Last year was awful for the mortgage space. As the Federal Reserve hiked interest rates, mortgage origination companies saw volumes collapse. Mortgage real estate investment trusts (REITs) saw the assets in their portfolios take a beating. Most mortgage REITs saw big declines in book value per share, and many were forced to cut their dividends.
Two Harbors Investment (TWO -0.72%) was one of the REITs that cut its dividend. That said, the worst might be over for the space.
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Two Harbors focuses on agency mortgage-backed securities and servicing
Two Harbors is an agency and mortgage servicing REIT. It invests primarily in mortgage-backed securities, which are guaranteed by the U.S. government. This means that Two Harbors bears little credit risk on its mortgage-backed security portfolio. But it can be harmed by interest rate movement.
Agency mortgage-backed securities struggled in 2022 as the Federal Reserve aggressively hiked the federal funds rate in an effort to rein in outsized inflation. This caused mortgage-backed securities (MBS) to underperform Treasuries, which translated into declining book values for the mortgage REIT sector.
Mortgage servicing is an unusual asset
Two Harbors also holds a large mortgage servicing portfolio. Mortgage servicing is an unusual asset. Mortgage servicers handle the administrative tasks of a mortgage on behalf of the MBS investor. The servicer sends out the monthly bills, collects the payments, forwards the principal and interest payments to the investor, ensures property taxes are paid, and deals with delinquent borrowers. The mortgage servicer is generally paid a fee of 0.25% of the mortgage loan per year as compensation. So if the mortgage is $400,000, the servicer gets paid $1,000 a year. The right to perform this service is worth something, and Two Harbors includes it as an asset on the balance sheet.
Mortgage servicing is unusual, as it increases in value when interest rates rise. This is because the chance of a loan getting paid off early declines. This means that the mortgage servicer can expect to get that 0.25% fee for a longer period of time. The average interest rate on a loan in Two Harbors' servicing book is 3.27%. With the average mortgage rate at 6.5%, rates would have to fall by a lot to bring the refinancing option back into consideration. Two Harbors is valuing its servicing book at 5.5 times the annual servicing fee, which is on the high side. If rates begin to fall or delinquencies pick up, that multiple will fall.
Widening MBS spreads were a problem, but servicing helped offset some of the losses
The MBS portfolio struggled last year as mortgage-backed security spreads widened. This means that MBSs underperformed Treasuries. From the beginning of 2022 to the end of the third quarter, book value per share fell from $23.47 to $16.42. MBS spreads peaked in October and have narrowed since. This spread narrowing drove an increase in book value per share to $17.72 in the fourth quarter of 2022. If MBS spreads continue to narrow, Two Harbors should see further increases in book value per share.
One of the determinants of MBS spreads is interest rate volatility. Volatility means that security prices are moving quickly and often. Volatility is bad for MBSs in particular, and this was one of the big reasons why those securities struggled so much last year. The Fed Funds futures indicate that the Federal Reserve is close to wrapping up its tightening regime, which will support MBS prices and should help narrow MBS spreads.
Two Harbors cut its quarterly dividend from $0.68 per share to $0.60. That said, earnings available for distribution were only $0.26 last quarter, so the dividend still wasn't covered. In the quarterly presentation, Two Harbors' management said that earnings available for distribution were expected to moderate over the next several quarters and that it could diverge from expected ongoing earnings power. Maybe Two Harbors will be able to maintain the dividend if earnings available for distribution fall, but another dividend cut seems like a risk.
