Two Harbors Investment Corp. Annual report pursuant to Section 13 and 15(d)

Annual report pursuant to Section 13 and 15(d)

Derivative Instruments and Hedging Activities

Derivative Instruments and Hedging Activities

12 Months Ended

Dec. 31, 2020

Derivative Instruments and Hedging Activities Disclosure [Abstract]

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 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 (e.g., LIBOR or the OIS rate) of certain derivatives match the terms of the underlying debt, resulting in an effective conversion of the rate of the related borrowing agreement 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 TBAs, interest rate swap and swaption agreements and U.S. Treasury futures. 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, the Company records derivative financial instruments on its 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 are designated or qualifying as hedge instruments. Due to the volatility of the interest rate and credit markets and difficulty in effectively matching pricing or cash flows, the Company has not designated any current derivatives as hedging instruments.

The following tables present the gross fair value and notional amounts of the Company’s derivative financial instruments treated as trading derivatives as of December 31, 2020 and December 31, 2019.


	December 31, 2020
	Derivative Assets				Derivative Liabilities
(in thousands)	Fair Value		Notional		Fair Value		Notional
Inverse interest-only securities	$	62,200	$	318,162	$	—	$	—
Interest rate swap agreements	—		—		—		12,646,341


Swaptions, net	—		—		(596)		3,750,000
TBAs	30,062		7,700,000		(10,462)		(2,503,000)


U.S. Treasury futures	3,675		2,021,100		—		—


Total	$	95,937	$	10,039,262	$	(11,058)	$	13,893,341


	December 31, 2019
	Derivative Assets				Derivative Liabilities
(in thousands)	Fair Value		Notional		Fair Value		Notional
Inverse interest-only securities	$	69,469	$	397,137	$	—	$	—
Interest rate swap agreements	102,268		2,725,000		—		36,977,470


Swaptions, net	7,801		1,257,000		—		—
TBAs	8,011		9,584,000		(6,711)		(2,157,000)


U.S. Treasury futures	502		380,000		—		—
Markit IOS total return swaps	—		—		(29)		41,890

Total	$	188,051	$	14,343,137	$	(6,740)	$	34,862,360

Comprehensive (Loss) Income Statement Presentation

The Company has not applied hedge accounting to its current derivative portfolio held to mitigate interest rate risk and credit risk. As a result, the Company is subject to volatility in its earnings due to movement in the unrealized gains and losses associated with its derivative instruments.

The following table summarizes the location and amount of gains and losses on derivative instruments reported in the consolidated statements of comprehensive (loss) income:


Derivative Instruments	Location of Gain (Loss) Recognized in Income		Amount of Gain (Loss) Recognized in Income
		Year Ended
(in thousands)		December 31,
				2020		2019		2018
Interest rate risk management
TBAs	Gain (loss) on other derivative instruments			$	60,798	$	214,414	$	(12,521)
Short U.S. Treasuries	Gain (loss) on other derivative instruments			—		(6,801)		(26,988)
U.S. Treasury futures	Gain (loss) on other derivative instruments			18,143		44,474		—
Put and call options for TBAs	Gain (loss) on other derivative instruments			—		(7,666)		(18,457)

Interest rate swaps - Payers	(Loss) gain on interest rate swap, cap and swaption agreements			(1,128,788)		(637,307)		48,995
Interest rate swaps - Receivers	(Loss) gain on interest rate swap, cap and swaption agreements			879,289		461,801		(74,407)
Swaptions	(Loss) gain on interest rate swap, cap and swaption agreements			(61,307)		74,901		45,954
Interest rate caps	(Loss) gain on interest rate swap, cap and swaption agreements			—		(7,684)		(4,499)
Markit IOS total return swaps	Gain (loss) on other derivative instruments			(2,430)		(1,213)		125


Non-risk management

Inverse interest-only securities	Gain (loss) on other derivative instruments			13,512		16,790		2,984

Total				$	(220,783)	$	151,709	$	(38,814)

For the years ended December 31, 2020, 2019 and 2018, the Company recognized $66.2 million of expense and $70.5 million and $49.2 million of income, respectively, for the accrual and/or settlement of the net interest expense associated with its interest rate swaps and caps. The income resulted from paying either a fixed interest rate or a floating interest rate (LIBOR or the OIS rate) and receiving either a floating interest rate (LIBOR or the OIS rate) or a fixed interest rate on an average $27.1 billion, $40.0 billion and $29.4 billion notional, respectively.

The following tables present information with respect to the volume of activity in the Company’s derivative instruments during the years ended December 31, 2020 and 2019:


	Year Ended December 31, 2020
(in thousands)	Beginning of Period Notional Amount		Additions		Settlement, Termination, Expiration or Exercise		End of Period Notional Amount		Average Notional Amount		Realized Gain (Loss), net (1)
Inverse interest-only securities	$	397,137	$	—	$	(78,975)	$	318,162	$	360,000	$	(116)
Interest rate swap agreements	39,702,470		56,867,740		(83,923,869)		12,646,341		27,137,669		(334,458)


Swaptions, net	1,257,000		6,767,000		(4,274,000)		3,750,000		2,188,661		(53,290)
TBAs, net	7,427,000		60,103,000		(62,333,000)		5,197,000		4,540,759		42,499

U.S. Treasury futures	(380,000)		13,385,800		(10,984,700)		2,021,100		791,420		14,996


Markit IOS total return swaps	41,890		—		(41,890)		—		10,141		(2,077)

Total	$	48,445,497	$	137,123,540	$	(161,636,434)	$	23,932,603	$	35,028,650	$	(332,446)


	Year Ended December 31, 2019
(in thousands)	Beginning of Period Notional Amount		Additions		Settlement, Termination, Expiration or Exercise		End of Period Notional Amount		Average Notional Amount		Realized Gain (Loss), net (1)
Inverse interest-only securities	$	476,299	$	—	$	(79,162)	$	397,137	$	437,039	$	—
Interest rate swap agreements	29,523,605		35,458,291		(25,279,426)		39,702,470		38,951,332		41,975
Interest rate cap contracts	2,500,000		—		(2,500,000)		—		1,060,000		(8,690)

Swaptions, net	63,000		14,457,000		(13,263,000)		1,257,000		2,846,660		61,644
TBAs, net	6,484,000		143,008,000		(142,065,000)		7,427,000		8,895,340		234,716
Short U.S. Treasuries	(800,000)		—		800,000		—		(45,697)		(23,172)
U.S. Treasury futures	—		7,197,000		(7,577,000)		(380,000)		684,647		43,977
Put and call options for TBAs, net	(1,767,000)		—		1,767,000		—		(110,401)		(32,962)

Markit IOS total return swaps	48,265		—		(6,375)		41,890		45,092		—

Total	$	36,528,169	$	200,120,291	$	(188,202,963)	$	48,445,497	$	52,764,012	$	317,488

____________________

(1)Excludes net interest paid or received in full settlement of the net interest spread liability.

Cash flow activity related to derivative instruments is reflected within the operating activities and investing activities sections of the consolidated statements of cash flows. Realized gains and losses and derivative fair value adjustments are reflected within the realized and unrealized losses on interest rate swaps, caps and swaptions and unrealized (gain) loss on other derivative instruments line items within the operating activities section of the consolidated statements of cash flows. The remaining cash flow activity related to derivative instruments is reflected within the (purchases) short sales of other derivative instruments, (payments for termination and settlement) proceeds from sales and settlements of derivative instruments, net and increase (decrease) in due to counterparties, net line items within the investing activities section of the consolidated statements of cash flows.

Interest Rate Sensitive Assets/Liabilities

The Company’s Agency RMBS portfolio is generally subject to change in value when interest rates decline or increase, depending on the type of investment. Rising interest rates generally result in a decline in the value of the Company’s fixed-rate Agency principal and interest (P&I) RMBS. To mitigate the impact of this risk on the Company’s fixed-rate Agency P&I RMBS portfolio, the Company maintains a portfolio of fixed-rate interest-only securities and MSR, which increase in value when interest rates increase. As of December 31, 2020 and December 31, 2019, the Company had $245.9 million and $122.2 million, respectively, of interest-only securities, and $1.6 billion and $1.9 billion, respectively, of MSR in place to primarily hedge its Agency RMBS. Interest-only securities are included in AFS securities, at fair value, in the consolidated balance sheets.

The Company monitors its borrowings under repurchase agreements, FHLB advances and revolving credit facilities, which are generally floating-rate debt, in relation to the rate profile of its portfolio. In connection with its risk management activities, the Company enters into a variety of 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 borrowing agreements with maturities or interest rate resets of less than six months. Typically, the interest receivable terms (e.g., LIBOR or the OIS rate) of certain derivatives match the terms of the underlying debt, resulting in an effective conversion of the rate of the related borrowing agreement 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, TBAs, options, futures, swaps, caps, credit default swaps and total return swaps. In executing on the Company’s current interest rate risk management strategy, the Company has entered into TBAs, interest rate swap and swaption agreements and U.S. Treasury futures.

TBAs. At times, the Company may use TBAs as a means of deploying capital until targeted investments are available or to take advantage of temporary displacements, funding advantages or valuation differentials in the marketplace. Additionally, the Company may use TBAs independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. TBAs are forward contracts for the purchase (long notional positions) or sale (short notional positions) of Agency RMBS. The issuer, coupon and stated maturity of the Agency RMBS are predetermined as well as the trade price, face amount and future settle date (published each month by the Securities Industry and Financial Markets Association). However, the specific Agency RMBS to be delivered upon settlement is not known at the time of the TBA transaction. As a result, and because physical delivery of the Agency RMBS upon settlement cannot be assured, the Company accounts for TBAs as derivative instruments.

The Company may hold both long and short notional TBA positions, which are disclosed on a gross basis according to the unrealized gain or loss position of each TBA contract regardless of long or short notional position. The following tables present the notional amount, cost basis, market value and carrying value (which approximates fair value) of the Company’s TBA positions as of December 31, 2020 and December 31, 2019:


	December 31, 2020
							Net Carrying Value (4)
(in thousands)	Notional Amount (1)		Cost Basis (2)		Market Value (3)		Derivative Assets		Derivative Liabilities
Purchase contracts	$	7,700,000	$	8,102,344	$	8,132,406	$	30,062	$	—
Sale contracts	(2,503,000)		(2,640,465)		(2,650,927)		—		(10,462)
TBAs, net	$	5,197,000	$	5,461,879	$	5,481,479	$	30,062	$	(10,462)


	December 31, 2019
							Net Carrying Value (4)
(in thousands)	Notional Amount (1)		Cost Basis (2)		Market Value (3)		Derivative Assets		Derivative Liabilities
Purchase contracts	$	10,223,000	$	10,557,745	$	10,565,556	$	8,011	$	(200)
Sale contracts	(2,796,000)		(2,902,858)		(2,909,369)		—		(6,511)
TBAs, net	$	7,427,000	$	7,654,887	$	7,656,187	$	8,011	$	(6,711)

___________________

(1)Notional amount represents the face amount of the underlying Agency RMBS.

(2)Cost basis represents the forward price to be paid (received) for the underlying Agency RMBS.

(3)Market value represents the current market value of the TBA (or of the underlying Agency RMBS) as of period-end.

(4)Net carrying value represents the difference between the market value of the TBA as of period-end and its cost basis, and is reported in derivative assets / (liabilities), at fair value, in the consolidated balance sheets.

U.S. Treasury Futures. The Company may use U.S. Treasury futures independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. As of December 31, 2020 and December 31, 2019, the Company had purchased U.S. Treasury futures with a notional amount of $2.0 billion and $380.0 million and a fair market value of $3.7 million and $0.5 million included in derivative assets, at fair value, on the consolidated balance sheet as of December 31, 2020 and December 31, 2019, respectively.

Interest Rate Swap Agreements. The Company may use interest rate swaps independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. As of December 31, 2020 and December 31, 2019, the Company held the following interest rate swaps that were utilized as economic hedges of interest rate exposure (or duration) whereby the Company receives interest at a floating interest rate (LIBOR or the OIS rate):


(notional in thousands)
December 31, 2020
Swaps Maturities	Notional Amount		Weighted Average Fixed Pay Rate		Weighted Average Receive Rate		Weighted Average Maturity (Years)
2021	$	—	—	%	—	%	0.00
2022	7,415,818		0.042	%	0.090	%	1.66
2023	2,281,500		0.023	%	0.090	%	2.48
2024	—		—	%	—	%	0.00
2025 and Thereafter	1,497,500		0.257	%	0.090	%	6.49
Total	$	11,194,818	0.067	%	0.090	%	2.47


(notional in thousands)
December 31, 2019
Swaps Maturities	Notional Amount		Weighted Average Fixed Pay Rate		Weighted Average Receive Rate		Weighted Average Maturity (Years)
2020	$	3,640,000	1.806	%	1.937	%	0.83
2021	15,740,977		1.681	%	1.910	%	1.47
2022	2,578,640		1.911	%	1.901	%	2.74
2023	215,000		3.057	%	1.910	%	3.90
2024 and Thereafter	8,739,092		2.224	%	1.935	%	7.20
Total	$	30,913,709	1.878	%	1.921	%	3.14

Additionally, as of December 31, 2020 and December 31, 2019, the Company held the following interest rate swaps in order to mitigate mortgage interest rate exposure (or duration) risk whereby the Company pays interest at a floating interest rate (LIBOR or the OIS rate):


(notional in thousands)
December 31, 2020
Swaps Maturities	Notional Amounts		Weighted Average Pay Rate		Weighted Average Fixed Receive Rate		Weighted Average Maturity (Years)
2021	$	—	—	%	—	%	0.00
2022	—		—	%	—	%	0.00
2023	—		—	%	—	%	0.00
2024	—		—	%	—	%	0.00
2025 and Thereafter	1,451,523		0.090	%	0.468	%	9.49
Total	$	1,451,523	0.090	%	0.468	%	9.49


(notional in thousands)
December 31, 2019
Swaps Maturities	Notional Amounts		Weighted Average Pay Rate		Weighted Average Fixed Receive Rate		Weighted Average Maturity (Years)
2020	$	250,000	1.953	%	2.258	%	0.06
2021	915,000		1.894	%	2.516	%	1.10
2022	—		—	%	—	%	0.00
2023	—		—	%	—	%	0.00
2024 and Thereafter	7,623,761		1.937	%	2.232	%	8.64
Total	$	8,788,761	1.933	%	2.262	%	7.61

Interest Rate Swaptions. The Company may use options on interest rate, or “swaptions” (options to enter into interest rate swaps in the future for which the Company would either pay or receive a fixed rate) independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. As of December 31, 2020 and December 31, 2019, the Company had the following outstanding interest rate swaptions:


	December 31, 2020
(notional and dollars in thousands)	Option						Underlying Swap
Swaption	Expiration	Cost Basis		Fair Value		Average Months to Expiration	Notional Amount		Average Pay Rate		Average Receive Rate		Average Term (Years)
Purchase contracts:
Payer	< 6 Months	$	7,210	$	2,448	4.23	$	2,800,000	1.32	%	SOFR		10.0



Receiver	< 6 Months	$	3,010	$	—	0.97	$	2,000,000	SOFR		0.23	%	10.0



Sale contracts:




Receiver	< 6 Months	$	(2,600)	$	(3,044)	5.13	$	(1,050,000)	SOFR		0.55	%	10.0


	December 31, 2019
(notional and dollars in thousands)	Option						Underlying Swap
Swaption	Expiration	Cost		Fair Value		Average Months to Expiration	Notional Amount		Average Pay Rate		Average Receive Rate		Average Term (Years)
Purchase contracts:
Payer	< 6 Months	$	24,700	$	16,095	3.20	$	7,525,000	2.27	%	3M Libor		10.0



Receiver	< 6 Months	$	4,100	$	342	1.10	$	500,000	3M Libor		1.55	%	10.0



Sale contracts:




Receiver	< 6 Months	$	(20,800)	$	(8,636)	3.24	$	(6,768,000)	3M Libor		1.28	%	10.0

Markit IOS Total Return Swaps. The Company may use total return swaps (agreements whereby the Company receives or makes payments based on the total return of an underlying instrument or index, such as the Markit IOS Index, in exchange for fixed or floating rate interest payments) independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. The Company enters into total return swaps to help mitigate the potential impact of larger increases or decreases in interest rates on the performance of our portfolio (referred to as “convexity risk”). Total return swaps based on the Markit IOS Index are intended to synthetically replicate the performance of interest-only securities. The Company did not hold any total return swaps as of December 31, 2020. As of December 31, 2019, the Company had the following total return swap agreements in place:


(notional and dollars in thousands)
December 31, 2019
Maturity Date	Current Notional Amount		Fair Value		Cost Basis		Unrealized Gain (Loss)
January 12, 2043	$	(18,625)	$	5	$	(30)	$	35
January 12, 2044	(23,265)		(34)		(29)		(5)

Total	$	(41,890)	$	(29)	$	(59)	$	30

Credit Risk

The Company’s exposure to credit losses on its Agency RMBS portfolio is limited due to implicit or explicit backing from the GSEs. The payment of principal and interest on the Freddie Mac and Fannie Mae mortgage-backed securities are guaranteed by those respective agencies, and the payment of principal and interest on the Ginnie Mae mortgage-backed securities are backed by the full faith and credit of the U.S. government.

In future periods, the Company could enhance its credit risk protection, enter into further paired derivative positions, including both long and short credit default swaps, and/or seek opportunistic trades in the event of a market disruption (see discussion under “Non-Risk Management Activities” below). The Company also has processes and controls in place to monitor, analyze, manage and mitigate its credit risk with respect to non-Agency securities.

Derivative financial instruments contain an element of credit risk if counterparties are unable to meet the terms of the agreements. Credit risk associated with derivative financial instruments is measured as the net replacement cost should the counterparties that owe the Company under such contracts completely fail to perform under the terms of these contracts, assuming there are no recoveries of underlying collateral, as measured by the market value of the derivative financial instruments. As of December 31, 2020, the fair value of derivative financial instruments as an asset and liability position was $95.9 million and $11.1 million, respectively.

The Company attempts to mitigate its credit risk exposure on derivative financial instruments by limiting its counterparties to banks and financial institutions that meet established internal credit guidelines. The Company also seeks to spread its credit risk exposure across multiple counterparties in order to reduce its exposure to any single counterparty. Additionally, the Company reduces credit risk on the majority of its derivative instruments by entering into agreements that permit the closeout and netting of transactions with the same counterparty or clearing agency, in the case of centrally cleared interest rate swaps, upon the occurrence of certain events. To further mitigate the risk of counterparty default, the Company maintains collateral agreements with certain of its counterparties and clearing agencies, which require both parties to maintain cash deposits in the event the fair values of the derivative financial instruments exceed established thresholds. The Company’s centrally cleared interest rate swaps require that the Company posts an “initial margin” amount determined by the clearing exchange, which is generally intended to be set at a level sufficient to protect the exchange from the interest rate swap’s maximum estimated single-day price movement. The Company also exchanges “variation margin” based upon daily changes in fair value, as measured by the exchange. The exchange of variation margin is considered a settlement of the interest rate swap, as opposed to pledged collateral. Accordingly, the Company accounts for the receipt or payment of variation margin as a direct reduction to the carrying value of the interest rate swap asset or liability.