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, 2017

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, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x
 
 
Accelerated filer o
Non-accelerated filer o
(Do not check if a smaller reporting company)
 
Smaller reporting company o
 
 
 
Emerging growth company o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 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 3, 2017 there were 348,918,401 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,
2017
 
December 31,
2016
ASSETS
(unaudited)
 
 
Available-for-sale securities, at fair value
$
17,318,697

 
$
13,128,857

Commercial real estate assets
1,548,603

 
1,412,543

Mortgage servicing rights, at fair value
747,580

 
693,815

Residential mortgage loans held-for-investment in securitization trusts, at fair value
3,181,811

 
3,271,317

Residential mortgage loans held-for-sale, at fair value
32,686

 
40,146

Cash and cash equivalents
405,110

 
406,883

Restricted cash
381,664

 
408,312

Accrued interest receivable
76,104

 
62,751

Due from counterparties
54,940

 
60,380

Derivative assets, at fair value
253,564

 
324,182

Other assets
270,085

 
302,870

Total Assets (1)
$
24,270,844

 
$
20,112,056

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Liabilities
 
 
 
Repurchase agreements
$
13,640,720

 
$
9,316,351

Collateralized borrowings in securitization trusts, at fair value
2,941,990

 
3,037,196

Federal Home Loan Bank advances
3,571,762

 
4,000,000

Revolving credit facilities
15,000

 
70,000

Convertible senior notes
282,263

 

Derivative liabilities, at fair value
20,363

 
12,501

Due to counterparties
31,301

 
111,884

Dividends payable
87,228

 
83,437

Other liabilities
77,656

 
79,576

Total Liabilities (1)
20,668,283

 
16,710,945

Stockholders’ Equity
 
 
 
Preferred stock, par value $0.01 per share; 50,000,000 shares authorized and 5,750,000 and 0 shares issued and outstanding, respectively (liquidation preference of $143,750)
138,872

 

Common stock, par value $0.01 per share; 900,000,000 shares authorized and 348,913,014 and 347,652,326 shares issued and outstanding, respectively
3,489

 
3,477

Additional paid-in capital
3,664,020

 
3,659,973

Accumulated other comprehensive income
272,989

 
199,227

Cumulative earnings
2,110,018

 
2,038,033

Cumulative distributions to stockholders
(2,586,827
)
 
(2,499,599
)
Total Stockholders’ Equity
3,602,561

 
3,401,111

Total Liabilities and Stockholders’ Equity
$
24,270,844

 
$
20,112,056

____________________
(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, 2017 and December 31, 2016, assets of the VIEs totaled $3,246,363 and $3,336,292, and liabilities of the VIEs totaled $2,962,598 and $3,058,278, respectively. See Note 3 - Variable Interest Entities for additional information.
The accompanying notes are an integral part of these condensed consolidated financial statements.

1

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands, except share data)
 
Three Months Ended
 
March 31,
 
2017
 
2016
Interest income:
(unaudited)
Available-for-sale securities
$
135,573

 
$
79,428

Commercial real estate assets
23,570

 
11,072

Residential mortgage loans held-for-investment in securitization trusts
31,628

 
32,771

Residential mortgage loans held-for-sale
398

 
7,202

Cash and cash equivalents
453

 
290

Total interest income
191,622

 
130,763

Interest expense:
 
 
 
Repurchase agreements
37,012

 
16,029

Collateralized borrowings in securitization trusts
25,386

 
19,359

Federal Home Loan Bank advances
8,793

 
5,972

Revolving credit facilities
429

 

Convertible senior notes
3,821

 

Total interest expense
75,441

 
41,360

Net interest income
116,181

 
89,403

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

 
(717
)
Other income (loss):
 
 
 
(Loss) gain on investment securities
(52,352
)
 
29,474

Gain (loss) on interest rate swap and swaption agreements
9,927

 
(125,484
)
(Loss) gain on other derivative instruments
(27,864
)
 
16,015

Servicing income
39,773

 
34,133

Loss on servicing asset
(14,565
)
 
(101,440
)
Gain on residential mortgage loans held-for-sale
1,461

 
10,803

Other income
8,035

 
2,827

Total other loss
(35,585
)
 
(133,672
)
Expenses:
 
 
 
Management fees
11,470

 
12,044

Servicing expenses
5,620

 
7,861

Securitization deal costs

 
3,732

Other operating expenses
16,037

 
14,856

Total expenses
33,127

 
38,493

Income (loss) before income taxes
47,469

 
(83,479
)
(Benefit from) provision for income taxes
(24,516
)
 
5,451

Net income (loss)
$
71,985

 
$
(88,930
)
Basic and diluted earnings (loss) per weighted average common share
$
0.21

 
$
(0.25
)
Dividends declared per common share
$
0.25

 
$
0.23

Basic and diluted weighted average number of shares of common stock outstanding
348,563,930

 
349,436,015

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

2

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS), continued
(in thousands, except share data)
 
Three Months Ended
 
March 31,
 
2017
 
2016
 
(unaudited)
Comprehensive income (loss):
 
 
 
Net income (loss)
$
71,985

 
$
(88,930
)
Other comprehensive income, net of tax:
 
 
 
Unrealized gain on available-for-sale securities
73,762

 
21,345

Other comprehensive income
73,762

 
21,345

Comprehensive income (loss)
$
145,747

 
$
(67,585
)
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)
 
Preferred Stock
 
Common Stock
 
 
 
 
 
 
 
 
 
 
 
Shares
 
Amount
 
Shares
 
Amount
 
Additional Paid-in Capital
 
Accumulated Other Comprehensive Income
 
Cumulative Earnings
 
Cumulative Distributions to Stockholders
 
Total Stockholders’ Equity
 
 
 
 
 
 
 
 
 
(unaudited)

 
 
 
 
 
 
 
 
Balance,
December 31, 2015

 
$

 
353,906,807

 
$
3,539

 
$
3,705,519

 
$
359,061

 
$
1,684,755

 
$
(2,176,313
)
 
$
3,576,561

Net loss

 

 

 

 

 

 
(88,930
)
 

 
(88,930
)
Other comprehensive income before reclassifications, net of tax

 

 

 

 

 
39,754

 

 

 
39,754

Amounts reclassified from accumulated other comprehensive income, net of tax

 

 

 

 

 
(18,409
)
 

 

 
(18,409
)
Net other comprehensive income, net of tax

 

 

 

 

 
21,345

 

 

 
21,345

Issuance of common stock, net of offering costs

 

 
14,648

 

 
110

 

 

 

 
110

Repurchase of common stock

 

 
(8,020,000
)
 
(80
)
 
(61,227
)
 

 

 

 
(61,307
)
Common dividends declared

 

 

 

 

 

 

 
(79,939
)
 
(79,939
)
Non-cash equity award compensation

 

 
1,661,315

 
17

 
2,834

 

 

 

 
2,851

Balance,
March 31, 2016

 
$

 
347,562,770

 
$
3,476

 
$
3,647,236

 
$
380,406

 
$
1,595,825

 
$
(2,256,252
)
 
$
3,370,691

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance,
December 31, 2016

 
$

 
347,652,326

 
$
3,477

 
$
3,659,973

 
$
199,227

 
$
2,038,033

 
$
(2,499,599
)
 
$
3,401,111

Net income

 

 

 

 

 

 
71,985

 

 
71,985

Other comprehensive income before reclassifications, net of tax

 

 

 

 

 
64,449

 

 

 
64,449

Amounts reclassified from accumulated other comprehensive income, net of tax

 

 

 

 

 
9,313

 

 

 
9,313

Net other comprehensive income, net of tax

 

 

 

 

 
73,762

 

 

 
73,762

Issuance of preferred stock, net of offering costs
5,750,000

 
138,872

 

 

 

 

 

 

 
138,872

Issuance of common stock, net of offering costs

 

 
11,265

 

 
102

 

 

 

 
102

Common dividends declared

 

 

 

 

 

 

 
(87,228
)
 
(87,228
)
Non-cash equity award compensation

 

 
1,249,423

 
12

 
3,945

 

 

 

 
3,957

Balance,
March 31, 2017
5,750,000

 
$
138,872

 
348,913,014

 
$
3,489

 
$
3,664,020

 
$
272,989

 
$
2,110,018

 
$
(2,586,827
)
 
$
3,602,561

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,
 
2017
 
2016
Cash Flows From Operating Activities:
(unaudited
Net income (loss)
$
71,985

 
$
(88,930
)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
 
 
 
Amortization of premiums and discounts on investment securities and commercial real estate assets, net
6,078

 
5,735

Amortization of deferred debt issuance costs on convertible senior notes
78

 

Other-than-temporary impairment losses

 
717

Realized and unrealized losses (gains) on investment securities, net
52,352

 
(29,474
)
Loss on servicing asset
14,565

 
101,440

Gain on residential mortgage loans held-for-sale
(1,461
)
 
(10,803
)
Gain on residential mortgage loans held-for-investment and collateralized borrowings in securitization trusts
(6,683
)
 
(1,484
)
Gain on termination and option expiration of interest rate swaps and swaptions
(66,031
)
 
(30,629
)
Unrealized loss on interest rate swaps and swaptions
48,200

 
149,923

Unrealized loss (gain) on other derivative instruments
59,841

 
(4,387
)
Equity based compensation
3,957

 
2,851

Depreciation of fixed assets
285

 
328

Purchases of residential mortgage loans held-for-sale
(437
)
 
(271,448
)
Proceeds from sales of residential mortgage loans held-for-sale
3,987

 
19,830

Proceeds from repayment of residential mortgage loans held-for-sale
3,716

 
36,360

Net change in assets and liabilities:


 
 
Increase in accrued interest receivable
(13,353
)
 
(4,547
)
(Increase) decrease in deferred income taxes, net
(24,710
)
 
7,048

Decrease (increase) in income taxes receivable
84

 
(839
)
Decrease (increase) in prepaid and fixed assets
242

 
(87
)
Decrease in other receivables
10,307

 
208

Decrease (increase) in servicing advances
1,466

 
(7,173
)
Increase in accrued interest payable
11,481

 
406

Increase (decrease) in income taxes payable
30

 
(70
)
Decrease in accrued expenses and other liabilities
(13,715
)
 
(6,657
)
Net cash provided by (used in) operating activities
$
162,264

 
$
(131,682
)
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)
 
Three Months Ended
 
March 31,
 
2017
 
2016
Cash Flows From Investing Activities:
(unaudited
Purchases of available-for-sale securities
$
(6,837,176
)
 
$
(4,185,685
)
Proceeds from sales of available-for-sale securities
2,414,267

 
2,270,454

Principal payments on available-for-sale securities
272,954

 
192,171

(Purchases) short sales of derivative instruments, net
(42,293
)
 
(14,687
)
Proceeds from sales (payments for termination) of derivative instruments, net
78,763

 
44,027

Proceeds from repayment of residential mortgage loans held-for-investment in securitization trusts
102,545

 
133,374

Originations and purchases of commercial real estate assets, net of deferred fees
(137,445
)
 
(86,156
)
Proceeds from repayment of commercial real estate assets
3,809

 
4,531

Purchases of mortgage servicing rights, net of purchase price adjustments
(68,551
)
 
(51,453
)
Proceeds from sales of mortgage servicing rights
250

 

Purchases of Federal Home Loan Bank stock

 
(11,206
)
Redemptions of Federal Home Loan Bank stock
19,760

 

Decrease in due to counterparties, net
(75,143
)
 
(158,919
)
Net cash used in investing activities
(4,268,260
)
 
(1,863,549
)
Cash Flows From Financing Activities:
 
 
 
Proceeds from repurchase agreements
36,676,708

 
10,535,094

Principal payments on repurchase agreements
(32,352,339
)
 
(9,353,516
)
Proceeds from issuance of collateralized borrowings in securitization trusts

 
883,633

Principal payments on collateralized borrowings in securitization trusts
(101,562
)
 
(96,188
)
Proceeds from Federal Home Loan Bank advances

 
215,000

Principal payments on Federal Home Loan Bank advances
(428,238
)
 

Principal payments on revolving credit facilities
(55,000
)
 

Proceeds from convertible senior notes
282,469

 

Proceeds from issuance of preferred stock, net of offering costs
138,872

 

Proceeds from issuance of common stock, net of offering costs
102

 
110

Repurchase of common stock

 
(61,307
)
Dividends paid on common stock
(83,437
)
 
(92,016
)
Net cash provided by financing activities
4,077,575

 
2,030,810

Net (decrease) increase in cash, cash equivalents and restricted cash
(28,421
)
 
35,579

Cash, cash equivalents and restricted cash at beginning of period
815,195

 
1,000,393

Cash, cash equivalents and restricted cash at end of period
$
786,774

 
$
1,035,972

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)
 
Three Months Ended
 
March 31,
 
2017
 
2016
Supplemental Disclosure of Cash Flow Information:
(unaudited
Cash paid for interest
$
38,237

 
$
23,276

Cash paid (received) for taxes
$
81

 
$
(689
)
Noncash Activities:
 
 
 
Transfers of residential mortgage loans held-for-sale to residential mortgage loans held-for-investment in securitization trusts
$

 
$
641,738

Transfers of residential mortgage loans held-for-sale to other receivables for foreclosed government-guaranteed loans
$
1,626

 
$
5,194

Transfer of fair value of mortgage servicing rights to fair value of Ginnie Mae residential mortgage loans held-for-sale upon buyout
$
9

 
$
2,265

Additions to mortgage servicing rights due to sale of residential mortgage loans held-for-sale
$
20

 
$
204

Dividends declared but not paid at end of period
$
87,228

 
$
79,939

Reconciliation of residential mortgage loans held-for-sale:
 
 
 
Residential mortgage loans held-for-sale at beginning of period
$
40,146

 
$
811,431

Purchases of residential mortgage loans held-for-sale
437

 
271,448

Transfers to residential mortgage loans held-for-investment in securitization trusts

 
(641,738
)
Transfers to other receivables for foreclosed government-guaranteed loans
(1,626
)
 
(5,194
)
Transfer of fair value of mortgage servicing rights to fair value of Ginnie Mae residential mortgage loans held-for-sale upon buyout
(9
)
 
(2,265
)
Proceeds from sales of residential mortgage loans held-for-sale
(3,987
)
 
(19,830
)
Proceeds from repayment of residential mortgage loans held-for-sale
(3,716
)
 
(36,360
)
Realized and unrealized gains on residential mortgage loans held-for-sale
1,441

 
9,767

Residential mortgage loans held-for-sale at end of period
$
32,686

 
$
387,259

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, 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, 2016. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at March 31, 2017 and results of operations for all periods presented have been made. The results of operations for the three months ended March 31, 2017 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. The Company’s Chief Investment Officer manages the investment portfolio as a whole and resources are allocated and financial performance is assessed on a consolidated basis.
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. Whenever the Company has both the power to direct the activities of a trust 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 trust.

8

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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 2016 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, 2017.
Convertible Senior Notes
Convertible senior notes include unsecured convertible debt that are carried at their unpaid principal balance, net of any unamortized deferred issuance costs, on the Company’s condensed consolidated balance sheet. Interest on the notes is payable semiannually until such time the notes mature or are converted into shares of the Company’s common stock.
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 by 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.
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, 2017 and December 31, 2016:
 
March 31, 2017
 
 
 
 
 
 
 
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
$
343,279

 
$
(89,715
)
 
$
253,564

 
$
(20,363
)
 
$

 
$
233,201

Total Assets
$
343,279

 
$
(89,715
)
 
$
253,564

 
$
(20,363
)
 
$

 
$
233,201

Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(13,640,720
)
 
$

 
$
(13,640,720
)
 
$
13,640,720

 
$

 
$

Derivative liabilities
(110,078
)
 
89,715

 
(20,363
)
 
20,363

 

 

Total Liabilities
$
(13,750,798
)
 
$
89,715

 
$
(13,661,083
)
 
$
13,661,083

 
$

 
$


9

Table of Contents

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

 
December 31, 2016
 
 
 
 
 
 
 
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
$
388,522

 
$
(64,340
)
 
$
324,182

 
$
(12,501
)
 
$

 
$
311,681

Total Assets
$
388,522

 
$
(64,340
)
 
$
324,182

 
$
(12,501
)
 
$

 
$
311,681

Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(9,316,351
)
 
$

 
$
(9,316,351
)
 
$
9,316,351

 
$

 
$

Derivative liabilities
(76,841
)
 
64,340

 
(12,501
)
 
12,501

 

 

Total Liabilities
$
(9,463,192
)
 
$
64,340

 
$
(9,398,852
)
 
$
9,398,852

 
$

 
$

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

Recently Issued and/or Adopted Accounting Standards
Revenue from Contracts with Customers
In May 2014, the Financial Accounting Standards Board, or 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. As a result of the issuance of ASU No. 2015-14 in August 2015 deferring the effective date of ASU No. 2014-09 by one year, the ASU is effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2017, 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.
Recognition and Measurement of Financial Assets and Financial Liabilities
In January 2016, the FASB issued ASU No. 2016-01, which changes how entities measure certain equity investments and present changes in the fair value of financial liabilities measured under the fair value option that are attributable to their own credit. 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, 2017, with early adoption permitted. Early adoption of this ASU did not have an impact on the Company’s financial condition, results of operations or financial statement disclosures.
Lease Classification and Accounting
In February 2016, the FASB issued ASU No. 2016-02, which requires lessees to recognize on their balance sheets both a lease liability for the obligation to make lease payments and a right-of-use asset for the right to use the underlying asset for the lease term. The ASU is effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2018, with early adoption permitted. The Company has determined this ASU will not have a material impact on the Company’s financial condition or results of operations.

10

Table of Contents

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

Measurement of Credit Losses on Financial Instruments
In June 2016, the FASB issued ASU No. 2016-13, which changes the impairment model for most financial assets and certain other instruments. Allowances for credit losses on AFS debt securities will be recognized, rather than direct reductions in the amortized cost of the investments. The new model also requires the estimation of lifetime expected credit losses and corresponding recognition of allowance for losses on trade and other receivables, held-to-maturity debt securities, loans, and other instruments held at amortized cost. 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, 2019, with early adoption permitted for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2018. The Company is evaluating the adoption of this ASU.
Classification of Certain Cash Receipts and Cash Payments and Restricted Cash
In August 2016, the FASB issued ASU No. 2016-15, which clarifies how entities should classify certain cash receipts and cash payments and how the predominance principle should be applied on the statement of cash flows. Additionally, in November 2016, the FASB issued ASU No. 2016-18, which requires entities to show the changes in the total of cash, cash equivalents, restricted cash and restricted cash equivalents, but no longer present transfers between cash and cash equivalents and restricted cash and cash equivalents in the statement of cash flows. Both ASUs are effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2017, with early adoption permitted. Early adoption of these ASUs did not impact the Company’s financial condition or results of operations but impacted the presentation of the statements of cash flows and related footnote disclosures. The Company included restricted cash of $381.7 million, $408.3 million, $281.1 million and $262.6 million as of March 31, 2017, December 31, 2016, March 31, 2016 and December 31, 2015, respectively, with cash and cash equivalents, as shown on the condensed consolidated statements of cash flows.

Note 3. Variable Interest Entities
The Company retains subordinated debt and excess servicing rights purchased 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 as of March 31, 2017 and December 31, 2016:
(in thousands)
March 31,
2017
 
December 31,
2016
Residential mortgage loans held-for-investment in securitization trusts
$
3,181,811

 
$
3,271,317

Commercial real estate assets
45,886

 
45,885

Accrued interest receivable
18,666

 
19,090

Total Assets
$
3,246,363

 
$
3,336,292

Collateralized borrowings in securitization trusts
$
2,941,990

 
$
3,037,196

Accrued interest payable
8,370

 
8,708

Other liabilities
12,238

 
12,374

Total Liabilities
$
2,962,598

 
$
3,058,278


The Company is not required to consolidate VIEs for which it has concluded it does not have both the power to direct the activities of the VIEs 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’s investments in these unconsolidated VIEs include non-Agency RMBS, which are classified within available-for-sale securities, at fair value on the condensed consolidated balance sheets. As of March 31, 2017 and December 31, 2016, the carrying value, which also represents the maximum exposure to loss, of all non-Agency RMBS in unconsolidated VIEs was $2.2 billion and $1.9 billion, respectively.

11

Table of Contents

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


Note 4. Available-for-Sale Securities, at Fair Value
The Company holds AFS investment securities which are carried at fair value on the condensed consolidated balance sheets. 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, 2017 and December 31, 2016:
(in thousands)
March 31,
2017
 
December 31,
2016
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
10,880,230

 
$
2,742,630

Federal National Mortgage Association
4,023,228

 
8,274,507

Government National Mortgage Association
216,427

 
209,337

Non-Agency
2,198,812

 
1,902,383

Total available-for-sale securities
$
17,318,697

 
$
13,128,857


At March 31, 2017 and December 31, 2016, the Company pledged AFS securities with a carrying value of $17.1 billion and $13.1 billion, respectively, as collateral for repurchase agreements and advances from the Federal Home Loan Bank of Des Moines, or the FHLB. See Note 15 - Repurchase Agreements and Note 17 - Federal Home Loan Bank of Des Moines Advances.
At March 31, 2017 and December 31, 2016, the Company did not have any securities purchased from and financed with the same counterparty that did not meet the conditions of ASC 860, Transfers and Servicing, or ASC 860, to be considered linked transactions and, therefore, classified as derivatives.
The following tables present the amortized cost and carrying value (which approximates fair value) of AFS securities by collateral type as of March 31, 2017 and December 31, 2016:
 
March 31, 2017
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
17,294,143

 
$
3,087,543

 
$
20,381,686

Unamortized premium
769,384

 

 
769,384

Unamortized discount
 
 
 
 
 
Designated credit reserve

 
(442,856
)
 
(442,856
)
Net, unamortized
(2,840,374
)
 
(836,341
)
 
(3,676,715
)
Amortized Cost
15,223,153

 
1,808,346

 
17,031,499

Gross unrealized gains
81,271

 
395,652

 
476,923

Gross unrealized losses
(184,539
)
 
(5,186
)
 
(189,725
)
Carrying Value
$
15,119,885

 
$
2,198,812

 
$
17,318,697

 
December 31, 2016
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
13,571,417


$
2,732,139

 
$
16,303,556

Unamortized premium
571,749



 
571,749

Unamortized discount
 
 
 
 
 
Designated credit reserve


(367,437
)
 
(367,437
)
Net, unamortized
(2,758,445
)

(808,975
)
 
(3,567,420
)
Amortized Cost
11,384,721


1,555,727

 
12,940,448

Gross unrealized gains
79,040


353,358

 
432,398

Gross unrealized losses
(237,287
)

(6,702
)
 
(243,989
)
Carrying Value
$
11,226,474

 
$
1,902,383

 
$
13,128,857


12

Table of Contents

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


The following tables present the carrying value of the Company’s AFS securities by rate type as of March 31, 2017 and December 31, 2016:
 
March 31, 2017
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
28,422

 
$
1,898,693

 
$
1,927,115

Fixed Rate
15,091,463

 
300,119

 
15,391,582

Total
$
15,119,885

 
$
2,198,812

 
$
17,318,697

 
December 31, 2016
(in thousands)
Agency
 
Non-Agency
 
Total
Adjustable Rate
$
30,463

 
$
1,574,850

 
$
1,605,313

Fixed Rate
11,196,011

 
327,533

 
11,523,544

Total
$
11,226,474

 
$
1,902,383

 
$
13,128,857


The following table presents the Company’s AFS securities according to their estimated weighted average life classifications as of March 31, 2017:
 
March 31, 2017
(in thousands)
 Agency
 
 Non-Agency
 
 Total
≤ 1 year
$
1,344

 
$
38,909

 
$
40,253

> 1 and ≤ 3 years
49,281

 
121,183

 
170,464

> 3 and ≤ 5 years
906,170

 
347,435

 
1,253,605

> 5 and ≤ 10 years
14,132,919

 
964,767

 
15,097,686

> 10 years
30,171

 
726,518

 
756,689

Total
$
15,119,885

 
$
2,198,812

 
$
17,318,697


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 the Company does not expect to collect the entire discount 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.

13

Table of Contents

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

The following table presents the changes for the three months ended March 31, 2017 and 2016 of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
 
Three Months Ended March 31,
 
2017
 
2016
(in thousands)
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
 
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
Beginning balance at January 1
$
(367,437
)
 
$
(808,975
)
 
$
(1,176,412
)
 
$
(409,077
)
 
$
(707,021
)
 
$
(1,116,098
)
Acquisitions
(88,719
)
 
(71,471
)
 
(160,190
)
 
1,013

 
(25,222
)
 
(24,209
)
Accretion of net discount

 
22,183

 
22,183

 

 
16,760

 
16,760

Realized credit losses
4,546

 

 
4,546

 
3,093

 

 
3,093

Reclassification adjustment for other-than-temporary impairments

 

 

 
(121
)
 

 
(121
)
Transfers from (to)
8,754

 
(8,754
)
 

 
19,454

 
(19,454
)
 

Sales, calls, other

 
30,676

 
30,676

 
32,562

 
55,535

 
88,097

Ending balance at March 31
$
(442,856
)
 
$
(836,341
)
 
$
(1,279,197
)
 
$
(353,076
)
 
$
(679,402
)
 
$
(1,032,478
)

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, 2017 and December 31, 2016. At March 31, 2017, the Company held 1,295 AFS securities, of which 255 were in an unrealized loss position for less than twelve consecutive months and 125 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2016, the Company held 1,239 AFS securities, of which 252 were in an unrealized loss position for less than twelve consecutive months and 125 were in an unrealized loss position for more than twelve consecutive months. Of the $7.2 billion and $6.4 billion of AFS securities in an unrealized loss position for less than twelve consecutive months as of March 31, 2017 and December 31, 2016, $6.9 billion, or 96.3%, and $6.1 billion, or 95.8%, respectively, were Agency AFS securities, whose principal and interest are guaranteed by the GSEs.
 
Unrealized Loss Position for
 
Less than 12 Months
 
12 Months or More
 
Total
(in thousands)
Estimated Fair Value
 
Gross Unrealized Losses
 
Estimated Fair Value
 
Gross Unrealized Losses
 
Estimated Fair Value
 
Gross Unrealized Losses
March 31, 2017
$
7,207,659

 
$
(148,297
)
 
$
483,937

 
$
(41,428
)
 
$
7,691,596

 
$
(189,725
)
December 31, 2016
$
6,416,820

 
$
(204,034
)
 
$
504,978

 
$
(39,955
)
 
$
6,921,798

 
$
(243,989
)

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 either other comprehensive income, net of tax, or (loss) gain on investment securities, depending on the accounting treatment. 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.

14

Table of Contents

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

The Company did not record an other-than-temporary credit impairment during the three months ended March 31, 2017. During the three months ended March 31, 2016, the Company recorded $0.7 million in other-than-temporary credit impairments on three non-Agency RMBS where the future expected cash flows for each security were less than its amortized cost. As of March 31, 2017, impaired securities with a carrying value of $113.7 million had actual weighted average cumulative losses of 5.2%, weighted average three-month prepayment speed of 2.1%, weighted average 60+ day delinquency of 22.5% of the pool balance, and weighted average FICO score of 659. At March 31, 2017, 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.
The following table presents the changes in OTTI included in earnings for the three months ended March 31, 2017 and 2016:
 
Three Months Ended
 
March 31,
(in thousands)
2017
 
2016
Cumulative credit loss at beginning of period
$
(5,606
)
 
$
(6,499
)
Additions:
 
 
 
Other-than-temporary impairments not previously recognized

 
(292
)
Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments

 
(425
)
Reductions:
 
 
 
Decreases related to other-than-temporary impairments on securities paid down

 

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

 
596

Cumulative credit loss at end of period
$
(5,606
)
 
$
(6,620
)

Cumulative credit losses related to OTTI may be reduced for securities sold as well as for securities that mature, are paid down, or are prepaid such that the outstanding principal balance is reduced to zero. Additionally, increases in cash flows expected to be collected over the remaining life of the security cause a reduction in the cumulative credit loss.
Gross Realized Gains and Losses
Gains and losses from the sale of AFS securities are recorded as realized gains (losses) within (loss) gain on investment securities in the Company’s condensed consolidated statements of comprehensive income (loss). For the three months ended March 31, 2017 and 2016, the Company sold AFS securities for $2.4 billion and $2.3 billion with an amortized cost of $2.5 billion and $2.2 billion for net realized losses of $50.4 million and gains of $21.7 million, respectively.
The following table presents the gross realized gains and losses on sales of AFS securities for the three months ended March 31, 2017 and 2016:
 
Three Months Ended
 
March 31,
(in thousands)
2017
 
2016
Gross realized gains
$
8,731

 
$
35,194

Gross realized losses
(59,134
)
 
(13,493
)
Total realized (losses) gains on sales, net
$
(50,403
)
 
$
21,701


Note 5. Commercial Real Estate Assets
The Company originates and purchases commercial real estate debt and related instruments generally to be held as long-term investments. These assets are classified as commercial real estate assets on the condensed consolidated balance sheets. Additionally, 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 is consolidated on the Company’s condensed consolidated balance sheet and classified as commercial real estate assets. See Note 3 - Variable Interest Entities for additional information regarding consolidation of the trust. Commercial real estate assets are reported at cost, net of any unamortized acquisition premiums or discounts, loan fees and origination costs as applicable, unless the assets are deemed impaired.

15

Table of Contents

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

The following tables summarize the Company’s commercial real estate assets by asset type, property type and geographic location as of March 31, 2017 and December 31, 2016:
 
March 31,
2017
(dollars in thousands)
Mezzanine Loans
 
First Mortgages
 
B-Notes
 
Total
Unpaid principal balance
$
135,364

 
$
1,409,678

 
$
14,979

 
$
1,560,021

Unamortized (discount) premium
(14
)
 
(181
)
 

 
(195
)
Unamortized net deferred origination fees
(111
)
 
(11,112
)
 

 
(11,223
)
Carrying value
$
135,239

 
$
1,398,385

 
$
14,979

 
$
1,548,603

Unfunded commitments
$
1,580

 
$
180,295

 
$

 
$
181,875

Number of loans
6

 
33

 
1

 
40

Weighted average coupon
8.8
%
 
5.3
%
 
8.0
%
 
5.6
%
Weighted average years to maturity (1)
2.2

 
2.7

 
9.8

 
2.7


 
December 31,
2016
(dollars in thousands)
Mezzanine Loans
 
First Mortgages
 
B-Notes
 
Total
Unpaid principal balance
$
138,245

 
$
1,286,200

 
$

 
$
1,424,445

Unamortized (discount) premium
(15
)
 
(185
)
 

 
(200
)
Unamortized net deferred origination fees
(221
)
 
(11,481
)
 

 
(11,702
)
Carrying value
$
138,009

 
$
1,274,534

 
$

 
$
1,412,543

Unfunded commitments
$
1,580

 
$
170,890

 
$

 
$
172,470

Number of loans
6

 
30

 

 
36

Weighted average coupon
8.6
%
 
5.1
%
 
%
 
5.4
%
Weighted average years to maturity (1)
1.5

 
2.9

 
0.0

 
2.8

____________________
(1)
Based on contractual maturity date. Certain loans are subject to contractual extension options which may be subject to conditions as stipulated in the loan agreement. Actual maturities may differ from contractual maturities stated herein as certain borrowers may have the right to prepay with or without paying a prepayment penalty. The Company may also extend contractual maturities in connection with loan modifications.

(in thousands)
 
March 31,
2017
 
December 31,
2016
Property Type
 
Carrying Value
 
% of Commercial Portfolio
 
Carrying Value
 
% of Commercial Portfolio
Retail
 
$
246,000

 
15.9
%
 
$
237,414

 
16.8
%
Hotel
 
107,193

 
6.9
%
 
90,585

 
6.4
%
Industrial
 
144,116

 
9.3
%
 
105,081

 
7.4
%
Multifamily
 
264,197

 
17.1
%
 
260,683

 
18.5
%
Office
 
787,097

 
50.8
%
 
718,780

 
50.9
%
Total
 
$
1,548,603

 
100.0
%
 
$
1,412,543

 
100.0
%

16

Table of Contents

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

(in thousands)
 
March 31,
2017
 
December 31,
2016
Geographic Location
 
Carrying Value
 
% of Commercial Portfolio
 
Carrying Value
 
% of Commercial Portfolio
West
 
$
305,731

 
19.8
%
 
$
250,044

 
17.7
%
Southeast
 
291,433

 
18.8
%
 
239,194

 
16.9
%
Southwest
 
289,686

 
18.7
%
 
267,944

 
19.0
%
Northeast
 
582,351

 
37.6
%
 
578,762

 
41.0
%
Midwest
 
79,402

 
5.1
%
 
76,599

 
5.4
%
Total
 
$
1,548,603

 
100.0
%
 
$
1,412,543

 
100.0
%
 
At March 31, 2017 and December 31, 2016, the Company pledged commercial real estate assets with a carrying value of $1.5 billion and $1.4 billion, respectively, as collateral for repurchase agreements and FHLB advances. See Note 15 - Repurchase Agreements and Note 17 - Federal Home Loan Bank of Des Moines Advances.
The following table summarizes activity related to commercial real estate assets for the three months ended March 31, 2017 and 2016.
 
Three Months Ended
March 31,
(in thousands)
2017
 
2016
Balance at beginning of period
$
1,412,543

 
$
660,953

Originations and purchases
139,384

 
87,266

Repayments
(3,809
)
 
(4,531
)
Net discount accretion (premium amortization)
1

 
73

(Increase) decrease in net deferred origination fees
(1,939
)
 
(1,110
)
Amortization of net deferred origination fees
2,423

 
1,608

Allowance for loan losses

 

Balance at end of period
$
1,548,603

 
$
744,259


The Company evaluates each loan for impairment at least quarterly by assessing the risk factors of each loan and assigning a risk rating based on a variety of factors. Risk factors include property type, geographic and local market dynamics, physical condition, leasing and tenant profile, projected cash flow, loan structure and exit plan, loan-to-value ratio, project sponsorship, and other factors deemed necessary. Risk ratings are defined as follows:

1 –
Lower Risk
2 –
Average Risk
3 –
Acceptable Risk
4 –
Higher Risk: A loan that has exhibited material deterioration in cash flows and/or other credit factors, which, if negative trends continue, could be indicative of future loss.
5 –
Impaired/Loss Likely: A loan that has a significantly increased probability of default or principal loss.


17

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

The following table presents the number of loans, unpaid principal balance and carrying value (amortized cost) by risk rating for commercial real estate assets as of March 31, 2017 and December 31, 2016:
(dollars in thousands)
 
March 31,
2017
 
December 31,
2016
Risk Rating
 
Number of Loans
 
Unpaid Principal Balance
 
Carrying Value
 
Number of Loans
 
Unpaid Principal Balance
 
Carrying Value
1 – 3
 
40

 
$
1,560,021

 
$
1,548,603

 
36

 
$
1,424,445

 
$
1,412,543

4 – 5
 

 

 

 

 

 

Total
 
40

 
$
1,560,021

 
$
1,548,603

 
36

 
$
1,424,445

 
$
1,412,543


The Company has not recorded any allowances for losses as no loans are past-due and it is not deemed probable that the Company will not be able to collect all amounts due pursuant to the contractual terms of the loans.

Note 6. Servicing Activities
Mortgage Servicing Rights, at Fair Value
One of the Company’s wholly owned subsidiaries has approvals from Fannie Mae, Freddie Mac, and Ginnie Mae to own 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 appropriately 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, 2017 and 2016.
 
Three Months Ended
 
March 31,
(in thousands)
2017
 
2016
Balance at beginning of period
$
693,815

 
$
493,688

Additions from purchases of mortgage servicing rights
76,956

 
50,273

Additions from sales of residential mortgage loans
20

 
204

Subtractions from sales of mortgage servicing rights

 

Changes in fair value due to:
 
 
 
Changes in valuation inputs or assumptions used in the valuation model
3,182

 
(84,359
)
Other changes in fair value (1)
(17,997
)
 
(17,081
)
Other changes (2)
(8,396
)
 
3,445

Balance at end of period
$
747,580

 
$
446,170

____________________
(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.

At March 31, 2017 and December 31, 2016, the Company pledged MSR with a carrying value of $175.4 million and $180.9 million, respectively, as collateral for revolving credit facilities. See Note 18 - Revolving Credit Facilities.

18

Table of Contents

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

As of March 31, 2017 and December 31, 2016, 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:
(dollars in thousands)
March 31,
2017
 
December 31,
2016
Weighted average prepayment speed:
9.3
%
 
9.2
%
Impact on fair value of 10% adverse change
$
(27,287
)
 
$
(25,012
)
Impact on fair value of 20% adverse change
$
(53,003
)
 
$
(48,602
)
Weighted average delinquency:
2.0
%
 
1.9
%
Impact on fair value of 10% adverse change
$
(2,056
)
 
$
(1,908
)
Impact on fair value of 20% adverse change
$
(4,112
)
 
$
(3,816
)
Weighted average discount rate:
9.5
%
 
9.4
%
Impact on fair value of 10% adverse change
$
(26,091
)
 
$
(23,590
)
Impact on fair value of 20% adverse change
$
(50,312
)
 
$
(45,861
)

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.
Risk Mitigation Activities
The primary risk associated with 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 its Agency RMBS portfolio.
Mortgage Servicing Income
The following table presents the components of servicing income recorded on the Company’s condensed consolidated statements of comprehensive income (loss) for the three months ended March 31, 2017 and 2016:
 
Three Months Ended
 
March 31,
(in thousands)
2017
 
2016
Servicing fee income
$
38,500

 
$
33,109

Ancillary fee income
140

 
485

Float income
1,133

 
539

Total
$
39,773

 
$
34,133


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 $24.7 million and $26.1 million and were included in other assets on the condensed consolidated balance sheets as of March 31, 2017 and December 31, 2016, respectively.

19

Table of Contents

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

Serviced Mortgage Assets
The Company’s total serviced mortgage assets consist of loans underlying MSR, loans held in consolidated VIEs classified as residential mortgage loans held-for-investment in securitization trusts and loans owned and classified as residential mortgage loans held-for-sale. 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, 2017 and December 31, 2016:
 
March 31, 2017
 
December 31, 2016
(dollars in thousands)
Number of Loans
 
Unpaid Principal Balance
 
Number of Loans
 
Unpaid Principal Balance
Mortgage servicing rights
304,515

 
$
68,128,011

 
280,185

 
$
62,827,975

Residential mortgage loans held-for-investment in securitization trusts
4,489

 
3,131,499

 
4,604

 
3,234,044

Residential mortgage loans held-for-sale
265

 
40,912

 
333

 
49,986

Total serviced mortgage assets
309,269

 
$
71,300,422

 
285,122

 
$
66,112,005


Note 7. Residential Mortgage Loans Held-for-Investment in Securitization Trusts, at Fair Value
The Company retains subordinated debt and excess servicing rights purchased 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 March 31, 2017 and December 31, 2016:
(in thousands)
March 31,
2017
 
December 31,
2016
Unpaid principal balance
$
3,131,499

 
$
3,234,044

Fair value adjustment
50,312

 
37,273

Carrying value
$
3,181,811

 
$
3,271,317


Note 8. 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, 2017 and December 31, 2016:
(in thousands)
March 31,
2017
 
December 31,
2016
Unpaid principal balance
$
40,912

 
$
49,986

Fair value adjustment
(8,226
)
 
(9,840
)
Carrying value
$
32,686

 
$
40,146


Note 9. Cash, Cash Equivalents and Restricted Cash
Cash and cash equivalents include cash held in bank accounts and cash held in money market funds on an overnight basis.
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.

20

Table of Contents

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

The following table presents the Company’s restricted cash balances as of March 31, 2017 and December 31, 2016:
(in thousands)
March 31,
2017
 
December 31,
2016
Restricted cash balances held by trading counterparties:
 
 
 
For securities and loan trading activity
$
27,810

 
$
26,310

For derivatives trading activity
218,654

 
218,896

As restricted collateral for repurchase agreements and Federal Home Loan Bank advances
134,853

 
162,759

Total restricted cash balances held by trading counterparties
381,317

 
407,965

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

 
347

Total
$
381,664

 
$
408,312


The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported on the Company’s condensed consolidated balance sheets as of March 31, 2017 and December 31, 2016 that sum to the total of the same such amounts shown in the statements of cash flows:
(in thousands)
March 31,
2017
 
December 31,
2016
Cash and cash equivalents
$
405,110

 
$
406,883

Restricted cash
381,664

 
408,312

Total cash, cash equivalents and restricted cash
$
786,774

 
$
815,195


Note 10. Accrued Interest Receivable
The following table presents the Company’s accrued interest receivable by collateral type as of March 31, 2017 and December 31, 2016:
(in thousands)
March 31,
2017
 
December 31,
2016
Available-for-sale securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
34,321

 
$
8,914

Federal National Mortgage Association
12,868

 
25,273

Government National Mortgage Association
3,167

 
3,068

Non-Agency
2,681

 
2,705

Total available-for-sale securities
53,037

 
39,960

Commercial real estate assets
4,440

 
3,699

Residential mortgage loans held-for-investment in securitization trusts
18,499

 
18,928

Residential mortgage loans held-for-sale
128

 
164

Total
$
76,104

 
$
62,751



21

Table of Contents

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

Note 11. 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 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, principally market risk and cash flow volatility associated with interest rate risk (including associated prepayment risk). Specifically, the Company enters into derivative and non-derivative instruments to economically hedge interest rate risk or “duration mismatch (or gap)” by adjusting the duration of its floating-rate borrowings into fixed-rate borrowings to more closely match the duration of its assets. This particularly applies to floating-rate borrowing agreements with maturities or interest rate resets of less than six months. Typically, the interest receivable terms (i.e., LIBOR) of certain derivatives match the terms of the underlying debt, resulting in an effective conversion of the rate of the related repurchase agreement or FHLB advance from floating to fixed. The objective is to manage the cash flows associated with current and anticipated interest payments on borrowings, as well as the ability to roll or refinance borrowings at the desired amount by adjusting the duration.
To help manage the adverse impact of interest rate changes on the value of the Company’s portfolio as well as its cash flows, the Company may, at times, enter into various forward contracts, including short securities, Agency to-be-announced securities, or TBAs, options, futures, swaps, caps and 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, 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 MSR and Agency interest-only securities (see discussion below).
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 these risks. The discussion includes both derivative and non-derivative instruments used as part of these risk management activities. Any of the Company’s derivative and non-derivative instruments may be entered into in conjunction with one another in order to mitigate risks. As a result, the following discussions of each type of instrument should be read as a collective representation of the Company’s risk mitigation efforts and should not be considered independent of one another. While the Company uses derivative and non-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, 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 March 31, 2017 and December 31, 2016.
(in thousands)
 
March 31, 2017
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
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