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, 2014
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.) |
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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 November 5, 2014 there were 366,117,954 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)
|
| | | | | | | |
| September 30, 2014 | | December 31, 2013 |
ASSETS | (unaudited) | |
|
|
Available-for-sale securities, at fair value | $ | 12,697,908 |
| | $ | 12,256,727 |
|
Trading securities, at fair value | 1,993,124 |
| | 1,000,180 |
|
Mortgage loans held-for-sale, at fair value | 445,065 |
| | 544,581 |
|
Mortgage loans held-for-investment in securitization trusts, at fair value | 1,428,890 |
| | 792,390 |
|
Mortgage servicing rights, at fair value | 498,466 |
| | 514,402 |
|
Cash and cash equivalents | 1,225,281 |
| | 1,025,487 |
|
Restricted cash | 310,421 |
| | 401,647 |
|
Accrued interest receivable | 52,605 |
| | 50,303 |
|
Due from counterparties | 23,341 |
| | 25,087 |
|
Derivative assets, at fair value | 353,893 |
| | 549,859 |
|
Other assets | 125,831 |
| | 13,199 |
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Total Assets (1) | $ | 19,154,825 |
| | $ | 17,173,862 |
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LIABILITIES AND STOCKHOLDERS’ EQUITY |
|
| |
|
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Liabilities |
|
| | |
Repurchase agreements | $ | 12,274,878 |
| | $ | 12,250,450 |
|
Collateralized borrowings in securitization trusts, at fair value | 938,506 |
| | 639,731 |
|
Federal Home Loan Bank advances | 1,500,000 |
| | — |
|
Derivative liabilities, at fair value | 4,221 |
| | 22,081 |
|
Accrued interest payable | 14,924 |
| | 20,277 |
|
Due to counterparties | 167,444 |
| | 318,848 |
|
Dividends payable | 95,205 |
| | — |
|
Other liabilities | 41,548 |
| | 67,480 |
|
Total liabilities (1) | 15,036,726 |
| | 13,318,867 |
|
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 366,107,149 and 364,935,168 shares issued and outstanding, respectively | 3,661 |
| | 3,649 |
|
Additional paid-in capital | 3,808,015 |
| | 3,795,372 |
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Accumulated other comprehensive income | 776,648 |
| | 444,735 |
|
Cumulative earnings | 1,232,499 |
| | 1,028,397 |
|
Cumulative distributions to stockholders | (1,702,724 | ) | | (1,417,158 | ) |
Total stockholders’ equity | 4,118,099 |
| | 3,854,995 |
|
Total Liabilities and Stockholders’ Equity | $ | 19,154,825 |
| | $ | 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 Two Harbors Investment Corp., or the Company. At September 30, 2014 and December 31, 2013, assets of the VIEs totaled $1,436,027 and $796,896, and liabilities of the VIEs totaled $945,002 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)
|
| | | | | | | | | | | | | | | |
| Three Months Ended | | Nine Months Ended |
| September 30, | | September 30, |
| 2014 | | 2013 | | 2014 | | 2013 |
| (unaudited) | | (unaudited) |
Interest income: | | | | | | | |
Available-for-sale securities | $ | 123,056 |
| | $ | 121,303 |
| | $ | 374,574 |
| | $ | 386,246 |
|
Trading securities | 4,308 |
| | 1,509 |
| | 8,174 |
| | 4,034 |
|
Mortgage loans held-for-sale | 5,268 |
| | 9,297 |
| | 12,553 |
| | 15,409 |
|
Mortgage loans held-for-investment in securitization trusts | 9,526 |
| | 5,649 |
| | 25,180 |
| | 11,672 |
|
Cash and cash equivalents | 145 |
| | 216 |
| | 506 |
| | 773 |
|
Total interest income | 142,303 |
| | 137,974 |
| | 420,987 |
| | 418,134 |
|
Interest expense: | | | | |
|
| |
|
|
Repurchase agreements | 17,509 |
| | 21,802 |
| | 56,684 |
| | 67,373 |
|
Collateralized borrowings in securitization trusts | 5,678 |
| | 3,125 |
| | 16,623 |
| | 6,112 |
|
Federal Home Loan Bank advances | 1,531 |
| | — |
| | 2,439 |
| | — |
|
Total interest expense | 24,718 |
| | 24,927 |
| | 75,746 |
| | 73,485 |
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Net interest income | 117,585 |
| | 113,047 |
| | 345,241 |
| | 344,649 |
|
Other-than-temporary impairments: | | | | |
| |
|
Total other-than-temporary impairment losses | — |
| | — |
| | (212 | ) | | (1,662 | ) |
Non-credit portion of loss recognized in other comprehensive (loss) income | — |
| | — |
| | — |
| | — |
|
Net other-than-temporary credit impairment losses | — |
| | — |
| | (212 | ) |
| (1,662 | ) |
Other income: | | | | |
| |
|
Gain (loss) on investment securities | 59,471 |
| | (230,111 | ) | | 58,504 |
| | (152,280 | ) |
Gain (loss) on interest rate swap and swaption agreements | 28,519 |
| | (55,410 | ) | | (193,028 | ) | | 223,388 |
|
Gain (loss) on other derivative instruments | 6,056 |
| | 20,434 |
| | (12,345 | ) | | 66,055 |
|
(Loss) gain on mortgage loans held-for-sale | (2,387 | ) | | (4,443 | ) | | 6,233 |
| | (25,262 | ) |
Servicing income | 32,264 |
| | 989 |
| | 96,573 |
| | 1,234 |
|
(Loss) gain on servicing asset | (10,711 | ) | | 861 |
| | (73,042 | ) | | 816 |
|
Other (loss) income | (1,515 | ) | | 8,938 |
| | 19,948 |
| | 16,837 |
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Total other income (loss) | 111,697 |
| | (258,742 | ) | | (97,157 | ) | | 130,788 |
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Expenses: | | | | |
| |
|
Management fees | 12,258 |
| | 12,036 |
| | 36,559 |
| | 29,388 |
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Securitization deal costs | 3,355 |
| | 2,125 |
| | 3,355 |
| | 4,153 |
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Servicing expenses | 12,513 |
| | 862 |
| | 24,595 |
| | 1,200 |
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Other operating expenses | 12,424 |
| | 9,155 |
| | 41,281 |
| | 24,864 |
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Total expenses | 40,550 |
| | 24,178 |
| | 105,790 |
| | 59,605 |
|
Income (loss) from continuing operations before income taxes | 188,732 |
| | (169,873 | ) | | 142,082 |
| | 414,170 |
|
(Benefit from) provision for income taxes | (4,858 | ) | | 23,726 |
| | (62,020 | ) | | 77,809 |
|
Net income (loss) from continuing operations | 193,590 |
| | (193,599 | ) | | 204,102 |
| | 336,361 |
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Income from discontinued operations | — |
| | 871 |
| | — |
| | 3,264 |
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Net income (loss) | $ | 193,590 |
| | $ | (192,728 | ) | | $ | 204,102 |
| | $ | 339,625 |
|
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 | | Nine Months Ended |
| September 30, | | September 30, |
| 2014 | | 2013 | | 2014 | | 2013 |
| (unaudited) | | (unaudited) |
Basic earnings (loss) per weighted average common share: | | | | |
|
| | |
Continuing operations | $ | 0.53 |
| | $ | (0.53 | ) | | $ | 0.56 |
| | $ | 0.97 |
|
Discontinued operations | — |
| | — |
| | — |
| | 0.01 |
|
Net income (loss) | $ | 0.53 |
| | $ | (0.53 | ) | | $ | 0.56 |
| | $ | 0.98 |
|
Diluted earnings (loss) per weighted average common share: | | | | |
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| | |
Continuing operations | $ | 0.53 |
| | $ | (0.53 | ) | | $ | 0.56 |
| | $ | 0.97 |
|
Discontinued operations | — |
| | — |
| | — |
| | 0.01 |
|
Net income (loss) | $ | 0.53 |
| | $ | (0.53 | ) | | $ | 0.56 |
| | $ | 0.98 |
|
Dividends declared per common share | $ | 0.26 |
| | $ | 0.28 |
| | $ | 0.78 |
| | $ | 0.91 |
|
Weighted average number of shares of common stock: | | | | |
|
| | |
Basic | 366,118,866 |
| | 365,057,767 |
| | 365,938,150 |
| | 345,529,611 |
|
Diluted | 366,118,866 |
| | 365,166,992 |
| | 365,938,150 |
| | 346,370,358 |
|
Comprehensive income: | | | | |
|
| | |
Net income (loss) | $ | 193,590 |
| | $ | (192,728 | ) | | $ | 204,102 |
| | $ | 339,625 |
|
Other comprehensive (loss) income: | | | | |
|
| | |
Unrealized (loss) gain on available-for-sale securities, net | (40,982 | ) | | 246,777 |
| | 331,913 |
| | (183,684 | ) |
Other comprehensive (loss) income | (40,982 | ) | | 246,777 |
| | 331,913 |
| | (183,684 | ) |
Comprehensive income | $ | 152,608 |
| | $ | 54,049 |
| | $ | 536,015 |
| | $ | 155,941 |
|
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 |
|
Net income | — |
| | — |
| | — |
| | — |
| | 339,625 |
| | — |
| | 339,625 |
|
Other comprehensive loss before reclassifications | — |
| | — |
| | — |
| | (308,435 | ) | | — |
| | — |
| | (308,435 | ) |
Amounts reclassified from accumulated other comprehensive loss | — |
| | — |
| | — |
| | 124,751 |
| | — |
| | — |
| | 124,751 |
|
Net other comprehensive loss | — |
| | — |
| | — |
| | (183,684 | ) | | — |
| | — |
| | (183,684 | ) |
Issuance of common stock, net of offering costs | 57,553,749 |
| | 576 |
| | 762,808 |
| | — |
| | — |
| | — |
| | 763,384 |
|
Issuance of common stock in connection with exercise of warrants | 9,391,406 |
| | 94 |
| | 102,182 |
| | — |
| | — |
| | — |
| | 102,276 |
|
Repurchase of common stock | (2,450,700 | ) | | (25 | ) | | (23,869 | ) | | — |
| | — |
| | — |
| | (23,894 | ) |
Common dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | (332,224 | ) | | (332,224 | ) |
Special dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | (343,481 | ) | | (343,481 | ) |
Non-cash equity award compensation | 1,057,304 |
| | 11 |
| | 463 |
| | — |
| | — |
| | — |
| | 474 |
|
Balance, September 30, 2013 | 364,365,017 |
| | $ | 3,644 |
| | $ | 3,789,929 |
| | $ | 512,774 |
| | $ | 788,983 |
| | $ | (1,322,277 | ) | | $ | 3,773,053 |
|
| | | | | | | | | | | | | |
Balance, December 31, 2013 | 364,935,168 |
| | $ | 3,649 |
| | $ | 3,795,372 |
| | $ | 444,735 |
| | $ | 1,028,397 |
| | $ | (1,417,158 | ) | | $ | 3,854,995 |
|
Net income | — |
| | — |
| | — |
| | — |
| | 204,102 |
| | — |
| | 204,102 |
|
Other comprehensive income before reclassifications | — |
| | — |
| | — |
| | 364,026 |
| | — |
| | — |
| | 364,026 |
|
Amounts reclassified from accumulated other comprehensive income | — |
| | — |
| | — |
| | (32,113 | ) | | — |
| | — |
| | (32,113 | ) |
Net other comprehensive income | — |
| | — |
| | — |
| | 331,913 |
| | — |
| | — |
| | 331,913 |
|
Issuance of common stock, net of offering costs | 38,742 |
| | — |
| | 399 |
| | — |
| | — |
| | — |
| | 399 |
|
Common dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | (285,566 | ) | | (285,566 | ) |
Non-cash equity award compensation | 1,133,239 |
| | 12 |
| | 12,244 |
| | — |
| | — |
| | — |
| | 12,256 |
|
Balance, September 30, 2014 | 366,107,149 |
| | $ | 3,661 |
| | $ | 3,808,015 |
| | $ | 776,648 |
| | $ | 1,232,499 |
| | $ | (1,702,724 | ) | | $ | 4,118,099 |
|
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)
|
| | | | | | | |
| Nine Months Ended |
| September 30, |
| 2014 | | 2013 |
Cash Flows From Operating Activities: | (unaudited) |
Net income | $ | 204,102 |
| | $ | 339,625 |
|
Adjustments to reconcile net income to net cash used in operating activities: | | | |
Amortization of premiums and discounts on investment securities, net | 7,415 |
| | 16,511 |
|
Other-than-temporary impairment losses | 212 |
| | 1,662 |
|
Realized and unrealized (gains) losses on investment securities, net | (58,504 | ) | | 152,458 |
|
(Gain) loss on mortgage loans held-for-sale | (6,233 | ) | | 25,262 |
|
Gain on mortgage loans held-for-investment and collateralized borrowings in securitization trusts | (18,940 | ) | | (16,621 | ) |
Loss (gain) on servicing asset | 73,042 |
| | (816 | ) |
Loss on termination and option expiration of interest rate swaps and swaptions | 51,712 |
| | 21,904 |
|
Unrealized loss (gain) on interest rate swaps and swaptions | 81,805 |
| | (293,783 | ) |
Unrealized (gain) loss on other derivative instruments | (5,625 | ) | | 79,553 |
|
Equity based compensation | 12,256 |
| | 474 |
|
Depreciation of fixed assets | 768 |
| | 424 |
|
Amortization of intangible assets | 533 |
| | — |
|
Purchases of mortgage loans held-for-sale | (991,990 | ) | | (989,665 | ) |
Proceeds from sales of mortgage loans held-for-sale | 415,889 |
| | 25,404 |
|
Proceeds from repayment of mortgage loans held-for-sale | 25,164 |
| | 24,256 |
|
Net change in assets and liabilities: |
|
| | |
Increase in accrued interest receivable | (2,302 | ) | | (6,241 | ) |
(Increase)/decrease in deferred income taxes, net | (65,496 | ) | | 75,384 |
|
Decrease in income taxes receivable | — |
| | 4,323 |
|
Increase in prepaid and fixed assets | (1,481 | ) | | (602 | ) |
(Increase)/decrease in other receivables | (10,885 | ) | | 29,687 |
|
Increase in servicing advances | (12,485 | ) | | (5,368 | ) |
Increase in Federal Home Loan Bank stock | (60,000 | ) | | — |
|
Increase in equity investments | (3,000 | ) | | — |
|
Decrease in accrued interest payable | (5,353 | ) | | (3,278 | ) |
(Decrease)/increase in income taxes payable | (430 | ) | | 2,356 |
|
Increase in accrued expenses and other liabilities | 13,912 |
| | 9,274 |
|
Net change in assets and liabilities due to purchase of entity | — |
| | 3,306 |
|
Net cash used in operating activities | $ | (355,914 | ) | | $ | (504,511 | ) |
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)
|
| | | | | | | |
| Nine Months Ended |
| September 30, |
| 2014 | | 2013 |
Cash Flows From Investing Activities: | (unaudited) |
Purchases of available-for-sale securities | $ | (4,017,640 | ) | | $ | (4,288,995 | ) |
Proceeds from sales of available-for-sale securities | 3,176,234 |
| | 4,056,691 |
|
Principal payments on available-for-sale securities | 783,308 |
| | 860,984 |
|
Short sales and purchases of other derivative instruments | 590 |
| | (72,158 | ) |
Proceeds from sales of other derivative instruments, net | 49,729 |
| | 126,347 |
|
Purchases of trading securities | (2,138,647 | ) | | (995,625 | ) |
Proceeds from sales of trading securities | 1,145,410 |
| | 1,000,946 |
|
Purchases of beneficial interests in securitization trusts | — |
| | (30,550 | ) |
Proceeds from repayment of mortgage loans held-for-investment in securitization trusts | 51,763 |
| | 28,568 |
|
Purchases of mortgage servicing rights, net of purchase price adjustments | (57,106 | ) | | (13,390 | ) |
Purchase of entity | — |
| | (6,404 | ) |
Decrease in due to counterparties, net | (149,658 | ) | | (135,162 | ) |
Decrease/(increase) in restricted cash | 91,226 |
| | (376,006 | ) |
Net cash (used in) provided by investing activities | (1,064,791 | ) | | 155,246 |
|
Cash Flows From Financing Activities: | | | |
Proceeds from repurchase agreements | 200,827,955 |
| | 145,909,686 |
|
Principal payments on repurchase agreements | (200,803,527 | ) | | (146,382,131 | ) |
Proceeds from issuance of collateralized borrowings in securitization trusts | 693,717 |
| | 307,119 |
|
Principal payments on collateralized borrowings in securitization trusts | (407,684 | ) | | (30,574 | ) |
Proceeds from Federal Home Loan Bank advances | 3,796,411 |
| | — |
|
Principal payments on Federal Home Loan Bank advances | (2,296,411 | ) | | — |
|
Proceeds from issuance of common stock, net of offering costs | 399 |
| | 763,384 |
|
Proceeds from exercise of warrants | — |
| | 102,276 |
|
Repurchase of common stock | — |
| | (23,894 | ) |
Dividends paid on common stock | (190,361 | ) | | (394,549 | ) |
Net cash provided by financing activities | 1,620,499 |
| | 251,317 |
|
Net increase (decrease) in cash and cash equivalents | 199,794 |
| | (97,948 | ) |
Cash and cash equivalents at beginning of period | 1,025,487 |
| | 821,108 |
|
Cash and cash equivalents at end of period | $ | 1,225,281 |
| | $ | 723,160 |
|
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)
|
| | | | | | | |
| Nine Months Ended |
| September 30, |
| 2014 | | 2013 |
Supplemental Disclosure of Cash Flow Information: | (unaudited) |
Cash paid for interest | $ | 81,100 |
| | $ | 76,762 |
|
Cash paid (received) for taxes | $ | 3,905 |
| | $ | (4,254 | ) |
Noncash Investing and Financing Activities: | | | |
Transfers of mortgage loans held-for-sale to mortgage loans held-for-investment in securitization trusts | $ | 656,581 |
| | $ | 413,848 |
|
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 |
|
Distribution of Silver Bay common stock | $ | — |
| | $ | 343,481 |
|
Cash dividends declared but not paid at end of period | $ | 95,205 |
| | $ | 102,022 |
|
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 | 991,990 |
| | 989,665 |
|
Transfers to mortgage loans held-for-investment in securitization trusts | (656,581 | ) | | (413,848 | ) |
Proceeds from sales of mortgage loans held-for-sale | (415,889 | ) | | (25,404 | ) |
Proceeds from repayment of mortgage loans held-for-sale | (25,164 | ) | | (24,256 | ) |
Realized and unrealized gains (losses) on mortgage loans held-for-sale | 6,128 |
| | (25,027 | ) |
Mortgage loans held-for-sale at end of period | $ | 445,065 |
| | $ | 559,737 |
|
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 and nine months ended September 30, 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 September 30, 2014 and results of operations for all periods presented have been made. The results of operations for the three and nine months ended September 30, 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 nine months ended September 30, 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 September 30, 2014, the Company had 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 September 30, 2014 and December 31, 2013:
|
| | | | | | | | | | | | | | | | | | | | | | | |
| September 30, 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 | $ | 370,906 |
| | $ | (17,013 | ) | | $ | 353,893 |
| | $ | (4,221 | ) | | $ | — |
| | $ | 349,672 |
|
Total Assets | $ | 370,906 |
| | $ | (17,013 | ) | | $ | 353,893 |
| | $ | (4,221 | ) | | $ | — |
| | $ | 349,672 |
|
| | | | | | | | | | | |
Liabilities | | | | | | | | | | | |
Repurchase agreements | $ | (12,274,878 | ) | | $ | — |
| | $ | (12,274,878 | ) | | $ | 12,274,878 |
| | $ | — |
| | $ | — |
|
Federal Home Loan Bank advances | (1,500,000 | ) | | — |
| | (1,500,000 | ) | | 1,500,000 |
| | — |
| | — |
|
Derivative liabilities | (21,234 | ) | | 17,013 |
| | (4,221 | ) | | 4,221 |
| | — |
| | — |
|
Total Liabilities | $ | (13,796,112 | ) | | $ | 17,013 |
| | $ | (13,779,099 | ) | | $ | 13,779,099 |
| | $ | — |
| | $ | — |
|
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.
Measuring the Financial Assets and the Financial Liabilities of a Consolidated Collateralized Financing Entity
In August 2014, the FASB issued ASU No. 2014-13, which updates the guidance on measuring the financial assets and financial liabilities of consolidated collateralized financing entities, or CFEs. The update will allow an entity to measure both the financial assets and financial liabilities of a qualifying CFE it consolidates using the fair value of either the CFE’s financial assets or financial liabilities, whichever is more observable. The ASU will require certain recurring disclosures and is effective for annual periods beginning on or after December 15, 2015, with early adoption permitted as of the beginning of an annual period. The Company is evaluating the adoption of this ASU.
Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure
In August 2014, the FASB issued ASU No. 2014-14, which requires that, upon foreclosure, a mortgage loan that is fully guaranteed under certain government programs be derecognized and a separate receivable be recognized when specific criteria are met. The ASU will require certain recurring disclosures and is effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2014, with early adoption permitted. The Company is evaluating the adoption of this ASU.
Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern
In August 2014, the FASB issued ASU No. 2014-15, which requires management to evaluate whether there are conditions and events that raise substantial doubt about the entity’s ability to continue as a going concern for both annual and interim
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
reporting periods. The ASU will require certain disclosures if it concludes that substantial doubt exists and plans to alleviate that doubt. It is effective for annual periods ending after December 15, 2016, and for both annual and interim periods thereafter, with early adoption permitted. The Company does not expect this ASU to have any impact on the Company’s condensed consolidated financial condition or results of operations.
Note 3. Variable Interest Entities
The Company purchases subordinated debt and excess servicing rights from securitization trusts sponsored by either third parties or the Company’s subsidiaries. These 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.
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) | September 30, 2014 | | December 31, 2013 |
Mortgage loans held-for-investment in securitization trusts | $ | 1,428,890 |
| | $ | 792,390 |
|
Accrued interest receivable | 7,137 |
| | 4,506 |
|
Total Assets | $ | 1,436,027 |
| | $ | 796,896 |
|
Collateralized borrowings in securitization trusts | $ | 938,506 |
| | $ | 639,731 |
|
Accrued interest payable | 2,933 |
| | 1,596 |
|
Accrued expenses | 3,563 |
| | 2,724 |
|
Total Liabilities | $ | 945,002 |
| | $ | 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 and nine months ended September 30, 2014 and 2013.
Summarized financial information for the discontinued operations are presented below.
|
| | | | | | | | | | | | | | | |
| Three Months Ended | | Nine Months Ended |
| September 30, | | September 30, |
(in thousands) | 2014 | | 2013 | | 2014 | | 2013 |
Income: | | | | | | | |
Gain on contribution of entity | $ | — |
| | $ | 871 |
| | $ | — |
| | $ | 3,126 |
|
Real estate related revenues | — |
| | — |
| | — |
| | — |
|
Total income | — |
| | 871 |
| | — |
| | 3,126 |
|
Expenses: | | | | | | | |
Management fees | — |
| | — |
| | — |
| | — |
|
Real estate related expenses | — |
| | — |
| | — |
| | — |
|
Other operating expenses | — |
| | — |
| | — |
| | (138 | ) |
Total expenses | — |
| | — |
| | — |
| | (138 | ) |
Income from discontinued operations | $ | — |
| | $ | 871 |
| | $ | — |
| | $ | 3,264 |
|
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
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, $0.9 million and $3.2 million of the installment sales gain was recorded as a gain on contribution of entity within discontinued operations for the three and nine months ended September 30, 2013, respectively, 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 nine months ended September 30, 2013. The remaining $0.1 million recorded within discontinued operations on the condensed consolidated statements of comprehensive income for the nine months ended September 30, 2013 relates to accrual adjustments for transaction expenses related to the contribution. No further adjustments were recognized during 2014. See Note 24 - Related Party Transactions for additional information.
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 September 30, 2014 and December 31, 2013:
|
| | | | | | | |
(in thousands) | September 30, 2014 | | December 31, 2013 |
Mortgage-backed securities: | | | |
Agency | | | |
Federal Home Loan Mortgage Corporation | $ | 2,086,057 |
| | $ | 2,977,291 |
|
Federal National Mortgage Association | 5,477,888 |
| | 4,435,820 |
|
Government National Mortgage Association | 2,134,467 |
| | 2,084,298 |
|
Non-Agency | 2,999,496 |
| | 2,759,318 |
|
Total mortgage-backed securities | $ | 12,697,908 |
| | $ | 12,256,727 |
|
At September 30, 2014 and December 31, 2013, the Company pledged AFS securities with a carrying value of $12.4 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 September 30, 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 September 30, 2014 and December 31, 2013:
|
| | | | | | | | | | | |
| September 30, 2014 |
(in thousands) | Agency | | Non-Agency | | Total |
Face Value | $ | 12,040,854 |
| | $ | 4,314,943 |
| | $ | 16,355,797 |
|
Unamortized premium | 626,470 |
| | — |
| | 626,470 |
|
Unamortized discount | | | | | |
Designated credit reserve | — |
| | (969,031 | ) | | (969,031 | ) |
Net, unamortized | (3,072,511 | ) | | (1,019,465 | ) | | (4,091,976 | ) |
Amortized Cost | 9,594,813 |
| | 2,326,447 |
| | 11,921,260 |
|
Gross unrealized gains | 168,871 |
| | 674,181 |
| | 843,052 |
|
Gross unrealized losses | (65,272 | ) | | (1,132 | ) | | (66,404 | ) |
Carrying Value | $ | 9,698,412 |
| | $ | 2,999,496 |
| | $ | 12,697,908 |
|
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
|
| | | | | | | | | | | |
| 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 |
|
The following tables present the carrying value of the Company’s AFS investment securities by rate type as of September 30, 2014 and December 31, 2013:
|
| | | | | | | | | | | |
| September 30, 2014 |
(in thousands) | Agency | | Non-Agency | | Total |
Adjustable Rate | $ | 132,157 |
| | $ | 2,503,733 |
| | $ | 2,635,890 |
|
Fixed Rate | 9,566,255 |
| | 495,763 |
| | 10,062,018 |
|
Total | $ | 9,698,412 |
| | $ | 2,999,496 |
| | $ | 12,697,908 |
|
|
| | | | | | | | | | | |
| 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.
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, 2014 and 2013, of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
|
| | | | | | | | | | | | | | | | | | | | | | | |
| Nine Months Ended September 30, |
| 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 | (69,663 | ) | | (57,174 | ) | | (126,837 | ) | | (181,122 | ) | | (390,269 | ) | | (571,391 | ) |
Accretion of net discount | — |
| | 96,873 |
| | 96,873 |
| | 886 |
| | 108,829 |
| | 109,715 |
|
Realized credit losses | 11,325 |
| | — |
| | 11,325 |
| | 28,684 |
| | — |
| | 28,684 |
|
Reclassification adjustment for other-than-temporary impairments | (212 | ) | | — |
| | (212 | ) | | (1,662 | ) | | — |
| | (1,662 | ) |
Transfers from (to) | 91,086 |
| | (91,086 | ) | | — |
| | 35,201 |
| | (35,201 | ) | | — |
|
Sales, calls, other | 232,881 |
| | 103,481 |
| | 336,362 |
| | 36,331 |
| | 151,310 |
| | 187,641 |
|
Ending balance at September 30 | $ | (969,031 | ) | | $ | (1,019,465 | ) | | $ | (1,988,496 | ) | | $ | (1,372,628 | ) | | $ | (1,161,821 | ) | | $ | (2,534,449 | ) |
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, 2014 and December 31, 2013. At September 30, 2014, the Company held 1,423 AFS securities, of which 89 were in an unrealized loss position for less than twelve consecutive months and 200 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 $1.4 billion and $4.9 billion of AFS securities in an unrealized loss position for less than twelve consecutive months as of September 30, 2014 and December 31, 2013, $1.3 billion, or 93.6%, 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 |
September 30, 2014 | $ | 1,409,676 |
| | $ | (5,261 | ) | | $ | 1,605,423 |
| | $ | (61,143 | ) | | $ | 3,015,099 |
| | $ | (66,404 | ) |
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 (loss) 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 nine months ended September 30, 2014 on a total of three non-Agency RMBS where the future expected cash flows for each security were less than its amortized cost. The Company did not record any other-than-temporary credit impairments during the three months ended September 30,
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
2014. As of September 30, 2014, impaired securities with a carrying value of $162.6 million had actual weighted average cumulative losses of 10.6%, weighted average three-month prepayment speed of 3.8%, weighted average 60+ day delinquency of 29.5% of the pool balance, and weighted average FICO score of 664. At September 30, 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 nine months ended September 30, 2013, the Company recorded a $1.7 million other-than-temporary credit impairment on a total of four non-Agency RMBS where the future expected cash flows for the security were less than its amortized cost. The Company did not record any other-than-temporary impairments during the three months ended September 30, 2013.
The following table presents the changes in OTTI included in earnings for three and nine months ended September 30, 2014 and 2013:
|
| | | | | | | | | | | | | | | |
| Three Months Ended | | Nine Months Ended |
| September 30, | | September 30, |
(in thousands) | 2014 | | 2013 | | 2014 | | 2013 |
Cumulative credit loss at beginning of period | $ | (8,061 | ) | | $ | (15,046 | ) | | $ | (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 | ) | | (1,662 | ) |
Reductions: | | | | | | | |
Decreases related to other-than-temporary impairments on securities paid down | — |
| | 1,446 |
| | 464 |
| | 1,677 |
|
Decreases related to other-than-temporary impairments on securities sold | — |
| | 406 |
| | 1,154 |
| | 2,352 |
|
Cumulative credit loss at end of period | $ | (8,061 | ) | | $ | (13,194 | ) | | $ | (8,061 | ) | | $ | (13,194 | ) |
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 (loss) on investment securities in the Company’s condensed consolidated statements of comprehensive income. For the three and nine months ended September 30, 2014, the Company sold AFS securities for $1.9 billion and $3.2 billion with an amortized cost of $1.8 billion and $3.1 billion, for net realized gains of $62.7 million and $59.9 million, respectively. For the three and nine months ended September 30, 2013, the Company sold AFS securities for $3.1 billion and $4.1 billion with an amortized cost of $3.3 billion and $4.2 billion, for net realized losses of $234.5 million and $163.2 million, respectively.
The following table presents the gross realized gains and losses on sales of AFS securities for the three and nine months ended September 30, 2014 and 2013:
|
| | | | | | | | | | | | | | | |
| Three Months Ended | | Nine Months Ended |
| September 30, | | September 30, |
(in thousands) | 2014 | | 2013 | | 2014 | | 2013 |
Gross realized gains | $ | 87,842 |
| | $ | 27,786 |
| | $ | 131,005 |
| | $ | 103,451 |
|
Gross realized losses | (25,122 | ) | | (262,323 | ) | | (71,119 | ) | | (266,620 | ) |
Total realized (losses) gains on sales, net | $ | 62,720 |
| | $ | (234,537 | ) | | $ | 59,886 |
| | $ | (163,169 | ) |
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
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 September 30, 2014 and December 31, 2013, the Company held U.S. Treasuries with an amortized cost of $2.0 billion and $996.1 million, and a fair value of $2.0 billion and $1.0 billion, respectively, classified as trading securities. Included within trading securities were unrealized losses of $2.8 million and unrealized gains of $4.1 million as of September 30, 2014 and December 31, 2013, respectively.
For the three and nine months ended September 30, 2014, the Company sold trading securities for $1.0 billion and $1.1 billion with an amortized cost of $996.9 million and $1.1 billion, resulting in realized gains of $5.1 million and $5.5 million, respectively, on the sale of these securities. For both the three and nine months ended September 30, 2013, the Company sold trading securities for $1.0 billion with an amortized cost of $997.9 million, resulting in realized gains of $3.1 million.
For the three and nine months ended September 30, 2014, trading securities experienced change in unrealized losses of $8.4 million and $6.9 million, respectively. For the three and nine months ended September 30, 2013, trading securities experienced change in unrealized gains of $1.4 million and change in unrealized losses of $0.2 million, respectively. Both realized and unrealized gains and losses are recorded as a component of gain (loss) on investment securities in the Company’s condensed consolidated statements of comprehensive income.
At September 30, 2014 and December 31, 2013, the Company pledged trading securities with a carrying value of $2.0 billion and $1.0 billion, respectively, as collateral for repurchase agreements. See Note 16 - Repurchase Agreements.
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 September 30, 2014 and December 31, 2013:
|
| | | | | | | |
(in thousands) | September 30, 2014 | | December 31, 2013 |
Unpaid principal balance | $ | 445,692 |
| | $ | 680,840 |
|
Fair value adjustment | (627 | ) | | (136,259 | ) |
Carrying value | $ | 445,065 |
| | $ | 544,581 |
|
At September 30, 2014 and December 31, 2013, the Company pledged mortgage loans with a carrying value of $407.8 million and $200.8 million, 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.
Note 8. Mortgage Loans Held-for-Investment in Securitization Trusts, at Fair Value
The Company purchases subordinated debt and excess servicing rights from securitization trusts sponsored by either third parties or the Company’s subsidiaries. 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 September 30, 2014 and December 31, 2013:
|
| | | | | | | |
(in thousands) | September 30, 2014 | | December 31, 2013 |
Unpaid principal balance | $ | 1,402,782 |
| | $ | 812,538 |
|
Fair value adjustment | 26,108 |
| | (20,148 | ) |
Carrying value | $ | 1,428,890 |
| | $ | 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 and nine months ended September 30, 2014 and 2013.
|
| | | | | | | | | | | | | | | |
| Three Months Ended | | Nine Months Ended |
| September 30, | | September 30, |
(in thousands) | 2014 | | 2013 | | 2014 | | 2013 |
Balance at beginning of period | $ | 500,490 |
| | $ | 1,452 |
| | $ | 514,402 |
| | $ | — |
|
Additions from purchases of servicing rights | 7,542 |
| | 13,390 |
| | 61,835 |
| | 14,887 |
|
Changes in fair value due to: | | | | | | | |
Changes in valuation inputs or assumptions used in the valuation model | 3,964 |
| | — |
| | (31,941 | ) | | — |
|
Other changes in fair value (1) | (14,674 | ) | | 861 |
| | (41,101 | ) | | 816 |
|
Other changes (2) | 1,144 |
| | — |
| | (4,729 | ) | | — |
|
Balance at end of period | $ | 498,466 |
| | $ | 15,703 |
| | $ | 498,466 |
| | $ | 15,703 |
|
____________________
| |
(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 September 30, 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) | September 30, 2014 | | December 31, 2013 |
Weighted average prepayment speed: | 10.7 | % | | 9.5 | % |
Impact on fair value of 10% adverse change | $ | (18,942 | ) | | $ | (19,305 | ) |
Impact on fair value of 20% adverse change | $ | (36,388 | ) | | $ | (37,187 | ) |
Weighted average delinquency: | 4.5 | % | | 4.0 | % |
Impact on fair value of 10% adverse change | $ | (3,489 | ) | | $ | (8,835 | ) |
Impact on fair value of 20% adverse change | $ | (7,477 | ) | | $ | (17,642 | ) |
Weighted average discount rate: | 9.5 | % | | 9.0 | % |
Impact on fair value of 10% adverse change | $ | (18,443 | ) | | $ | (21,037 | ) |
Impact on fair value of 20% adverse change | $ | (35,890 | ) | | $ | (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 AFS securities and 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 and nine months ended September 30, 2014 and 2013:
|
| | | | | | | | | | | | | | | |
| Three Months Ended | | Nine Months Ended |
| September 30, | | September 30, |
(in thousands) | 2014 | | 2013 | | 2014 | | 2013 |
Servicing fee income | $ | 31,390 |
| | $ | 899 |
| | $ | 94,340 |
| | $ | 1,114 |
|
Ancillary fee income | 874 |
| | 90 |
| | 2,233 |
| | 120 |
|
| $ | 32,264 |
| | $ | 989 |
| | $ | 96,573 |
| | $ | 1,234 |
|
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 $19.8 million and $7.3 million and were included in other assets on the condensed consolidated balance sheet as of September 30, 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 September 30, 2014 and December 31, 2013:
|
| | | | | | | | | | | | | |
(dollars in thousands) | September 30, 2014 | | December 31, 2013 |
| Number of Loans | | Unpaid Principal Balance | | Number of Loans | | Unpaid Principal Balance |
Mortgage loans held-for-sale | 825 |
| | $ | 445,692 |
| | 2,890 |
| | $ | 680,840 |
|
Mortgage loans held-for-investment in securitization trusts | 499 |
| | 368,358 |
| | 537 |
| | 425,209 |
|
Mortgage servicing rights (1) | 226,369 |
| | 45,526,752 |
| | 210,441 |
| | 42,324,328 |
|
Total serviced mortgage assets | 227,693 |
| | $ | 46,340,802 |
| | 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 September 30, 2014 and December 31, 2013:
|
| | | | | | | |
(in thousands) | September 30, 2014 | | December 31, 2013 |
Restricted cash balances held by trading counterparties: | | | |
For securities trading activity | $ | 9,000 |
| | $ | 9,000 |
|
For derivatives trading activity | 207,780 |
| | 191,107 |
|
As restricted collateral for repurchase agreements and Federal Home Loan Bank advances | 93,295 |
| | 201,194 |
|
| 310,075 |
| | 401,301 |
|
Restricted cash balance pursuant to letter of credit on office lease | 346 |
| | 346 |
|
Total | $ | 310,421 |
| | $ | 401,647 |
|
Note 11. Accrued Interest Receivable
The following table presents the Company’s accrued interest receivable by collateral type:
|
| | | | | | | |
(in thousands) | September 30, 2014 | | December 31, 2013 |
Accrued Interest Receivable: | | | |
U.S. Treasuries | $ | 3,709 |
| | $ | 2,361 |
|
Mortgage-backed securities: | | | |
Agency | | | |
Federal Home Loan Mortgage Corporation | 7,826 |
| | 10,583 |
|
Federal National Mortgage Association | 18,950 |
| | 15,034 |
|
Government National Mortgage Association | 10,270 |
| | 10,007 |
|
Non-Agency | 3,543 |
| | 3,676 |
|
Total mortgage-backed securities | 40,589 |
| | 39,300 |
|
Mortgage loans held-for-sale | 1,170 |
| | 4,136 |
|
Mortgage loans held-for-investment in securitization trusts | 7,137 |
| | 4,506 |
|
Total | $ | 52,605 |
| | $ | 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 (based on the Markit IOS Index). 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.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
Balance Sheet Presentation
In accordance with ASC 815, Derivatives and Hedging, as amended and interpreted, or ASC 815, 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.
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, 2014 and December 31, 2013.
|
| | | | | | | | | | | | | | | | |
(in thousands) | | September 30, 2014 |
| | Derivative Assets | | Derivative Liabilities |
Trading instruments | | Fair Value | | Notional | | Fair Value | | Notional |
Inverse interest-only securities | | $ | 188,701 |
| | $ | 1,211,965 |
| | $ | — |
| | $ | — |
|
Interest rate swap agreements | | 62,560 |
| | 27,770,655 |
| | — |
| | — |
|
Credit default swaps | | — |
| | — |
| | (1,825 | ) | | 125,000 |
|
Swaptions, net | | 94,388 |
| | |