield, which is certainly low for a mortgage REIT. However, Two Harbors is one of those stocks to bookmark and revisit in a month or two. 

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