August 6 , 2014 Two Harbors│Subprime Bond Case Study
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Subprime Bond Overview 3 M A R K E T C H A R ACT E R IST I C S • Subprime sector since the crisis has functioned like a distressed market • Legacy subprime bonds have been purchased at a significant discount to par due to the credit sensitivities of the security – Became deeply discounted as borrower performance deteriorated during the housing/financial crisis • Mispricing of credit risk presents an opportunity for investors with strong expertise in credit analysis • Subordination and excess spread built into the capital structure can provide sub-prime bonds protection against substantial losses on the underlying loans. • Performance of underlying collateral is driver of realized yield on the asset; not all bonds are created equal BO R ROW E R C H A R AC T E RI ST I C S • Low credit score • Impaired or limited credit history • High debt-to-income ratio • Undisclosed or verified income • Minimal down payment (e.g. high loan-to-value ratio) \
Two Harbors Subprime Bond Portfolio S U BP R I M E H O L D I N GS (1 ) • Approximately 80% of non-Agency RMBS portfolio • Carrying value of $2.4 billion • Face value of $3.5 billion • Average purchase price $47.50 • Average coupon of 1.3% – Approximately 87% of subprime holdings have floating rate(2) – Average floating coupon rate 0.62% • 60+ day delinquencies 31.2% • 3-month Constant Prepayment Rate (CPR) 3.2% • Credit enhancement 11.1% – Not including excess interest spread that offsets credit losses 4 (1) As of June 30, 2014. (2) Floating rate is based on carrying value.
Bond and Col la tera l Character i s t i cs at Issuance Home Equity Asset Trust (HEAT) 2006-3 at Issuance(1) • Senior bonds pay sequentially; A1 through A4 – Backed by group 2 collateral • Senior bonds initially AAA rated • Receives protection from credit losses from the subordinate bonds and ongoing excess interest • Original group 2 collateral summary:(4) – Vintages: 2005 to 2006 – Over 83% single-family properties – Over 89% with 30-year amortization period – 29% located in California; 12% in Florida; 4% in Georgia – 45% with LTV of 71% to 80%; 31% with LTV of 81% to 90%(5) 5 (1) As it pertains to this presentation, HEAT 2006-3 will be used to reference the senior bonds backed by group 2 collateral, as well as the corresponding subordinate bonds. (2) Represents senior bonds backed by second collateral group. HEAT 2006-3 1A1, a senior bond, was also issued but is backed by group 1 collateral. (3) Subordinated bonds protect all senior bonds regardless if they are backed by either group 1 or group 2 collateral. (4) Source: Bloomberg. (5) “LTV” is defined as original Loan-to-Value. Senior Bonds(2) A1 $345 million Face Value A2 $90 million Face Value A3 $101 million Face Value A4 $70.9 million Face Value Subordinate Bonds – 19.2% at Issuance(3)(4)
HEAT 2006-3 at Two Harbors Acquisition in 2011 D E A L S U M M A RY (1 ) • A1 and A2 were paid off • A3 was receiving principal payments • A4 downgraded to “C” rating C O L L AT E RAL S U M M A RY (2 ) • 60+ day delinquencies 32% • 6-month severities 71% • Credit enhancement 37% – Not including excess interest spread of approximately 4% T WO H A R BO R S P U RC H A S E S U M M A RY • Purchased A4 at a price of $62.41 in April 2011 – Expected returns were approximately 10% – Pays a coupon of LIBOR +0.31% M S A V I D E O L I N K http://vimeo.com/102537046 6 S eni o r B o n d s A1 & A2 Paid off A3 37%-100%(1) $45.4M Face Value A4 37%-100%(1) $70.9M Face Value S ub B o n d s SUBORDINATE BONDS Absorb the first 37% of losses, after depletion of ongoing excess spread. (1) Senior bonds absorb losses 37%-100%. (2) Source: Bloomberg.
HEAT 2006-3 2A4 Price Path – 4/1/2011 to 6/30/2014 7 (1) Source: Bloomberg 4/15/11 - Bond acquired by Two Harbors at $62.41 6/26/14 - Bond sold by Two Harbors at $97.50
HEAT 2006-3 at Two Harbors Sale in 2014 8 S eni o r B o n d s A1, A2 & A3 Paid off A4 44%-100%(1) $65.0M Face Value S ub B o n d s SUBORDINATE BONDS Absorb the first 44% of losses, after depletion of ongoing excess spread. D E A L S U M M A RY (1 ) • A1, A2 and A3 were paid off • A4 had been upgraded to “B” rating • A4 started receiving principal payments in March 2014 C O L L AT E RAL S U M M A RY (2 ) • 60+ day delinquencies 26% • 6-month severities 59% • Credit enhancement 44% – Not including excess interest spread of approximately 1% T WO H A R BO R S S A L E S U M M A RY • Sold A4 at a price of $97.50 in June 2014 – Up 56% in approximately 3 years – Yield was low; minimal upside remaining (1) Senior bonds absorb losses 44%-100%. (2) Source: Bloomberg.
Outlook for Subprime Bond Portfolio W E BE L I E V E U P S I D E P OT E N T I AL R E M A I N S I N O U R S U BP R I M E P O RT FO L I O • Conservative prepay/default assumptions • Higher prepayment behavior and potential servicing actions could provide value in the future ‒ Refinancing due to low interest rates ‒ Better economic growth ‒ Home Price Appreciation (HPA) ‒ Increasing housing turnover from better mobility as employment metrics improve • Servicer actions are helping borrowers • Consider other plausible scenarios when reviewing the expected fundamental performance of these bonds • Legacy subprime bonds provide attractive loss-adjusted yields against a backdrop of improving loan performance R I S K C O N S I D E R AT I O NS T H AT M AY R E S U LT I N VA LUAT I O N D E C L I NE S • Potential HPA declines; increased delinquencies and defaults • Uncertain cash flow because of potential servicer actions 9
Contact Information 10 FO R F U RT H E R I N FO R M AT IO N, P L E A S E C O N TAC T: July Hugen Director of Investor Relations Two Harbors Investment Corp. 612.629.2514 July.Hugen@twoharborsinvestment.com Investor Relations Two Harbors Investment Corp. 612.629.2500 investors@twoharborsinvestment.com
