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: March 31, 2014
Commission File Number 001-34506
______________________________
TWO HARBORS INVESTMENT CORP.
(Exact Name of Registrant as Specified in Its Charter)
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Maryland | | 27-0312904 |
(State or Other Jurisdiction of Incorporation or Organization) | | (I.R.S. Employer Identification No.) |
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590 Madison Avenue, 36th Floor New York, New York | | 10022 |
(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):
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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 May 8, 2014 there were 366,055,319 shares of outstanding common stock, par value $.01 per share, issued and outstanding.
TWO HARBORS INVESTMENT CORP.
INDEX
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| PART I - FINANCIAL INFORMATION | |
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| PART II - OTHER INFORMATION | |
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
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| | | | | | | |
| March 31, 2014 | | December 31, 2013 |
ASSETS | (unaudited) | |
|
|
Available-for-sale securities, at fair value | $ | 12,634,056 |
| | $ | 12,256,727 |
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Trading securities, at fair value | 1,000,312 |
| | 1,000,180 |
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Mortgage loans held-for-sale, at fair value | 161,021 |
| | 544,581 |
|
Mortgage loans held-for-investment in securitization trusts, at fair value | 781,085 |
| | 792,390 |
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Mortgage servicing rights, at fair value | 476,663 |
| | 514,402 |
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Cash and cash equivalents | 1,540,431 |
| | 1,025,487 |
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Restricted cash | 220,202 |
| | 401,647 |
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Accrued interest receivable | 46,724 |
| | 50,303 |
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Due from counterparties | 74,997 |
| | 25,087 |
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Derivative assets, at fair value | 429,419 |
| | 549,859 |
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Other assets | 60,888 |
| | 13,199 |
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Total Assets (1) | $ | 17,425,798 |
| | $ | 17,173,862 |
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LIABILITIES AND STOCKHOLDERS’ EQUITY |
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Liabilities |
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Repurchase agreements | $ | 12,021,177 |
| | $ | 12,250,450 |
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Collateralized borrowings in securitization trusts, at fair value | 658,953 |
| | 639,731 |
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Federal Home Loan Bank advances | 464,476 |
| | — |
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Derivative liabilities, at fair value | 8,395 |
| | 22,081 |
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Accrued interest payable | 16,069 |
| | 20,277 |
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Due to counterparties | 195,928 |
| | 318,848 |
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Dividends payable | 95,172 |
| | — |
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Other liabilities | 46,624 |
| | 67,480 |
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Total liabilities (1) | 13,506,794 |
| | 13,318,867 |
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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; 900,000,000 shares authorized and 366,046,045 and 364,935,168 shares issued and outstanding, respectively | 3,660 |
| | 3,649 |
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Additional paid-in capital | 3,801,952 |
| | 3,795,372 |
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Accumulated other comprehensive income | 626,470 |
| | 444,735 |
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Cumulative earnings | 999,252 |
| | 1,028,397 |
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Cumulative distributions to stockholders | (1,512,330 | ) | | (1,417,158 | ) |
Total stockholders’ equity | 3,919,004 |
| | 3,854,995 |
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Total Liabilities and Stockholders’ Equity | $ | 17,425,798 |
| | $ | 17,173,862 |
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____________________
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(1) | The condensed consolidated balance sheets include assets of consolidated variable interest entities, or VIEs, that can only be used to settle obligations of these VIEs and liabilities of the consolidated VIEs for which creditors do not have recourse to the Company (Two Harbors Investment Corp.). At March 31, 2014 and December 31, 2013, assets of the VIEs totaled $785,601 and $796,896, and liabilities of the VIEs totaled $663,785 and $644,051, respectively. See Note 3 - Variable Interest Entities for additional information. |
The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands, except share data)
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| | | | | | | |
| Three Months Ended |
| March 31, |
| 2014 | | 2013 |
| (unaudited) |
Interest income: | | | |
Available-for-sale securities | $ | 123,913 |
| | $ | 130,292 |
|
Trading securities | 1,926 |
| | 1,264 |
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Mortgage loans held-for-sale | 4,586 |
| | 1,318 |
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Mortgage loans held-for-investment in securitization trusts | 7,893 |
| | 1,654 |
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Cash and cash equivalents | 217 |
| | 307 |
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Total interest income | 138,535 |
| | 134,835 |
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Interest expense: |
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| |
|
|
Repurchase agreements | 20,572 |
| | 23,018 |
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Collateralized borrowings in securitization trusts | 5,353 |
| | 818 |
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Federal Home Loan Bank advances | 153 |
| | — |
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Total interest expense | 26,078 |
| | 23,836 |
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Net interest income | 112,457 |
| | 110,999 |
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Other-than-temporary impairments: |
| |
|
Total other-than-temporary impairment losses | (212 | ) | | (236 | ) |
Non-credit portion of loss recognized in other comprehensive income | — |
| | — |
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Net other-than-temporary credit impairment losses | (212 | ) |
| (236 | ) |
Other income: |
| |
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(Loss) gain on investment securities | (38,655 | ) | | 26,968 |
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(Loss) gain on interest rate swap and swaption agreements | (105,528 | ) | | 18,972 |
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Gain (loss) on other derivative instruments | 5,801 |
| | (16,662 | ) |
(Loss) gain on mortgage loans held-for-sale | (3,181 | ) | | 14,323 |
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Servicing income | 30,441 |
| | — |
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Loss on servicing asset | (32,760 | ) | | — |
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Other income | 460 |
| | 6,289 |
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Total other (loss) income | (143,422 | ) | | 49,890 |
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Expenses: |
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Management fees | 12,111 |
| | 4,761 |
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Securitization deal costs | — |
| | 2,028 |
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Servicing expenses | 5,225 |
| | 31 |
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Other operating expenses | 14,534 |
| | 6,530 |
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Total expenses | 31,870 |
| | 13,350 |
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(Loss) income from continuing operations before income taxes | (63,047 | ) | | 147,303 |
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(Benefit from) provision for income taxes | (33,902 | ) | | 4,964 |
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Net (loss) income from continuing operations | (29,145 | ) | | 142,339 |
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Income from discontinued operations | — |
| | 1,377 |
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Net (loss) income attributable to common stockholders | $ | (29,145 | ) | | $ | 143,716 |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME, continued
(in thousands, except share data)
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| | | | | | | |
| Three Months Ended |
| March 31, |
| 2014 | | 2013 |
| (unaudited) |
Basic (loss) earnings per weighted average common share: |
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Continuing operations | $ | (0.08 | ) | | $ | 0.47 |
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Discontinued operations | — |
| | — |
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Net (loss) income | $ | (0.08 | ) | | $ | 0.47 |
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Diluted (loss) earnings per weighted average common share: |
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Continuing operations | $ | (0.08 | ) | | $ | 0.47 |
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Discontinued operations | — |
| | — |
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Net (loss) income | $ | (0.08 | ) | | $ | 0.47 |
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Dividends declared per common share | $ | 0.26 |
| | $ | 0.32 |
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Weighted average number of shares of common stock: |
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Basic | 365,611,890 |
| | 305,284,922 |
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Diluted | 365,611,890 |
| | 306,963,711 |
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Comprehensive income: |
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Net (loss) income | $ | (29,145 | ) | | $ | 143,716 |
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Other comprehensive income: |
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Unrealized gain on available-for-sale securities, net | 181,735 |
| | 104,252 |
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Other comprehensive income | 181,735 |
| | 104,252 |
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Comprehensive income | $ | 152,590 |
| | $ | 247,968 |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except share data)
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| Common Stock | | | | | | | | | | |
| Shares | | Amount | | Additional Paid-in Capital | | Accumulated Other Comprehensive Income | | Cumulative Earnings | | Cumulative Distributions to Stockholders | | Total Stockholders’ Equity |
| | | | | | | (unaudited) | | | | | | |
Balance, December 31, 2012 | 298,813,258 |
| | $ | 2,988 |
| | $ | 2,948,345 |
| | $ | 696,458 |
| | $ | 449,358 |
| | $ | (646,572 | ) | | $ | 3,450,577 |
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Net income | — |
| | — |
| | — |
| | — |
| | 143,716 |
| | — |
| | 143,716 |
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Other comprehensive income before reclassifications | — |
| | — |
| | — |
| | 122,791 |
| | — |
| | — |
| | 122,791 |
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Amounts reclassified from accumulated other comprehensive income | — |
| | — |
| | — |
| | (18,539 | ) | | — |
| | — |
| | (18,539 | ) |
Net other comprehensive income | — |
| | — |
| | — |
| | 104,252 |
| | — |
| | — |
| | 104,252 |
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Issuance of common stock, net of offering costs | 57,525,457 |
| | 575 |
| | 762,467 |
| | — |
| | — |
| | — |
| | 763,042 |
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Issuance of common stock in connection with exercise of warrants | 5,803,679 |
| | 58 |
| | 63,713 |
| | — |
| | — |
| | — |
| | 63,771 |
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Common dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | (116,821 | ) | | (116,821 | ) |
Special dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | (343,481 | ) | | (343,481 | ) |
Non-cash equity award compensation | — |
| | — |
| | 23 |
| | — |
| | — |
| | — |
| | 23 |
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Balance, March 31, 2013 | 362,142,394 |
| | $ | 3,621 |
| | $ | 3,774,548 |
| | $ | 800,710 |
| | $ | 593,074 |
| | $ | (1,106,874 | ) | | $ | 4,065,079 |
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| | | | | | | | | | | | | |
Balance, December 31, 2013 | 364,935,168 |
| | $ | 3,649 |
| | $ | 3,795,372 |
| | $ | 444,735 |
| | $ | 1,028,397 |
| | $ | (1,417,158 | ) | | $ | 3,854,995 |
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Net loss | — |
| | — |
| | — |
| | — |
| | (29,145 | ) | | — |
| | (29,145 | ) |
Other comprehensive income before reclassifications | — |
| | — |
| | — |
| | 138,343 |
| | — |
| | — |
| | 138,343 |
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Amounts reclassified from accumulated other comprehensive income | — |
| | — |
| | — |
| | 43,392 |
| | — |
| | — |
| | 43,392 |
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Net other comprehensive income | — |
| | — |
| | — |
| | 181,735 |
| | — |
| | — |
| | 181,735 |
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Issuance of common stock, net of offering costs | 10,780 |
| | — |
| | 110 |
| | — |
| | — |
| | — |
| | 110 |
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Common dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | (95,172 | ) | | (95,172 | ) |
Non-cash equity award compensation | 1,100,097 |
| | 11 |
| | 6,470 |
| | — |
| | — |
| | — |
| | 6,481 |
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Balance, March 31, 2014 | 366,046,045 |
| | $ | 3,660 |
| | $ | 3,801,952 |
| | $ | 626,470 |
| | $ | 999,252 |
| | $ | (1,512,330 | ) | | $ | 3,919,004 |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
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| | | | | | | |
| Three Months Ended |
| March 31, |
| 2014 | | 2013 |
Cash Flows From Operating Activities: | (unaudited) |
Net (loss) income | $ | (29,145 | ) | | $ | 143,716 |
|
Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities: | | | |
Amortization of premiums and discounts on available-for-sale securities, net | (26 | ) | | 2,802 |
|
Other-than-temporary impairment losses | 212 |
| | 236 |
|
Realized and unrealized losses (gains) on investment securities, net | 38,655 |
| | (26,790 | ) |
Loss (gain) on mortgage loans held-for-sale | 3,181 |
| | (14,323 | ) |
Gain on mortgage loans held-for-investment and collateralized borrowings in securitization trusts | (313 | ) | | (6,289 | ) |
Loss on servicing asset | 32,760 |
| | — |
|
Loss on termination and option expiration of interest rate swaps and swaptions | 1,240 |
| | 58,692 |
|
Unrealized loss (gain) on interest rate swaps and swaptions | 90,452 |
| | (91,680 | ) |
Unrealized loss on other derivative instruments | 1,162 |
| | 6,923 |
|
Equity based compensation | 6,481 |
| | 23 |
|
Depreciation of fixed assets | 207 |
| | 114 |
|
Amortization of intangible assets | 400 |
| | — |
|
Purchases of mortgage loans held-for-sale | (28,867 | ) | | (147,050 | ) |
Proceeds from sales of mortgage loans held-for-sale | 403,336 |
| | 25,404 |
|
Proceeds from repayment of mortgage loans held-for-sale | 6,296 |
| | 2,284 |
|
Net change in assets and liabilities: |
|
| | |
Decrease/(increase) in accrued interest receivable | 3,579 |
| | (4,476 | ) |
(Increase)/decrease in deferred income taxes, net | (41,799 | ) | | 4,893 |
|
Increase in income taxes receivable | (321 | ) | | (303 | ) |
Increase in prepaid and fixed assets | (400 | ) | | (187 | ) |
(Increase)/decrease in other receivables | (10,516 | ) | | 29,049 |
|
Increase in servicing advances | (5,416 | ) | | — |
|
Increase in Federal Home Loan Bank stock | (18,579 | ) | | — |
|
Increase in equity investments | (3,000 | ) | | — |
|
(Decrease)/increase in accrued interest payable | (4,208 | ) | | 288 |
|
Increase in income taxes payable | 7,084 |
| | — |
|
Increase/(decrease) in accrued expenses and other liabilities | 3,795 |
| | (3,810 | ) |
Net cash provided by (used in) operating activities | 456,250 |
| | (20,484 | ) |
The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
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| | | | | | | |
| Three Months Ended |
| March 31, |
| 2014 | | 2013 |
Cash Flows From Investing Activities: | (unaudited) |
Purchases of available-for-sale securities | $ | (1,274,784 | ) | | $ | (2,208,951 | ) |
Proceeds from sales of available-for-sale securities | 814,872 |
| | 796,653 |
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Principal payments on available-for-sale securities | 224,982 |
| | 235,530 |
|
Purchases of other derivative instruments | (12,902 | ) | | (66,277 | ) |
Proceeds from sales of other derivative instruments, net | 26,416 |
| | (41,323 | ) |
Purchases of trading securities | (98,219 | ) | | — |
|
Proceeds from sales of trading securities | 98,582 |
| | — |
|
Purchases of beneficial interests in securitization trusts | — |
| | (30,550 | ) |
Proceeds from repayment of mortgage loans held-for-investment in securitization trusts | 13,280 |
| | 697 |
|
Purchases of mortgage servicing rights, net of purchase price adjustments | 4,979 |
| | — |
|
(Decrease)/increase in due to counterparties, net | (172,830 | ) | | 147,585 |
|
Decrease in restricted cash | 181,445 |
| | 24,894 |
|
Net cash used in investing activities | (194,179 | ) | | (1,141,742 | ) |
Cash Flows From Financing Activities: | | | |
Proceeds from repurchase agreements | 70,826,091 |
| | 24,103,888 |
|
Principal payments on repurchase agreements | (71,055,364 | ) | | (23,283,833 | ) |
Proceeds from issuance of collateralized borrowings in securitization trusts | 33,483 |
| | — |
|
Principal payments on collateralized borrowings in securitization trusts | (15,923 | ) | | (697 | ) |
Proceeds from Federal Home Loan Bank advances | 464,476 |
| | — |
|
Proceeds from issuance of common stock, net of offering costs | 110 |
| | 763,042 |
|
Proceeds from exercise of warrants | — |
| | 63,771 |
|
Dividends paid on common stock | — |
| | (164,347 | ) |
Net cash provided by financing activities | 252,873 |
| | 1,481,824 |
|
Net increase in cash and cash equivalents | 514,944 |
| | 319,598 |
|
Cash and cash equivalents at beginning of period | 1,025,487 |
| | 821,108 |
|
Cash and cash equivalents at end of period | $ | 1,540,431 |
| | $ | 1,140,706 |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
|
| | | | | | | |
| Three Months Ended |
| March 31, |
| 2014 | | 2013 |
Supplemental Disclosure of Cash Flow Information: | (unaudited) |
Cash paid for interest | $ | 30,286 |
| | $ | 23,548 |
|
Cash paid for taxes | $ | 1,134 |
| | $ | 373 |
|
Noncash Investing and Financing Activities: | | | |
Consolidation of mortgage loans held-for-investment in securitization trusts | $ | — |
| | $ | 442,767 |
|
Consolidation of collateralized borrowings in securitization trusts | $ | — |
| | $ | 412,217 |
|
Cashless exercise of warrants | $ | — |
| | $ | 75 |
|
Special dividend of Silver Bay common stock declared but not paid at end of period | $ | — |
| | $ | 368,970 |
|
Cash dividends declared but not paid at end of period | $ | 95,172 |
| | $ | 116,821 |
|
Reconciliation of mortgage loans held-for-sale: | | | |
Mortgage loans held-for-sale at beginning of period | $ | 544,581 |
| | $ | 58,607 |
|
Purchases of mortgage loans held-for-sale | 28,867 |
| | 147,050 |
|
Proceeds from sales of mortgage loans held-for-sale | (403,336 | ) | | (25,404 | ) |
Proceeds from repayment of mortgage loans held-for-sale | (6,296 | ) | | (2,284 | ) |
Realized and unrealized (losses) gains on mortgage loans held-for-sale | (2,795 | ) | | 14,448 |
|
Mortgage loans held-for-sale at end of period | $ | 161,021 |
| | $ | 192,417 |
|
The accompanying notes are an integral part of these condensed consolidated financial statements.
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, mortgage servicing rights, or MSR, and other financial assets. The Company is externally managed and advised by PRCM Advisers LLC, or PRCM Advisers, which is 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 under the symbol “TWO”.
The Company was incorporated on May 21, 2009 and commenced operations as a publicly traded company on October 28, 2009, upon completion of a merger with Capitol Acquisition Corp., or Capitol, which became a wholly owned indirect subsidiary as a result of the merger.
The Company has elected to be treated as a real estate investment trust, or REIT, as defined under the Internal Revenue Code of 1986, as amended, or the Code, 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 December 19, 2012, the Company completed the contribution of its portfolio of single-family rental properties to Silver Bay Realty Trust Corp., or Silver Bay, a newly organized Maryland corporation intended to qualify as a REIT and focused on the acquisition, renovation, leasing and management of single-family residential properties for rental income and long-term capital appreciation. The Company contributed its equity interests in its wholly owned subsidiary, Two Harbors Property Investment LLC, to Silver Bay, and in exchange for its contribution, received shares of common stock of Silver Bay. Silver Bay completed its initial public offering, or IPO, of its common stock on December 19, 2012. Because the Company will not have any significant continuing involvement in Two Harbors Property Investment LLC, all of the associated operating results were removed from continuing operations and are presented separately as discontinued operations for the three months ended March 31, 2014 and 2013. See Note 4 - Discontinued Operations for additional information.
On April 30, 2013, one of the Company’s wholly owned subsidiaries acquired a company that has approvals from the Federal National Mortgage Association, or Fannie Mae, the Federal Home Loan Mortgage Corporation, or Freddie Mac, and the Government National Mortgage Association, or Ginnie Mae, to hold and manage MSR. The MSR acquired in conjunction with the acquisition of this entity and those subsequently purchased represent the right to service mortgage loans. The Company and its subsidiaries do not originate or directly service mortgage loans, and instead contract with fully licensed subservicers to handle all servicing functions for the loans underlying the Company’s MSR. See Note 9 - Servicing Activities for additional information.
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 U.S. GAAP, have been condensed or omitted according to such SEC rules and regulations. However, management believes 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, 2013. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at March 31, 2014 and results of operations for all periods presented have been made. The results of operations for the three months ended March 31, 2014 should not be construed as indicative of the results to be expected for future periods or the full year.
The condensed consolidated financial statements of the Company have been prepared on the accrual basis of accounting in accordance with U.S. GAAP. The preparation of financial statements in conformity with U.S. 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
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
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.
The legal entities used in securitization (i.e., the securitization trusts), which are considered VIEs for financial reporting purposes, were reviewed for consolidation under the applicable consolidation guidance. Because the Company has both the power to direct the activities of the securitization trusts that most significantly impact the entities’ performance, and the obligation to absorb losses or the right to receive benefits of the entities that could be significant, the Company consolidates the trusts. The accounting is consistent with a secured financing, where the loans and securitized debt are both carried on the Company’s condensed consolidated balance sheets.
Significant Accounting Policies
Included in Note 2 to the Consolidated Financial Statements of the Company’s 2013 Annual Report on Form 10-K is a summary of the Company’s significant accounting policies. Provided below is a summary of additional accounting policies that are significant to the Company’s consolidated financial condition and results of operations for the three months ended March 31, 2014.
Federal Home Loan Bank Advances
In December 2013, the Company’s wholly owned subsidiary, TH Insurance Holdings Company LLC, or TH Insurance Holdings, was accepted for membership in the Federal Home Loan Bank of Des Moines, or the FHLB. As a member of the FHLB, TH Insurance Holdings has access to a variety of products and services offered by the FHLB, including secured advances.
As of March 31, 2014, the Company held FHLB advances with both short-term and long-term maturities. The advances generally bear interest rates of one- or three-month LIBOR. FHLB advances are treated as secured financing transactions and are carried at their contractual amounts.
Offsetting Assets and Liabilities
Certain of the Company’s repurchase agreements, as well as its FHLB advances, are governed by underlying agreements that provide for a right of setoff in the event of default of either party to the agreement. The Company also has netting arrangements in place with all derivative counterparties pursuant to standard documentation developed by the International Swap and Derivatives Association, or ISDA. Additionally, the Company and the counterparty are required to post cash collateral based upon the net underlying market value of the Company’s open positions with the counterparty.
Under U.S. GAAP, if the Company has a valid right of setoff, it may offset the related asset and liability and report the net amount. The Company presents repurchase agreements and FHLB advances subject to master netting arrangements or similar agreements on a gross basis, and derivative assets and liabilities subject to such arrangements on a net basis, based on derivative type and counterparty, in its condensed consolidated balance sheets. Separately, the Company presents cash collateral subject to such arrangements on a net basis, based on counterparty, in its condensed consolidated balance sheets. However, the Company does not offset financial assets and liabilities with the associated cash collateral on its condensed consolidated balance sheets.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
The following tables present information about the Company’s assets and liabilities that are subject to master netting arrangements or similar agreements and can potentially be offset on the Company’s condensed consolidated balance sheets as of March 31, 2014 and December 31, 2013:
|
| | | | | | | | | | | | | | | | | | | | | | | |
| March 31, 2014 |
| | | | | | | Gross Amounts Not Offset with Financial Assets (Liabilities) in the Condensed Consolidated Balance Sheets (1) | | |
(in thousands) | Gross Amounts of Recognized Assets (Liabilities) | | Gross Amounts Offset in the Condensed Consolidated Balance Sheets | | Net Amounts of Assets (Liabilities) Presented in the Condensed Consolidated Balance Sheets | | Financial Instruments | | Cash Collateral (Received) Pledged | | Net Amount |
Assets | | | | | | | | | | | |
Derivative assets | $ | 431,013 |
| | $ | (1,594 | ) | | $ | 429,419 |
| | $ | (8,395 | ) | | $ | — |
| | $ | 421,024 |
|
Total Assets | $ | 431,013 |
| | $ | (1,594 | ) | | $ | 429,419 |
| | $ | (8,395 | ) | | $ | — |
| | $ | 421,024 |
|
| | | | | | | | | | | |
Liabilities | | | | | | | | | | | |
Repurchase agreements | $ | (12,021,177 | ) | | $ | — |
| | $ | (12,021,177 | ) | | $ | 12,021,177 |
| | $ | — |
| | $ | — |
|
Federal Home Loan Bank advances | (464,476 | ) | | — |
| | (464,476 | ) | | 464,476 |
| | — |
| | — |
|
Derivative liabilities | (9,989 | ) | | 1,594 |
| | (8,395 | ) | | 8,395 |
| | — |
| | — |
|
Total Liabilities | $ | (12,495,642 | ) | | $ | 1,594 |
| | $ | (12,494,048 | ) | | $ | 12,494,048 |
| | $ | — |
| | $ | — |
|
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
|
| | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2013 |
| | | | | | | Gross Amounts Not Offset with Financial Assets (Liabilities) in the Condensed Consolidated Balance Sheets (1) | | |
(in thousands) | Gross Amounts of Recognized Assets (Liabilities) | | Gross Amounts Offset in the Condensed Consolidated Balance Sheets | | Net Amounts of Assets (Liabilities) Presented in the Condensed Consolidated Balance Sheets | | Financial Instruments | | Cash Collateral (Received) Pledged | | Net Amount |
Assets | | | | | | | | | | | |
Derivative assets | $ | 572,050 |
| | $ | (22,191 | ) | | $ | 549,859 |
| | $ | (22,081 | ) | | $ | — |
| | $ | 527,778 |
|
Total Assets | $ | 572,050 |
| | $ | (22,191 | ) | | $ | 549,859 |
| | $ | (22,081 | ) | | $ | — |
| | $ | 527,778 |
|
| | | | | | | | | | | |
Liabilities | | | | | | | | | | | |
Repurchase agreements | $ | (12,250,450 | ) | | $ | — |
| | $ | (12,250,450 | ) | | $ | 12,250,450 |
| | $ | — |
| | $ | — |
|
Derivative liabilities | (44,272 | ) | | 22,191 |
| | (22,081 | ) | | 22,081 |
| | — |
| | — |
|
Total Liabilities | $ | (12,294,722 | ) | | $ | 22,191 |
| | $ | (12,272,531 | ) | | $ | 12,272,531 |
| | $ | — |
| | $ | — |
|
____________________
| |
(1) | Amounts presented are limited in total to the net amount of assets or liabilities presented in the condensed consolidated balance sheets by instrument. Excess cash collateral or financial assets that are pledged to counterparties may exceed the financial liabilities subject to a master netting arrangement or similar agreement, or counterparties may have pledged excess cash collateral to the Company that exceed the corresponding financial assets. These excess amounts are excluded from the table above, although separately reported within restricted cash, due from counterparties, or due to counterparties in the Company’s condensed consolidated balance sheets. |
Recently Issued and/or Adopted Accounting Standards
Presentation of an Unrecognized Tax Benefit
In July 2013, the FASB issued ASU No. 2013-11, which requires an entity to present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss, or NOL, carryforward, or similar tax loss or tax credit carryforward, rather than as a liability when (1) the uncertain tax position would reduce the NOL or other carryforward under the tax law of the applicable jurisdiction and (2) the entity intends to use the deferred tax asset for that purpose. The ASU does not require any new recurring disclosures. It is effective prospectively for fiscal years, and interim periods within those years, beginning on or after December 15, 2013, with early adoption permitted. Adopting this ASU did not have any impact on the Company’s condensed consolidated financial condition or results of operations.
Note 3. Variable Interest Entities
During 2013, the Company purchased subordinated debt and excess servicing rights from two securitization trusts, one sponsored by a third party and one sponsored by a subsidiary of the Company. Both securitization trusts are considered VIEs for financial reporting purposes and, thus, were reviewed for consolidation under the applicable consolidation guidance. Because the Company has both the power to direct the activities of the securitization trusts that most significantly impact the entities’ performance, and the obligation to absorb losses or the right to receive benefits of the entities that could be significant, the Company consolidates the trusts. As the Company is required to reassess VIE consolidation guidance each quarter, new facts and circumstances may change the Company’s determination. A change in the Company’s determination could result in a material impact to the Company’s financial statements during subsequent reporting periods.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
The following table presents a summary of the assets and liabilities of the consolidated securitization trusts as reported on the condensed consolidated balance sheets:
|
| | | | | | | |
(in thousands) | March 31, 2014 | | December 31, 2013 |
Mortgage loans held-for-investment in securitization trusts | $ | 781,085 |
| | $ | 792,390 |
|
Accrued interest receivable | 4,516 |
| | 4,506 |
|
Total Assets | $ | 785,601 |
| | $ | 796,896 |
|
Collateralized borrowings in securitization trusts | 658,953 |
| | 639,731 |
|
Accrued interest payable | 2,018 |
| | 1,596 |
|
Accrued expenses | 2,814 |
| | 2,724 |
|
Total Liabilities | $ | 663,785 |
| | $ | 644,051 |
|
Note 4. Discontinued Operations
On December 19, 2012, the Company completed the contribution of its equity interests in its wholly owned subsidiary, Two Harbors Property Investment LLC, to Silver Bay. Two Harbors Property Investment LLC previously held the Company’s portfolio of single-family rental properties. Because the Company will not have any significant continuing involvement in Two Harbors Property Investment LLC, all of the associated operating results were removed from continuing operations and are presented separately as discontinued operations for the three months ended March 31, 2014 and 2013.
Summarized financial information for the discontinued operations are presented below.
|
| | | | | | | |
| Three Months Ended |
| March 31, |
(in thousands) | 2014 | | 2013 |
Income: | | | |
Gain on contribution of entity | $ | — |
| | $ | 1,239 |
|
Real estate related revenues | — |
| | — |
|
Total income | — |
| | 1,239 |
|
Expenses: | | | |
Management fees | — |
| | — |
|
Real estate related expenses | — |
| | — |
|
Other operating expenses | — |
| | (138 | ) |
Total expenses | — |
| | (138 | ) |
Income (loss) from discontinued operations | $ | — |
| | $ | 1,377 |
|
In addition to the gain on contribution of entity that was recorded in 2012 in connection with the closing of the contribution, certain adjustments were agreed to be recognized in 2013. These include an installment sales gain of approximately $4.0 million from Silver Bay, a reduction of 2013 management fees payable to PRCM Advisers of $4.3 million, and an immaterial amount of additional working capital adjustments determined in accordance with the contribution agreement entered into with Silver Bay. Of these amounts, $1.2 million of the installment sales gain was recorded as a gain on contribution of entity within discontinued operations for the three months ended March 31, 2013 and the full $4.3 million of the reduction of 2013 management fees payable to PRCM Advisers was recorded within management fees, on the condensed consolidated statements of comprehensive income for the three months ended March 31, 2013. The remaining $0.1 million recorded within discontinued operations on the condensed consolidated statements of comprehensive income for the three months ended March 31, 2013 relates to accrual adjustments for transaction expenses related to the contribution. See Note 24 - Related Party Transactions for additional information.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
Note 5. Available-for-Sale Securities, at Fair Value
The Company holds available-for-sale, or AFS, investment securities, which are carried at fair value. AFS securities exclude the retained interests from the Company’s on-balance sheet securitizations, as they are eliminated in consolidation in accordance with U.S. GAAP. The following table presents the Company’s AFS investment securities by collateral type as of March 31, 2014 and December 31, 2013:
|
| | | | | | | |
(in thousands) | March 31, 2014 | | December 31, 2013 |
Mortgage-backed securities: | | | |
Agency | | | |
Federal Home Loan Mortgage Corporation | $ | 2,814,452 |
| | $ | 2,977,291 |
|
Federal National Mortgage Association | 4,919,714 |
| | 4,435,820 |
|
Government National Mortgage Association | 2,089,759 |
| | 2,084,298 |
|
Non-Agency | 2,810,131 |
| | 2,759,318 |
|
Total mortgage-backed securities | $ | 12,634,056 |
| | $ | 12,256,727 |
|
At March 31, 2014 and December 31, 2013, the Company pledged investment securities with a carrying value of $12.5 billion and $12.3 billion, respectively, as collateral for repurchase agreements and FHLB advances. See Note 16 - Repurchase Agreements and Note 18 - Federal Home Loan Bank of Des Moines Advances.
At March 31, 2014 and December 31, 2013, 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, or ASC 860, 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 March 31, 2014 and December 31, 2013:
|
| | | | | | | | | | | |
| March 31, 2014 |
(in thousands) | Agency | | Non-Agency | | Total |
Face Value | $ | 12,098,833 |
| | $ | 4,423,616 |
| | $ | 16,522,449 |
|
Unamortized premium | 641,697 |
| | — |
| | 641,697 |
|
Unamortized discount | | | | | |
Designated credit reserve | — |
| | (1,196,798 | ) | | (1,196,798 | ) |
Net, unamortized | (2,895,960 | ) | | (1,063,802 | ) | | (3,959,762 | ) |
Amortized Cost | 9,844,570 |
| | 2,163,016 |
| | 12,007,586 |
|
Gross unrealized gains | 131,767 |
| | 650,533 |
| | 782,300 |
|
Gross unrealized losses | (152,412 | ) | | (3,418 | ) | | (155,830 | ) |
Carrying Value | $ | 9,823,925 |
| | $ | 2,810,131 |
| | $ | 12,634,056 |
|
|
| | | | | | | | | | | |
| December 31, 2013 |
(in thousands) | Agency | | Non-Agency | | Total |
Face Value | $ | 11,919,590 |
| | $ | 4,474,353 |
| | $ | 16,393,943 |
|
Unamortized premium | 621,279 |
| | — |
| | 621,279 |
|
Unamortized discount | | | | | |
Designated credit reserve | — |
| | (1,234,449 | ) | | (1,234,449 | ) |
Net, unamortized | (2,897,222 | ) | | (1,071,559 | ) | | (3,968,781 | ) |
Amortized Cost | 9,643,647 |
| | 2,168,345 |
| | 11,811,992 |
|
Gross unrealized gains | 102,600 |
| | 595,179 |
| | 697,779 |
|
Gross unrealized losses | (248,838 | ) | | (4,206 | ) | | (253,044 | ) |
Carrying Value | $ | 9,497,409 |
| | $ | 2,759,318 |
| | $ | 12,256,727 |
|
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 March 31, 2014 and December 31, 2013:
|
| | | | | | | | | | | |
| March 31, 2014 |
(in thousands) | Agency | | Non-Agency | | Total |
Adjustable Rate | $ | 944,503 |
| | $ | 2,449,928 |
| | $ | 3,394,431 |
|
Fixed Rate | 8,879,422 |
| | 360,203 |
| | 9,239,625 |
|
Total | $ | 9,823,925 |
| | $ | 2,810,131 |
| | $ | 12,634,056 |
|
|
| | | | | | | | | | | |
| December 31, 2013 |
(in thousands) | Agency | | Non-Agency | | Total |
Adjustable Rate | $ | 1,006,621 |
| | $ | 2,403,078 |
| | $ | 3,409,699 |
|
Fixed Rate | 8,490,788 |
| | 356,240 |
| | 8,847,028 |
|
Total | $ | 9,497,409 |
| | $ | 2,759,318 |
| | $ | 12,256,727 |
|
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 a 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 three months ended March 31, 2014 and 2013, of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
|
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended March 31, |
| 2014 | | 2013 |
(in thousands) | Designated Credit Reserve | | Unamortized Net Discount | | Total | | Designated Credit Reserve | | Unamortized Net Discount | | Total |
Beginning balance at January 1 | $ | (1,234,448 | ) | | $ | (1,071,559 | ) | | $ | (2,306,007 | ) | | $ | (1,290,946 | ) | | $ | (996,490 | ) | | $ | (2,287,436 | ) |
Acquisitions | (16,678 | ) | | (18,254 | ) | | (34,932 | ) | | (101,733 | ) | | (41,450 | ) | | (143,183 | ) |
Accretion of net discount | — |
| | 31,831 |
| | 31,831 |
| | 655 |
| | 34,636 |
| | 35,291 |
|
Realized credit losses | 3,867 |
| | — |
| | 3,867 |
| | 10,901 |
| | — |
| | 10,901 |
|
Reclassification adjustment for other-than-temporary impairments | (212 | ) | | — |
| | (212 | ) | | (236 | ) | | — |
| | (236 | ) |
Transfers from (to) | 22,639 |
| | (22,639 | ) | | — |
| | 1,691 |
| | (1,691 | ) | | — |
|
Sales, calls, other | 28,034 |
| | 16,819 |
| | 44,853 |
| | 2,975 |
| | 31,755 |
| | 34,730 |
|
Ending balance at March 31 | $ | (1,196,798 | ) | | $ | (1,063,802 | ) | | $ | (2,260,600 | ) | | $ | (1,376,693 | ) | | $ | (973,240 | ) | | $ | (2,349,933 | ) |
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 March 31, 2014 and December 31, 2013. At March 31, 2014, the Company held 1,480 AFS securities, of which 400 were in an unrealized loss position for less than twelve consecutive months and 125 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2013, the Company held 1,431 AFS securities, of which 447 were in an unrealized loss position for less than twelve months and 114 were in an unrealized loss position for more than twelve consecutive months. Of the $3.8 billion and $4.9 billion of AFS securities in an unrealized loss position for less than twelve consecutive months as of March 31, 2014 and December 31, 2013, $3.7 billion, or 97.2%, and $4.8 billion, or 96.9%, respectively, were Agency AFS securities, whose principal and interest are guaranteed by government sponsored entities, or GSEs.
|
| | | | | | | | | | | | | | | | | | | | | | | |
| 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 |
March 31, 2014 | $ | 3,760,486 |
| | $ | (99,760 | ) | | $ | 1,012,554 |
| | $ | (56,070 | ) | | $ | 4,773,040 |
| | $ | (155,830 | ) |
December 31, 2013 | $ | 4,902,813 |
| | $ | (171,651 | ) | | $ | 1,186,692 |
| | $ | (81,393 | ) | | $ | 6,089,505 |
| | $ | (253,044 | ) |
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 $0.2 million other-than-temporary credit impairment during the three months ended March 31, 2014 on a total of three non-Agency RMBS where the future expected cash flows for each security were less than its amortized cost. As of March 31, 2014, impaired securities had actual weighted average cumulative losses of 8.8%, weighted average three-month prepayment speed of 2.3%, weighted average 60+ day delinquency of 31.6% of the pool balance, and weighted average FICO score of 661. At March 31, 2014, 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 months ended March 31, 2013, the Company recorded a $0.2 million other-than-temporary credit impairment on one non-Agency RMBS where the future expected cash flows for the security were less than its amortized cost.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
The following table presents the changes in OTTI included in earnings for three months ended March 31, 2014 and 2013:
|
| | | | | | | |
| Three Months Ended |
| March 31, |
(in thousands) | 2014 | | 2013 |
Cumulative credit loss at beginning of period | $ | (9,467 | ) | | $ | (15,561 | ) |
Additions: | | | |
Other-than-temporary impairments not previously recognized | (91 | ) | | — |
|
Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments | (121 | ) | | (236 | ) |
Reductions: | | | |
Decreases related to other-than-temporary impairments on securities paid down | 464 |
| | — |
|
Decreases related to other-than-temporary impairments on securities sold | — |
| | 655 |
|
Cumulative credit loss at end of period | $ | (9,215 | ) | | $ | (15,142 | ) |
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 (loss) gain on investment securities in the Company’s condensed consolidated statements of comprehensive income. For the three months ended March 31, 2014 and 2013, the Company sold AFS securities for $814.9 million and $796.7 million with an amortized cost of $853.7 million and $777.7 million, for net realized losses of $38.8 million and net realized gains of $18.9 million, respectively.
The following table presents the gross realized gains and losses on sales of AFS securities for the three months ended March 31, 2014 and 2013:
|
| | | | | | | |
| Three Months Ended |
| March 31, |
(in thousands) | 2014 | | 2013 |
Gross realized gains | $ | 7,209 |
| | $ | 23,226 |
|
Gross realized losses | (45,997 | ) | | (4,296 | ) |
Total realized (losses) gains on sales, net | $ | (38,788 | ) | | $ | 18,930 |
|
Note 6. Trading Securities, at Fair Value
The Company holds U.S. Treasuries in a TRS and classifies these securities as trading instruments due to short-term investment objectives. As of March 31, 2014 and December 31, 2013, the Company held U.S. Treasuries with an amortized cost of $996.5 million and $996.1 million, 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 $3.8 million and $4.1 million as of March 31, 2014 and December 31, 2013, respectively.
For the three months ended March 31, 2014, the Company sold trading securities for $98.6 million with an amortized cost of $98.2 million, resulting in realized gains of $0.4 million on the sale of these securities. The Company did not sell any trading securities during the three months ended March 31, 2013. For the three months ended March 31, 2014 and 2013, trading securities experienced change in unrealized losses of $0.2 million and change in unrealized gains of $17,133, respectively. Both realized and unrealized gains and losses are recorded as a component of (loss) gain on investment securities in the Company’s condensed consolidated statements of comprehensive income.
At March 31, 2014 and December 31, 2013, the Company pledged trading securities with a carrying value of $1.0 billion and $1.0 billion, respectively, as collateral for repurchase agreements. See Note 16 - Repurchase Agreements.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
Note 7. 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 March 31, 2014 and December 31, 2013:
|
| | | | | | | |
(in thousands) | March 31, 2014 | | December 31, 2013 |
Unpaid principal balance | $ | 173,293 |
| | $ | 680,840 |
|
Fair value adjustment | (12,272 | ) | | (136,259 | ) |
Carrying value | $ | 161,021 |
| | $ | 544,581 |
|
At March 31, 2014 and December 31, 2013, the Company pledged mortgage loans with a carrying value of $130.9 million and $200.8 million, respectively, as collateral for repurchase agreements and and FHLB advances. See Note 16 - Repurchase Agreements and Note 18 - Federal Home Loan Bank of Des Moines Advances.
Note 8. Mortgage Loans Held-for-Investment in Securitization Trusts, at Fair Value
During 2013, the Company purchased subordinated debt and excess servicing rights from two securitization trusts, one sponsored by a third party and one sponsored by a subsidiary of the Company. The underlying residential mortgage loans held by the trusts, which are consolidated on the Company’s condensed consolidated balance sheet, are classified as mortgage loans held-for-investment in securitization trusts and carried at fair value as a result of a fair value option election. See Note 3 - Variable Interest Entities for additional information regarding consolidation of the securitization trusts. The following table presents the carrying value of the Company’s mortgage loans held-for-investment in securitization trusts as of March 31, 2014 and December 31, 2013:
|
| | | | | | | |
(in thousands) | March 31, 2014 | | December 31, 2013 |
Unpaid principal balance | $ | 799,258 |
| | $ | 812,538 |
|
Fair value adjustment | (18,173 | ) | | (20,148 | ) |
Carrying value | $ | 781,085 |
| | $ | 792,390 |
|
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
Note 9. Servicing Activities
Mortgage Servicing Rights, at Fair Value
On April 30, 2013, one of the Company’s wholly owned subsidiaries acquired a company that has approvals from Fannie Mae, Freddie Mac and Ginnie Mae to hold and manage MSR. The MSR acquired in conjunction with this acquisition and those subsequently purchased represent the right to service mortgage loans. The Company and its subsidiaries do not originate or directly service mortgage loans, and instead contract with fully licensed subservicers to handle all servicing functions for the loans underlying the Company’s MSR. The following table summarizes activity related to MSR for the three months ended March 31, 2014 and 2013.
|
| | | | | | | |
| Three Months Ended March 31, |
(in thousands) | 2014 | | 2013 |
Balance at beginning of period | $ | 514,402 |
| | $ | — |
|
Additions from purchases of servicing rights | 1,280 |
| | — |
|
Changes in fair value due to: | | | |
Changes in valuation inputs or assumptions used in the valuation model | (20,250 | ) | | — |
|
Other changes in fair value (1) | (12,510 | ) | | — |
|
Other changes (2) | (6,259 | ) | | — |
|
Balance at end of period | $ | 476,663 |
| | $ | — |
|
____________________
| |
(1) | Other changes in fair value primarily represents changes due to the realization of expected cash flows. |
| |
(2) | Other changes includes purchase price adjustments, principally contractual prepayment protection, and changes due to the Company’s repurchase of the underlying collateral. |
As of March 31, 2014 and December 31, 2013, the key economic assumptions and sensitivity of the fair value of MSR to immediate 10% and 20% adverse changes in these assumptions were as follows:
|
| | | | | | | |
(in thousands) | March 31, 2014 | | December 31, 2013 |
Weighted average prepayment speed: | 10.5 | % | | 9.5 | % |
Impact on fair value of 10% adverse change | $ | (18,106 | ) | | $ | (19,305 | ) |
Impact on fair value of 20% adverse change | $ | (34,881 | ) | | $ | (37,187 | ) |
Weighted average delinquency: | 4.0 | % | | 4.0 | % |
Impact on fair value of 10% adverse change | $ | (7,291 | ) | | $ | (8,835 | ) |
Impact on fair value of 20% adverse change | $ | (14,613 | ) | | $ | (17,642 | ) |
Weighted average discount rate: | 9.0 | % | | 9.0 | % |
Impact on fair value of 10% adverse change | $ | (14,139 | ) | | $ | (21,037 | ) |
Impact on fair value of 20% adverse change | $ | (27,514 | ) | | $ | (40,642 | ) |
These assumptions and sensitivities are hypothetical and should be considered with caution. Changes in fair value based on 10% and 20% variations in assumptions generally cannot be extrapolated because the relationship of the change in assumptions to the change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of MSR is calculated without changing any other assumptions. In reality, changes in one factor may result in changes in another (e.g., increased market interest rates may result in lower prepayments and increased credit losses) that could magnify or counteract the sensitivities. Further, these sensitivities show only the change in the asset balances and do not show any expected change in the fair value of the instruments used to manage the interest rates and prepayment risks associated with these assets.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
Risk Mitigation Activities
The primary risk of the Company’s MSR is interest rate risk and the resulting impact on prepayments. A significant decline in interest rates could lead to higher-than-expected prepayments that could reduce the value of the MSR. The Company economically hedges the impact of these risks with derivative financial instruments. Refer to Note 12 - Derivative Instruments and Hedging Activities for additional information regarding the derivative financial instruments used to economically hedge MSR.
Mortgage Servicing Income
The following table presents the components of servicing income recorded on the Company’s condensed consolidated statements of comprehensive income for the three months ended March 31, 2014 and 2013:
|
| | | | | | | |
| Three Months Ended March 31, |
(in thousands) | 2014 | | 2013 |
Servicing fee income | $ | 29,871 |
| | $ | — |
|
Ancillary fee income | 570 |
| | — |
|
| $ | 30,441 |
| | $ | — |
|
Mortgage Servicing Advances
In connection with the servicing of loans, the Company’s subservicers make certain payments for property taxes and insurance premiums, default and property maintenance payments, as well as advances of principal and interest payments before collecting them from individual borrowers. Servicing advances, including contractual interest, are priority cash flows in the event of a loan principal reduction or foreclosure and ultimate liquidation of the real estate-owned property, thus making their collection reasonably assured. These servicing advances, which are funded by the Company, totaled $12.7 million and $7.3 million and were included in other assets on the condensed consolidated balance sheet as of March 31, 2014 and December 31, 2013, respectively.
Serviced Mortgage Assets
The Company’s total serviced mortgage assets consist of loans owned and classified as mortgage loans held-for-sale, loans held in consolidated VIEs classified as mortgage loans held-for-investment in securitization trusts and loans underlying MSR. The following table presents the number of loans and unpaid principal balance of the mortgage assets for which the Company manages the servicing as of March 31, 2014 and December 31, 2013:
|
| | | | | | | | | | | | | |
(dollars in thousands) | March 31, 2014 | | December 31, 2013 |
| Number of Loans | | Unpaid Principal Balance | | Number of Loans | | Unpaid Principal Balance |
Mortgage loans held-for-sale | 335 |
| | $ | 173,293 |
| | 2,890 |
| | $ | 680,840 |
|
Mortgage loans held-for-investment in securitization trusts | 510 |
| | 381,455 |
| | 537 |
| | 425,209 |
|
Mortgage servicing rights (1) | 207,025 |
| | 41,596,256 |
| | 210,441 |
| | 42,324,328 |
|
Total serviced mortgage assets | 207,870 |
| | $ | 42,151,004 |
| | 213,868 |
| | $ | 43,430,377 |
|
____________________
| |
(1) | Includes mortgage loans held-for-investment in securitization trusts for which the Company is the named servicing administrator. |
Note 10. Restricted Cash
The Company is required to maintain certain cash balances with counterparties for securities and derivatives trading activity and collateral for the Company’s repurchase agreements and FHLB advances in restricted accounts. The Company has also placed cash in a restricted account pursuant to a letter of credit on an office space lease.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
The following table presents the Company’s restricted cash balances as of March 31, 2014 and December 31, 2013:
|
| | | | | | | |
(in thousands) | March 31, 2014 | | December 31, 2013 |
Restricted cash balances held by trading counterparties: | | | |
For securities trading activity | $ | 9,000 |
| | $ | 9,000 |
|
For derivatives trading activity | 122,893 |
| | 191,107 |
|
As restricted collateral for repurchase agreements and Federal Home Loan Bank advances | 87,963 |
| | 201,194 |
|
| 219,856 |
| | 401,301 |
|
Restricted cash balance pursuant to letter of credit on office lease | 346 |
| | 346 |
|
Total | $ | 220,202 |
| | $ | 401,647 |
|
Note 11. Accrued Interest Receivable
The following table presents the Company’s accrued interest receivable by collateral type:
|
| | | | | | | |
(in thousands) | March 31, 2014 | | December 31, 2013 |
Accrued Interest Receivable: | | | |
U.S. Treasuries | $ | 777 |
| | $ | 2,361 |
|
Mortgage-backed securities: | | | |
Agency | | | |
Federal Home Loan Mortgage Corporation | 10,160 |
| | 10,583 |
|
Federal National Mortgage Association | 16,784 |
| | 15,034 |
|
Government National Mortgage Association | 9,987 |
| | 10,007 |
|
Non-Agency | 3,636 |
| | 3,676 |
|
Total mortgage-backed securities | 40,567 |
| | 39,300 |
|
Mortgage loans held-for-sale | 864 |
| | 4,136 |
|
Mortgage loans held-for-investment in securitization trusts | 4,516 |
| | 4,506 |
|
Total | $ | 46,724 |
| | $ | 50,303 |
|
Note 12. 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 derivative 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, credit default swaps and total return swaps. In executing on the Company’s current risk management strategy, the Company has entered into interest rate swap and swaption agreements, TBAs, put and call options for TBAs, constant maturity swaps, credit default swaps and total return 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.
At times, the Company may use TBAs for risk management purposes, or as a means of deploying capital until targeted investments are available and to take advantage of temporary displacements in the marketplace. TBAs are forward contracts for the purchase (long notional positions) or sale (short notional positions) of Agency RMBS. The issuer, coupon and stated maturity of the Agency RMBS is predetermined as well as the trade price, face amount and future settle date (published each month by the Securities Industry and Financial Markets Association); however, the specific Agency RMBS to be delivered upon settlement is not known at the time of the TBA transaction. As a result, and because physical delivery of the Agency RMBS upon settlement cannot be assured, the Company accounts for TBAs as derivative instruments.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
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 March 31, 2014 and December 31, 2013.
|
| | | | | | | | | | | | | | | | |
(in thousands) | | March 31, 2014 |
| | Derivative Assets | | Derivative Liabilities |
Trading instruments | | Fair Value | | Notional | | Fair Value | | Notional |
Inverse interest-only securities | | $ | 212,984 |
| | $ | 1,412,374 |
| | $ | — |
| | $ | — |
|
Interest rate swap agreements | | 40,310 |
| | 21,663,148 |
| | — |
| | — |
|
Credit default swaps | | — |
| | — |
| | (2,395 | ) | | 125,000 |
|
Swaptions | | 164,296 |
| | 9,500,000 |
| | — |
| | — |
|
TBAs | | 4,331 |
| | 1,100,000 |
| | (5,487 | ) | | 2,372,000 |
|
Put and call options for TBAs | | 3,627 |
| | 1,500,000 |
| | — |
| | — |
|
Constant maturity swaps | | 3,871 |
| | 10,000,000 |
| | — |
| | — |
|
Total return swaps | | — |
| | — |
| | (126 | ) | | 243,987 |
|
Forward purchase commitment | | — |
| | — |
| | (387 | ) | | 153,637 |
|
Total | | $ | 429,419 |
| | $ | 45,175,522 |
| | $ | (8,395 | ) | | $ | 2,894,624 |
|
|
| | | | | | | | | | | | | | | | |
(in thousands) | | December 31, 2013 |
| | Derivative Assets | | Derivative Liabilities |
Trading instruments | | Fair Value | | Notional | | Fair Value | | Notional |
Inverse interest-only securities | | $ | 221,364 |
| | $ | 1,525,845 |
| | $ | — |
| | $ | — |
|
Interest rate swap agreements | | 25,325 |
| | 19,619,000 |
| | — |
| | — |
|
Credit default swaps | | — |
| | — |
| | (18,049 | ) | | 427,073 |
|
Swaptions | | 269,745 |
| | 5,130,000 |
| | — |
| | — |
|
TBAs | | 33,425 |
| | 4,097,000 |
| | (125 | ) | | 400,000 |
|
Constant maturity swaps | | — |
| | — |
| | (3,773 | ) | | 10,000,000 |
|
Total return swaps | | — |
| | — |
| | (134 | ) | | 49,629 |
|
Forward purchase commitment | | — |
| | 12,063 |
| | — |
| | — |
|
Total | | $ | 549,859 |
| | $ | 30,383,908 |
| | $ | (22,081 | ) | | $ | 10,876,702 |
|
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 months ended March 31, 2014.
|
| | | | | | | | |
(in thousands) | | Three Months Ended March 31, 2014 |
Trading instruments | | Derivative Assets | | Derivative Liabilities |
Inverse interest-only securities | | $ | 1,470,667 |
| | $ | — |
|
Interest rate swap agreements | | 19,156,878 |
| | — |
|
Credit default swaps | | — |
| | 179,418 |
|
Swaptions | | 8,979,111 |
| | — |
|
TBAs | | 1,289,500 |
| | 1,815,944 |
|
Put and call options for TBAs | | 255,556 |
| | — |
|
Constant maturity swaps | | 10,000,000 |
| | — |
|
Total return swaps | | — |
| | 153,910 |
|
Forward purchase commitment | | — |
| | 38,913 |
|
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.
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 statements 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 March 31, |
| | | | 2014 | | 2013 |
Interest rate risk management | | | | | | |
TBAs (1) | | Gain (loss) on other derivative instruments | | $ | (17,903 | ) | | $ | (12,652 | ) |
Put and call options for TBAs (1) | | Gain (loss) on other derivative instruments | | (1,705 | ) | | — |
|
Constant maturity swaps (1) | | Gain (loss) on other derivative instruments | | 11,531 |
| | — |
|
Interest rate swap agreements - Receivers (1) | | (Loss) gain on interest rate swap and swaption agreements | | 16,566 |
| | — |
|
Interest rate swap agreements - Payers (1) | | (Loss) gain on interest rate swap and swaption agreements | | (6,776 | ) | | — |
|
Total return swaps (2) | | Gain (loss) on other derivative instruments | | (1,725 | ) | | — |
|
Interest rate swap agreements - Receivers (2) | | (Loss) gain on interest rate swap and swaption agreements | | 24,413 |
| | — |
|
Interest rate swap agreements - Payers (2) | | (Loss) gain on interest rate swap and swaption agreements | | (6,644 | ) | | (89 | ) |
Interest rate swap agreements - Payers (3) | | (Loss) gain on interest rate swap and swaption agreements | | (20,529 | ) | | 1,090 |
|
Swaptions (3) | | (Loss) gain on interest rate swap and swaption agreements | | (112,558 | ) | | 17,971 |
|
Credit risk management | | | | | | |
Credit default swaps - Receive protection (4) | | Gain (loss) on other derivative instruments | | 1,981 |
| | (5,643 | ) |
Non-risk management | | | | | | |
TBAs | | Gain (loss) on other derivative instruments | | (4,701 | ) | | 403 |
|
Inverse interest-only securities | | Gain (loss) on other derivative instruments | | 18,323 |
| | 1,230 |
|
Forward purchase commitments | | (Loss) gain on mortgage loans held-for-sale | | (417 | ) | | 287 |
|
Total | | | | $ | (100,144 | ) | | $ | 2,597 |
|
____________________
| |
(1) | Includes derivative instruments held to mitigate interest rate risk associated with the Company’s AFS securities, mortgage loans held-for-sale and forward purchase commitments. |
| |
(2) | Includes derivative instruments held to mitigate interest rate risk associated with the Company’s U.S. Treasuries, TBAs and MSR. |
| |
(3) | Includes derivative instruments held to mitigate interest rate risk associated with the Company’s repurchase agreements and FHLB advances. |
| |
(4) | Includes derivative instruments held to mitigate credit risk associated with the Company’s non-Agency RMBS and mortgage loans held-for-sale. |
For the three months ended March 31, 2014 and 2013, the Company recognized $13.8 million and $14.0 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 $19.2 billion and $14.9 billion notional, respectively, to economically 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 months ended March 31, 2014 and 2013, the Company terminated, had agreements mature or had options expire on a total of 7 and 69 interest rate swap and swaption positions of $3.0 billion and $8.2 billion notional, respectively. Upon settlement of the early terminations, contractual maturities and option expirations, the Company paid $0.9 million and $17.2 million in full settlement of its net interest spread liability and recognized $1.2 million and $58.7 million in realized
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
losses on the swaps and swaptions for the three months ended March 31, 2014 and 2013, respectively, including early termination penalties.
For the three months ended March 31, 2014, the Company terminated or had agreements mature on three credit default swap positions of $305.0 million notional. Upon settlement of the early terminations, the Company paid $1.2 million in full settlement of its net interest spread liability and recognized $13.7 million, in realized losses on the credit default swaps for the three months ended March 31, 2014, including early terminations penalties. For the three months ended March 31, 2013, the Company did not terminate any credit default swap positions.
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, unrealized loss on other derivative instruments, and loss (gain) on mortgage loans held-for-sale line items within the operating activities section of the condensed consolidated statements of cash flows. 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 (decrease)/increase 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, put and call options for TBAs, constant maturity swaps and interest rate swap agreements to further mitigate its exposure to higher interest rates, decreased prepayment speeds and widening mortgage spreads. The objective is to reduce the risk of losses to the portfolio caused by interest rate changes and changes in prepayment speeds.
As of March 31, 2014 and December 31, 2013, the Company had outstanding fair value of $72.2 million and $75.6 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.
As of March 31, 2014, $1.2 billion of the Company’s long notional TBA positions and $2.2 billion of the Company’s short notional TBA positions were held as a means to mitigate exposure to higher interest rates and wider mortgage spreads. As of December 31, 2013, $0.4 billion of the Company’s long notional TBA positions and $1.9 billion of the Company’s short notional TBA positions were held as a means to mitigate exposure to higher interest rates and wider mortgage spreads, while the remaining $2.2 billion long notional TBA positions were held for non-risk management purposes (see discussion of “Non-Risk Management Activities” below). The Company discloses these positions on a gross basis according to the unrealized gain or loss position of each TBA contract regardless of long or short notional position. The following tables present the notional amount, cost basis, market value and carrying value (which approximates fair value) of the Company’s TBA positions as of March 31, 2014 and December 31, 2013:
|
| | | | | | | | | | | | | | | | | | | |
| As of March 31, 2014 |
| | | | | | | Net Carrying Value (4) |
(in thousands) | Notional Amount (1) | | Cost Basis (2) | | Market Value (3) | | Derivative Assets | | Derivative Liabilities |
Purchase contracts | $ | 1,225,000 |
| | $ | 1,183,028 |
| | $ | 1,186,866 |
| | $ | 4,331 |
| | $ | (493 | ) |
Sale contracts | (2,247,000 | ) | | (2,269,600 | ) | | (2,274,594 | ) | | — |
| | (4,994 | ) |
TBAs, net | $ | (1,022,000 | ) | | $ | (1,086,572 | ) | | $ | (1,087,728 | ) | | |