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, 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 November 7, 2012 there were 295,365,085 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)

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

 
  

Available-for-sale securities, at fair value
$
14,969,859

 
$
6,249,252

Trading securities, at fair value
1,002,461

 
1,003,301

Mortgage loans held-for-sale, at fair value
14,553

 
5,782

Investment in real estate, net
190,907

 
—

Cash and cash equivalents
833,608

 
360,016

Restricted cash
206,190

 
166,587

Accrued interest receivable
46,919

 
23,437

Due from counterparties
28,965

 
32,587

Derivative assets, at fair value
496,788

 
251,856

Other assets
74,445

 
7,566

Total Assets
$
17,864,695

 
$
8,100,384

LIABILITIES AND STOCKHOLDERS’ EQUITY
   

 
   

Liabilities
   

 
   

Repurchase agreements
$
14,034,327

 
$
6,660,148

Derivative liabilities, at fair value
132,322

 
49,080

Accrued interest payable
13,147

 
6,456

Due to counterparties
170,090

 
45,565

Accrued expenses
17,008

 
8,912

Dividends payable
106,325

 
56,239

Income taxes payable
—

 
3,898

Total liabilities
14,473,219

 
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 295,350,370 and 140,596,708 shares issued and outstanding, respectively
2,954

 
1,406

Additional paid-in capital
2,910,293

 
1,373,099

Accumulated other comprehensive income (loss)
700,396

 
(58,716
)
Cumulative earnings
260,058

 
157,452

Cumulative distributions to stockholders
(482,225
)
 
(203,155
)
Total stockholders’ equity
3,391,476

 
1,270,086

Total Liabilities and Stockholders’ Equity
$
17,864,695

 
$
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 (LOSS)
(in thousands, except share data)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
 
(unaudited)
 
(unaudited)
Interest income:
 
 
 
 
  

 
   

Available-for-sale securities
$
124,621

 
$
65,919

 
$
313,154

 
$
125,413

Trading securities
1,278

 
1,706

 
3,578

 
2,783

Mortgage loans held-for-sale
167

 
—

 
362

 
—

Cash and cash equivalents
243

 
114

 
620

 
241

Total interest income
126,309

 
67,739

 
317,714

 
128,437

Interest expense
20,743

 
7,218

 
47,737

 
13,580

Net interest income
105,566

 
60,521

 
269,977

 
114,857

Other-than-temporary impairments:
 
 
 
 
 
 
 
Total other-than temporary impairment losses
(559
)
 
(3,371
)
 
(9,310
)
 
(3,665
)
Non-credit portion of loss recognized in other comprehensive income (loss)
—

 
—

 
—

 
—

Net other-than-temporary credit impairment losses
(559
)
 
(3,371
)
 
(9,310
)
 
(3,665
)
Other income:
 
 
 
 
 
 
 
Gain on investment securities, net
2,527

 
31,432

 
14,247

 
36,159

Loss on interest rate swap and swaption agreements
(76,472
)
 
(39,311
)
 
(153,679
)
 
(88,180
)
Gain (loss) on other derivative instruments
3,454

 
22,361

 
(13,053
)
 
37,474

Other income
731

 
—

 
822

 
—

Total other (loss) income
(69,760
)
 
14,482

 
(151,663
)
 
(14,547
)
Expenses:
 
 
 
 
 
 
 
Management fees
9,733

 
4,785

 
24,086

 
9,063

Other operating expenses
6,546

 
2,850

 
14,328

 
6,516

Total expenses
16,279

 
7,635

 
38,414

 
15,579

Income before income taxes
18,968

 
63,997

 
70,590

 
81,066

(Benefit from) provision for income taxes
(7,834
)
 
9,388

 
(32,016
)
 
5,064

Net income attributable to common stockholders
$
26,802

 
$
54,609

 
$
102,606

 
$
76,002

Basic earnings per weighted average common share
$
0.10

 
$
0.42

 
$
0.46

 
$
0.90

Diluted earnings per weighted average common share
$
0.10

 
$
0.42

 
$
0.46

 
$
0.90

Dividends declared per common share
$
0.36

 
$
0.40

 
$
1.16

 
$
1.20

Weighted average number of shares of common stock:
 
 
 
 
 
 
 
Basic
270,005,212

 
130,607,566

 
224,058,762

 
84,751,854

Diluted
270,937,960

 
130,607,566

 
224,369,678

 
84,751,854

Comprehensive income (loss):
 
 
 
 
 
 
 
Net income
$
26,802

 
$
54,609

 
$
102,606

 
$
76,002

Other comprehensive income (loss):
 
 
 
 
 
 
 
Unrealized gain (loss) on available-for-sale securities, net
497,598

 
(72,573
)
 
759,112

 
(48,944
)
Other comprehensive income (loss)
497,598

 
(72,573
)
 
759,112

 
(48,944
)
Comprehensive income (loss)
$
524,400

 
$
(17,964
)
 
$
861,718

 
$
27,058


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 (LOSS)
(in thousands, except share data)

 
Common Stock
 
 
 
 
 
 
 
 
 
 
 
Shares
 
Amount
 
Additional Paid-in Capital
 
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
—

 
—

 
—

 
—

 
76,002

 
—

 
76,002

Other comprehensive loss
—

 
—

 
—

 
(48,944
)
 
—

 
—

 
(48,944
)
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

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, January 1, 2012
140,596,708

 
$
1,406

 
$
1,373,099

 
$
(58,716
)
 
$
157,452

 
$
(203,155
)
 
$
1,270,086

Net income
—

 
—

 
—

 
—

 
102,606

 
—

 
102,606

Other comprehensive income
—

 
—

 
—

 
759,112

 
—

 
—

 
759,112

Net proceeds from issuance of common stock, net of offering costs
138,731,623

 
1,388

 
1,361,167

 
—

 
—

 
—

 
1,362,555

Proceeds from issuance of common stock in connection with exercise of warrants
15,990,018

 
160

 
175,565

 
—

 
—

 
—

 
175,725

Common dividends declared
—

 
—

 
—

 
—

 
—

 
(279,070
)
 
(279,070
)
Non-cash equity award compensation
32,021

 
—

 
462

 
—

 
—

 
—

 
462

Balance, September 30, 2012
295,350,370

 
$
2,954

 
$
2,910,293

 
$
700,396

 
$
260,058

 
$
(482,225
)
 
$
3,391,476


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)
 
Nine Months Ended
 
September 30,
 
2012
 
2011
 
(unaudited)
Cash Flows From Operating Activities:
   

 
   

Net income
$
102,606

 
$
76,002

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

 
   

Amortization of premiums and discounts on RMBS, net
(5,566
)
 
(57
)
Other-than-temporary impairment losses
9,310

 
3,665

Gain on investment securities, net
(14,247
)
 
(36,159
)
Loss on mortgage loans held-for-sale
45

 
—

Loss on termination and option expiration of interest rate swaps and swaptions
26,084

 
18,074

Unrealized loss on interest rate swaps and swaptions
104,506

 
51,474

Unrealized gain on other derivative instruments
(6,493
)
 
(20,144
)
Unrealized gain on mortgage loans held-for-sale
(59
)
 
—

Equity based compensation expense
462

 
216

Depreciation of real estate
458

 
—

Purchases of mortgage loans held-for-sale
(10,797
)
 
—

Proceeds from repayment of mortgage loans held-for-sale
2,040

 
—

Net change in assets and liabilities:
   

 
 
Increase in accrued interest receivable
(23,482
)
 
(20,127
)
(Increase)/decrease in deferred income taxes, net
(27,288
)
 
4,136

Increase in current income tax receivable
(4,469
)
 
—

(Increase)/decrease in prepaid and fixed assets
(906
)
 
155

Increase in other receivables
(99
)
 
—

Increase in accrued interest payable, net
6,691

 
4,657

(Decrease)/increase in income taxes payable
(3,898
)
 
928

Increase in accrued expenses
8,096

 
5,684

Net cash provided by operating activities
162,994

 
88,504

Cash Flows From Investing Activities:
   

 
   

Purchases of available-for-sale securities
(8,705,850
)
 
(6,295,100
)
Proceeds from sales of available-for-sale securities
207,083

 
1,004,248

Principal payments on available-for-sale securities
542,727

 
208,965

Purchases of other derivative instruments
(372,483
)
 
(233,764
)
Proceeds from sales of other derivative instruments
86,696

 
23,179

Purchases of trading securities
(996,016
)
 
(2,019,959
)
Proceeds from sales of trading securities
1,001,904

 
700,156

Purchases of investments in real estate
(191,365
)
 
—

Increase in escrow deposits
(34,117
)
 
—

Increase (decrease) in due to counterparties, net
128,147

 
(162,458
)
Increase in restricted cash
(39,603
)
 
(141,728
)
Net cash used in investing activities
(8,372,877
)
 
(6,916,461
)

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)
 
Nine Months Ended
 
September 30,
 
2012
 
2011
 
(unaudited)
Cash Flows From Financing Activities:
   

 
   

Proceeds from repurchase agreements
$
45,160,427

 
$
19,621,767

Principal payments on repurchase agreements
(37,786,248
)
 
(13,490,957
)
Proceeds from issuance of common stock, net of offering costs
1,362,555

 
1,006,755

Proceeds from exercise of warrants
175,725

 
—

Dividends paid on common stock
(228,984
)
 
(63,561
)
Net cash provided by financing activities
8,683,475

 
7,074,004

Net increase in cash and cash equivalents
473,592

 
246,047

Cash and cash equivalents at beginning of period
360,016

 
163,900

Cash and cash equivalents at end of period
$
833,608

 
$
409,947

Supplemental Disclosure of Cash Flow Information:
   

 
 
Cash paid for interest
$
14,038

 
$
8,923

Cash paid for taxes
$
3,637

 
$
1

Non-Cash Financing Activities:
   

 
   

Cashless exercise of warrants
$
178

 
$
—

Dividends declared but not paid at end of period
$
106,325

 
$
56,235

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
10,797

 
—

Proceeds from repayment of mortgage loans held-for-sale
(2,040
)
 
—

Gain on mortgage loans held-for-sale
14

 
—

Loans held-for-sale at end of period
$
14,553

 
$
—


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 its qualification as a REIT, the Company generally will not be subject to U.S. federal income taxes to the extent that the Company distributes its taxable income to its stockholders on an annual basis and does not engage in prohibited transactions. However, certain activities that the Company may perform may cause it to earn income which will not be qualifying income for REIT purposes. The Company has designated certain of its subsidiaries as taxable REIT subsidiaries, or TRSs, as defined in the Code, to engage in such activities, and the Company may in the future form additional TRSs.
On September 11, 2012, the Company announced the proposed contribution of its portfolio of single-family rental properties to a newly formed entity intended to qualify as a REIT.  Specifically, the Company would contribute its equity interests in its wholly owned subsidiary, Two Harbors Property Investment LLC to Silver Bay Realty Trust Corp., a newly organized Maryland corporation focused on the acquisition, renovation, leasing and management of single-family residential properties for rental income and long-term capital appreciation.  In exchange for its contribution, the Company would receive shares of common stock of Silver Bay.  Silver Bay Realty Trust Corp. has filed a registration statement with the U.S. Securities and Exchange Commission with respect to the proposed initial public offering, or IPO, of its common stock.  The consummation of the proposed contribution transaction, which remains subject to approval of the Company's board of directors, is dependent upon the value of the contribution and amount of capital raised in the proposed IPO as well as market and other conditions.

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 September 30, 2012 and results of operations for all periods presented have been made. The results of operations for the three and nine months ended September 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.

6
Table of Contents

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

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. Property acquired not subject to an existing lease is recorded at purchase price, including acquisition costs, allocated between land and building based upon their fair values at the date of acquisition. Property acquired with an existing lease is recorded at fair value (approximated by the purchase price), allocated to land, building and the existing lease based upon their fair values at the date of acquisition, with acquisition costs expensed as incurred. Fair value is determined under the guidance of ASC 820, Fair Value Measurements and Disclosures, primarily based on unobservable market data inputs, which are categorized as Level 3 valuations. In making estimates of fair values for purposes of allocating purchase price, the Company utilizes its own market knowledge and published market data. The Company is currently utilizing information obtained from county tax assessment records to develop regional averages to assist in the determination of the fair value of land and building. The estimated fair value of acquired in-place leases are the costs the Company would have incurred to lease the property at the date of acquisition, based upon current leasing activity. 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. The Company considers the value of acquired in-place leases in the allocation of purchase price and the amortization period reflects the average remaining term of each respective in-place acquired lease. The lease periods are generally short term in nature (one year or less) and reflect market rental rates. Any difference between fair value and cost is recorded in the income statement.
The Company incurs costs to prepare its acquired properties to be rented. These costs are capitalized and allocated to building costs. Costs incurred by the Company to lease the properties are capitalized and amortized over the life of the lease (included in other assets).
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.
Rental income attributable to residential leases is recorded on a straight-line basis, which is not materially different than if it were recorded when due from residents and recognized monthly as it was earned. Leases entered into between residents and the Company for the rental of property units are generally year-to-year, renewable upon consent of both parties on an annual or monthly basis. 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. Gross rental income and expenses applicable to rental activities are reported in the statement of comprehensive income in other income and other operating expenses, respectively.
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

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

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.

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, 2012 and December 31, 2011:
(in thousands)
September 30,
2012
 
December 31,
2011
Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
3,699,453

 
$
1,609,003

Federal National Mortgage Association
6,704,798

 
2,414,637

Government National Mortgage Association
2,064,812

 
1,029,517

Non-Agency
2,500,796

 
1,196,095

Total mortgage-backed securities
$
14,969,859

 
$
6,249,252


At September 30, 2012 and December 31, 2011, the Company pledged investment securities with a carrying value of $14.5 billion and $6.2 billion, respectively, as collateral for repurchase agreements. See Note 12 - Repurchase Agreements.
At September 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 September 30, 2012 and December 31, 2011:
 
September 30, 2012
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
13,101,209

 
$
4,471,572

 
$
17,572,781

Unamortized premium
850,721

 
—

 
850,721

Unamortized discount
 
 
 
 
 
Designated credit reserve
—

 
(1,339,737
)
 
(1,339,737
)
Net, unamortized
(1,853,894
)
 
(960,408
)
 
(2,814,302
)
Amortized Cost
12,098,036

 
2,171,427

 
14,269,463

Gross unrealized gains
384,523

 
345,980

 
730,503

Gross unrealized losses
(13,496
)
 
(16,611
)
 
(30,107
)
Carrying Value
$
12,469,063

 
$
2,500,796

 
$
14,969,859


8
Table of Contents

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

 
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


The following tables present the carrying value of the Company's AFS investment securities by rate type as of September 30, 2012 and December 31, 2011:
 
September 30, 2012
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
200,556

 
$
2,207,347

 
$
2,407,903

Fixed Rate
12,268,507

 
293,449

 
12,561,956

Total
$
12,469,063

 
$
2,500,796

 
$
14,969,859

 
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.

9
Table of Contents

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

The following table presents the changes for the nine months ended September 30, 2012 and 2011 of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
 
Nine Months Ended September 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
(590,090
)
 
(534,000
)
 
(1,124,090
)
 
(640,451
)
 
(483,479
)
 
(1,123,930
)
Accretion of net discount
493

 
98,685

 
99,178

 
—

 
32,305

 
32,305

Realized credit losses
33,622

 
—

 
33,622

 
3,011

 
—

 
3,011

Reclassification adjustment for other-than-temporary impairments
(9,310
)
 
—

 
(9,310
)
 
(3,665
)
 
—

 
(3,665
)
Transfers from (to)
—

 
—

 
—

 
579

 
(579
)
 
—

Sales, calls, other
8,154

 
15,876

 
24,030

 
13,443

 
26,416

 
39,859

Ending balance at September 30
$
(1,339,737
)
 
$
(960,408
)
 
$
(2,300,145
)
 
$
(772,938
)
 
$
(555,329
)
 
$
(1,328,267
)

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, 2012 and December 31, 2011. At September 30, 2012, the Company held 1,490 AFS securities, of which 76 were in an unrealized loss position for less than twelve consecutive months and 70 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
September 30, 2012
$
301,709

 
$
(11,682
)
 
$
181,019

 
$
(18,425
)
 
$
482,728

 
$
(30,107
)
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 $0.6 million and a $9.3 million other-than-temporary credit impairment during the three and nine months ended September 30, 2012, respectively, on a total of 37 non-Agency RMBS where the future expected cash flows for each security was less than its amortized cost. As of September 30, 2012, the impaired securities had weighted average cumulative losses of 1.7%, weighted average three-month prepayment speed of 3.04, weighted average 60+ day delinquency of 36.6% of the pool balance, and weighted average FICO score of 650. At September 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,

10
Table of Contents

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

therefore, only the projected credit loss was recognized in earnings. During the three and nine months ended September 30, 2011, the Company recorded a $3.4 million and a $3.7 million other-than-temporary credit impairment, respectively, on eight 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 nine months ended September 30, 2012 and 2011:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2012
 
2011
 
2012
 
2011
Cumulative credit loss at beginning of period
$
(13,603
)
 
$
(294
)
 
$
(5,102
)
 
$
—

Additions:
 
 
 
 
 
 
 
Other-than-temporary impairments not previously recognized
(315
)
 
(3,371
)
 
(6,443
)
 
(3,665
)
Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments
(244
)
 
—

 
(2,867
)
 
—

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

 
—

 
250

 
—

Decreases related to other-than-temporary impairments on securities sold
243

 
—

 
243

 
—

Cumulative credit loss at end of period
$
(13,919
)
 
$
(3,665
)
 
$
(13,919
)
 
$
(3,665
)

Cumulative credit losses related to OTTI may be reduced for securities sold as well as for 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 nine months ended September 30, 2012, the Company sold AFS securities for $9.4 million and $207.1 million with an amortized cost of $9.6 million and $197.3 million, for a net realized loss of $0.2 million and a net realized gain of $9.8 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, 2012 and 2011:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2012
 
2011
 
2012
 
2011
Gross realized gains
$
—

 
$
27,472

 
$
11,663

 
$
29,422

Gross realized losses
(221
)
 
—

 
(1,850
)
 
(265
)
Total realized gains on sales, net
$
(221
)
 
$
27,472

 
$
9,813

 
$
29,157


Note 4. Trading Securities, at Fair Value
The Company holds U.S. Treasuries in a taxable REIT subsidiary and classifies these securities as trading instruments due to short-term investment objectives. As of September 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 $5.8 million and $3.1 million as of September 30, 2012 and December 31, 2011, respectively.
For the nine months ended September 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. The Company did not sell any trading securities during the three months ended September 30, 2012. For the three and nine months ended September 30, 2012, trading securities experienced unrealized gains of $2.7 million. Both realized and unrealized gains and losses are recorded as a

11
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TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements (unaudited)

component of gains on investment securities, net in the Company's condensed consolidated statements of comprehensive income.
At September 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 September 30, 2012 and December 31, 2011:
(in thousands)
September 30,
2012
 
December 31, 2011
Unpaid principal balance
$
14,156

 
$
5,655

Fair value adjustment
397

 
127

Carrying value
$
14,553

 
$
5,782


At September 30, 2012, the Company pledged mortgage loans with a carrying value of $14.6 million as collateral for repurchase agreements. See Note 12 - Repurchase Agreements.

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 September 30, 2012 and December 31, 2011:
(in thousands)
September 30,
2012
 
December 31,
2011
Land
$
39,377

 
$
—

Building
151,988

 
—

 
191,365

 
—

Accumulated depreciation (1)
(458
)
 
—

Investment in real estate, net
$
190,907

 
$
—

____________________
(1)
Depreciation expense for the three and nine months ended September 30, 2012 was $426,532 and $458,158, respectively.

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 September 30, 2012 and December 31, 2011:
(in thousands)
September 30,
2012
 
December 31,
2011
Restricted cash balances held by trading counterparties:
 
 
 
For securities trading activity
$
9,000

 
$
9,000

For derivatives trading activity
182,826

 
62,784

As restricted collateral for repurchase agreements
14,018

 
94,803

 
205,844

 
166,587

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

 
—

Total
$
206,190

 
$
166,587


12
Table of Contents

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


Note 8. Accrued Interest Receivable
The following table presents the Company's accrued interest receivable by collateral type:
(in thousands)
September 30,
2012
 
December 31,
2011
Accrued Interest Receivable:
 
 
 
U.S. Treasuries
$
166

 
$
1,003

Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
12,571

 
5,844

Federal National Mortgage Association
22,592

 
9,770

Government National Mortgage Association
8,613

 
4,454

Non-Agency
2,881

 
2,328

Total mortgage-backed securities
46,657

 
22,396

Mortgage loans held-for-sale
96

 
38

Total
$
46,919

 
$
23,437


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, and credit default swaps. At times, the Company may use TBAs for risk management or other purposes. 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 tables present the gross fair value and notional amounts of the Company's derivative financial instruments treated as trading instruments as of September 30, 2012 and December 31, 2011.
(in thousands)
 
September 30, 2012
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
Notional
 
Fair Value
Notional
Inverse interest-only securities
 
$
332,569

2,031,621

 
$
—

—

Interest rate swap agreements
 
—

—

 
(132,322
)
13,095,000

Credit default swap agreements
 
54,584

610,707

 
—

—

Swaptions
 
105,064

5,150,000

 
—

—

TBAs
 
3,967

450,000

 
—

—

Forward purchase commitment
 
604

319,931

 
—

—

Total
 
$
496,788

8,562,259

 
$
(132,322
)
13,095,000


13
Table of Contents

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

(in thousands)
 
December 31, 2011
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
Notional
 
Fair Value
Notional
Inverse interest-only securities
 
$
157,421

1,131,084

 
$
—

—

Interest rate swap agreements
 
—

—

 
(28,790
)
5,810,000

Credit default swap agreements
 
86,136

544,699

 
(14,638
)
154,812

Swaptions
 
5,635

2,900,000

 
—

—

TBAs
 
2,664

275,000

 
(5,652
)
850,000

Forward sale commitment
 
—

5,202

 
—

—

Total
 
$
251,856

4,855,985

 
$
(49,080
)
6,814,812


The following table provides the average outstanding notional amounts of the Company's derivative financial instruments treated as trading instruments for the three and nine months ended September 30, 2012.
(in thousands)
 
Three Months Ended September 30, 2012
 
Nine Months Ended September 30, 2012
Trading instruments
 
Derivative Assets
 
Derivative Liabilities
 
Derivative Assets
 
Derivative Liabilities
Inverse interest-only securities
 
1,953,128

 
—

 
1,669,944

 
—

Interest rate swap agreements
 
—

 
11,327,391

 
—

 
8,625,967

Credit default swaps
 
545,611

 
48,576

 
554,568

 
91,555

Swaptions
 
4,891,304

 
—

 
3,687,328

 
—

TBAs
 
304,348

 
—

 
278,741

 
564,416

Short treasuries
 
—

 
46,739

 
—

 
15,693

Forward purchase commitment
 
45,872

 
—

 
15,894

 
—

Forward sale commitment
 
—

 
—

 
3,199

 
—


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.

14
Table of Contents

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

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 September 30,
 
Nine Months Ended September 30,
 
 
 
 
2012
 
2011
 
2012
 
2011
Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Interest Rate Contracts
 
 
 
 
 
 
 
 
 
 
Investment securities - RMBS
 
Gain (loss) on other derivative instruments
 
$
2,170

 
$
5,729

 
$
(22,817
)
 
$
5,091

Investment securities - U.S. Treasuries and TBA contracts
 
Loss on interest rate swap and swaption agreements
 
(5,429
)
 
6,544

 
(12,774
)
 
2,733

Mortgage loans held-for-sale
 
Gain (loss) on other derivative instruments
 
604

 
—

 
578

 
—

Repurchase agreements
 
Loss gain on interest rate swap and swaption agreements
 
(71,043
)
 
(45,855
)
 
(140,905
)
 
(90,913
)
Credit default swaps - Receive protection
 
Gain (loss) on other derivative instruments
 
(18,661
)
 
21,994

 
(44,187
)
 
22,267

Non-Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Credit default swaps - Provide protection
 
Gain (loss) on other derivative instruments
 
3,015

 
(4,414
)
 
11,987

 
(5,589
)
Inverse interest-only securities
 
Gain (loss) on other derivative instruments
 
18,094

 
(948
)
 
43,154

 
15,705

Short treasuries
 
Gain (loss) on other derivative instruments
 
(1,768
)
 
—

 
(1,768
)
 
—

Total
 
 
 
$
(73,018
)
 
$
(16,950
)
 
$
(166,732
)
 
$
(50,706
)

For the three and nine months ended September 30, 2012, the Company recognized $10.7 million and $23.1 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 $11.3 billion and $8.6 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 nine months ended September 30, 2012, the Company terminated or had options expire on a total of 3 and 22 interest rate swap and swaption positions of $0.8 billion notional and $3.7 billion notional, respectively. Upon settlement of the early terminations and option expirations, the Company paid $1.5 million in full settlement of its net interest spread liability and recognized $7.5 million and $26.1 million in realized losses on the swaps and swaptions, respectively, including early termination penalties.
For the three and nine months ended September 30, 2012, the Company terminated a total of 3 and 13 credit default swap positions totaling $185.0 million and $425.0 million notional, respectively. Upon settlement of the early terminations, the Company received $94,069 and $30,861, respectively, in full settlement of its net interest spread receivable and recognized $1.0 million in realized gains and $2.3 million in realized losses for the three and nine months ended September 30, 2012, respectively, 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 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

15
Table of Contents

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

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 September 30, 2012 and December 31, 2011, the Company had outstanding fair value of $86.2 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. In addition, the Company held TBA positions with $450.0 million and $275.0 million in long notional as of September 30, 2012 and December 31, 2011, respectively, and an additional $850.0 million in short notional as of December 31, 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. These contracts held a fair market value of $4.0 million and $2.7 million, included in derivative assets, at fair value, as of September 30, 2012 and December 31, 2011, respectively, 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 September 30, 2012, the Company had entered into commitments to purchase mortgage loans of $319.9 million, subject to fallout if the loans do not close, with a fair value of $0.6 million at September 30, 2012.
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 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 September 30, 2012, the Company had no additional trades under the Forward Agreement. The Company may also enter into other derivative contracts to hedge the interest rate risk related to the commitments to purchase mortgage loans, such as interest rate swaps, swaptions or TBAs.
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.

16
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TWO HARBORS INVESTMENT CORP.  
Notes to the Condensed Consolidated Financial Statements (unaudited)

As of September 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)
 
 
 
 
 
 
September 30, 2012
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
25,000

 
0.868
%
 
0.502
%
 
0.23

2013
 
2,275,000

 
0.713
%
 
0.484
%
 
0.81

2014
 
1,675,000

 
0.644
%
 
0.497
%
 
1.82

2015
 
2,770,000

 
0.908
%
 
0.471
%
 
2.68

2016 and Thereafter
 
5,350,000

 
0.923
%
 
0.410
%
 
4.45

Total
 
12,095,000

 
0.841
%
 
0.450
%
 
2.99

(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 September 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)
 
 
 
 
 
 
September 30, 2012
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2015
 
1,000,000

 
0.799
%
 
0.470
%
 
2.53

Total
 
1,000,000

 
 
 
 
 
 
(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

 
 
 
 
 
 


17
Table of Contents

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

As of September 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 September 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:
September 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
 
$
1,995

 
$
—

 
0.87
 
200,000

 
3.25
%
 
3M Libor
 
7.0

Payer
 
≥ 6 Months
 
133,908

 
105,064

 
55.43
 
4,950,000

 
3.75
%
 
3M Libor
 
9.8

Total Payer
 
 
 
$
135,903

 
$
105,064

 
55.43
 
5,150,000

 
3.73
%
 
3M Libor
 
9.7

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.
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

18
Table of Contents

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

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, 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 September 30, 2012 and December 31, 2011:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
September 30, 2012
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront Payable
 
Unrealized Gain/(Loss)
Receive
9/20/2013
 
460.00

 
(45,000
)
 
$
(269
)
 
$
(3,127
)
 
$
(3,396
)
 
12/20/2013
 
181.91

 
(105,000
)
 
(178
)
 
(3,225
)
 
(3,403
)
 
6/20/2016
 
105.50

 
(100,000
)
 
(1,538
)
 
(260
)
 
(1,798
)
 
12/20/2016
 
682.82

 
(121,000
)
 
(1,029
)
 
(13,062
)
 
(14,091
)
 
6/20/2017
 
586.18

 
(99,000
)
 
(863
)
 
(3,563
)
 
(4,426
)
 
5/25/2046
 
306.99

 
(140,707
)
 
58,461

 
(61,852
)
 
(3,391
)
 
Total
 
383.49

 
(610,707
)
 
$
54,584

 
$
(85,089
)
 
$
(30,505
)
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2011
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront Payable
 
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


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, 2012, the fair value of derivative financial instruments as an asset and liability position was $496.8 million and $132.3 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, 2012, the Company has received cash deposits from counterparties of $102.9 million and placed cash deposits of $183.4 million in

19
Table of Contents

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

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, credit default swaps, and, on occasion, TBAs.
Inverse interest-only securities with a carrying value of $332.6 million, including accrued interest receivable of $3.9 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, 2012 and December 31, 2011:
(in thousands)
September 30,
2012
 
December 31,
2011
Face Value
$
2,031,621

 
$
1,131,084

Unamortized premium
—

 
—

Unamortized discount
 
 
 
Designated credit reserve
—

 
—

Net, unamortized
(1,721,349
)
 
(973,066
)
Amortized Cost
310,272

 
158,018

Gross unrealized gains
25,009

 
4,606

Gross unrealized losses
(6,646
)
 
(7,385
)
Carrying Value
$
328,635

 
$
155,239


As of 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. The Company did not hold any credit default swaps where the Company provides credit protection as of September 30, 2012.
The following table presents credit default swaps where the Company is providing protection held as of December 31, 2011:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2011
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Loss
Provide
7/25/2036
 
358.71