TWO 9.30.11 10Q document

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: September 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 November 4, 2011 there were 140,593,845 shares of common stock, par value $.01 per share, issued and outstanding.

TWO HARBORS INVESTMENT CORP.

INDEX



		Page
	PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements (unaudited)	1
	Condensed Consolidated Balance Sheets at September 30, 2011 and December 31, 2010	1
	Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2011 and 2010	2
	Condensed Consolidated Statements of Stockholders' Equity and Comprehensive (Loss) Income for the Nine Months Ended September 30, 2011 and 2010	3
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2011 and 2010	4
	Notes to Condensed Consolidated Financial Statements	5
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	27
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	48
Item 4.	Controls and Procedures	52
	PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	53
Item 1A.	Risk Factors	53
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	53
Item 3.	Defaults Upon Senior Securities	53
Item 4.	[Removed and Reserved]	53
Item 5.	Other Information	53
Item 6.	Exhibits	53
Signatures		54
Index of Exhibits		55

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

TWO HARBORS INVESTMENT CORP.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)



	September 30, 2011			December 31, 2010
	(unaudited)
ASSETS
Available-for-sale securities, at fair value	$	6,412,895		$	1,354,405
Trading securities, at fair value	1,526,330			199,523
Cash and cash equivalents	409,947			163,900
Total earning assets	8,349,172			1,717,828
Restricted cash	164,276			22,548
Accrued interest receivable	25,510			5,383
Due from counterparties	33,918			12,304
Derivative assets, at fair value	245,314			38,109
Other assets	619			1,260
Total Assets	$	8,818,809		$	1,797,432
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
Repurchase agreements	$	7,300,613		$	1,169,803
Derivative liabilities, at fair value	46,182			158
Accrued interest payable	5,442			785
Due to counterparties	90,880			231,724
Accrued expenses and other liabilities	7,747			2,063
Dividends payable	56,235			10,450
Other liabilities	4,579			1
Total liabilities	7,511,678			1,414,984
Stockholders’ Equity
Preferred stock, par value $0.01 per share; 50,000,000 shares authorized; no shares issued and outstanding	—			—
Common stock, par value $0.01 per share; 450,000,000 shares authorized and 140,586,736 and 40,501,212 shares issued and outstanding, respectively	1,406			405
Additional paid-in capital	1,372,944			366,974
Accumulated other comprehensive (loss) income	(26,325		)	22,619
Cumulative earnings	106,022			30,020
Cumulative distributions to stockholders	(146,916		)	(37,570		)
Total stockholders’ equity	1,307,131			382,448
Total Liabilities and Stockholders’ Equity	$	8,818,809		$	1,797,432

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

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TWO HARBORS INVESTMENT CORP.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except share data)



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2011			2010			2011			2010
	(unaudited)						(unaudited)
Interest income:
Available-for-sale securities	$	65,919		$	11,823		$	125,413		$	27,064
Trading securities	1,706			15			2,783			15
Cash and cash equivalents	114			27			241			70
Total interest income	67,739			11,865			128,437			27,149
Interest expense	7,218			1,395			13,580			2,777
Net interest income	60,521			10,470			114,857			24,372
Other-than-temporary impairments:
Total other-than-temporary impairment losses	(3,371		)	—			(3,665		)	—
Non-credit portion of loss recognized in other comprehensive income (loss)	—			—			—			—
Net other-than-temporary credit impairment losses	(3,371		)	—			(3,665		)	—
Other income:
Gain on investment securities, net	31,432			2,577			36,159			4,608
Loss on interest rate swap and swaption agreements	(39,311		)	(4,436		)	(88,180		)	(10,037		)
Gain on other derivative instruments	22,361			3,098			37,474			4,197
Total other income (loss)	14,482			1,239			(14,547		)	(1,232		)
Expenses:
Management fees	4,785			862			9,063			2,068
Other operating expenses	2,850			1,213			6,516			3,332
Total expenses	7,635			2,075			15,579			5,400
Net income before income taxes	63,997			9,634			81,066			17,740
Benefit from (provision for) income taxes	(9,388		)	246			(5,064		)	1,555
Net income attributable to common stockholders	$	54,609		$	9,880		$	76,002		$	19,295
Basic and diluted earnings per weighted average common share	$	0.42		$	0.38		$	0.90		$	0.93
Dividends declared per common share	$	0.40		$	0.39		$	1.20		$	1.08
Basic and diluted weighted average number of shares of common stock	130,607,566			26,126,212			84,751,854			20,691,461

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

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TWO HARBORS INVESTMENT CORP.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

AND COMPREHENSIVE (LOSS) INCOME

(in thousands, except share data)



	Common Stock
	Shares	Amount		Additional Paid-in Capital		Accumulated Other Comprehensive (Loss) 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	—	—		—		—			19,295			—			19,295
Net change in unrealized gain on available-for-sale securities	—	—		—		17,001			—			—			17,001
Total other comprehensive income	—	—		—		17,001			—			—			—
Total comprehensive income															36,296
Net proceeds from issuance of common stock, net of offering costs	12,688,381	127		106,699		—			—			—			106,826
Common dividends declared	—	—		—		—			—			(23,635		)	(23,635		)
Non-cash equity award compensation	36,463	—		145		—			—			—			145
Balance, September 30, 2010	26,126,212	$	261	$	238,600	$	16,051		$	13,560		$	(27,119	)	$	241,353

Balance, January 1, 2011	40,501,212	$	405	$	366,974	$	22,619		$	30,020		$	(37,570	)	$	382,448
Net income	—	—		—		—			76,002			—			76,002
Net change in unrealized losses on available-for-sale securities	—	—		—		(48,944		)	—			—			(48,944		)
Total other comprehensive loss	—	—		—		(48,944		)	—			—			—
Total comprehensive income															27,058
Net proceeds from issuance of common stock, net of offering costs	100,077,925	1,001		1,005,754		—			—			—			1,006,755
Common dividends declared	—	—		—		—			—			(109,346		)	(109,346		)
Non-cash equity award compensation	7,599	—		216		—			—			—			216
Balance, September 30, 2011	140,586,736	$	1,406	$	1,372,944	$	(26,325	)	$	106,022		$	(146,916	)	$	1,307,131

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

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TWO HARBORS INVESTMENT CORP.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



	Nine Months Ended
	September 30,
	2011			2010
	(unaudited)
Cash Flows From Operating Activities:
Net income	$	76,002		$	19,295
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of premiums and discounts on RMBS, net	(57		)	1,987
Other-than-temporary impairment losses	3,665			—
Gain on investment securities, net	(36,159		)	(4,608		)
Loss on termination of interest rate swaps and swaptions	18,074			2,486
Unrealized loss on interest rate swaps and swaptions	51,474			5,357
Unrealized gain on other derivative instruments	(20,144		)	(1,025		)
Equity based compensation expense	216			145
Net change in:
Increase in accrued interest receivable	(20,127		)	(1,671		)
Decrease/(increase) in deferred income taxes, net	4,136			(1,162		)
Increase in prepaid tax asset	—			400
Decrease in prepaid and fixed assets	155			432
Increase in accrued interest payable, net	4,657			526
Increase in income taxes payable, net	928			—
Increase in accrued expenses and other liabilities	5,684			752
Net cash provided by operating activities	88,504			22,914
Cash Flows From Investing Activities:
Purchases of available-for-sale securities	(6,295,100		)	(888,466		)
Proceeds from sales of available-for-sale securities	1,004,248			247,858
Principal payments on available-for-sale securities	208,965			78,520
Purchases of other derivative instruments	(233,764		)	(38,896		)
Proceeds from sales of other derivative instruments	23,179			26,632
Purchases of trading securities	(2,019,959		)	(58,189		)
Proceeds from sales of trading securities	700,156			58,516
Decrease in due to/from counterparties, net	(162,458		)	(10,978		)
Increase in restricted cash	(141,728		)	(18,814		)
Net cash used in investing activities	(6,916,461		)	(603,817		)
Cash Flows From Financing Activities:
Proceeds from repurchase agreements	19,621,767			3,043,458
Principal payments on repurchase agreements	(13,490,957		)	(2,512,357		)
Proceeds from issuance of common stock, net of offering costs	1,006,755			106,826
Dividends paid on common stock	(63,561		)	(16,930		)
Net cash provided by financing activities	7,074,004			620,997
Net increase in cash and cash equivalents	246,047			40,094
Cash and cash equivalents at beginning of period	163,900			26,105
Cash and cash equivalents at end of period	$	409,947		$	66,199
Supplemental Disclosure of Cash Flow Information:
Cash paid for interest	$	8,923		$	2,251
Cash paid for taxes	$	1		$	(497	)
Non-Cash Financing Activity:
Dividends declared but not paid at end of period	$	56,235		$	10,189

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

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements

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 September 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 September 30, 2011 continued to focus on establishing underwriting guidelines and originator relationships, addressing regulatory requirements and building an infrastructure to support a sustainable 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 September 30, 2011 and results of operations for all periods presented have been made. The results of operations for the three and nine months ended September 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 Condensed Consolidated Financial Statements - (continued)

Recently Issued and/or Adopted Accounting Standards

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.

Investment Company

In October 2011, the Financial Accounting Standards Board (FASB) issued two exposure drafts, Proposed Accounting Standards Update—Financial Services—Investment Companies (Topic 946): Amendments to the Scope, Measurement, and Disclosure Requirements and Proposed Accounting Standards Update—Real Estate—Investment Property Entities (Topic 973), that redefine an investment company and how it accounts for investments. The proposals eliminate the current scope exception for real estate investment trusts (REITs) and would require a REIT to assess itself under the FASB investment company act definition and adopt fair value accounting if it meets the criteria. The FASB has requested comments on these exposure drafts be submitted by January 5, 2012. Management is currently assessing the impacts of these exposure drafts.

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 September 30, 2011 and December 31, 2010:



(in thousands)	September 30, 2011		December 31, 2010
Mortgage-backed securities:
Agency
Federal Home Loan Mortgage Corporation	$	1,656,815	$	396,888
Federal National Mortgage Association	2,460,994		556,609
Government National Mortgage Association	1,038,885		62,972
Non-Agency	1,256,201		337,936
Total mortgage-backed securities	$	6,412,895	$	1,354,405

At September 30, 2011 and December 31, 2010, the Company pledged investment securities with a carrying value of $6.3 billion and $1.1 billion, respectively, as collateral for repurchase agreements. See Note 9 - Repurchase Agreements.

At September 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.

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed 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 September 30, 2011 and December 31, 2010:



	September 30, 2011
(in thousands)	Agency			Non-Agency			Total
Face Value	$	5,858,947		$	2,667,159		$	8,526,106
Unamortized premium	292,879			—			292,879
Unamortized discount
Designated credit reserve	—			(772,938		)	(772,938		)
Net, unamortized	(1,051,498		)	(555,329		)	(1,606,827		)
Amortized Cost	5,100,328			1,338,892			6,439,220
Gross unrealized gains	83,727			16,624			100,351
Gross unrealized losses	(27,361		)	(99,315		)	(126,676		)
Carrying Value	$	5,156,694		$	1,256,201		$	6,412,895



	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 September 30, 2011 and December 31, 2010:



	September 30, 2011
(in thousands)	Agency		Non-Agency		Total
Adjustable Rate	$	239,229	$	1,046,844	$	1,286,073
Fixed Rate	4,917,465		209,357		5,126,822
Total	$	5,156,694	$	1,256,201	$	6,412,895



	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

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed 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 the amortized cost will exceed the present value of expected future cash flows. The amount of principal that the Company does not amortize into income is designated as a credit reserve on the security, with unamortized net discounts or premiums amortized into income over time using the interest method in accordance with ASC 320.

The following table presents the changes for the nine months ended September 30, 2011 and September 30, 2010 of the unamortized net discount and designated credit reserves on non-Agency AFS securities.



	Nine Months Ended September 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	(640,451		)	(483,479		)	(1,123,930		)	(105,897		)	(98,264		)	(204,161		)
Accretion of net discount	—			32,305			32,305			—			6,654			6,654
Realized credit losses	3,011			—			3,011			1,409			8			1,417
Reclassification adjustment for other-than-temporary impairments	(3,665		)	—			(3,665		)	—			—			—
Transfers from (to)	579			(579		)	—			705			(705		)	—
Sales, calls, other	13,443			26,416			39,859			18,630			17,779			36,409
Ending balance at September 30	$	(772,938	)	$	(555,329	)	$	(1,328,267	)	$	(135,340	)	$	(115,578	)	$	(250,918	)

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 September 30, 2011 and December 31, 2010. At September 30, 2011, the Company held 1,081 AFS securities, of which 338 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
September 30, 2011	$	1,895,965	$	(125,479	)	$	3,103	$	(1,197	)	$	1,899,068	$	(126,676	)
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.

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements - (continued)

The Company recorded a $3.4 million and a $3.7 million other-than-temporary credit impairment during the three and nine months ended September 30, 2011 on a total of eight non-Agency RMBS where the future expected cash flows for each security was less than its amortized cost. As of September 30, 2011, the impaired securities had weighted average cumulative losses of 5.2%, weighted average three-month prepayment speed of 4.54, weighted average 60+ day delinquency of 35.0% of the pool balance, and weighted average FICO score of 643.

The following table presents the OTTI included in earnings for the three and nine months ended September 30, 2011 and September 30, 2010:



	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(in thousands)	2011			2010		2011			2010
Cumulative credit loss at beginning of period	$	(294	)	$	—	$	—		$	—
Additions:
Other-than-temporary impairments not previously recognized	(3,371		)	—		(3,665		)	—
Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments	—			—		—			—
Cumulative credit loss at September 30	$	(3,665	)	$	—	$	(3,665	)	$	—

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 condensed consolidated statements of income. For the three and nine months ended September 30, 2011, the Company sold AFS securities for $908.5 million and $1.0 billion with an amortized cost of $881.0 million and $975.1 million, for a net realized gain of $27.5 million and $29.2 million, respectively.

The following table presents the gross realized gains and losses on sales of AFS securities for the three and nine months ended September 30, 2011 and 2010:



	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(in thousands)	2011		2010			2011			2010
Gross realized gains	$	27,472	$	2,276		$	29,422		$	4,582
Gross realized losses	—		(27		)	(265		)	(303		)
Total realized gains (losses) on sales, net	$	27,472	$	2,249		$	29,157		$	4,279

Note 4. Trading Securities, at Fair Value

During the nine months ended September 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 September 30, 2011 and December 31, 2010, the Company held U.S. Treasuries with an amortized cost of $1.5 billion and $200.0 million and a fair value $1.5 billion and $199.5 million, respectively. The unrealized gains and losses included within trading securities was a positive $5.5 million as of September 30, 2011 and a negative $0.5 million as of December 31, 2010.

For the three and nine months ended September 30, 2011, the Company sold trading securities for $200.0 million and $700.1 million with an amortized cost of $199.7 million and $699.1 million resulting in realized gains of $0.3 million and $1.0 million, respectively, on the sale of these investment securities. For the three and nine months ended September 30, 2011, trading securities experienced unrealized gains of $3.7 million and $6.0 million, respectively. Both realized and unrealized gains are recorded as a component of gains on investment securities, net in the Company's condensed consolidated statement of income.

At September 30, 2011, the Company pledged trading securities with a carrying value of $1.5 billion as collateral for repurchase agreements. See Note 9 - Repurchase Agreements.

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements - (continued)

Note 5. Restricted Cash

As of September 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.

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



(in thousands)	September 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	71,220		1,914
Repurchase counterparties as restricted collateral	84,056		11,634
Total	$	164,276	$	22,548

Note 6. Accrued Interest Receivable

The following table presents the Company's accrued interest receivable by collateral type:



(in thousands)	September 30, 2011		December 31, 2010
Accrued Interest Receivable:
U.S. Treasuries	$	2,516	$	192
Mortgage-backed securities:
Agency
Federal Home Loan Mortgage Corporation	6,114		1,509
Federal National Mortgage Association	10,104		2,201
Government National Mortgage Association	4,479		532
Non-Agency	2,297		949
Total mortgage-backed securities	22,994		5,191
Total	$	25,510	$	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

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements - (continued)

Agency pools. To mitigate the impact of this risk, the Company maintains a portfolio of financial instruments, primarily 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 changes in prepayment speeds.

As of September 30, 2011 and December 31, 2010, the Company had outstanding fair value of $53.2 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 condensed consolidated balance sheets. In addition, the Company holds TBA positions with $375.0 million in long notional and $2.0 billion in short notional as of September 30, 2011. The Company discloses these on a gross basis according to the unrealized gain or loss position of each TBA contract regardless of long or short notional position. As of September 30, 2011, these contracts held a fair market value of $9.6 million, included in derivative assets, at fair value, and $2.0 million, included in derivative liabilities, at fair value, in the condensed consolidated balance sheet as of September 30, 2011. 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 September 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)
September 30, 2011
Swaps Maturities	Notional Amounts	Average Fixed Pay Rate		Average Receive Rate		Average Maturity (Years)
2012	25,000	0.868	%	0.295	%	1.23
2013	1,275,000	0.795	%	0.292	%	1.63
2014	1,275,000	0.670	%	0.355	%	2.97
2015	820,000	1.575	%	0.299	%	3.77
2016	240,000	2.156	%	0.276	%	4.57
Total	3,635,000	1.017	%	0.315	%	2.77



(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	%	0.343	%	0.96
2012	25,000	0.868	%	0.308	%	1.98
2013	175,000	1.376	%	0.306	%	2.61
2014	175,000	1.671	%	0.303	%	3.96
2015	175,000	1.830	%	0.287	%	4.84
Total	650,000	1.526	%	0.306	%	3.29

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements - (continued)

The Company has also entered into interest rate swaps in combination with U.S. Treasuries and other RMBS to economically hedge funding cost and macro-financing risk. As of September 30, 2011 and December 31, 2010, the Company held $1.5 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)
September 30, 2011
Swaps Maturities	Notional Amounts	Average Fixed Pay Rate		Average Receive Rate		Average Maturity (Years)
2013	1,750,000	0.659	%	0.28433	%	1.75
Total	1,750,000



(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, except the following interest rate swap entered in combination with TBA contracts to economically hedge mortgage basis widening where the Company pays interest at a 3-month LIBOR rate:



(notional in thousands)
September 30, 2011
Swaps Maturities	Notional Amounts	Average Pay Rate		Average Fixed Receive Rate		Average Maturity (Years)
2016	325,000	0.264	%	1.772	%	4.83
Total	325,000

The Company did not hold any interest rate swaps in combination with TBA contracts as of December 31, 2010.

Additionally, as of September 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:



September 30, 2011
(notional and dollars in thousands)	Option						Underlying Swap
Swaption	Expiration	Cost		Fair Value		Average Months to Expiration	Notional Amount	Average Fixed Pay Rate		Average Receive Rate	Average Term (Years)
Payer	< 6 Months	$	10,511	$	97	5.30	575,000	3.18	%	3M Libor	4.65
Payer	≥ 6 Months	14,646		2,749		11.65	1,875,000	3.09	%	3M Libor	4.04
Total Payer		$	25,157	$	2,846	11.60	2,450,000	3.11	%	3M Libor	4.18

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements - (continued)

December 31, 2010

(notional and dollars in thousands)

Option

Underlying Swap

Swaption

Expiration

Cost

Fair Value

Average Months to Expiration

Notional Amount

Average Fixed Pay Rate

Average Receive Rate

Average Term (Years)

Payer

≥ 6 Months

3,348

4,028

11.25

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 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.

For non-Agency investment securities, the Company currently enters into 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 September 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 September 30, 2011:



(notional and dollars in thousands)
September 30, 2011
Protection	Maturity Date	Average Implied Credit Spread	Current Notional Amount		Fair Value		Upfront (Payable)/Receivable			Unrealized Gain/(Loss)
Receive	9/20/2013	460.00	(45,000	)	$	2,802	$	(3,126	)	$	(324	)
	12/20/2013	370.00	(5,000	)	$	346	$	(294	)	$	52
	6/20/2016	264.23	(250,000	)	$	12,649	$	(480	)	$	12,169
	5/25/2046	356.00	(95,954	)	$	54,413	$	(42,930	)	$	11,483
	Total	310.06	(395,954	)	$	70,210	$	(46,830	)	$	23,380

The Company did not hold any credit default swaps where the Company receives credit protection as of December 31, 2010.

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements - (continued)

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 September 30, 2011, the fair value of derivative financial instruments as an asset and liability position was $245.3 million and $46.2 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 September 30, 2011, the Company has received cash deposits from counterparties of $34.0 million and placed cash deposits of $89.2 million in accounts maintained by counterparties, of which the amounts are netted on a counterparty basis and classified within restricted cash, due from counterparties, or due to counterparties on the condensed consolidated balance sheet.

In accordance with ASC 815, as amended and interpreted, the Company records derivative financial instruments on its condensed consolidated balance sheet as assets or liabilities at fair value. Changes in fair value are accounted for depending on the use of the derivative instruments and whether they qualify for hedge accounting treatment. Due to the volatility of the credit markets and difficulty in effectively matching pricing or cash flows, the Company has elected to treat all current derivative contracts as trading instruments.

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.

Inverse interest-only securities with a carrying value of $162.7 million, including accrued interest receivable of $2.2 million, are accounted for as derivative financial instruments in the condensed consolidated financial statements. The following table presents the amortized cost and carrying value (which approximates fair value) of inverse interest-only securities as of September 30, 2011 and December 31, 2010:



(in thousands)	September 30, 2011			December 31, 2010
Face Value	$	1,167,563		$	219,459
Unamortized premium	—			—
Unamortized discount
Designated credit reserve	—			—
Net, unamortized	(1,005,236		)	(190,162		)
Amortized Cost	162,327			29,297
Gross unrealized gains	5,888			1,902
Gross unrealized losses	(7,742		)	(665		)
Carrying Value	$	160,473		$	30,534

As of September 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.

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements - (continued)

The following tables present credit default swaps where the Company is providing protection held as of September 30, 2011 and December 31, 2010:



(notional and dollars in thousands)
September 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	117,043	$	7,372		$	(12,232	)	$	(4,860	)
	5/25/2046	146.18	57,355	$	(17,836	)	$	13,574		$	(4,262	)
	Total	289.64	174,398	$	(10,464	)	$	1,342		$	(9,122	)



(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	)

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 September 30, 2011 and December 31, 2010.



(in thousands)	September 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	$	162,703	1,167,563	$	—		—	$	30,944	219,459	$	—		—
Interest rate swap agreements	—		—	(33,726		)	5,060,000	—		—	(158		)	850,000
Credit default swap agreements	70,210		395,954	(10,464		)	174,398	3,137		41,576	—			—
Swaptions	2,846		2,450,000	—			—	4,028		100,000	—			—
TBAs	9,555		875,000	(1,992		)	750,000	—		—	—			—
Total	$	245,314	4,888,517	$	(46,182	)	5,984,398	$	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 nine months ended September 30, 2011:



(in thousands)	Three Months Ended September 30, 2011		Nine Months Ended September 30, 2011
Trading instruments	Derivative Assets	Derivative Liabilities	Derivative Assets	Derivative Liabilities
Inverse interest-only securities	1,135,141	—	771,476	—
Interest rate swap agreements	—	4,267,609	—	2,809,212
Credit default swaps	385,824	177,461	138,119	117,610
Swaptions	2,129,348	—	1,117,563	—
TBAs	545,109	1,230,435	85,834	132,621

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements - (continued)

Income Statement Presentation

The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed 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 September 30,						Nine Months Ended September 30,
		2011			2010			2011			2010
Risk Management Instruments
Interest Rate Contracts
Investment securities - RMBS	Gain on other derivative instruments	$	5,729		$	1,214		$	5,091		$	1,631
Investment securities - U.S. Treasuries and TBA contracts	Loss on interest rate swap and swaption agreements	6,544			(1,251		)	2,733			(2,299		)
Repurchase agreements	Loss on interest rate swap and swaption agreements	(45,855		)	(3,184		)	(90,913		)	(7,738		)
Credit default swaps - Receive protection	Gain on other derivative instruments	21,994			—			22,267			—
Non-Risk Management Instruments
Credit default swaps - Provide protection	Gain on other derivative instruments	(4,414		)	—			(5,589		)	—
Inverse interest-only securities	Gain on other derivative instruments	(948		)	1,884			15,705			2,566
Total		$	(16,950	)	$	(1,337	)	$	(50,706	)	$	(5,840	)

For the three and nine months ended September 30, 2011, the Company terminated 24 and 29 notional interest rate swap and swaption positions of $1.9 billion and $2.5 billion, respectively. Upon settlement of the early terminations, the Company paid $4.2 million and $5.1 million in full settlement of its net interest spread liability and recorded $17.8 million and $18.1 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.

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements - (continued)

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 condensed 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 September 30, 2011. The Company classified 99.8% of its RMBS AFS securities reported at fair value as Level 2 at September 30, 2011. AFS and trading securities account for 78.4% and 18.6%, respectively, of all assets reported at fair value at September 30, 2011.

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 its OTC 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 September 30, 2011.

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 September 30, 2011. The Company reported 100% of its TBAs as Level 1 as of September 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.

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements - (continued)

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 September 30, 2011
(in thousands)	Level 1		Level 2		Level 3		Total
Assets
Available-for-sale securities	$	—	$	6,402,075	$	10,820	$	6,412,895
Trading securities	1,526,330		—		—		1,526,330
Derivative assets	9,555		235,759		—		245,314
Total assets	$	1,535,885	$	6,637,834	$	10,820	$	8,184,539
Liabilities
Derivative liabilities	$	1,992	$	44,190	$	—	$	46,182
Total liabilities	$	1,992	$	44,190	$	—	$	46,182



	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 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

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements - (continued)

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 September 30, 2011
			Total Net Gains/(Losses) Included in Net Income
(in thousands)	Beginning of Period Level 3 Fair Value		Realized Gains/(Losses)			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	$	9,200	$	(254	)	$	—	$	40	(a)	$	1,834	$	—	$	—	$	10,820
Total assets	$	9,200	$	(254	)	$	—	$	40		$	1,834	$	—	$	—	$	10,820



	Level 3 Recurring Fair Value Measurements
	Nine Months Ended September 30, 2011
			Total Net Gains/(Losses) Included in Net Income
(in thousands)	Beginning of Period Level 3 Fair Value		Realized Gains/(Losses)			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	$	(208	)	$	—	$	594	(a)	$	1,834	$	—	$	—	$	10,820
Total assets	$	8,600	$	(208	)	$	—	$	594		$	1,834	$	—	$	—	$	10,820

____________________

(a) Change in unrealized gains on AFS securities is recorded in equity as accumulated other comprehensive income.


(b)	The Company purchased one Level 3 asset during the three and nine months ended September 30, 2011. However, there were no sales or settlements of the Company's Level 3 assets and liabilities during the three and nine months ended September 30, 2011.

The Company did not incur transfers between Level 1 and Level 2 or Level 2 and Level 3 for the three and nine months ended September 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 September 30, 2011, the Company did not have any assets or liabilities measured at fair value on a nonrecurring basis.

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TWO HARBORS INVESTMENT CORP.

Notes to the Condensed Consolidated Financial Statements - (continued)

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 condensed 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.