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, 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 August 5, 2015 there were 367,539,843 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,
2015
 
December 31,
2014
ASSETS
(unaudited)
 
 
Available-for-sale securities, at fair value
$
12,807,658

 
$
14,341,102

Trading securities, at fair value
—

 
1,997,656

Residential mortgage loans held-for-sale, at fair value
695,078

 
535,712

Residential mortgage loans held-for-investment in securitization trusts, at fair value
2,449,199

 
1,744,746

Commercial real estate loans held-for-investment
45,605

 
—

Mortgage servicing rights, at fair value
437,576

 
452,006

Cash and cash equivalents
933,579

 
1,005,792

Restricted cash
410,903

 
336,771

Accrued interest receivable
57,011

 
65,529

Due from counterparties
27,230

 
35,625

Derivative assets, at fair value
347,322

 
380,791

Other assets
236,560

 
188,579

Total Assets (1)
$
18,447,721

 
$
21,084,309

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Liabilities
 
 
 
Repurchase agreements
$
9,422,803

 
$
12,932,463

Collateralized borrowings in securitization trusts, at fair value
1,714,735

 
1,209,663

Federal Home Loan Bank advances
3,000,000

 
2,500,000

Derivative liabilities, at fair value
22,475

 
90,233

Due to counterparties
160,014

 
124,206

Dividends payable
95,557

 
95,263

Other liabilities
60,568

 
64,439

Total Liabilities (1)
14,476,152

 
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 367,527,725 and 366,395,920 shares issued and outstanding, respectively
3,675

 
3,664

Additional paid-in capital
3,816,861

 
3,811,027

Accumulated other comprehensive income
631,032

 
855,789

Cumulative earnings
1,508,839

 
1,195,536

Cumulative distributions to stockholders
(1,988,838
)
 
(1,797,974
)
Total Stockholders’ Equity
3,971,569

 
4,068,042

Total Liabilities and Stockholders’ Equity
$
18,447,721

 
$
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 June 30, 2015 and December 31, 2014, assets of the VIEs totaled $2,508,625 and $1,754,943, and liabilities of the VIEs totaled $1,727,995 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
 
Six Months Ended
 
June 30,
 
June 30,
 
2015
 
2014
 
2015
 
2014
Interest income:
(unaudited)
 
(unaudited)
Available-for-sale securities
$
118,129

 
$
127,605

 
$
253,654

 
$
251,518

Trading securities
3,981

 
1,940

 
8,676

 
3,866

Residential mortgage loans held-for-sale
7,518

 
2,699

 
11,789

 
7,285

Residential mortgage loans held-for-investment in securitization trusts
21,830

 
7,761

 
40,067

 
15,654

Commercial real estate loans held-for-investment
850

 
—

 
894

 
—

Cash and cash equivalents
221

 
144

 
418

 
361

Total interest income
152,529

 
140,149

 
315,498

 
278,684

Interest expense:
 
 
 
 


 


Repurchase agreements
19,398

 
18,603

 
39,963

 
39,175

Collateralized borrowings in securitization trusts
13,131

 
5,592

 
23,839

 
10,945

Federal Home Loan Bank advances
2,500

 
755

 
4,730

 
908

Total interest expense
35,029

 
24,950

 
68,532

 
51,028

Net interest income
117,500

 
115,199

 
246,966

 
227,656

Other-than-temporary impairments:
 
 
 
 

 

Total other-than-temporary impairment losses
(170
)
 
—

 
(297
)
 
(212
)
Non-credit portion of loss recognized in other comprehensive (loss) income
—

 
—

 
—

 
—

Net other-than-temporary credit impairment losses
(170
)
 
—

 
(297
)

(212
)
Other income:
 
 
 
 

 

Gain (loss) on investment securities
69,932

 
37,688

 
199,389

 
(967
)
Gain (loss) on interest rate swap and swaption agreements
44,952

 
(116,019
)
 
(81,491
)
 
(221,547
)
Loss on other derivative instruments
(5,484
)
 
(24,202
)
 
(2,517
)
 
(18,401
)
(Loss) gain on residential mortgage loans held-for-sale
(6,832
)
 
11,801

 
2,260

 
8,620

Servicing income
30,516

 
33,868

 
62,603

 
64,309

Gain (loss) on servicing asset
17,635

 
(29,571
)
 
(34,768
)
 
(62,331
)
Other (loss) income
(16,609
)
 
21,003

 
(18,466
)
 
21,463

Total other income (loss)
134,110

 
(65,432
)
 
127,010

 
(208,854
)
Expenses:
 
 
 
 

 

Management fees
12,686

 
12,190

 
25,407

 
24,301

Securitization deal costs
2,484

 
—

 
5,095

 
—

Servicing expenses
5,899

 
6,857

 
12,615

 
12,082

Other operating expenses
15,827

 
14,323

 
31,882

 
28,857

Total expenses
36,896

 
33,370

 
74,999

 
65,240

Income (loss) before income taxes
214,544

 
16,397

 
298,680

 
(46,650
)
Benefit from income taxes
(6,957
)
 
(23,260
)
 
(17,614
)
 
(57,162
)
Net income
$
221,501

 
$
39,657

 
$
316,294

 
$
10,512

Basic and diluted earnings per weighted average common share
$
0.60

 
$
0.11

 
$
0.86

 
$
0.03

Dividends declared per common share
$
0.26

 
$
0.26

 
$
0.52

 
$
0.52

Basic and diluted weighted average number of shares of common stock outstanding
367,074,131

 
366,078,124

 
366,792,459

 
365,846,295

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
 
Six Months Ended
 
June 30,
 
June 30,
 
2015
 
2014
 
2015
 
2014
 
(unaudited)
 
(unaudited)
Comprehensive income:
 
 
 
 
 
 
 
Net income
$
221,501

 
$
39,657

 
$
316,294

 
$
10,512

Other comprehensive (loss) income:
 
 
 
 
 
 
 
Unrealized (loss) gain on available-for-sale securities, net
(218,826
)
 
191,160

 
(224,757
)
 
372,895

Other comprehensive (loss) income
(218,826
)
 
191,160

 
(224,757
)
 
372,895

Comprehensive income
$
2,675

 
$
230,817

 
$
91,537

 
$
383,407

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 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

 
 
 
 
 
 
 
 
 
 
 
 
 
 
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
—

 
—

 
—

 
—

 
316,294

 
—

 
316,294

Other comprehensive loss before reclassifications
—

 
—

 
—

 
(49,983
)
 
—

 
—

 
(49,983
)
Amounts reclassified from accumulated other comprehensive loss
—

 
—

 
—

 
(174,774
)
 
—

 
—

 
(174,774
)
Net other comprehensive loss
—

 
—

 
—

 
(224,757
)
 
—

 
—

 
(224,757
)
Issuance of common stock, net of offering costs
36,184

 
—

 
226

 
—

 
—

 
—

 
226

Common dividends declared
—

 
—

 
—

 
—

 
—

 
(190,864
)
 
(190,864
)
Non-cash equity award compensation
1,095,621

 
11

 
5,608

 
—

 
—

 
—

 
5,619

Balance, June 30, 2015
367,527,725

 
$
3,675

 
$
3,816,861

 
$
631,032

 
$
1,508,839

 
$
(1,988,838
)
 
$
3,971,569

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)
 
Six Months Ended
 
June 30,
 
2015
 
2014
Cash Flows From Operating Activities:
(unaudited)
Net income
$
316,294

 
$
10,512

Adjustments to reconcile net income to net cash (used in) provided by operating activities:
 
 
 
Amortization of premiums and discounts on investment securities and commercial real estate loans held-for-investment, net
22,157

 
1,840

Other-than-temporary impairment losses
297

 
212

Realized and unrealized (gains) losses on investment securities, net
(199,389
)
 
967

Gain on residential mortgage loans held-for-sale
(2,260
)
 
(8,620
)
Loss (gain) on residential mortgage loans held-for-investment and collateralized borrowings in securitization trusts
20,525

 
(21,142
)
Loss on servicing asset
34,768

 
62,331

Loss on termination and option expiration of interest rate swaps and swaptions
63,076

 
6,401

Unrealized (gain) loss on interest rate swaps and swaptions
(35,258
)
 
182,420

Unrealized gain on other derivative instruments
(1,634
)
 
(51
)
Equity based compensation
5,619

 
10,224

Depreciation of fixed assets
652

 
463

Amortization of intangible assets
—

 
533

Purchases of residential mortgage loans held-for-sale
(1,382,061
)
 
(261,983
)
Proceeds from sales of residential mortgage loans held-for-sale
75,272

 
400,739

Proceeds from repayment of residential mortgage loans held-for-sale
53,452

 
11,160

Net change in assets and liabilities:


 
 
Decrease in accrued interest receivable
8,518

 
193

Increase in deferred income taxes, net
(11,393
)
 
(60,310
)
Increase in income taxes receivable
(7,175
)
 
(290
)
Increase in prepaid and fixed assets
(228
)
 
(929
)
Decrease (increase) in other receivables
6,059

 
(11,396
)
Increase in servicing advances
(3,338
)
 
(8,532
)
Decrease in accrued interest payable
(4,788
)
 
(3,756
)
Decrease in income taxes payable
(1,336
)
 
(465
)
Increase in accrued expenses and other liabilities
2,253

 
5,673

Net cash (used in) provided by operating activities
$
(1,039,918
)
 
$
316,194

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

5
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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Six Months Ended
 
June 30,
 
2015
 
2014
Cash Flows From Investing Activities:
(unaudited)
Purchases of available-for-sale securities
$
(1,705,012
)
 
$
(2,232,865
)
Proceeds from sales of available-for-sale securities
2,572,015

 
1,273,923

Principal payments on available-for-sale securities
611,850

 
474,696

Short sales and purchases of other derivative instruments
4,825

 
102,423

Proceeds from sales of other derivative instruments, net
(69,085
)
 
(74,476
)
Purchases of trading securities
—

 
(143,022
)
Proceeds from sales of trading securities
2,004,375

 
143,378

Proceeds from repayment of residential mortgage loans held-for-investment in securitization trusts
335,346

 
26,330

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

Purchases of mortgage servicing rights, net of purchase price adjustments
(19,522
)
 
(48,419
)
Purchases of Federal Home Loan Bank stock
(25,240
)
 
(60,000
)
Purchases of equity investments
—

 
(3,000
)
Increase (decrease) in due to counterparties, net
44,203

 
(183,167
)
(Increase) decrease in restricted cash
(74,132
)
 
114,682

Net cash provided by (used in) investing activities
3,634,067

 
(609,517
)
Cash Flows From Financing Activities:
 
 
 
Proceeds from repurchase agreements
28,285,657

 
140,931,599

Principal payments on repurchase agreements
(31,795,316
)
 
(141,790,862
)
Proceeds from issuance of collateralized borrowings in securitization trusts
771,271

 
33,483

Principal payments on collateralized borrowings in securitization trusts
(237,630
)
 
(128,756
)
Proceeds from Federal Home Loan Bank advances
500,000

 
3,793,911

Principal payments on Federal Home Loan Bank advances
—

 
(2,293,911
)
Proceeds from issuance of common stock, net of offering costs
226

 
240

Dividends paid on common stock
(190,570
)
 
(95,172
)
Net cash (used in) provided by financing activities
(2,666,362
)
 
450,532

Net (decrease) increase in cash and cash equivalents
(72,213
)
 
157,209

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

 
1,025,487

Cash and cash equivalents at end of period
$
933,579

 
$
1,182,696

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,
 
2015
 
2014
Supplemental Disclosure of Cash Flow Information:
(unaudited)
Cash paid for interest
$
50,932

 
$
54,785

Cash paid for taxes
$
2,286

 
$
3,903

Noncash Investing and Financing Activities:
 
 
 
Transfers of residential mortgage loans held-for-sale to residential mortgage loans held-for-investment in securitization trusts
$
1,091,884

 
$
—

Transfers of residential mortgage loans held-for-sale to other receivables for foreclosed government-guaranteed loans
$
7,318

 
$
—

Additions to mortgage servicing rights due to sale of residential mortgage loans held-for-sale
$
816

 
$
—

Cumulative-effect adjustment to equity for adoption of new accounting principle
$
(2,991
)
 
$
—

Cash dividends declared but not paid at end of period
$
95,557

 
$
95,189

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
1,382,061

 
261,983

Transfers to residential mortgage loans held-for-investment in securitization trusts
(1,091,884
)
 
—

Transfers to other receivables for foreclosed government-guaranteed loans
(7,318
)
 
—

Proceeds from sales of residential mortgage loans held-for-sale
(75,272
)
 
(400,739
)
Proceeds from repayment of residential mortgage loans held-for-sale
(53,452
)
 
(11,160
)
Realized and unrealized gains on residential mortgage loans held-for-sale
5,231

 
5,176

Residential mortgage loans held-for-sale at end of period
$
695,078

 
$
399,841

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 June 30, 2015 and results of operations for all periods presented have been made. The results of operations for the three and six months ended June 30, 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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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 six months ended June 30, 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.

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, 2015 and December 31, 2014:
 
June 30, 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
$
414,958

 
$
(67,636
)
 
$
347,322

 
$
(22,475
)
 
$
—

 
$
324,847

Total Assets
$
414,958

 
$
(67,636
)
 
$
347,322

 
$
(22,475
)
 
$
—

 
$
324,847

 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(9,422,803
)
 
$
—

 
$
(9,422,803
)
 
$
9,422,803

 
$
—

 
$
—

Derivative liabilities
(90,111
)
 
67,636

 
(22,475
)
 
22,475

 
—

 
—

Total Liabilities
$
(9,512,914
)
 
$
67,636

 
$
(9,445,278
)
 
$
9,445,278

 
$
—

 
$
—

 
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
Table of Contents

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

Recently Issued and/or Adopted Accounting Standards
Revenue from Contracts with Customers
In May 2014, the FASB issued ASU No. 2014-09, which is a comprehensive revenue recognition standard that supersedes virtually all existing revenue guidance under U.S. GAAP. The standard’s core principle is that an entity will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. The ASU is effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2016, with early adoption prohibited. The Company has determined this ASU will not have a material impact on the Company’s financial condition or results of operations.
Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures
In June 2014, the FASB issued ASU No. 2014-11, which requires repurchase-to-maturity transactions to be accounted for as secured borrowings, eliminates the existing guidance for repurchase financings, and requires new disclosures for certain transactions accounted for as secured borrowings and sales. This ASU is effective for the first interim or annual period beginning after December 15, 2014, except for the disclosures related to transactions accounted for as secured borrowings, which are effective for periods beginning on or after March 15, 2015. Adoption of this ASU did not have any impact on the Company’s financial condition or results of operations, but did impact financial statement disclosures.
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 is 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 update 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. 2015-02, 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.


11
Table of Contents

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

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 condensed consolidated financial statements during subsequent reporting periods.
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)
June 30,
2015
 
December 31,
2014
Residential mortgage loans held-for-investment in securitization trusts
$
2,449,199

 
$
1,744,746

Commercial real estate loans held-for-investment
45,605

 
—

Accrued interest receivable
13,821

 
10,197

Total Assets
$
2,508,625

 
$
1,754,943

Collateralized borrowings in securitization trusts
$
1,714,735

 
$
1,209,663

Accrued interest payable
5,128

 
3,678

Other liabilities
8,132

 
6,480

Total Liabilities
$
1,727,995

 
$
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 June 30, 2015 and December 31, 2014:
(in thousands)
June 30,
2015
 
December 31,
2014
Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
2,279,632

 
$
2,418,546

Federal National Mortgage Association
5,796,614

 
6,768,875

Government National Mortgage Association
2,024,567

 
2,104,896

Non-Agency
2,706,845

 
3,048,785

Total mortgage-backed securities
$
12,807,658

 
$
14,341,102


At June 30, 2015 and December 31, 2014, the Company pledged AFS securities with a carrying value of $12.6 billion and $14.2 billion, respectively, 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 June 30, 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
Table of Contents

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 June 30, 2015 and December 31, 2014:
 
June 30, 2015
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
12,222,579

 
$
3,667,195

 
$
15,889,774

Unamortized premium
612,534

 
—

 
612,534

Unamortized discount
 
 
 
 
 
Designated credit reserve
—

 
(657,626
)
 
(657,626
)
Net, unamortized
(2,848,032
)
 
(820,024
)
 
(3,668,056
)
Amortized Cost
9,987,081

 
2,189,545

 
12,176,626

Gross unrealized gains
189,522

 
522,291

 
711,813

Gross unrealized losses
(75,790
)
 
(4,991
)
 
(80,781
)
Carrying Value
$
10,100,813

 
$
2,706,845

 
$
12,807,658

 
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 June 30, 2015 and December 31, 2014:
 
June 30, 2015
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
119,710

 
$
2,231,509

 
$
2,351,219

Fixed Rate
9,981,103

 
475,336

 
10,456,439

Total
$
10,100,813

 
$
2,706,845

 
$
12,807,658

 
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



13
Table of Contents

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

When the Company purchases a credit-sensitive AFS security at a significant discount to its face value, the Company often does not amortize into income a significant portion of this discount that the Company is entitled to earn because it does not expect to collect it due to the inherent credit risk of the security. The Company may also record an other-than-temporary impairment, or OTTI, for a portion of its investment in the security to the extent the Company believes that the amortized cost will exceed the present value of expected future cash flows. The amount of principal that the Company does not amortize into income is designated as a credit reserve on the security, with unamortized net discounts or premiums amortized into income over time to the extent realizable.
The following table presents the changes for the six months ended June 30, 2015 and 2014, of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
 
Six Months Ended June 30,
 
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
(1,284
)
 
(3,283
)
 
(4,567
)
 
(62,752
)
 
(46,581
)
 
(109,333
)
Accretion of net discount
—

 
52,759

 
52,759

 
—

 
64,084

 
64,084

Realized credit losses
8,470

 
—

 
8,470

 
6,607

 
—

 
6,607

Reclassification adjustment for other-than-temporary impairments
1,619

 
—

 
1,619

 
(212
)
 
—

 
(212
)
Transfers from (to)
58,716

 
(58,716
)
 
—

 
47,495

 
(47,495
)
 
—

Sales, calls, other
202,458

 
156,584

 
359,042

 
80,854

 
45,251

 
126,105

Ending balance at June 30
$
(657,626
)
 
$
(820,024
)
 
$
(1,477,650
)
 
$
(1,162,457
)
 
$
(1,056,300
)
 
$
(2,218,757
)

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 June 30, 2015 and December 31, 2014. At June 30, 2015, the Company held 1,455 AFS securities, of which 198 were in an unrealized loss position for less than twelve consecutive months and 177 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
June 30, 2015
$
2,659,052

 
$
(40,295
)
 
$
1,204,291

 
$
(40,486
)
 
$
3,863,343

 
$
(80,781
)
December 31, 2014
$
413,102

 
$
(3,146
)
 
$
1,323,688

 
$
(32,885
)
 
$
1,736,790

 
$
(36,031
)


14
Table of Contents

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

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 $0.2 million and $0.3 million in other-than-temporary credit impairments during the three and six months ended June 30, 2015, respectively, on one non-Agency RMBS where the future expected cash flows for each security were less than its amortized cost. As of June 30, 2015, impaired securities with a carrying value of $141.2 million had actual weighted average cumulative losses of 10.4%, weighted average three-month prepayment speed of 4.3%, weighted average 60+ day delinquency of 27.2% of the pool balance, and weighted average FICO score of 664. At June 30, 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 six months ended June 30, 2014, the Company recorded $0.2 million in other-than-temporary credit impairments on a total of three non-Agency RMBS where the future expected cash flows for each security were less than its amortized cost.
The following table presents the changes in OTTI included in earnings for three and six months ended June 30, 2015 and 2014:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Cumulative credit loss at beginning of period
$
(6,452
)
 
$
(9,215
)
 
$
(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
(170
)
 
—

 
(297
)
 
(121
)
Reductions:
 
 
 
 
 
 
 
Decreases related to other-than-temporary impairments on securities paid down
—

 
—

 
—

 
464

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

 
1,154

 
1,916

 
1,154

Cumulative credit loss at end of period
$
(6,622
)
 
$
(8,061
)
 
$
(6,622
)
 
$
(8,061
)

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, 2015, the Company sold AFS securities for $1.7 billion and $2.6 billion with an amortized cost of $1.6 billion and $2.4 billion for net realized gains of $75.9 million and $193.3 million, respectively. 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.

15
Table of Contents

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

The following table presents the gross realized gains and losses on sales of AFS securities for the three and six months ended June 30, 2015 and 2014:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Gross realized gains
$
76,199

 
$
35,954

 
$
193,887

 
$
43,163

Gross realized losses
(336
)
 
—

 
(556
)
 
(45,997
)
Total realized gains (losses) on sales, net
$
75,863

 
$
35,954

 
$
193,331

 
$
(2,834
)

Note 5. Trading Securities, at Fair Value
At December 31, 2014 and during the three and six months ended June 30, 2015, the Company held U.S. Treasuries in a TRS and classified these securities as trading instruments due to short-term investment objectives. The following table presents the carrying value of the Company’s trading securities as of June 30, 2015 and December 31, 2014:
(in thousands)
June 30,
2015
 
December 31,
2014
Amortized cost
$
—

 
$
1,996,289

Unrealized gains (losses), net
—

 
1,367

Carrying value
$
—

 
$
1,997,656


For both the three and six months ended June 30, 2015, the Company sold trading securities for $2.0 billion with an amortized cost of $2.0 billion, resulting in realized gains of $7.4 million on the sale of these securities. 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.
For the three and six months ended June 30, 2015, trading securities experienced changes in unrealized losses of $13.4 million and $1.4 million, respectively. For the three and six months ended June 30, 2014, trading securities experienced changes in unrealized gains of $1.7 million and $1.5 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.
At 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 June 30, 2015 and December 31, 2014:
(in thousands)
June 30,
2015
 
December 31,
2014
Unpaid principal balance
$
703,966

 
$
534,101

Fair value adjustment
(8,888
)
 
1,611

Carrying value
$
695,078

 
$
535,712


At June 30, 2015 and December 31, 2014, the Company pledged residential mortgage loans with a carrying value of $561.8 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.


16
Table of Contents

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

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 sheets, 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 June 30, 2015 and December 31, 2014:
(in thousands)
June 30,
2015
 
December 31,
2014
Unpaid principal balance
$
2,431,573

 
$
1,699,748

Fair value adjustment
17,626

 
44,998

Carrying value
$
2,449,199

 
$
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 June 30, 2015 and December 31, 2014:
(in thousands)
June 30,
2015
 
December 31,
2014
Unpaid principal balance
$
45,900

 
$
—

Unamortized discount
(295
)
 
—

Carrying value
$
45,605

 
$
—


As of June 30, 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 June 30, 2015, the properties collateralizing the Company’s one commercial real estate loan have continued to perform as originally underwritten, and as such, are considered to have very low risk. The Company has not recorded any allowances for losses as it is 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. At June 30, 2015, the Company pledged commercial real estate loans held-for-investment with a carrying value of $45.6 million as collateral for repurchase agreements. See Note 16 - Repurchase Agreements.


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
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 and six months ended June 30, 2015 and 2014.
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Balance at beginning of period
$
410,229

 
$
476,663

 
$
452,006

 
$
514,402

Additions from purchases of servicing rights
4,210

 
53,013

 
8,534

 
54,293

Additions from sales of residential mortgage loans
589

 
—

 
816

 
—

Changes in fair value due to:
 
 
 
 
 
 
 
Changes in valuation inputs or assumptions used in the valuation model
25,440

 
(15,655
)
 
(17,649
)
 
(35,905
)
Other changes in fair value (1)
(7,805
)
 
(13,916
)
 
(17,119
)
 
(26,427
)
Other changes (2)
4,913

 
385

 
10,988

 
(5,873
)
Balance at end of period
$
437,576

 
$
500,490

 
$
437,576

 
$
500,490

____________________
(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 June 30, 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)
June 30,
2015
 
December 31,
2014
Weighted average prepayment speed:
11.2
%
 
11.9
%
Impact on fair value of 10% adverse change
$
(17,941
)
 
$
(14,012
)
Impact on fair value of 20% adverse change
$
(34,131
)
 
$
(31,640
)
Weighted average delinquency:
4.6
%
 
5.6
%
Impact on fair value of 10% adverse change
$
(2,188
)
 
$
(3,616
)
Impact on fair value of 20% adverse change
$
(4,376
)
 
$
(6,780
)
Weighted average discount rate:
9.4
%
 
9.5
%
Impact on fair value of 10% adverse change
$
(15,753
)
 
$
(16,272
)
Impact on fair value of 20% adverse change
$
(30,630
)
 
$
(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 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 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 and six months ended June 30, 2015 and 2014:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Servicing fee income
$
29,586

 
$
33,079

 
$
60,823

 
$
62,950

Ancillary fee income
551

 
581

 
1,115

 
1,044

Float income
379

 
208

 
665

 
315

Total
$
30,516

 
$
33,868

 
$
62,603

 
$
64,309


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 sheets as of June 30, 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 June 30, 2015 and December 31, 2014:
 
June 30, 2015
 
December 31, 2014
(dollars in thousands)
Number of Loans
 
Unpaid Principal Balance
 
Number of Loans
 
Unpaid Principal Balance
Residential mortgage loans held-for-sale
1,293

 
$
703,966

 
1,008

 
$
534,101

Residential mortgage loans held-for-investment in securitization trusts
441

 
322,335

 
487

 
358,458

Mortgage servicing rights (1)
214,745

 
42,811,294

 
224,073

 
44,949,061

Total serviced mortgage assets
216,479

 
$
43,837,595

 
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.


19
Table of Contents

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 June 30, 2015 and December 31, 2014:
(in thousands)
June 30,
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
210,597

 
211,989

As restricted collateral for repurchase agreements and Federal Home Loan Bank advances
182,709

 
112,435

Total restricted cash balances held by trading counterparties
410,556

 
336,424

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

 
347

Total
$
410,903

 
$
336,771


Note 11. Accrued Interest Receivable
The following table presents the Company’s accrued interest receivable by collateral type:
(in thousands)
June 30,
2015
 
December 31,
2014
Accrued Interest Receivable:
 
 
 
U.S. Treasuries
$
—

 
$
8,084

Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
8,042

 
8,734

Federal National Mortgage Association
19,223

 
22,392

Government National Mortgage Association
9,901

 
10,290

Non-Agency
3,576

 
3,835

Total mortgage-backed securities
40,742

 
45,251

Residential mortgage loans held-for-sale
2,448

 
1,997

Residential mortgage loans held-for-investment in securitization trusts
13,680

 
10,197

Commercial real estate loans held-for-investment
141

 
—

Total
$
57,011

 
$
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, short U.S. Treasuries, put and call options for TBAs and U.S. Treasuries, 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.

20
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 sheets 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, 2015 and December 31, 2014.
(in thousands)
 
June 30, 2015
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
178,848

 
$
1,049,743

 
$
—

 
$
—

Interest rate swap agreements
 
46,935

 
14,325,523

 
(1,402
)
 
1,900,000

Credit default swaps
 
—

 
—

 
(1,164
)
 
125,000

Swaptions, net
 
120,707

 
10,050,000

 
(11,887
)
 
640,000

TBAs
 
—

 
—

 
(5,187
)
 
1,434,000

Put and call options for TBAs, net
 
—

 
—

 
(105
)
 
—

Constant maturity swaps
 
—

 
—

 
—

 
—

Markit IOS total return swaps
 
725

 
855,872

 
(134
)
 
132,537

Forward purchase commitments
 
107

 
135,181

 
(2,596
)
 
491,479

Total
 
$
347,322

 
$
26,416,319

 
$
(22,475
)
 
$
4,723,016

(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



21
Table of Contents

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

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