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

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended: June 30, 2011
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.)

601 Carlson Parkway, Suite 150
Minnetonka, Minnesota
 
55305
(Address of Principal Executive Offices)
 
(Zip Code)
(612) 629-2500
(Registrant's Telephone Number, Including Area Code)


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o
 
Accelerated filer x
 
Non-accelerated filer o
 
Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
As of August 4, 2011 there were 140,583,363 shares of outstanding common stock, par value $.01 per share, issued and outstanding.
 
 
 
 
 

TWO HARBORS INVESTMENT CORP. 
INDEX

 
 
 
Page
 
PART I - FINANCIAL INFORMATION
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
PART II - OTHER INFORMATION
 
 
 
 
 
 
 
 
 
 
 


i

Table of Contents



PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)

 
June 30,
2011
 
December 31,
2010
 
(unaudited)
 
 
ASSETS
  

 
  

Available-for-sale securities, at fair value
$
4,500,825

 
$
1,354,405

Trading securities, at fair value
1,022,394

 
199,523

Cash and cash equivalents
181,909

 
163,900

Total earning assets
5,705,128

 
1,717,828

Restricted cash
89,243

 
22,548

Accrued interest receivable
17,717

 
5,383

Due from counterparties

 
12,304

Derivative assets, at fair value
190,416

 
38,109

Other assets
5,433

 
1,260

Total Assets
$
6,007,937

 
$
1,797,432

LIABILITIES AND STOCKHOLDERS’ EQUITY
   

 
   

Liabilities
   

 
   

Repurchase agreements
$
4,827,202

 
$
1,169,803

Derivative liabilities, at fair value
38,892

 
158

Accrued interest payable
2,870

 
785

Due to counterparties
199,554

 
231,724

Accrued expenses and other liabilities
4,921

 
2,063

Dividends payable
36,911

 
10,450

Income taxes payable
6

 
1

Total liabilities
5,110,356

 
1,414,984

Stockholders’ Equity
   

 
  

Preferred stock, par value $0.01per share; 50,000,000 shares authorized; no shares issued and outstanding

 

Common stock, par value $0.01per share; 450,000,000 shares authorized and 92,277,991 and 40,501,212 shares issued and outstanding, respectively
923

 
405

Additional paid-in capital
889,679

 
366,974

Accumulated other comprehensive income
46,248

 
22,619

Cumulative earnings
51,413

 
30,020

Cumulative distributions to stockholders
(90,682
)
 
(37,570
)
Total stockholders’ equity
897,581

 
382,448

Total Liabilities and Stockholders’ Equity
$
6,007,937

 
$
1,797,432


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


1

Table of Contents



TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)
(in thousands, except share data)

 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2011
 
2010
 
2011
 
2010
 
(unaudited)  
 
(unaudited)  
Interest income:
 
 
 
 
 
 
 
Available-for-sale securities
$
39,959

 
$
9,088

 
$
59,494

 
$
15,241

Trading securities
805

 

 
1,077

 

Cash and cash equivalents
64

 
37

 
127

 
43

Total interest income
40,828

 
9,125

 
60,698

 
15,284

Interest expense
3,863

 
863

 
6,362

 
1,381

Net interest income
36,965

 
8,262

 
54,336

 
13,903

Other-than-temporary impairments:
 
 
 
 
 
 
 
Total other-than-temporary impairment losses
(294
)
 

 
(294
)
 

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

 

 

 

Net other-than-temporary credit impairment losses
(294
)
 

 
(294
)
 

Other income:
 
 
 
 
 
 
 
Gain on investment securities, net
3,189

 
834

 
4,728

 
2,031

Loss on interest rate swap and swaption agreements
(50,808
)
 
(4,054
)
 
(48,869
)
 
(5,601
)
Gain on other derivative instruments
9,766

 
152

 
15,113

 
1,098

Total other income
(37,853
)
 
(3,068
)
 
(29,028
)
 
(2,472
)
Expenses:
 
 
 
 
 
 
 
Management fees
2,728

 
748

 
4,278

 
1,205

Other operating expenses
2,155

 
1,132

 
3,667

 
2,119

Total expenses
4,883

 
1,880

 
7,945

 
3,324

Net (loss) income before income taxes
(6,065
)
 
3,314

 
17,069

 
8,107

Benefit from income taxes
5,081

 
774

 
4,324

 
1,308

Net (loss) income attributable to common stockholders
$
(984
)
 
$
4,088

 
$
21,393

 
$
9,415

Basic and diluted (loss) earnings per weighted average common share
$
(0.01
)
 
$
0.18

 
$
0.35

 
$
0.52

Dividends declared per common share
$
0.40

 
$
0.33

 
$
0.80

 
$
0.69

Basic and diluted weighted average number of shares of common stock
77,101,606

 
22,466,691

 
61,443,978

 
17,959,072


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


2

Table of Contents



TWO HARBORS INVESTMENT CORP. 
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
AND COMPREHENSIVE INCOME
(in thousands, except share data)

 
Common Stock
 
 
 
 
 
 
 
 
 
 
 
Shares
 
Amount
 
Additional Paid-in Capital
 
Accumulated Other Comprehensive Income
 
Cumulative Earnings
 
Cumulative Distributions to Stockholders
 
Total Stockholders' Equity
 
 
 
 
 
 
 
(unaudited)
 
 
 
 
 
 
Balance, January 1, 2010
13,401,368

 
$
134

 
$
131,756

 
$
(950
)
 
$
(5,735
)
 
$
(3,484
)
 
$
121,721

Net income

 

 

 

 
9,415

 

 
9,415

Net change in unrealized gain on available-for-sale securities

 

 

 
2,772

 

 

 
2,772

Total other comprehensive income

 

 

 
2,772

 

 

 

Total comprehensive income
 
 
 
 
 
 
 
 
 
 
 
 
12,187

Net proceeds from issuance of common stock, net of offering costs
12,688,381

 
127

 
106,699

 

 

 

 
106,826

Common dividends declared

 

 

 

 

 
(13,446
)
 
(13,446
)
Non-cash equity award compensation
36,463

 

 
65

 

 

 

 
65

Balance, June 30, 2010
26,126,212

 
$
261

 
$
238,520

 
$
1,822

 
$
3,680

 
$
(16,930
)
 
$
227,353

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, January 1, 2011
40,501,212

 
$
405

 
$
366,974

 
$
22,619

 
$
30,020

 
$
(37,570
)
 
$
382,448

Net income

 

 

 

 
21,393

 

 
21,393

Net change in unrealized gain on available-for-sale securities

 

 

 
23,629

 

 

 
23,629

Total other comprehensive income

 

 

 
23,629

 

 

 

Total comprehensive income
 
 
 
 
 
 
 
 
 
 
 
 
45,022

Net proceeds from issuance of common stock, net of offering costs
51,769,180

 
518

 
522,558

 

 

 

 
523,076

Common dividends declared

 

 

 

 

 
(53,112
)
 
(53,112
)
Non-cash equity award compensation
7,599

 

 
147

 

 

 

 
147

Balance, June 30, 2011
92,277,991

 
$
923

 
$
889,679

 
$
46,248

 
$
51,413

 
$
(90,682
)
 
$
897,581


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


3

Table of Contents



TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
Six Months Ended
 
June 30,
 
2011
 
2010
 
(unaudited)
Cash Flows From Operating Activities:
   

 
   

Net income
$
21,393

 
$
9,415

Adjustments to reconcile net income to net cash provided by operating activities:
   

 
   

Amortization of premiums and discounts on RMBS, net
4,693

 
1,774

Other-than-temporary impairment loss
294

 

Gain on investment securities, net
(4,728
)
 
(2,031
)
Loss on termination of interest rate swaps and swaptions
227

 

Unrealized loss on interest rate swaps and swaptions
38,351

 
4,392

Unrealized gain on other derivative instruments
(5,893
)
 
(396
)
Equity based compensation expense
147

 
65

Net change in:
   

 
 
Increase in accrued interest receivable
(12,334
)
 
(1,177
)
Increase in deferred income taxes, net
(4,330
)
 
(1,018
)
Increase in prepaid tax asset

 
(142
)
Decrease in prepaid and fixed assets
157

 
453

Increase in accrued interest payable, net
2,085

 
346

Increase in income taxes payable, net
5

 

Increase in accrued expenses and other liabilities
2,858

 
1,392

Net cash provided by operating activities
42,925

 
13,073

Cash Flows From Investing Activities:
   

 
   

Purchases of available-for-sale securities
(3,338,528
)
 
(706,619
)
Proceeds from sales of available-for-sale securities
95,782

 
176,090

Principal payments on available-for-sale securities
116,651

 
50,140

Purchases of other derivative instruments
(165,831
)
 
(38,896
)
Proceeds from sales of other derivative instruments
19,572

 
24,266

Purchases of trading securities
(1,319,959
)
 

Proceeds from sales of trading securities
500,133

 

Decrease in due to/from counterparties, net
(19,866
)
 
(15,887
)
Increase in restricted cash
(66,695
)
 
(9,734
)
Net cash used in investing activities
(4,178,741
)
 
(520,640
)
Cash Flows From Financing Activities:
   

 
   

Proceeds from repurchase agreements
8,283,571

 
1,651,661

Principal payments on repurchase agreements
(4,626,172
)
 
(1,197,275
)
Proceeds from issuance of common stock, net of offering costs
523,076

 
106,826

Dividends paid on common stock
(26,650
)
 
(8,309
)
Net cash provided by financing activities
4,153,825

 
552,903

Net increase in cash and cash equivalents
18,009

 
45,336

Cash and cash equivalents at beginning of period
163,900

 
26,105

Cash and cash equivalents at end of period
$
181,909

 
$
71,441

Supplemental Disclosure of Cash Flow Information:
   

 
 
Cash paid for interest
$
4,277

 
$
1,035

Cash paid for taxes
$
1

 
$

Non-Cash Financing Activity:
   

 
   

Dividends declared but not paid at end of period
$
36,911

 
$
8,622

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

4

Table of Contents



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

Note 1. Organization and Operations
Two Harbors Investment Corp., or the Company, is a Maryland corporation focused on investing in, financing and managing residential mortgage-backed securities, or RMBS, residential mortgage loans and other financial assets. The Company is externally managed and advised by PRCM Advisers LLC, 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 and its warrants are listed on the NYSE Amex under the symbols “TWO” and “TWO.WS,” respectively.
On May 18, 2011, the Company announced that it had taken the first step toward setting up a securitization issuance program by partnering with Barclays Bank PLC, or Barclays, to close on a $100 million mortgage loan warehouse facility, or Barclays facility, subject to future increase. The Barclays facility will be used to aggregate prime jumbo residential mortgage loans that the Company will acquire from select mortgage loan originators with whom the Company has chosen to build strategic relationships, including those with a nationwide presence. The Company is targeting a $250 million deal size for its initial securitization, with Barclays Capital acting as underwriter. As of June 30, 2011, the Company has neither purchased any mortgage loan assets nor established the securitization program as a distinct operational business segment. As anticipated, the Company's initiatives in the three months ended June 30, 2011 focused on establishing underwriting guidelines and originator relationships, addressing regulatory requirements and building an infrastructure to support a sustainable issuance program.
The Company has elected to be treated as a real estate investment trust, or REIT, for U.S. federal income tax purposes commencing with its initial taxable period ended December 31, 2009. As long as the Company continues to comply with a number of requirements under federal tax law and maintains its qualification as a REIT, the Company generally will not be subject to U.S. federal income tax to the extent that the Company distributes its taxable income to its stockholders on an annual basis and does not engage in prohibited transactions. Certain activities the Company performs may cause us to earn income which will not be qualifying income for REIT purposes. For these activities, the Company utilizes its taxable REIT subsidiaries, which are subject to U.S. federal income tax.

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 GAAP, have been condensed or omitted according to such SEC rules and regulations. Management believes, however, 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, 2010. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at June 30, 2011 and results of operations for all periods presented have been made. The results of operations for the three and six months ended June 30, 2011 should not be construed as indicative of the results to be expected for the full year.
The condensed consolidated financial statements of the Company have been prepared on the accrual basis of accounting in accordance with GAAP. The preparation of financial statements in conformity with 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.

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TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

Recently Issued and/or Adopted Accounting Standards
Broad Transactions
Fair Value Measurements and Disclosures (Accounting Standards Codification “ASC 820”). On January 21, 2010, the FASB issued an accounting standard update, or ASU, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements, which provides guidance on how investment assets and liabilities are to be valued and disclosed. Specifically, the amendment requires reporting entities to disclose: (i) the input and valuation techniques used to measure fair value for both recurring and nonrecurring fair value measurements, for Level 2 or Level 3 positions, (ii) transfers between all levels (including Level 1 and Level 2) on a gross basis (i.e., transfers out are disclosed separately from transfers in) as well as the reason(s) for the transfer and (iii) purchases, sales, issuances and settlements on a gross basis in the Level 3 rollforward, rather than as one net number. The effective date of the amendment is for interim and annual periods beginning after December 15, 2009; however, the requirement to provide the Level 3 activity for purchases, sales, issuances and settlements on a gross basis is effective for interim and annual periods beginning after December 15, 2010. The impact of adopting this ASU, including the Level 3 activity requirement, did not have a material impact on the Company's consolidated financial condition or results of operations.
Comprehensive Income
In June 2011, the Financial Accounting Standards Board issued ASU No. 2011-05, Comprehensive Income (Topic 220), and Amendments to IAS 1, Presentation of Financial Statements, which provides guidance on the presentation of other comprehensive income, or OCI. The amendment requires companies to present OCI separately in the statement of operations and comprehensive income rather than include in the statement of stockholders' equity. The components of OCI have not changed. ASU 2011-05 is effective for the first interim or annual period beginning on or after December 15, 2011. The impact of adopting this ASU will not have a material impact on the Company's consolidated financial condition or results of operations.

Note 3. Available-for-Sale Securities, at Fair Value
The following table presents the Company's available-for-sale, or AFS, investment securities by collateral type, which were carried at their fair value as of June 30, 2011 and December 31, 2010:

(in thousands)
June 30,
2011
 
December 31,
2010
Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
1,125,267

 
$
396,888

Federal National Mortgage Association
1,870,784

 
556,609

Government National Mortgage Association
748,498

 
62,972

Non-Agency
756,276

 
337,936

Total mortgage-backed securities
$
4,500,825

 
$
1,354,405


At June 30, 2011 and December 31, 2010, the Company pledged investment securities with a carrying value of $4.1 billion and $1.1 billion, respectively, as collateral for repurchase agreements. See Note 9 - Repurchase Agreements.
At June 30, 2011 and December 31, 2010, 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, to be considered linked transactions and therefore classified as derivatives.

6

Table of Contents

TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

The following tables present the amortized cost and carrying value (which approximates fair value) of AFS securities by collateral type as of June 30, 2011 and December 31, 2010:

 
June 30, 2011
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
4,614,324

 
$
1,416,289

 
$
6,030,613

Unamortized premium
183,528

 

 
183,528

Unamortized discount
 
 
 
 
 
Designated credit reserve

 
(385,741
)
 
(385,741
)
Net, unamortized
(1,093,108
)
 
(280,715
)
 
(1,373,823
)
Amortized Cost
3,704,744

 
749,833

 
4,454,577

Gross unrealized gains
49,586

 
28,583

 
78,169

Gross unrealized losses
(9,781
)
 
(22,140
)
 
(31,921
)
Carrying Value
$
3,744,549

 
$
756,276

 
$
4,500,825


 
December 31, 2010
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
1,306,655

 
$
594,306

 
$
1,900,961

Unamortized premium
41,651

 

 
41,651

Unamortized discount
  

 
  

 
  

Designated credit reserve

 
(145,855
)
 
(145,855
)
Net, unamortized
(334,979
)
 
(129,992
)
 
(464,971
)
Amortized Cost
1,013,327

 
318,459

 
1,331,786

Gross unrealized gains
9,308

 
21,503

 
30,811

Gross unrealized losses
(6,166
)
 
(2,026
)
 
(8,192
)
Carrying Value
$
1,016,469

 
$
337,936

 
$
1,354,405


The following tables present the carrying value of the Company's AFS investment securities by rate type as of June 30, 2011 and December 31, 2010:

 
June 30, 2011
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
249,713

 
$
636,364

 
$
886,077

Fixed Rate
3,494,836

 
119,912

 
3,614,748

Total
$
3,744,549

 
$
756,276

 
$
4,500,825


 
December 31, 2010
(in thousands)
Agency
 
Non-Agency
 
Total
Adjustable Rate
$
269,512

 
$
245,517

 
$
515,029

Fixed Rate
746,957

 
92,419

 
839,376

Total
$
1,016,469

 
$
337,936

 
$
1,354,405


When the Company purchases a credit-sensitive AFS security at a significant discount to its face value, the Company often does not amortize into income a significant portion of this discount that the Company is entitled to earn because it

7

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TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

does not expect to collect it due to the inherent credit risk of the security. The Company may also record an other-than-temporary impairment, or OTTI, for a portion of its investment in the security to the extent the Company believes that principal losses will exceed the discount. 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 using the interest method in accordance with ASC 320.
The following table presents the changes for the six months ended June 30, 2011 and June 30, 2010 of the unamortized net discount and designated credit reserves on non-Agency AFS securities.

 
Six Months Ended June 30,
 
2011
 
2010
(in thousands)
Designated credit reserve
 
Unamortized net discount
 
Total
 
Designated credit reserve
 
Unamortized net discount
 
Total
Beginning balance at January 1
$
(145,855
)
 
$
(129,992
)
 
$
(275,847
)
 
$
(50,187
)
 
$
(41,050
)
 
$
(91,237
)
Acquisitions
(249,153
)
 
(168,684
)
 
(417,837
)
 
(67,131
)
 
(61,124
)
 
(128,255
)
Accretion of net discount

 
12,409

 
12,409

 

 
3,570

 
3,570

Realized credit losses
1,242

 

 
1,242

 
956

 
8

 
964

Reclassification adjustment for other-than-temporary impairments
(294
)
 

 
(294
)
 

 

 

Transfers from (to)
66

 
(66
)
 

 
2,287

 
(2,287
)
 

Sales, calls, other
8,253

 
5,618

 
13,871

 
17,465

 
12,584

 
30,049

Ending balance at June 30
$
(385,741
)
 
$
(280,715
)
 
$
(666,456
)
 
$
(96,610
)
 
$
(88,299
)
 
$
(184,909
)

The following table presents the components comprising the carrying value of AFS securities not deemed to be other than temporarily impaired by length of time the securities had an unrealized loss position as of June 30, 2011 and December 31, 2010. At June 30, 2011, the Company held 862 AFS securities, of which 241 were in an unrealized loss position for less than twelve consecutive months and 15 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2010, the Company held 373 AFS securities, of which 108 were in an unrealized loss position for less than twelve months and 5 were in an unrealized loss position for more than twelve consecutive months.
 
Unrealized Loss Position for
 
Less than 12 Months
 
12 Months or More
Total
(in thousands)
Estimated Fair Value
 
Gross Unrealized Losses
 
Estimated Fair Value
Gross Unrealized Losses
Estimated Fair Value
Gross Unrealized Losses
June 30, 2011
$
1,244,106

 
$
(31,433
)
 
$
4,526

$
(488
)
$
1,248,632

$
(31,921
)
December 31, 2010
$
310,445

 
$
(7,183
)
 
$
1,405

$
(1,009
)
$
311,850

$
(8,192
)


Evaluating AFS Securities for Other-than-Temporary Impairments
The Company has adopted the provisions of ASC 320 to evaluate AFS securities for OTTI. This evaluation requires us to determine 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, an other-than-temporary credit impairment has occurred. If the Company does not intend to sell and is not more likely than not required to sell the security, the credit loss is recognized in earnings and the balance of the unrealized loss is recognized in other comprehensive income (loss). If the Company intends to sell the security or will be more likely than not required to sell the security, the full unrealized loss is recognized in earnings.
The Company recorded a $0.3 million other-than-temporary credit impairment during the quarter ended June 30, 2011

8

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TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

on one non-Agency RMBS where the future expected cash flows was less than its amortized cost. As of June 30, 2011, the impaired security had cumulative losses of 37.2%, three-month prepayment speed of 0.11, 60+ day delinquency of 14.1% of the pool balance, and weighted average FICO score of 691.
The following table presents the OTTI included in earnings as of June 30, 2011 and June 30, 2010:
(in thousands)
June 30, 2011
 
June 30, 2010
Cumulative credit loss beginning balance
$

 
$

Additions:
 
 
 
Other-than-temporary impairments not previously recognized
(294
)
 

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

 

Cumulative credit loss ending balance
$
(294
)
 
$


Gross Realized Gains and Losses
Gains and losses from the sale of AFS securities are recorded as realized gains (losses) within gain on investment securities, net in the Company's consolidated statements of income. For the three and six months ended June 30, 2011, the Company sold AFS securities for $24.4 million and $95.8 million with an amortized cost of $24.3 million and $94.1 million, for a net realized gain of $0.1 million and $1.7 million, respectively.
The following table presents the gross realized gains and losses on sales of AFS securities for the three and six months ended June 30, 2011 and 2010:

 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2011
 
2010
 
2011
 
2010
Gross realized gains
$
141

 
$
1,085

 
$
1,949

 
$
2,306

Gross realized losses
(95
)
 
(252
)
 
(265
)
 
(276
)
Total realized gains (losses) on sales, net
$
46

 
$
833

 
$
1,684

 
$
2,030


Note 4. Trading Securities, at Fair Value
During the six months ended June 30, 2011, the Company acquired and sold U.S. Treasuries in its taxable REIT subsidiary and classified these securities as trading instruments due to its short-term investment objectives. As of June 30, 2011 and December 31, 2010, the Company held U.S. Treasuries with an amortized cost of $1.0 billion and $200.0 million and a fair value $1.0 billion and $199.5 million, respectively, classified as trading securities. The unrealized gains and losses included within trading securities was a positive $1.8 million as of June 30, 2011 and a negative $0.5 million as of December 31, 2010.
For the three and six months ended June 30, 2011, the Company sold trading securities for $300.6 million and $500.1 million with an amortized cost of $299.4 million and $499.4 million resulting in realized gains of $1.2 million and $0.7 million, respectively, on the sale of these investment securities. For the three and six months ended June 30, 2011, trading securities experienced unrealized gains of $1.9 million and $2.3 million, respectively. Both realized and unrealized gains are recorded as a component of gains on investment securities, net in the Company's consolidated statement of income.
At June 30, 2011, the Company pledged trading securities with a carrying value of $1.0 billion as collateral for repurchase agreements. See Note 9 - Repurchase Agreements.

Note 5. Restricted Cash
As of June 30, 2011 and December 31, 2010, the Company is required to maintain certain cash balances with counterparties for broker activity and collateral for the Company's repurchase agreements in non-interest bearing accounts.

9

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TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

The following table presents the Company's restricted cash balances:

(in thousands)
June 30,
2011
 
December 31,
2010
Restricted cash balances held by:
 
 
 
Broker counterparties for securities trading activity
$
9,000

 
$
9,000

Broker counterparties for derivatives trading activity
62,091

 
1,914

Repurchase counterparties as restricted collateral
18,152

 
11,634

Total
$
89,243

 
$
22,548


Note 6. Accrued Interest Receivable
The following table presents the Company's accrued interest receivable by collateral type:

(in thousands)
June 30,
2011
 
December 31,
2010
Accrued Interest Receivable:
 
 
 
U.S. Treasuries
$
759

 
$
192

Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
4,123

 
1,509

Federal National Mortgage Association
8,082

 
2,201

Government National Mortgage Association
3,507

 
532

Non-Agency
1,246

 
949

Total mortgage-backed securities
16,958

 
5,191

Total
$
17,717

 
$
5,383


Note 7. Derivative Instruments and Hedging Activities
The Company enters into a variety of derivative and non-derivative instruments in connection with its risk management activities. The Company's primary objective for executing these derivatives and non-derivative instruments is to mitigate the Company's economic exposure to future events that are outside its control. The Company's derivative financial instruments are utilized principally to manage market risk and cash flow volatility associated with interest rate risk (including associated prepayment risk) related to certain assets and liabilities. As part of its risk management activities, the Company may, at times, enter into various forward contracts including short securities, Agency to-be-announced securities, or TBAs, options, futures, swaps and caps. In executing on the Company's current risk management strategy, the Company has entered into interest rate swap and swaption agreements, TBA positions, and credit default swaps. The Company has also entered into a number of non-derivative instruments to manage interest rate risk, principally U.S. Treasuries and Agency interest-only securities.
The following summarizes the Company's significant asset and liability classes, the risk exposure for these classes, and the Company's risk management activities used to mitigate certain of these risks. The discussion includes both derivative and non-derivative instruments used as part of these risk management activities. While the Company uses non-derivative and derivative instruments to achieve the Company's risk management activities, it is possible that these instruments will not effectively mitigate all or a substantial portion of the Company's market rate risk. In addition, the Company might elect, at times, not to enter into certain hedging arrangements in order to maintain compliance with REIT requirements.
Interest Rate Sensitive Assets/Liabilities
Available-for-sale Securities  - The Company's RMBS investment securities are generally subject to change in value when mortgage rates decline or increase, depending on the type of investment. Rising mortgage rates generally result in a slowing of refinancing activity, which slows prepayments and results in a decline in the value of the Company's fixed-rate Agency pools. To mitigate the impact of this risk, the Company maintains a portfolio of financial instruments, primarily

10

Table of Contents

TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

fixed-rate interest-only securities, which increase in value when interest rates increase. In addition, the Company has initiated TBA positions to further mitigate its exposure to increased prepayment speeds. The objective is to reduce the risk of losses to the portfolio caused by interest rate changes and their related impact on prepayments.
As of June 30, 2011 and December 31, 2010, the Company had outstanding fair value of $88.3 million and $18.4 million, respectively, of interest-only securities in place to economically hedge its investment securities. These interest-only securities are included in AFS securities, at fair value, in the consolidated balance sheets. In addition, the Company holds TBA positions with $300.0 million in long notional and $300.0 million in short notional as of June 30, 2011. The Company discloses these on a net basis in accordance with master netting arrangements resulting in a net fair market value of negative $1.0 million as of June 30, 2011, which are included in derivative liabilities, at fair value, in the condensed consolidated balance sheet. The Company did not hold any long or short notional TBA positions as of December 31, 2010.
Repurchase Agreements  - The Company monitors its repurchase agreements, which are generally floating rate debt, in relationship to the rate profile of its investment securities. When it is cost effective to do so, the Company may enter into interest rate swap arrangements to align the interest rate composition of its investment securities and debt portfolios, specifically repurchase agreements with maturities of less than 6 months. Typically, the interest receivable terms (i.e., LIBOR) of the interest rate swaps match the terms of the underlying debt, resulting in an effective conversion of the rate of the related repurchase agreement from floating to fixed.
As of June 30, 2011 and December 31, 2010, the Company had the following outstanding interest rate swaps that were utilized as economic hedges of interest rate risk associated with the Company's short-term repurchase agreements:

(notional in thousands)
 
 
 
 
 
 
June 30, 2011
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
25,000

 
0.868
%
 
0.307
%
 
1.48
2013
 
825,000

 
0.994
%
 
0.296
%
 
1.78
2014
 
925,000

 
1.411
%
 
0.283
%
 
2.90
2015
 
545,000

 
1.890
%
 
0.292
%
 
3.92
2016
 
190,000

 
2.193
%
 
0.285
%
 
4.77
Total
 
2,510,000

 
 
 
 
 
 
(notional in thousands)
 
 
 
 
 
 
December 31, 2010
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2011
 
100,000

 
1.168
%
 
0.3425
%
 
0.96

2012
 
25,000

 
0.868
%
 
0.3080
%
 
1.98

2013
 
175,000

 
1.376
%
 
0.3055
%
 
2.61

2014
 
175,000

 
1.671
%
 
0.3026
%
 
3.96

2015
 
175,000

 
1.830
%
 
0.2874
%
 
4.84

Total
 
650,000

 
 
 
 
 
 


11

Table of Contents

TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

The Company has also entered into interest rate swaps in combination with U.S. Treasuries to economically hedge funding cost risk. As of June 30, 2011 and December 31, 2010, the Company held $1.0 billion and $199.5 million, respectively, in fair value of U.S. Treasuries classified as trading securities and the following outstanding interest rate swaps:

(notional in thousands)
 
 
 
 
 
 
June 30, 2011
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2013
 
1,000,000

 
0.726
%
 
0.25978
%
 
1.91
Total
 
1,000,000

 
 
 
 
 
 
(notional in thousands)
 
 
 
 
 
 
December 31, 2010
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
200,000

 
0.557
%
 
0.278
%
 
1.80
Total
 
200,000

 
 
 
 
 
 

All of the Company's interest rate swap contracts receive interest at a 1-month or 3-month LIBOR rate.
Additionally, as of June 30, 2011 and December 31, 2010, the Company had the following outstanding interest rate swaptions (agreements to enter into interest rate swaps in the future for which the Company would pay a fixed rate) that were utilized as macro-economic hedges:
June 30, 2011
(notional and dollars in thousands)
 
Option
 
Underlying Swap
Swaption
 
Cost
 
Fair Value
 
Average Months to Expiration
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Term (Years)
Payer
 
$
17,613

 
$
6,006

 
38.21
 
1,650,000

 
3.23
%
 
3M Libor
 
3.79

December 31, 2010
(notional and dollars in thousands)
 
Option
 
Underlying Swap
Swaption
 
Cost
 
Fair Value
 
Average Months to Expiration
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Term (Years)
Payer
 
$
3,348

 
$
4,028

 
11.23
 
100,000

 
3.52
%
 
3M Libor
 
8.50


The Company has not applied hedge accounting to its current derivative portfolio held to mitigate the interest rate risk associated with its debt portfolio. As a result, the Company is subject to volatility in its earnings due to movement in the unrealized gains and losses associated with its interest rate swaps and its other derivative instruments.
Foreign Currency Risk
In compliance with the Company's REIT requirements, the Company does not have exposure to foreign denominated assets or liabilities. As such, the Company is not subject to foreign currency risk.
Credit Risk
The Company has limited its exposure to credit losses on its U.S. Treasuries and Agency portfolio of investment securities because these securities are issued by the U.S. Department of the Treasury or government sponsored entities, or GSEs. The payment of principal and interest on the FHLMC and FNMA mortgage-backed securities are guaranteed by those respective agencies, and the payment of principal and interest on the GNMA mortgage-backed securities are backed by the full faith and credit of the U.S. Government.

12

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TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

For non-Agency investment securities, the Company currently enters into a minimal number of credit default swaps to specifically hedge credit risk. 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 "Non-Risk Management Activities" section). The Company also has processes and controls in place to monitor, analyze, manage and mitigate its credit risk with respect to non-Agency RMBS.
As of June 30, 2011, the Company held credit default swaps where the Company receives credit protection for a fixed premium. The maximum payouts for these credit default swaps are limited to the current notional amounts of each swap contract. Maximum payouts for credit default swaps do not represent the expected future cash requirements, as the Company's credit default swaps are typically liquidated or expire and are not exercised by the holder of the credit default swaps.
The following table presents credit default swaps where the Company is receiving protection held as of June 30, 2011:

(notional and dollars in thousands)
 
 
 
 
 
 
 
 
 
 
June 30, 2011
Protection
 
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Receive
 
5/25/2046
 
356.00

 
(96,275
)
 
$
47,798

 
$
(42,930
)
 
$
4,868

 
 
6/20/2016
 
304.78

 
(300,000
)
 
$
(3,751
)
 
$
(636
)
 
$
(4,387
)

The Company did not hold any credit default swaps where the Company receives credit protection as of December 31, 2010.
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 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 June 30, 2011, the fair value of derivative financial instruments as an asset and liability position was $190.4 million and $38.9 million, respectively.
The Company mitigates the credit risk exposure on derivative financial instruments by limiting the counterparties to those major banks and financial institutions that meet established credit guidelines, and the Company seeks to transact with several different counterparties in order to reduce the 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 upon occurrence of certain events. To further mitigate the risk of counterparty default, the Company maintains collateral agreements with certain of its counterparties. The agreements require both parties to maintain cash deposits in the event the fair values of the derivative financial instruments exceed established thresholds. As of June 30, 2011, the Company has received cash deposits from counterparties of $28.4 million and placed cash deposits of $75.0 million in accounts maintained by counterparties, of which the amounts are netted on a counterparty basis and classified within restricted cash or due to counterparties on the consolidated balance sheet.
In accordance with ASC 815, as amended and interpreted, the Company records derivative financial instruments on its consolidated balance sheet as assets or liabilities at fair value. Changes in fair value are accounted for depending on the use of the derivative instruments and whether they qualify for hedge accounting treatment. Due to the volatility of the credit markets and difficulty in effectively matching pricing or cash flows, the Company has elected to treat all current derivative contracts as trading instruments.
Non-Risk Management Activities
The Company has entered into certain financial instruments that are considered derivative contracts under ASC 815 that are not for purposes of hedging. These contracts are currently limited to inverse interest-only residential mortgage securities and credit default swaps.

13

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TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

Inverse interest-only securities with a carrying value of $140.4 million, including accrued interest receivable, are accounted for as derivative financial instruments in the consolidated financial statements. The following table presents the amortized cost and carrying value (which approximates fair value) of inverse interest-only securities as of June 30, 2011 and December 31, 2010:

(in thousands)
June 30, 2011
 
December 31, 2010
Face Value
$
972,795

 
$
219,459

Unamortized premium

 

Unamortized discount
 
 

Designated credit reserve

 

Net, unamortized
(843,095
)
 
(190,162
)
Amortized Cost
129,700

 
29,297

Gross unrealized gains
10,063

 
1,902

Gross unrealized losses
(1,293
)
 
(665
)
Carrying Value
$
138,470

 
$
30,534


As of June 30, 2011 and December 31, 2010, the Company also held credit default swaps where the Company provides credit protection for a fixed premium. The maximum payouts for these credit default swaps are limited to the current notional amounts of each swap contract. Maximum payouts for credit default swaps do not represent the expected future cash requirements, as the Company's credit default swaps are typically liquidated or expire and are not exercised by the holder of the credit default swaps.
The following tables present credit default swaps where the Company is providing protection held as of June 30, 2011 and December 31, 2010:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
 
 
June 30, 2011
Protection
 
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Provide
 
7/25/2036
 
359.94

 
122,763

 
$
10,480

 
$
(12,232
)
 
$
(1,752
)
 
 
5/25/2046
 
146.18

 
59,986

 
$
(15,248
)
 
$
13,574

 
$
(1,674
)

(notional and dollars in thousands)
 
 
 
 
 
 
 
 
 
 
December 31, 2010
Protection
 
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Provide
 
7/25/2036
 
378.47

 
41,576

 
$
3,137

 
$
(3,554
)
 
$
(417
)


14

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TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

Balance Sheet Presentation
The following table represents the gross fair value and notional amounts of the Company's derivative financial instruments treated as trading instruments as of June 30, 2011 and December 31, 2010.

(in thousands)
 
June 30, 2011
 
December 31, 2010
 
 
Derivative Assets
 
Derivative Liabilities
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
Notional
 
Fair Value
Notional
 
Fair Value
Notional
 
Fair Value
Notional
Inverse interest-only securities
 
$
140,363

972,795

 
$


 
$
30,944

219,459

 
$


Interest rate swap agreements
 


 
(33,140
)
3,510,000

 


 
(158
)
850,000

Credit default swap agreements
 
44,047

396,275

 
(4,768
)
182,749

 
3,137

41,576

 


Swaptions
 
6,006

1,650,000

 


 
4,028

100,000

 


TBAs
 


 
(984
)

 


 


Total
 
$
190,416

3,019,070

 
$
(38,892
)
3,692,749

 
$
38,109

361,035

 
$
(158
)
850,000


The following table provides the average monthly outstanding notional amounts of the Company's derivative financial instruments treated as trading instruments for the three and six months ended June 30, 2011:

(in thousands)
 
Three Months Ended June 30, 2011
 
Six Months Ended June 30, 2011
Trading instruments
 
Derivative Assets
 
Derivative Liabilities
 
Derivative Assets
 
Derivative Liabilities
Inverse interest-only securities
 
853,003

 

 
586,630

 

Interest rate swap agreements
 

 
2,841,319

 

 
2,067,912

Credit default swaps
 
126,477

 
129,255

 
7,261

 
67,377

Swaptions
 
1,356,593

 

 
684,159

 

TBAs
 
201,099

 
201,099

 
34,154

 
34,154


Income Statement Presentation
The following table summarizes the location and amount of gains and losses on derivative instruments reported in the consolidated statement of income on its derivative instruments.

(in thousands)
 
 
 
 
 
 
 
 
 
 
Trading Instruments
 
Location of Gain/(Loss) Recognized in Income on Derivatives
 
Amount of Gain/(Loss) Recognized in Income on Derivatives
 
Amount of Gain/(Loss) Recognized in Income on Derivatives
 
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
 
 
2011
 
2010
 
2011
 
2010
Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Interest Rate Contracts
 
 
 
 
 
 
 
 
 
 
Investment securities - RMBS
 
Gain on other derivative instruments
 
$
(381
)
 
$
(392
)
 
$
(639
)
 
$
417

Investment securities - U.S. Treasuries
 
Gain (loss) on interest rate swap and swaption agreements
 
(3,401
)
 
(1,048
)
 
(3,811
)
 
(1,048
)
Repurchase agreements
 
Gain (loss) on interest rate swap and swaption agreements
 
(47,407
)
 
(3,006
)
 
(45,058
)
 
(4,553
)
Non-Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Credit default swaps
 
Gain on other derivative instruments
 
(3,240
)
 

 
(902
)
 

Inverse interest-only securities
 
Gain on other derivative instruments
 
13,387

 
545

 
16,654

 
682

Total
 
 
 
$
(41,042
)
 
$
(3,901
)
 
$
(33,756
)
 
$
(4,502
)

15

Table of Contents

TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

For the three and six months ended June 30, 2011, the Company terminated one and five notional interest rate swap and swaption positions of $300.0 million and $650.0 million, respectively. Upon settlement of the early terminations, the Company paid $0.5 million and $0.9 million in full settlement of its net interest spread liability and recorded $1.5 million and $0.2 million in realized losses on the swaps and swaptions, respectively, including an early termination penalty.

Note 8. Fair Value
Fair Value Measurements
ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices available in active markets (i.e., observable inputs) and the lowest priority to data lacking transparency (i.e., unobservable inputs). Additionally, ASC 820 requires an entity to consider all aspects of nonperformance risk, including the entity's own credit standing, when measuring fair value of a liability.
ASC 820 establishes a three level hierarchy to be used when measuring and disclosing fair value. An instrument's categorization within the fair value hierarchy is based on the lowest level of significant input to its valuation. Following is a description of the three levels:

Level 1
Inputs are quoted prices in active markets for identical assets or liabilities as of the measurement date. Additionally, the entity must have the ability to access the active market and the quoted prices cannot be adjusted by the entity.
Level 2
Inputs include quoted prices in active markets for similar assets or liabilities; quoted prices in inactive markets for identical or similar assets or liabilities; or inputs that are observable or can be corroborated by observable market data by correlation or other means for substantially the full-term of the assets or liabilities.
Level 3
Unobservable inputs are supported by little or no market activity. The unobservable inputs represent management's best assumptions of how market participants would price the assets and liabilities. Generally, Level 3 assets and liabilities are valued using pricing models, discounted cash flow methodologies, or similar techniques that require significant judgment or estimation.

Following are descriptions of the valuation methodologies used to measure material assets and liabilities at fair value and details of the valuation models, key inputs to those models and significant assumptions utilized.
Investment securities  - The Company holds a portfolio of AFS and trading securities that are carried at fair value in the consolidated balance sheet. AFS securities are primarily composed of Agency and non-Agency RMBS while the Company's U.S. Treasuries are classified as trading securities. The Company determines the fair value of its U.S. Treasuries and Agency RMBS based upon prices obtained from third-party pricing providers or broker quotes received using bid price, which are deemed indicative of market activity. In determining the fair value of its non-Agency RMBS, management judgment is used to arrive at fair value that considers prices obtained from third-party pricing providers, broker quotes received and other applicable market data. If observable market prices are not available or insufficient to determine fair value due to principally illiquidity in the marketplace, then fair value is based upon internally developed models that are primarily based on observable market-based inputs but also include unobservable market data inputs (including prepayment speeds, delinquency levels, and credit losses). The Company classified 100% of its U.S. Treasuries as Level 1 fair value assets at June 30, 2011. The Company classified 99.8% of its RMBS available for sale securities reported at fair value as Level 2 at June 30, 2011. Available-for-sale and trading securities account for 78.8% and 17.9% of all assets reported at fair value at June 30, 2011, respectively.
Derivative instruments  - The Company may enter into a variety of derivative financial instruments as part of its hedging strategies. The Company principally executes over-the-counter, or OTC, derivative contracts, such as interest rate swaps. The Company utilizes internally developed models that are widely accepted in the market to value their over-the-counter derivative contracts. The specific terms of the contract are entered into the model, as well as market observable inputs such as interest rate forward curves and interpolated volatility assumptions. As all significant inputs into these models are market observable, the Company classified 100% of the interest rate swaps, swaptions and credit default swaps reported at fair value as Level 2 at June 30, 2011.

16

Table of Contents

TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

The Company also enters into certain other derivative financial instruments, such as TBAs and inverse interest-only securities. These instruments are similar in form to the Company's AFS securities and the Company utilizes broker quotes to value these instruments. The Company classified 100% of its inverse interest-only securities at fair value as Level 2 at June 30, 2011. The Company reported 100% of its TBAs as Level 1 as of June 30, 2011.
The Company's Risk Management Committee governs trading activity relating to derivative instruments. The Company's policy is to minimize credit exposure related to financial derivatives used for hedging, by limiting the hedge counterparties to major banks, financial institutions, exchanges, and private investors who meet established capital and credit guidelines, as well as by limiting the amount of exposure to any individual counterparty.
The Company has netting arrangements in place with all derivative counterparties pursuant to standard documentation developed by the International Swap and Derivatives Association, or ISDA. Additionally, both the Company and the counterparty are required to post cash collateral based upon the net underlying market value of the Company's open positions with the counterparty. Posting of cash collateral typically occurs daily, subject to certain dollar thresholds. Due to the existence of netting arrangements, as well as frequent cash collateral posting at low posting thresholds, credit exposure to the Company and/or to the counterparty is considered materially mitigated. Based on the Company's assessment, there is no requirement for any additional adjustment to derivative valuations specifically for credit.
Recurring Fair Value
The following tables display the Company's assets and liabilities measured at fair value on a recurring basis. The Company often economically hedges the fair value change of its assets or liabilities with derivatives and other financial instruments. The tables below display the hedges separately from the hedged items, and therefore do not directly display the impact of the Company's risk management activities.

 
Recurring Fair Value Measurements
 
At June 30, 2011
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$

 
$
4,491,625

 
$
9,200

 
$
4,500,825

Trading securities
1,022,394

 

 

 
1,022,394

Derivative assets

 
190,416

 

 
190,416

Total assets
$
1,022,394

 
$
4,682,041

 
$
9,200

 
$
5,713,635

Liabilities
 
 
 
 
 
 
 
Derivative liabilities
$
984

 
$
37,908

 
$

 
$
38,892

Total liabilities
$
984

 
$
37,908

 
$

 
$
38,892


 
Recurring Fair Value Measurements
 
At December 31, 2010
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$

 
$
1,345,805

 
$
8,600

 
$
1,354,405

Trading securities
199,523

 

 

 
199,523

Derivative assets

 
38,109

 

 
38,109

Total assets
$
199,523

 
$
1,383,914

 
$
8,600

 
$
1,592,037

Liabilities
 
 
 
 
 
 
 
Derivative liabilities
$

 
$
158

 
$

 
$
158

Total liabilities
$

 
$
158

 
$

 
$
158


The valuation of Level 3 instruments requires significant judgment by the third-party pricing providers and/or management. The third-party pricing providers and/or management rely on inputs such as market price quotations from

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TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

market makers (either market or indicative levels), original transaction price, recent transactions in the same or similar instruments, and changes in financial ratios or cash flows to determine fair value. Level 3 instruments may also be discounted to reflect illiquidity and/or non-transferability, with the amount of such discount estimated by the third-party pricing provider in the absence of market information. Assumptions used by the third-party pricing provider due to lack of observable inputs may significantly impact the resulting fair value and therefore the Company's financial statements. The Company's valuation committee reviews all valuations that are based on pricing information received from a third-party pricing provider. As part of this review, prices are compared against other pricing or input data points in the marketplace, along with internal valuation expertise, to ensure the pricing is reasonable. In addition, the Company performs back-testing of pricing information to validate price information and identify any pricing trends of a third-party price provider.
In determining fair value, third-party pricing providers use various valuation approaches, including market and income approaches. Inputs that are used in determining fair value of an instrument may include pricing information, credit data, volatility statistics, and other factors. In addition, inputs can be either observable or unobservable.
The availability of observable inputs can vary by instrument and is affected by a wide variety of factors, including the type of instrument, whether the instrument is new and not yet established in the marketplace and other characteristics particular to the instrument. The third-party pricing provider uses prices and inputs that are current as of the measurement date, including during periods of market dislocations. In periods of market dislocation, the availability of prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified to or from various levels within the fair value hierarchy.
Securities for which market quotations are readily available are valued at the bid price (in the case of long positions) or the ask price (in the case of short positions) at the close of trading on the date as of which value is determined. Exchange-traded securities for which no bid or ask price is available are valued at the last traded price.
OTC derivative contracts, including interest rate swaps, are valued by the Company using observable inputs, such as quotations received from the counterparty, dealers or brokers, whenever available and considered reliable. In instances where models are used, the value of an OTC derivative depends upon the contractual terms of, and specific risks inherent in, the instrument as well as the availability and reliability of observable inputs. Such inputs include market prices for reference securities, yield curves, credit curves, volatility measures, prepayment rates and correlation of such inputs. Certain OTC derivatives, such as swaps, have inputs which can generally be corroborated by market data and are therefore classified within Level 2.
The table below presents the reconciliation for all of the Company's Level 3 assets and liabilities measured at fair value on a recurring basis. The Level 3 items presented below may be hedged by derivatives and other financial instruments that are classified as Level 1 or Level 2. Thus, the table below does not fully reflect the impact of the Company's risk management activities.

 
Level 3 Recurring Fair Value Measurements
 
Three Months Ended June 30, 2011
 
 
 
Total Net Gains Included in Net Income
 
 
 
 
 
 
 
 
 
 
(in thousands)
Beginning of Period Level 3 Fair Value
 
Realized Gains
 
Unrealized Gains
 
Other Comprehensive Income
 
Gross Purchases, Sales and Settlements (b)
 
Gross Transfers Into Level 3
 
Gross Transfers Out of Level 3
 
End of Period Level 3 Fair Value
Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Available-for-sale securities
$
9,100

 
$
24

 
$

 
$
76

(a)
$

 
$

 
$

 
$
9,200

Derivative assets

 

 

 

 

 

 

 

Total assets
$
9,100

 
$
24

 
$

 
$
76

 
$

 
$

 
$

 
$
9,200


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TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

 
Level 3 Recurring Fair Value Measurements
 
Six Months Ended June 30, 2011
 
 
 
Total Net Gains Included in Net Income
 
 
 
 
 
 
 
 
 
 
(in thousands)
Beginning of Period Level 3 Fair Value
 
Realized Gains
 
Unrealized Gains
 
Other Comprehensive Income
 
Gross Purchases, Sales and Settlements (b)
 
Gross Transfers Into Level 3
 
Gross Transfers Out of Level 3
 
End of Period Level 3 Fair Value
Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Available-for-sale securities
$
8,600

 
$
47

 
$

 
$
553

(a)
$

 
$

 
$

 
$
9,200

Derivative assets

 

 

 

 

 

 

 

Total assets
$
8,600

 
$
47

 
$

 
$
553

 
$

 
$

 
$

 
$
9,200

____________________
(a) Change in unrealized gains on AFS securities recorded in equity as accumulated other comprehensive income.
(b)    There were no purchases, sales or settlements of the Company's Level 3 assets and liabilities during the three and six months ended June 30, 2011.
The Company did not incur transfers between Level 1 and Level 2 or Level 2 and Level 3 for the three and six months ended June 30, 2011. Transfers between Levels are deemed to take place on the first day of the reporting period in which the transfer has taken place.
Nonrecurring Fair Value
The Company may be required to measure certain assets or liabilities at fair value from time to time. These periodic fair value measures typically result from application of certain impairment measures under GAAP. These items would constitute nonrecurring fair value measures under ASC 820. As of June 30, 2011, the Company did not have any assets or liabilities measured at fair value on a nonrecurring basis. 
Fair Value of Financial Instruments
In accordance with ASC 820, the Company is required to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the consolidated balance sheet, for which fair value can be estimated.
The following describes the Company's methods for estimating the fair value for financial instruments. Descriptions are not provided for those items that have zero balances as of the current balance sheet date.
AFS securities, trading securities, derivative assets and liabilities are recurring fair value measurements; carrying value equals fair value. See discussion of valuation methods and assumptions within the Fair Value Measurements section of this footnote.
Cash and cash equivalents and restricted cash have a carrying value which approximates fair value because of the short maturities of these instruments.
The carrying value of repurchase agreements approximates fair value due to the maturities of less than one year of these financial instruments. The Company's repurchase agreements have floating rates based on an index plus a spread. These borrowings have been recently entered into and the credit spread is typically consistent with those demanded in the market. Accordingly, the interest rates on these borrowings are at market and thus carrying value approximates fair value.

Note 9. Repurchase Agreements
The Company had outstanding $4.8 billion of repurchase agreements, including repurchase agreements funding the Company's U.S. Treasuries of $1.0 billion. Excluding the debt associated with the Company's U.S. Treasuries and the effect of the Company's interest rate swaps, the repurchase agreements had a weighted average borrowing rate of 0.52% and weighted average remaining maturities of 86 days as of June 30, 2011. The Company had outstanding $1.2 billion of repurchase agreements with a weighted average borrowing rate of 0.74% excluding the effect of the Company's interest rate swaps, and weighted average remaining maturities of 90 days as of December 31, 2010. As of June 30, 2011 and December 31, 2010, the debt associated with the Company's U.S. Treasuries had a weighted average borrowing rate of 0.07% and 0.28%, respectively.

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TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

At June 30, 2011 and December 31, 2010, the repurchase agreements had the following characteristics:

(dollars in thousands)
 
June 30, 2011
 
December 31, 2010
Collateral Type
 
Amount Outstanding
 
Weighted Average Borrowing Rate
 
Amount Outstanding
 
Weighted Average Borrowing Rate
U.S. Treasuries
 
$
1,019,400

 
0.07
%
 
$
198,750

 
0.28
%
Agency RMBS
 
3,355,189

 
0.32
%
 
745,861

 
0.37
%
Non-Agency RMBS
 
375,613

 
2.24
%
 
201,976

 
2.05
%
Agency derivatives
 
77,000

 
0.87
%
 
23,216

 
1.07
%
Total
 
$
4,827,202

 
0.42
%
 
$
1,169,803

 
0.66
%

As of June 30, 2011, the Company's amounts outstanding under repurchase agreements includes $64.3 million of borrowings under the 364-day repurchase facility with Wells Fargo Bank National Association, or Wells Fargo. As of June 30, 2011, the facility provided an aggregate maximum borrowing capacity of $75 million and it was set to mature on August 3, 2011. See Note 16 - Subsequent Events. The facility is collateralized by non-Agency RMBS and its weighted average borrowing rate as of June 30, 2011 was 1.9%. The facility also subjects the Company to maintain certain financial covenants under the guaranty agreement with Wells Fargo. As of June 30, 2011, the Company is in compliance with these covenants.
As of June 30, 2011, the Company does not have any borrowings outstanding under the 364-day repurchase facility with Barclays Bank PLC, or Barclays. The facility provides an aggregate maximum borrowing capacity of $100 million and it is set to mature on May 16, 2012, unless extended pursuant to its terms. The facility will be collateralized by eligible residential mortgage loans, which will be subject to margin call provisions that provide Barclays with certain rights when there has been a decline in the market value of the purchased mortgage loans. The facility also subjects the Company to maintain certain financial covenants under the guaranty agreement with Barclays. As of June 30, 2011, the Company is in compliance with these covenants.
At June 30, 2011 and December 31, 2010, the repurchase agreements had the following remaining maturities:
(in thousands)
June 30,
2011
 
December 31,
2010
Within 30 days
$
1,223,115

 
$
197,286

30 to 59 days (1)
325,876

 
211,556

60 to 89 days
603,752

 
117,621

90 to 119 days
718,158

 
152,433

Over 120 days
936,901

 
292,157

Open maturity (2)
1,019,400

 
198,750

Total
$
4,827,202

 
$
1,169,803

____________________
(1)
30 to 59 days includes the amounts outstanding under the Wells Fargo 364-day borrowing facility.
(2)
Repurchase agreements collateralized by U.S. Treasuries include an open maturity period (i.e., rolling 1-day maturity) renewable at the discretion of either party to the agreements.


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TWO HARBORS INVESTMENT CORP.  
Notes to the Consolidated Financial Statements - (continued)

The following table summarizes assets at carrying value that are pledged or restricted as collateral for the future payment obligations of repurchase agreements:

(in thousands)
June 30,
2011
 
December 31,
2010
Available-for-sale securities, at fair value
$
4,114,269

 
$
1,090,598

Trading securities, at fair value
1,022,394

 
199,523

Cash and cash equivalents
15,000

 
14,467

Restricted cash
18,152

 
11,634

Due from counterparties
13,237

 
10,508

Derivative assets, at fair value
107,006

 
30,534

Total