10-Q 1 two331201210qdocument.htm QUARTERLY REPORT TWO 3/31/2012 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: March 31, 2012

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 x
 
Accelerated filer o
 
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 May 4, 2012 there were 214,217,304 shares of outstanding 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)

 
March 31,
2012
 
December 31,
2011
 
(unaudited)
 
 
ASSETS
  

 
  

Available-for-sale securities, at fair value
$
9,171,511

 
$
6,249,252

Trading securities, at fair value
1,002,090

 
1,003,301

Mortgage loans held-for-sale, at fair value
5,711

 
5,782

Investment in real estate, net
6,107

 

Cash and cash equivalents
545,688

 
360,016

Restricted cash
154,283

 
166,587

Accrued interest receivable
30,801

 
23,437

Due from counterparties
50,738

 
32,587

Derivative assets, at fair value
340,715

 
251,856

Other assets
23,338

 
7,566

Total Assets
$
11,330,982

 
$
8,100,384

LIABILITIES AND STOCKHOLDERS’ EQUITY
   

 
   

Liabilities
   

 
   

Repurchase agreements
$
8,693,756

 
$
6,660,148

Derivative liabilities, at fair value
47,475

 
49,080

Accrued interest payable
9,314

 
6,456

Due to counterparties
413,086

 
45,565

Accrued expenses
9,495

 
8,912

Dividends payable
85,683

 
56,239

Income taxes payable

 
3,898

Total liabilities
9,258,809

 
6,830,298

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 214,207,346 and 140,596,708 shares issued and outstanding, respectively
2,142

 
1,406

Additional paid-in capital
2,064,423

 
1,373,099

Accumulated other comprehensive income (loss)
85,194

 
(58,716
)
Cumulative earnings
209,252

 
157,452

Cumulative distributions to stockholders
(288,838
)
 
(203,155
)
Total stockholders’ equity
2,072,173

 
1,270,086

Total Liabilities and Stockholders’ Equity
$
11,330,982

 
$
8,100,384


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


1


TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands, except share data)
 
Three Months Ended
 
March 31,
 
2012
 
2011
 
(unaudited)
Interest income:
  

 
   

Available-for-sale securities
$
84,214

 
$
19,535

Trading securities
1,050

 
272

Mortgage loans held-for-sale
69

 

Cash and cash equivalents
168

 
63

Total interest income
85,501

 
19,870

Interest expense
11,467

 
2,499

Net interest income
74,034

 
17,371

Other-than-temporary impairments:
 
 
 
Total other-than temporary impairment losses
(4,275
)
 

Non-credit portion of loss recognized in other comprehensive income

 

Net other-than-temporary credit impairment losses
(4,275
)
 

Other income:
 
 
 
Gain on investment securities, net
9,931

 
1,539

(Loss) gain on interest rate swap and swaption agreements
(16,193
)
 
1,939

(Loss) gain on other derivative instruments
(8,890
)
 
5,347

Other loss
(40
)
 

Total other (loss) income
(15,192
)
 
8,825

Expenses:
 
 
 
Management fees
6,743

 
1,550

Other operating expenses
3,601

 
1,512

Total expenses
10,344

 
3,062

Income before income taxes
44,223

 
23,134

(Benefit from) provision for income taxes
(7,577
)
 
757

Net income attributable to common stockholders
$
51,800

 
$
22,377

Basic and diluted earnings per weighted average common share
$
0.28

 
$
0.49

Dividends declared per common share
$
0.40

 
$
0.40

Basic and diluted weighted average number of shares of common stock
186,855,589

 
45,612,376

Comprehensive income:
 
 
 
Net income
$
51,800

 
$
22,377

Other comprehensive income:
 
 
 
Unrealized gain on available-for-sale securities, net
143,910

 
9,115

Other comprehensive income
143,910

 
9,115

Comprehensive income
$
195,710

 
$
31,492


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

2


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

 
Common Stock
 
 
 
 
 
 
 
 
 
 
 
Shares
 
Amount
 
Additional Paid-in Capital
 
Accumulated Other Comprehensive Income (Loss)
 
Cumulative Earnings
 
Cumulative Distributions to Stockholders
 
Total Stockholders' Equity
 
 
 
 
 
 
 
(unaudited)
 
 
 
 
 
 
Balance, January 1, 2011
40,501,212

 
$
405

 
$
366,974

 
$
22,619

 
$
30,020

 
$
(37,570
)
 
$
382,448

Net income

 

 

 

 
22,377

 

 
22,377

Other comprehensive income

 

 

 
9,115

 

 

 
9,115

Net proceeds from issuance of common stock, net of offering costs
28,750,545

 
288

 
287,478

 

 

 

 
287,766

Common dividends declared

 

 

 

 

 
(16,200
)
 
(16,200
)
Non-cash equity award compensation

 

 
62

 

 

 

 
62

Balance, March 31, 2011
69,251,757

 
$
693

 
$
654,514

 
$
31,734

 
$
52,397

 
$
(53,770
)
 
$
685,568

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, January 1, 2012
140,596,708

 
$
1,406

 
$
1,373,099

 
$
(58,716
)
 
$
157,452

 
$
(203,155
)
 
$
1,270,086

Net income

 

 

 

 
51,800

 

 
51,800

Other comprehensive income

 

 

 
143,910

 

 

 
143,910

Net proceeds from issuance of common stock, net of offering costs
73,610,638

 
736

 
691,264

 

 

 

 
692,000

Common dividends declared

 

 

 

 

 
(85,683
)
 
(85,683
)
Non-cash equity award compensation

 

 
60

 

 

 

 
60

Balance, March 31, 2012
214,207,346

 
$
2,142

 
$
2,064,423

 
$
85,194

 
$
209,252

 
$
(288,838
)
 
$
2,072,173


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)
 
Three Months Ended
 
March 31,
 
2012
 
2011
 
(unaudited)
Cash Flows From Operating Activities:
   

 
   

Net income
$
51,800

 
$
22,377

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
   

 
   

Amortization of premiums and discounts on RMBS, net
(5,925
)
 
2,467

Other-than-temporary impairment losses
4,275

 

Gain on investment securities, net
(9,931
)
 
(1,539
)
Loss (gain) on termination and option expiration of interest rate swaps and swaptions
11,265

 
(1,253
)
Unrealized loss (gain) on interest rate swaps and swaptions
212

 
(3,838
)
Unrealized loss (gain) on other derivative instruments
8,026

 
(1,971
)
Unrealized loss on mortgage loans
45

 

Equity based compensation expense
60

 
62

Depreciation of real estate
1

 

Proceeds from repayment of mortgage loans held-for-sale
26

 

Net change in assets and liabilities:
   

 
 
Increase in accrued interest receivable
(7,364
)
 
(5,627
)
Decrease in deferred income taxes, net
638

 
482

Increase in current tax receivable
(7,952
)
 

Decrease in prepaid and fixed assets
38

 
204

Increase in escrow deposits
(8,496
)
 

Increase in accrued interest payable, net
2,858

 
520

(Decrease)/increase in income taxes payable
(3,898
)
 
275

Increase in accrued expenses
583

 
934

Net cash provided by operating activities
36,261

 
13,093

Cash Flows From Investing Activities:
   

 
   

Purchases of available-for-sale securities
(3,065,659
)
 
(1,636,366
)
Proceeds from sales of available-for-sale securities
170,102

 
71,405

Principal payments on available-for-sale securities
130,002

 
44,659

Purchases of other derivative instruments
(124,323
)
 
(70,302
)
Proceeds from sales of other derivative instruments
14,354

 
11,342

Purchases of trading securities

 
(299,337
)
Proceeds from sales of trading securities

 
199,500

Purchases of investments in real estate
(6,108
)
 

Increase in due to counterparties, net
349,370

 
97,269

Decrease (increase) in restricted cash
12,304

 
(16,443
)
Net cash used in investing activities
(2,519,958
)
 
(1,598,273
)

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


4


TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Three Months Ended
 
March 31,
 
2012
 
2011
 
(unaudited)
Cash Flows From Financing Activities:
   

 
   

Proceeds from repurchase agreements
$
10,564,948

 
$
3,131,249

Principal payments on repurchase agreements
(8,531,340
)
 
(1,685,022
)
Proceeds from issuance of common stock, net of offering costs
692,000

 
287,766

Dividends paid on common stock
(56,239
)
 
(10,450
)
Net cash provided by financing activities
2,669,369

 
1,723,543

Net increase in cash and cash equivalents
185,672

 
138,363

Cash and cash equivalents at beginning of period
360,016

 
163,900

Cash and cash equivalents at end of period
$
545,688

 
$
302,263

Supplemental Disclosure of Cash Flow Information:
   

 
 
Cash paid for interest
$
8,609

 
$
1,980

Cash paid for taxes
$
3,635

 
$
1

Non-Cash Financing Activity:
   

 
   

Dividends declared but not paid at end of period
$
85,683

 
$
16,200

Reconciliation of mortgage loans held-for-sale:
 
 
 
Mortgage loans held-for-sale at beginning of period
$
5,782

 
$

Proceeds from repayment of mortgage loans held-for-sale
(26
)
 

Unrealized loss on mortgage loans
(45
)
 

Loans held-for-sale at end of period
$
5,711

 
$


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

5


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

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, residential real properties, 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.
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 is qualification as a REIT, the Company generally will not be subject to U.S. federal income taxes to the extent that the Company distributes its taxable income to its stockholders on an annual basis and does not engage in prohibited transactions. However, certain activities that the Company may perform may cause it to earn income which will not be qualifying income for REIT purposes. The Company has designated certain of its subsidiaries as taxable REIT subsidiaries, or TRSs, as defined in the Code, to engage in such activities, and the Company may in the future form additional TRSs.

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, 2011. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at March 31, 2012 and results of operations for all periods presented have been made. The results of operations for the three months ended March 31, 2012 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.
Significant Accounting Policies
Investment in Real Estate, Net
Beginning in early 2012, the Company began investing in single family residential properties with the intention of holding and renting the properties. Real estate is recorded at acquisition cost, allocated between land and building. Building depreciation is computed on the straight-line basis over the estimated useful lives of the assets. The Company generally uses a 27.5-year estimated life with no salvage value. For properties purchased subject to an existing lease, the assets are recorded at fair value, allocated to land, building and the existing lease. Any difference between fair value and cost is recorded in the income statement. The lease value is amortized over the expected benefit period (i.e., the lease term).

6


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

The Company evaluates its long-lived assets for impairment periodically or whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. If an impairment indicator exists, the Company compares the expected future undiscounted cash flows against the carrying amount of an asset. If the sum of the estimated undiscounted cash flows is less that the carrying amount of the asset, the Company would record an impairment loss for the difference between the estimated fair value and the carrying amount of the asset.
The lease periods are generally short term in nature (one year or less) and reflect market rental rates. Gross rental income and expenses applicable to rental income are reported in the statement of comprehensive income in other loss and other operating expenses, respectively. Expenditures for ordinary maintenance and repairs are expensed to operations as incurred and expenditures for significant renovations that improve the asset and extend the useful life of the asset are capitalized and depreciated over their estimated useful life.
Refer to Note 2 to the Consolidated Financial Statements in the Company's 2011 Annual Report on Form 10-K regarding additional significant accounting policies.
Recently Issued and/or Adopted Accounting Standards
Comprehensive Income
In June 2011, the Financial Accounting Standards Board, or FASB, issued ASU No. 2011-05, which amends ASC 820, Comprehensive Income. The amendments are intended to make the presentation of items within Other Comprehensive Income (OCI) more prominent. ASU 2011-05 eliminates the option to present components of OCI in the statement of changes in stockholders' equity and requires companies to present all non-owner changes in stockholders' equity either as a single continuous statement of comprehensive income or as two separate but consecutive statements. In addition, reclassification adjustments between OCI and net income must be presented separately on the face of the financial statements. The new guidance does not change the components of OCI or the calculation of earnings per share. ASU 2011-05 is effective for the first interim or annual period beginning on or after December 15, 2011. Adopting this ASU did not have a material impact on the Company's condensed consolidated financial condition or results of operations. On December 23, 2011, the FASB issued ASU 2011-12, which defers those changes in ASU 2011-05 that relate to the presentation of reclassification adjustments. This was done to allow the FASB time to re-deliberate whether to present on the face of the financial statements the effects of reclassification out of accumulated OCI on the components of net income and comprehensive income for all periods presented. No other requirements under ASU 2011-05 are affected by this update.
Fair Value
In May 2011, the FASB issued ASU No. 2011-04, which amends ASC 820, Fair Value Measurements. The amendments in this ASU clarify the requirements for measuring fair value and disclosing information about fair value. It is intended to improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with GAAP and International Financial Reporting Standards, or IFRS. The ASU is effective for the first interim or annual period beginning on or after December 15, 2011. Adopting this ASU did not have a material impact on the Company's condensed consolidated financial condition or results of operations.
Offsetting Assets and Liabilities
In December 2011, the FASB issued ASU No. 2011-11, which amends ASC 210, Balance Sheet. The amendments in this ASU enhance disclosures required by U.S. GAAP by requiring improved information about financial instruments and derivative instruments that are either (1) offset in accordance with ASC 210, Balance Sheet or ASC 815, Other Presentation Matters or (2) subject to an enforceable master netting arrangement or similar agreement. ASU 2011-11 is effective for the first interim or annual period beginning on or after January 1, 2013. We anticipate that adopting this ASU will not have a material impact on the Company's condensed consolidated financial condition or results of operations.












7


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

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 March 31, 2012 and December 31, 2011:
(in thousands)
March 31,
2012
 
December 31,
2011
Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
2,034,926

 
$
1,609,003

Federal National Mortgage Association
3,801,065

 
2,414,637

Government National Mortgage Association
1,391,615

 
1,029,517

Non-Agency
1,943,905

 
1,196,095

Total mortgage-backed securities
$
9,171,511

 
$
6,249,252


At March 31, 2012 and December 31, 2011, the Company pledged investment securities with a carrying value of $8.6 billion and $6.2 billion, respectively, as collateral for repurchase agreements. See Note 12 - Repurchase Agreements.
At March 31, 2012 and December 31, 2011, 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.
The following tables present the amortized cost and carrying value (which approximates fair value) of AFS securities by collateral type as of March 31, 2012 and December 31, 2011:
 
March 31, 2012
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
7,722,200

 
$
4,233,247

 
$
11,955,447

Unamortized premium
458,949

 

 
458,949

Unamortized discount
 
 
 
 
 
Designated credit reserve

 
(1,304,753
)
 
(1,304,753
)
Net, unamortized
(1,074,953
)
 
(948,373
)
 
(2,023,326
)
Amortized Cost
7,106,196

 
1,980,121

 
9,086,317

Gross unrealized gains
142,484

 
48,976

 
191,460

Gross unrealized losses
(21,074
)
 
(85,192
)
 
(106,266
)
Carrying Value
$
7,227,606

 
$
1,943,905

 
$
9,171,511

 
December 31, 2011
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
5,692,754

 
$
2,667,929

 
$
8,360,683

Unamortized premium
279,640

 

 
279,640

Unamortized discount
  

 
  

 
  

Designated credit reserve

 
(782,606
)
 
(782,606
)
Net, unamortized
(1,008,780
)
 
(540,969
)
 
(1,549,749
)
Amortized Cost
4,963,614

 
1,344,354

 
6,307,968

Gross unrealized gains
108,864

 
11,881

 
120,745

Gross unrealized losses
(19,321
)
 
(160,140
)
 
(179,461
)
Carrying Value
$
5,053,157

 
$
1,196,095

 
$
6,249,252



8


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

The following tables present the carrying value of the Company's AFS investment securities by rate type as of March 31, 2012 and December 31, 2011:
 
March 31, 2012
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
227,164

 
$
1,683,540

 
$
1,910,704

Fixed Rate
7,000,442

 
260,365

 
7,260,807

Total
$
7,227,606

 
$
1,943,905

 
$
9,171,511

 
December 31, 2011
(in thousands)
Agency
 
Non-Agency
 
Total
Adjustable Rate
$
231,678

 
$
995,014

 
$
1,226,692

Fixed Rate
4,821,479

 
201,081

 
5,022,560

Total
$
5,053,157

 
$
1,196,095

 
$
6,249,252


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 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 an off balance sheet credit reserve on the security, with unamortized net discounts or premiums amortized into income over time to the extent realizable.
The following table presents the changes for the three months ended March 31, 2012 and 2011 of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
 
Three Months Ended March 31,
 
2012
 
2011
(in thousands)
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
 
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
Beginning balance at January 1
$
(782,606
)
 
$
(540,969
)
 
$
(1,323,575
)
 
$
(145,855
)
 
$
(129,992
)
 
$
(275,847
)
Acquisitions
(521,424
)
 
(437,331
)
 
(958,755
)
 
(96,343
)
 
(38,763
)
 
(135,106
)
Accretion of net discount

 
28,897

 
28,897

 

 
5,376

 
5,376

Realized credit losses
3,309

 

 
3,309

 
771

 

 
771

Reclassification adjustment for other-than-temporary impairments
(4,275
)
 

 
(4,275
)
 

 

 

Transfers from (to)

 

 

 
(123
)
 
123

 

Sales, calls, other
243

 
1,030

 
1,273

 
8,085

 
5,145

 
13,230

Ending balance at March 31
$
(1,304,753
)
 
$
(948,373
)
 
$
(2,253,126
)
 
$
(233,465
)
 
$
(158,111
)
 
$
(391,576
)


9


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

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 March 31, 2012 and December 31, 2011. At March 31, 2012, the Company held 1,074 AFS securities, of which 315 were in an unrealized loss position for less than twelve consecutive months and 41 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2011, the Company held 854 AFS securities, of which 264 were in an unrealized loss position for less than twelve months and 20 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
March 31, 2012
$
2,893,328

 
$
(89,623
)
 
$
172,780

 
$
(16,643
)
 
$
3,066,108

 
$
(106,266
)
December 31, 2011
$
1,277,120

 
$
(175,348
)
 
$
15,608

 
$
(4,113
)
 
$
1,292,728

 
$
(179,461
)

Evaluating AFS Securities for Other-than-Temporary Impairments
In order to evaluate AFS securities for OTTI, the Company determines 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 using the original yield as the discount rate, 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. 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.
The Company recorded a $4.3 million other-than-temporary credit impairment during three months ended March 31, 2012 on a total of fifteen non-Agency RMBS where the future expected cash flows for each security was less than its amortized cost. As of March 31, 2012, the impaired securities had weighted average cumulative losses of 2.5%, weighted average three-month prepayment speed of 2.31, weighted average 60+ day delinquency of 37.5% of the pool balance, and weighted average FICO score of 650. At March 31, 2012 the Company did not intend to sell the securities and it is not more likely than not that the Company will be required to sell the securities, therefore, only the projected credit loss was recognized in earnings. The Company did not record an other-than-temporary credit impairment during the three months ended March 31, 2011.
The following table presents the OTTI included in earnings for three months ended March 31, 2012 and 2011:
 
Three Months Ended
 
March 31,
(in thousands)
2012
 
2011
Cumulative credit loss at beginning of period
$
(5,102
)
 
$

Additions:
 
 
 
Other-than-temporary impairments not previously recognized
(3,483
)
 

Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments
(792
)
 

Cumulative credit loss at end of period
$
(9,377
)
 
$


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 comprehensive income. For the three months ended March 31, 2012, the Company sold AFS securities for $170.1 million with an amortized cost of $159.0 million, for a net

10


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

realized gain of $11.1 million. For the three months ended March 31, 2011, the Company sold AFS securities for $71.4 million with an amortized cost of $69.8 million, for a net realized gain of $1.6 million.
The following table presents the gross realized gains and losses on sales of AFS securities for the three months ended March 31, 2012 and 2011:
 
Three Months Ended
 
March 31,
(in thousands)
2012
 
2011
Gross realized gains
$
11,103

 
$
1,808

Gross realized losses

 
(170
)
Total realized gains on sales, net
$
11,103

 
$
1,638


Note 4. Trading Securities, at Fair Value
The Company holds U.S. Treasuries in its taxable REIT subsidiary and classifies these securities as trading instruments due to its short-term investment objectives. As of March 31, 2012 and December 31, 2011, the Company held U.S. Treasuries with an amortized cost of $1.0 billion and a fair value of $1.0 billion for both periods, classified as trading securities. The unrealized gains included within trading securities were $1.9 million and $3.1 million as of March 31, 2012 and December 31, 2011, respectively.
For the three months ended March 31, 2012, the Company did not sell any trading securities. For the three months ended March 31, 2011, the Company sold trading securities for $199.5 million with an amortized cost of $200.0 million, resulting in realized losses of $0.5 million on the sale of these investment securities. For the three months ended March 31, 2012 and March 31, 2011, trading securities experienced unrealized losses of $1.2 million and unrealized gains of $0.4 million, respectively. Both realized and unrealized gains and losses are recorded as a component of gains on investment securities, net in the Company's condensed consolidated statements of comprehensive income.
At March 31, 2012, the Company pledged trading securities with a carrying value of $1.0 billion as collateral for repurchase agreements. See Note 12 - Repurchase Agreements.

Note 5. Mortgage Loans Held-for-Sale, at Fair Value
Mortgage loans held-for-sale consists of residential mortgage loans carried at fair value as a result of a fair value option election. The following table presents the carrying value of the Company's mortgage loans held-for-sale as of March 31, 2012 and December 31, 2011:
(in thousands)
March 31, 2012
 
December 31, 2011
Unpaid principal balance
$
5,629

 
$
5,655

Fair value adjustment
82

 
127

Carrying value
$
5,711

 
$
5,782


At March 31, 2012, the Company pledged mortgage loans with a carrying value of $5.7 million as collateral for repurchase agreements. See Note 12 - Repurchase Agreements.













11


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

Note 6. Investment in Real Estate, Net
Investments in real estate consists of single family residential properties purchased by the Company with the intention to hold and rent the properties. The following table presents the carrying value of the Company's investment in real estate as of March 31, 2012 and December 31, 2011:
(in thousands)
March 31, 2012
 
December 31, 2011
Land
$
1,191

 
$

Building
4,917

 

 
6,108

 

Accumulated depreciation
(1
)
 

Carrying value
$
6,107

 
$


Note 7. Restricted Cash
As of March 31, 2012 and December 31, 2011, 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)
March 31,
2012
 
December 31,
2011
Restricted cash balances held by:
 
 
 
Broker counterparties for securities trading activity
$
9,000

 
$
9,000

Broker counterparties for derivatives trading activity
99,103

 
62,784

Repurchase counterparties as restricted collateral
46,180

 
94,803

Total
$
154,283

 
$
166,587


Note 8. Accrued Interest Receivable
The following table presents the Company's accrued interest receivable by collateral type:
(in thousands)
March 31,
2012
 
December 31,
2011
Accrued Interest Receivable:
 
 
 
U.S. Treasuries
$
1,155

 
$
1,003

Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
7,203

 
5,844

Federal National Mortgage Association
13,830

 
9,770

Government National Mortgage Association
5,725

 
4,454

Non-Agency
2,854

 
2,328

Total mortgage-backed securities
29,612

 
22,396

Mortgage loans held-for-sale
34

 
38

Total
$
30,801

 
$
23,437


Note 9. 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

12


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

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.
Balance Sheet Presentation
The following table presents the gross fair value and notional amounts of the Company's derivative financial instruments treated as trading instruments as of March 31, 2012 and December 31, 2011.
(in thousands)
 
March 31, 2012
 
December 31, 2011
 
 
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
 
$
246,066

1,666,707

 
$


 
$
157,421

1,131,084

 
$


Interest rate swap agreements
 


 
(34,540
)
7,035,000

 


 
(28,790
)
5,810,000

Credit default swap agreements
 
62,924

541,426

 
(9,802
)
111,450

 
86,136

544,699

 
(14,638
)
154,812

Swaptions
 
30,214

4,300,000

 


 
5,635

2,900,000

 


TBAs
 
1,484

500,000

 
(3,133
)
2,000,000

 
2,664

275,000

 
(5,652
)
850,000

Forward sale commitment
 
27

5,178

 


 

5,202

 


Total
 
$
340,715

7,013,311

 
$
(47,475
)
9,146,450

 
$
251,856

4,855,985

 
$
(49,080
)
6,814,812


The following table provides the average outstanding notional amounts of the Company's derivative financial instruments treated as trading instruments for the three months ended March 31, 2012.
(in thousands)
 
Three Months Ended March 31, 2012
Trading instruments
 
Derivative Assets
 
Derivative Liabilities
Inverse interest-only securities
 
1,330,835

 

Interest rate swap agreements
 

 
6,366,593

Credit default swaps
 
541,888

 
137,567

Swaptions
 
3,573,077

 

TBAs
 
207,418

 
754,396

Forward sale commitment
 
5,186

 


Comprehensive Income Statement Presentation
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.

13


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

The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed consolidated statement of comprehensive 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
 
 
 
 
Three Months Ended March 31,
 
 
 
 
2012
 
2011
Risk Management Instruments
 
 
 
 
 
 
Interest Rate Contracts
 
 
 
 
 
 
Investment securities - RMBS
 
(Loss) gain on other derivative instruments
 
$
(2,637
)
 
$
(258
)
Investment securities - U.S. Treasuries and TBA contracts
 
(Loss) gain on interest rate swap and swaption agreements
 
(1,648
)
 
(410
)
Mortgage loans held-for-sale
 
(Loss) gain on other derivative instruments
 
13

 

Repurchase agreements
 
(Loss) gain on interest rate swap and swaption agreements
 
(14,545
)
 
2,349

Credit default swaps - Receive protection
 
(Loss) gain on other derivative instruments
 
(24,301
)
 

Non-Risk Management Instruments
 
 
 
 
 
 
Credit default swaps - Provide protection
 
(Loss) gain on other derivative instruments
 
8,220

 
2,338

Inverse interest-only securities
 
(Loss) gain on other derivative instruments
 
9,815

 
3,267

Total
 
 
 
$
(25,083
)
 
$
7,286


For the three months ended March 31, 2012 and 2011, the Company recognized $4.7 million and $3.2 million, respectively, of expenses for the accrual and/or settlement of the net interest expense associated with its interest rate swaps. The expenses result from generally paying a fixed interest rate on an average $6.4 billion and $1.3 billion notional, respectively, to hedge a portion of the Company's interest rate risk on its short-term repurchase agreements, funding costs, and macro-financing risk and generally receiving LIBOR interest.
For the three months ended March 31, 2012 and 2011, the Company terminated or had options expire on a total of 11 and 4 interest rate swap and swaption positions of $0.9 billion notional and $0.4 billion notional, respectively. Upon settlement of the early terminations and option expirations, the Company paid $0.5 million and $0.4 million in 2012 and 2011, respectively, in full settlement of its net interest spread liability and recognized $11.3 million in realized losses and and $1.3 million in realized gains on the swaps and swaptions in 2012 and 2011, respectively, including early termination penalties.
For the three months ended March 31, 2012, the Company terminated a total of 4 credit default swap positions totaling $85.0 million notional. Upon settlement of the early terminations, the Company received $10,492 in full settlement of its net interest spread receivable and recognized $1.6 million in realized losses on the credit default swaps, including early termination penalties. The Company did not terminate any credit default swap positions during the three months ended March 31, 2011.
Cash flow activity related to derivative instruments is reflected within the operating activities and investing activities sections of the condensed consolidated statements of cash flows. Derivative fair value adjustments are reflected within the unrealized loss (gain) on interest rate swaps and swaptions and unrealized loss (gain) on other derivative instruments line items and realized losses on interest rate swap and swaption agreements are reflected within the loss on termination of interest rate swaps and swaptions line item within the operating activities section of the condensed consolidated statements of cash flows. The remaining cash flow activity related to derivative instruments is reflected within the purchases of other derivative instruments, proceeds from sales of other derivative instruments and (decrease) increase in due to counterparties, net line items within the investing activities section of the condensed consolidated statements of cash flows.

14


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

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 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 March 31, 2012 and December 31, 2011, the Company had outstanding fair value of $60.6 million and $48.4 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 held TBA positions with $500.0 million and $275.0 million in long notional and $2.0 billion and $850.0 million in short notional as of March 31, 2012 and December 31, 2011, respectively. 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 March 31, 2012 and December 31, 2011, these contracts held a fair market value of $1.5 million and $2.7 million, included in derivative assets, at fair value, and $3.1 million and $5.7 million, included in derivative liabilities, at fair value, in the condensed consolidated balance sheets as of March 31, 2012 and December 31, 2011, respectively.
Mortgage Loans Held-for-Sale  - The Company is exposed to interest rate risk on mortgage loans from the time of purchase until the mortgage loan is sold. Changes in interest rates impact the market price for the mortgage loans. For example, as market interest rates decline, the value of mortgage loans held-for-sale increases, and vice versa. To mitigate the impact of this risk, the Company entered into a Forward AAA Securities Agreement, or the Forward Agreement, with Barclays Bank PLC, or Barclays, under which Barclays would purchase certain securities issued in connection with a potential securitization transaction involving mortgage loans subject to the Forward Agreement. As of March 31, 2012 and December 31, 2011, one trade has been executed under the Forward Agreement with a notional of $5.2 million for both period ends and a fair value of $26,701 as of March 31, 2012. No fair value was assigned to the derivative at December 31, 2011 as it was entered into at market terms at the end of the year.
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 March 31, 2012 and December 31, 2011, 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)
 
 
 
 
 
 
March 31, 2012
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
25,000

 
0.868
%
 
0.563
%
 
0.73

2013
 
2,275,000

 
0.713
%
 
0.513
%
 
1.31

2014
 
1,675,000

 
0.644
%
 
0.553
%
 
2.32

2015
 
1,670,000

 
1.136
%
 
0.504
%
 
3.09

2016 and Thereafter
 
390,000

 
1.342
%
 
0.498
%
 
4.46

Total
 
6,035,000

 
0.852
%
 
0.521
%
 
2.28


15


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

(notional in thousands)
 
 
 
 
 
 
December 31, 2011
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
25,000

 
0.868
%
 
0.315
%
 
0.98

2013
 
2,025,000

 
0.737
%
 
0.368
%
 
1.55

2014
 
1,275,000

 
0.670
%
 
0.380
%
 
2.72

2015
 
820,000

 
1.575
%
 
0.329
%
 
3.52

2016
 
240,000

 
2.156
%
 
0.316
%
 
4.32

Total
 
4,385,000

 
0.952
%
 
0.361
%
 
2.41


The Company has also entered into interest rate swaps in combination with U.S. Treasuries to economically hedge funding cost risk. As of March 31, 2012 and December 31, 2011, the Company held $1.0 billion in fair value of U.S. Treasuries classified as trading securities and the following outstanding interest rate swaps:
(notional in thousands)
 
 
 
 
 
 
March 31, 2012
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2013
 
1,000,000

 
0.644
%
 
0.515
%
 
1.26

Total
 
1,000,000

 
 
 
 
 
 
(notional in thousands)
 
 
 
 
 
 
December 31, 2011
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2013
 
1,250,000

 
0.620
%
 
0.339
%
 
1.54

Total
 
1,250,000

 
 
 
 
 
 

As of March 31, 2012, all of the Company's interest rate swap contracts receive interest at a 1-month or 3-month LIBOR rate. As of December 31, 2011, all of the Company's interest rate swap contracts received 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 paid interest at a 3-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
December 31, 2011
Swaps Maturities
 
Notional Amounts
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2016
 
175,000

 
0.420
%
 
1.772
%
 
4.58

Total
 
175,000

 
 
 
 
 
 


16


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

Additionally, as of March 31, 2012 and December 31, 2011, 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:
March 31, 2012
(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
 
$
13,653

 
$
452

 
5.84
 
1,800,000

 
3.06
%
 
3M Libor
 
4.0

Payer
 
≥ 6 Months
 
30,965

 
29,762

 
16.40
 
2,500,000

 
3.73
%
 
3M Libor
 
9.3

Total Payer
 
 
 
$
44,618

 
$
30,214

 
15.89
 
4,300,000

 
3.45
%
 
3M Libor
 
7.1

December 31, 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
 
$
16,147

 
$
4

 
4.97
 
1,600,000

 
3.22
%
 
3M Libor
 
3.7

Payer
 
≥ 6 Months
 
13,523

 
5,631

 
12.27
 
1,300,000

 
3.19
%
 
3M Libor
 
6.5

Total Payer
 
 
 
$
29,670

 
$
5,635

 
12.26
 
2,900,000

 
3.21
%
 
3M Libor
 
4.9


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's exposure to credit losses on its U.S. Treasuries and Agency portfolio of investment securities is limited 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 Freddie Mac and Fannie Mae mortgage-backed securities are guaranteed by those respective agencies, and the payment of principal and interest on the Ginnie Mae mortgage-backed securities are backed by the full faith and credit of the U.S. Government.
For non-Agency investment securities, the Company enters into credit default swaps to 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 March 31, 2012, 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.

17


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

The following tables present credit default swaps where the Company is receiving protection held as of March 31, 2012 and December 31, 2011:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
March 31, 2012
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
)
 
$
277

 
$
(3,127
)
 
$
(2,850
)
 
12/20/2013
 
181.91

 
(105,000
)
 
1,312

 
(3,225
)
 
(1,913
)
 
6/20/2016
 
105.00

 
(150,000
)
 
(2,480
)
 
(355
)
 
(2,835
)
 
12/20/2016
 
683.22

 
(122,000
)
 
3,556

 
(13,062
)
 
(9,506
)
 
5/25/2046
 
377.23

 
(119,426
)
 
60,259

 
(57,322
)
 
2,937

 
Total
 
339.76

 
(541,426
)
 
$
62,924

 
$
(77,091
)
 
$
(14,167
)
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 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
)
 
$
2,422

 
$
(3,127
)
 
$
(705
)
 
12/20/2013
 
172.50

 
(105,000
)
 
3,742

 
(3,225
)
 
517

 
6/20/2016
 
105.00

 
(150,000
)
 
2,074

 
(355
)
 
1,719

 
12/20/2016
 
684.38

 
(125,000
)
 
10,200

 
(13,062
)
 
(2,862
)
 
5/25/2046
 
377.23

 
(119,699
)
 
67,698

 
(57,322
)
 
10,376

 
Total
 
341.94

 
(544,699
)
 
$
86,136

 
$
(77,091
)
 
$
9,045


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 March 31, 2012, the fair value of derivative financial instruments as an asset and liability position was $340.7 million and $47.5 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 March 31, 2012, the Company has received cash deposits from counterparties of $55.6 million and placed cash deposits of $101.8 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.

18


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

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 RMBS and credit default swaps.
Inverse interest-only securities with a carrying value of $246.1 million, including accrued interest receivable of $3.1 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 March 31, 2012 and December 31, 2011:
(in thousands)
March 31,
2012
 
December 31,
2011
Face Value
$
1,666,707

 
$
1,131,084

Unamortized premium

 

Unamortized discount
 
 
 
Designated credit reserve

 

Net, unamortized
(1,424,110
)
 
(973,066
)
Amortized Cost
242,597

 
158,018

Gross unrealized gains
9,475

 
4,606

Gross unrealized losses
(9,127
)
 
(7,385
)
Carrying Value
$
242,945

 
$
155,239


As of March 31, 2012 and December 31, 2011, 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.
The following tables present credit default swaps where the Company is providing protection held as of March 31, 2012 and December 31, 2011:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
March 31, 2012
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Provide
7/25/2036
 
352.46

 
58,795

 
$
3,682

 
$
(7,403
)
 
$
(3,721
)
 
5/25/2046
 
146.18

 
52,655

 
(13,484
)
 
13,574

 
90

 
 
 
255.01

 
111,450

 
$
(9,802
)
 
$
6,171

 
$
(3,631
)
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2011
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Provide
7/25/2036
 
358.71

 
99,890

 
$
2,733

 
$
(11,089
)
 
$
(8,356
)
 
5/25/2046
 
146.18

 
54,922

 
(17,371
)
 
13,574

 
(3,797
)
 
 
 
289.59

 
154,812

 
$
(14,638
)
 
$
2,485

 
$
(12,153
)



19


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

Note 10. Other Assets
Other assets as of March 31, 2012 and December 31, 2011 are summarized in the following table:
(in thousands)
March 31,
2012
 
December 31,
2011
Property and equipment at cost
$
465

 
$
322

Accumulated depreciation (1)
(72
)
 
(39
)
Net property and equipment
393

 
283

Prepaid expenses
574

 
722

Current tax receivable
8,109

 
157

Deferred tax assets
5,753

 
6,391

Escrow deposits
8,496

 

Lease deposit
13

 
13

Total other assets
$
23,338

 
$
7,566

____________________
(1)
Depreciation expense for the three months ended March 31, 2012 was $33,182.

Note 11. 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.
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 under current market conditions. 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 the assumptions that market participants would use to price the assets and liabilities, including risk. 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 comprised 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,

20


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

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 100.0% of its U.S. Treasuries as Level 1 fair value assets at March 31, 2012. The Company classified 100.0% of its RMBS AFS securities reported at fair value as Level 2 at March 31, 2012. AFS and trading securities account for 87.2% and 9.5% of all assets reported at fair value at March 31, 2012, respectively.
Mortgage loans held-for-sale  - The Company holds a portfolio of mortgage loans held-for-sale that are carried at fair value in the condensed consolidated balance sheet as a result of a fair value option election. The Company determines fair value of its mortgage loans based on prices obtained from third-party pricing providers and other applicable market data. If observable market prices are not available or insufficient to determine fair value due principally to illiquidity in the marketplace, then fair value is based upon cash flow 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 100.0% of its mortgage loans held-for-sale as Level 3 fair value assets at March 31, 2012.
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 their 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 March 31, 2012.
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 March 31, 2012. The Company reported 100% of its TBAs as Level 1 as of March 31, 2012.
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.

21


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

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 March 31, 2012
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$

 
$
9,171,511

 
$

 
$
9,171,511

Trading securities
1,002,090

 

 

 
1,002,090

Mortgage loans held-for-sale

 

 
5,711

 
5,711

Derivative assets
1,484

 
339,231

 

 
340,715

Total assets
$
1,003,574

 
$
9,510,742

 
$
5,711

 
$
10,520,027

Liabilities
 
 
 
 
 
 
 
Derivative liabilities
$
3,133

 
$
44,342

 
$

 
$
47,475

Total liabilities
$
3,133

 
$
44,342

 
$

 
$
47,475

 
Recurring Fair Value Measurements
 
At December 31, 2011
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$

 
$
6,238,136

 
$
11,116

 
$
6,249,252

Trading securities
1,003,301

 

 

 
1,003,301

Mortgage loans held-for-sale

 

 
5,782

 
5,782

Derivative assets
2,664

 
249,192

 

 
251,856

Total assets
$
1,005,965

 
$
6,487,328

 
$
16,898

 
$
7,510,191

Liabilities
 
 
 
 
 
 
 
Derivative liabilities
$
5,652

 
$
43,428

 
$

 
$
49,080

Total liabilities
$
5,652

 
$
43,428

 
$

 
$
49,080


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 March 31, 2012, the Company did not have any assets or liabilities measured at fair value on a nonrecurring basis in the periods presented. 
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.

22


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

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 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 March 31, 2012
 
 
Assets
 
(in thousands)
Available-For-Sale Securities
 
Mortgage Loans Held-For-Sale
 
Beginning of period level 3 fair value
$
11,116

 
$
5,782

 
Gains/(losses) Included in net income:
 
 
 
 
Realized gains (losses)

 

 
Unrealized gains (losses)

 
(45
)
(2) 
Total net gains/(losses) Included in net income

 
(45
)
 
Other comprehensive income (1)

 

 
Purchases