10-Q 1 two9301110qdocument.htm QUARTERLY REPORT TWO 9.30.11 10Q document
 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
______________________________
FORM 10-Q
______________________________

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended: September 30, 2011
Commission File Number 001-34506
______________________________
TWO HARBORS INVESTMENT CORP.
(Exact Name of Registrant as Specified in Its Charter)

Maryland
 
27-0312904
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)

601 Carlson Parkway, Suite 150
Minnetonka, Minnesota
 
55305
(Address of Principal Executive Offices)
 
(Zip Code)
(612) 629-2500
(Registrant's Telephone Number, Including Area Code)


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o
 
Accelerated filer x
 
Non-accelerated filer o
 
Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
As of November 4, 2011 there were 140,593,845 shares of common stock, par value $.01 per share, issued and outstanding.
 
 
 
 
 

TWO HARBORS INVESTMENT CORP. 
INDEX

 
 
 
Page
 
PART I - FINANCIAL INFORMATION
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
PART II - OTHER INFORMATION
 
 
 
 
 
 
 
 
 
 
 


i


PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)

 
September 30,
2011
 
December 31,
2010
 
(unaudited)
 
 
ASSETS
  

 
  

Available-for-sale securities, at fair value
$
6,412,895

 
$
1,354,405

Trading securities, at fair value
1,526,330

 
199,523

Cash and cash equivalents
409,947

 
163,900

Total earning assets
8,349,172

 
1,717,828

Restricted cash
164,276

 
22,548

Accrued interest receivable
25,510

 
5,383

Due from counterparties
33,918

 
12,304

Derivative assets, at fair value
245,314

 
38,109

Other assets
619

 
1,260

Total Assets
$
8,818,809

 
$
1,797,432

LIABILITIES AND STOCKHOLDERS’ EQUITY
   

 
   

Liabilities
   

 
   

Repurchase agreements
$
7,300,613

 
$
1,169,803

Derivative liabilities, at fair value
46,182

 
158

Accrued interest payable
5,442

 
785

Due to counterparties
90,880

 
231,724

Accrued expenses and other liabilities
7,747

 
2,063

Dividends payable
56,235

 
10,450

Other liabilities
4,579

 
1

Total liabilities
7,511,678

 
1,414,984

Stockholders’ Equity
   

 
  

Preferred stock, par value $0.01 per share; 50,000,000 shares authorized; no shares issued and outstanding

 

Common stock, par value $0.01 per share; 450,000,000 shares authorized and 140,586,736 and 40,501,212 shares issued and outstanding, respectively
1,406

 
405

Additional paid-in capital
1,372,944

 
366,974

Accumulated other comprehensive (loss) income
(26,325
)
 
22,619

Cumulative earnings
106,022

 
30,020

Cumulative distributions to stockholders
(146,916
)
 
(37,570
)
Total stockholders’ equity
1,307,131

 
382,448

Total Liabilities and Stockholders’ Equity
$
8,818,809

 
$
1,797,432


The accompanying notes are an integral part of these condensed consolidated financial statements.


1


TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except share data)

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2011
 
2010
 
2011
 
2010
 
(unaudited)  
 
(unaudited)  
Interest income:
 
 
 
 
 
 
 
Available-for-sale securities
$
65,919

 
$
11,823

 
$
125,413

 
$
27,064

Trading securities
1,706

 
15

 
2,783

 
15

Cash and cash equivalents
114

 
27

 
241

 
70

Total interest income
67,739

 
11,865

 
128,437

 
27,149

Interest expense
7,218

 
1,395

 
13,580

 
2,777

Net interest income
60,521

 
10,470

 
114,857

 
24,372

Other-than-temporary impairments:
 
 
 
 
 
 
 
Total other-than-temporary impairment losses
(3,371
)
 

 
(3,665
)
 

Non-credit portion of loss recognized in other comprehensive income (loss)

 

 

 

Net other-than-temporary credit impairment losses
(3,371
)
 

 
(3,665
)
 

Other income:
 
 
 
 
 
 
 
Gain on investment securities, net
31,432

 
2,577

 
36,159

 
4,608

Loss on interest rate swap and swaption agreements
(39,311
)
 
(4,436
)
 
(88,180
)
 
(10,037
)
Gain on other derivative instruments
22,361

 
3,098

 
37,474

 
4,197

Total other income (loss)
14,482

 
1,239

 
(14,547
)
 
(1,232
)
Expenses:
 
 
 
 
 
 
 
Management fees
4,785

 
862

 
9,063

 
2,068

Other operating expenses
2,850

 
1,213

 
6,516

 
3,332

Total expenses
7,635

 
2,075

 
15,579

 
5,400

Net income before income taxes
63,997

 
9,634

 
81,066

 
17,740

Benefit from (provision for) income taxes
(9,388
)
 
246

 
(5,064
)
 
1,555

Net income attributable to common stockholders
$
54,609

 
$
9,880

 
$
76,002

 
$
19,295

Basic and diluted earnings per weighted average common share
$
0.42

 
$
0.38

 
$
0.90

 
$
0.93

Dividends declared per common share
$
0.40

 
$
0.39

 
$
1.20

 
$
1.08

Basic and diluted weighted average number of shares of common stock
130,607,566

 
26,126,212

 
84,751,854

 
20,691,461


The accompanying notes are an integral part of these condensed consolidated financial statements.


2


TWO HARBORS INVESTMENT CORP. 
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
AND COMPREHENSIVE (LOSS) INCOME
(in thousands, except share data)

 
Common Stock
 
 
 
 
 
 
 
 
 
 
 
Shares
 
Amount
 
Additional Paid-in Capital
 
Accumulated Other Comprehensive (Loss) Income
 
Cumulative Earnings
 
Cumulative Distributions to Stockholders
 
Total Stockholders' Equity
 
 
 
 
 
 
 
(unaudited)
 
 
 
 
 
 
Balance, January 1, 2010
13,401,368

 
$
134

 
$
131,756

 
$
(950
)
 
$
(5,735
)
 
$
(3,484
)
 
$
121,721

Net income

 

 

 

 
19,295

 

 
19,295

Net change in unrealized gain on available-for-sale securities

 

 

 
17,001

 

 

 
17,001

Total other comprehensive income

 

 

 
17,001

 

 

 

Total comprehensive income
 
 
 
 
 
 
 
 
 
 
 
 
36,296

Net proceeds from issuance of common stock, net of offering costs
12,688,381

 
127

 
106,699

 

 

 

 
106,826

Common dividends declared

 

 

 

 

 
(23,635
)
 
(23,635
)
Non-cash equity award compensation
36,463

 

 
145

 

 

 

 
145

Balance, September 30, 2010
26,126,212

 
$
261

 
$
238,600

 
$
16,051

 
$
13,560

 
$
(27,119
)
 
$
241,353

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, January 1, 2011
40,501,212

 
$
405

 
$
366,974

 
$
22,619

 
$
30,020

 
$
(37,570
)
 
$
382,448

Net income

 

 

 

 
76,002

 

 
76,002

Net change in unrealized losses on available-for-sale securities

 

 

 
(48,944
)
 

 

 
(48,944
)
Total other comprehensive loss

 

 

 
(48,944
)
 

 

 

Total comprehensive income
 
 
 
 
 
 
 
 
 
 
 
 
27,058

Net proceeds from issuance of common stock, net of offering costs
100,077,925

 
1,001

 
1,005,754

 

 

 

 
1,006,755

Common dividends declared

 

 

 

 

 
(109,346
)
 
(109,346
)
Non-cash equity award compensation
7,599

 

 
216

 

 

 

 
216

Balance, September 30, 2011
140,586,736

 
$
1,406

 
$
1,372,944

 
$
(26,325
)
 
$
106,022

 
$
(146,916
)
 
$
1,307,131


The accompanying notes are an integral part of these condensed consolidated financial statements.


3


TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
Nine Months Ended
 
September 30,
 
2011
 
2010
 
(unaudited)
Cash Flows From Operating Activities:
   

 
   

Net income
$
76,002

 
$
19,295

Adjustments to reconcile net income to net cash provided by operating activities:
   

 
   

Amortization of premiums and discounts on RMBS, net
(57
)
 
1,987

Other-than-temporary impairment losses
3,665

 

Gain on investment securities, net
(36,159
)
 
(4,608
)
Loss on termination of interest rate swaps and swaptions
18,074

 
2,486

Unrealized loss on interest rate swaps and swaptions
51,474

 
5,357

Unrealized gain on other derivative instruments
(20,144
)
 
(1,025
)
Equity based compensation expense
216

 
145

Net change in:
   

 
 
Increase in accrued interest receivable
(20,127
)
 
(1,671
)
Decrease/(increase) in deferred income taxes, net
4,136

 
(1,162
)
Increase in prepaid tax asset

 
400

Decrease in prepaid and fixed assets
155

 
432

Increase in accrued interest payable, net
4,657

 
526

Increase in income taxes payable, net
928

 

Increase in accrued expenses and other liabilities
5,684

 
752

Net cash provided by operating activities
88,504

 
22,914

Cash Flows From Investing Activities:
   

 
   

Purchases of available-for-sale securities
(6,295,100
)
 
(888,466
)
Proceeds from sales of available-for-sale securities
1,004,248

 
247,858

Principal payments on available-for-sale securities
208,965

 
78,520

Purchases of other derivative instruments
(233,764
)
 
(38,896
)
Proceeds from sales of other derivative instruments
23,179

 
26,632

Purchases of trading securities
(2,019,959
)
 
(58,189
)
Proceeds from sales of trading securities
700,156

 
58,516

Decrease in due to/from counterparties, net
(162,458
)
 
(10,978
)
Increase in restricted cash
(141,728
)
 
(18,814
)
Net cash used in investing activities
(6,916,461
)
 
(603,817
)
Cash Flows From Financing Activities:
   

 
   

Proceeds from repurchase agreements
19,621,767

 
3,043,458

Principal payments on repurchase agreements
(13,490,957
)
 
(2,512,357
)
Proceeds from issuance of common stock, net of offering costs
1,006,755

 
106,826

Dividends paid on common stock
(63,561
)
 
(16,930
)
Net cash provided by financing activities
7,074,004

 
620,997

Net increase in cash and cash equivalents
246,047

 
40,094

Cash and cash equivalents at beginning of period
163,900

 
26,105

Cash and cash equivalents at end of period
$
409,947

 
$
66,199

Supplemental Disclosure of Cash Flow Information:
   

 
 
Cash paid for interest
$
8,923

 
$
2,251

Cash paid for taxes
$
1

 
$
(497
)
Non-Cash Financing Activity:
   

 
   

Dividends declared but not paid at end of period
$
56,235

 
$
10,189

The accompanying notes are an integral part of these condensed consolidated financial statements.

4


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements

Note 1. Organization and Operations
Two Harbors Investment Corp., or the Company, is a Maryland corporation focused on investing in, financing and managing residential mortgage-backed securities, or RMBS, residential mortgage loans and other financial assets. The Company is externally managed and advised by PRCM Advisers LLC, a subsidiary of Pine River Capital Management L.P., or Pine River, a global multi-strategy asset management firm. The Company's common stock is listed on the NYSE and its warrants are listed on the NYSE Amex under the symbols “TWO” and “TWO.WS,” respectively.
On May 18, 2011, the Company announced that it had taken the first step toward setting up a securitization issuance program by partnering with Barclays Bank PLC, or Barclays, to close on a $100 million mortgage loan warehouse facility, or Barclays facility, subject to future increase. The Barclays facility will be used to aggregate prime jumbo residential mortgage loans that the Company will acquire from select mortgage loan originators with whom the Company has chosen to build strategic relationships, including those with a nationwide presence. The Company is targeting a $250 million deal size for its initial securitization, with Barclays Capital acting as underwriter. As of September 30, 2011, the Company has neither purchased any mortgage loan assets nor established the securitization program as a distinct operational business segment. As anticipated, the Company's initiatives in the three months ended September 30, 2011 continued to focus on establishing underwriting guidelines and originator relationships, addressing regulatory requirements and building an infrastructure to support a sustainable program.
The Company has elected to be treated as a real estate investment trust, or REIT, for U.S. federal income tax purposes commencing with its initial taxable period ended December 31, 2009. As long as the Company continues to comply with a number of requirements under federal tax law and maintains its qualification as a REIT, the Company generally will not be subject to U.S. federal income tax to the extent that the Company distributes its taxable income to its stockholders on an annual basis and does not engage in prohibited transactions. Certain activities the Company performs may cause us to earn income which will not be qualifying income for REIT purposes. For these activities, the Company utilizes its taxable REIT subsidiaries, which are subject to U.S. federal income tax.

Note 2. Basis of Presentation and Significant Accounting Policies
Consolidation and Basis of Presentation
The interim unaudited condensed consolidated financial statements of the Company have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission, or SEC. Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles, or GAAP, have been condensed or omitted according to such SEC rules and regulations. Management believes, however, that the disclosures included in these interim condensed consolidated financial statements are adequate to make the information presented not misleading. The accompanying condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2010. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at September 30, 2011 and results of operations for all periods presented have been made. The results of operations for the three and nine months ended September 30, 2011 should not be construed as indicative of the results to be expected for the full year.
The condensed consolidated financial statements of the Company have been prepared on the accrual basis of accounting in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires us to make a number of significant estimates and assumptions. These estimates include estimates of fair value of certain assets and liabilities, amount and timing of credit losses, prepayment rates, the period of time during which the Company anticipates an increase in the fair values of real estate securities sufficient to recover unrealized losses in those securities, and other estimates that affect the reported amounts of certain assets and liabilities and disclosure of contingent assets and liabilities as of the date of the condensed consolidated financial statements and the reported amounts of certain revenues and expenses during the reported period. It is likely that changes in these estimates (e.g., valuation changes due to supply and demand, credit performance, prepayments, interest rates, or other reasons) will occur in the near term. The Company's estimates are inherently subjective in nature and actual results could differ from its estimates and the differences may be material.
The condensed consolidated financial statements of the Company include the accounts of all subsidiaries; inter-company accounts and transactions have been eliminated. Certain prior period amounts have been reclassified to conform to the current period presentation.

5


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

Recently Issued and/or Adopted Accounting Standards
Comprehensive Income
In June 2011, the Financial Accounting Standards Board issued ASU No. 2011-05, Comprehensive Income (Topic 220), and Amendments to IAS 1, Presentation of Financial Statements, which provides guidance on the presentation of other comprehensive income, or OCI. The amendment requires companies to present OCI separately in the statement of operations and comprehensive income rather than include in the statement of stockholders' equity. The components of OCI have not changed. ASU 2011-05 is effective for the first interim or annual period beginning on or after December 15, 2011. The impact of adopting this ASU will not have a material impact on the Company's consolidated financial condition or results of operations.
Investment Company
In October 2011, the Financial Accounting Standards Board (FASB) issued two exposure drafts, Proposed Accounting Standards Update—Financial Services—Investment Companies (Topic 946): Amendments to the Scope, Measurement, and Disclosure Requirements and Proposed Accounting Standards Update—Real Estate—Investment Property Entities (Topic 973), that redefine an investment company and how it accounts for investments. The proposals eliminate the current scope exception for real estate investment trusts (REITs) and would require a REIT to assess itself under the FASB investment company act definition and adopt fair value accounting if it meets the criteria. The FASB has requested comments on these exposure drafts be submitted by January 5, 2012. Management is currently assessing the impacts of these exposure drafts.

Note 3. Available-for-Sale Securities, at Fair Value
The following table presents the Company's available-for-sale, or AFS, investment securities by collateral type, which were carried at their fair value as of September 30, 2011 and December 31, 2010:

(in thousands)
September 30,
2011
 
December 31,
2010
Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
1,656,815

 
$
396,888

Federal National Mortgage Association
2,460,994

 
556,609

Government National Mortgage Association
1,038,885

 
62,972

Non-Agency
1,256,201

 
337,936

Total mortgage-backed securities
$
6,412,895

 
$
1,354,405


At September 30, 2011 and December 31, 2010, the Company pledged investment securities with a carrying value of $6.3 billion and $1.1 billion, respectively, as collateral for repurchase agreements. See Note 9 - Repurchase Agreements.
At September 30, 2011 and December 31, 2010, the Company did not have any securities purchased from and financed with the same counterparty that did not meet the conditions of ASC 860, Transfers and Servicing, to be considered linked transactions and therefore classified as derivatives.

6


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

The following tables present the amortized cost and carrying value (which approximates fair value) of AFS securities by collateral type as of September 30, 2011 and December 31, 2010:

 
September 30, 2011
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
5,858,947

 
$
2,667,159

 
$
8,526,106

Unamortized premium
292,879

 

 
292,879

Unamortized discount
 
 
 
 
 
Designated credit reserve

 
(772,938
)
 
(772,938
)
Net, unamortized
(1,051,498
)
 
(555,329
)
 
(1,606,827
)
Amortized Cost
5,100,328

 
1,338,892

 
6,439,220

Gross unrealized gains
83,727

 
16,624

 
100,351

Gross unrealized losses
(27,361
)
 
(99,315
)
 
(126,676
)
Carrying Value
$
5,156,694

 
$
1,256,201

 
$
6,412,895


 
December 31, 2010
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
1,306,655

 
$
594,306

 
$
1,900,961

Unamortized premium
41,651

 

 
41,651

Unamortized discount
  

 
  

 
  

Designated credit reserve

 
(145,855
)
 
(145,855
)
Net, unamortized
(334,979
)
 
(129,992
)
 
(464,971
)
Amortized Cost
1,013,327

 
318,459

 
1,331,786

Gross unrealized gains
9,308

 
21,503

 
30,811

Gross unrealized losses
(6,166
)
 
(2,026
)
 
(8,192
)
Carrying Value
$
1,016,469

 
$
337,936

 
$
1,354,405


The following tables present the carrying value of the Company's AFS investment securities by rate type as of September 30, 2011 and December 31, 2010:

 
September 30, 2011
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
239,229

 
$
1,046,844

 
$
1,286,073

Fixed Rate
4,917,465

 
209,357

 
5,126,822

Total
$
5,156,694

 
$
1,256,201

 
$
6,412,895


 
December 31, 2010
(in thousands)
Agency
 
Non-Agency
 
Total
Adjustable Rate
$
269,512

 
$
245,517

 
$
515,029

Fixed Rate
746,957

 
92,419

 
839,376

Total
$
1,016,469

 
$
337,936

 
$
1,354,405


When the Company purchases a credit-sensitive AFS security at a significant discount to its face value, the Company often does not amortize into income a significant portion of this discount that the Company is entitled to earn because it

7


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

does not expect to collect it due to the inherent credit risk of the security. The Company may also record an other-than-temporary impairment, or OTTI, for a portion of its investment in the security to the extent the Company believes that the amortized cost will exceed the present value of expected future cash flows. The amount of principal that the Company does not amortize into income is designated as a credit reserve on the security, with unamortized net discounts or premiums amortized into income over time using the interest method in accordance with ASC 320.
The following table presents the changes for the nine months ended September 30, 2011 and September 30, 2010 of the unamortized net discount and designated credit reserves on non-Agency AFS securities.

 
Nine Months Ended September 30,
 
2011
 
2010
(in thousands)
Designated credit reserve
 
Unamortized net discount
 
Total
 
Designated credit reserve
 
Unamortized net discount
 
Total
Beginning balance at January 1
$
(145,855
)
 
$
(129,992
)
 
$
(275,847
)
 
$
(50,187
)
 
$
(41,050
)
 
$
(91,237
)
Acquisitions
(640,451
)
 
(483,479
)
 
(1,123,930
)
 
(105,897
)
 
(98,264
)
 
(204,161
)
Accretion of net discount

 
32,305

 
32,305

 

 
6,654

 
6,654

Realized credit losses
3,011

 

 
3,011

 
1,409

 
8

 
1,417

Reclassification adjustment for other-than-temporary impairments
(3,665
)
 

 
(3,665
)
 

 

 

Transfers from (to)
579

 
(579
)
 

 
705

 
(705
)
 

Sales, calls, other
13,443

 
26,416

 
39,859

 
18,630

 
17,779

 
36,409

Ending balance at September 30
$
(772,938
)
 
$
(555,329
)
 
$
(1,328,267
)
 
$
(135,340
)
 
$
(115,578
)
 
$
(250,918
)

The following table presents the components comprising the carrying value of AFS securities not deemed to be other than temporarily impaired by length of time the securities had an unrealized loss position as of September 30, 2011 and December 31, 2010. At September 30, 2011, the Company held 1,081 AFS securities, of which 338 were in an unrealized loss position for less than twelve consecutive months and 15 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2010, the Company held 373 AFS securities, of which 108 were in an unrealized loss position for less than twelve months and 5 were in an unrealized loss position for more than twelve consecutive months.
 
Unrealized Loss Position for
 
Less than 12 Months
 
12 Months or More
Total
(in thousands)
Estimated Fair Value
 
Gross Unrealized Losses
 
Estimated Fair Value
Gross Unrealized Losses
Estimated Fair Value
Gross Unrealized Losses
September 30, 2011
$
1,895,965

 
$
(125,479
)
 
$
3,103

$
(1,197
)
$
1,899,068

$
(126,676
)
December 31, 2010
$
310,445

 
$
(7,183
)
 
$
1,405

$
(1,009
)
$
311,850

$
(8,192
)


Evaluating AFS Securities for Other-than-Temporary Impairments
The Company has adopted the provisions of ASC 320 to evaluate AFS securities for OTTI. This evaluation requires us to determine whether there has been a significant adverse quarterly change in the cash flow expectations for a security. The Company compares the amortized cost of each security in an unrealized loss position against the present value of expected future cash flows of the security. The Company also considers whether there has been a significant adverse change in the regulatory and/or economic environment as part of this analysis. If the amortized cost of the security is greater than the present value of expected future cash flows, an other-than-temporary credit impairment has occurred. If the Company does not intend to sell and is not more likely than not required to sell the security, the credit loss is recognized in earnings and the balance of the unrealized loss is recognized in other comprehensive income (loss). If the Company intends to sell the security or will be more likely than not required to sell the security, the full unrealized loss is recognized in earnings.

8


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

The Company recorded a $3.4 million and a $3.7 million other-than-temporary credit impairment during the three and nine months ended September 30, 2011 on a total of eight non-Agency RMBS where the future expected cash flows for each security was less than its amortized cost. As of September 30, 2011, the impaired securities had weighted average cumulative losses of 5.2%, weighted average three-month prepayment speed of 4.54, weighted average 60+ day delinquency of 35.0% of the pool balance, and weighted average FICO score of 643.
The following table presents the OTTI included in earnings for the three and nine months ended September 30, 2011 and September 30, 2010:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2011
 
2010
 
2011
 
2010
Cumulative credit loss at beginning of period
$
(294
)
 
$

 
$

 
$

Additions:
 
 
 
 
 
 
 
Other-than-temporary impairments not previously recognized
(3,371
)
 

 
(3,665
)
 

Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments

 

 

 

Cumulative credit loss at September 30
$
(3,665
)
 
$

 
$
(3,665
)
 
$


Gross Realized Gains and Losses
Gains and losses from the sale of AFS securities are recorded as realized gains (losses) within gain on investment securities, net in the Company's condensed consolidated statements of income. For the three and nine months ended September 30, 2011, the Company sold AFS securities for $908.5 million and $1.0 billion with an amortized cost of $881.0 million and $975.1 million, for a net realized gain of $27.5 million and $29.2 million, respectively.
The following table presents the gross realized gains and losses on sales of AFS securities for the three and nine months ended September 30, 2011 and 2010:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2011
 
2010
 
2011
 
2010
Gross realized gains
$
27,472

 
$
2,276

 
$
29,422

 
$
4,582

Gross realized losses

 
(27
)
 
(265
)
 
(303
)
Total realized gains (losses) on sales, net
$
27,472

 
$
2,249

 
$
29,157

 
$
4,279


Note 4. Trading Securities, at Fair Value
During the nine months ended September 30, 2011, the Company acquired and sold U.S. Treasuries in its taxable REIT subsidiary and classified these securities as trading instruments due to its short-term investment objectives. As of September 30, 2011 and December 31, 2010, the Company held U.S. Treasuries with an amortized cost of $1.5 billion and $200.0 million and a fair value $1.5 billion and $199.5 million, respectively. The unrealized gains and losses included within trading securities was a positive $5.5 million as of September 30, 2011 and a negative $0.5 million as of December 31, 2010.
For the three and nine months ended September 30, 2011, the Company sold trading securities for $200.0 million and $700.1 million with an amortized cost of $199.7 million and $699.1 million resulting in realized gains of $0.3 million and $1.0 million, respectively, on the sale of these investment securities. For the three and nine months ended September 30, 2011, trading securities experienced unrealized gains of $3.7 million and $6.0 million, respectively. Both realized and unrealized gains are recorded as a component of gains on investment securities, net in the Company's condensed consolidated statement of income.
At September 30, 2011, the Company pledged trading securities with a carrying value of $1.5 billion as collateral for repurchase agreements. See Note 9 - Repurchase Agreements.

9


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)


Note 5. Restricted Cash
As of September 30, 2011 and December 31, 2010, the Company is required to maintain certain cash balances with counterparties for broker activity and collateral for the Company's repurchase agreements in non-interest bearing accounts.
The following table presents the Company's restricted cash balances:

(in thousands)
September 30,
2011
 
December 31,
2010
Restricted cash balances held by:
 
 
 
Broker counterparties for securities trading activity
$
9,000

 
$
9,000

Broker counterparties for derivatives trading activity
71,220

 
1,914

Repurchase counterparties as restricted collateral
84,056

 
11,634

Total
$
164,276

 
$
22,548


Note 6. Accrued Interest Receivable
The following table presents the Company's accrued interest receivable by collateral type:

(in thousands)
September 30,
2011
 
December 31,
2010
Accrued Interest Receivable:
 
 
 
U.S. Treasuries
$
2,516

 
$
192

Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
6,114

 
1,509

Federal National Mortgage Association
10,104

 
2,201

Government National Mortgage Association
4,479

 
532

Non-Agency
2,297

 
949

Total mortgage-backed securities
22,994

 
5,191

Total
$
25,510

 
$
5,383


Note 7. Derivative Instruments and Hedging Activities
The Company enters into a variety of derivative and non-derivative instruments in connection with its risk management activities. The Company's primary objective for executing these derivatives and non-derivative instruments is to mitigate the Company's economic exposure to future events that are outside its control. The Company's derivative financial instruments are utilized principally to manage market risk and cash flow volatility associated with interest rate risk (including associated prepayment risk) related to certain assets and liabilities. As part of its risk management activities, the Company may, at times, enter into various forward contracts including short securities, Agency to-be-announced securities, or TBAs, options, futures, swaps and caps. In executing on the Company's current risk management strategy, the Company has entered into interest rate swap and swaption agreements, TBA positions, and credit default swaps. The Company has also entered into a number of non-derivative instruments to manage interest rate risk, principally U.S. Treasuries and Agency interest-only securities.
The following summarizes the Company's significant asset and liability classes, the risk exposure for these classes, and the Company's risk management activities used to mitigate certain of these risks. The discussion includes both derivative and non-derivative instruments used as part of these risk management activities. While the Company uses non-derivative and derivative instruments to achieve the Company's risk management activities, it is possible that these instruments will not effectively mitigate all or a substantial portion of the Company's market rate risk. In addition, the Company might elect, at times, not to enter into certain hedging arrangements in order to maintain compliance with REIT requirements.
Interest Rate Sensitive Assets/Liabilities
Available-for-sale Securities  - The Company's RMBS investment securities are generally subject to change in value when mortgage rates decline or increase, depending on the type of investment. Rising mortgage rates generally result in a slowing of refinancing activity, which slows prepayments and results in a decline in the value of the Company's fixed-rate

10


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

Agency pools. To mitigate the impact of this risk, the Company maintains a portfolio of financial instruments, primarily fixed-rate interest-only securities, which increase in value when interest rates increase. In addition, the Company has initiated TBA positions to further mitigate its exposure to increased prepayment speeds. The objective is to reduce the risk of losses to the portfolio caused by interest rate changes and changes in prepayment speeds.
As of September 30, 2011 and December 31, 2010, the Company had outstanding fair value of $53.2 million and $18.4 million, respectively, of interest-only securities in place to economically hedge its investment securities. These interest-only securities are included in AFS securities, at fair value, in the condensed consolidated balance sheets. In addition, the Company holds TBA positions with $375.0 million in long notional and $2.0 billion in short notional as of September 30, 2011. The Company discloses these on a gross basis according to the unrealized gain or loss position of each TBA contract regardless of long or short notional position. As of September 30, 2011, these contracts held a fair market value of $9.6 million, included in derivative assets, at fair value, and $2.0 million, included in derivative liabilities, at fair value, in the condensed consolidated balance sheet as of September 30, 2011. The Company did not hold any long or short notional TBA positions as of December 31, 2010.
Repurchase Agreements  - The Company monitors its repurchase agreements, which are generally floating rate debt, in relationship to the rate profile of its investment securities. When it is cost effective to do so, the Company may enter into interest rate swap arrangements to align the interest rate composition of its investment securities and debt portfolios, specifically repurchase agreements with maturities of less than 6 months. Typically, the interest receivable terms (i.e., LIBOR) of the interest rate swaps match the terms of the underlying debt, resulting in an effective conversion of the rate of the related repurchase agreement from floating to fixed.
As of September 30, 2011 and December 31, 2010, the Company had the following outstanding interest rate swaps that were utilized as economic hedges of interest rate risk associated with the Company's short-term repurchase agreements:

(notional in thousands)
 
 
 
 
 
 
September 30, 2011
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
25,000

 
0.868
%
 
0.295
%
 
1.23

2013
 
1,275,000

 
0.795
%
 
0.292
%
 
1.63

2014
 
1,275,000

 
0.670
%
 
0.355
%
 
2.97

2015
 
820,000

 
1.575
%
 
0.299
%
 
3.77

2016
 
240,000

 
2.156
%
 
0.276
%
 
4.57

Total
 
3,635,000

 
1.017
%
 
0.315
%
 
2.77

(notional in thousands)
 
 
 
 
 
 
December 31, 2010
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2011
 
100,000

 
1.168
%
 
0.343
%
 
0.96

2012
 
25,000

 
0.868
%
 
0.308
%
 
1.98

2013
 
175,000

 
1.376
%
 
0.306
%
 
2.61

2014
 
175,000

 
1.671
%
 
0.303
%
 
3.96

2015
 
175,000

 
1.830
%
 
0.287
%
 
4.84

Total
 
650,000

 
1.526
%
 
0.306
%
 
3.29



11


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

The Company has also entered into interest rate swaps in combination with U.S. Treasuries and other RMBS to economically hedge funding cost and macro-financing risk. As of September 30, 2011 and December 31, 2010, the Company held $1.5 billion and $199.5 million, respectively, in fair value of U.S. Treasuries classified as trading securities and the following outstanding interest rate swaps:

(notional in thousands)
 
 
 
 
 
 
September 30, 2011
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2013
 
1,750,000

 
0.659
%
 
0.28433
%
 
1.75
Total
 
1,750,000

 
 
 
 
 
 
(notional in thousands)
 
 
 
 
 
 
December 31, 2010
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
200,000

 
0.557
%
 
0.278
%
 
1.80
Total
 
200,000

 
 
 
 
 
 

All of the Company's interest rate swap contracts receive interest at a 1-month or 3-month LIBOR rate, except the following interest rate swap entered in combination with TBA contracts to economically hedge mortgage basis widening where the Company pays interest at a 3-month LIBOR rate:

(notional in thousands)
 
 
 
 
 
 
September 30, 2011
Swaps Maturities
 
Notional Amounts
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2016
 
325,000

 
0.264
%
 
1.772
%
 
4.83
Total
 
325,000

 
 
 
 
 
 

The Company did not hold any interest rate swaps in combination with TBA contracts as of December 31, 2010.
Additionally, as of September 30, 2011 and December 31, 2010, the Company had the following outstanding interest rate swaptions (agreements to enter into interest rate swaps in the future for which the Company would pay a fixed rate) that were utilized as macro-economic hedges:
September 30, 2011
(notional and dollars in thousands)
Option
 
Underlying Swap
Swaption
Expiration
 
Cost
 
Fair Value
 
Average Months to Expiration
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Term (Years)
Payer
< 6 Months
 
$
10,511

 
$
97

 
5.30
 
575,000

 
3.18
%
 
3M Libor
 
4.65

Payer
≥ 6 Months
 
14,646

 
2,749

 
11.65
 
1,875,000

 
3.09
%
 
3M Libor
 
4.04

Total Payer
 
 
$
25,157

 
$
2,846

 
11.60

 
2,450,000

 
3.11
%
 
3M Libor
 
4.18


12


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

December 31, 2010
(notional and dollars in thousands)
Option
 
Underlying Swap
Swaption
Expiration
 
Cost
 
Fair Value
 
Average Months to Expiration
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Term (Years)
Payer
≥ 6 Months
 
$
3,348

 
$
4,028

 
11.25
 
100,000

 
3.52
%
 
3M Libor
 
8.50


The Company has not applied hedge accounting to its current derivative portfolio held to mitigate the interest rate risk associated with its debt portfolio. As a result, the Company is subject to volatility in its earnings due to movement in the unrealized gains and losses associated with its interest rate swaps and its other derivative instruments.
Foreign Currency Risk
In compliance with the Company's REIT requirements, the Company does not have exposure to foreign denominated assets or liabilities. As such, the Company is not subject to foreign currency risk.
Credit Risk
The Company has limited exposure to credit losses on its U.S. Treasuries and Agency portfolio of investment securities because these securities are issued by the U.S. Department of the Treasury or government sponsored entities, or GSEs. The payment of principal and interest on the FHLMC and FNMA mortgage-backed securities are guaranteed by those respective agencies, and the payment of principal and interest on the GNMA mortgage-backed securities are backed by the full faith and credit of the U.S. Government.
For non-Agency investment securities, the Company currently enters into credit default swaps to specifically hedge credit risk. In future periods, the Company could enhance its credit risk protection, enter into further paired derivative positions, including both long and short credit default swaps and/or seek opportunistic trades in the event of a market disruption (see "Non-Risk Management Activities" section). The Company also has processes and controls in place to monitor, analyze, manage and mitigate its credit risk with respect to non-Agency RMBS.
As of September 30, 2011, the Company held credit default swaps where the Company receives credit protection for a fixed premium. The maximum payouts for these credit default swaps are limited to the current notional amounts of each swap contract. Maximum payouts for credit default swaps do not represent the expected future cash requirements, as the Company's credit default swaps are typically liquidated or expire and are not exercised by the holder of the credit default swaps.
The following table presents credit default swaps where the Company is receiving protection held as of September 30, 2011:

(notional and dollars in thousands)
 
 
 
 
 
 
 
 
 
 
September 30, 2011
Protection
 
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Receive
 
9/20/2013
 
460.00

 
(45,000
)
 
$
2,802

 
$
(3,126
)
 
$
(324
)
 
 
12/20/2013
 
370.00

 
(5,000
)
 
$
346

 
$
(294
)
 
$
52

 
 
6/20/2016
 
264.23

 
(250,000
)
 
$
12,649

 
$
(480
)
 
$
12,169

 
 
5/25/2046
 
356.00

 
(95,954
)
 
$
54,413

 
$
(42,930
)
 
$
11,483

 
 
Total
 
310.06

 
(395,954
)
 
$
70,210

 
$
(46,830
)
 
$
23,380


The Company did not hold any credit default swaps where the Company receives credit protection as of December 31, 2010.

13


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

Derivative financial instruments contain an element of credit risk if counterparties are unable to meet the terms of the agreements. Credit risk associated with derivative financial instruments is measured as the net replacement cost should the counterparties that owe the Company under contracts completely fail to perform under the terms of these contracts, assuming there are no recoveries of underlying collateral, as measured by the market value of the derivative financial instruments. As of September 30, 2011, the fair value of derivative financial instruments as an asset and liability position was $245.3 million and $46.2 million, respectively.
The Company mitigates the credit risk exposure on derivative financial instruments by limiting the counterparties to those major banks and financial institutions that meet established credit guidelines, and the Company seeks to transact with several different counterparties in order to reduce the exposure to any single counterparty. Additionally, the Company reduces credit risk on the majority of its derivative instruments by entering into agreements that permit the closeout and netting of transactions with the same counterparty upon occurrence of certain events. To further mitigate the risk of counterparty default, the Company maintains collateral agreements with certain of its counterparties. The agreements require both parties to maintain cash deposits in the event the fair values of the derivative financial instruments exceed established thresholds. As of September 30, 2011, the Company has received cash deposits from counterparties of $34.0 million and placed cash deposits of $89.2 million in accounts maintained by counterparties, of which the amounts are netted on a counterparty basis and classified within restricted cash, due from counterparties, or due to counterparties on the condensed consolidated balance sheet.
In accordance with ASC 815, as amended and interpreted, the Company records derivative financial instruments on its condensed consolidated balance sheet as assets or liabilities at fair value. Changes in fair value are accounted for depending on the use of the derivative instruments and whether they qualify for hedge accounting treatment. Due to the volatility of the credit markets and difficulty in effectively matching pricing or cash flows, the Company has elected to treat all current derivative contracts as trading instruments.
Non-Risk Management Activities
The Company has entered into certain financial instruments that are considered derivative contracts under ASC 815 that are not for purposes of hedging. These contracts are currently limited to inverse interest-only residential mortgage securities and credit default swaps.
Inverse interest-only securities with a carrying value of $162.7 million, including accrued interest receivable of $2.2 million, are accounted for as derivative financial instruments in the condensed consolidated financial statements. The following table presents the amortized cost and carrying value (which approximates fair value) of inverse interest-only securities as of September 30, 2011 and December 31, 2010:

(in thousands)
September 30, 2011
 
December 31, 2010
Face Value
$
1,167,563

 
$
219,459

Unamortized premium

 

Unamortized discount
 
 

Designated credit reserve

 

Net, unamortized
(1,005,236
)
 
(190,162
)
Amortized Cost
162,327

 
29,297

Gross unrealized gains
5,888

 
1,902

Gross unrealized losses
(7,742
)
 
(665
)
Carrying Value
$
160,473

 
$
30,534


As of September 30, 2011 and December 31, 2010, the Company also held credit default swaps where the Company provides credit protection for a fixed premium. The maximum payouts for these credit default swaps are limited to the current notional amounts of each swap contract. Maximum payouts for credit default swaps do not represent the expected future cash requirements, as the Company's credit default swaps are typically liquidated or expire and are not exercised by the holder of the credit default swaps.

14


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

The following tables present credit default swaps where the Company is providing protection held as of September 30, 2011 and December 31, 2010:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
 
 
September 30, 2011
Protection
 
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Provide
 
7/25/2036
 
359.94

 
117,043

 
$
7,372

 
$
(12,232
)
 
$
(4,860
)
 
 
5/25/2046
 
146.18

 
57,355

 
$
(17,836
)
 
$
13,574

 
$
(4,262
)
 
 
Total
 
289.64

 
174,398

 
$
(10,464
)
 
$
1,342

 
$
(9,122
)

(notional and dollars in thousands)
 
 
 
 
 
 
 
 
 
 
December 31, 2010
Protection
 
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Provide
 
7/25/2036
 
378.47

 
41,576

 
$
3,137

 
$
(3,554
)
 
$
(417
)

Balance Sheet Presentation
The following table represents the gross fair value and notional amounts of the Company's derivative financial instruments treated as trading instruments as of September 30, 2011 and December 31, 2010.

(in thousands)
 
September 30, 2011
 
December 31, 2010
 
 
Derivative Assets
 
Derivative Liabilities
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
Notional
 
Fair Value
Notional
 
Fair Value
Notional
 
Fair Value
Notional
Inverse interest-only securities
 
$
162,703

1,167,563

 
$


 
$
30,944

219,459

 
$


Interest rate swap agreements
 


 
(33,726
)
5,060,000

 


 
(158
)
850,000

Credit default swap agreements
 
70,210

395,954

 
(10,464
)
174,398

 
3,137

41,576

 


Swaptions
 
2,846

2,450,000

 


 
4,028

100,000

 


TBAs
 
9,555

875,000

 
(1,992
)
750,000

 


 


Total
 
$
245,314

4,888,517

 
$
(46,182
)
5,984,398

 
$
38,109

361,035

 
$
(158
)
850,000


The following table provides the average monthly outstanding notional amounts of the Company's derivative financial instruments treated as trading instruments for the three and nine months ended September 30, 2011:

(in thousands)
 
Three Months Ended September 30, 2011
 
Nine Months Ended September 30, 2011
Trading instruments
 
Derivative Assets
 
Derivative Liabilities
 
Derivative Assets
 
Derivative Liabilities
Inverse interest-only securities
 
1,135,141

 

 
771,476

 

Interest rate swap agreements
 

 
4,267,609

 

 
2,809,212

Credit default swaps
 
385,824

 
177,461

 
138,119

 
117,610

Swaptions
 
2,129,348

 

 
1,117,563

 

TBAs
 
545,109

 
1,230,435

 
85,834

 
132,621



15


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

Income Statement Presentation
The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed consolidated statement of income on its derivative instruments.

(in thousands)
 
 
 
 
 
 
 
 
 
 
Trading Instruments
 
Location of Gain/(Loss) Recognized in Income on Derivatives
 
Amount of Gain/(Loss) Recognized in Income on Derivatives
 
Amount of Gain/(Loss) Recognized in Income on Derivatives
 
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
 
 
2011
 
2010
 
2011
 
2010
Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Interest Rate Contracts
 
 
 
 
 
 
 
 
 
 
Investment securities - RMBS
 
Gain on other derivative instruments
 
$
5,729

 
$
1,214

 
$
5,091

 
$
1,631

Investment securities - U.S. Treasuries and TBA contracts
 
Loss on interest rate swap and swaption agreements
 
6,544

 
(1,251
)
 
2,733

 
(2,299
)
Repurchase agreements
 
Loss on interest rate swap and swaption agreements
 
(45,855
)
 
(3,184
)
 
(90,913
)
 
(7,738
)
Credit default swaps - Receive protection
 
Gain on other derivative instruments
 
21,994

 

 
22,267

 

Non-Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Credit default swaps - Provide protection
 
Gain on other derivative instruments
 
(4,414
)
 

 
(5,589
)
 

Inverse interest-only securities
 
Gain on other derivative instruments
 
(948
)
 
1,884

 
15,705

 
2,566

Total
 
 
 
$
(16,950
)
 
$
(1,337
)
 
$
(50,706
)
 
$
(5,840
)
For the three and nine months ended September 30, 2011, the Company terminated 24 and 29 notional interest rate swap and swaption positions of $1.9 billion and $2.5 billion, respectively. Upon settlement of the early terminations, the Company paid $4.2 million and $5.1 million in full settlement of its net interest spread liability and recorded $17.8 million and $18.1 million in realized losses on the swaps and swaptions, respectively, including an early termination penalty.

Note 8. Fair Value
Fair Value Measurements
ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices available in active markets (i.e., observable inputs) and the lowest priority to data lacking transparency (i.e., unobservable inputs). Additionally, ASC 820 requires an entity to consider all aspects of nonperformance risk, including the entity's own credit standing, when measuring fair value of a liability.

16


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

ASC 820 establishes a three level hierarchy to be used when measuring and disclosing fair value. An instrument's categorization within the fair value hierarchy is based on the lowest level of significant input to its valuation. Following is a description of the three levels:

Level 1
Inputs are quoted prices in active markets for identical assets or liabilities as of the measurement date. Additionally, the entity must have the ability to access the active market and the quoted prices cannot be adjusted by the entity.
Level 2
Inputs include quoted prices in active markets for similar assets or liabilities; quoted prices in inactive markets for identical or similar assets or liabilities; or inputs that are observable or can be corroborated by observable market data by correlation or other means for substantially the full-term of the assets or liabilities.
Level 3
Unobservable inputs are supported by little or no market activity. The unobservable inputs represent management's best assumptions of how market participants would price the assets and liabilities. Generally, Level 3 assets and liabilities are valued using pricing models, discounted cash flow methodologies, or similar techniques that require significant judgment or estimation.

Following are descriptions of the valuation methodologies used to measure material assets and liabilities at fair value and details of the valuation models, key inputs to those models and significant assumptions utilized.
Investment securities  - The Company holds a portfolio of AFS and trading securities that are carried at fair value in the condensed consolidated balance sheet. AFS securities are primarily composed of Agency and non-Agency RMBS while the Company's U.S. Treasuries are classified as trading securities. The Company determines the fair value of its U.S. Treasuries and Agency RMBS based upon prices obtained from third-party pricing providers or broker quotes received using bid price, which are deemed indicative of market activity. In determining the fair value of its non-Agency RMBS, management judgment is used to arrive at fair value that considers prices obtained from third-party pricing providers, broker quotes received and other applicable market data. If observable market prices are not available or insufficient to determine fair value due to principally illiquidity in the marketplace, then fair value is based upon internally developed models that are primarily based on observable market-based inputs but also include unobservable market data inputs (including prepayment speeds, delinquency levels, and credit losses). The Company classified 100% of its U.S. Treasuries as Level 1 fair value assets at September 30, 2011. The Company classified 99.8% of its RMBS AFS securities reported at fair value as Level 2 at September 30, 2011. AFS and trading securities account for 78.4% and 18.6%, respectively, of all assets reported at fair value at September 30, 2011.
Derivative instruments  - The Company may enter into a variety of derivative financial instruments as part of its hedging strategies. The Company principally executes over-the-counter, or OTC, derivative contracts, such as interest rate swaps. The Company utilizes internally developed models that are widely accepted in the market to value its OTC derivative contracts. The specific terms of the contract are entered into the model as well as market observable inputs such as interest rate forward curves and interpolated volatility assumptions. As all significant inputs into these models are market observable, the Company classified 100% of the interest rate swaps, swaptions and credit default swaps reported at fair value as Level 2 at September 30, 2011.
The Company also enters into certain other derivative financial instruments, such as TBAs and inverse interest-only securities. These instruments are similar in form to the Company's AFS securities and the Company utilizes broker quotes to value these instruments. The Company classified 100% of its inverse interest-only securities at fair value as Level 2 at September 30, 2011. The Company reported 100% of its TBAs as Level 1 as of September 30, 2011.
The Company's Risk Management Committee governs trading activity relating to derivative instruments. The Company's policy is to minimize credit exposure related to financial derivatives used for hedging, by limiting the hedge counterparties to major banks, financial institutions, exchanges, and private investors who meet established capital and credit guidelines, as well as by limiting the amount of exposure to any individual counterparty.
The Company has netting arrangements in place with all derivative counterparties pursuant to standard documentation developed by the International Swap and Derivatives Association, or ISDA. Additionally, both the Company and the counterparty are required to post cash collateral based upon the net underlying market value of the Company's open positions with the counterparty. Posting of cash collateral typically occurs daily, subject to certain dollar thresholds. Due to the existence of netting arrangements, as well as frequent cash collateral posting at low posting thresholds, credit exposure to the Company and/or to the counterparty is considered materially mitigated. Based on the Company's assessment, there is no requirement for any additional adjustment to derivative valuations specifically for credit.

17


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

Recurring Fair Value
The following tables display the Company's assets and liabilities measured at fair value on a recurring basis. The Company often economically hedges the fair value change of its assets or liabilities with derivatives and other financial instruments. The tables below display the hedges separately from the hedged items, and therefore do not directly display the impact of the Company's risk management activities.

 
Recurring Fair Value Measurements
 
At September 30, 2011
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$

 
$
6,402,075

 
$
10,820

 
$
6,412,895

Trading securities
1,526,330

 

 

 
1,526,330

Derivative assets
9,555

 
235,759

 

 
245,314

Total assets
$
1,535,885

 
$
6,637,834

 
$
10,820

 
$
8,184,539

Liabilities
 
 
 
 
 
 
 
Derivative liabilities
$
1,992

 
$
44,190

 
$

 
$
46,182

Total liabilities
$
1,992

 
$
44,190

 
$

 
$
46,182


 
Recurring Fair Value Measurements
 
At December 31, 2010
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$

 
$
1,345,805

 
$
8,600

 
$
1,354,405

Trading securities
199,523

 

 

 
199,523

Derivative assets

 
38,109

 

 
38,109

Total assets
$
199,523

 
$
1,383,914

 
$
8,600

 
$
1,592,037

Liabilities
 
 
 
 
 
 
 
Derivative liabilities
$

 
$
158

 
$

 
$
158

Total liabilities
$

 
$
158

 
$

 
$
158


The valuation of Level 3 instruments requires significant judgment by the third-party pricing providers and/or management. The third-party pricing providers and/or management rely on inputs such as market price quotations from market makers (either market or indicative levels), original transaction price, recent transactions in the same or similar instruments, and changes in financial ratios or cash flows to determine fair value. Level 3 instruments may also be discounted to reflect illiquidity and/or non-transferability, with the amount of such discount estimated by the third-party pricing provider in the absence of market information. Assumptions used by the third-party pricing provider due to lack of observable inputs may significantly impact the resulting fair value and therefore the Company's financial statements. The Company's Valuation Committee reviews all valuations that are based on pricing information received from a third-party pricing provider. As part of this review, prices are compared against other pricing or input data points in the marketplace, along with internal valuation expertise, to ensure the pricing is reasonable. In addition, the Company performs back-testing of pricing information to validate price information and identify any pricing trends of a third-party price provider.
In determining fair value, third-party pricing providers use various valuation approaches, including market and income approaches. Inputs that are used in determining fair value of an instrument may include pricing information, credit data, volatility statistics, and other factors. In addition, inputs can be either observable or unobservable.
The availability of observable inputs can vary by instrument and is affected by a wide variety of factors, including the type of instrument, whether the instrument is new and not yet established in the marketplace and other characteristics particular to the instrument. The third-party pricing provider uses prices and inputs that are current as of the measurement date, including during periods of market dislocations. In periods of market dislocation, the availability of prices and inputs

18


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

may be reduced for many instruments. This condition could cause an instrument to be reclassified to or from various levels within the fair value hierarchy.
Securities for which market quotations are readily available are valued at the bid price (in the case of long positions) or the ask price (in the case of short positions) at the close of trading on the date as of which value is determined. Exchange-traded securities for which no bid or ask price is available are valued at the last traded price.
OTC derivative contracts, including interest rate swaps, are valued by the Company using observable inputs, such as quotations received from the counterparty, dealers or brokers, whenever available and considered reliable. In instances where models are used, the value of an OTC derivative depends upon the contractual terms of, and specific risks inherent in, the instrument as well as the availability and reliability of observable inputs. Such inputs include market prices for reference securities, yield curves, credit curves, volatility measures, prepayment rates and correlation of such inputs. Certain OTC derivatives, such as swaps, have inputs which can generally be corroborated by market data and are therefore classified within Level 2.
The table below presents the reconciliation for all of the Company's Level 3 assets and liabilities measured at fair value on a recurring basis. The Level 3 items presented below may be hedged by derivatives and other financial instruments that are classified as Level 1 or Level 2. Thus, the table below does not fully reflect the impact of the Company's risk management activities.

 
Level 3 Recurring Fair Value Measurements
 
Three Months Ended September 30, 2011
 
 
 
Total Net Gains/(Losses) Included in Net Income
 
 
 
 
 
 
 
 
 
 
(in thousands)
Beginning of Period Level 3 Fair Value
 
Realized Gains/(Losses)
 
Unrealized Gains
 
Other Comprehensive Income
 
Gross Purchases, Sales and Settlements (b)
 
Gross Transfers Into Level 3
 
Gross Transfers Out of Level 3
 
End of Period Level 3 Fair Value
Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Available-for-sale securities
$
9,200

 
$
(254
)
 
$

 
$
40

(a)
$
1,834

 
$

 
$

 
$
10,820

Total assets
$
9,200

 
$
(254
)
 
$

 
$
40

 
$
1,834

 
$

 
$

 
$
10,820

 
Level 3 Recurring Fair Value Measurements
 
Nine Months Ended September 30, 2011
 
 
 
Total Net Gains/(Losses) Included in Net Income
 
 
 
 
 
 
 
 
 
 
(in thousands)
Beginning of Period Level 3 Fair Value
 
Realized Gains/(Losses)
 
Unrealized Gains
 
Other Comprehensive Income
 
Gross Purchases, Sales and Settlements (b)
 
Gross Transfers Into Level 3
 
Gross Transfers Out of Level 3
 
End of Period Level 3 Fair Value
Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Available-for-sale securities
$
8,600

 
$
(208
)
 
$

 
$
594

(a)
$
1,834

 
$

 
$

 
$
10,820

Total assets
$
8,600

 
$
(208
)
 
$

 
$
594

 
$
1,834

 
$

 
$

 
$
10,820

____________________
(a) Change in unrealized gains on AFS securities is recorded in equity as accumulated other comprehensive income.
(b)
The Company purchased one Level 3 asset during the three and nine months ended September 30, 2011. However, there were no sales or settlements of the Company's Level 3 assets and liabilities during the three and nine months ended September 30, 2011.
The Company did not incur transfers between Level 1 and Level 2 or Level 2 and Level 3 for the three and nine months ended September 30, 2011. Transfers between Levels are deemed to take place on the first day of the reporting period in which the transfer has taken place.
Nonrecurring Fair Value
The Company may be required to measure certain assets or liabilities at fair value from time to time. These periodic fair value measures typically result from application of certain impairment measures under GAAP. These items would constitute nonrecurring fair value measures under ASC 820. As of September 30, 2011, the Company did not have any assets or liabilities measured at fair value on a nonrecurring basis. 

19


TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements - (continued)

Fair Value of Financial Instruments
In accordance with ASC 820, the Company is required to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the condensed consolidated balance sheet, for which fair value can be estimated.
The following describes the Company's methods for estimating the fair value for financial instruments. Descriptions are not provided for those items that have zero balances as of the current balance sheet date.
AFS securities, trading securities, derivative assets and liabilities are recurring fair value measurements; carrying value equals fair value. See discussion of valuation methods and assumptions within the Fair Value Measurements section of this footnote.
Cash and cash equivalents and restricted cash have a carrying value which approximates fair value because of the short maturities of these instruments.
The carrying value of repurchase agreements approximates fair value due to the maturities of less than one year of these financial instruments. The Company's repurchase agreements have floating rates based on an index plus a spread. These borrowings have been recently entered into and the credit spread is typically consistent with those demanded in the market. Accordingly, the interest rates on these borrowings are at market and thus carrying value approximates fair value.