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, 2012

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
As of August 3, 2012 there were 279,354,704 shares of outstanding common stock, par value $.01 per share, issued and outstanding.
 
 
 
 
 


Table of Contents



TWO HARBORS INVESTMENT CORP.
INDEX

 
 
Page
 
PART I - FINANCIAL INFORMATION
 
 
 
 
 
 
 
PART II - OTHER INFORMATION
 


i

Table of Contents



PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

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

 
June 30,
2012
 
December 31,
2011
 
(unaudited)
 
 
ASSETS
  

 
  

Available-for-sale securities, at fair value
$
10,724,149

 
$
6,249,252

Trading securities, at fair value
999,375

 
1,003,301

Mortgage loans held-for-sale, at fair value
11,378

 
5,782

Investment in real estate, net
71,726

 

Cash and cash equivalents
496,674

 
360,016

Restricted cash
138,336

 
166,587

Accrued interest receivable
35,954

 
23,437

Due from counterparties
81,039

 
32,587

Derivative assets, at fair value
361,073

 
251,856

Other assets
60,998

 
7,566

Total Assets
$
12,980,702

 
$
8,100,384

LIABILITIES AND STOCKHOLDERS’ EQUITY
   

 
   

Liabilities
   

 
   

Repurchase agreements
$
10,438,441

 
$
6,660,148

Derivative liabilities, at fair value
82,619

 
49,080

Accrued interest payable
11,545

 
6,456

Due to counterparties
166,949

 
45,565

Accrued expenses
11,164

 
8,912

Dividends payable
87,061

 
56,239

Income taxes payable
266

 
3,898

Total liabilities
10,798,045

 
6,830,298

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 219,655,462 and 140,596,708 shares issued and outstanding, respectively
2,196

 
1,406

Additional paid-in capital
2,142,554

 
1,373,099

Receivable from issuance of common stock
(22,248
)
 

Accumulated other comprehensive income (loss)
202,798

 
(58,716
)
Cumulative earnings
233,256

 
157,452

Cumulative distributions to stockholders
(375,899
)
 
(203,155
)
Total stockholders’ equity
2,182,657

 
1,270,086

Total Liabilities and Stockholders’ Equity
$
12,980,702

 
$
8,100,384


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


1

Table of Contents



TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands, except share data)
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2012
 
2011
 
2012
 
2011
 
(unaudited)
 
(unaudited)
Interest income:
 
 
 
 
  

 
   

Available-for-sale securities
$
104,319

 
$
39,959

 
$
188,533

 
$
59,494

Trading securities
1,250

 
805

 
2,300

 
1,077

Mortgage loans held-for-sale
126

 

 
195

 

Cash and cash equivalents
209

 
64

 
377

 
127

Total interest income
105,904

 
40,828

 
191,405

 
60,698

Interest expense
15,527

 
3,863

 
26,994

 
6,362

Net interest income
90,377

 
36,965

 
164,411

 
54,336

Other-than-temporary impairments:
 
 
 
 
 
 
 
Total other-than temporary impairment losses
(4,476
)
 
(294
)
 
(8,751
)
 
(294
)
Non-credit portion of loss recognized in other comprehensive income

 

 

 

Net other-than-temporary credit impairment losses
(4,476
)
 
(294
)
 
(8,751
)
 
(294
)
Other income:
 
 
 
 
 
 
 
Gain on investment securities, net
1,789

 
3,189

 
11,720

 
4,728

Loss on interest rate swap and swaption agreements
(61,014
)
 
(50,808
)
 
(77,207
)
 
(48,869
)
(Loss) gain on other derivative instruments
(7,617
)
 
9,766

 
(16,507
)
 
15,113

Other income
131

 

 
91

 

Total other loss
(66,711
)
 
(37,853
)
 
(81,903
)
 
(29,028
)
Expenses:
 
 
 
 
 
 
 
Management fees
7,610

 
2,728

 
14,353

 
4,278

Other operating expenses
4,181

 
2,155

 
7,782

 
3,667

Total expenses
11,791

 
4,883

 
22,135

 
7,945

Income (loss) before income taxes
7,399

 
(6,065
)
 
51,622

 
17,069

Benefit from income taxes
(16,605
)
 
(5,081
)
 
(24,182
)
 
(4,324
)
Net income (loss) attributable to common stockholders
$
24,004

 
$
(984
)
 
$
75,804

 
$
21,393

Basic and diluted earnings (loss) per weighted average common share
$
0.11

 
$
(0.01
)
 
$
0.38

 
$
0.35

Dividends declared per common share
$
0.40

 
$
0.40

 
$
0.80

 
$
0.80

Basic and diluted weighted average number of shares of common stock
214,810,579

 
77,101,606

 
200,833,084

 
61,443,978

Comprehensive income:
 
 
 
 
 
 
 
Net income (loss)
$
24,004

 
$
(984
)
 
$
75,804

 
$
21,393

Other comprehensive income:
 
 
 
 
 
 
 
Unrealized gain on available-for-sale securities, net
117,604

 
14,514

 
261,514

 
23,629

Other comprehensive income
117,604

 
14,514

 
261,514

 
23,629

Comprehensive income
$
141,608

 
$
13,530

 
$
337,318

 
$
45,022


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

2

Table of Contents



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

 
Common Stock
 
 
 
 
 
 
 
 
 
 
 
 
 
Shares
 
Amount
 
Additional Paid-in Capital
 
Receivable from Issuance of Common Stock
 
Accumulated Other Comprehensive Income (Loss)
 
Cumulative Earnings
 
Cumulative Distributions to Stockholders
 
Total Stockholders' Equity
 
 
 
 
 
 
 
 
 
(unaudited)
 
 
 
 
 
 
Balance, January 1, 2011
40,501,212

 
$
405

 
$
366,974

 
$

 
$
22,619

 
$
30,020

 
$
(37,570
)
 
$
382,448

Net income

 

 

 

 

 
21,393

 

 
21,393

Other comprehensive income

 

 

 

 
23,629

 

 

 
23,629

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

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, January 1, 2012
140,596,708

 
$
1,406

 
$
1,373,099

 
$

 
$
(58,716
)
 
$
157,452

 
$
(203,155
)
 
$
1,270,086

Net income

 

 

 

 

 
75,804

 

 
75,804

Other comprehensive income

 

 

 

 
261,514

 

 

 
261,514

Net proceeds from issuance of common stock, net of offering costs
79,058,754

 
790

 
769,022

 

 

 

 

 
769,812

Increase in receivable from issuance of common stock

 

 

 
(22,248
)
 

 

 

 
(22,248
)
Common dividends declared

 

 

 

 

 

 
(172,744
)
 
(172,744
)
Non-cash equity award compensation

 

 
433

 

 

 

 

 
433

Balance, June 30, 2012
219,655,462

 
$
2,196

 
$
2,142,554

 
$
(22,248
)
 
$
202,798

 
$
233,256

 
$
(375,899
)
 
$
2,182,657


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


3

Table of Contents



TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
Six Months Ended
 
June 30,
 
2012
 
2011
 
(unaudited)
Cash Flows From Operating Activities:
   

 
   

Net income
$
75,804

 
$
21,393

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
   

 
   

Amortization of premiums and discounts on RMBS, net
(9,058
)
 
4,693

Other-than-temporary impairment losses
8,751

 
294

Gain on investment securities, net
(11,720
)
 
(4,728
)
Loss on termination and option expiration of interest rate swaps and swaptions
18,540

 
227

Unrealized loss on interest rate swaps and swaptions
46,296

 
38,351

Unrealized gain on other derivative instruments
(4,773
)
 
(5,893
)
Unrealized gain on mortgage loans
(4
)
 

Equity based compensation expense
433

 
147

Depreciation of real estate
32

 

Purchases of mortgage loans held-for-sale
(6,618
)
 

Proceeds from repayment of mortgage loans held-for-sale
1,026

 

Net change in assets and liabilities:
   

 
 
Increase in accrued interest receivable
(12,517
)
 
(12,334
)
Increase in deferred income taxes, net
(19,720
)
 
(4,330
)
Increase in current income tax receivable
(4,465
)
 

(Increase)/decrease in prepaid and fixed assets
(554
)
 
157

Increase in accrued interest payable, net
5,089

 
2,085

(Decrease)/increase in income taxes payable
(3,632
)
 
5

Increase in accrued expenses
2,252

 
2,858

Net cash provided by operating activities
85,162

 
42,925

Cash Flows From Investing Activities:
   

 
   

Purchases of available-for-sale securities
(4,696,861
)
 
(3,338,528
)
Proceeds from sales of available-for-sale securities
197,714

 
95,782

Principal payments on available-for-sale securities
295,829

 
116,651

Purchases of other derivative instruments
(205,440
)
 
(165,831
)
Proceeds from sales of other derivative instruments
69,699

 
19,572

Purchases of trading securities
(996,016
)
 
(1,319,959
)
Proceeds from sales of trading securities
1,001,904

 
500,133

Purchases of investments in real estate
(71,758
)
 

Increase in escrow deposits
(28,693
)
 

Increase (decrease) in due to counterparties, net
72,932

 
(19,866
)
Decrease (increase) in restricted cash
28,251

 
(66,695
)
Net cash used in investing activities
(4,332,439
)
 
(4,178,741
)

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


4

Table of Contents



TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Six Months Ended
 
June 30,
 
2012
 
2011
 
(unaudited)
Cash Flows From Financing Activities:
   

 
   

Proceeds from repurchase agreements
$
23,100,723

 
$
8,283,571

Principal payments on repurchase agreements
(19,322,430
)
 
(4,626,172
)
Proceeds from issuance of common stock, net of offering costs
769,812

 
523,076

Increase in receivable from issuance of common stock
(22,248
)
 

Dividends paid on common stock
(141,922
)
 
(26,650
)
Net cash provided by financing activities
4,383,935

 
4,153,825

Net increase in cash and cash equivalents
136,658

 
18,009

Cash and cash equivalents at beginning of period
360,016

 
163,900

Cash and cash equivalents at end of period
$
496,674

 
$
181,909

Supplemental Disclosure of Cash Flow Information:
   

 
 
Cash paid for interest
$
10,438

 
$
4,277

Cash paid for taxes
$
3,635

 
$
1

Non-Cash Financing Activity:
   

 
   

Dividends declared but not paid at end of period
$
87,061

 
$
36,911

Reconciliation of mortgage loans held-for-sale:
 
 
 
Mortgage loans held-for-sale at beginning of period
$
5,782

 
$

Purchases of mortgage loans held-for-sale
6,618

 

Proceeds from repayment of mortgage loans held-for-sale
(1,026
)
 

Unrealized gain on mortgage loans
4

 

Loans held-for-sale at end of period
$
11,378

 
$


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

5

Table of Contents



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

Note 1. Organization and Operations
Two Harbors Investment Corp., or the Company, is a Maryland corporation focused on investing in, financing and managing residential mortgage-backed securities, or RMBS, residential mortgage loans, residential real properties, 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 MKT under the symbols “TWO” and “TWO.WS,” respectively.
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 is qualification as a REIT, the Company generally will not be subject to U.S. federal income taxes to the extent that the Company distributes its taxable income to its stockholders on an annual basis and does not engage in prohibited transactions. However, certain activities that the Company may perform may cause it to earn income which will not be qualifying income for REIT purposes. The Company has designated certain of its subsidiaries as taxable REIT subsidiaries, or TRSs, as defined in the Code, to engage in such activities, and the Company may in the future form additional TRSs.

Note 2. Basis of Presentation and Significant Accounting Policies
Consolidation and Basis of Presentation
The interim unaudited condensed consolidated financial statements of the Company have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission, or SEC. Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles, or 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, 2011. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at June 30, 2012 and results of operations for all periods presented have been made. The results of operations for the three and six months ended June 30, 2012 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.
Significant Accounting Policies
Investment in Real Estate, Net
Beginning in early 2012, the Company began investing in single family residential properties with the intention of renting the properties. Real estate is recorded at acquisition cost, allocated between land and building. In making estimates of fair values for purposes of allocating purchase price, the Company utilizes information obtained from county tax assessment records to develop regional averages. Building depreciation is computed on the straight-line basis over the estimated useful lives of the assets. The Company generally uses a 27.5-year estimated life with no salvage value. For properties purchased subject to an existing lease, the assets are recorded at fair value, allocated to land, building and the existing lease. Any difference between fair value and cost is recorded in the income statement. The lease value is amortized over the expected benefit period (i.e., the lease term).

6

Table of Contents

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

The Company evaluates its long-lived assets for impairment periodically or whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. If an impairment indicator exists, the Company compares the expected future undiscounted cash flows against the carrying amount of an asset. If the sum of the estimated undiscounted cash flows is less than the carrying amount of the asset, the Company would record an impairment loss for the difference between the estimated fair value and the carrying amount of the asset.
The lease periods are generally short term in nature (one year or less) and reflect market rental rates. Gross rental income and expenses applicable to rental income are reported in the statement of comprehensive income in other income and other operating expenses, respectively. Expenditures for ordinary maintenance and repairs are expensed to operations as incurred and expenditures for significant renovations that improve the asset and extend the useful life of the asset are capitalized and depreciated over their estimated useful life.
Refer to Note 2 to the Consolidated Financial Statements in the Company's 2011 Annual Report on Form 10-K regarding additional significant accounting policies.
Recently Issued and/or Adopted Accounting Standards
Comprehensive Income
In June 2011, the Financial Accounting Standards Board, or FASB, issued ASU No. 2011-05, which amends ASC 820, Comprehensive Income. The amendments are intended to make the presentation of items within Other Comprehensive Income (OCI) more prominent. ASU 2011-05 eliminates the option to present components of OCI in the statement of changes in stockholders' equity and requires companies to present all non-owner changes in stockholders' equity either as a single continuous statement of comprehensive income or as two separate but consecutive statements. In addition, reclassification adjustments between OCI and net income must be presented separately on the face of the financial statements. The new guidance does not change the components of OCI or the calculation of earnings per share. ASU 2011-05 is effective for the first interim or annual period beginning on or after December 15, 2011. Adopting this ASU did not have a material impact on the Company's condensed consolidated financial condition or results of operations. On December 23, 2011, the FASB issued ASU 2011-12, which defers those changes in ASU 2011-05 that relate to the presentation of reclassification adjustments. This was done to allow the FASB time to re-deliberate whether to present on the face of the financial statements the effects of reclassification out of accumulated OCI on the components of net income and comprehensive income for all periods presented. No other requirements under ASU 2011-05 are affected by this update.
Fair Value
In May 2011, the FASB issued ASU No. 2011-04, which amends ASC 820, Fair Value Measurements. The amendments in this ASU clarify the requirements for measuring fair value and disclosing information about fair value. It is intended to improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with GAAP and International Financial Reporting Standards, or IFRS. The ASU is effective for the first interim or annual period beginning on or after December 15, 2011. Adopting this ASU did not have a material impact on the Company's condensed consolidated financial condition or results of operations.
Offsetting Assets and Liabilities
In December 2011, the FASB issued ASU No. 2011-11, which amends ASC 210, Balance Sheet. The amendments in this ASU enhance disclosures required by U.S. GAAP by requiring improved information about financial instruments and derivative instruments that are either (1) offset in accordance with ASC 210, Balance Sheet or ASC 815, Other Presentation Matters or (2) subject to an enforceable master netting arrangement or similar agreement. ASU 2011-11 is effective for the first interim or annual period beginning on or after January 1, 2013. We anticipate that adopting this ASU will not have a material impact on the Company's condensed consolidated financial condition or results of operations.


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Table of Contents

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

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, 2012 and December 31, 2011:
(in thousands)
June 30,
2012
 
December 31,
2011
Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
2,647,214

 
$
1,609,003

Federal National Mortgage Association
4,412,010

 
2,414,637

Government National Mortgage Association
1,652,978

 
1,029,517

Non-Agency
2,011,947

 
1,196,095

Total mortgage-backed securities
$
10,724,149

 
$
6,249,252


At June 30, 2012 and December 31, 2011, the Company pledged investment securities with a carrying value of $10.5 billion and $6.2 billion, respectively, as collateral for repurchase agreements. See Note 12 - Repurchase Agreements.
At June 30, 2012 and December 31, 2011, 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.
The following tables present the amortized cost and carrying value (which approximates fair value) of AFS securities by collateral type as of June 30, 2012 and December 31, 2011:
 
June 30, 2012
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
9,298,257

 
$
4,291,928

 
$
13,590,185

Unamortized premium
548,956

 

 
548,956

Unamortized discount
 
 
 
 
 
Designated credit reserve

 
(1,322,098
)
 
(1,322,098
)
Net, unamortized
(1,351,394
)
 
(944,298
)
 
(2,295,692
)
Amortized Cost
8,495,819

 
2,025,532

 
10,521,351

Gross unrealized gains
230,117

 
62,491

 
292,608

Gross unrealized losses
(13,734
)
 
(76,076
)
 
(89,810
)
Carrying Value
$
8,712,202

 
$
2,011,947

 
$
10,724,149

 
December 31, 2011
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
5,692,754

 
$
2,667,929

 
$
8,360,683

Unamortized premium
279,640

 

 
279,640

Unamortized discount
  

 
  

 
  

Designated credit reserve

 
(782,606
)
 
(782,606
)
Net, unamortized
(1,008,780
)
 
(540,969
)
 
(1,549,749
)
Amortized Cost
4,963,614

 
1,344,354

 
6,307,968

Gross unrealized gains
108,864

 
11,881

 
120,745

Gross unrealized losses
(19,321
)
 
(160,140
)
 
(179,461
)
Carrying Value
$
5,053,157

 
$
1,196,095

 
$
6,249,252



8

Table of Contents

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

The following tables present the carrying value of the Company's AFS investment securities by rate type as of June 30, 2012 and December 31, 2011:
 
June 30, 2012
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
221,568

 
$
1,750,513

 
$
1,972,081

Fixed Rate
8,490,634

 
261,434

 
8,752,068

Total
$
8,712,202

 
$
2,011,947

 
$
10,724,149

 
December 31, 2011
(in thousands)
Agency
 
Non-Agency
 
Total
Adjustable Rate
$
231,678

 
$
995,014

 
$
1,226,692

Fixed Rate
4,821,479

 
201,081

 
5,022,560

Total
$
5,053,157

 
$
1,196,095

 
$
6,249,252


When the Company purchases a credit-sensitive AFS security at a significant discount to its face value, the Company often does not amortize into income a significant portion of this discount that the Company is entitled to earn because it does not expect to collect it due to the inherent credit risk of the security. The Company may also record an other-than-temporary impairment, or OTTI, for a portion of its investment in the security to the extent the Company believes that the amortized cost will exceed the present value of expected future cash flows. The amount of principal that the Company does not amortize into income is designated as an off balance sheet credit reserve on the security, with unamortized net discounts or premiums amortized into income over time to the extent realizable.
The following table presents the changes for the six months ended June 30, 2012 and 2011 of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
 
Six Months Ended June 30,
 
2012
 
2011
(in thousands)
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
 
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
Beginning balance at January 1
$
(782,606
)
 
$
(540,969
)
 
$
(1,323,575
)
 
$
(145,855
)
 
$
(129,992
)
 
$
(275,847
)
Acquisitions
(553,552
)
 
(479,435
)
 
(1,032,987
)
 
(249,153
)
 
(168,684
)
 
(417,837
)
Accretion of net discount
250

 
62,768

 
63,018

 

 
12,409

 
12,409

Realized credit losses
17,908

 

 
17,908

 
1,242

 

 
1,242

Reclassification adjustment for other-than-temporary impairments
(8,751
)
 

 
(8,751
)
 
(294
)
 

 
(294
)
Transfers from (to)

 

 

 
66

 
(66
)
 

Sales, calls, other
4,653

 
13,338

 
17,991

 
8,253

 
5,618

 
13,871

Ending balance at June 30
$
(1,322,098
)
 
$
(944,298
)
 
$
(2,266,396
)
 
$
(385,741
)
 
$
(280,715
)
 
$
(666,456
)


9

Table of Contents

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

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, 2012 and December 31, 2011. At June 30, 2012, the Company held 1,233 AFS securities, of which 194 were in an unrealized loss position for less than twelve consecutive months and 95 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2011, the Company held 854 AFS securities, of which 264 were in an unrealized loss position for less than twelve months and 20 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, 2012
$
1,257,841

 
$
(33,629
)
 
$
452,791

 
$
(56,181
)
 
$
1,710,632

 
$
(89,810
)
December 31, 2011
$
1,277,120

 
$
(175,348
)
 
$
15,608

 
$
(4,113
)
 
$
1,292,728

 
$
(179,461
)

Evaluating AFS Securities for Other-Than-Temporary Impairments
In order to evaluate AFS securities for OTTI, the Company determines whether there has been a significant adverse quarterly change in the cash flow expectations for a security. The Company compares the amortized cost of each security in an unrealized loss position against the present value of expected future cash flows of the security. The Company also considers whether there has been a significant adverse change in the regulatory and/or economic environment as part of this analysis. If the amortized cost of the security is greater than the present value of expected future cash flows using the original yield as the discount rate, an other-than-temporary credit impairment has occurred. If the Company does not intend to sell and 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. 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 $4.5 million and an $8.8 million other-than-temporary credit impairment during the three and six months ended June 30, 2012, respectively, on a total of 27 non-Agency RMBS where the future expected cash flows for each security was less than its amortized cost. As of June 30, 2012, the impaired securities had weighted average cumulative losses of 1.1%, weighted average three-month prepayment speed of 2.17, weighted average 60+ day delinquency of 36.1% of the pool balance, and weighted average FICO score of 653. At June 30, 2012, the Company did not intend to sell the securities and determined that it was not more likely than not that the Company will be required to sell the securities, therefore, only the projected credit loss was recognized in earnings. During the three and six months ended June 30, 2011, the Company recorded a $0.3 million other-than-temporary credit impairment on one non-Agency RMBS where the future expected cash flows for each security was less than its amortized cost.
The following table presents the changes in OTTI included in earnings for six months ended June 30, 2012 and 2011:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2012
 
2011
 
2012
 
2011
Cumulative credit loss at beginning of period
$
(9,377
)
 
$

 
$
(5,102
)
 
$

Additions:
 
 
 
 
 
 
 
Other-than-temporary impairments not previously recognized
(2,644
)
 
(294
)
 
(6,128
)
 
(294
)
Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments
(1,832
)
 

 
(2,623
)
 

Reductions:
 
 
 
 
 
 
 
Decreases related to other-than-temporary impairments on securities paid down
250

 

 
250

 

Cumulative credit loss at end of period
$
(13,603
)
 
$
(294
)
 
$
(13,603
)
 
$
(294
)


10

Table of Contents

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

Cumulative credit losses related to OTTI may be reduced for securities sold as well as securities that mature, pay down, or are prepaid such that the outstanding principal balance is reduced to zero. Additionally, increases in cash flows expected to be collected over the remaining life of the security cause a reduction in the cumulative credit loss.
Gross Realized Gains and Losses
Gains and losses from the sale of AFS securities are recorded as realized gains (losses) within gain on investment securities, net in the Company's condensed consolidated statements of comprehensive income. For the three and six months ended June 30, 2012, the Company sold AFS securities for $27.6 million and $197.7 million with an amortized cost of $28.7 million and $187.7 million, for a net realized loss of $1.1 million and a net realized gain of $10.0 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, 2012 and 2011:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2012
 
2011
 
2012
 
2011
Gross realized gains
$
560

 
$
141

 
$
11,663

 
$
1,949

Gross realized losses
(1,629
)
 
(95
)
 
(1,629
)
 
(265
)
Total realized gains on sales, net
$
(1,069
)
 
$
46

 
$
10,034

 
$
1,684


Note 4. Trading Securities, at Fair Value
The Company holds U.S. Treasuries in its taxable REIT subsidiary and classifies these securities as trading instruments due to its short-term investment objectives. As of June 30, 2012 and December 31, 2011, the Company held U.S. Treasuries with an amortized cost of $1.0 billion and $1.0 billion and a fair value of $1.0 billion and $1.0 billion, respectively, classified as trading securities. The unrealized gains included within trading securities were $3.0 million and $3.1 million as of June 30, 2012 and December 31, 2011, respectively.
For the three and six months ended June 30, 2012, the Company sold trading securities for $1.0 billion with an amortized cost of $1.0 billion resulting in realized gains of $1.7 million on the sale of these securities. For the three and six months ended June 30, 2012, trading securities experienced unrealized gains of $1.2 million and unrealized losses of $0.1 million, respectively. Both realized and unrealized gains and losses are recorded as a component of gains on investment securities, net in the Company's condensed consolidated statements of comprehensive income.
At June 30, 2012, the Company pledged trading securities with a carrying value of $1.0 billion as collateral for repurchase agreements. See Note 12 - Repurchase Agreements.

Note 5. Mortgage Loans Held-for-Sale, at Fair Value
Mortgage loans held-for-sale consists of residential mortgage loans carried at fair value as a result of a fair value option election. The following table presents the carrying value of the Company's mortgage loans held-for-sale as of June 30, 2012 and December 31, 2011:
(in thousands)
June 30,
2012
 
December 31, 2011
Unpaid principal balance
$
11,093

 
$
5,655

Fair value adjustment
285

 
127

Carrying value
$
11,378

 
$
5,782


At June 30, 2012, the Company pledged mortgage loans with a carrying value of $4.8 million as collateral for repurchase agreements. See Note 12 - Repurchase Agreements.


11

Table of Contents

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

Note 6. Investment in Real Estate, Net
Investments in real estate consists of single family residential properties purchased by the Company with the intention to hold and rent the properties. The following table presents the carrying value of the Company's investment in real estate as of June 30, 2012 and December 31, 2011:
(in thousands)
June 30,
2012
 
December 31,
2011
Land
$
15,106

 
$

Building
56,652

 

 
71,758

 

Accumulated depreciation
(32
)
 

Investment in real estate, net
$
71,726

 
$


Note 7. Restricted Cash
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 Company has also placed cash in a restricted account pursuant to a letter of credit on an office space lease.
The following table presents the Company's restricted cash balances as of June 30, 2012 and December 31, 2011:
(in thousands)
June 30,
2012
 
December 31,
2011
Restricted cash balances held by trading counterparties:
 
 
 
For securities trading activity
$
9,000

 
$
9,000

For derivatives trading activity
114,064

 
62,784

As restricted collateral for repurchase agreements
14,926

 
94,803

 
137,990

 
166,587

Restricted cash balance pursuant to letter of credit on office lease
346

 

Total
$
138,336

 
$
166,587


Note 8. Accrued Interest Receivable
The following table presents the Company's accrued interest receivable by collateral type:
(in thousands)
June 30,
2012
 
December 31,
2011
Accrued Interest Receivable:
 
 
 
U.S. Treasuries
$
1,101

 
$
1,003

Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
9,089

 
5,844

Federal National Mortgage Association
16,049

 
9,770

Government National Mortgage Association
6,869

 
4,454

Non-Agency
2,767

 
2,328

Total mortgage-backed securities
34,774

 
22,396

Mortgage loans held-for-sale
79

 
38

Total
$
35,954

 
$
23,437



12

Table of Contents

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

Note 9. 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, caps, and credit default swaps. 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.
Balance Sheet Presentation
The following table presents the gross fair value and notional amounts of the Company's derivative financial instruments treated as trading instruments as of June 30, 2012 and December 31, 2011.
(in thousands)
 
June 30, 2012
 
December 31, 2011
 
 
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
 
$
280,672

1,790,065

 
$


 
$
157,421

1,131,084

 
$


Interest rate swap agreements
 


 
(71,793
)
9,135,000

 


 
(28,790
)
5,810,000

Credit default swap agreements
 
42,173

541,444

 
(10,826
)
83,591

 
86,136

544,699

 
(14,638
)
154,812

Swaptions
 
38,228

4,200,000

 


 
5,635

2,900,000

 


TBAs
 


 


 
2,664

275,000

 
(5,652
)
850,000

Forward purchase commitment
 

32,406

 


 


 


Forward sale commitment
 


 


 

5,202

 


Total
 
$
361,073

6,563,915

 
$
(82,619
)
9,218,591

 
$
251,856

4,855,985

 
$
(49,080
)
6,814,812



13

Table of Contents

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

The following table provides the average outstanding notional amounts of the Company's derivative financial instruments treated as trading instruments for the three and six months ended June 30, 2012.
(in thousands)
 
Three Months Ended June 30, 2012
 
Six Months Ended June 30, 2012
Trading instruments
 
Derivative Assets
 
Derivative Liabilities
 
Derivative Assets
 
Derivative Liabilities
Inverse interest-only securities
 
1,727,601

 

 
1,529,218

 

Interest rate swap agreements
 

 
8,154,231

 

 
7,300,525

Credit default swaps
 
570,354

 
88,077

 
556,121

 
112,822

Swaptions
 
3,790,110

 

 
3,307,792

 

TBAs
 
324,176

 
945,055

 
267,265

 
854,420

Forward purchase commitment
 
1,480

 

 
601

 

Forward sale commitment
 
4,446

 

 
4,816

 


Comprehensive Income Statement Presentation
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.
The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed consolidated statement of comprehensive 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
 
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
 
 
2012
 
2011
 
2012
 
2011
Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Interest Rate Contracts
 
 
 
 
 
 
 
 
 
 
Investment securities - RMBS
 
(Loss) gain on other derivative instruments
 
$
(22,350
)
 
$
(381
)
 
$
(24,987
)
 
$
(639
)
Investment securities - U.S. Treasuries and TBA contracts
 
(Loss) gain on interest rate swap and swaption agreements
 
(5,697
)
 
(3,401
)
 
(7,345
)
 
(3,811
)
Mortgage loans held-for-sale
 
(Loss) gain on other derivative instruments
 
(39
)
 

 
(26
)
 

Repurchase agreements
 
(Loss) gain on interest rate swap and swaption agreements
 
(55,317
)
 
(47,407
)
 
(69,862
)
 
(45,058
)
Credit default swaps - Receive protection
 
(Loss) gain on other derivative instruments
 
(1,225
)
 
273

 
(25,526
)
 
273

Non-Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Credit default swaps - Provide protection
 
(Loss) gain on other derivative instruments
 
752

 
(3,513
)
 
8,972

 
(1,175
)
Inverse interest-only securities
 
(Loss) gain on other derivative instruments
 
15,245

 
13,387

 
25,060

 
16,654

Total
 
 
 
$
(68,631
)
 
$
(41,042
)
 
$
(93,714
)
 
$
(33,756
)


14

Table of Contents

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

For the three and six months ended June 30, 2012, the Company recognized $7.7 million and $12.4 million, respectively, of expenses for the accrual and/or settlement of the net interest expense associated with its interest rate swaps. The expenses result from generally paying a fixed interest rate on an average $8.2 billion and $7.3 billion notional, respectively, to hedge a portion of the Company's interest rate risk on its short-term repurchase agreements, funding costs, and macro-financing risk and generally receiving LIBOR interest.
For the three and six months ended June 30, 2012, the Company terminated or had options expire on a total of 8 and 19 interest rate swap and swaption positions of $2.0 billion notional and $2.9 billion notional, respectively. Upon settlement of the early terminations and option expirations, the Company paid $1.0 million and $1.5 million in full settlement of its net interest spread liability and recognized $7.3 million and $18.5 million in realized losses on the swaps and swaptions, respectively, including early termination penalties.
For the three and six months ended June 30, 2012, the Company terminated a total of 6 and 10 credit default swap positions totaling $155.0 million and $240.0 million notional, respectively. Upon settlement of the early terminations, the Company received $73,700 and $63,208 in full settlement of its net interest spread receivable and recognized $1.7 million and $3.3 million in realized losses on the credit default swaps, including early termination penalties.
Cash flow activity related to derivative instruments is reflected within the operating activities and investing activities sections of the condensed consolidated statements of cash flows. Derivative fair value adjustments are reflected within the unrealized loss (gain) on interest rate swaps and swaptions and unrealized loss (gain) on other derivative instruments line items and realized losses on interest rate swap and swaption agreements are reflected within the loss on termination of interest rate swaps and swaptions line item within the operating activities section of the condensed consolidated statements of cash flows. The remaining cash flow activity related to derivative instruments is reflected within the purchases of other derivative instruments, proceeds from sales of other derivative instruments and increase (decrease) in due to counterparties, net line items within the investing activities section of the condensed consolidated statements of cash flows.
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 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 June 30, 2012 and December 31, 2011, the Company had outstanding fair value of $61.2 million and $48.4 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. The Company did not hold any long or short notional TBA positions as of June 30, 2012, but held TBA positions with $275.0 million in long notional and $850.0 million in short notional as of December 31, 2011, respectively. 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 December 31, 2011, these contracts held a fair market value of $2.7 million, included in derivative assets, at fair value, and $5.7 million, included in derivative liabilities, at fair value, in the condensed consolidated balance sheet as of December 31, 2011.
Commitments to Purchase and/or Sell Mortgage Loans Held-for-Sale  - Prior to a mortgage loan purchase, the Company may enter into forward purchase commitments with counterparties whereby the Company commits to purchasing the loans at a particular interest rate, provided the borrower elects to close the loan. These commitments to purchase mortgage loans have been defined as derivatives and are therefore recorded on the balance sheet as assets or liabilities and measured at fair value. Subsequent changes in fair value are recorded on the balance sheet as adjustments to the carrying value of these assets or liabilities with a corresponding adjustment recognized in current period earnings. As of June 30, 2012, the Company had entered into commitments to purchase mortgage loans of $32.4 million, subject to fallout if the loans do not close. No fair value was assigned to the derivative at June 30, 2012 as it was entered into at market terms at the end of the period.
The Company is exposed to interest rate risk on mortgage loans from the time it commits to purchase the mortgage loan until the mortgage loan is sold. Changes in interest rates impact the market price for the mortgage loans. For example, as market interest rates decline, the value of mortgage loans held-for-sale increases, and vice versa. To mitigate the impact of this risk, the Company may from time to time enter into a forward sale commitment under the Forward AAA Securities

15

Table of Contents

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

Agreement, or the Forward Agreement, with Barclays Bank PLC, or Barclays, pursuant to which Barclays would purchase certain securities issued in connection with a potential securitization transaction involving mortgage loans subject to the Forward Agreement. As of December 31, 2011, one trade had been executed under the Forward Agreement with a notional of $5.2 million. No fair value was assigned to the derivative at December 31, 2011 as it was entered into at market terms at the end of the year. This trade was settled by the Company in the three months ended June 30, 2012. As of June 30, 2012, the Company had no additional trades under the Forward Agreement.
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, 2012 and December 31, 2011, 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, 2012
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
25,000

 
0.868
%
 
0.522
%
 
0.48

2013
 
2,275,000

 
0.713
%
 
0.500
%
 
1.06

2014
 
1,675,000

 
0.644
%
 
0.517
%
 
2.07

2015
 
2,070,000

 
1.039
%
 
0.447
%
 
2.87

2016 and Thereafter
 
2,090,000

 
1.053
%
 
0.476
%
 
4.28

Total
 
8,135,000

 
0.870
%
 
0.484
%
 
2.55

(notional in thousands)
 
 
 
 
 
 
December 31, 2011
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
25,000

 
0.868
%
 
0.315
%
 
0.98

2013
 
2,025,000

 
0.737
%
 
0.368
%
 
1.55

2014
 
1,275,000

 
0.670
%
 
0.380
%
 
2.72

2015
 
820,000

 
1.575
%
 
0.329
%
 
3.52

2016
 
240,000

 
2.156
%
 
0.316
%
 
4.32

Total
 
4,385,000

 
0.952
%
 
0.361
%
 
2.41


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, 2012 and December 31, 2011, the Company held $1.0 billion in fair value of U.S. Treasuries classified as trading securities and the following outstanding interest rate swaps:
(notional in thousands)
 
 
 
 
 
 
June 30, 2012
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2015
 
1,000,000

 
0.799
%
 
0.476
%
 
2.78

Total
 
1,000,000

 
 
 
 
 
 

16

Table of Contents

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

(notional in thousands)
 
 
 
 
 
 
December 31, 2011
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2013
 
1,250,000

 
0.620
%
 
0.339
%
 
1.54

Total
 
1,250,000

 
 
 
 
 
 

As of June 30, 2012, all of the Company's interest rate swap contracts receive interest at a 1-month or 3-month LIBOR rate. As of December 31, 2011, all of the Company's interest rate swap contracts received 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 paid interest at a 3-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
December 31, 2011
Swaps Maturities
 
Notional Amounts
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2016
 
175,000

 
0.420
%
 
1.772
%
 
4.58

Total
 
175,000

 
 
 
 
 
 

Additionally, as of June 30, 2012 and December 31, 2011, 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, 2012
(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
 
$
9,540

 
$
3

 
3.38
 
1,000,000

 
2.95
%
 
3M Libor
 
5.4

Payer
 
≥ 6 Months
 
60,800

 
38,225

 
48.33
 
3,200,000

 
3.70
%
 
3M Libor
 
9.6

Total Payer
 
 
 
$
70,340

 
$
38,228

 
48.33
 
4,200,000

 
3.52
%
 
3M Libor
 
8.6

December 31, 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
 
$
16,147

 
$
4

 
4.97
 
1,600,000

 
3.22
%
 
3M Libor
 
3.7

Payer
 
≥ 6 Months
 
13,523

 
5,631

 
12.27
 
1,300,000

 
3.19
%
 
3M Libor
 
6.5

Total Payer
 
 
 
$
29,670

 
$
5,635

 
12.26
 
2,900,000

 
3.21
%
 
3M Libor
 
4.9


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.

17

Table of Contents

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

Credit Risk
The Company's exposure to credit losses on its U.S. Treasuries and Agency portfolio of investment securities is limited 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 Freddie Mac and Fannie Mae mortgage-backed securities are guaranteed by those respective agencies, and the payment of principal and interest on the Ginnie Mae mortgage-backed securities are backed by the full faith and credit of the U.S. Government.
For non-Agency investment securities, the Company enters into credit default swaps to 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, 2012, 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 tables present credit default swaps where the Company is receiving protection held as of June 30, 2012 and December 31, 2011:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
June 30, 2012
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
)
 
$
47

 
$
(3,127
)
 
$
(3,080
)
 
12/20/2013
 
181.91

 
(105,000
)
 
479

 
(3,225
)
 
(2,746
)
 
6/20/2016
 
105.50

 
(100,000
)
 
(1,051
)
 
(260
)
 
(1,311
)
 
12/20/2016
 
682.82

 
(121,000
)
 
4,360

 
(13,062
)
 
(8,702
)
 
6/20/2017
 
586.18

 
(99,000
)
 
3,190

 
(3,563
)
 
(373
)
 
5/25/2046
 
356.00

 
(71,444
)
 
35,148

 
(32,558
)
 
2,590

 
Total
 
365.95

 
(541,444
)
 
$
42,173

 
$
(55,795
)
 
$
(13,622
)
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 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
)
 
$
2,422

 
$
(3,127
)
 
$
(705
)
 
12/20/2013
 
172.50

 
(105,000
)
 
3,742

 
(3,225
)
 
517

 
6/20/2016
 
105.00

 
(150,000
)
 
2,074

 
(355
)
 
1,719

 
12/20/2016
 
684.38

 
(125,000
)
 
10,200

 
(13,062
)
 
(2,862
)
 
5/25/2046
 
377.23

 
(119,699
)
 
67,698

 
(57,322
)
 
10,376

 
Total
 
341.94

 
(544,699
)
 
$
86,136

 
$
(77,091
)
 
$
9,045



18

Table of Contents

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

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, 2012, the fair value of derivative financial instruments as an asset and liability position was $361.1 million and $82.6 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, 2012, the Company has received cash deposits from counterparties of $34.2 million and placed cash deposits of $124.1 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 RMBS and credit default swaps.
Inverse interest-only securities with a carrying value of $280.7 million, including accrued interest receivable of $3.5 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 June 30, 2012 and December 31, 2011:
(in thousands)
June 30,
2012
 
December 31,
2011
Face Value
$
1,790,065

 
$
1,131,084

Unamortized premium

 

Unamortized discount
 
 
 
Designated credit reserve

 

Net, unamortized
(1,520,825
)
 
(973,066
)
Amortized Cost
269,240

 
158,018

Gross unrealized gains
15,138

 
4,606

Gross unrealized losses
(7,166
)
 
(7,385
)
Carrying Value
$
277,212

 
$
155,239


As of June 30, 2012 and December 31, 2011, 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.

19

Table of Contents

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

The following tables present credit default swaps where the Company is providing protection held as of June 30, 2012 and December 31, 2011:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
June 30, 2012
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Provide
7/25/2036
 
345.69

 
33,577

 
$
2,186

 
$
(6,374
)
 
$
(4,188
)
 
5/25/2046
 
146.18

 
50,014

 
(13,012
)
 
13,573

 
561

 
 
 
226.32

 
83,591

 
$
(10,826
)
 
$
7,199

 
$
(3,627
)
(notional and dollars in thousands)