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, 2013

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 1400
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 November 6, 2013 there were 364,375,976 shares of outstanding common stock, par value $.01 per share, issued and outstanding.
 
 
 
 
 

Table of Contents



TWO HARBORS INVESTMENT CORP.
INDEX

 
 
Page
 
PART I - FINANCIAL INFORMATION
 
 
 
 
 
 
 
PART II - OTHER INFORMATION
 


i
Table of Contents



PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
 
September 30,
2013
 
December 31,
2012
ASSETS
  (unaudited)
 
  

Available-for-sale securities, at fair value
$
12,672,233

 
$
13,666,954

Trading securities, at fair value
1,000,625

 
1,002,062

Equity securities, at fair value
—

 
335,638

Mortgage loans held-for-sale, at fair value
559,737

 
58,607

Mortgage loans held-for-investment in securitization trusts, at fair value
804,988

 
—

Cash and cash equivalents
723,160

 
821,108

Restricted cash
678,328

 
302,322

Accrued interest receivable
48,854

 
42,613

Due from counterparties
94,485

 
39,974

Derivative assets, at fair value
544,515

 
462,080

Other assets
27,241

 
82,586

Total Assets (1)
$
17,154,166

 
$
16,813,944

LIABILITIES AND STOCKHOLDERS’ EQUITY
   

 
   

Liabilities
   

 
   

Repurchase agreements
$
12,152,065

 
$
12,624,510

Collateralized borrowings in securitization trusts, at fair value
649,082

 
—

Derivative liabilities, at fair value
73,827

 
129,294

Accrued interest payable
15,782

 
19,060

Due to counterparties
332,210

 
412,861

Dividends payable
102,022

 
164,347

Other liabilities
56,125

 
13,295

Total liabilities (1)
13,381,113

 
13,363,367

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; 900,000,000 shares authorized and 364,365,017 and 298,813,258 shares issued and outstanding, respectively
3,644

 
2,988

Additional paid-in capital
3,789,929

 
2,948,345

Accumulated other comprehensive income
512,774

 
696,458

Cumulative earnings
788,983

 
449,358

Cumulative distributions to stockholders
(1,322,277
)
 
(646,572
)
Total stockholders’ equity
3,773,053

 
3,450,577

Total Liabilities and Stockholders’ Equity
$
17,154,166

 
$
16,813,944

____________________
(1)
The condensed consolidated balance sheets include assets of a consolidated variable interest entity (“VIE”) that can only be used to settle obligations of this VIE and liabilities of the consolidated VIE for which creditors do not have recourse to the Company (Two Harbors Investment Corp.). At September 30, 2013, assets of consolidated the VIE totaled $808,647 and liabilities of the consolidated VIE totaled $652,227. The Company did not consolidate any VIEs as of December 31, 2012. See Note 3 - Variable Interest Entities for additional information.
The accompanying notes are an integral part of these condensed consolidated financial statements.

1
Table of Contents



TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands, except share data)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
 
(unaudited)
 
(unaudited)
Interest income:
 
 
 
 
  

 
   

Available-for-sale securities
$
121,303

 
$
124,621

 
$
386,246

 
$
313,154

Trading securities
1,509

 
1,278

 
4,034

 
3,578

Mortgage loans held-for-sale
9,297

 
167

 
15,409

 
362

Mortgage loans held-for-investment in securitization trusts
5,649

 
—

 
11,672

 
—

Cash and cash equivalents
216

 
243

 
773

 
620

Total interest income
137,974

 
126,309

 
418,134

 
317,714

Interest expense:
 
 
 
 
 
 
 
Repurchase agreements
21,802

 
20,743

 
67,373

 
47,737

Collateralized borrowings in securitization trusts
3,125

 
—

 
6,112

 
—

Total interest expense
24,927

 
20,743

 
73,485

 
47,737

Net interest income
113,047

 
105,566

 
344,649

 
269,977

Other-than-temporary impairments:
 
 
 
 
 
 
 
Total other-than-temporary impairment losses
—

 
(559
)
 
(1,662
)
 
(9,310
)
Non-credit portion of loss recognized in other comprehensive income (loss)
—

 
—

 
—

 
—

Net other-than-temporary credit impairment losses
—

 
(559
)
 
(1,662
)

(9,310
)
Other income:
 
 
 
 
 
 
 
(Loss) gain on investment securities
(230,111
)
 
2,527

 
(152,280
)
 
14,247

(Loss) gain on interest rate swap and swaption agreements
(55,410
)
 
(76,472
)
 
223,388

 
(153,679
)
Gain (loss) on other derivative instruments
20,434

 
2,850

 
66,055

 
(13,631
)
(Loss) gain on mortgage loans held-for-sale
(4,443
)
 
613

 
(25,262
)
 
592

Other income
10,788

 
—

 
18,887

 
—

Total other (loss) income
(258,742
)
 
(70,482
)
 
130,788

 
(152,471
)
Expenses:
 
 
 
 
 
 
 
Management fees
12,036

 
8,929

 
29,388

 
23,282

Securitization deal costs
2,125

 
—

 
4,153

 
—

Other operating expenses
10,017

 
3,954

 
26,064

 
11,423

Total expenses
24,178

 
12,883

 
59,605

 
34,705

(Loss) income from continuing operations before income taxes
(169,873
)
 
21,642

 
414,170

 
73,491

Provision for (benefit from) income taxes
23,726

 
(7,834
)
 
77,809

 
(32,016
)
Net (loss) income from continuing operations
(193,599
)
 
29,476

 
336,361

 
105,507

Income (loss) from discontinued operations
871

 
(2,674
)
 
3,264

 
(2,901
)
Net (loss) income attributable to common stockholders
$
(192,728
)
 
$
26,802

 
$
339,625

 
$
102,606

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

2
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TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME, continued
(in thousands, except share data)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
 
(unaudited)
 
(unaudited)
Basic (loss) earnings per weighted average common share:
 
 
 
 
 
 
 
Continuing operations
$
(0.53
)
 
$
0.11

 
$
0.97

 
$
0.47

Discontinued operations
—

 
(0.01
)
 
0.01

 
(0.01
)
Net (loss) income
$
(0.53
)
 
$
0.10

 
$
0.98

 
$
0.46

Diluted (loss) earnings per weighted average common share:
 
 
 
 
 
 
 
Continuing operations
$
(0.53
)
 
$
0.11

 
$
0.97

 
$
0.47

Discontinued operations
—

 
(0.01
)
 
0.01

 
(0.01
)
Net (loss) income
$
(0.53
)
 
$
0.10

 
$
0.98

 
$
0.46

Dividends declared per common share
$
0.28

 
$
0.36

 
$
0.91

 
$
1.16

Weighted average number of shares of common stock:
 
 
 
 
 
 
 
Basic
365,057,767

 
270,005,212

 
345,529,611

 
224,058,762

Diluted
365,166,992

 
270,937,960

 
346,370,358

 
224,369,678

Comprehensive income:
 
 
 
 
 
 
 
Net (loss) income
$
(192,728
)
 
$
26,802

 
$
339,625

 
$
102,606

Other comprehensive income (loss):
 
 
 
 
 
 
 
Unrealized gain (loss) on available-for-sale securities, net
246,777

 
497,598

 
(183,684
)
 
759,112

Other comprehensive income (loss)
246,777

 
497,598

 
(183,684
)
 
759,112

Comprehensive income
$
54,049

 
$
524,400

 
$
155,941

 
$
861,718

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


3
Table of Contents



TWO HARBORS INVESTMENT CORP. 
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(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, 2012
140,596,708

 
$
1,406

 
$
1,373,099

 
$
(58,716
)
 
$
157,452

 
$
(203,155
)
 
$
1,270,086

Net income
—

 
—

 
—

 
—

 
102,606

 
—

 
102,606

Other comprehensive income before reclassifications
—

 
—

 
—

 
756,143

 
—

 
—

 
756,143

Amounts reclassified from accumulated other comprehensive income
—

 
—

 
—

 
2,969

 
—

 
—

 
2,969

Net other comprehensive income
—

 
—

 
—

 
759,112

 
—

 
—

 
759,112

Issuance of common stock, net of offering costs
138,731,623

 
1,388

 
1,361,167

 
—

 
—

 
—

 
1,362,555

Issuance of common stock in connection with exercise of warrants
15,990,018

 
160

 
175,565

 
—

 
—

 
—

 
175,725

Common dividends declared
—

 
—

 
—

 
—

 
—

 
(279,070
)
 
(279,070
)
Non-cash equity award compensation
32,021

 
—

 
462

 
—

 
—

 
—

 
462

Balance, September 30, 2012
295,350,370

 
$
2,954

 
$
2,910,293

 
$
700,396

 
$
260,058

 
$
(482,225
)
 
$
3,391,476

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, January 1, 2013
298,813,258

 
$
2,988

 
$
2,948,345

 
$
696,458

 
$
449,358

 
$
(646,572
)
 
$
3,450,577

Net income
—

 
—

 
—

 
—

 
339,625

 
—

 
339,625

Other comprehensive loss before reclassifications
—

 
—

 
—

 
(308,435
)
 
—

 
—

 
(308,435
)
Amounts reclassified from accumulated other comprehensive loss
—

 
—

 
—

 
124,751

 
—

 
—

 
124,751

Net other comprehensive loss
—

 
—

 
—

 
(183,684
)
 
—

 
—

 
(183,684
)
Issuance of common stock, net of offering costs
57,553,749

 
576

 
762,808

 
—

 
—

 
—

 
763,384

Issuance of common stock in connection with exercise of warrants
9,391,406

 
94

 
102,182

 
—

 
—

 
—

 
102,276

Repurchase of common stock
(2,450,700
)
 
(25
)
 
(23,869
)
 
—

 
—

 
—

 
(23,894
)
Common dividends declared
—

 
—

 
—

 
—

 
—

 
(332,224
)
 
(332,224
)
Special dividends declared
—

 
—

 
—

 
—

 
—

 
(343,481
)
 
(343,481
)
Non-cash equity award compensation
1,057,304

 
11

 
463

 
—

 
—

 
—

 
474

Balance, September 30, 2013
364,365,017

 
$
3,644

 
$
3,789,929

 
$
512,774

 
$
788,983

 
$
(1,322,277
)
 
$
3,773,053

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


4
Table of Contents



TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
Nine Months Ended
 
September 30,
 
2013
 
2012
Cash Flows From Operating Activities:
(unaudited)
Net income
$
339,625

 
$
102,606

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

 
   

Amortization of premiums and discounts on available-for-sale securities, net
17,527

 
(5,566
)
Other-than-temporary impairment losses
1,662

 
9,310

Realized and unrealized losses (gains) on investment securities, net
152,458

 
(14,247
)
Loss (gain) on mortgage loans held-for-sale
25,262

 
(592
)
Gain on mortgage loans held-for-investment and collateralized borrowings in securitization trusts
(16,621
)
 
—

Unrealized gain on mortgage servicing rights
(816
)
 
—

Loss on termination and option expiration of interest rate swaps and swaptions
21,904

 
26,084

Unrealized (gain) loss on interest rate swaps and swaptions
(293,783
)
 
104,506

Unrealized loss (gain) on other derivative instruments
79,553

 
(5,889
)
Equity based compensation expense
474

 
462

Depreciation of fixed assets
424

 
—

Depreciation of real estate
—

 
458

Purchases of mortgage loans held-for-sale
(989,665
)
 
(10,797
)
Proceeds from sales of mortgage loans held-for-sale
25,404

 
—

Proceeds from repayment of mortgage loans held-for-sale
24,256

 
2,040

Net change in assets and liabilities:
   

 
 
Increase in accrued interest receivable
(6,241
)
 
(23,482
)
Decrease/(increase) in deferred income taxes, net
75,384

 
(27,288
)
Decrease/(increase) in current income tax receivable
4,323

 
(4,469
)
Increase in prepaid and fixed assets
(602
)
 
(906
)
Decrease/(increase) in other receivables
29,687

 
(99
)
Increase in servicing advances
(5,368
)
 
—

(Decrease)/increase in accrued interest payable, net
(3,278
)
 
6,691

Increase/(decrease) in income taxes payable
2,356

 
(3,898
)
Increase in accrued expenses and other liabilities
9,274

 
8,096

Net change in assets and liabilities due to purchase of entity
3,306

 
—

Net cash (used in) provided by operating activities
(503,495
)
 
163,020

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

5
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TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Nine Months Ended
 
September 30,
 
2013
 
2012
Cash Flows From Investing Activities:
(unaudited)
Purchases of available-for-sale securities
$
(4,290,011
)
 
$
(8,705,850
)
Proceeds from sales of available-for-sale securities
4,056,691

 
207,083

Principal payments on available-for-sale securities
860,984

 
542,727

Purchases of other derivative instruments
(72,158
)
 
(372,509
)
Proceeds from sales of other derivative instruments, net
126,347

 
86,696

Purchases of trading securities
(995,625
)
 
(996,016
)
Proceeds from sales of trading securities
1,000,946

 
1,001,904

Purchases of beneficial interests in securitization trusts
(30,550
)
 
—

Proceeds from repayment of mortgage loans held-for-investment in securitization trusts
28,568

 
—

Purchases of mortgage servicing rights
(13,390
)
 
—

Purchases of investments in real estate
—

 
(191,365
)
Purchase of entity
(6,404
)
 
—

(Decrease)/increase in due to counterparties, net
(135,162
)
 
128,147

Increase in restricted cash
(376,006
)
 
(39,603
)
Increase in escrow deposits of discontinued operations
—

 
(34,117
)
Net cash used in investing activities
154,230

 
(8,372,903
)
Cash Flows From Financing Activities:
   

 
   

Proceeds from repurchase agreements
145,909,686

 
45,160,427

Principal payments on repurchase agreements
(146,382,131
)
 
(37,786,248
)
Proceeds from issuance of collateralized borrowings in securitization trusts
307,119

 
—

Principal payments on collateralized borrowings in securitization trusts
(30,574
)
 
—

Proceeds from issuance of common stock, net of offering costs
763,384

 
1,362,555

Proceeds from exercise of warrants
102,276

 
175,725

Repurchase of common stock
(23,894
)
 
—

Dividends paid on common stock
(394,549
)
 
(228,984
)
Net cash provided by financing activities
251,317

 
8,683,475

Net (decrease) increase in cash and cash equivalents
(97,948
)
 
473,592

Cash and cash equivalents at beginning of period
821,108

 
360,016

Cash and cash equivalents at end of period
$
723,160

 
$
833,608

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

6
Table of Contents



TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Nine Months Ended
 
September 30,
 
2013
 
2012
Supplemental Disclosure of Cash Flow Information:
(unaudited)
Cash paid for interest
$
76,762

 
$
14,038

Cash (received) paid for taxes
$
(4,254
)
 
$
3,637

Noncash Investing and Financing Activities:
 
 
 
Transfers of mortgage loans held-for-sale to mortgage loans held-for-investment in securitization trusts
$
413,848

 
$
—

Consolidation of mortgage loans held-for-investment in securitization trusts
$
442,767

 
$
—

Consolidation of collateralized borrowings in securitization trusts
$
412,217

 
$
—

Distribution of Silver Bay common stock
$
343,481

 
$
—

Cashless exercise of warrants
$
75

 
$
178

Cash dividends declared but not paid at end of period
$
102,022

 
$
106,325

Reconciliation of mortgage loans held-for-sale:
 
 
 
Mortgage loans held-for-sale at beginning of period
$
58,607

 
$
5,782

Purchases of mortgage loans held-for-sale
989,665

 
10,797

Transfers to mortgage loans held-for-investment in securitization trusts
(413,848
)
 
—

Proceeds from sales of mortgage loans held-for-sale
(25,404
)
 
—

Proceeds from repayment of mortgage loans held-for-sale
(24,256
)
 
(2,040
)
Realized and unrealized (losses) gains on mortgage loans held-for-sale
(25,027
)
 
14

Mortgage loans held-for-sale at end of period
$
559,737

 
$
14,553

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

7
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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, and other financial assets. The Company is externally managed and advised by PRCM Advisers LLC, or PRCM Advisers, which is 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 MKT under the symbols “TWO” and “TWO.WS,” respectively.
The Company was incorporated on May 21, 2009 and commenced operations as a publicly traded company on October 28, 2009, upon completion of a merger with Capitol Acquisition Corp., or Capitol, which became a wholly owned indirect subsidiary as a result of the merger.
The Company has elected to be treated as a real estate investment trust, or REIT, as defined under the Internal Revenue Code of 1986, as amended, or the Code, 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 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.
On December 19, 2012, the Company completed the contribution of its portfolio of single-family rental properties to Silver Bay Realty Trust Corp., or Silver Bay, a newly organized Maryland corporation intended to qualify as a REIT and focused on the acquisition, renovation, leasing and management of single-family residential properties for rental income and long-term capital appreciation. The Company contributed its equity interests in its wholly owned subsidiary, Two Harbors Property Investment LLC, to Silver Bay, and in exchange for its contribution, received shares of common stock of Silver Bay. Silver Bay completed its initial public offering, or IPO, of its common stock on December 19, 2012. Because the Company will not have any significant continuing involvement in Two Harbors Property Investment LLC, all of the associated operating results were removed from continuing operations and are presented separately as discontinued operations for the three and nine months ended September 30, 2013 and 2012. See Note 4 - Discontinued Operations for additional information.
On April 30, 2013, one of the Company’s wholly owned subsidiaries acquired a company that has seller-servicer approvals from the Federal National Mortgage Association, or Fannie Mae, the Federal Home Loan Mortgage Corporation, or Freddie Mac, and the Government National Mortgage Association, or Ginnie Mae, to hold and manage mortgage servicing rights, or MSRs. The MSRs acquired in conjunction with the acquisition of this entity and those subsequently purchased represent the right to service mortgage loans. The Company and its subsidiaries do not originate or directly service mortgage loans, and instead contract with fully licensed subservicers to handle all servicing functions for the loans underlying the Company’s MSRs. See Note 13 - Other Assets for additional information.

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, 2012. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at September 30, 2013 and results of operations for all periods presented have been made. The results of operations for the three and nine months ended September 30, 2013 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

8
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TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements (unaudited)

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.
The Company’s investment in the common stock of Silver Bay was reviewed for consolidation under the applicable consolidation guidance, including voting control and variable interest entity, or VIE, models. The Company concluded that it did not have voting control of Silver Bay nor was Silver Bay considered a VIE and, therefore, consolidation of Silver Bay was not required.
The legal entities used in securitization (i.e., the securitization trusts), which are considered VIEs for financial reporting purposes, were also reviewed for consolidation under the applicable consolidation guidance. Because the Company has both the power to direct the activities of the securitization trusts that most significantly impact the entities’ performance, and the obligation to absorb losses or the right to receive benefits of the entities that could be significant, the Company consolidates the trusts. The accounting is consistent with a secured financing, where the loans and securitized debt are both carried on the Company’s condensed consolidated balance sheets.
Significant Accounting Policies
Included in Note 2 to the Consolidated Financial Statements of the Company’s 2012 Annual Report on Form 10-K is a summary of the Company’s significant accounting policies. Provided below is a summary of additional accounting policies that are significant to the Company’s consolidated financial condition and results of operations for the nine months ended September 30, 2013.
Securitization and Variable Interest Entities
During the nine months ended September 30, 2013, the Company purchased subordinated debt and excess servicing rights from a securitization trust issued by a third party. Also during the nine months ended September 30, 2013, the Company purchased subordinated debt and excess servicing rights from a securitization trust sponsored by a subsidiary of the Company. The securitization trusts are considered VIEs for financial reporting purposes and, thus, were reviewed for consolidation under the applicable consolidation guidance. As the Company has both the power to direct the activities of the securitization trusts that most significantly impact the entities’ performance, and the obligation to absorb losses or the right to receive benefits of the entities that could be significant, the Company consolidates the trusts. The underlying loans are classified as mortgage loans held-for-investment in securitization trusts and the underlying debt is classified as collateralized borrowings in securitization trusts on the condensed consolidated balance sheets. The interest income on mortgage loans held-for-investment and interest expense on collateralized borrowings are recorded on the condensed consolidated statements of comprehensive income. See Note 15 - Fair Value of these notes to the condensed consolidated financial statements for details on fair value measurement.
Mortgage Loans Held-for-Investment in Securitization Trusts, at Fair Value
Mortgage loans held-for-investment in securitization trusts related to the Company's on-balance sheet securitizations are reported at fair value as a result of a fair value option election. These securitized mortgage loans are legally isolated from the Company and have been structured to be beyond the reach of creditors. Fair value is determined under the guidance of ASC 820. The Company determines the fair value of its mortgage loans held-for-investment in securitization trusts by type of loan and the determination is generally based on current secondary market pricing or cash flow models using market-based yield requirements. See Note 15 - Fair Value of these notes to the condensed consolidated financial statements for details on fair value measurement.
Interest income on mortgage loans held-for-investment is recognized at the loan coupon rate. Loans are considered past due when they are 30 days past their contractual due date. Interest income recognition is suspended when mortgage loans are placed on nonaccrual status. Generally, mortgage loans are placed on nonaccrual status when delinquent for more than 60 days or when determined not to be probable of full collection. Interest accrued, but not collected, at the date mortgage loans are placed on nonaccrual is reversed and subsequently recognized only to the extent it is received in cash or until it qualifies for return to accrual status. However, where there is doubt regarding the ultimate collectability of loan principal, all cash received is applied to reduce the carrying value of such loans. Mortgage loans are restored to accrual status only when contractually current or the collection of future payments is reasonably assured.

9
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TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements (unaudited)

Collateralized Borrowings in Securitization Trusts, at Fair Value
Collateralized borrowings in securitization trusts related to the Company's on-balance sheet securitizations are reported at fair value as a result of a fair value option election. This long-term debt is nonrecourse to the Company beyond the assets held in the trusts. Fair value is determined under the guidance of ASC 820. The Company determines the fair value of its collateralized borrowings in securitization trusts based on prices obtained from third-party pricing providers, broker quotes received and other applicable market data. See Note 15 - Fair Value of these notes to the condensed consolidated financial statements for details on fair value measurement.
Mortgage Servicing Rights, at Fair Value
The Company’s MSRs represent the right to service mortgage loans. The Company and its subsidiaries do not originate or directly service mortgage loans, and instead contract with fully licensed subservicers to handle all servicing functions for the loans underlying the Company’s MSRs. However, as an owner and manager of MSRs, the Company may be obligated to fund advances of principal and interest payments due to third-party owners of the loans, but not yet received from the individual borrowers. These advances are reported as servicing advances within the other assets line item on the condensed consolidated balance sheets.
MSRs are reported at fair value within the other assets line item on the condensed consolidated balance sheets. Changes in the fair value of MSRs as well as servicing fee income are reported within other income on the condensed consolidated statements of comprehensive income. The related subservicing expenses are recorded in other operating expenses on the condensed consolidated statements of comprehensive income.
See Note 13 - Other Assets for further discussion on MSRs.
Equity Incentive Plan
The Company adopted an equity incentive plan in 2009, which provides incentive compensation to attract and retain qualified directors, officers, advisors, consultants and other personnel, including PRCM Advisers and its affiliates. The 2009 equity incentive plan is administered by the compensation committee of the Company’s board of directors. The 2009 equity incentive plan permits the granting of restricted shares of common stock, phantom shares, dividend equivalent rights and other equity-based awards.
On May 21, 2013, the Company’s stockholders approved the restated 2009 equity incentive plan, which effectuated, among other changes, an increase in the number of shares available for issuance under the restated 2009 equity incentive plan by 2,800,000 shares of common stock. Other amendments provide for the possibility of making grants of equity-based compensation to the Company’s executive officers and other key employees of the Company’s external manager, PRCM Advisers, upon a determination by the compensation committee, and the implementation of certain best practices of equity-based compensation.
The cost of equity-based compensation awarded to employees of our manager is determined using fair value liability accounting in accordance with ASC 718, Compensation - Stock Compensation, or ASC 718, and amortized over the vesting term.
Offsetting Assets and Liabilities
Certain of the Company’s repurchase agreements are governed by underlying agreements that provide for a right of setoff in the event of default of either party to the agreement. The Company also has netting arrangements in place with all derivative counterparties pursuant to standard documentation developed by the International Swap and Derivatives Association, or ISDA. Additionally, 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.
Under GAAP, if the Company has a valid right of setoff, it may offset the related asset and liability and report the net amount. The Company presents repurchase agreements subject to master netting arrangements or similar agreements on a gross basis, and derivative assets and liabilities subject to such arrangements on a net basis, based on derivative type and counterparty, in its condensed consolidated balance sheets. Separately, the Company presents cash collateral subject to such arrangements on a net basis, based on counterparty, in its condensed consolidated balance sheets. However, the Company does not offset financial assets and liabilities with the associated cash collateral on its condensed consolidated balance sheets.

10
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TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements (unaudited)

The following tables present information about the Company’s assets and liabilities that are subject to master netting arrangements or similar agreements and can potentially be offset on the Company’s condensed consolidated balance sheets as of September 30, 2013 and December 31, 2012:
 
September 30, 2013
 
 
 
 
 
 
 
Gross Amounts Not Offset with Financial Assets (Liabilities) in the Condensed Consolidated Balance Sheets (1)
 
 
(in thousands)
Gross Amounts of Recognized Assets (Liabilities)
 
Gross Amounts Offset in the Condensed Consolidated Balance Sheets
 
Net Amounts of Assets (Liabilities) Presented in the Condensed Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral (Received) Pledged
 
Net Amount
Assets
 
 
 
 
 
 
 
 
 
 
 
Derivative assets
$
604,297

 
$
(59,782
)
 
$
544,515

 
$
(73,827
)
 
$
—

 
$
470,688

Total Assets
$
604,297

 
$
(59,782
)
 
$
544,515

 
$
(73,827
)
 
$
—

 
$
470,688

 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(12,152,065
)
 
$
—

 
$
(12,152,065
)
 
$
12,152,065

 
$
—

 
$
—

Derivative liabilities
(133,609
)
 
59,782

 
(73,827
)
 
73,827

 
—

 
—

Total Liabilities
$
(12,285,674
)
 
$
59,782

 
$
(12,225,892
)
 
$
12,225,892

 
$
—

 
$
—

 
December 31, 2012
 
 
 
 
 
 
 
Gross Amounts Not Offset with Financial Assets (Liabilities) in the Condensed Consolidated Balance Sheets (1)
 
 
(in thousands)
Gross Amounts of Recognized Assets (Liabilities)
 
Gross Amounts Offset in the Condensed Consolidated Balance Sheets
 
Net Amounts of Assets (Liabilities) Presented in the Condensed Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral (Received) Pledged
 
Net Amount
Assets
 
 
 
 
 
 
 
 
 
 
 
Derivative assets
$
463,027

 
$
(947
)
 
$
462,080

 
$
(129,294
)
 
$
85,798

 
$
418,584

Total Assets
$
463,027

 
$
(947
)
 
$
462,080

 
$
(129,294
)
 
$
85,798

 
$
418,584

 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(12,624,510
)
 
$
—

 
$
(12,624,510
)
 
$
12,624,510

 
$
—

 
$
—

Derivative liabilities
(130,241
)
 
947

 
(129,294
)
 
129,294

 
—

 
—

Total Liabilities
$
(12,754,751
)
 
$
947

 
$
(12,753,804
)
 
$
12,753,804

 
$
—

 
$
—

____________________
(1)
Amounts presented are limited in total to the net amount of assets or liabilities presented in the condensed consolidated balance sheets by instrument. Excess cash collateral or financial assets that are pledged to counterparties may exceed the financial liabilities subject to a master netting arrangement or similar agreement, or counterparties may have pledged excess cash collateral to the Company that exceed the corresponding financial assets. These excess amounts are excluded from the table above, although separately reported within restricted cash, due from counterparties, or due to counterparties in the Company’s condensed consolidated balance sheets.


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

Recently Issued and/or Adopted Accounting Standards
Offsetting Assets and Liabilities
In December 2011, the Financial Accounting Standards Board, or 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. In January 2013, the FASB issued ASU No. 2013-01, which limits the scope of ASU 2011-11 to certain derivatives, repurchase agreements and securities lending arrangements. ASU 2013-01 is also effective for the first interim or annual period beginning on or after January 1, 2013. Adopting both ASU 2011-11 and ASU 2013-01 did not have any impact on the Company’s condensed consolidated financial condition or results of operations, but did impact financial statement disclosures.
Comprehensive Income
In February 2013, the FASB issued ASU No. 2013-02, which amends ASC 220, Comprehensive Income. The amendments are intended to make the presentation of items within Other Comprehensive Income (OCI) more prominent. ASU 2013-02 requires reclassification adjustments between OCI and net income to be presented separately on the face of the financial statements. The new guidance does not change the requirement to present items of net income and OCI, and totals for net income, OCI and comprehensive income in a single continuous statement or two consecutive statements. ASU 2013-02 is effective for the first interim or annual period beginning on or after December 15, 2012. Adopting this ASU did not have any impact on the Company’s condensed consolidated financial condition or results of operations, but did impact financial statement disclosures.
Presentation of an Unrecognized Tax Benefit
In July 2013, the FASB issued ASU No. 2013-11, which requires an entity to present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss, or NOL, carryforward, or similar tax loss or tax credit carryforward, rather than as a liability when (1) the uncertain tax position would reduce the NOL or other carryforward under the tax law of the applicable jurisdiction and (2) the entity intends to use the deferred tax asset for that purpose. The ASU does not require any new recurring disclosures. It is effective prospectively for fiscal years, and interim periods within those years, beginning on or after December 15, 2013, with early adoption permitted. Adopting this ASU did not have any impact on the Company’s consolidated financial condition or results of operations.

Note 3. Variable Interest Entities
During the nine months ended September 30, 2013, the Company purchased subordinated debt and excess servicing rights from a securitization trust issued by a third party. Also during the nine months ended September 30, 2013, the Company purchased subordinated debt and excess servicing rights from a securitization trust sponsored by a subsidiary of the Company. Both securitization trusts are considered VIEs for financial reporting purposes and, thus, were reviewed for consolidation under the applicable consolidation guidance. Since the Company has both the power to direct the activities of the securitization trusts that most significantly impact the entities’ performance, and the obligation to absorb losses or the right to receive benefits of the entities that could be significant, the Company consolidates the trusts. As the Company is required to reassess VIE consolidation guidance each quarter, new facts and circumstances may change the Company’s determination. This could result in a material impact to the Company’s financial statements during subsequent reporting periods.
The following table presents a summary of the assets and liabilities of the securitization trusts:
(in thousands)
September 30,
2013
 
December 31,
2012
Mortgage loans held-for-investment in securitization trusts
$
804,988

 
$
—

Accrued interest receivable
3,659

 
—

Total Assets
$
808,647

 
$
—

Collateralized borrowings in securitization trusts
649,082

 
—

Accrued interest payable
1,622

 
—

Accrued expenses
1,523

 
—

Total Liabilities
$
652,227

 
$
—



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Table of Contents

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

Note 4. Discontinued Operations
On December 19, 2012, the Company completed the contribution of its equity interests in its wholly owned subsidiary, Two Harbors Property Investment LLC, to Silver Bay. Two Harbors Property Investment LLC previously held the Company’s portfolio of single-family rental properties. Because the Company will not have any significant continuing involvement in Two Harbors Property Investment LLC, all of the associated operating results were removed from continuing operations and are presented separately as discontinued operations for the three and nine months ended September 30, 2013 and 2012.
Summarized financial information for the discontinued operations are presented below.
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2013
 
2012
 
2013
 
2012
Income:
  

 
   

 
  

 
   

Gain on contribution of entity
$
871

 
$
—

 
$
3,126

 
$
—

Real estate related revenues
—

 
721

 
—

 
808

Total income
871

 
721

 
3,126

 
808

Expenses:
 
 
 
 
 
 
 
Management fees
—

 
804

 
—

 
804

Real estate related expenses
—

 
1,786

 
—

 
1,984

Other operating expenses
—

 
805

 
(138
)
 
921

Total expenses
—

 
3,395

 
(138
)
 
3,709

Income (loss) from discontinued operations
$
871

 
$
(2,674
)
 
$
3,264

 
$
(2,901
)

In addition to the gain on contribution of entity that was recorded in 2012 in connection with the closing of the contribution, certain adjustments were agreed to be recognized in 2013. These include an installment sales gain of approximately $4.0 million from Silver Bay, a reduction of 2013 management fees payable to PRCM Advisers of $4.3 million, and an immaterial amount of additional working capital adjustments determined in accordance with the contribution agreement entered into with Silver Bay. Of these amounts, $0.9 million and $3.2 million of the installment sales gain was recorded as a gain on contribution of entity within discontinued operations for the three and nine months ended September 30, 2013, respectively, and the full $4.3 million of the reduction of 2013 management fees payable to PRCM Advisers was recorded within management fees, on the condensed consolidated statements of comprehensive income for the nine months ended September 30, 2013, respectively. The remaining $0.1 million recorded within discontinued operations on the condensed consolidated statements of comprehensive income for the nine months ended September 30, 2013 relates to accrual adjustments for transaction expenses related to the contribution. See Note 23 - Related Party Transactions for additional information.

Note 5. 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, 2013 and December 31, 2012:
(in thousands)
September 30,
2013
 
December 31,
2012
Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
3,091,964

 
$
3,608,272

Federal National Mortgage Association
4,550,673

 
5,130,965

Government National Mortgage Association
2,075,301

 
2,272,866

Non-Agency
2,954,295

 
2,654,851

Total mortgage-backed securities
$
12,672,233

 
$
13,666,954



13
Table of Contents

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

At September 30, 2013 and December 31, 2012, the Company pledged investment securities with a carrying value of $12.2 billion and $12.8 billion, respectively, as collateral for repurchase agreements. See Note 16 - Repurchase Agreements.
At September 30, 2013 and December 31, 2012, 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 September 30, 2013 and December 31, 2012:
 
September 30, 2013
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
12,039,928

 
$
4,919,072

 
$
16,959,000

Unamortized premium
636,576

 
—

 
636,576

Unamortized discount
 
 
 
 
 
Designated credit reserve
—

 
(1,372,628
)
 
(1,372,628
)
Net, unamortized
(2,901,668
)
 
(1,161,821
)
 
(4,063,489
)
Amortized Cost
9,774,836

 
2,384,623

 
12,159,459

Gross unrealized gains
113,221

 
580,004

 
693,225

Gross unrealized losses
(170,119
)
 
(10,332
)
 
(180,451
)
Carrying Value
$
9,717,938

 
$
2,954,295

 
$
12,672,233

 
December 31, 2012
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
11,934,492

 
$
4,503,999

 
$
16,438,491

Unamortized premium
749,252

 
—

 
749,252

Unamortized discount
  

 
  

 
  

Designated credit reserve
—

 
(1,290,946
)
 
(1,290,946
)
Net, unamortized
(1,929,811
)
 
(996,490
)
 
(2,926,301
)
Amortized Cost
10,753,933

 
2,216,563

 
12,970,496

Gross unrealized gains
276,293

 
448,403

 
724,696

Gross unrealized losses
(18,123
)
 
(10,115
)
 
(28,238
)
Carrying Value
$
11,012,103

 
$
2,654,851

 
$
13,666,954


The following tables present the carrying value of the Company’s AFS investment securities by rate type as of September 30, 2013 and December 31, 2012:
 
September 30, 2013
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
1,007,715

 
$
2,527,240

 
$
3,534,955

Fixed Rate
8,710,223

 
427,055

 
9,137,278

Total
$
9,717,938

 
$
2,954,295

 
$
12,672,233

 
December 31, 2012
(in thousands)
Agency
 
Non-Agency
 
Total
Adjustable Rate
$
188,429

 
$
2,334,950

 
$
2,523,379

Fixed Rate
10,823,674

 
319,901

 
11,143,575

Total
$
11,012,103

 
$
2,654,851

 
$
13,666,954



14
Table of Contents

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

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 a 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 nine months ended September 30, 2013 and 2012, of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
 
Nine Months Ended September 30,
 
2013
 
2012
(in thousands)
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
 
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
Beginning balance at January 1
$
(1,290,946
)
 
$
(996,490
)
 
$
(2,287,436
)
 
$
(782,606
)
 
$
(540,969
)
 
$
(1,323,575
)
Acquisitions
(181,122
)
 
(390,269
)
 
(571,391
)
 
(590,090
)
 
(534,000
)
 
(1,124,090
)
Accretion of net discount
886

 
108,829

 
109,715

 
493

 
98,685

 
99,178

Realized credit losses
28,684

 
—

 
28,684

 
33,622

 
—

 
33,622

Reclassification adjustment for other-than-temporary impairments
(1,662
)
 
—

 
(1,662
)
 
(9,310
)
 
—

 
(9,310
)
Transfers from (to)
35,201

 
(35,201
)
 
—

 
—

 
—

 
—

Sales, calls, other
36,331

 
151,310

 
187,641

 
8,154

 
15,876

 
24,030

Ending balance at September 30
$
(1,372,628
)
 
$
(1,161,821
)
 
$
(2,534,449
)
 
$
(1,339,737
)
 
$
(960,408
)
 
$
(2,300,145
)

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, 2013 and December 31, 2012. At September 30, 2013, the Company held 1,453 AFS securities, of which 493 were in an unrealized loss position for less than twelve consecutive months and 64 were in an unrealized loss position for more than twelve consecutive months. Of the $4.8 billion and $2.5 billion of AFS securities in an unrealized loss position for less than twelve consecutive months as of September 30, 2013 and December 31, 2012, $4.5 billion, or 94.5%, and $2.4 billion, or 95.8%, respectively, were Agency AFS securities, whose principal and interest are guaranteed by government sponsored entities, or GSEs. At December 31, 2012, the Company held 1,493 AFS securities, of which 250 were in an unrealized loss position for less than twelve months and 47 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, 2013
$
4,784,704

 
$
(151,442
)
 
$
538,129

 
$
(29,009
)
 
$
5,322,833

 
$
(180,451
)
December 31, 2012
$
2,548,995

 
$
(18,610
)
 
$
52,689

 
$
(9,628
)
 
$
2,601,684

 
$
(28,238
)

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

15
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TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements (unaudited)

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 $1.7 million other-than-temporary credit impairment during the nine months ended September 30, 2013 on a total of four non-Agency RMBS where the future expected cash flows for each security was less than its amortized cost. No OTTI was recorded for the three months ended September 30, 2013. As of September 30, 2013, impaired securities had weighted average cumulative losses of 7.8%, weighted average three-month prepayment speed of 4.3%, weighted average 60+ day delinquency of 34.5% of the pool balance, and weighted average FICO score of 629. At September 30, 2013, the Company did not intend to sell the securities and determined that it was 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. During the three and nine months ended September 30, 2012, the Company recorded a $0.6 million and an $9.3 million other-than-temporary credit impairment on a total of 31 non-Agency RMBS where the future expected cash flows for each security was less than its amortized cost.
The following table presents the changes in OTTI included in earnings for three and nine months ended September 30, 2013 and 2012:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2013
 
2012
 
2013
 
2012
Cumulative credit loss at beginning of period
$
(15,046
)
 
$
(13,603
)
 
$
(15,561
)
 
$
(5,102
)
Additions:
 
 
 
 
 
 
 
Other-than-temporary impairments not previously recognized
—

 
(315
)
 
—

 
(6,443
)
Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments
—

 
(244
)
 
(1,662
)
 
(2,867
)
Reductions:
 
 
 
 
 
 
 
Decreases related to other-than-temporary impairments on securities paid down
1,446

 
—

 
1,677

 
250

Decreases related to other-than-temporary impairments on securities sold
406

 
243

 
2,352

 
243

Cumulative credit loss at end of period
$
(13,194
)
 
$
(13,919
)
 
$
(13,194
)
 
$
(13,919
)

Cumulative credit losses related to OTTI may be reduced for securities sold as well as for securities that mature, pay down, or are prepaid such that the outstanding principal balance is reduced to zero. Additionally, increases in cash flows expected to be collected over the remaining life of the security cause a reduction in the cumulative credit loss.
Gross Realized Gains and Losses
Gains and losses from the sale of AFS securities are recorded as realized gains (losses) within (loss) gain on investment securities in the Company’s condensed consolidated statements of comprehensive income. For the three and nine months ended September 30, 2013, the Company sold AFS securities for $3.1 billion and $4.1 billion with an amortized cost of $3.3 billion and $4.2 billion, for net realized losses of $234.5 million and $163.2 million, respectively.

16
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TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements (unaudited)

The following table presents the gross realized gains and losses on sales of AFS securities for the three and nine months ended September 30, 2013 and 2012:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2013
 
2012
 
2013
 
2012
Gross realized gains
$
27,786

 
$
—

 
$
103,451

 
$
11,663

Gross realized losses
(262,323
)
 
(221
)
 
(266,620
)
 
(1,850
)
Total realized (losses) gains on sales, net
$
(234,537
)
 
$
(221
)
 
$
(163,169
)
 
$
9,813


Note 6. Trading Securities, at Fair Value
The Company holds U.S. Treasuries in a taxable REIT subsidiary and classifies these securities as trading instruments due to short-term investment objectives. As of September 30, 2013 and December 31, 2012, the Company held U.S. Treasuries with an amortized cost of $995.8 million and a fair value of $1.0 billion for both periods classified as trading securities. The unrealized gains included within trading securities were $4.9 million and $5.1 million as of September 30, 2013 and December 31, 2012, respectively.
For the three and nine months ended September 30, 2013, the Company sold trading securities for $1.0 billion with an amortized cost of $997.9 million, resulting in realized gains of $3.1 million on the sale of these securities. For the three and nine months ended September 30, 2013, trading securities experienced change in unrealized gains of $1.4 million and change in unrealized losses of $0.2 million, respectively. Unrealized gains and losses are recorded as a component of (loss) gain on investment securities in the Company’s condensed consolidated statements of comprehensive income.
At September 30, 2013, the Company pledged trading securities with a carrying value of $1.0 billion as collateral for repurchase agreements. See Note 16 - Repurchase Agreements.

Note 7. Equity Securities, at Fair Value
At December 31, 2012, equity securities consisted of shares of Silver Bay common stock carried at fair value as a result of a fair value option election. In exchange for the contribution of the Company’s equity interests in its wholly owned subsidiary, Two Harbors Property Investment LLC, to Silver Bay on December 19, 2012, the Company received 17,824,647 shares of common stock, or 47.7%, of Silver Bay at the initial public offering price of $18.50. The initial carrying value of the Company’s equity securities was $329.8 million and the carrying value as of December 31, 2012 was $335.6 million, which included $5.9 million in unrealized gains.
On March 18, 2013, the Company declared a special dividend pursuant to which the 17,824,647 shares of Silver Bay common stock would be distributed, on a pro rata basis, to the Company’s stockholders of record at the close of business on April 2, 2013. The dividend was paid on or about April 24, 2013. As a result, the Company recognized $13.7 million of realized gains on distribution as well as $5.9 million of change in unrealized losses within (loss) gain on investment securities on the condensed consolidated statements of comprehensive income for the nine months ended September 30, 2013. Because the shares were distributed to the Company’s stockholders during the nine months ended September 30, 2013, equity securities are no longer recognized on the condensed consolidated balance sheet as of September 30, 2013.

Note 8. 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 September 30, 2013 and December 31, 2012:
(in thousands)
September 30,
2013
 
December 31,
2012
Unpaid principal balance
$
688,620

 
$
56,976

Fair value adjustment
(128,883
)
 
1,631

Carrying value
$
559,737

 
$
58,607



17
Table of Contents

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

At September 30, 2013 and December 31, 2012, the Company pledged mortgage loans with a carrying value of $19.0 million and $52.5 million, respectively, as collateral for repurchase agreements. See Note 16 - Repurchase Agreements.

Note 9. Mortgage Loans Held-for-Investment in Securitization Trusts, at Fair Value
During the nine months ended September 30, 2013, the Company purchased subordinated debt and excess servicing rights from a securitization trust issued by a third party. Also during the nine months ended September 30, 2013, the Company purchased subordinated debt and excess servicing rights from a securitization trust sponsored by a subsidiary of the Company. The underlying residential mortgage loans held by the trusts, which are consolidated on the Company’s condensed consolidated balance sheet, are classified as mortgage loans held-for-investment in securitization trusts and carried at fair value as a result of a fair value option election. See Note 3 - Variable Interest Entities for additional information regarding consolidation of the securitization trusts. The following table presents the carrying value of the Company’s mortgage loans held-for-investment in securitization trusts as of September 30, 2013 and December 31, 2012:
(in thousands)
September 30,
2013
 
December 31,
2012
Unpaid principal balance
$
825,285

 
$
—

Fair value adjustment
(20,297
)
 
—

Carrying value
$
804,988

 
$
—


Note 10. Restricted Cash
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 Company has also placed cash in a restricted account pursuant to a letter of credit on an office space lease.
The following table presents the Company’s restricted cash balances as of September 30, 2013 and December 31, 2012:
(in thousands)
September 30,
2013
 
December 31,
2012
Restricted cash balances held by trading counterparties:
 
 
 
For securities trading activity
$
9,000

 
$
9,000

For derivatives trading activity
409,340

 
208,669

As restricted collateral for repurchase agreements
259,642

 
84,307

 
677,982

 
301,976

Restricted cash balance pursuant to letter of credit on office lease
346

 
346

Total
$
678,328

 
$
302,322



18
Table of Contents

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

Note 11. Accrued Interest Receivable
The following table presents the Company’s accrued interest receivable by collateral type:
(in thousands)
September 30,
2013
 
December 31,
2012
Accrued Interest Receivable:
 
 
 
U.S. Treasuries
$
798

 
$
1,119

Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
10,902

 
11,888

Federal National Mortgage Association
15,622

 
17,101

Government National Mortgage Association
9,712

 
8,962

Non-Agency
3,875

 
3,296

Total mortgage-backed securities
40,111

 
41,247

Mortgage loans held-for-sale
4,286

 
247

Mortgage loans held-for-investment in securitization trusts
3,659

 
—

Total
$
48,854

 
$
42,613


Note 12. 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 derivative 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, caps and credit default swaps. In executing on the Company’s current risk management strategy, the Company has entered into interest rate swap and swaption agreements 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.
At times, the Company may use TBAs for risk management purposes, or as a means of deploying capital until targeted investments are available and to take advantage of temporary displacements in the marketplace. TBAs are forward contracts for the purchase (long notional positions) or sale (short notional positions) of Agency RMBS. The issuer, coupon and stated maturity of the Agency RMBS is predetermined as well as the trade price, face amount and future settle date (published each month by the Securities Industry and Financial Markets Association); however, the specific Agency RMBS to be delivered upon settlement is not known at the time of the TBA transaction. As a result, and since physical delivery of the Agency RMBS upon settlement cannot be assured, the Company accounts for TBAs as derivative instruments.
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.

19
Table of Contents

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

Balance Sheet Presentation
The following tables present the gross fair value and notional amounts of the Company’s derivative financial instruments treated as trading instruments as of September 30, 2013 and December 31, 2012.
(in thousands)
 
September 30, 2013
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
226,744

 
$
1,648,236

 
$
—

 
$
—

Interest rate swap agreements
 
51,374

 
17,575,000

 
—

 
—

Credit default swaps
 
—

 
—

 
(29,852
)
 
1,462,165

Swaptions
 
237,871

 
4,430,000

 
—

 
—

TBAs
 
21,896

 
1,504,000

 
(34,634
)
 
4,247,000

Put and call options for TBAs
 
6,630

 
2,500,000

 
—

 
—

Constant maturity swaps
 
—

 
—

 
(9,341
)
 
8,000,000

Total
 
$
544,515

 
$
27,657,236

 
$
(73,827
)
 
$
13,709,165

(in thousands)
 
December 31, 2012
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
304,975

 
$
1,909,351

 
$
—

 
$
—

Interest rate swap agreements
 
—

 
—

 
(129,055
)
 
14,070,000

Credit default swaps
 
52,906

 
438,440

 
—

 
—

Swaptions
 
102,048

 
4,950,000

 
—

 
—

TBAs
 
1,917

 
2,414,000

 
(239
)
 
139,000

Forward purchase commitment
 
234

 
56,865

 
—

 
—

Total
 
$
462,080

 
$
9,768,656

 
$
(129,294
)
 
$
14,209,000


The following table provides the average outstanding notional amounts of the Company’s derivative financial instruments treated as trading instruments for the three and nine months ended September 30, 2013.
(in thousands)
 
Three Months Ended September 30, 2013
 
Nine Months Ended September 30, 2013
Trading instruments
 
Derivative Assets
 
Derivative Liabilities
 
Derivative Assets
 
Derivative Liabilities
Inverse interest-only securities
 
$
1,735,973

 
$
—

 
$
1,850,637

 
$
—

Interest rate swap agreements
 
19,884,272

 
—

 
17,486,421

 
—

Credit default swaps
 
—

 
1,525,716

 
—

 
913,477

Swaptions
 
6,002,717

 
—

 
5,766,300

 
—

TBAs
 
2,584,391

 
2,270,489

 
1,904,608

 
1,295,974

Put and call options for TBAs
 
413,043

 
—

 
95,560

 
—

Constant maturity swaps
 
—

 
10,032,609

 
—

 
5,225,275

Short U.S. Treasuries
 
—

 
—

 
—

 
8,901

Forward purchase commitment
 
—

 
6,672

 
—

 
75,117



20
Table of Contents

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

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.
The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed consolidated statements 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 September 30,
 
 
 
 
2013
 
2012
Interest rate risk management
 
 
 
 
 
 
TBAs (1)
 
Gain (loss) on other derivative instruments
 
$
71,751

 
$
2,170