UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
______________________________
FORM 10-Q
______________________________

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended: March 31, 2015

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 May 7, 2015 there were 366,576,359 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)
 
March 31,
2015
 
December 31,
2014
ASSETS
(unaudited)
 
 
Available-for-sale securities, at fair value
$
14,342,845

 
$
14,341,102

Trading securities, at fair value
2,010,000

 
1,997,656

Residential mortgage loans held-for-sale, at fair value
568,582

 
535,712

Residential mortgage loans held-for-investment in securitization trusts, at fair value
2,170,206

 
1,744,746

Commercial real estate loans held-for-investment
45,556

 

Mortgage servicing rights, at fair value
410,229

 
452,006

Cash and cash equivalents
1,020,338

 
1,005,792

Restricted cash
441,158

 
336,771

Accrued interest receivable
62,516

 
65,529

Due from counterparties
30,723

 
35,625

Derivative assets, at fair value
362,646

 
380,791

Other assets
213,256

 
188,579

Total Assets (1)
$
21,678,055

 
$
21,084,309

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Liabilities
 
 
 
Repurchase agreements
$
13,094,878

 
$
12,932,463

Collateralized borrowings in securitization trusts, at fair value
1,400,571

 
1,209,663

Federal Home Loan Bank advances
2,625,000

 
2,500,000

Derivative liabilities, at fair value
155,149

 
90,233

Due to counterparties
186,352

 
124,206

Dividends payable
95,307

 
95,263

Other liabilities
59,303

 
64,439

Total liabilities (1)
17,616,560

 
17,016,267

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 366,566,133 and 366,395,920 shares issued and outstanding, respectively
3,666

 
3,664

Additional paid-in capital
3,813,914

 
3,811,027

Accumulated other comprehensive income
849,858

 
855,789

Cumulative earnings
1,287,338

 
1,195,536

Cumulative distributions to stockholders
(1,893,281
)
 
(1,797,974
)
Total stockholders’ equity
4,061,495

 
4,068,042

Total Liabilities and Stockholders’ Equity
$
21,678,055

 
$
21,084,309

____________________
(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 Two Harbors Investment Corp. At March 31, 2015 and December 31, 2014, assets of the VIEs totaled $2,227,499 and $1,754,943, and liabilities of the VIEs totaled $1,411,375 and $1,219,821, 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
(in thousands, except share data)
 
Three Months Ended
 
March 31,
 
2015
 
2014
 
(unaudited)
Interest income:
 
 
 
Available-for-sale securities
$
135,525

 
$
123,913

Trading securities
4,695

 
1,926

Residential mortgage loans held-for-sale
4,271

 
4,586

Residential mortgage loans held-for-investment in securitization trusts
18,237

 
7,893

Commercial real estate loans held-for-investment
44

 

Cash and cash equivalents
197

 
217

Total interest income
162,969

 
138,535

Interest expense:


 


Repurchase agreements
20,565

 
20,572

Collateralized borrowings in securitization trusts
10,708

 
5,353

Federal Home Loan Bank advances
2,230

 
153

Total interest expense
33,503

 
26,078

Net interest income
129,466

 
112,457

Other-than-temporary impairments:

 

Total other-than-temporary impairment losses
(127
)
 
(212
)
Non-credit portion of loss recognized in other comprehensive (loss) income

 

Net other-than-temporary credit impairment losses
(127
)

(212
)
Other income:

 

Gain (loss) on investment securities
129,457

 
(38,655
)
Loss on interest rate swap and swaption agreements
(126,443
)
 
(105,528
)
Gain on other derivative instruments
2,967

 
5,801

Gain (loss) on residential mortgage loans held-for-sale
9,092

 
(3,181
)
Servicing income
32,087

 
30,441

Loss on servicing asset
(52,403
)
 
(32,760
)
Other (loss) income
(1,857
)
 
460

Total other loss
(7,100
)
 
(143,422
)
Expenses:

 

Management fees
12,721

 
12,111

Securitization deal costs
2,611

 

Servicing expenses
6,716

 
5,225

Other operating expenses
16,055

 
14,534

Total expenses
38,103

 
31,870

Income (loss) before income taxes
84,136

 
(63,047
)
Benefit from income taxes
(10,657
)
 
(33,902
)
Net income (loss)
$
94,793

 
$
(29,145
)
Basic and diluted earnings (loss) per weighted average common share
$
0.26

 
$
(0.08
)
Dividends declared per common share
$
0.26

 
$
0.26

Basic and diluted weighted average number of shares of common stock outstanding
366,507,657

 
365,611,890

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
 
March 31,
 
2015
 
2014
 
(unaudited)
Comprehensive income:
 
 
 
Net income (loss)
$
94,793

 
$
(29,145
)
Other comprehensive (loss) income:
 
 
 
Unrealized (loss) gain on available-for-sale securities, net
(5,931
)
 
181,735

Other comprehensive (loss) income
(5,931
)
 
181,735

Comprehensive income
$
88,862

 
$
152,590

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, 2013
364,935,168

 
$
3,649

 
$
3,795,372

 
$
444,735

 
$
1,028,397

 
$
(1,417,158
)
 
$
3,854,995

Net loss

 

 

 

 
(29,145
)
 

 
(29,145
)
Other comprehensive income before reclassifications

 

 

 
138,343

 

 

 
138,343

Amounts reclassified from accumulated other comprehensive income

 

 

 
43,392

 

 

 
43,392

Net other comprehensive income

 

 

 
181,735

 

 

 
181,735

Issuance of common stock, net of offering costs
10,780

 

 
110

 

 

 

 
110

Common dividends declared

 

 

 

 

 
(95,172
)
 
(95,172
)
Non-cash equity award compensation
1,100,097

 
11

 
6,470

 

 

 

 
6,481

Balance, March 31, 2014
366,046,045

 
$
3,660

 
$
3,801,952

 
$
626,470

 
$
999,252

 
$
(1,512,330
)
 
$
3,919,004

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2014
366,395,920

 
$
3,664

 
$
3,811,027

 
$
855,789

 
$
1,195,536

 
$
(1,797,974
)
 
$
4,068,042

Cumulative effect of adoption of new accounting principle

 

 

 

 
(2,991
)
 

 
(2,991
)
Adjusted balance, January 1, 2015
366,395,920

 
3,664

 
3,811,027

 
855,789

 
1,192,545

 
(1,797,974
)
 
4,065,051

Net income

 

 

 

 
94,793

 

 
94,793

Other comprehensive income before reclassifications

 

 

 
93,877

 

 

 
93,877

Amounts reclassified from accumulated other comprehensive income

 

 

 
(99,808
)
 

 

 
(99,808
)
Net other comprehensive loss

 

 

 
(5,931
)
 

 

 
(5,931
)
Issuance of common stock, net of offering costs
19,412

 

 
200

 

 

 

 
200

Common dividends declared

 

 

 

 

 
(95,307
)
 
(95,307
)
Non-cash equity award compensation
150,801

 
2

 
2,687

 

 

 

 
2,689

Balance, March 31, 2015
366,566,133

 
$
3,666

 
$
3,813,914

 
$
849,858

 
$
1,287,338

 
$
(1,893,281
)
 
$
4,061,495

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


4

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
Three Months Ended
 
March 31,
 
2015
 
2014
Cash Flows From Operating Activities:
(unaudited)
Net income (loss)
$
94,793

 
$
(29,145
)
Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities:
 
 
 
Amortization of premiums and discounts on investment securities, net
7,554

 
(26
)
Other-than-temporary impairment losses
127

 
212

Realized and unrealized (gains) losses on investment securities, net
(129,457
)
 
38,655

(Gain) loss on residential mortgage loans held-for-sale
(9,092
)
 
3,181

Loss (gain) on residential mortgage loans held-for-investment and collateralized borrowings in securitization trusts
2,919

 
(313
)
Loss on servicing asset
52,403

 
32,760

(Gain) loss on termination and option expiration of interest rate swaps and swaptions
(11,775
)
 
1,240

Unrealized loss on interest rate swaps and swaptions
110,693

 
90,452

Unrealized (gain) loss on other derivative instruments
(4,425
)
 
1,162

Equity based compensation
2,689

 
6,481

Depreciation of fixed assets
319

 
207

Amortization of intangible assets

 
400

Purchases of residential mortgage loans held-for-sale
(662,064
)
 
(28,867
)
Proceeds from sales of residential mortgage loans held-for-sale
23,831

 
402,298

Proceeds from repayment of residential mortgage loans held-for-sale
24,947

 
7,334

Net change in assets and liabilities:


 
 
Decrease in accrued interest receivable
3,013

 
3,579

Increase in deferred income taxes, net
(11,537
)
 
(41,799
)
Increase in income taxes receivable
(293
)
 
(321
)
Decrease/(increase) in prepaid and fixed assets
25

 
(400
)
Decrease/(increase) in other receivables
396

 
(10,516
)
Increase in servicing advances
(3,347
)
 
(5,416
)
Decrease in accrued interest payable
(5,353
)
 
(4,208
)
(Decrease)/increase in income taxes payable
(1,342
)
 
7,084

Increase in accrued expenses and other liabilities
1,560

 
3,795

Net cash (used in) provided by operating activities
$
(513,416
)
 
$
477,829

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

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Three Months Ended
 
March 31,
 
2015
 
2014
Cash Flows From Investing Activities:
(unaudited)
Purchases of available-for-sale securities
$
(1,084,742
)
 
$
(1,274,784
)
Proceeds from sales of available-for-sale securities
900,107

 
814,872

Principal payments on available-for-sale securities
286,393

 
224,982

Short sales and purchases of other derivative instruments
(34,834
)
 
(12,902
)
Proceeds from sales of other derivative instruments, net
23,428

 
26,416

Purchases of trading securities

 
(98,219
)
Proceeds from sales of trading securities

 
98,582

Proceeds from repayment of residential mortgage loans held-for-investment in securitization trusts
160,853

 
13,280

Purchases of commercial real estate loans held-for-investment
(45,556
)
 

Purchases of mortgage servicing rights, net of purchase price adjustments
(10,399
)
 
4,979

Purchases of Federal Home Loan Bank stock
(10,240
)
 
(18,579
)
Purchases of equity investments

 
(3,000
)
Increase/(decrease) in due to counterparties, net
67,048

 
(172,830
)
(Increase)/decrease in restricted cash
(104,387
)
 
181,445

Net cash provided by (used in) investing activities
147,671

 
(215,758
)
Cash Flows From Financing Activities:
 
 
 
Proceeds from repurchase agreements
14,782,724

 
70,826,091

Principal payments on repurchase agreements
(14,620,309
)
 
(71,055,364
)
Proceeds from issuance of collateralized borrowings in securitization trusts
310,173

 
33,483

Principal payments on collateralized borrowings in securitization trusts
(122,232
)
 
(15,923
)
Proceeds from Federal Home Loan Bank advances
125,000

 
464,476

Proceeds from issuance of common stock, net of offering costs
200

 
110

Dividends paid on common stock
(95,263
)
 

Net cash provided by financing activities
380,293

 
252,873

Net increase in cash and cash equivalents
14,546

 
514,944

Cash and cash equivalents at beginning of period
1,005,792

 
1,025,487

Cash and cash equivalents at end of period
$
1,020,338

 
$
1,540,431

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

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Three Months Ended
 
March 31,
 
2015
 
2014
Supplemental Disclosure of Cash Flow Information:
(unaudited)
Cash paid for interest
$
28,623

 
$
30,286

Cash paid for taxes
$
2,511

 
$
1,134

Noncash Investing and Financing Activities:
 
 
 
Transfers of residential mortgage loans held-for-sale to residential mortgage loans held-for-investment in securitization trusts
$
589,255

 
$

Additions to mortgage servicing rights due to sale of residential mortgage loans held-for-sale
$
227

 
$

Cumulative effect of adoption of new accounting principle
$
(2,991
)
 
$

Cash dividends declared but not paid at end of period
$
95,307

 
$
95,172

Reconciliation of residential mortgage loans held-for-sale:
 
 
 
Residential mortgage loans held-for-sale at beginning of period
$
535,712

 
$
544,581

Purchases of residential mortgage loans held-for-sale
662,064

 
28,867

Transfers to residential mortgage loans held-for-investment in securitization trusts
(589,255
)
 

Proceeds from sales of residential mortgage loans held-for-sale
(23,831
)
 
(402,298
)
Proceeds from repayment of residential mortgage loans held-for-sale
(24,947
)
 
(7,334
)
Realized and unrealized gains (losses) on residential mortgage loans held-for-sale
8,839

 
(2,795
)
Residential mortgage loans held-for-sale at end of period
$
568,582

 
$
161,021

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, commercial real estate 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 of the Company 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. 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.

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, 2014. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at March 31, 2015 and results of operations for all periods presented have been made. The results of operations for the three months ended March 31, 2015 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 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.
All trust entities in which the Company holds investments that 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 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.

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Table of Contents

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

Significant Accounting Policies
Included in Note 2 to the Consolidated Financial Statements of the Company’s 2014 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 three months ended March 31, 2015.
Commercial Real Estate Loans Held-for-Investment
The Company is the sole certificate holder of a trust entity that holds a commercial real estate loan. The trust is considered a VIE for financial reporting purposes and, thus, is reviewed for consolidation under the applicable consolidation guidance. As the Company has both the power to direct the activities of the trust that most significantly impact the entity’s performance, and the obligation to absorb losses or the right to receive benefits of the entity that could be significant, the Company consolidates the trust. The underlying loan is classified as commercial real estate loans held-for-investment on the condensed consolidated balance sheets. The loan is legally isolated from the Company and has been structured to be beyond the reach of creditors of the Company. Interest income on commercial real estate loans held-for-investment is recorded on the condensed consolidated statements of comprehensive income.
Commercial real estate loans held-for-investment are reported at cost, net of any unamortized premiums or discounts, unless deemed impaired. The Company evaluates each loan for impairment at least quarterly. Impairment occurs when it is deemed probable that the Company will not be able to collect all amounts due according to the contractual terms of the loan. If a loan is considered to be impaired, the Company records an allowance to reduce the carrying value of the loan to the present value of expected future cash flows.
The Company’s commercial real estate loans are collateralized either by real property or by equity interests in the commercial real estate borrower. As a result, the Company regularly evaluates the extent and impact of any credit deterioration associated with the performance and/or value of the underlying collateral property, as well as the financial and operating capability of the borrower, borrowing entity or loan sponsor. The Company also evaluates the financial wherewithal of any loan guarantors as well as the borrower’s competency in managing and operating the properties. In addition, the Company considers the overall economic environment, real estate sector, and geographic sub-market in which the borrower operates.
Interest income on commercial real estate loans held-for-investment is recognized at the loan coupon rate. Any premiums or discounts are amortized or accreted into interest income using the effective interest method. Loans are considered past due when they are 30 days past their contractual due date. Interest income recognition is suspended when loans are placed on nonaccrual status. Generally, commercial real estate 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 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. Commercial real estate loans are restored to accrual status only when contractually current or the collection of future payments is reasonably assured.
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, or central clearing exchange agreements, in the case of centrally cleared interest rate swaps. Additionally, the Company and the counterparty or clearing agency 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 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.

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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 March 31, 2015 and December 31, 2014:
 
March 31, 2015
 
 
 
 
 
 
 
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
$
455,084

 
$
(92,438
)
 
$
362,646

 
$
(155,149
)
 
$

 
$
207,497

Total Assets
$
455,084

 
$
(92,438
)
 
$
362,646

 
$
(155,149
)
 
$

 
$
207,497

 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(13,094,878
)
 
$

 
$
(13,094,878
)
 
$
13,094,878

 
$

 
$

Derivative liabilities
(247,587
)
 
92,438

 
(155,149
)
 
155,149

 

 

Total Liabilities
$
(13,342,465
)
 
$
92,438

 
$
(13,250,027
)
 
$
13,250,027

 
$

 
$

 
December 31, 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
$
443,490

 
$
(62,699
)
 
$
380,791

 
$
(90,233
)
 
$

 
$
290,558

Total Assets
$
443,490

 
$
(62,699
)
 
$
380,791

 
$
(90,233
)
 
$

 
$
290,558

 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(12,932,463
)
 
$

 
$
(12,932,463
)
 
$
12,932,463

 
$

 
$

Derivative liabilities
(152,932
)
 
62,699

 
(90,233
)
 
90,233

 

 

Total Liabilities
$
(13,085,395
)
 
$
62,699

 
$
(13,022,696
)
 
$
13,022,696

 
$

 
$

____________________
(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.


10

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

Recently Issued and/or Adopted Accounting Standards
Measuring the Financial Assets and the Financial Liabilities of a Consolidated Collateralized Financing Entity
In August 2014, the FASB issued ASU No. 2014-13, which updates the guidance on measuring the financial assets and financial liabilities of consolidated collateralized financing entities, or CFEs. The update allows an entity to measure both the financial assets and financial liabilities of a qualifying CFE it consolidates using the fair value of either the CFE’s financial assets or financial liabilities, whichever is more observable. The ASU requires certain recurring disclosures and was effective for annual periods beginning on or after December 15, 2015, with early adoption permitted as of the beginning of an annual period. Early adoption of this ASU was applied using a modified retrospective approach by recording a cumulative-effect adjustment to equity as of January 1, 2015, which did not have a material impact on the Company’s financial condition or results of operations.
Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure
In August 2014, the FASB issued ASU No. 2014-14, which requires that, upon foreclosure, a mortgage loan that is fully guaranteed under certain government programs be derecognized and a separate receivable be recognized when specific criteria are met. The ASU requires certain recurring disclosures and is effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2014, with early adoption permitted. Adoption of this ASU did not have a material impact on the Company’s financial condition or results of operations.
Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern
In August 2014, the FASB issued ASU No. 2014-15, which requires management to evaluate whether there are conditions and events that raise substantial doubt about the entity’s ability to continue as a going concern for both annual and interim reporting periods. The ASU requires certain disclosures if management concludes that substantial doubt exists and plans to alleviate that doubt. The ASU is effective for annual periods ending after December 15, 2016, and for both annual and interim periods thereafter, with early adoption permitted.
Amendments to the Consolidation Analysis
In February 2015, the FASB issued ASU No. 2015-2, which changes the guidance on the consolidation of certain investment funds as well as both the variable interest model and the voting model. The ASU requires certain recurring disclosures and is effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2015, with early adoption permitted. Early adoption of this ASU did not have a material impact on the Company’s financial condition or results of operations.

Note 3. Variable Interest Entities
The Company purchases subordinated debt and excess servicing rights from securitization trusts sponsored by either third parties or the Company’s subsidiaries. Additionally, the Company is the sole certificate holder of a trust entity that holds a commercial real estate loan. All of these 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 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

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

The following table presents a summary of the assets and liabilities of all consolidated trusts as reported on the condensed consolidated balance sheets:
(in thousands)
March 31,
2015
 
December 31,
2014
Residential mortgage loans held-for-investment in securitization trusts
$
2,170,206

 
$
1,744,746

Commercial real estate loans held-for-investment
45,556

 

Accrued interest receivable
11,737

 
10,197

Total Assets
$
2,227,499

 
$
1,754,943

Collateralized borrowings in securitization trusts
$
1,400,571

 
$
1,209,663

Accrued interest payable
4,152

 
3,678

Other liabilities
6,652

 
6,480

Total Liabilities
$
1,411,375

 
$
1,219,821


Note 4. 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 March 31, 2015 and December 31, 2014:
(in thousands)
March 31,
2015
 
December 31,
2014
Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
2,641,286

 
$
2,418,546

Federal National Mortgage Association
6,802,084

 
6,768,875

Government National Mortgage Association
2,083,548

 
2,104,896

Non-Agency
2,815,927

 
3,048,785

Total mortgage-backed securities
$
14,342,845

 
$
14,341,102


At both March 31, 2015 and December 31, 2014, the Company pledged AFS securities with a carrying value of $14.2 billion as collateral for repurchase agreements and advances from Federal Home Loan Bank of Des Moines, or the FHLB. See Note 16 - Repurchase Agreements and Note 18 - Federal Home Loan Bank of Des Moines Advances.
At March 31, 2015 and December 31, 2014, 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.

12

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

The following tables present the amortized cost and carrying value (which approximates fair value) of AFS securities by collateral type as of March 31, 2015 and December 31, 2014:
 
March 31, 2015
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
13,492,873

 
$
3,858,345

 
$
17,351,218

Unamortized premium
701,133

 

 
701,133

Unamortized discount
 
 
 
 
 
Designated credit reserve

 
(747,384
)
 
(747,384
)
Net, unamortized
(2,939,997
)
 
(871,983
)
 
(3,811,980
)
Amortized Cost
11,254,009

 
2,238,978

 
13,492,987

Gross unrealized gains
299,826

 
578,482

 
878,308

Gross unrealized losses
(26,917
)
 
(1,533
)
 
(28,450
)
Carrying Value
$
11,526,918

 
$
2,815,927

 
$
14,342,845

 
December 31, 2014
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
13,421,555


$
4,291,872

 
$
17,713,427

Unamortized premium
676,641



 
676,641

Unamortized discount
 
 
 
 
 
Designated credit reserve


(927,605
)
 
(927,605
)
Net, unamortized
(3,009,782
)

(967,368
)
 
(3,977,150
)
Amortized Cost
11,088,414


2,396,899

 
13,485,313

Gross unrealized gains
238,291


653,529

 
891,820

Gross unrealized losses
(34,388
)

(1,643
)
 
(36,031
)
Carrying Value
$
11,292,317

 
$
3,048,785

 
$
14,341,102


The following tables present the carrying value of the Company’s AFS investment securities by rate type as of March 31, 2015 and December 31, 2014:
 
March 31, 2015
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
124,939

 
$
2,340,052

 
$
2,464,991

Fixed Rate
11,401,979

 
475,875

 
11,877,854

Total
$
11,526,918

 
$
2,815,927

 
$
14,342,845

 
December 31, 2014
(in thousands)
Agency
 
Non-Agency
 
Total
Adjustable Rate
$
128,285


$
2,558,832

 
$
2,687,117

Fixed Rate
11,164,032


489,953

 
11,653,985

Total
$
11,292,317


$
3,048,785

 
$
14,341,102


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

13

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

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 three months ended March 31, 2015 and 2014, of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
 
Three Months Ended March 31,
 
2015
 
2014
(in thousands)
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
 
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
Beginning balance at January 1
$
(927,605
)
 
$
(967,368
)
 
$
(1,894,973
)
 
$
(1,234,449
)
 
$
(1,071,559
)
 
$
(2,306,008
)
Acquisitions
1,183

 
(935
)
 
248

 
(16,678
)
 
(18,254
)
 
(34,932
)
Accretion of net discount

 
27,465

 
27,465

 

 
31,831

 
31,831

Realized credit losses
3,727

 

 
3,727

 
3,868

 

 
3,868

Reclassification adjustment for other-than-temporary impairments
1,789

 

 
1,789

 
(212
)
 

 
(212
)
Transfers from (to)
41,092

 
(41,092
)
 

 
22,639

 
(22,639
)
 

Sales, calls, other
132,430

 
109,947

 
242,377

 
28,034

 
16,819

 
44,853

Ending balance at March 31
$
(747,384
)
 
$
(871,983
)
 
$
(1,619,367
)
 
$
(1,196,798
)
 
$
(1,063,802
)
 
$
(2,260,600
)

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 that the securities had an unrealized loss position as of March 31, 2015 and December 31, 2014. At March 31, 2015, the Company held 1,506 AFS securities, of which 116 were in an unrealized loss position for less than twelve consecutive months and 171 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2014, the Company held 1,452 AFS securities, of which 57 were in an unrealized loss position for less than twelve months and 172 were in an unrealized loss position for more than twelve consecutive months.
 
Unrealized Loss Position for
 
Less than 12 Months
 
12 Months or More
 
Total
(in thousands)
Estimated Fair Value
 
Gross Unrealized Losses
 
Estimated Fair Value
 
Gross Unrealized Losses
 
Estimated Fair Value
 
Gross Unrealized Losses
March 31, 2015
$
1,075,418

 
$
(6,006
)
 
$
1,276,019

 
$
(22,444
)
 
$
2,351,437

 
$
(28,450
)
December 31, 2014
$
413,102

 
$
(3,146
)
 
$
1,323,688

 
$
(32,885
)
 
$
1,736,790

 
$
(36,031
)

Evaluating AFS Securities for Other-Than-Temporary Impairments
In evaluating 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 will not be 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 (loss) 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 $0.1 million other-than-temporary credit impairment during the three months ended March 31, 2015 on one non-Agency RMBS where the future expected cash flows for the security were less than its amortized cost. As of March 31, 2015, impaired securities with a carrying value of $144.8 million had actual weighted average cumulative losses of 10.1%, weighted average three-month prepayment speed of 4.6%, weighted average 60+ day delinquency of 28.8% of the pool

14

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

balance, and weighted average FICO score of 664. At March 31, 2015, 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 months ended March 31, 2014, the Company recorded a $0.2 million other-than-temporary credit impairment on a total of three non-Agency RMBS where the future expected cash flows for the security were less than its amortized cost.
The following table presents the changes in OTTI included in earnings for three months ended March 31, 2015 and 2014:
 
Three Months Ended
 
March 31,
(in thousands)
2015
 
2014
Cumulative credit loss at beginning of period
$
(8,241
)
 
$
(9,467
)
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
(127
)
 
(121
)
Reductions:
 
 
 
Decreases related to other-than-temporary impairments on securities paid down

 
464

Decreases related to other-than-temporary impairments on securities sold
1,916

 

Cumulative credit loss at end of period
$
(6,452
)
 
$
(9,215
)

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 months ended March 31, 2015 and 2014, the Company sold AFS securities for $900.1 million and $814.9 million with an amortized cost of $782.6 million and $853.7 million, for net realized gains of $117.5 million and losses of $38.8 million, respectively.
The following table presents the gross realized gains and losses on sales of AFS securities for the three months ended March 31, 2015 and 2014:
 
Three Months Ended
 
March 31,
(in thousands)
2015
 
2014
Gross realized gains
$
117,688

 
$
7,209

Gross realized losses
(220
)
 
(45,997
)
Total realized gains (losses) on sales, net
$
117,468

 
$
(38,788
)

Note 5. 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 both March 31, 2015 and December 31, 2014, the Company held U.S. Treasuries with an amortized cost of $2.0 billion and a fair value of $2.0 billion classified as trading securities. Included within trading securities were unrealized gains of $13.4 million and $1.4 million as of March 31, 2015 and December 31, 2014, respectively.
For the three months ended March 31, 2014, the Company sold trading securities for $98.6 million with an amortized cost of $98.2 million, resulting in realized gains of $0.4 million on the sale of these securities. The Company did not sell any trading securities during the three months ended March 31, 2015.
For the three months ended March 31, 2015 and 2014, trading securities experienced change in unrealized gains of $12.0 million and losses of $0.2 million, respectively. 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.

15

Table of Contents

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

At both March 31, 2015 and December 31, 2014, the Company pledged trading securities with a carrying value of $2.0 billion as collateral for repurchase agreements. See Note 16 - Repurchase Agreements.

Note 6. Residential Mortgage Loans Held-for-Sale, at Fair Value
Residential 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 residential mortgage loans held-for-sale as of March 31, 2015 and December 31, 2014:
(in thousands)
March 31,
2015
 
December 31,
2014
Unpaid principal balance
$
569,553

 
$
534,101

Fair value adjustment
(971
)
 
1,611

Carrying value
$
568,582

 
$
535,712


At March 31, 2015 and December 31, 2014, the Company pledged residential mortgage loans with a carrying value of $415.9 million and $416.8 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 7. Residential Mortgage Loans Held-for-Investment in Securitization Trusts, at Fair Value
The Company purchases subordinated debt and excess servicing rights from securitization trusts sponsored by either third parties or 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 residential 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 residential mortgage loans held-for-investment in securitization trusts as of March 31, 2015 and December 31, 2014:
(in thousands)
March 31,
2015
 
December 31,
2014
Unpaid principal balance
$
2,112,775

 
$
1,699,748

Fair value adjustment
57,431

 
44,998

Carrying value
$
2,170,206

 
$
1,744,746


Note 8. Commercial Real Estate Loans Held-for-Investment
The Company is the sole certificate holder of a trust entity that holds a commercial real estate loan. The underlying loan held by the trust, which is consolidated on the Company’s condensed consolidated balance sheet, is classified as commercial real estate loans held-for-investment and carried at cost, net of any unamortized premiums or discounts, unless deemed impaired. See Note 3 - Variable Interest Entities for additional information regarding consolidation of the trust.
The following table presents the carrying value of the Company’s commercial real estate loans held-for-investment as of March 31, 2015 and December 31, 2014:
(in thousands)
March 31,
2015
 
December 31,
2014
Unpaid principal balance
$
45,900

 
$

Unamortized discount
(344
)
 

Carrying value
$
45,556

 
$


As of March 31, 2015, the Company’s commercial real estate loans held-for-investment were comprised of one newly-issued senior mezzanine commercial real estate loan with a two-year interest-only term. The Company evaluates each loan for impairment at least quarterly as described in Note 2 - Basis of Presentation and Significant Accounting Policies. As of

16

Table of Contents

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

March 31, 2015, the Company had not recorded any allowances for losses as it was not deemed probable that the Company will not be able to collect all amounts due according to the contractual terms of the loan. The Company did not hold any commercial real estate loans held-for-investment as of December 31, 2014.

Note 9. Servicing Activities
Mortgage Servicing Rights, at Fair Value
One of the Company’s wholly owned subsidiaries 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, which represent the right to control the servicing of mortgage loans. The Company and its subsidiaries do not originate or directly service mortgage loans, and instead contract with fully licensed subservicers to handle substantially all servicing functions for the loans underlying the Company’s MSR. The following table summarizes activity related to MSR for the three months ended March 31, 2015 and 2014.
 
Three Months Ended
 
March 31,
(in thousands)
2015
 
2014
Balance at beginning of period
$
452,006

 
$
514,402

Additions from purchases of servicing rights
4,324

 
1,280

Additions from sales of residential mortgage loans
227

 

Changes in fair value due to:
 
 
 
Changes in valuation inputs or assumptions used in the valuation model
(43,089
)
 
(20,250
)
Other changes in fair value (1)
(9,314
)
 
(12,510
)
Other changes (2)
6,075

 
(6,259
)
Balance at end of period
$
410,229

 
$
476,663

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

As of March 31, 2015 and December 31, 2014, 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)
March 31,
2015
 
December 31,
2014
Weighted average prepayment speed:
13.1
%
 
11.9
%
Impact on fair value of 10% adverse change
$
(18,050
)
 
$
(14,012
)
Impact on fair value of 20% adverse change
$
(34,459
)
 
$
(31,640
)
Weighted average delinquency:
4.6
%
 
5.6
%
Impact on fair value of 10% adverse change
$
(2,461
)
 
$
(3,616
)
Impact on fair value of 20% adverse change
$
(4,513
)
 
$
(6,780
)
Weighted average discount rate:
9.9
%
 
9.5
%
Impact on fair value of 10% adverse change
$
(14,358
)
 
$
(16,272
)
Impact on fair value of 20% adverse change
$
(27,896
)
 
$
(31,640
)

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

17

Table of Contents

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

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.
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 AFS securities and 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 months ended March 31, 2015 and 2014:
 
Three Months Ended
 
March 31,
(in thousands)
2015
 
2014
Servicing fee income
$
31,237

 
$
29,871

Ancillary fee income
564

 
463

Float income
286

 
107

Total
$
32,087

 
$
30,441


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 $30.8 million and $27.5 million and were included in other assets on the condensed consolidated balance sheet as of March 31, 2015 and December 31, 2014, respectively.
Serviced Mortgage Assets
The Company’s total serviced mortgage assets consist of loans owned and classified as residential mortgage loans held-for-sale, loans held in consolidated VIEs classified as residential 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 March 31, 2015 and December 31, 2014:
(dollars in thousands)
March 31, 2015
 
December 31, 2014
 
Number of Loans
 
Unpaid Principal Balance
 
Number of Loans
 
Unpaid Principal Balance
Residential mortgage loans held-for-sale
1,210

 
$
569,553

 
1,008

 
$
534,101

Residential mortgage loans held-for-investment in securitization trusts
465

 
341,824

 
487

 
358,458

Mortgage servicing rights (1)
220,033

 
43,974,908

 
224,073

 
44,949,061

Total serviced mortgage assets
221,708

 
$
44,886,285

 
225,568

 
$
45,841,620

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


18

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

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.
The following table presents the Company’s restricted cash balances as of March 31, 2015 and December 31, 2014:
(in thousands)
March 31,
2015
 
December 31,
2014
Restricted cash balances held by trading counterparties:
 
 
 
For securities and loan trading activity
$
17,250

 
$
12,000

For derivatives trading activity
333,602

 
211,989

As restricted collateral for repurchase agreements and Federal Home Loan Bank advances
89,959

 
112,435

Total restricted cash balances held by trading counterparties
440,811

 
336,424

Restricted cash balance pursuant to letter of credit on office lease
347

 
347

Total
$
441,158

 
$
336,771


Note 11. Accrued Interest Receivable
The following table presents the Company’s accrued interest receivable by collateral type:
(in thousands)
March 31,
2015
 
December 31,
2014
Accrued Interest Receivable:
 
 
 
U.S. Treasuries
$
3,674

 
$
8,084

Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
9,210

 
8,734

Federal National Mortgage Association
22,315

 
22,392

Government National Mortgage Association
10,137

 
10,290

Non-Agency
3,765

 
3,835

Total mortgage-backed securities
45,427

 
45,251

Residential mortgage loans held-for-sale
1,678

 
1,997

Residential mortgage loans held-for-investment in securitization trusts
11,693

 
10,197

Commercial real estate loans held-for-investment
44

 

Total
$
62,516

 
$
65,529


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.

19

Table of Contents

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

The following summarizes the Company’s significant asset and liability classes, the risk exposure for these classes, and the Company’s risk management activities used to mitigate certain of these risks. The discussion includes both derivative and non-derivative instruments used as part of these risk management activities. While the Company uses non-derivative and derivative instruments to achieve the Company’s risk management activities, it is possible that these instruments will not effectively mitigate all or a substantial portion of the Company’s market rate risk. In addition, the Company might elect, at times, not to enter into certain hedging arrangements in order to maintain compliance with REIT requirements.
Balance Sheet Presentation
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 March 31, 2015 and December 31, 2014.
(in thousands)
 
March 31, 2015
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
189,875

 
$
1,106,210

 
$

 
$

Interest rate swap agreements
 
49,485

 
9,614,000

 
(126,063
)
 
10,315,000

Credit default swaps
 

 

 
(1,460
)
 
125,000

Swaptions, net
 
108,348

 
11,600,000

 
(3,840
)
 
1,360,000

TBAs
 

 

 
(17,930
)
 
2,496,000

Put and call options for TBAs, net
 

 

 
(5,776
)
 
2,500,000

Constant maturity swaps
 
1,236

 
3,000,000

 

 

Markit IOS total return swaps
 
12,299

 
877,529

 

 

Forward purchase commitments
 
1,403

 
598,009

 
(80
)
 
109,295

Total
 
$
362,646

 
$
26,795,748

 
$
(155,149
)
 
$
16,905,295

(in thousands)
 
December 31, 2014
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
188,592

 
$
1,168,226

 
$

 
$

Interest rate swap agreements
 
55,471

 
9,569,000

 
(65,392
)
 
9,015,000

Credit default swaps
 

 

 
(1,672
)
 
125,000

Swaptions, net
 
121,591

 
9,550,000

 
(4,999
)
 
2,860,000

TBAs
 
10,350

 
875,000

 
(17,687
)
 
2,200,000

Put and call options for TBAs, net
 
90

 
2,000,000

 

 

Constant maturity swaps
 
2,013

 
12,000,000

 
(483
)
 
2,000,000

Markit IOS total return swaps
 
1,387

 
598,459

 

 

Forward purchase commitments
 
1,297

 
554,838

 

 

Total
 
$
380,791

 
$
36,315,523

 
$
(90,233
)
 
$
16,200,000


Comprehensive Income Statement Presentation
The Company has not applied hedge accounting to its current derivative portfolio held to mitigate the interest rate risk and credit risk associated with its 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.

20

Table of Contents

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

The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed consolidated statements of comprehensive income on the Company’s derivative trading instruments:
(in thousands)
 
 
 
 
 
 
Trading Instruments
 
Location of Gain/(Loss) Recognized in Income on Derivatives
 
Amount of Gain/(Loss) Recognized in Income on Derivatives
 
 
 
 
Three Months Ended March 31,
 
 
 
 
2015
 
2014
Interest rate risk management
 
 
 
 
 
 
TBAs (1)
 
Gain (loss) on other derivative instruments
 
$
(27,958
)
 
$
(17,903
)
Put and call options for TBAs (1)
 
Gain (loss) on other derivative instruments
 
2,535

 
(1,705
)
Constant maturity swaps (1)
 
Gain (loss) on other derivative instruments
 
6,090

 
11,531

Short U.S. Treasuries (1)
 
Gain (loss) on other derivative instruments
 

 

Interest rate swap agreements - Receivers (1)
 
Gain (loss) on interest rate swap and swaption agreements
 
42,326

 
40,979

Interest rate swap agreements - Payers (1)
 
Gain (loss) on interest rate swap and swaption agreements
 
(52,559
)
 
(13,420
)
Swaptions (1)
 
Gain (loss) on interest rate swap and swaption agreements
 
(18,506
)
 
(112,558
)
Markit IOS total return swaps (1)
 
Gain (loss) on other derivative instruments
 
3,132

 
(1,725
)
Interest rate swap agreements - Payers (2)
 
Gain (loss) on interest rate swap and swaption agreements
 
(97,704
)
 
(20,529
)
Credit risk management
 
 
 
 
 
 
Credit default swaps - Receive protection (3)
 
Gain (loss) on other derivative instruments
 
(93
)
 
1,981

Non-risk management
 
 
 
 
 
 
TBAs
 
Gain (loss) on other derivative instruments
 

 
(4,701
)
Inverse interest-only securities
 
Gain (loss) on other derivative instruments
 
19,261

 
18,323

Forward purchase commitments
 
(Loss) gain on residential mortgage loans held-for-sale
 
970

 
(417
)
Total
 
 
 
$
(122,506
)
 
$
(100,144
)
____________________
(1)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s investment portfolio.
(2)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s repurchase agreements and FHLB advances.
(3)
Includes derivative instruments held to mitigate credit risk associated with the Company’s non-Agency RMBS and residential mortgage loans held-for-sale.

For the three months ended March 31, 2015 and 2014, the Company recognized $27.5 million and $13.8 million, respectively, of expenses for the accrual and/or settlement of the net interest expense associated with its interest rate swaps. The expenses result from paying either a fixed interest rate or LIBOR interest on an average $18.2 billion and $19.2 billion notional, respectively, and receiving either LIBOR interest or a fixed interest rate.

21

Table of Contents

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

The following table presents information with respect to the volume of activity in the Company’s derivative instruments during the three months ended March 31, 2015 and 2014:
(in thousands)
 
 
 
 
 
 
 
 
 
 
 
Three Months Ended
March 31,
Beginning of Period Notional Amount
 
Additions
 
Settlement, Termination, Expiration or Exercise
 
End of Period Notional Amount
 
Average Notional Amount
 
Realized Gain (Loss), net (1)
2015
 
 
 
 
 
 

 
 
 
 
Inverse interest-only securities
$
1,168,226

 
$

 
$
(62,016
)
 
$
1,106,210

 
$
1,138,468

 
$

Interest rate swap agreements
18,584,000

 
5,620,000

 
(4,275,000
)
 
19,929,000

 
18,238,389

 
(1,070
)
Credit default swaps
125,000

 

 

 
125,000

 
125,000

 

Swaptions, net
12,410,000

 
5,550,000

 
(5,000,000
)
 
12,960,000

 
12,851,667

 
12,845

TBAs, net
(1,325,000
)
 
(6,933,000
)
 
5,762,000

 
(2,496,000
)
 
2,121,700

 
(17,364
)
Put and call options for TBAs, net
2,000,000

 
250,000

 
(4,750,000
)
 
(2,500,000
)
 
8,333

 
(3,047
)
Constant maturity swaps
14,000,000

 
6,000,000

 
(17,000,000
)
 
3,000,000

 
6,988,889

 
6,384

Markit IOS total return swaps
598,459

 
676,633

 
(397,563
)
 
877,529

 
875,346

 
4,202

Forward purchase commitments
554,838

 
1,128,634

 
(976,168
)
 
707,304

 
648,343

 
943

Total
$
48,115,523

 
$
12,292,267

 
$
(26,698,747
)
 
$
33,709,043

 
$
42,996,135

 
$
2,893

2014
 
 
 
 
 
 
 
 
 
 
 
Inverse interest-only securities
$
1,525,845

 
$

 
$
(113,471
)
 
$
1,412,374

 
$
1,470,667

 
$
193

Interest rate swap agreements
19,619,000

 
2,944,148

 
(900,000
)
 
21,663,148

 
19,156,878

 
(22
)
Credit default swaps
427,073

 

 
(302,073
)
 
125,000

 
179,418

 
(13,705
)
Swaptions, net
5,130,000

 
3,900,000

 
470,000

 
9,500,000

 
8,979,111

 
(1,219
)
TBAs, net
603,000

 
(892,000
)
 
(733,000
)
 
(1,022,000
)