Q4 book of $11.54. An increase from Q3 despite a small drop in MBS from that quarter to Q4 at 12/31. This is thanks to the nonagency that has driven the returns in that space. Nonagency has continued to do well in Q1, driving further unrealized gains in the area.
Q4 Agency: 6.6% as of Q4, to drop in Q1 as prepayments slow. Positive event. However, Agency mbs has been selling off very hard in Q1. Interest rates have been going up. The hedges help offset some damage but the obvious remains.. a 5 to 7% decrease in NAV. But for the sake of this discussion we give them a 5% decrease to NAV. That means new book is $10.96. Now lets look at how SBY effected the book, it has fallen since the Q4 marks.. so that means the 5% drop in book is very conservative, 7% would most likely be the correct number. But just to error on the side of longs for this, 5% drop altogether given the low leverage compared to peers on the agency side and the mark to market change since Q4 on the SBY position. So $10.96 is NAV today... we assume. Now lets get the dividend factored back in for this, because the stock price is still factoring in some sort of distribution we assume. Lets look at earnings and see what they probably made for Q1.
"Two Harbors reported Core Earnings for the quarter ended December 31, 2012 of $84.0 million, or $0.28 per diluted weighted average common share outstanding, as compared to Core Earnings for the quarter ended September 30, 2012 of $87.1 million, or $0.32 per diluted weighted average common share outstanding."
Declining core earnings. Okay. So In Q3 it was 0.32, and now in Q4 even with a wider spread, it is 0.28. So Q1 I think, since the LOW CPR on agency and no secondary yet.. the spread is about the same. So not much to reinvest to help the spreads. so $0.22 to 0.32 is the CORE EARNINGS range we will assume in this model for Q1. 0.22 is low you would think, but CYS and others did face compressions in Q1 and did make cuts.. Obviously TWO is not CYS.
Okay so TWO Is not CYS but they still could be facing squeezing on net interest margins.. with nonagency space feeling the pinch as the prices have rallied, reducing the spreads there while at the same time reinvestment has been low in agency space because of the LOW CPR and no capital raised to increase the spreads. TWO has made if obvious, from their own remarks in the latest conference call that they will not try to maintain a particular yield and think of things as a "total return basis." Okay, this basically means they are TELLING you.. FORGET ABOUT THE YIELD, ITS GOING TO BE CUT. They said:
"Carrying lower leverage at certain times to protect book value is worth the short-term sacrifice in core earnings. Broadly speaking we continue to target a leverage ratio of six to seven times for the agency portfolio and 1 to 1.5 time for the non-agency portfolio. And we anticipate increasing our leverage on the agency strategy from 5.7 times should valuations look more compelling to us. On the non-agency side, our leverage remains low and within the 1 to 1.5 times range we have historically carried."
They are justifying the dividend cut by saying you are better protected from rising interest rates. The exact opposite it is true too.. if rates go down again, and agency mbs rally (much more likely given the fed purchases at this point) increasing the agency side of MBS would be terrible for net interest margins.. thus they would be forced to sticking with the nonagency side but even there the net interest margins are declining due to the improving fundamentals in the housing market and overall improvement to the nonagency assets reducing yield there on new purchases! Even being "better protected" from a rising rate scenario, A rising rate scenario will still cause damage to the book value as they are still net long agency mbs. It is this reason I expect book value to decline over the near term, with nonagency hedging some of the drop in book value, as well as reduced EPS
$11 pt on the shares. Thats a $9.96 NAV ($1.00 or there abouts to be given as dividend in the form of SBY common shares and that number also factors in the reductions to NAV from Q4 due to the agency mbs sell off. So post distribution you have a $9.96 NAV. That leaves TWO trading at a 10% premium to NAV, a nice premium still due to the company's premium overall total performance.
Overpriced asset: 17% overpriced, includes the distribution of SBY.. total return for a short seller until the correction in price to a 10% premium is about 17% minus any dividend income (core earnings) while we wait. These earnings can be offset by purchasing the preferred shares of another mreit that yields 8% to 8.5%.. RSO-B used to fit the bill until its recent run up to above par which i don't like or someone like me can buy the AMTG preferred or Mitt's preferred to offset most if not all of the dividend cost of shorting this.
Note: this is just a near term price target, obviously the fundamentals could erode further and cause a larger swing to the downside.. but either way the upside is rather limited.