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: June 30, 2014

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.)

590 Madison Avenue, 36th Floor
New York, New York
 
10022
(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 August 7, 2014 there were 366,121,400 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)
 
June 30,
2014
 
December 31,
2013
ASSETS
(unaudited)
 


Available-for-sale securities, at fair value
$
13,108,251

 
$
12,256,727

Trading securities, at fair value
1,002,422

 
1,000,180

Mortgage loans held-for-sale, at fair value
399,841

 
544,581

Mortgage loans held-for-investment in securitization trusts, at fair value
804,666

 
792,390

Mortgage servicing rights, at fair value
500,490

 
514,402

Cash and cash equivalents
1,182,696

 
1,025,487

Restricted cash
286,965

 
401,647

Accrued interest receivable
50,110

 
50,303

Due from counterparties
30,381

 
25,087

Derivative assets, at fair value
331,601

 
549,859

Other assets
117,246

 
13,199

Total Assets (1)
$
17,814,669

 
$
17,173,862

LIABILITIES AND STOCKHOLDERS’ EQUITY


 


Liabilities


 
 
Repurchase agreements
$
11,391,187

 
$
12,250,450

Collateralized borrowings in securitization trusts, at fair value
561,921

 
639,731

Federal Home Loan Bank advances
1,500,000

 

Derivative liabilities, at fair value
17,097

 
22,081

Accrued interest payable
16,521

 
20,277

Due to counterparties
140,975

 
318,848

Dividends payable
95,189

 

Other liabilities
33,274

 
67,480

Total liabilities (1)
13,756,164

 
13,318,867

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 366,110,919 and 364,935,168 shares issued and outstanding, respectively
3,661

 
3,649

Additional paid-in capital
3,805,824

 
3,795,372

Accumulated other comprehensive income
817,630

 
444,735

Cumulative earnings
1,038,909

 
1,028,397

Cumulative distributions to stockholders
(1,607,519
)
 
(1,417,158
)
Total stockholders’ equity
4,058,505

 
3,854,995

Total Liabilities and Stockholders’ Equity
$
17,814,669

 
$
17,173,862

____________________
(1)
The condensed consolidated balance sheets include assets of consolidated variable interest entities, or VIEs, that can only be used to settle obligations of these VIEs and liabilities of the consolidated VIEs for which creditors do not have recourse to the Company (Two Harbors Investment Corp.). At June 30, 2014 and December 31, 2013, assets of the VIEs totaled $808,997 and $796,896, and liabilities of the VIEs totaled $566,296 and $644,051, respectively. See Note 3 - Variable Interest Entities for additional information.
The accompanying notes are an integral part of these condensed consolidated financial statements.

1

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands, except share data)
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
 
(unaudited)
 
(unaudited)
Interest income:
 
 
 
 
 
 
 
Available-for-sale securities
$
127,605

 
$
134,651

 
$
251,518

 
$
264,943

Trading securities
1,940

 
1,261

 
3,866

 
2,525

Mortgage loans held-for-sale
2,699

 
4,794

 
7,285

 
6,112

Mortgage loans held-for-investment in securitization trusts
7,761

 
4,369

 
15,654

 
6,023

Cash and cash equivalents
144

 
250

 
361

 
557

Total interest income
140,149

 
145,325

 
278,684

 
280,160

Interest expense:
 
 
 
 


 


Repurchase agreements
18,603

 
22,553

 
39,175

 
45,571

Collateralized borrowings in securitization trusts
5,592

 
2,169

 
10,945

 
2,987

Federal Home Loan Bank advances
755

 

 
908

 

Total interest expense
24,950

 
24,722

 
51,028

 
48,558

Net interest income
115,199

 
120,603

 
227,656

 
231,602

Other-than-temporary impairments:
 
 
 
 

 

Total other-than-temporary impairment losses

 
(1,426
)
 
(212
)
 
(1,662
)
Non-credit portion of loss recognized in other comprehensive income

 

 

 

Net other-than-temporary credit impairment losses

 
(1,426
)
 
(212
)

(1,662
)
Other income:
 
 
 
 

 

Gain (loss) on investment securities
37,688

 
50,863

 
(967
)
 
77,831

(Loss) gain on interest rate swap and swaption agreements
(116,019
)
 
259,826

 
(221,547
)
 
278,798

(Loss) gain on other derivative instruments
(24,202
)
 
62,283

 
(18,401
)
 
45,621

Gain (loss) on mortgage loans held-for-sale
11,801

 
(35,142
)
 
8,620

 
(20,819
)
Servicing income
33,868

 
245

 
64,309

 
245

Loss on servicing asset
(29,571
)
 
(45
)
 
(62,331
)
 
(45
)
Other income
21,003

 
1,610

 
21,463

 
7,899

Total other (loss) income
(65,432
)
 
339,640

 
(208,854
)
 
389,530

Expenses:
 
 
 
 

 

Management fees
12,190

 
12,591

 
24,301

 
17,352

Securitization deal costs

 

 

 
2,028

Servicing expenses
6,229

 
307

 
11,454

 
338

Other operating expenses
14,951

 
9,179

 
29,485

 
15,709

Total expenses
33,370

 
22,077

 
65,240

 
35,427

Income (loss) from continuing operations before income taxes
16,397

 
436,740

 
(46,650
)
 
584,043

(Benefit from) provision for income taxes
(23,260
)
 
49,119

 
(57,162
)
 
54,083

Net income from continuing operations
39,657

 
387,621

 
10,512

 
529,960

Income from discontinued operations

 
1,016

 

 
2,393

Net income
$
39,657

 
$
388,637

 
$
10,512

 
$
532,353

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 (LOSS), continued
(in thousands, except share data)
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2014
 
2013
 
2014
 
2013
 
(unaudited)
 
(unaudited)
Basic earnings per weighted average common share:
 
 
 
 


 
 
Continuing operations
$
0.11

 
$
1.06

 
$
0.03

 
$
1.58

Discontinued operations

 

 

 
0.01

Net income
$
0.11

 
$
1.06

 
$
0.03

 
$
1.59

Diluted earnings per weighted average common share:
 
 
 
 


 
 
Continuing operations
$
0.11

 
$
1.06

 
$
0.03

 
$
1.57

Discontinued operations

 

 

 
0.01

Net income
$
0.11

 
$
1.06

 
$
0.03

 
$
1.58

Dividends declared per common share
$
0.26

 
$
0.31

 
$
0.52

 
$
0.63

Weighted average number of shares of common stock:
 
 
 
 


 
 
Basic
366,078,124

 
365,589,300

 
365,846,295

 
335,603,697

Diluted
366,078,124

 
366,057,203

 
365,846,295

 
336,677,044

Comprehensive income (loss):
 
 
 
 


 
 
Net income
$
39,657

 
$
388,637

 
$
10,512

 
$
532,353

Other comprehensive income (loss):
 
 
 
 


 
 
Unrealized gain (loss) on available-for-sale securities, net
191,160

 
(534,713
)
 
372,895

 
(430,461
)
Other comprehensive income (loss)
191,160

 
(534,713
)
 
372,895

 
(430,461
)
Comprehensive income (loss)
$
230,817

 
$
(146,076
)
 
$
383,407

 
$
101,892

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


3

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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
 
Cumulative Earnings
 
Cumulative Distributions to Stockholders
 
Total Stockholders’ Equity
 
 
 
 
 
 
 
(unaudited)
 
 
 
 
 
 
Balance, December 31, 2012
298,813,258

 
$
2,988

 
$
2,948,345

 
$
696,458

 
$
449,358

 
$
(646,572
)
 
$
3,450,577

Net income

 

 

 

 
532,353

 

 
532,353

Other comprehensive loss before reclassifications

 

 

 
(368,205
)
 

 

 
(368,205
)
Amounts reclassified from accumulated other comprehensive loss

 

 

 
(62,256
)
 

 

 
(62,256
)
Net other comprehensive loss

 

 

 
(430,461
)
 

 

 
(430,461
)
Issuance of common stock, net of offering costs
57,541,664

 
575

 
762,651

 

 

 

 
763,226

Issuance of common stock in connection with exercise of warrants
9,321,705

 
93

 
101,517

 

 

 

 
101,610

Repurchase of common stock
(1,000,000
)
 
(10
)
 
(10,488
)
 

 

 

 
(10,498
)
Common dividends declared

 

 

 

 

 
(230,202
)
 
(230,202
)
Special dividends declared

 

 

 

 

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

 
11

 
988

 

 

 

 
999

Balance, June 30, 2013
365,733,931

 
$
3,657

 
$
3,803,013

 
$
265,997

 
$
981,711

 
$
(1,220,255
)
 
$
3,834,123

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2013
364,935,168

 
$
3,649

 
$
3,795,372

 
$
444,735

 
$
1,028,397

 
$
(1,417,158
)
 
$
3,854,995

Net income

 

 

 

 
10,512

 

 
10,512

Other comprehensive income before reclassifications

 

 

 
350,455

 

 

 
350,455

Amounts reclassified from accumulated other comprehensive income

 

 

 
22,440

 

 

 
22,440

Net other comprehensive income

 

 

 
372,895

 

 

 
372,895

Issuance of common stock, net of offering costs
23,474

 

 
240

 

 

 

 
240

Common dividends declared

 

 

 

 

 
(190,361
)
 
(190,361
)
Non-cash equity award compensation
1,152,277

 
12

 
10,212

 

 

 

 
10,224

Balance, June 30, 2014
366,110,919

 
$
3,661

 
$
3,805,824

 
$
817,630

 
$
1,038,909

 
$
(1,607,519
)
 
$
4,058,505

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)
 
Six Months Ended
 
June 30,
 
2014
 
2013
Cash Flows From Operating Activities:
(unaudited)
Net income
$
10,512

 
$
532,353

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
 
 
Amortization of premiums and discounts on available-for-sale securities, net
1,840

 
12,406

Other-than-temporary impairment losses
212

 
1,662

Realized and unrealized losses (gains) on investment securities, net
967

 
(77,653
)
(Gain) loss on mortgage loans held-for-sale
(8,620
)
 
20,819

Gain on mortgage loans held-for-investment and collateralized borrowings in securitization trusts
(21,142
)
 
(7,847
)
Loss on servicing asset
62,331

 
45

Loss on termination and option expiration of interest rate swaps and swaptions
6,401

 
62,675

Unrealized loss (gain) on interest rate swaps and swaptions
182,420

 
(374,884
)
Unrealized gain on other derivative instruments
(51
)
 
(8,131
)
Equity based compensation
10,224

 
999

Depreciation of fixed assets
463

 
256

Amortization of intangible assets
533

 

Purchases of mortgage loans held-for-sale
(261,983
)
 
(954,027
)
Proceeds from sales of mortgage loans held-for-sale
400,739

 
25,404

Proceeds from repayment of mortgage loans held-for-sale
11,160

 
9,649

Net change in assets and liabilities:


 
 
Decrease/(increase) in accrued interest receivable
193

 
(11,467
)
(Increase)/decrease in deferred income taxes, net
(60,310
)
 
52,692

(Increase)/decrease in income taxes receivable
(290
)
 
4,323

Increase in prepaid and fixed assets
(929
)
 
(557
)
(Increase)/decrease in other receivables
(11,396
)
 
28,437

Increase in servicing advances
(8,532
)
 
(4,881
)
Increase in Federal Home Loan Bank stock
(60,000
)
 

Increase in equity investments
(3,000
)
 

Decrease in accrued interest payable
(3,756
)
 
(1,550
)
(Decrease)/increase in income taxes payable
(465
)
 
1,320

Increase in accrued expenses and other liabilities
5,673

 
379

Net change in assets and liabilities due to purchase of entity

 
3,306

Net cash provided by (used in) operating activities
$
253,194

 
$
(684,272
)
The accompanying notes are an integral part of these condensed consolidated financial statements.

5

Table of Contents



TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Six Months Ended
 
June 30,
 
2014
 
2013
Cash Flows From Investing Activities:
(unaudited)
Purchases of available-for-sale securities
$
(2,232,865
)
 
$
(3,142,095
)
Proceeds from sales of available-for-sale securities
1,273,923

 
986,357

Principal payments on available-for-sale securities
474,696

 
556,549

Short sales and purchases of other derivative instruments
102,423

 
(49,526
)
Proceeds from sales of other derivative instruments, net
(74,476
)
 
47,890

Purchases of trading securities
(143,022
)
 

Proceeds from sales of trading securities
143,378

 

Purchases of beneficial interests in securitization trusts

 
(30,550
)
Proceeds from repayment of mortgage loans held-for-investment in securitization trusts
26,330

 
16,662

Purchases of mortgage servicing rights, net of purchase price adjustments
(48,419
)
 

Purchase of entity

 
(6,404
)
Decrease in due to counterparties, net
(183,167
)
 
(50,054
)
Decrease/(increase) in restricted cash
114,682

 
(383,643
)
Net cash used in investing activities
(546,517
)
 
(2,054,814
)
Cash Flows From Financing Activities:
 
 
 
Proceeds from repurchase agreements
140,931,599

 
73,388,331

Principal payments on repurchase agreements
(141,790,862
)
 
(71,109,686
)
Proceeds from issuance of collateralized borrowings in securitization trusts
33,483

 

Principal payments on collateralized borrowings in securitization trusts
(128,756
)
 
(16,600
)
Proceeds from Federal Home Loan Bank advances
3,793,911

 

Principal payments on Federal Home Loan Bank advances
(2,293,911
)
 

Proceeds from issuance of common stock, net of offering costs
240

 
763,226

Proceeds from exercise of warrants

 
101,600

Repurchase of common stock

 
(10,498
)
Dividends paid on common stock
(95,172
)
 
(281,171
)
Net cash provided by financing activities
450,532

 
2,835,202

Net increase in cash and cash equivalents
157,209

 
96,116

Cash and cash equivalents at beginning of period
1,025,487

 
821,108

Cash and cash equivalents at end of period
$
1,182,696

 
$
917,224

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

6

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Six Months Ended
 
June 30,
 
2014
 
2013
Supplemental Disclosure of Cash Flow Information:
(unaudited)
Cash paid for interest
$
54,785

 
$
50,108

Cash paid (received) for taxes
$
3,903

 
$
(4,252
)
Noncash Investing and Financing Activities:
 
 
 
Consolidation of mortgage loans held-for-investment in securitization trusts
$

 
$
442,767

Consolidation of collateralized borrowings in securitization trusts
$

 
$
412,217

Cashless exercise of warrants
$

 
$
75

Distribution of Silver Bay common stock
$

 
$
343,481

Cash dividends declared but not paid at end of period
$
95,189

 
$
113,378

Reconciliation of mortgage loans held-for-sale:
 
 
 
Mortgage loans held-for-sale at beginning of period
$
544,581

 
$
58,607

Purchases of mortgage loans held-for-sale
261,983

 
954,027

Proceeds from sales of mortgage loans held-for-sale
(400,739
)
 
(25,404
)
Proceeds from repayment of mortgage loans held-for-sale
(11,160
)
 
(9,649
)
Realized and unrealized (losses) gains on mortgage loans held-for-sale
5,176

 
(19,380
)
Mortgage loans held-for-sale at end of period
$
399,841

 
$
958,201

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

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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, mortgage servicing rights, or MSR, 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 under the symbol “TWO”.
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 six months ended June 30, 2014 and 2013. 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 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 MSR. The MSR 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 MSR. See Note 9 - Servicing Activities 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 U.S. GAAP, have been condensed or omitted according to such SEC rules and regulations. However, management believes 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, 2013. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at June 30, 2014 and results of operations for all periods presented have been made. The results of operations for the three and six months ended June 30, 2014 should not be construed as indicative of the results to be expected for future periods or the full year.
The condensed consolidated financial statements of the Company have been prepared on the accrual basis of accounting in accordance with U.S. GAAP. The preparation of financial statements in conformity with U.S. 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

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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 legal entities used in securitization (i.e., the securitization trusts), which are considered VIEs for financial reporting purposes, were 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 2013 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 six months ended June 30, 2014.
Federal Home Loan Bank Advances
In December 2013, the Company’s wholly owned subsidiary, TH Insurance Holdings Company LLC, or TH Insurance Holdings, was accepted for membership in the Federal Home Loan Bank of Des Moines, or the FHLB. As a member of the FHLB, TH Insurance Holdings has access to a variety of products and services offered by the FHLB, including secured advances.
As of June 30, 2014, the Company held FHLB advances with both short-term and long-term maturities. The advances generally bear interest rates of one- or three-month LIBOR. FHLB advances are treated as secured financing transactions and are carried at their contractual amounts.
Offsetting Assets and Liabilities
Certain of the Company’s repurchase agreements, as well as its FHLB advances, 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 U.S. 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 and FHLB advances 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.

9

Table of Contents

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 June 30, 2014 and December 31, 2013:
 
June 30, 2014
 
 
 
 
 
 
 
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
$
371,007

 
$
(39,406
)
 
$
331,601

 
$
(17,097
)
 
$

 
$
314,504

Total Assets
$
371,007

 
$
(39,406
)
 
$
331,601

 
$
(17,097
)
 
$

 
$
314,504

 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(11,391,187
)
 
$

 
$
(11,391,187
)
 
$
11,391,187

 
$

 
$

Federal Home Loan Bank advances
(1,500,000
)
 

 
(1,500,000
)
 
1,500,000

 

 

Derivative liabilities
(56,503
)
 
39,406

 
(17,097
)
 
17,097

 

 

Total Liabilities
$
(12,947,690
)
 
$
39,406

 
$
(12,908,284
)
 
$
12,908,284

 
$

 
$


10

Table of Contents

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

 
December 31, 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
$
572,050

 
$
(22,191
)
 
$
549,859

 
$
(22,081
)
 
$

 
$
527,778

Total Assets
$
572,050

 
$
(22,191
)
 
$
549,859

 
$
(22,081
)
 
$

 
$
527,778

 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(12,250,450
)
 
$

 
$
(12,250,450
)
 
$
12,250,450

 
$

 
$

Derivative liabilities
(44,272
)
 
22,191

 
(22,081
)
 
22,081

 

 

Total Liabilities
$
(12,294,722
)
 
$
22,191

 
$
(12,272,531
)
 
$
12,272,531

 
$

 
$

____________________
(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.

Recently Issued and/or Adopted Accounting Standards
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 condensed consolidated financial condition or results of operations.

Note 3. Variable Interest Entities
During 2013, the Company purchased subordinated debt and excess servicing rights from two securitization trusts, one sponsored by a third party and one sponsored by one of the Company’s subsidiaries. Both securitization trusts are considered VIEs for financial reporting purposes and, thus, were 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. As the Company is required to reassess VIE consolidation guidance each quarter, new facts and circumstances may change the Company’s determination. A change in the Company’s determination could result in a material impact to the Company’s financial statements during subsequent reporting periods.

11

Table of Contents

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

The following table presents a summary of the assets and liabilities of the consolidated securitization trusts as reported on the condensed consolidated balance sheets:
(in thousands)
June 30,
2014
 
December 31,
2013
Mortgage loans held-for-investment in securitization trusts
$
804,666

 
$
792,390

Accrued interest receivable
4,331

 
4,506

Total Assets
$
808,997

 
$
796,896

Collateralized borrowings in securitization trusts
$
561,921

 
$
639,731

Accrued interest payable
1,765

 
1,596

Accrued expenses
2,610

 
2,724

Total Liabilities
$
566,296

 
$
644,051


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 six months ended June 30, 2014 and 2013.
Summarized financial information for the discontinued operations are presented below.
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2014
 
2013
 
2014
 
2013
Income:
 
 
 
 
 
 
 
Gain on contribution of entity
$

 
$
1,016

 
$

 
$
2,255

Real estate related revenues

 

 

 

Total income

 
1,016

 

 
2,255

Expenses:
 
 
 
 
 
 
 
Management fees

 

 

 

Real estate related expenses

 

 

 

Other operating expenses

 

 

 
(138
)
Total expenses

 

 

 
(138
)
Income from discontinued operations
$

 
$
1,016

 
$

 
$
2,393


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, $1.0 million and $2.3 million of the installment sales gain was recorded as a gain on contribution of entity within discontinued operations for the three and six months ended June 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 six months ended June 30, 2013. The remaining $0.1 million recorded within discontinued operations on the condensed consolidated statements of comprehensive income for the six months ended June 30, 2013 relates to accrual adjustments for transaction expenses related to the contribution. No further adjustments were recognized during 2014. See Note 24 - Related Party Transactions for additional information.


12

Table of Contents

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

Note 5. Available-for-Sale Securities, at Fair Value
The Company holds available-for-sale, or AFS, investment securities, which are carried at fair value. AFS securities exclude the retained interests from the Company’s on-balance sheet securitizations, as they are eliminated in consolidation in accordance with U.S. GAAP. The following table presents the Company’s AFS investment securities by collateral type as of June 30, 2014 and December 31, 2013:
(in thousands)
June 30,
2014
 
December 31,
2013
Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
2,948,930

 
$
2,977,291

Federal National Mortgage Association
4,985,142

 
4,435,820

Government National Mortgage Association
2,117,456

 
2,084,298

Non-Agency
3,056,723

 
2,759,318

Total mortgage-backed securities
$
13,108,251

 
$
12,256,727


At June 30, 2014 and December 31, 2013, the Company pledged AFS securities with a carrying value of $12.8 billion and $12.3 billion, respectively, as collateral for repurchase agreements and FHLB advances. See Note 16 - Repurchase Agreements and Note 18 - Federal Home Loan Bank of Des Moines Advances.
At June 30, 2014 and December 31, 2013, 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, or ASC 860, 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 June 30, 2014 and December 31, 2013:
 
June 30, 2014
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
12,285,416

 
$
4,575,302

 
$
16,860,718

Unamortized premium
656,843

 

 
656,843

Unamortized discount
 
 
 
 
 
Designated credit reserve

 
(1,162,457
)
 
(1,162,457
)
Net, unamortized
(3,008,183
)
 
(1,056,300
)
 
(4,064,483
)
Amortized Cost
9,934,076

 
2,356,545

 
12,290,621

Gross unrealized gains
194,613

 
702,430

 
897,043

Gross unrealized losses
(77,161
)
 
(2,252
)
 
(79,413
)
Carrying Value
$
10,051,528

 
$
3,056,723

 
$
13,108,251

 
December 31, 2013
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
11,919,590


$
4,474,353

 
$
16,393,943

Unamortized premium
621,279



 
621,279

Unamortized discount
 
 
 
 
 
Designated credit reserve


(1,234,449
)
 
(1,234,449
)
Net, unamortized
(2,897,222
)

(1,071,559
)
 
(3,968,781
)
Amortized Cost
9,643,647


2,168,345

 
11,811,992

Gross unrealized gains
102,600


595,179

 
697,779

Gross unrealized losses
(248,838
)

(4,206
)
 
(253,044
)
Carrying Value
$
9,497,409

 
$
2,759,318

 
$
12,256,727


13

Table of Contents

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 June 30, 2014 and December 31, 2013:
 
June 30, 2014
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
548,509

 
$
2,513,222

 
$
3,061,731

Fixed Rate
9,503,019

 
543,501

 
10,046,520

Total
$
10,051,528

 
$
3,056,723

 
$
13,108,251

 
December 31, 2013
(in thousands)
Agency
 
Non-Agency
 
Total
Adjustable Rate
$
1,006,621


$
2,403,078

 
$
3,409,699

Fixed Rate
8,490,788


356,240

 
8,847,028

Total
$
9,497,409


$
2,759,318

 
$
12,256,727


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 six months ended June 30, 2014 and 2013, of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
 
Six Months Ended June 30,
 
2014
 
2013
(in thousands)
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
 
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
Beginning balance at January 1
$
(1,234,448
)
 
$
(1,071,559
)
 
$
(2,306,007
)
 
$
(1,290,946
)
 
$
(996,490
)
 
$
(2,287,436
)
Acquisitions
(62,752
)
 
(46,581
)
 
(109,333
)
 
(158,955
)
 
(365,348
)
 
(524,303
)
Accretion of net discount

 
64,084

 
64,084

 
886

 
71,625

 
72,511

Realized credit losses
6,607

 

 
6,607

 
22,658

 

 
22,658

Reclassification adjustment for other-than-temporary impairments
(212
)
 

 
(212
)
 
(1,662
)
 

 
(1,662
)
Transfers from (to)
47,495

 
(47,495
)
 

 
30,883

 
(30,883
)
 

Sales, calls, other
80,853

 
45,251

 
126,104

 
10,529

 
98,478

 
109,007

Ending balance at June 30
$
(1,162,457
)
 
$
(1,056,300
)
 
$
(2,218,757
)
 
$
(1,386,607
)
 
$
(1,222,618
)
 
$
(2,609,225
)


14

Table of Contents

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 June 30, 2014 and December 31, 2013. At June 30, 2014, the Company held 1,498 AFS securities, of which 47 were in an unrealized loss position for less than twelve consecutive months and 287 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2013, the Company held 1,431 AFS securities, of which 447 were in an unrealized loss position for less than twelve months and 114 were in an unrealized loss position for more than twelve consecutive months. Of the $0.3 billion and $4.9 billion of AFS securities in an unrealized loss position for less than twelve consecutive months as of June 30, 2014 and December 31, 2013, $0.1 billion, or 42.4%, and $4.8 billion, or 96.9%, respectively, were Agency AFS securities, whose principal and interest are guaranteed by government sponsored entities, or GSEs.
 
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
June 30, 2014
$
293,662

 
$
(3,620
)
 
$
2,847,553

 
$
(75,793
)
 
$
3,141,215

 
$
(79,413
)
December 31, 2013
$
4,902,813

 
$
(171,651
)
 
$
1,186,692

 
$
(81,393
)
 
$
6,089,505

 
$
(253,044
)

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 $0.2 million other-than-temporary credit impairment during the six months ended June 30, 2014 on a total of three non-Agency RMBS where the future expected cash flows for each security were less than its amortized cost. The Company did not record any other-than-temporary impairments during the three months ended June 30, 2014. As of June 30, 2014, impaired securities had actual weighted average cumulative losses of 9.6%, weighted average three-month prepayment speed of 4.2%, weighted average 60+ day delinquency of 30.0% of the pool balance, and weighted average FICO score of 664. At June 30, 2014, 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 six months ended June 30, 2013, the Company recorded a $1.4 million and a $1.7 million other-than-temporary credit impairment on a total of four non-Agency RMBS where the future expected cash flows for the security were less than its amortized cost.

15

Table of Contents

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

The following table presents the changes in OTTI included in earnings for three and six months ended June 30, 2014 and 2013:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2014
 
2013
 
2014
 
2013
Cumulative credit loss at beginning of period
$
(9,215
)
 
$
(15,142
)
 
$
(9,467
)
 
$
(15,561
)
Additions:
 
 
 
 
 
 
 
Other-than-temporary impairments not previously recognized

 

 
(91
)
 

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

 
(1,426
)
 
(121
)
 
(1,662
)
Reductions:
 
 
 
 
 
 
 
Decreases related to other-than-temporary impairments on securities paid down

 
231

 
464

 
231

Decreases related to other-than-temporary impairments on securities sold
1,154

 
1,291

 
1,154

 
1,946

Cumulative credit loss at end of period
$
(8,061
)
 
$
(15,046
)
 
$
(8,061
)
 
$
(15,046
)

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 gain (loss) on investment securities in the Company’s condensed consolidated statements of comprehensive income. For the three and six months ended June 30, 2014, the Company sold AFS securities for $459.4 million and $1.3 billion with an amortized cost of $423.4 million and $1.3 billion, for net realized gains of $36.0 million and losses of $2.8 million, respectively. For the three and six months ended June 30, 2013, the Company sold AFS securities for $189.7 million and $986.4 million with an amortized cost of $137.3 million and $915.0 million, for net realized gains of $52.4 million and $71.4 million, respectively.
The following table presents the gross realized gains and losses on sales of AFS securities for the three and six months ended June 30, 2014 and 2013:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2014
 
2013
 
2014
 
2013
Gross realized gains
$
35,954

 
$
52,439

 
$
43,163

 
$
75,665

Gross realized losses

 
(1
)
 
(45,997
)
 
(4,297
)
Total realized (losses) gains on sales, net
$
35,954

 
$
52,438

 
$
(2,834
)
 
$
71,368


Note 6. Trading Securities, at Fair Value
The Company holds U.S. Treasuries in a TRS and classifies these securities as trading instruments due to short-term investment objectives. As of June 30, 2014 and December 31, 2013, the Company held U.S. Treasuries with an amortized cost of $996.9 million and $996.1 million, and a fair value of $1.0 billion and $1.0 billion, respectively, classified as trading securities. The unrealized gains included within trading securities were $5.6 million and $4.1 million as of June 30, 2014 and December 31, 2013, respectively.
For the three and six months ended June 30, 2014, the Company sold trading securities for $44.8 million and $143.4 million with an amortized cost of $44.8 million and $143.0 million, resulting in realized losses of $7,031 and gains of $0.4 million, respectively, on the sale of these securities. The Company did not sell any trading securities during the three and six months ended June 30, 2013. For the three and six months ended June 30, 2014, trading securities experienced change in unrealized

16

Table of Contents

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

losses of $1.7 million and $1.5 million, respectively. Trading securities experienced change in unrealized losses of $1.6 million for both the three and six months ended June 30, 2013. Both realized and unrealized gains and losses are recorded as a component of gain (loss) on investment securities in the Company’s condensed consolidated statements of comprehensive income.
At June 30, 2014 and December 31, 2013, the Company pledged trading securities with a carrying value of $1.0 billion and $1.0 billion, respectively, as collateral for repurchase agreements. See Note 16 - Repurchase Agreements.

Note 7. 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 June 30, 2014 and December 31, 2013:
(in thousands)
June 30,
2014
 
December 31,
2013
Unpaid principal balance
$
398,302

 
$
680,840

Fair value adjustment
1,539

 
(136,259
)
Carrying value
$
399,841

 
$
544,581


At June 30, 2014 and December 31, 2013, the Company pledged mortgage loans with a carrying value of $290.4 million and $200.8 million, respectively, as collateral for repurchase agreements and FHLB advances. See Note 16 - Repurchase Agreements and Note 18 - Federal Home Loan Bank of Des Moines Advances.

Note 8. Mortgage Loans Held-for-Investment in Securitization Trusts, at Fair Value
During 2013, the Company purchased subordinated debt and excess servicing rights from two securitization trusts, one sponsored by a third party and one sponsored by one of the Company’s subsidiaries. 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 June 30, 2014 and December 31, 2013:
(in thousands)
June 30,
2014
 
December 31,
2013
Unpaid principal balance
$
786,208

 
$
812,538

Fair value adjustment
18,458

 
(20,148
)
Carrying value
$
804,666

 
$
792,390



17

Table of Contents

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

Note 9. Servicing Activities
Mortgage Servicing Rights, at Fair Value
On April 30, 2013, one of the Company’s wholly owned subsidiaries acquired a company that has approvals from Fannie Mae, Freddie Mac and Ginnie Mae to hold and manage MSR. The MSR acquired in conjunction with this acquisition 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 MSR. The following table summarizes activity related to MSR for the three and six months ended June 30, 2014 and 2013.
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2014
 
2013
 
2014
 
2013
Balance at beginning of period
$
476,663

 
$

 
$
514,402

 
$

Additions from purchases of servicing rights
53,013

 
1,497

 
54,293

 
1,497

Changes in fair value due to:
 
 
 
 
 
 
 
Changes in valuation inputs or assumptions used in the valuation model
(15,655
)
 

 
(35,905
)
 

Other changes in fair value (1)
(13,916
)
 
(45
)
 
(26,427
)
 
(45
)
Other changes (2)
385

 

 
(5,873
)
 

Balance at end of period
$
500,490

 
$
1,452

 
$
500,490

 
$
1,452

____________________
(1)
Other changes in fair value primarily represents changes due to the realization of expected cash flows.
(2)
Other changes includes purchase price adjustments, principally contractual prepayment protection, and changes due to the Company’s repurchase of the underlying collateral.

As of June 30, 2014 and December 31, 2013, the key economic assumptions and sensitivity of the fair value of MSR to immediate 10% and 20% adverse changes in these assumptions were as follows:
(in thousands)
June 30,
2014
 
December 31,
2013
Weighted average prepayment speed:
12.5
%
 
9.5
%
Impact on fair value of 10% adverse change
$
(20,138
)
 
$
(19,305
)
Impact on fair value of 20% adverse change
$
(38,757
)
 
$
(37,187
)
Weighted average delinquency:
4.0
%
 
4.0
%
Impact on fair value of 10% adverse change
$
(3,786
)
 
$
(8,835
)
Impact on fair value of 20% adverse change
$
(7,823
)
 
$
(17,642
)
Weighted average discount rate:
10.0
%
 
9.0
%
Impact on fair value of 10% adverse change
$
(14,591
)
 
$
(21,037
)
Impact on fair value of 20% adverse change
$
(28,398
)
 
$
(40,642
)

These assumptions and sensitivities are hypothetical and should be considered with caution. Changes in fair value based on 10% and 20% variations in assumptions generally cannot be extrapolated because the relationship of the change in assumptions to the change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of MSR is calculated without changing any other assumptions. In reality, changes in one factor may result in changes in another (e.g., increased market interest rates may result in lower prepayments and increased credit losses) that could magnify or counteract the sensitivities. Further, these sensitivities show only the change in the asset balances and do not show any expected change in the fair value of the instruments used to manage the interest rates and prepayment risks associated with these assets.

18

Table of Contents

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

Risk Mitigation Activities
The primary risk of the Company’s MSR is interest rate risk and the resulting impact on prepayments. A significant decline in interest rates could lead to higher-than-expected prepayments that could reduce the value of the MSR. The Company economically hedges the impact of these risks with derivative financial instruments. Refer to Note 12 - Derivative Instruments and Hedging Activities for additional information regarding the derivative financial instruments used to economically hedge MSR.
Mortgage Servicing Income
The following table presents the components of servicing income recorded on the Company’s condensed consolidated statements of comprehensive income for the three and six months ended June 30, 2014 and 2013:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2014
 
2013
 
2014
 
2013
Servicing fee income
$
33,079

 
$
215

 
$
62,950

 
$
215

Ancillary fee income
789

 
30

 
1,359

 
30

 
$
33,868

 
$
245

 
$
64,309

 
$
245


Mortgage Servicing Advances
In connection with the servicing of loans, the Company’s subservicers make certain payments for property taxes and insurance premiums, default and property maintenance payments, as well as advances of principal and interest payments before collecting them from individual borrowers. Servicing advances, including contractual interest, are priority cash flows in the event of a loan principal reduction or foreclosure and ultimate liquidation of the real estate-owned property, thus making their collection reasonably assured. These servicing advances, which are funded by the Company, totaled $15.8 million and $7.3 million and were included in other assets on the condensed consolidated balance sheet as of June 30, 2014 and December 31, 2013, respectively.
Serviced Mortgage Assets
The Company’s total serviced mortgage assets consist of loans owned and classified as mortgage loans held-for-sale, loans held in consolidated VIEs classified as mortgage loans held-for-investment in securitization trusts and loans underlying MSR. The following table presents the number of loans and unpaid principal balance of the mortgage assets for which the Company manages the servicing as of June 30, 2014 and December 31, 2013:
(dollars in thousands)
June 30, 2014
 
December 31, 2013
 
Number of Loans
 
Unpaid Principal Balance
 
Number of Loans
 
Unpaid Principal Balance
Mortgage loans held-for-sale
678

 
$
398,302

 
2,890

 
$
680,840

Mortgage loans held-for-investment in securitization trusts
506

 
376,339

 
537

 
425,209

Mortgage servicing rights (1)
227,244

 
45,629,169

 
210,441

 
42,324,328

Total serviced mortgage assets
228,428

 
$
46,403,810

 
213,868

 
$
43,430,377

____________________
(1)
Includes mortgage loans held-for-investment in securitization trusts for which the Company is the named servicing administrator.

Note 10. Restricted Cash
The Company is required to maintain certain cash balances with counterparties for securities and derivatives trading activity and collateral for the Company’s repurchase agreements and FHLB advances in restricted accounts. The Company has also placed cash in a restricted account pursuant to a letter of credit on an office space lease.

19

Table of Contents

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

The following table presents the Company’s restricted cash balances as of June 30, 2014 and December 31, 2013:
(in thousands)
June 30,
2014
 
December 31,
2013
Restricted cash balances held by trading counterparties:
 
 
 
For securities trading activity
$
9,000

 
$
9,000

For derivatives trading activity
215,037

 
191,107

As restricted collateral for repurchase agreements and Federal Home Loan Bank advances
62,582

 
201,194

 
286,619

 
401,301

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

 
346

Total
$
286,965

 
$
401,647


Note 11. Accrued Interest Receivable
The following table presents the Company’s accrued interest receivable by collateral type:
(in thousands)
June 30,
2014
 
December 31,
2013
Accrued Interest Receivable:
 
 
 
U.S. Treasuries
$
2,348

 
$
2,361

Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
10,488

 
10,583

Federal National Mortgage Association
17,157

 
15,034

Government National Mortgage Association
10,160

 
10,007

Non-Agency
3,953

 
3,676

Total mortgage-backed securities
41,758

 
39,300

Mortgage loans held-for-sale
1,673

 
4,136

Mortgage loans held-for-investment in securitization trusts
4,331

 
4,506

Total
$
50,110

 
$
50,303


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, credit default swaps and total return swaps. In executing on the Company’s current risk management strategy, the Company has entered into interest rate swap and swaption agreements, TBAs, put and call options for TBAs, constant maturity swaps, credit default swaps and total return swaps (based on the Markit IOS Index). 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.

20

Table of Contents

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

Balance Sheet Presentation
In accordance with ASC 815, Derivatives and Hedging, as amended and interpreted, or ASC 815, 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.
The following tables present the gross fair value and notional amounts of the Company’s derivative financial instruments treated as trading instruments as of June 30, 2014 and December 31, 2013.
(in thousands)
 
June 30, 2014
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
207,260

 
$
1,323,650

 
$

 
$

Interest rate swap agreements
 
4,978

 
23,628,148

 

 

Credit default swaps
 

 

 
(2,081
)
 
125,000

Swaptions, net
 
106,828

 
11,450,000

 

 

TBAs
 
9,063

 
1,450,000

 
(13,566
)
 
1,822,000

Put and call options for TBAs, net
 
28

 

 

 

Constant maturity swaps