Q1 2023 Two Harbors Investment Corp Earnings Call
Participants
Margaret Field Karr; Head of IR; Two Harbors Investment Corp.
Mary Kathryn Riskey; VP & CFO; Two Harbors Investment Corp.
Nicholas Letica; VP & CIO; Two Harbors Investment Corp.
William Ross Greenberg; President, CEO & Director; Two Harbors Investment Corp.
Arren Saul Cyganovich; VP & Senior Analyst; Citigroup Inc., Research Division
Bose Thomas George; MD; Keefe, Bruyette, & Woods, Inc., Research Division
Douglas Michael Harter; Director; Crédit Suisse AG, Research Division
Eric J. Hagen; MD & Mortgage and Specialty Finance Analyst; BTIG, LLC, Research Division
Kenneth S. Lee; VP of Equity Research; RBC Capital Markets, Research Division
Richard Barry Shane; Senior Equity Analyst; JPMorgan Chase & Co, Research Division
Trevor John Cranston; MD & Equity Research Analyst; JMP Securities LLC, Research Division
Presentation
Operator
Good morning. My name is Diego, and I will be your conference facilitator. At this time, I would like to welcome everyone to Two Harbors First Quarter 2023 Financial Results Conference Call. (Operator Instructions) I would now like to turn the call over to Maggie Karr.
Margaret Field Karr
Good morning, everyone, and welcome to our call to discuss Two Harbors First Quarter 2023 financial results. With me on the call this morning are Bill Greenberg, our President and Chief Executive Officer; Nick Letica, our Chief Investment Officer; and Mary Riskey, our Chief Financial Officer.
The earnings press release and presentation associated with today's call have been filed with the SEC and are available on the SEC's website as well as the Investor Relations page of our website at twoharborinvestment.com. In our earnings release and presentation, we have provided reconciliations of GAAP to non-GAAP financial measures, and we urge you to review this information in conjunction with today's call.
As a reminder, our comments today will include forward-looking statements, which are subject to risks and uncertainties that may cause our results to differ materially from expectations. These are described on Page 2 of the presentation and in our Form 10-K and subsequent reports filed with the SEC. Except as may be required by law, Two Harbors does not update forward-looking statements and disclaims any obligation to do so.
I will now turn the call over to Bill.
William Ross Greenberg
Thank you, Maggie. Good morning, everyone, and welcome to our first quarter earnings call. This morning, I will provide color on our quarterly performance and the market environments. Mary will provide information around our financial results, and Nick will discuss our portfolio activity and positioning.
Please turn to Slide 3 for an overview of our quarterly results. Our book value at March 31st was $16.48 per share, representing a negative 3.6% total economic quarterly return. Our book value was impacted by the violent move lower in rates arising from the banking crisis as our portfolio had a slight short duration bias heading into March, consistent with what we disclosed in our fourth quarter earnings call. As more regional bank headlines hit the tapes, rate volatility continued to be elevated, which caused increased hedging costs and mortgage spread widening.
Our earnings available for distribution or EAD, was $0.09 per share. As we've discussed on prior earnings calls, EAD does not necessarily reflect the earnings potential of our portfolio. For this reason, last quarter, we introduced the metric income excluding market-driven value changes or IXM, which we believe should better assist our investors and analysts when thinking about our earnings potential. IXM was $0.59 per share for the first quarter, representing a 13.3% annualized return on average common equity. This compares to $0.73 per share in the fourth quarter. The change in IXM quarter-over-quarter is mainly the result of timing differences of realized MSR cash flows. This backward-looking metric of realized return is meant to be viewed in conjunction with Slide 15, which is our forward-looking return potential slide.
Please turn to Slide 4. After beginning 2023 with 2 months of relative calm, the financial markets were royal in early March by the seizure of 2 regional banks, Silicon Valley Bank and Signature Bank by banking regulators, which sent tremors throughout the banking system. The undercurrent of the Fed's campaign of raising rates was called into question and the market, which was already extremely sensitive quickly reacted to the new information. Interest rates on the front end of the yield curve plunged with the 2-year treasury yield declining by 109 basis points over a 3-day period, culminating in the largest 1-day move ever on March 13th. Just a few days prior, the 2-year yield had hit a cycle high of 5.07%, its highest level since 2007.
These effects can be seen clearly in figure 1. At the beginning of the year, the market was pricing in just one more interest rate hike with a peak Fed Funds rate of just over 5% and a terminal rate of 4.5% as shown by the light blue line. By early March, the market became more bearish, pricing in 3 rate hikes only to snap back after the SVB news broke and all rate height expectations were replaced with rate cuts. Despite the market's expectations, the Fed raised its benchmark rate by 25 basis points on March 22nd in a continued effort to slow down the economy and drive inflation down towards their long-term annual target of 2%.
Interestingly, however, by late April, the market was again predicting a forward path of Fed activity almost exactly as it had been on December 31. If an investor had flipped through it, they wouldn't have known that a 300 basis point round trip in Fed expectations had even occurred. This kind of interest rate volatility, especially for maturities inside of 1 year are breathtaking and are good reminders of why we keep our interest rate exposures low across the curve.
Moving to Figure 2. I'd like to change gears and expand upon a subject that may be underappreciated in the market, which is the float income component of MSR. Float income refers to the interest that is earned on principal and interest and taxes and insurance before those monies need to be remitted to the relevant investors. While MSR and fixed coupon interest-only or IO bonds, share many similarities and risks, MSR is not a bond. It has important additional cash flows that include cost of service and compensating interest, which detracts from the overall cash flow as well as additive cash flows like float income, late fees and ancillary income and recapture. In different interest rate environments, these components will add more or less to the value of servicing.
Looking at the chart in Figure 2, you can see in the light blue line that in a rising rate environment, an IO extends as prepayment speeds slow, which causes the price to increase. At very high rates, the prepayment speeds can't go any slower, which ultimately results in an IO acquiring positive duration and decreasing in price as rates increase. In contrast, the float components of MSR behaves differently. You can see this in the navy blue line on the chart in Figure 2.
The price goes up for 2 reasons as rates rise. First, like in IO, MSR extends as rates rise and prepayments slow, causing the price to rise. Second, as rates rise, the effective coupon of float income also increases since the cash flow is based on the short-term earnings rate on those custodial balances. At very high rates, even when the prepayment speeds can't slow anymore, the effective coupon of this component continues to rise, which causes the price of this component to continue to increase.
In Figure 2, as you can see, in higher rate environments, these additional cash flows caused the value of MSR to outperform the IO. While in a normal rate environment, the float components of MSR can contribute about 50% of the duration of the MSR asset, when rates are higher and the MSR is deeply out of the money, the float components can contribute closer to 80% of the duration of the entire MSR assets. Main point here that float income, which is essentially uncapped adds materially to the negative duration of out-of-the-money MSR and is now the primary reason why MSR multiples could continue to rise somewhat in a further sell-off.
Looking forward, we are cautiously optimistic about the investing environment with high interest rate volatility and with the FDIC selling large amounts of bonds, spreads on RMBS are at historically attractive levels. Nevertheless, the remain uncertainties in the market from potential follow-on effects from the banking crisis to political uncertainty related to the debt ceiling debate. As a result, while fundamentally, we might expect that an overweight position in mortgages is justified. We think a more neutral posture is prudent given the technical backdrop.
Furthermore, with banks likely on the sidelines of the MBS market for the time being and with the Fed and GSEs out of the market, we think that wide spreads available in the market can persist for some time. Wider for longer suits us just fine as we believe those spreads are attractive for our portfolio and should be supportive of our ongoing earnings generation. With all of that said, we are committed to and confident in our portfolio construction of Agency RMBS paired with MSR, and we believe that our portfolio with less mortgage spread duration than portfolios without MSR is very well positioned to benefit from the current environment.
Now I will turn it over to Mary to discuss our financial results in more detail.
Mary Kathryn Riskey
Thank you, Bill, and good morning, everyone. Please turn to Slide 5. For the first quarter, the company incurred a comprehensive loss of $63.2 million or negative $0.69 per weighted average share. Our book value was $16.48 per share at March 31st compared to $17.72 at December 31st. Including the $0.60 common dividend results in a quarterly economic return of negative 3.6%. The results primarily reflect mortgage spread widening in March and increased hedging costs.
Moving to Slide 6. I'd like to add some detail around IXM. In the first quarter, IXM was $0.59 per share, representing an annualized return of 13.3%. This quarter, we refined the calculation of IXM for determining expected price changes to use the realized forwards methodology, which is a change from Q4 when we use the unchanged term structure methodology. Expanding on that, the methodology for determining expected price changes may be computed based on either of 2 commonly assumed scenarios, realized forwards and unchanged term structure.
The unchanged term structure methodology assumes that the term structure of the yield curve is unchanged day over day. The realized forward methodology assumes that rates follow the 1-day forward, Q4 IXM under both methods was a return per weighted average share of $0.73. Quarter-over-quarter, IXM decreased to $0.59 from $0.73, which can almost entirely be attributed to timing differences in the realization of certain MSR cash flows. The service fee that is collected depends on the precise day of the month that borrowers make their mortgage payments. There is also a seasonality component to float income as some of the custodial balances like taxes and insurance are due to be remitted once, twice or 4 times per year.
Finally, certain servicing costs also fluctuate from period to period, such as non-recoverable advances and interest on escrows. IXM takes into account these natural cash flow timing variations. As a result, the difference between Q1 and Q4 does not reflect significant degradation in the earnings power of the portfolio but rather a reflection of the realization of MSR cash flows. Slide 15, our return outlook slide is the forward-looking version of IXM, and those prospective return ranges are consistent, albeit wider with the prior quarter.
Please turn to Slide 7. The fact that it would be helpful to provide investors and analysts a comparison of GAAP and non-GAAP measures. GAAP comprehensive income, excluding realized and unrealized gains and losses and nonrecurring expenses as compared to EAD and IXM. In future quarters, this comparison will be included in the appendix slide, but we would like to highlight a few things this quarter. As you see on this page, the actual cash flows for income and expense are the same in all 3 measures with a few minor exceptions. For example, if you look at the RMBS section, coupon income and funding expense are the same across all 3. This is also generally true for MSR servicing income, float and ancillary, servicing expenses and funding expenses. The primary differences in the measures result from the amortization lines are what we refer to as price changes.
IXM for RMBS and MSR is based on market value and expected return, which is different from GAAP and EAD amortization. For RMBS, GAAP and EAD amortization is based on amortized cost and yield to maturity at purchase. For MSR, GAAP amortization is based on the percentage of principal paid multiplied by the beginning market value. And for EAD, amortization is based on amortized cost and the original pricing yield. We hope that this disclosure helps reconcile the differences between our GAAP and non-GAAP measures.
Please turn to Slide 8. Earnings available for distribution was $0.09 per share compared to $0.26 for the fourth quarter. As a reminder, we expect EAD to continue to diverge from expected ongoing earnings power. The decline in EAD this quarter was primarily driven by changes in interest income and expense. Interest income increased by $17.3 million, primarily due to 4 things: higher rates on cash holdings and reverse repo balances and increase in the size of our RMBS portfolio, rotation to higher net yielding RMBS and slower prepayment speeds. Likewise, interest expense increased by $26.9 million on higher financing rates and higher borrowing balances on RMBS, partly offset by lower borrowing balances on MSR financing.
Turning to Slide 9. The portfolio yield increased 17 basis points to 5.09% due to the rotation to higher net yielding RMBS, lower agency CPR and a higher proportion of the portfolio invested in higher-yielding assets. Our net realized spread in the quarter narrowed by 45 basis points to 0.52% from 0.97% primarily due to higher rates on financing. As a reminder, the portfolio yields in this table are EAD based calculations and not market-based measures.
Please turn to Slide 10. Let's spend a moment talking about financing and what we are seeing in the repo markets. Despite the extreme volatility and news about the banking crisis, funding in the repo market remains liquid and well supported. Spreads on repurchase agreement financing for RMBS improved in January and February from year-end, but increased in March following the news of bank failures. At the end of the quarter, spreads on the repurchase agreements were coming back in and were sulfur plus 15 to 20 basis points with no signs of balance sheet stress.
To finance our MSR across 4 lenders with $1.5 billion of outstanding borrowings under bilateral MSR asset financing facilities and $400 million of outstanding 5-year MSR term notes. We maintained access to diverse funding sources for MSR with a total of approximately $606 million unused MSR financing capacity at quarter end.
I will now turn the call over to Nick.
Nicholas Letica
Thank you, Mary. Please turn to Slide 11. I'd like to focus my opening comments on the supply and demand dynamics for mortgage-backed securities, which, in our minds, is the primary narrative in our market. Preview 1 shows current coupon spreads since the beginning of last year. Spreads are unquestionably wide with nominal and OAS spreads, respectively, in the 92nd and 82nd percentile of the long-term history, generating attractive levered returns in the low to mid-teens as shown in our return potential a few slides forward.
Despite these positive signals and a strong belief that over a longer horizon, this time period will be viewed as a great entry point. Our enthusiasm is tempered by the belief that over the short to medium term, supply is likely to keep mortgage spreads wider than long-term averages and could potentially push them wider than their already generous levels. In fact, we have seen spreads widen into the beginning of this quarter.
In addition to $200 billion of projected net organic supply for 2023, the FDIC through BlackRock has commenced auctions of the asset seeds from Silicon Valley Bank and Signature Bank, which will likely persist for the next 6 months. Sales of the lower coupon deep discount Agency RMBS and CMO positions totaled approximately $85 billion, inclusive of these sales, other bank selling and Fed paydowns, which are effectively on a form of supply. The total net supply for Agency RMBS is projected to top $500 billion for 2023 with the bulk of the supply ahead of us.
In an environment where many banks are either on the sidelines are perhaps selling, it will be up to relative value accounts like money managers, REITs and hedge funds to absorb the bulk of the supply. This group of investors typically demands a higher risk premium than depository institutions. As such, it is reasonable to assume that spreads will remain wider than long-term averages. Figure 2 provides some historical context of the relationship between option-adjusted spreads and who is buying and who is selling. The blue bars are institutional accounts, like banks, the Fed or the GSEs, while the gray bars are relative value accounts like money managers and REITs.
The line is the option-adjusted spread of the MBS index as measured by Bloomberg at the end of each year and for 2023 at the end of the first quarter. In periods of which institutional demand dominates, spreads tend to be tighter or tighten. Conversely, in periods when relative value accounts for the buyers and institutional accounts for the sellers, spreads widened. There are several periods that we could point to, but the most recent experience of tightening was the 2020 to 2021 period with strong bank and Fed buying. Then into 2022 to 2023, the Fed and banks stepped back from buying, which drove spreads wider by over 30 basis points to what now are historically attractive levels.
(inaudible) 0:19:24, spreads have already reacted to the shift in the buyer base and the anticipation of excess supply and at present levels are supportive of our strategy. That said, it remains to be seen whether these effects are fully priced into the market as the thick of the supply is still ahead. The FDIC bank-related selling has made lower coupon MBS valuation more attractive. Post quarter end, we have moved some of our mortgage exposure down in coupon, but have plenty of dry powder to do more of that trade and/or increase our spread exposure as opportunities present themselves in the coming months.
Now let's turn to Slide 12 and discuss our portfolio in the first quarter. At March 31st, our portfolio was $15.8 billion, up from $14.7 billion at the end of the fourth quarter. On the top right of the slide, you can see a few bullet points about our risk positioning and leverage. From a risk perspective, we opportunistically moved about 30% of our hedges from treasury futures to swaps to take advantage of deeply negative swap spreads in the quarter. Given the macroeconomic uncertainty, we are keeping exposures low across a wide range of interest rate and curve scenarios. You can see more detail on our risk positioning by looking at Slide 17, 18, 28 and 29 in the appendix.
Our debt-to-equity ratio increased slightly to 6.5x, maintaining a neutral leverage position as we were balancing the wide nominal spreads available in the market versus historically high volatility and the supply/demand dynamics that we just discussed. In terms of portfolio activity, in February, we completed a common stock capital raise for net proceeds of $176 million. In line with our stated objective at that time, we settled $11 billion UPB of MSR through a bulk purchase paired with an additional $1 billion of current coupon TBA. We have committed to acquire an additional $15 billion UPB of MSR to settle in the second quarter. Given the subsequent widening of mortgage spreads, this capital allocation proved to be the right one.
In the quarter, we were active in moving positions between TBA and specified pools as highlighted in the bullets under portfolio activity. We moved $2 billion of higher coupon TBAs into loan balance, credit and geo pools to capture relative spread pickup and mitigate future prepayment risk. We then moved some 4 and 4.5 specified pools, which we believe were fully valued into TBA. Finally, we covered a short position of Fannie Mae 2 TBAs after the sharp underperformance of the lower coupons in March.
Moving to Slide 13. Our specified pool portfolio was predominantly positioned in higher coupon loan balance and Geo pools at quarter end. Mortgages had mixed performance across the coupon stack in the quarter with low coupon 2 and 2.5, widening about 0.5 point, driven primarily by supply concerns from FDIC-related sales. Current coupon RMBS wind by a similar magnitude given their persistent supply. The belly coupons of 3% to 4.5% remains roughly unchanged without the supply pressures felt by the lower and higher coupons. In the quarter, specified pools modestly outperformed TBAs, as you can see in Figure 2. Specified pool prepayment speeds also declined to 5.3% CPR, as you can see in Figure 3.
Please turn to Slide 14. Our MSR portfolio was $3.1 billion at March 31st, comprised entirely of Agency MSR. We saw a 35% increase in supply of MSR in the quarter for the reasons we discussed on our last earnings call, as rates have risen, originations have slowed and mortgage companies are selling MSR to fund their ongoing businesses. This is occurring at the same time as several large MSR holders announced their intention to step back from the MSR market. As previously discussed, we added 4 bulk purchases, opportunistically take advantage of the selling in the market. Our price multiple modestly decreased to 5.4x, which incorporates the effect of the settled bulk purchase. As anticipated and providing a tailwind for our MSR prepayments continued to slow, coming in at 4.1% CPR in the first quarter.
Finally, please turn to Slide 15, our return potential and outlook slide. The top half of this table is meant to show what returns we believe are available in the market. We estimate that about 61% of our capital is allocated to hedged MSR with a market static return projection of 14% to 17%. The remaining capital is allocated to hedged RMBS with a static return estimate of 12% to 14%. The lower section of this slide is specific to our portfolio with a focus on common equity and estimated returns per common share.
With our portfolio allocation shown in the top half of the table, and after expenses, the static return estimate for our portfolio is between 10.4% to 13.1% before applying any capital structure leverage to the portfolio. After giving effect to our outstanding convertible notes and preferred stock, we believe that the potential static return on common equity falls in the range of 12.3% to 16.6% for a prospective quarterly static return per share of $0.50 to $0.69.
Thank you very much for joining us today. And now we will be happy to take any questions you might have.
Question and Answer Session
Operator
(Operator Instructions) Our first question comes from Doug Harter with Credit Suisse.
Douglas Michael Harter
Hoping you could talk a little bit about how you're thinking about when the time might be to want to increase your mortgage basis exposure kind of given your comments that spreads are towards the wider side and kind of what are the factors you'd be looking at?
William Ross Greenberg
Doug, thanks very much for the question. As Nick said in his prepared remarks, on a fundamental basis, the spreads are certainly attractive. They're at historical wide levels, but there's just so much out there that we see that temper our enthusiasm. The banking crisis stuff out there is still ongoing even with the resolution of First Republic. So there's a lot of uncertainty there. And of course, we have some debt ceiling stuff coming up this month to be resolved. And there's a whole bunch of stuff in the market that seems, I guess, not giving the all clear sign. And so we're going to wait a little bit to see how that unfolds.
As I said with -- or as Nick said, with the banks out and with the GSEs out, we think there's -- that is more likely than not that spreads can stay at these levels for quite some time here. And so that's sort of our outlook, and that's what we're looking for, and we think that suits us fine.
Douglas Michael Harter
I guess just given that uncertainty, I guess how would you characterize the risk for further widening versus how much of that kind of those risks are kind of priced into the market?
Nicholas Letica
Doug, this is Nick. Yes, very good question, something that honestly we grapple with day in and day out these days. It's not as though, as we said in the comments, where spreads are right now. And when you see our return potential, it is -- they are very supportive of our strategy to generate a high level of return and income. So as Bill said, I don't -- we don't feel pressed to increase leverage or exposure given all the uncertainties are ahead of us. And as I said in my comments, we have seen spreads widen since quarter end, and that's amidst some technicals that have not moved in the same direction.
For example, longer-term volatility has pretty much moved sideways. We had a strong correlation between those things prior to the event in March with the banks. And -- but since then, given the supply concerns, we've seen spreads kind of widen out in a fairly flat volatility environment. So we're watching it. We'll see where things go, but it's a very hard thing to predict right now.
Operator
Our next question comes from Kenneth Lee with RBC Capital Markets.
Kenneth S. Lee
Just one on the static returns prospectively. Just wondering if I could just get a little bit more thoughts around potential volatility there? And what could be sort of like the key drivers that you think over the near term that could drive some of that volatility in terms of the static returns there?
William Ross Greenberg
Ken, that's a great question. And as you can see, if you compare our -- the range of our -- a range of our results compared to this quarter versus last, you can see that we actually have a wider range we did last time, and that is reflective of the volatility we're seeing in the market and the assumptions that go into this analysis. And of course, a big component of it is just the spread level in the market, right? So to the extent that spreads are wider or more volatile, you're going to see a wider variation in these numbers. But it takes into account all the assumptions that you would expect in a levered mortgage return. Obviously, prepayments are a big part of it. Funding levels are a part of it, all those things. And we feel like this range that we have this quarter that we're giving a $0.50 to $0.69 range does incorporate a wider variation in the underlying assumptions that could drive these numbers.
Kenneth S. Lee
Got you. Very helpful there. And then just one on the hedging strategy. There were some changes in the book value sensitivity to rates, but I just wanted to get a higher level. What's the best way to think about your current hedging strategy? What kind of scenarios are you positioning yourself for?
William Ross Greenberg
We're really trying to be very balanced right now. We're not -- we are trying to be pretty agnostic with regard to direction of rates or curve shape, just given all the variabilities that are in the market right now. And a path, I think, ahead of the banking crisis we had in March was probably a little bit more predictable than it is right now. The effects of what the bank crisis will do to the economy and how much work that's actually going to do for the Fed are all things that are, I think, very, very hard to judge. So we're trying to stay pretty neutral across the curve. I think if you look at our exposures, they are pretty balanced in -- as I said, across the curve and in various current scenarios, we're trying not to take a strong view one way or the other.
Operator
Our next question comes from Bose George with KBW.
Bose Thomas George
Actually just on sticking to Slide 15. As your allocation to MSR increases, does the prospective range of that return go up just as a hedged MSR percentage increases?
William Ross Greenberg
Yes. Well, I think just from a -- thanks for the question, Bose. I think if you look at the top of Slide 15, the higher the percentage to MSR, given the fact that the static return estimates for MSR is higher than that from the RMBS right now that would increase that results, the more that we did that.
Bose Thomas George
And how high could that percentage to hedge MSR percentage potentially go this year?
William Ross Greenberg
Well, we don't have a set number in mind. It depends on market opportunities and such things. We do see value even aside from it being as we show here a higher static return potential than RMBS. We do think there's value in having some RMBS and RMBS portfolio as a balance here. And so it can go higher, but you're unlikely to see it be 100%?
Bose Thomas George
Okay. Great. And then actually switching just wanted to ask about book value. Can you just give us an update on book value (inaudible) 0:33:01 to date?
William Ross Greenberg
Yes, you bet Bose. So as Nick said during his comments as well as in the Q&A here, spreads have been volatile. They've been wider in the month of April. For the first half of the month, through the 21st, we were rolling down between 1% and 2%. But in the last week of the month with FDIC sales and the First Republic noise, spreads have been pretty rocky here. And as of Friday, we were down about 4%.
Operator
Our next question comes from Trevor Cranston with JMP Securities.
Trevor John Cranston
A question on the float income you guys talked about earlier in the presentation. A couple of things there. I guess, number one, do you have what the average balance of custodial funds was in the first quarter? And also, I was wondering if you could -- Barry talked about the seasonal impact of tax payments on float income. I was wondering if you could provide any sort of numbers around the estimated seasonal impact for the first quarter.
William Ross Greenberg
So thank you for the question. We don't have those numbers handy as to what the average balance is we can circle back on that. In terms of the seasonality that Mary mentions, some states require interest in escrow, some sat stone. Some states require the remits to be done annually. Some were drives semiannually, some do it monthly and so forth. And so that provides a natural seasonality among the states and the balances that exist between the states between when things need to be remitted and how long it can hold on to it for. So that's a very detailed question. It's not a simple seasonality like you have in prepayments, where it's slower in winter and faster in summer. It's a more complex shape than that, if you were to graph it out.
Operator
Our next question comes from Arren Cyganovich with Citi.
Arren Saul Cyganovich
Just kind of following up on Doug's earlier question about spreads and when they could potentially tighten. What are the kind of scenarios that would likely lead to tighter spreads? Would it be -- would we have to enter into a recession and see generally lower rates and slower kind of growth overall to bring folks back to wanting to get, I guess, more demand for our MBS assets?
William Ross Greenberg
Arren, yes, thank you for that question. Look, the traditional drivers for tighter mortgage spreads are lower volatility and generally speaking, steeper yield curve and a rally. I mean, those are the historically have been the elements to drive spreads tighter. It's very interesting, the market that we're in right now with this lack of bank buying and potentially a little bit different response than from the banking community than we've seen. In the past, given the focus on bank portfolios and duration of bank portfolios and what that means and really, that's what's driving our comments and belief that we're going to see spreads wider than long-term averages for a long period of time.
But I think to answer your question, as usual, I think more predictability on the path of rates, the movement of the Fed should drive mortgage spreads tighter and just a passage of time a little bit here as we get through the supply that is in front of us, both from an organic nature of some of the higher coupon production numbers, which are not over -- not like overwhelmingly large but big -- but large enough in the current market, especially without banks buying and then the dual effect of the slug of lower coupon supply that's coming into the market.
What I would say is the -- what has held mortgage spreads in and one of the reasons that we were very optimistic about mortgage spreads early in the year has been just the amount of retail flow that's come into fixed income that has been supportive of all fixed income and mortgages, and that's flowing through the money manager channel. So the state of spreads here in many ways is sitting with the money management community and how much they can absorb of the supply that's coming into the market.
Arren Saul Cyganovich
Okay. And do you think that whenever the Fed does pivot and provide kind of a instead of a tightening guide path to a kind of loosening guide path with lower short-term rates, would that be enough on them to likely lead to tighter spreads as you kind of get away from this inverted yield curve?
William Ross Greenberg
I mean, it should be helpful. The one thing that's been set in the market, which I think is an interesting point is that with these sales coming from the FDIC and through BlackRock, there is potentially some market sensitivity to those sale levels and that if rates rally and prices go up, it could cause potentially an acceleration of those sales. That might temper mortgage performance in that kind of scenario. But overall, I would agree with your -- I would agree the assertion that if we see a turnaround and a little bit more predictability out of the Fed, that should be positive for mortgage spreads.
Arren Saul Cyganovich
And then my last question is Slide 7, you have kind of listed various GAAP and non-GAAP earnings. Which one of these is setting your dividend policy? I fully understand like the IXM is kind of more illustrative of what your earnings power can be and -- but we're struggling a little bit with trying to figure out where dividend might go relative to the potential earnings power and the actual earnings that you're producing?
Mary Kathryn Riskey
Arren, this is Mary. So we obviously consider several measures and I think the -- what I would point you to is Slide 15. That is probably the most significant factor in determining where we think return potential is and where we set the dividend.
Arren Saul Cyganovich
But in terms of the actual earnings that you have, I mean, are you going to be end up -- like if you produce a quarter like you did this quarter, are you going to be returning capital relative versus actual earnings relative to that distribution?
Mary Kathryn Riskey
Well the characterization of the dividend depends on taxable income, which is different than all these measures. But I think I would point you to the cash flow information on Page 7. And again, we believe the dividend is reflective of the return potential of the portfolio.
Operator
Our next question comes from Eric Hagen with BTIG.
Eric J. Hagen
I think just one for me. When you think about your stock valuation and where you could trade on a near- and longer-term basis, how does that drive the amount of leverage that you're comfortable running? Like how much more risk do you think you can take at your current valuation? And what scenarios do you think you could maybe trade at a higher valuation with higher leverage?
William Ross Greenberg
Well, thanks for the question, Eric. I would say that we don't really think of the stock prices having an input into the amount of leverage that we've run. That's really a risk question. We're always trying to have performance so that the returns are high-quality returns with an acceptable level of risk. And so we're making those decisions based on the existing portfolio and the existing assets and the existing book value rather than looking at what the stock price is. We're not trying to link the 2 in any way. If that answers your question or not.
Operator
And our next question comes from Rick Shane with JPMorgan.
Richard Barry Shane
Nick, I had some questions on Slide 29, which is the interest rate swaps and swaptions. You had talked a little bit about the hedging strategy during your comments. But can you help me understand what's going on, on the slide. It looks like a lot of netting trades. But again, I think there's something much more sophisticated going on there than I understand. Maybe you can just help us understand both the interest rate swaps and the swaptions because the notional seem to largely net out.
Nicholas Letica
Yes. Thank you for that question. So I don't think it's actually as complicated as you may be inferring from that slide. As we noted in our prepared remarks, we did move some of our hedges this quarter from futures to swaps, and that was really driven by the fact that there were some opportunities with some fairly deeply negative swap spreads to put that trade on at levels we thought were effective and to boost our spot carry on our hedges in what we thought was an efficient way.
And as I said, it's about 30% of our hedge book that moved away from futures. We like to have a mix of those hedging instruments because as markets have moved around with the volatility in the markets and you run into potential bout of illiquidity, having both of those instruments at our disposal can be helpful when things are moving around as fast as they are. I think what you're seeing in terms of the -- some of that netting is just the -- you're seeing the portfolio activity and the rehedging that we did as the quarter progressed, rates, as you know, when we discussed, rates moved an epic amount in March, and we had put some hedges on earlier in the quarter that we needed to reverse as the market rallied and our portfolio will get shorter. We obviously have to adjust our hedges. So I think that's what you're seeing in those numbers. The interest rate swaption is -- was a small trade we put on to -- for some protection on some rate scenarios, and that's what you're looking at on that page.
Richard Barry Shane
Got it. Okay. So I heard the initial comment as you saw an opportunity and I would assume that, that opportunity had persisted and what you're saying is that there was an opportunity in terms of the curve that you saw benefited from it and then largely netted that trade out as you move through the quarter?
Nicholas Letica
Well, I wouldn't say we netted it out. We're ending the quarter with -- we ended the quarter with some of our hedging and swaps. It's just that as we rehedged through the quarter, some of the initial trades we did, we had to pare down along with other traits because our hedge book has to move with the duration of our underlying securities.
Operator
There are no further questions at this time. I'll hand the floor back to management for closing remarks.
William Ross Greenberg
I want to thank you all for those good questions. I want to thank you all for taking the time to join us today, and thank you, as always, for your interest in Two Harbors.
Operator
Thank you. And with that, we conclude today's conference. All parties may disconnect. Have a great day.
