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, 2015

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.)

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):

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 4, 2015 there were 364,055,176 shares of outstanding common stock, par value $.01 per share, issued and outstanding.
 
 
 
 
 


Table of Contents



TWO HARBORS INVESTMENT CORP.
INDEX

 
 
Page
 
PART I - FINANCIAL INFORMATION
 
 
 
 
 
 
 
PART II - OTHER INFORMATION
 


i

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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,
2015
 
December 31,
2014
ASSETS
(unaudited)
 
 
Available-for-sale securities, at fair value
$
11,433,195

 
$
14,341,102

Trading securities, at fair value

 
1,997,656

Residential mortgage loans held-for-sale, at fair value
768,008

 
535,712

Residential mortgage loans held-for-investment in securitization trusts, at fair value
2,978,586

 
1,744,746

Commercial real estate loans held-for-investment
290,910

 

Mortgage servicing rights, at fair value
447,345

 
452,006

Cash and cash equivalents
811,839

 
1,005,792

Restricted cash
384,029

 
336,771

Accrued interest receivable
56,250

 
65,529

Due from counterparties
47,069

 
35,625

Derivative assets, at fair value
296,731

 
380,791

Other assets
271,351

 
188,579

Total Assets (1)
$
17,785,313

 
$
21,084,309

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Liabilities
 
 
 
Repurchase agreements
$
7,982,928

 
$
12,932,463

Collateralized borrowings in securitization trusts, at fair value
1,990,769

 
1,209,663

Federal Home Loan Bank advances
3,710,000

 
2,500,000

Derivative liabilities, at fair value
81,473

 
90,233

Due to counterparties
78,385

 
124,206

Dividends payable
95,459

 
95,263

Other liabilities
73,561

 
64,439

Total Liabilities (1)
14,012,575

 
17,016,267

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 366,156,759 and 366,395,920 shares issued and outstanding, respectively
3,662

 
3,664

Additional paid-in capital
3,806,323

 
3,811,027

Accumulated other comprehensive income
573,001

 
855,789

Cumulative earnings
1,474,049

 
1,195,536

Cumulative distributions to stockholders
(2,084,297
)
 
(1,797,974
)
Total Stockholders’ Equity
3,772,738

 
4,068,042

Total Liabilities and Stockholders’ Equity
$
17,785,313

 
$
21,084,309

____________________
(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. At September 30, 2015 and December 31, 2014, assets of the VIEs totaled $3,040,394 and $1,754,943, and liabilities of the VIEs totaled $2,005,849 and $1,219,821, respectively. See Note 3 - Variable Interest Entities for additional information.
The accompanying notes are an integral part of these condensed consolidated financial statements.

1

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME
(in thousands, except share data)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2015
 
2014
 
2015
 
2014
Interest income:
(unaudited)
 
(unaudited)
Available-for-sale securities
$
116,318

 
$
123,056

 
$
369,972

 
$
374,574

Trading securities

 
4,308

 
8,676

 
8,174

Residential mortgage loans held-for-sale
9,479

 
5,268

 
21,268

 
12,553

Residential mortgage loans held-for-investment in securitization trusts
24,841

 
9,526

 
64,908

 
25,180

Commercial real estate loans held-for-investment
1,947

 

 
2,841

 

Cash and cash equivalents
249

 
145

 
667

 
506

Total interest income
152,834

 
142,303

 
468,332

 
420,987

Interest expense:
 
 
 
 


 


Repurchase agreements
18,235

 
17,509

 
58,198

 
56,684

Collateralized borrowings in securitization trusts
15,562

 
5,678

 
39,401

 
16,623

Federal Home Loan Bank advances
3,282

 
1,531

 
8,012

 
2,439

Total interest expense
37,079

 
24,718

 
105,611

 
75,746

Net interest income
115,755

 
117,585

 
362,721

 
345,241

Other-than-temporary impairments:
 
 
 
 

 

Total other-than-temporary impairment losses
(238
)
 

 
(535
)
 
(212
)
Non-credit portion of loss recognized in other comprehensive (loss) income

 

 

 

Net other-than-temporary credit impairment losses
(238
)
 

 
(535
)

(212
)
Other income:
 
 
 
 

 

Gain on investment securities
64,123

 
59,471

 
263,512

 
58,504

(Loss) gain on interest rate swap and swaption agreements
(171,656
)
 
28,519

 
(253,147
)
 
(193,028
)
(Loss) gain on other derivative instruments
(455
)
 
6,056

 
(2,972
)
 
(12,345
)
Gain (loss) on residential mortgage loans held-for-sale
16,040

 
(2,387
)
 
18,300

 
6,233

Servicing income
32,010

 
32,264

 
94,613

 
96,573

Loss on servicing asset
(61,549
)
 
(10,711
)
 
(96,317
)
 
(73,042
)
Other income (loss)
2,201

 
(1,515
)
 
(16,265
)
 
19,948

Total other (loss) income
(119,286
)
 
111,697

 
7,724

 
(97,157
)
Expenses:
 
 
 
 

 

Management fees
12,617

 
12,258

 
38,024

 
36,559

Securitization deal costs
2,676

 
3,355

 
7,771

 
3,355

Servicing expenses
7,234

 
12,513

 
19,849

 
24,595

Other operating expenses
16,150

 
12,424

 
48,032

 
41,281

Total expenses
38,677

 
40,550

 
113,676

 
105,790

(Loss) income before income taxes
(42,446
)
 
188,732

 
256,234

 
142,082

Benefit from income taxes
(7,656
)
 
(4,858
)
 
(25,270
)
 
(62,020
)
Net (loss) income
$
(34,790
)
 
$
193,590

 
$
281,504

 
$
204,102

Basic and diluted (loss) earnings per weighted average common share
$
(0.09
)
 
$
0.53

 
$
0.77

 
$
0.56

Dividends declared per common share
$
0.26

 
$
0.26

 
$
0.78

 
$
0.78

Basic and diluted weighted average number of shares of common stock outstanding
367,365,973

 
366,118,866

 
366,985,731

 
365,938,150

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

2

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME, continued
(in thousands, except share data)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2015
 
2014
 
2015
 
2014
 
(unaudited)
 
(unaudited)
Comprehensive (loss) income:
 
 
 
 
 
 
 
Net (loss) income
$
(34,790
)
 
$
193,590

 
$
281,504

 
$
204,102

Other comprehensive (loss) income, net of tax:
 
 
 
 
 
 
 
Unrealized (loss) gain on available-for-sale securities
(58,031
)
 
(40,982
)
 
(282,788
)
 
331,913

Other comprehensive (loss) income
(58,031
)
 
(40,982
)
 
(282,788
)
 
331,913

Comprehensive (loss) income
$
(92,821
)
 
$
152,608

 
$
(1,284
)
 
$
536,015

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


3

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TWO HARBORS INVESTMENT CORP. 
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except share data)
 
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, 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, net of tax

 

 

 
364,026

 

 

 
364,026

Amounts reclassified from accumulated other comprehensive income, net of tax

 

 

 
(32,113
)
 

 

 
(32,113
)
Net other comprehensive income, net of tax

 

 

 
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

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2014
366,395,920

 
$
3,664

 
$
3,811,027

 
$
855,789

 
$
1,195,536

 
$
(1,797,974
)
 
$
4,068,042

Cumulative effect of adoption of new accounting principle

 

 

 

 
(2,991
)
 

 
(2,991
)
Adjusted balance, January 1, 2015
366,395,920

 
3,664

 
3,811,027

 
855,789

 
1,192,545

 
(1,797,974
)
 
4,065,051

Net income

 

 

 

 
281,504

 

 
281,504

Other comprehensive loss before reclassifications, net of tax

 

 

 
(54,805
)
 

 

 
(54,805
)
Amounts reclassified from accumulated other comprehensive loss, net of tax

 

 

 
(227,983
)
 

 

 
(227,983
)
Net other comprehensive loss, net of tax

 

 

 
(282,788
)
 

 

 
(282,788
)
Issuance of common stock, net of offering costs
54,088

 
1

 
403

 

 

 

 
404

Repurchase of common stock
(1,391,887
)
 
(14
)
 
(12,462
)
 

 

 

 
(12,476
)
Common dividends declared

 

 

 

 

 
(286,323
)
 
(286,323
)
Non-cash equity award compensation
1,098,638

 
11

 
7,355

 

 

 

 
7,366

Balance, September 30, 2015
366,156,759

 
$
3,662

 
$
3,806,323

 
$
573,001

 
$
1,474,049

 
$
(2,084,297
)
 
$
3,772,738

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


4

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
Nine Months Ended
 
September 30,
 
2015
 
2014
Cash Flows From Operating Activities:
(unaudited)
Net income
$
281,504

 
$
204,102

Adjustments to reconcile net income to net cash used in operating activities:
 
 
 
Amortization of premiums and discounts on investment securities and commercial real estate loans held-for-investment, net
32,556

 
7,415

Other-than-temporary impairment losses
535

 
212

Realized and unrealized gains on investment securities, net
(263,512
)
 
(58,504
)
Gain on residential mortgage loans held-for-sale
(18,300
)
 
(6,233
)
Loss (gain) on residential mortgage loans held-for-investment and collateralized borrowings in securitization trusts
19,441

 
(18,940
)
Loss on servicing asset
96,317

 
73,042

Loss on termination and option expiration of interest rate swaps and swaptions
124,984

 
51,712

Unrealized loss on interest rate swaps and swaptions
55,079

 
81,805

Unrealized gain on other derivative instruments
(15,563
)
 
(5,625
)
Equity based compensation
7,366

 
12,256

Depreciation of fixed assets
1,002

 
768

Amortization of intangible assets

 
533

Purchases of residential mortgage loans held-for-sale
(2,151,417
)
 
(991,990
)
Proceeds from sales of residential mortgage loans held-for-sale
137,612

 
415,889

Proceeds from repayment of residential mortgage loans held-for-sale
80,152

 
25,164

Net change in assets and liabilities:


 
 
Decrease (increase) in accrued interest receivable
9,279

 
(2,302
)
Increase in deferred income taxes, net
(19,592
)
 
(65,496
)
Increase in income taxes receivable
(6,854
)
 

Increase in prepaid and fixed assets
(221
)
 
(1,481
)
Decrease (increase) in other receivables
8,563

 
(10,885
)
Increase in servicing advances
(3,465
)
 
(12,485
)
Decrease in accrued interest payable
(4,780
)
 
(5,353
)
Decrease in income taxes payable
(1,215
)
 
(430
)
Increase in accrued expenses and other liabilities
6,324

 
13,912

Net cash used in operating activities
$
(1,624,205
)
 
$
(292,914
)
The accompanying notes are an integral part of these condensed consolidated financial statements.

5

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Nine Months Ended
 
September 30,
 
2015
 
2014
Cash Flows From Investing Activities:
(unaudited)
Purchases of available-for-sale securities
$
(1,732,979
)
 
$
(4,017,640
)
Proceeds from sales of available-for-sale securities
3,666,974

 
3,176,234

Principal payments on available-for-sale securities
918,798

 
783,308

Short sales and purchases of other derivative instruments, net
3,592

 
590

(Payments for termination) proceeds from sales of other derivative instruments, net
(93,352
)
 
49,729

Purchases of trading securities

 
(2,138,647
)
Proceeds from sales of trading securities
2,004,375

 
1,145,410

Proceeds from repayment of residential mortgage loans held-for-investment in securitization trusts
435,967

 
51,763

Purchases of commercial real estate loans held-for-investment
(290,683
)
 

Purchases of mortgage servicing rights, net of purchase price adjustments
(90,088
)
 
(57,106
)
Purchases of Federal Home Loan Bank stock
(53,640
)
 
(60,000
)
Purchases of equity investments

 
(3,000
)
Decrease in due to counterparties, net
(57,265
)
 
(149,658
)
(Increase) decrease in restricted cash
(47,258
)
 
91,226

Net cash provided by (used in) investing activities
4,664,441

 
(1,127,791
)
Cash Flows From Financing Activities:
 
 
 
Proceeds from repurchase agreements
37,275,034

 
200,827,955

Principal payments on repurchase agreements
(42,224,569
)
 
(200,803,527
)
Proceeds from issuance of collateralized borrowings in securitization trusts
1,104,093

 
693,717

Principal payments on collateralized borrowings in securitization trusts
(309,341
)
 
(407,684
)
Proceeds from Federal Home Loan Bank advances
1,415,000

 
3,796,411

Principal payments on Federal Home Loan Bank advances
(205,000
)
 
(2,296,411
)
Proceeds from issuance of common stock, net of offering costs
404

 
399

Repurchase of common stock
(3,683
)
 

Dividends paid on common stock
(286,127
)
 
(190,361
)
Net cash (used in) provided by financing activities
(3,234,189
)
 
1,620,499

Net (decrease) increase in cash and cash equivalents
(193,953
)
 
199,794

Cash and cash equivalents at beginning of period
1,005,792

 
1,025,487

Cash and cash equivalents at end of period
$
811,839

 
$
1,225,281

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

6

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Nine Months Ended
 
September 30,
 
2015
 
2014
Supplemental Disclosure of Cash Flow Information:
(unaudited)
Cash paid for interest
$
73,187

 
$
81,100

Cash paid for taxes
$
2,389

 
$
3,905

Noncash Investing and Financing Activities:
 
 
 
Transfers of residential mortgage loans held-for-sale to residential mortgage loans held-for-investment in securitization trusts
$
1,705,885

 
$
656,581

Transfers of residential mortgage loans held-for-sale to other receivables for foreclosed government-guaranteed loans
$
12,764

 
$

Additions to mortgage servicing rights due to sale of residential mortgage loans held-for-sale
$
1,568

 
$

Cumulative-effect adjustment to equity for adoption of new accounting principle
$
(2,991
)
 
$

Shares repurchase payable at end of period
$
8,793

 
$

Cash dividends declared but not paid at end of period
$
95,459

 
$
95,205

Reconciliation of residential mortgage loans held-for-sale:
 
 
 
Residential mortgage loans held-for-sale at beginning of period
$
535,712

 
$
544,581

Purchases of residential mortgage loans held-for-sale
2,151,417

 
991,990

Transfers to residential mortgage loans held-for-investment in securitization trusts
(1,705,885
)
 
(656,581
)
Transfers to other receivables for foreclosed government-guaranteed loans
(12,764
)
 

Proceeds from sales of residential mortgage loans held-for-sale
(137,612
)
 
(415,889
)
Proceeds from repayment of residential mortgage loans held-for-sale
(80,152
)
 
(25,164
)
Realized and unrealized gains on residential mortgage loans held-for-sale
17,292

 
6,128

Residential mortgage loans held-for-sale at end of period
$
768,008

 
$
445,065

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

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TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (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, commercial real estate 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 of the Company 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. 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.

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, 2014. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at September 30, 2015 and results of operations for all periods presented have been made. The results of operations for the three and nine months ended September 30, 2015 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 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.
All trust entities in which the Company holds investments that 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 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.

8

Table of Contents

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

Significant Accounting Policies
Included in Note 2 to the Consolidated Financial Statements of the Company’s 2014 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, 2015.
Available-for-Sale Securities, at Fair Value
The Company invests primarily in mortgage pass-through certificates, collateralized mortgage obligations and other residential mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans (collectively “RMBS”) issued by 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, or collectively, the government sponsored entities, or GSEs. The Company also invests in residential mortgage-backed securities that are not issued by the GSEs, or non-Agency RMBS.
Designation
The Company classifies its RMBS securities, excluding inverse interest-only Agency securities classified as derivatives for purposes of U.S. GAAP, as available-for-sale, or AFS, investments. Although the Company generally intends to hold most of its investment securities until maturity, it may, from time to time, sell any of its investment securities as part of its overall management of its portfolio. Accordingly, the Company classifies all of its RMBS investment securities as AFS, including its interest-only strips, which represent the Company’s right to receive a specified portion of the contractual interest flows of specific Agency or Non-Agency securities. All assets classified as AFS, excluding Agency interest-only mortgage-backed securities and GSE credit risk transfer securities, are reported at estimated fair value with unrealized gains and losses, excluding other than temporary impairments, included in accumulated other comprehensive income a separate component of stockholders’ equity, on an after-tax basis.
On July 1, 2015, the Company elected the fair value option for Agency interest-only securities and GSE credit risk transfer securities acquired on or after such date. All Agency interest-only securities and GSE credit risk transfer securities acquired on or after July 1, 2015 are carried at estimated fair value with changes in fair value, excluding other than temporary impairments, recorded as a component of gain on investment securities in the condensed consolidated statements of comprehensive (loss) income.
Commercial Real Estate Loans Held-for-Investment
The Company originates and purchases commercial real estate debt and related instruments generally to be held as long-term investments. These assets are classified as commercial real estate loans held-for-investment on the condensed consolidated balance sheets. Additionally, the Company is the sole certificate holder of a trust entity that holds a commercial real estate loan. The trust is considered a VIE for financial reporting purposes and, thus, is reviewed for consolidation under the applicable consolidation guidance. As the Company has both the power to direct the activities of the trust that most significantly impact the entity’s performance, and the obligation to absorb losses or the right to receive benefits of the entity that could be significant, the Company consolidates the trust. The underlying loan is classified as commercial real estate loans held-for-investment on the condensed consolidated balance sheets. The loan is legally isolated from the Company and has been structured to be beyond the reach of creditors of the Company. Interest income on commercial real estate loans held-for-investment is recorded on the condensed consolidated statements of comprehensive (loss) income.
Commercial real estate loans held-for-investment are reported at cost, net of any unamortized acquisition premiums or discounts, loan fees and origination costs as applicable, unless the loans are deemed impaired. Impairment is indicated when it is deemed probable that the Company will not be able to collect all amounts due pursuant to the contractual terms of the loan. Because the Company’s commercial real estate loans are collateralized either by real property or by equity interests in the commercial real estate borrower, impairment is measured by comparing the estimated fair value of the underlying collateral to the amortized cost of the respective loan. The valuation of the underlying collateral requires significant judgment, which includes assumptions regarding capitalization rates, leasing, credit worthiness of major tenants, occupancy rates, availability of financing, exit plan, loan sponsorship, actions of other lenders, overall economic conditions, the broader commercial real estate market, local geographic sub-markets, and other factors deemed necessary. If a loan is determined to be impaired, the Company records an allowance to reduce the carrying value of the loan through a charge to provision for loan losses. Actual losses, if any, could ultimately differ from these estimates.
Interest income on commercial real estate loans held-for-investment is recognized at the loan coupon rate. Any premiums or discounts are amortized or accreted into interest income using the effective interest method. Loans are considered past due when they are 30 days past their contractual due date. Interest income recognition is suspended when loans are placed on nonaccrual status. Generally, commercial real estate loans are placed on nonaccrual status when delinquent for more than 60

9

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

days or when determined not to be probable of full collection. Interest accrued, but not collected, at the date loans are placed on nonaccrual is reversed and subsequently recognized only to the extent it is received in cash or until it qualifies for return to accrual status. However, where there is doubt regarding the ultimate collectability of loan principal, all cash received is applied to reduce the carrying value of such loans. Commercial real estate loans are restored to accrual status only when contractually current or the collection of future payments is reasonably assured.
Other Comprehensive (Loss) Income
Current period net unrealized gains and losses on AFS securities, excluding Agency interest-only securities and GSE credit risk transfer securities, are reported as components of accumulated other comprehensive income on our condensed consolidated statements of stockholders’ equity and statements of comprehensive (loss) income. Net unrealized gains and losses on securities held by our taxable subsidiaries that are reported in accumulated other comprehensive income are adjusted for the effects of taxation and may create deferred tax assets or liabilities.
Offsetting Assets and Liabilities
Certain of the Company’s repurchase agreements 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, or central clearing exchange agreements, in the case of centrally cleared interest rate swaps. Additionally, the Company and the counterparty or clearing agency 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 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.
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, 2015 and December 31, 2014:
 
September 30, 2015
 
 
 
 
 
 
 
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
$
398,472

 
$
(101,741
)
 
$
296,731

 
$
(81,473
)
 
$

 
$
215,258

Total Assets
$
398,472

 
$
(101,741
)
 
$
296,731

 
$
(81,473
)
 
$

 
$
215,258

Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(7,982,928
)
 
$

 
$
(7,982,928
)
 
$
7,982,928

 
$

 
$

Derivative liabilities
(183,214
)
 
101,741

 
(81,473
)
 
81,473

 

 

Total Liabilities
$
(8,166,142
)
 
$
101,741

 
$
(8,064,401
)
 
$
8,064,401

 
$

 
$


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

 
December 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
$
443,490

 
$
(62,699
)
 
$
380,791

 
$
(90,233
)
 
$

 
$
290,558

Total Assets
$
443,490

 
$
(62,699
)
 
$
380,791

 
$
(90,233
)
 
$

 
$
290,558

Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(12,932,463
)
 
$

 
$
(12,932,463
)
 
$
12,932,463

 
$

 
$

Derivative liabilities
(152,932
)
 
62,699

 
(90,233
)
 
90,233

 

 

Total Liabilities
$
(13,085,395
)
 
$
62,699

 
$
(13,022,696
)
 
$
13,022,696

 
$

 
$

____________________
(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
Revenue from Contracts with Customers
In May 2014, the Financial Accounting Standards Board, or FASB, issued ASU No. 2014-09, which is a comprehensive revenue recognition standard that supersedes virtually all existing revenue guidance under U.S. GAAP. The standard’s core principle is that an entity will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. As a result of the issuance of ASU No. 2015-14 in August 2015 deferring the effective date of ASU No. 2014-09 by one year, the ASU is effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2017, with early adoption prohibited. The Company has determined this ASU will not have a material impact on the Company’s financial condition or results of operations.
Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures
In June 2014, the FASB issued ASU No. 2014-11, which requires repurchase-to-maturity transactions to be accounted for as secured borrowings, eliminates the existing guidance for repurchase financings, and requires new disclosures for certain transactions accounted for as secured borrowings and sales. This ASU is effective for the first interim or annual period beginning after December 15, 2014, except for the disclosures related to transactions accounted for as secured borrowings, which are effective for periods beginning on or after March 15, 2015. Adoption of this ASU did not have any impact on the Company’s financial condition or results of operations, but did impact financial statement disclosures.
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 allows 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 requires 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. Early adoption of this ASU was applied using a modified retrospective approach by recording a cumulative-effect adjustment to equity as of January 1, 2015, which did not have a material impact on the Company’s financial condition or results of operations.

11

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

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 requires 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. Adoption of this ASU did not have a material impact on the Company’s financial condition or results of operations.
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 reporting periods. The update requires certain disclosures if management concludes that substantial doubt exists and plans to alleviate that doubt. The ASU is effective for annual periods ending after December 15, 2016, and for both annual and interim periods thereafter, with early adoption permitted.
Amendments to the Consolidation Analysis
In February 2015, the FASB issued ASU No. 2015-02, which changes the guidance on the consolidation of certain investment funds as well as both the variable interest model and the voting model. The ASU requires certain recurring disclosures and is effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2015, with early adoption permitted. Early adoption of this ASU did not have a material impact on the Company’s 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. Additionally, the Company is the sole certificate holder of a trust entity that holds a commercial real estate loan. All of these 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 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 condensed consolidated financial statements during subsequent reporting periods.
The following table presents a summary of the assets and liabilities of all consolidated trusts as reported on the condensed consolidated balance sheets:
(in thousands)
September 30,
2015
 
December 31,
2014
Residential mortgage loans held-for-investment in securitization trusts
$
2,978,586

 
$
1,744,746

Commercial real estate loans held-for-investment
45,651

 

Accrued interest receivable
16,157

 
10,197

Total Assets
$
3,040,394

 
$
1,754,943

Collateralized borrowings in securitization trusts
$
1,990,769

 
$
1,209,663

Accrued interest payable
5,874

 
3,678

Other liabilities
9,206

 
6,480

Total Liabilities
$
2,005,849

 
$
1,219,821



12

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

Note 4. Available-for-Sale Securities, at Fair Value
The Company holds AFS investment securities which are carried at fair value on the condensed consolidated balance sheets. 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, 2015 and December 31, 2014:
(in thousands)
September 30,
2015
 
December 31,
2014
Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
2,224,045

 
$
2,418,546

Federal National Mortgage Association
5,150,287

 
6,768,875

Government National Mortgage Association
1,651,668

 
2,104,896

Non-Agency
2,407,195

 
3,048,785

Total mortgage-backed securities
$
11,433,195

 
$
14,341,102


At September 30, 2015 and December 31, 2014, the Company pledged AFS securities with a carrying value of $11.4 billion and $14.2 billion, respectively, as collateral for repurchase agreements and advances from Federal Home Loan Bank of Des Moines, or the FHLB. See Note 16 - Repurchase Agreements and Note 18 - Federal Home Loan Bank of Des Moines Advances.
At September 30, 2015 and December 31, 2014, 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, 2015 and December 31, 2014:
 
September 30, 2015
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
11,120,631

 
$
3,286,574

 
$
14,407,205

Unamortized premium
547,121

 

 
547,121

Unamortized discount
 
 
 
 
 
Designated credit reserve

 
(544,173
)
 
(544,173
)
Net, unamortized
(2,798,321
)
 
(753,489
)
 
(3,551,810
)
Amortized Cost
8,869,431

 
1,988,912

 
10,858,343

Gross unrealized gains
197,980

 
429,480

 
627,460

Gross unrealized losses
(41,411
)
 
(11,197
)
 
(52,608
)
Carrying Value
$
9,026,000

 
$
2,407,195

 
$
11,433,195

 
December 31, 2014
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
13,421,555


$
4,291,872

 
$
17,713,427

Unamortized premium
676,641



 
676,641

Unamortized discount
 
 
 
 
 
Designated credit reserve


(927,605
)
 
(927,605
)
Net, unamortized
(3,009,782
)

(967,368
)
 
(3,977,150
)
Amortized Cost
11,088,414


2,396,899

 
13,485,313

Gross unrealized gains
238,291


653,529

 
891,820

Gross unrealized losses
(34,388
)

(1,643
)
 
(36,031
)
Carrying Value
$
11,292,317

 
$
3,048,785

 
$
14,341,102


13

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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 September 30, 2015 and December 31, 2014:
 
September 30, 2015
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
114,929

 
$
1,980,728

 
$
2,095,657

Fixed Rate
8,911,071

 
426,467

 
9,337,538

Total
$
9,026,000

 
$
2,407,195

 
$
11,433,195

 
December 31, 2014
(in thousands)
Agency
 
Non-Agency
 
Total
Adjustable Rate
$
128,285


$
2,558,832

 
$
2,687,117

Fixed Rate
11,164,032


489,953

 
11,653,985

Total
$
11,292,317


$
3,048,785

 
$
14,341,102


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 the Company does not expect to collect the entire discount 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 nine months ended September 30, 2015 and 2014, of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
 
Nine Months Ended September 30,
 
2015
 
2014
(in thousands)
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
 
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
Beginning balance at January 1
$
(927,605
)
 
$
(967,368
)
 
$
(1,894,973
)
 
$
(1,234,449
)
 
$
(1,071,559
)
 
$
(2,306,008
)
Acquisitions
(274
)
 
(4,293
)
 
(4,567
)
 
(69,663
)
 
(57,174
)
 
(126,837
)
Accretion of net discount

 
76,861

 
76,861

 

 
96,873

 
96,873

Realized credit losses
13,376

 

 
13,376

 
11,325

 

 
11,325

Reclassification adjustment for other-than-temporary impairments
1,742

 

 
1,742

 
(212
)
 

 
(212
)
Transfers from (to)
85,767

 
(85,767
)
 

 
91,086

 
(91,086
)
 

Sales, calls, other
282,821

 
227,078

 
509,899

 
232,882

 
103,481

 
336,363

Ending balance at September 30
$
(544,173
)
 
$
(753,489
)
 
$
(1,297,662
)
 
$
(969,031
)
 
$
(1,019,465
)
 
$
(1,988,496
)


14

Table of Contents

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

The following table presents the components comprising the carrying value of AFS securities not deemed to be other than temporarily impaired by length of time that the securities had an unrealized loss position as of September 30, 2015 and December 31, 2014. At September 30, 2015, the Company held 1,358 AFS securities, of which 112 were in an unrealized loss position for less than twelve consecutive months and 182 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2014, the Company held 1,452 AFS securities, of which 57 were in an unrealized loss position for less than twelve consecutive months and 172 were in an unrealized loss position for more than twelve consecutive months.
 
Unrealized Loss Position for
 
Less than 12 Months
 
12 Months or More
 
Total
(in thousands)
Estimated Fair Value
 
Gross Unrealized Losses
 
Estimated Fair Value
 
Gross Unrealized Losses
 
Estimated Fair Value
 
Gross Unrealized Losses
September 30, 2015
$
1,326,610

 
$
(23,444
)
 
$
1,191,161

 
$
(29,164
)
 
$
2,517,771

 
$
(52,608
)
December 31, 2014
$
413,102

 
$
(3,146
)
 
$
1,323,688

 
$
(32,885
)
 
$
1,736,790

 
$
(36,031
)

Evaluating AFS Securities for Other-Than-Temporary Impairments
In evaluating 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 will not be 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 either other comprehensive (loss) income, net of tax, or gain on investment securities, depending on the accounting treatment. 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 $0.2 million and $0.5 million in other-than-temporary credit impairments during the three and nine months ended September 30, 2015, respectively, on one non-Agency RMBS where the future expected cash flows for each security were less than its amortized cost. As of September 30, 2015, impaired securities with a carrying value of $133.3 million had actual weighted average cumulative losses of 10.9%, weighted average three-month prepayment speed of 5.5%, weighted average 60+ day delinquency of 25.9% of the pool balance, and weighted average FICO score of 666. At September 30, 2015, 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, 2014, the Company recorded $0.2 million in other-than-temporary credit impairments on a total of three non-Agency RMBS where the future expected cash flows for each security were less than its amortized cost.

15

Table of Contents

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

The following table presents the changes in OTTI included in earnings for the three and nine months ended September 30, 2015 and 2014:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Cumulative credit loss at beginning of period
$
(6,622
)
 
$
(8,061
)
 
$
(8,241
)
 
$
(9,467
)
Additions:
 
 
 
 
 
 
 
Other-than-temporary impairments not previously recognized
(238
)
 

 
(238
)
 
(91
)
Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments

 

 
(297
)
 
(121
)
Reductions:
 
 
 
 
 
 
 
Decreases related to other-than-temporary impairments on securities paid down

 

 

 
464

Decreases related to other-than-temporary impairments on securities sold
361

 

 
2,277

 
1,154

Cumulative credit loss at end of period
$
(6,499
)
 
$
(8,061
)
 
$
(6,499
)
 
$
(8,061
)

Cumulative credit losses related to OTTI may be reduced for securities sold as well as for securities that mature, are paid down, or are prepaid such that the outstanding principal balance is reduced to zero. Additionally, increases in cash flows expected to be collected over the remaining life of the security cause a reduction in the cumulative credit loss.
Gross Realized Gains and Losses
Gains and losses from the sale of AFS securities are recorded as realized gains (losses) within gain on investment securities in the Company’s condensed consolidated statements of comprehensive (loss) income. For the three and nine months ended September 30, 2015, the Company sold AFS securities for $1.1 billion and $3.7 billion with an amortized cost of $1.0 billion and $3.4 billion for net realized gains of $66.5 million and $259.8 million, respectively. 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 losses of $59.9 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, 2015 and 2014:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Gross realized gains
$
75,427

 
$
87,842

 
$
269,314

 
$
131,005

Gross realized losses
(8,955
)
 
(25,122
)
 
(9,511
)
 
(71,119
)
Total realized gains on sales, net
$
66,472

 
$
62,720

 
$
259,803

 
$
59,886


Note 5. Trading Securities, at Fair Value
At December 31, 2014 and during the nine months ended September 30, 2015, the Company held U.S. Treasuries in a TRS and classified these securities as trading instruments due to short-term investment objectives. The following table presents the carrying value of the Company’s trading securities as of September 30, 2015 and December 31, 2014:
(in thousands)
September 30,
2015
 
December 31,
2014
Amortized cost
$

 
$
1,996,289

Unrealized gains, net

 
1,367

Carrying value
$

 
$
1,997,656


16

Table of Contents

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


For the nine months ended September 30, 2015, the Company sold trading securities for $2.0 billion with an amortized cost of $2.0 billion, resulting in realized gains of $7.4 million on the sale of these securities. The Company did not sell any trading securities during the three months ended September 30, 2015. 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 the nine months ended September 30, 2015, trading securities experienced changes in unrealized losses of $1.4 million. The Company did not hold trading securities during the three months ended September 30, 2015. For the three and nine months ended September 30, 2014, trading securities experienced changes in unrealized losses of $8.4 million and $6.9 million, respectively. Both realized and unrealized gains and losses are recorded as components of gain on investment securities in the Company’s condensed consolidated statements of comprehensive (loss) income.
At December 31, 2014, the Company pledged trading securities with a carrying value of $2.0 billion as collateral for repurchase agreements. See Note 16 - Repurchase Agreements.

Note 6. Residential Mortgage Loans Held-for-Sale, at Fair Value
Residential 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 residential mortgage loans held-for-sale as of September 30, 2015 and December 31, 2014:
(in thousands)
September 30,
2015
 
December 31,
2014
Unpaid principal balance
$
765,246

 
$
534,101

Fair value adjustment
2,762

 
1,611

Carrying value
$
768,008

 
$
535,712


At September 30, 2015 and December 31, 2014, the Company pledged residential mortgage loans with a carrying value of $703.0 million and $416.8 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 7. Residential 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 sheets, are classified as residential 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 residential mortgage loans held-for-investment in securitization trusts as of September 30, 2015 and December 31, 2014:
(in thousands)
September 30,
2015
 
December 31,
2014
Unpaid principal balance
$
2,936,810

 
$
1,699,748

Fair value adjustment
41,776

 
44,998

Carrying value
$
2,978,586

 
$
1,744,746



17

Table of Contents

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

Note 8. Commercial Real Estate Loans Held-for-Investment
The Company originates and purchases commercial real estate debt and related instruments generally to be held as long-term investments. These assets are classified as commercial real estate loans held-for-investment on the condensed consolidated balance sheets. Additionally, the Company is the sole certificate holder of a trust entity that holds a commercial real estate loan. The underlying loan held by the trust is consolidated on the Company’s condensed consolidated balance sheet and classified as commercial real estate loans held-for-investment. See Note 3 - Variable Interest Entities for additional information regarding consolidation of the trust. Commercial real estate loans held-for-investment are reported at cost, net of any unamortized acquisition premiums or discounts, loan fees and origination costs as applicable, unless the loans are deemed impaired.
The following tables summarize the Company’s commercial real estate loans held-for-investment by asset type, property type and geographic location as of September 30, 2015 and December 31, 2014:
 
September 30,
2015
 
December 31,
2014
(in thousands)
Mezzanine Loans
 
First Mortgages
 
Total
 
Mezzanine Loans
 
First Mortgages
 
Total
Unpaid principal balance
$
146,237

 
$
146,350

 
$
292,587

 
$

 
$

 
$

Unamortized (discount) premium
(289
)
 

 
(289
)
 

 

 

Unamortized net deferred origination fees
(127
)
 
(1,261
)
 
(1,388
)
 

 

 

Carrying value
$
145,821

 
$
145,089

 
$
290,910

 
$

 
$

 
$

Unfunded commitments
$

 
$
6,772

 
$
6,772

 
$

 
$

 
$

Number of loans
5

 
4

 
9

 

 

 

Weighted average coupon
8.0
%
 
3.9
%
 
5.9
%
 
%
 
%
 
%
Weighted average life (years)
2.4

 
3.0

 
2.7

 

 

 

(in thousands)
September 30,
2015
 
December 31,
2014
Property Type
Carrying Value
 
% of Commercial Portfolio
 
Carrying Value
 
% of Commercial Portfolio
Retail
$
104,159

 
35.8
%
 
$

 
%
Hotel
62,611

 
21.5
%
 

 
%
Multifamily
40,930

 
14.1
%
 

 
%
Office
83,210

 
28.6
%
 

 
%
Total
$
290,910

 
100.0
%
 
$

 
%
(in thousands)
September 30,
2015
 
December 31,
2014
Geographic Location
Carrying Value
 
% of Commercial Portfolio
 
Carrying Value
 
% of Commercial Portfolio
West
$
132,158

 
45.4
%
 
$

 
%
Southeast
78,302

 
26.9
%
 

 
%
Northeast
48,528

 
16.7
%
 

 
%
Midwest
31,922

 
11.0
%
 

 
%
Total
$
290,910

 
100.0
%
 
$

 
%
 

18

Table of Contents

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

The Company did not hold any commercial real estate loans held-for-investment as of December 31, 2014. At September 30, 2015, the Company pledged commercial real estate loans held-for-investment with a carrying value of $45.7 million as collateral for repurchase agreements. See Note 16 - Repurchase Agreements.
The following table summarizes activity related to commercial real estate loans held-for-investment for the three and nine months ended September 30, 2015 and 2014.
 
Three Months Ended September 30,
 
Nine Months Ended
September 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Balance at beginning of period
$
45,605

 
$

 
$

 
$

Originations and purchases
246,644

 

 
292,200

 

Repayments

 

 

 

Net discount accretion (premium amortization)
49

 

 
98

 

(Increase) decrease in net deferred origination fees
(1,517
)
 

 
(1,517
)
 

Amortization of net deferred origination fees
129

 

 
129

 

Allowance for loan losses

 

 

 

Balance at end of period
$
290,910

 
$

 
$
290,910

 
$


The Company evaluates each loan for impairment at least quarterly by assessing the risk factors of each loan and assigning a risk rating based on a variety of factors. Risk factors include property type, geographic and local market dynamics, physical condition, leasing and tenant profile, projected cash flow, loan structure and exit plan, loan-to-value ratio, project sponsorship, and other factors deemed necessary. Risk ratings are defined as follows:

1 –
Lower Risk
2 –
Average Risk
3 –
Acceptable Risk
4 –
Higher Risk: A loan that has exhibited material deterioration in cash flows and/or other credit factors, which, if negative trends continue, could be indicative of future loss.
5 –
Impaired/Loss Likely: A loan that has a significantly increased probability of default or principal loss.

The following table presents the number of loans, unpaid principal balance and carrying value (amortized cost) by risk rating for commercial real estate loans as of September 30, 2015 and December 31, 2014:
(dollars in thousands)
September 30,
2015
 
December 31,
2014
Risk Rating
Number of Loans
 
Unpaid Principal Balance
 
Carrying Value
 
Number of Loans
 
Unpaid Principal Balance
 
Carrying Value
1 – 3
9

 
$
292,587

 
$
290,910

 

 
$

 
$

4 – 5

 

 

 

 

 

Total
9

 
$
292,587

 
$
290,910

 

 
$

 
$


The Company has not recorded any allowances for losses as it is not deemed probable that the Company will not be able to collect all amounts due pursuant to the contractual terms of the loans.


19

Table of Contents

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

Note 9. Servicing Activities
Mortgage Servicing Rights, at Fair Value
One of the Company’s wholly owned subsidiaries has approvals from Fannie Mae, Freddie Mac, and Ginnie Mae, to hold and manage MSR, which represent the right to control the servicing of mortgage loans. The Company and its subsidiaries do not originate or directly service mortgage loans, and instead contract with fully licensed subservicers to handle substantially 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, 2015 and 2014.
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Balance at beginning of period
$
437,576

 
$
500,490

 
$
452,006

 
$
514,402

Additions from purchases of servicing rights
67,175

 
7,542

 
75,709

 
61,835

Additions from sales of residential mortgage loans
752

 

 
1,568

 

Changes in fair value due to:
 
 
 
 
 
 
 
Changes in valuation inputs or assumptions used in the valuation model
(55,618
)
 
3,964

 
(73,267
)
 
(31,941
)
Other changes in fair value (1)
(5,931
)
 
(14,674
)
 
(23,050
)
 
(41,101
)
Other changes (2)
3,391

 
1,144

 
14,379

 
(4,729
)
Balance at end of period
$
447,345

 
$
498,466

 
$
447,345

 
$
498,466

____________________
(1)
Other changes in fair value primarily represents changes due to the realization of expected cash flows.
(2)
Other changes includes purchase price adjustments, contractual prepayment protection, and changes due to the Company’s purchase of the underlying collateral.

As of September 30, 2015 and December 31, 2014, 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,
2015
 
December 31,
2014
Weighted average prepayment speed:
13.0
%
 
11.9
%
Impact on fair value of 10% adverse change
$
(19,683
)
 
$
(14,012
)
Impact on fair value of 20% adverse change
$
(38,024
)
 
$
(31,640
)
Weighted average delinquency:
3.7
%
 
5.6
%
Impact on fair value of 10% adverse change
$
(3,579
)
 
$
(3,616
)
Impact on fair value of 20% adverse change
$
(5,368
)
 
$
(6,780
)
Weighted average discount rate:
10.3
%
 
9.5
%
Impact on fair value of 10% adverse change
$
(14,315
)
 
$
(16,272
)
Impact on fair value of 20% adverse change
$
(28,183
)
 
$
(31,640
)

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.

20

Table of Contents

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 (loss) income for the three and nine months ended September 30, 2015 and 2014:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Servicing fee income
$
31,073

 
$
31,390

 
$
91,896

 
$
94,340

Ancillary fee income
535

 
588

 
1,650

 
1,632

Float income
402

 
286

 
1,067

 
601

Total
$
32,010

 
$
32,264

 
$
94,613

 
$
96,573


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 foreclosu