UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
______________________________
FORM 10-Q
______________________________

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended: March 31, 2016

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 May 4, 2016 there were 347,566,626 shares of outstanding common stock, par value $.01 per share, issued and outstanding.
 
 
 
 
 

Table of Contents



TWO HARBORS INVESTMENT CORP.
INDEX

 
 
Page
 
PART I - FINANCIAL INFORMATION
 
 
 
 
 
 
 
PART II - OTHER INFORMATION
 


i
Table of Contents



PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
 
March 31,
2016
 
December 31,
2015
ASSETS
(unaudited)
 
 
Available-for-sale securities, at fair value
$
9,584,454

 
$
7,825,320

Residential mortgage loans held-for-sale, at fair value
387,259

 
811,431

Residential mortgage loans held-for-investment in securitization trusts, at fair value
3,705,647

 
3,173,727

Commercial real estate assets
744,259

 
660,953

Mortgage servicing rights, at fair value
446,170

 
493,688

Cash and cash equivalents
754,827

 
737,831

Restricted cash
281,145

 
262,562

Accrued interest receivable
54,517

 
49,970

Due from counterparties
233,378

 
17,206

Derivative assets, at fair value
197,847

 
271,509

Other assets
295,102

 
271,575

Total Assets (1)
$
16,684,605

 
$
14,575,772

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Liabilities
 
 
 
Repurchase agreements
$
6,189,852

 
$
5,008,274

Collateralized borrowings in securitization trusts, at fair value
2,809,627

 
2,000,110

Federal Home Loan Bank advances
4,000,000

 
3,785,000

Derivative liabilities, at fair value
77,038

 
7,285

Due to counterparties
91,547

 
34,294

Dividends payable
79,939

 
92,016

Other liabilities
65,911

 
72,232

Total Liabilities (1)
13,313,914

 
10,999,211

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 347,562,770 and 353,906,807 shares issued and outstanding, respectively
3,476

 
3,539

Additional paid-in capital
3,647,236

 
3,705,519

Accumulated other comprehensive income
380,406

 
359,061

Cumulative earnings
1,595,825

 
1,684,755

Cumulative distributions to stockholders
(2,256,252
)
 
(2,176,313
)
Total Stockholders’ Equity
3,370,691

 
3,576,561

Total Liabilities and Stockholders’ Equity
$
16,684,605

 
$
14,575,772

____________________
(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 March 31, 2016 and December 31, 2015, assets of the VIEs totaled $3,772,081 and $3,237,918, and liabilities of the VIEs totaled $2,829,662 and $2,017,677, 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
 
March 31,
 
2016
 
2015
Interest income:
(unaudited)
Available-for-sale securities
$
79,428

 
$
135,525

Trading securities
—

 
4,695

Residential mortgage loans held-for-sale
7,202

 
4,271

Residential mortgage loans held-for-investment in securitization trusts
32,771

 
18,237

Commercial real estate assets
11,072

 
44

Cash and cash equivalents
290

 
197

Total interest income
130,763

 
162,969

Interest expense:
 
 
 
Repurchase agreements
16,029

 
20,565

Collateralized borrowings in securitization trusts
19,359

 
10,708

Federal Home Loan Bank advances
5,972

 
2,230

Total interest expense
41,360

 
33,503

Net interest income
89,403

 
129,466

Other-than-temporary impairments:
 
 
 
Total other-than-temporary impairment losses
(717
)
 
(127
)
Non-credit portion of loss recognized in other comprehensive income (loss)
—

 
—

Net other-than-temporary credit impairment losses
(717
)
 
(127
)
Other income (loss):
 
 
 
Gain on investment securities
29,474

 
129,457

Loss on interest rate swap and swaption agreements
(125,484
)
 
(126,443
)
Gain on other derivative instruments
16,015

 
2,967

Gain on residential mortgage loans held-for-sale
10,803

 
9,092

Servicing income
34,133

 
32,087

Loss on servicing asset
(101,440
)
 
(52,403
)
Other income (loss)
2,827

 
(1,857
)
Total other loss
(133,672
)
 
(7,100
)
Expenses:
 
 
 
Management fees
12,044

 
12,721

Securitization deal costs
3,732

 
2,611

Servicing expenses
7,861

 
6,716

Other operating expenses
14,856

 
16,055

Total expenses
38,493

 
38,103

(Loss) income before income taxes
(83,479
)
 
84,136

Provision for (benefit from) income taxes
5,451

 
(10,657
)
Net (loss) income
$
(88,930
)
 
$
94,793

Basic and diluted (loss) earnings per weighted average common share
$
(0.25
)
 
$
0.26

Dividends declared per common share
$
0.23

 
$
0.26

Basic and diluted weighted average number of shares of common stock outstanding
349,436,015

 
366,507,657

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
 
March 31,
 
2016
 
2015
 
(unaudited)
Comprehensive (loss) income:
 
 
 
Net (loss) income
$
(88,930
)
 
$
94,793

Other comprehensive income (loss), net of tax:
 
 
 
Unrealized gain (loss) on available-for-sale securities
21,345

 
(5,931
)
Other comprehensive income (loss)
21,345

 
(5,931
)
Comprehensive (loss) income
$
(67,585
)
 
$
88,862

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, 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
—

 
—

 
—

 
—

 
94,793

 
—

 
94,793

Other comprehensive income before reclassifications, net of tax
—

 
—

 
—

 
93,877

 
—

 
—

 
93,877

Amounts reclassified from accumulated other comprehensive income, net of tax
—

 
—

 
—

 
(99,808
)
 
—

 
—

 
(99,808
)
Net other comprehensive loss, net of tax
—

 
—

 
—

 
(5,931
)
 
—

 
—

 
(5,931
)
Issuance of common stock, net of offering costs
19,412

 
—

 
200

 
—

 
—

 
—

 
200

Common dividends declared
—

 
—

 
—

 
—

 
—

 
(95,307
)
 
(95,307
)
Non-cash equity award compensation
150,801

 
2

 
2,687

 
—

 
—

 
—

 
2,689

Balance, March 31, 2015
366,566,133

 
$
3,666

 
$
3,813,914

 
$
849,858

 
$
1,287,338

 
$
(1,893,281
)
 
$
4,061,495

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2015
353,906,807

 
$
3,539

 
$
3,705,519

 
$
359,061

 
$
1,684,755

 
$
(2,176,313
)
 
$
3,576,561

Net loss
—

 
—

 
—

 
—

 
(88,930
)
 
—

 
(88,930
)
Other comprehensive income before reclassifications, net of tax
—

 
—

 
—

 
39,754

 
—

 
—

 
39,754

Amounts reclassified from accumulated other comprehensive income, net of tax
—

 
—

 
—

 
(18,409
)
 
—

 
—

 
(18,409
)
Net other comprehensive income, net of tax
—

 
—

 
—

 
21,345

 
—

 
—

 
21,345

Issuance of common stock, net of offering costs
14,648

 
—

 
110

 
—

 
—

 
—

 
110

Repurchase of common stock
(8,020,000
)
 
(80
)
 
(61,227
)
 
—

 
—

 
—

 
(61,307
)
Common dividends declared
—

 
—

 
—

 
—

 
—

 
(79,939
)
 
(79,939
)
Non-cash equity award compensation
1,661,315

 
17

 
2,834

 
—

 
—

 
—

 
2,851

Balance, March 31, 2016
347,562,770

 
$
3,476

 
$
3,647,236

 
$
380,406

 
$
1,595,825

 
$
(2,256,252
)
 
$
3,370,691

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)
 
Three Months Ended
 
March 31,
 
2016
 
2015
Cash Flows From Operating Activities:
(unaudited)
Net (loss) income
$
(88,930
)
 
$
94,793

Adjustments to reconcile net (loss) income to net cash used in operating activities:
 
 
 
Amortization of premiums and discounts on investment securities and commercial real estate assets, net
5,735

 
7,554

Other-than-temporary impairment losses
717

 
127

Realized and unrealized gains on investment securities, net
(29,474
)
 
(129,457
)
Gain on residential mortgage loans held-for-sale
(10,803
)
 
(9,092
)
(Gain) loss on residential mortgage loans held-for-investment and collateralized borrowings in securitization trusts
(1,484
)
 
2,919

Loss on servicing asset
101,440

 
52,403

Gain on termination and option expiration of interest rate swaps and swaptions
(30,629
)
 
(11,775
)
Unrealized loss on interest rate swaps and swaptions
149,923

 
110,693

Unrealized gain on other derivative instruments
(4,387
)
 
(4,426
)
Equity based compensation
2,851

 
2,689

Depreciation of fixed assets
328

 
319

Purchases of residential mortgage loans held-for-sale
(271,448
)
 
(662,064
)
Proceeds from sales of residential mortgage loans held-for-sale
19,830

 
23,831

Proceeds from repayment of residential mortgage loans held-for-sale
36,360

 
24,947

Net change in assets and liabilities:


 
 
(Increase) decrease in accrued interest receivable
(4,547
)
 
3,013

Decrease (increase) in deferred income taxes, net
7,048

 
(11,537
)
Increase in income taxes receivable
(839
)
 
(293
)
(Increase) decrease in prepaid and fixed assets
(87
)
 
25

Decrease in other receivables
208

 
396

Increase in servicing advances
(7,173
)
 
(3,347
)
Increase (decrease) in accrued interest payable
406

 
(5,353
)
Decrease in income taxes payable
(70
)
 
(1,342
)
(Decrease) increase in accrued expenses and other liabilities
(6,657
)
 
1,560

Net cash used in operating activities
$
(131,682
)
 
$
(513,417
)
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)
 
Three Months Ended
 
March 31,
 
2016
 
2015
Cash Flows From Investing Activities:
(unaudited)
Purchases of available-for-sale securities
$
(4,185,685
)
 
$
(1,084,742
)
Proceeds from sales of available-for-sale securities
2,270,454

 
900,107

Principal payments on available-for-sale securities
192,171

 
286,393

Short sales and purchases of other derivative instruments, net
(14,687
)
 
(34,834
)
Proceeds from sales of other derivative instruments, net
44,027

 
23,427

Proceeds from repayment of residential mortgage loans held-for-investment in securitization trusts
133,374

 
160,853

Purchases of commercial real estate assets
(86,156
)
 
(45,556
)
Proceeds from repayment of commercial real estate assets
4,531

 
—

Purchases of mortgage servicing rights, net of purchase price adjustments
(51,453
)
 
(10,399
)
Purchases of Federal Home Loan Bank stock
(11,206
)
 
(10,240
)
(Decrease) increase in due to counterparties, net
(158,919
)
 
67,048

Increase in restricted cash
(18,583
)
 
(104,387
)
Net cash (used in) provided by investing activities
(1,882,132
)
 
147,670

Cash Flows From Financing Activities:
 
 
 
Proceeds from repurchase agreements
10,535,094

 
14,782,724

Principal payments on repurchase agreements
(9,353,516
)
 
(14,620,309
)
Proceeds from issuance of collateralized borrowings in securitization trusts
883,633

 
310,173

Principal payments on collateralized borrowings in securitization trusts
(96,188
)
 
(122,232
)
Proceeds from Federal Home Loan Bank advances
215,000

 
125,000

Proceeds from issuance of common stock, net of offering costs
110

 
200

Repurchase of common stock
(61,307
)
 
—

Dividends paid on common stock
(92,016
)
 
(95,263
)
Net cash provided by financing activities
2,030,810

 
380,293

Net increase in cash and cash equivalents
16,996

 
14,546

Cash and cash equivalents at beginning of period
737,831

 
1,005,792

Cash and cash equivalents at end of period
$
754,827

 
$
1,020,338

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)
 
Three Months Ended
 
March 31,
 
2016
 
2015
Supplemental Disclosure of Cash Flow Information:
(unaudited)
Cash paid for interest
$
23,276

 
$
28,623

Cash (received) paid for taxes
$
(689
)
 
$
2,511

Noncash Activities:
 
 
 
Transfers of residential mortgage loans held-for-sale to residential mortgage loans held-for-investment in securitization trusts
$
641,738

 
$
589,255

Transfers of residential mortgage loans held-for-sale to other receivables for foreclosed government-guaranteed loans
$
5,194

 
$
—

Additions to mortgage servicing rights due to sale of residential mortgage loans held-for-sale
$
204

 
$
227

Transfer of fair value of mortgage servicing rights to fair value of Ginnie Mae residential mortgage loans held-for-sale upon buyout
$
2,265

 
$
—

Cumulative-effect adjustment to equity for adoption of new accounting principle
$
—

 
$
(2,991
)
Dividends declared but not paid at end of period
$
79,939

 
$
95,307

Reconciliation of residential mortgage loans held-for-sale:
 
 
 
Residential mortgage loans held-for-sale at beginning of period
$
811,431

 
$
535,712

Purchases of residential mortgage loans held-for-sale
271,448

 
662,064

Transfer of fair value of mortgage servicing rights to fair value of Ginnie Mae residential mortgage loans held-for-sale upon buyout
(2,265
)
 
—

Transfers to residential mortgage loans held-for-investment in securitization trusts
(641,738
)
 
(589,255
)
Transfers to other receivables for foreclosed government-guaranteed loans
(5,194
)
 
—

Proceeds from sales of residential mortgage loans held-for-sale
(19,830
)
 
(23,831
)
Proceeds from repayment of residential mortgage loans held-for-sale
(36,360
)
 
(24,947
)
Realized and unrealized gains on residential mortgage loans held-for-sale
9,767

 
8,839

Residential mortgage loans held-for-sale at end of period
$
387,259

 
$
568,582

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

7
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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, 2015. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at March 31, 2016 and results of operations for all periods presented have been made. The results of operations for the three months ended March 31, 2016 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. The Company’s Chief Investment Officer manages the investment portfolio as a whole and resources are allocated and financial performance is assessed on a consolidated basis.
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. Whenever the Company has both the power to direct the activities of a 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.

8
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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 2015 Annual Report on Form 10-K is a summary of the Company’s significant accounting policies. Provided below is a summary of additional accounting policies that are significant to the Company’s consolidated financial condition and results of operations for the three months ended March 31, 2016.
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 March 31, 2016 and December 31, 2015:
 
March 31, 2016
 
 
 
 
 
 
 
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
$
311,134

 
$
(113,287
)
 
$
197,847

 
$
(77,038
)
 
$
—

 
$
120,809

Total Assets
$
311,134

 
$
(113,287
)
 
$
197,847

 
$
(77,038
)
 
$
—

 
$
120,809

Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(6,189,852
)
 
$
—

 
$
(6,189,852
)
 
$
6,189,852

 
$
—

 
$
—

Derivative liabilities
(190,325
)
 
113,287

 
(77,038
)
 
77,038

 
—

 
—

Total Liabilities
$
(6,380,177
)
 
$
113,287

 
$
(6,266,890
)
 
$
6,266,890

 
$
—

 
$
—


9
Table of Contents

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

 
December 31, 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
$
325,755

 
$
(54,246
)
 
$
271,509

 
$
(7,285
)
 
$
—

 
$
264,224

Total Assets
$
325,755

 
$
(54,246
)
 
$
271,509

 
$
(7,285
)
 
$
—

 
$
264,224

Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(5,008,274
)
 
$
—

 
$
(5,008,274
)
 
$
5,008,274

 
$
—

 
$
—

Derivative liabilities
(61,531
)
 
54,246

 
(7,285
)
 
7,285

 
—

 
—

Total Liabilities
$
(5,069,805
)
 
$
54,246

 
$
(5,015,559
)
 
$
5,015,559

 
$
—

 
$
—

____________________
(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.
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.
Recognition and Measurement of Financial Assets and Financial Liabilities
In January 2016, the FASB issued ASU No. 2016-01, which changes how entities measure certain equity investments and present changes in the fair value of financial liabilities measured under the fair value option that are attributable to their own credit. 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, 2017, with early adoption permitted. The Company has determined this ASU will not have a material impact on the Company’s financial condition or results of operations.

10
Table of Contents

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

Lease Classification and Accounting
In February 2016, the FASB issued ASU No. 2016-02, which requires lessees to recognize on their balance sheets both a lease liability for the obligation to make lease payments and a right-of-use asset for the right to use the underlying asset for the lease term. The ASU is effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2018, with early adoption permitted. The Company has determined this ASU will 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 as of March 31, 2016 and December 31, 2015:
(in thousands)
March 31,
2016
 
December 31,
2015
Residential mortgage loans held-for-investment in securitization trusts
$
3,705,647

 
$
3,173,727

Commercial real estate assets
45,744

 
45,698

Accrued interest receivable
20,690

 
18,493

Total Assets
$
3,772,081

 
$
3,237,918

Collateralized borrowings in securitization trusts
$
2,809,627

 
$
2,000,110

Accrued interest payable
7,625

 
5,943

Other liabilities
12,410

 
11,624

Total Liabilities
$
2,829,662

 
$
2,017,677


The Company is not required to consolidate VIEs for which it has concluded it does not have both the power to direct the activities of the VIEs 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’s investments in these unconsolidated VIEs include non-Agency RMBS, which are classified within available-for-sale securities, at fair value on the consolidated balance sheets. As of March 31, 2016 and December 31, 2015, the carrying value, which also represents the maximum exposure to loss, of all non-Agency RMBS in unconsolidated VIEs was $1.6 billion and $1.9 billion, respectively.


11
Table of Contents

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 March 31, 2016 and December 31, 2015:
(in thousands)
March 31,
2016
 
December 31,
2015
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
1,578,471

 
$
1,678,814

Federal National Mortgage Association
6,177,794

 
3,602,348

Government National Mortgage Association
252,831

 
691,728

Non-Agency
1,575,358

 
1,852,430

Total available-for-sale securities
$
9,584,454

 
$
7,825,320


At March 31, 2016 and December 31, 2015, the Company pledged AFS securities with a carrying value of $9.5 billion and $7.8 billion, respectively, as collateral for repurchase agreements and advances from the Federal Home Loan Bank of Des Moines, or the FHLB. See Note 15 - Repurchase Agreements and Note 17 - Federal Home Loan Bank of Des Moines Advances.
At March 31, 2016 and December 31, 2015, the Company did not have any securities purchased from and financed with the same counterparty that did not meet the conditions of ASC 860, Transfers and Servicing, or ASC 860, to be considered linked transactions and, therefore, classified as derivatives.
The following tables present the amortized cost and carrying value (which approximates fair value) of AFS securities by collateral type as of March 31, 2016 and December 31, 2015:
 
March 31, 2016
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
10,080,013

 
$
2,345,601

 
$
12,425,614

Unamortized premium
462,545

 
—

 
462,545

Unamortized discount
 
 
 
 
 
Designated credit reserve
—

 
(353,076
)
 
(353,076
)
Net, unamortized
(2,649,932
)
 
(679,402
)
 
(3,329,334
)
Amortized Cost
7,892,626

 
1,313,123

 
9,205,749

Gross unrealized gains
147,958

 
279,660

 
427,618

Gross unrealized losses
(31,488
)
 
(17,425
)
 
(48,913
)
Carrying Value
$
8,009,096

 
$
1,575,358

 
$
9,584,454

 
December 31, 2015
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
8,257,030


$
2,655,381

 
$
10,912,411

Unamortized premium
394,787


—

 
394,787

Unamortized discount
 
 
 
 
 
Designated credit reserve
—


(409,077
)
 
(409,077
)
Net, unamortized
(2,721,979
)

(707,021
)
 
(3,429,000
)
Amortized Cost
5,929,838


1,539,283

 
7,469,121

Gross unrealized gains
98,389


329,206

 
427,595

Gross unrealized losses
(55,337
)

(16,059
)
 
(71,396
)
Carrying Value
$
5,972,890

 
$
1,852,430

 
$
7,825,320


12
Table of Contents

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


The following tables present the carrying value of the Company’s AFS securities by rate type as of March 31, 2016 and December 31, 2015:
 
March 31, 2016
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
36,800

 
$
1,391,317

 
$
1,428,117

Fixed Rate
7,972,296

 
184,041

 
8,156,337

Total
$
8,009,096

 
$
1,575,358

 
$
9,584,454

 
December 31, 2015
(in thousands)
Agency
 
Non-Agency
 
Total
Adjustable Rate
$
108,596

 
$
1,673,038

 
$
1,781,634

Fixed Rate
5,864,294

 
179,392

 
6,043,686

Total
$
5,972,890

 
$
1,852,430

 
$
7,825,320


The following table presents the Company’s AFS securities according to their estimated weighted average life classifications as of March 31, 2016:
 
March 31, 2016
(in thousands)
 Agency
 
 Non-Agency
 
 Total
≤ 1 year
$
1,435

 
$
79,887

 
$
81,322

> 1 and ≤ 3 years
55,448

 
53,897

 
109,345

> 3 and ≤ 5 years
2,609,341

 
289,683

 
2,899,024

> 5 and ≤ 10 years
5,337,237

 
751,508

 
6,088,745

> 10 years
5,635

 
400,383

 
406,018

Total
$
8,009,096

 
$
1,575,358

 
$
9,584,454


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.

13
Table of Contents

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

The following table presents the changes for the three months ended March 31, 2016 and 2015, of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
 
Three Months Ended March 31,
 
2016
 
2015
(in thousands)
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
 
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
Beginning balance at January 1
$
(409,077
)
 
$
(707,021
)
 
$
(1,116,098
)
 
$
(927,605
)
 
$
(967,368
)
 
$
(1,894,973
)
Acquisitions
1,013

 
(25,222
)
 
(24,209
)
 
1,183

 
(935
)
 
248

Accretion of net discount
—

 
16,760

 
16,760

 
—

 
27,465

 
27,465

Realized credit losses
3,093

 
—

 
3,093

 
3,727

 
—

 
3,727

Reclassification adjustment for other-than-temporary impairments
(121
)
 
—

 
(121
)
 
1,789

 
—

 
1,789

Transfers from (to)
19,454

 
(19,454
)
 
—

 
41,092

 
(41,092
)
 
—

Sales, calls, other
32,562

 
55,535

 
88,097

 
132,430

 
109,947

 
242,377

Ending balance at March 31
$
(353,076
)
 
$
(679,402
)
 
$
(1,032,478
)
 
$
(747,384
)
 
$
(871,983
)
 
$
(1,619,367
)

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 March 31, 2016 and December 31, 2015. At March 31, 2016, the Company held 1,147 AFS securities, of which 65 were in an unrealized loss position for less than twelve consecutive months and 190 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2015, the Company held 1,181 AFS securities, of which 121 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.
 
Unrealized Loss Position for
 
Less than 12 Months
 
12 Months or More
 
Total
(in thousands)
Estimated Fair Value
 
Gross Unrealized Losses
 
Estimated Fair Value
 
Gross Unrealized Losses
 
Estimated Fair Value
 
Gross Unrealized Losses
March 31, 2016
$
513,067

 
$
(20,746
)
 
$
1,240,930

 
$
(28,167
)
 
$
1,753,997

 
$
(48,913
)
December 31, 2015
$
1,503,939

 
$
(26,984
)
 
$
1,141,839

 
$
(44,412
)
 
$
2,645,778

 
$
(71,396
)

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 income (loss), 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.

14
Table of Contents

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

The Company recorded $0.7 million and $0.1 million in other-than-temporary credit impairments during the three months ended March 31, 2016 and 2015 on three and one non-Agency RMBS, respectively, where the future expected cash flows for each security were less than its amortized cost. As of March 31, 2016, impaired securities with a carrying value of $113.3 million had actual weighted average cumulative losses of 12.3%, weighted average three-month prepayment speed of 4.3%, weighted average 60+ day delinquency of 24.4% of the pool balance, and weighted average FICO score of 671. At March 31, 2016, 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.
The following table presents the changes in OTTI included in earnings for the three months ended March 31, 2016 and 2015:
 
Three Months Ended
 
March 31,
(in thousands)
2016
 
2015
Cumulative credit loss at beginning of period
$
(6,499
)
 
$
(8,241
)
Additions:
 
 
 
Other-than-temporary impairments not previously recognized
(292
)
 
—

Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments
(425
)
 
(127
)
Reductions:
 
 
 
Decreases related to other-than-temporary impairments on securities paid down
—

 
—

Decreases related to other-than-temporary impairments on securities sold
596

 
1,916

Cumulative credit loss at end of period
$
(6,620
)
 
$
(6,452
)

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 months ended March 31, 2016 and 2015, the Company sold AFS securities for $2.3 billion and $0.9 billion with an amortized cost of $2.2 billion and $0.8 billion for net realized gains of $21.7 million and $117.5 million, respectively.
The following table presents the gross realized gains and losses on sales of AFS securities for the three months ended March 31, 2016 and 2015:
 
Three Months Ended
 
March 31,
(in thousands)
2016
 
2015
Gross realized gains
$
35,194

 
$
117,688

Gross realized losses
(13,493
)
 
(220
)
Total realized gains on sales, net
$
21,701

 
$
117,468



15
Table of Contents

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

Note 5. 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 March 31, 2016 and December 31, 2015:
(in thousands)
March 31,
2016
 
December 31,
2015
Unpaid principal balance
$
390,461

 
$
812,661

Fair value adjustment
(3,202
)
 
(1,230
)
Carrying value
$
387,259

 
$
811,431


At March 31, 2016 and December 31, 2015, the Company pledged residential mortgage loans with a carrying value of $323.2 million and $745.5 million, respectively, as collateral for repurchase agreements and FHLB advances. See Note 15 - Repurchase Agreements and Note 17 - Federal Home Loan Bank of Des Moines Advances.

Note 6. 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 March 31, 2016 and December 31, 2015:
(in thousands)
March 31,
2016
 
December 31,
2015
Unpaid principal balance
$
3,638,407

 
$
3,143,515

Fair value adjustment
67,240

 
30,212

Carrying value
$
3,705,647

 
$
3,173,727


Note 7. Commercial Real Estate Assets
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 assets 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 assets. See Note 3 - Variable Interest Entities for additional information regarding consolidation of the trust. Commercial real estate assets are reported at cost, net of any unamortized acquisition premiums or discounts, loan fees and origination costs as applicable, unless the assets are deemed impaired.

16
Table of Contents

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

The following tables summarize the Company’s commercial real estate assets by asset type, property type and geographic location as of March 31, 2016 and December 31, 2015:
 
March 31,
2016
 
December 31,
2015
(in thousands)
Mezzanine Loans
 
First Mortgages
 
Total
 
Mezzanine Loans
 
First Mortgages
 
Total
Unpaid principal balance
$
149,779

 
$
600,502

 
$
750,281

 
$
153,913

 
$
513,433

 
$
667,346

Unamortized (discount) premium
(165
)
 
(198
)
 
(363
)
 
(237
)
 
—

 
(237
)
Unamortized net deferred origination fees
(665
)
 
(4,994
)
 
(5,659
)
 
(830
)
 
(5,326
)
 
(6,156
)
Carrying value
$
148,949

 
$
595,310

 
$
744,259

 
$
152,846

 
$
508,107

 
$
660,953

Unfunded commitments
$
1,900

 
$
64,568

 
$
66,468

 
$
1,900

 
$
50,334

 
$
52,234

Number of loans
6

 
14

 
20

 
6

 
12

 
18

Weighted average coupon
8.3
%
 
4.6
%
 
5.3
%
 
8.1
%
 
4.5
%
 
5.4
%
Weighted average years to maturity (1)
2.3

 
3.5

 
3.2

 
2.6

 
3.3

 
3.1

____________________
(1)
Based on contractual maturity date. Certain loans are subject to contractual extension options which may be subject to conditions as stipulated in the loan agreement. Actual maturities may differ from contractual maturities stated herein as certain borrowers may have the right to prepay with or without paying a prepayment penalty. The Company may also extend contractual maturities in connection with loan modifications.

(in thousands)
March 31,
2016
 
December 31,
2015
Property Type
Carrying Value
 
% of Commercial Portfolio
 
Carrying Value
 
% of Commercial Portfolio
Retail
$
186,401

 
25.0
%
 
$
185,883

 
28.1
%
Hotel
81,502

 
11.0
%
 
80,843

 
12.2
%
Multifamily
165,916

 
22.3
%
 
139,011

 
21.1
%
Office
310,440

 
41.7
%
 
255,216

 
38.6
%
Total
$
744,259

 
100.0
%
 
$
660,953

 
100.0
%
(in thousands)
March 31,
2016
 
December 31,
2015
Geographic Location
Carrying Value
 
% of Commercial Portfolio
 
Carrying Value
 
% of Commercial Portfolio
West
$
131,099

 
17.6
%
 
$
131,488

 
19.9
%
Southeast
80,443

 
10.8
%
 
79,118

 
12.0
%
Southwest
201,499

 
27.1
%
 
161,721

 
24.4
%
Northeast
264,077

 
35.5
%
 
238,913

 
36.2
%
Midwest
67,141

 
9.0
%
 
49,713

 
7.5
%
Total
$
744,259

 
100.0
%
 
$
660,953

 
100.0
%
 
At March 31, 2016 and December 31, 2015, the Company pledged commercial real estate assets with a carrying value of $666.8 million and $361.1 million, respectively, as collateral for repurchase agreements and FHLB advances. See Note 15 - Repurchase Agreements and Note 17 - Federal Home Loan Bank of Des Moines Advances.

17
Table of Contents

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

The following table summarizes activity related to commercial real estate assets for the three months ended March 31, 2016 and 2015.
 
Three Months Ended
March 31,
(in thousands)
2016
 
2015
Balance at beginning of period
$
660,953

 
$
—

Originations and purchases
86,870

 
45,556

Repayments
(4,135
)
 
—

Net discount accretion (premium amortization)
73

 
—

(Increase) decrease in net deferred origination fees
(1,110
)
 
—

Amortization of net deferred origination fees
1,608

 
—

Allowance for loan losses
—

 
—

Balance at end of period
$
744,259

 
$
45,556


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 assets as of March 31, 2016 and December 31, 2015:
(dollars in thousands)
March 31,
2016
 
December 31,
2015
Risk Rating
Number of Loans
 
Unpaid Principal Balance
 
Carrying Value
 
Number of Loans
 
Unpaid Principal Balance
 
Carrying Value
1 – 3
20

 
$
750,281

 
$
744,259

 
18

 
$
667,346

 
$
660,953

4 – 5
—

 
—

 
—

 
—

 
—

 
—

Total
20

 
$
750,281

 
$
744,259

 
18

 
$
667,346

 
$
660,953


The Company has not recorded any allowances for losses as no loans are past-due and 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.


18
Table of Contents

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

Note 8. 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 own 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 months ended March 31, 2016 and 2015.
 
Three Months Ended
 
March 31,
(in thousands)
2016
 
2015
Balance at beginning of period
$
493,688

 
$
452,006

Additions from purchases of servicing rights
50,273

 
4,324

Additions from sales of residential mortgage loans
204

 
227

Changes in fair value due to:
 
 
 
Changes in valuation inputs or assumptions used in the valuation model
(84,359
)
 
(38,170
)
Other changes in fair value (1)
(17,081
)
 
(14,233
)
Other changes (2)
3,445

 
6,075

Balance at end of period
$
446,170

 
$
410,229

____________________
(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 March 31, 2016 and December 31, 2015, the key economic assumptions and sensitivity of the fair value of MSR to immediate 10% and 20% adverse changes in these assumptions were as follows:
(in thousands)
March 31,
2016
 
December 31,
2015
Weighted average prepayment speed:
15.6
%
 
11.8
%
Impact on fair value of 10% adverse change
$
(24,272
)
 
$
(20,093
)
Impact on fair value of 20% adverse change
$
(46,245
)
 
$
(38,656
)
Weighted average delinquency:
3.3
%
 
4.0
%
Impact on fair value of 10% adverse change
$
(3,034
)
 
$
(3,826
)
Impact on fair value of 20% adverse change
$
(6,001
)
 
$
(6,640
)
Weighted average discount rate:
9.0
%
 
10.1
%
Impact on fair value of 10% adverse change
$
(11,868
)
 
$
(16,316
)
Impact on fair value of 20% adverse change
$
(23,223
)
 
$
(31,522
)

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.

19
Table of Contents

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

Risk Mitigation Activities
The primary risk associated with 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 11 - 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 months ended March 31, 2016 and 2015:
 
Three Months Ended
 
March 31,
(in thousands)
2016
 
2015
Servicing fee income
$
33,109

 
$
31,237

Ancillary fee income
485

 
564

Float income
539

 
286

Total
$
34,133

 
$
32,087


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 $44.7 million and $37.5 million and were included in other assets on the condensed consolidated balance sheets as of March 31, 2016 and December 31, 2015, respectively.
Serviced Mortgage Assets
The Company’s total serviced mortgage assets consist of loans owned and classified as residential mortgage loans held-for-sale, loans held in consolidated VIEs classified as residential mortgage loans held-for-investment in securitization trusts, and loans underlying MSR. The following table presents the number of loans and unpaid principal balance of the mortgage assets for which the Company manages the servicing as of March 31, 2016 and December 31, 2015:
 
March 31, 2016
 
December 31, 2015
(dollars in thousands)
Number of Loans
 
Unpaid Principal Balance
 
Number of Loans
 
Unpaid Principal Balance
Residential mortgage loans held-for-sale
994

 
$
390,461

 
1,415

 
$
812,661

Residential mortgage loans held-for-investment in securitization trusts
402

 
286,258

 
413

 
297,379

Mortgage servicing rights (1)
260,648

 
55,344,297

 
245,144

 
51,386,141

Total serviced mortgage assets
262,044

 
$
56,021,016

 
246,972

 
$
52,496,181

____________________
(1)
Includes residential mortgage loans held-for-investment in securitization trusts for which the Company is the named servicing administrator.


20
Table of Contents

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

Note 9. 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.
The following table presents the Company’s restricted cash balances as of March 31, 2016 and December 31, 2015:
(in thousands)
March 31,
2016
 
December 31,
2015
Restricted cash balances held by trading counterparties:
 
 
 
For securities and loan trading activity
$
12,560

 
$
12,550

For derivatives trading activity
217,695

 
130,355

As restricted collateral for repurchase agreements and Federal Home Loan Bank advances
50,543

 
119,310

Total restricted cash balances held by trading counterparties
280,798

 
262,215

Restricted cash balance pursuant to letter of credit on office lease
347

 
347

Total
$
281,145

 
$
262,562


Note 10. Accrued Interest Receivable
The following table presents the Company’s accrued interest receivable by collateral type as of March 31, 2016 and December 31, 2015:
(in thousands)
March 31,
2016
 
December 31,
2015
Available-for-sale securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
5,894

 
$
6,235

Federal National Mortgage Association
19,046

 
12,407

Government National Mortgage Association
3,181

 
4,910

Non-Agency
2,189

 
2,339

Total available-for-sale securities
30,310

 
25,891

Residential mortgage loans held-for-sale
1,732

 
4,173

Residential mortgage loans held-for-investment in securitization trusts
20,534

 
18,339

Commercial real estate assets
1,941

 
1,567

Total
$
54,517

 
$
49,970


Note 11. 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, short U.S. Treasuries, put and call options for TBAs and U.S. Treasuries, 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 Agency interest-only securities.

21
Table of Contents

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

The following summarizes the Company’s significant asset and liability classes, the risk exposure for these classes, and the Company’s risk management activities used to mitigate certain of these risks. The discussion includes both derivative and non-derivative instruments used as part of these risk management activities. While the Company uses derivative and non-derivative instruments to achieve the Company’s risk management activities, it is possible that these instruments will not effectively mitigate all or a substantial portion of the Company’s market rate risk. In addition, the Company might elect, at times, not to enter into certain hedging arrangements in order to maintain compliance with REIT requirements.
Balance Sheet Presentation
In accordance with ASC 815, Derivatives and Hedging, or ASC 815, the Company records derivative financial instruments on its condensed consolidated balance sheets 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 March 31, 2016 and December 31, 2015.
(in thousands)
 
March 31, 2016
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
158,786

 
$
882,726

 
$
—

 
$
—

Interest rate swap agreements
 
18,162

 
8,865,513

 
(65,715
)
 
6,560,000

Credit default swaps
 
—

 
—

 
(390
)
 
125,000

Swaptions, net
 
10,482

 
3,700,000

 
(473
)
 
1,500,000

TBAs
 
9,557

 
2,187,000

 
(3,328
)
 
550,000

Put and call options for TBAs, net
 
366

 
2,000,000

 
—

 
—

Markit IOS total return swaps
 
—

 
—

 
(7,120
)
 
868,145

Forward purchase commitments
 
494

 
234,259

 
(12
)
 
17,953

Total
 
$
197,847

 
$
17,869,498

 
$
(77,038
)
 
$
9,621,098

(in thousands)
 
December 31, 2015
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
159,582

 
$
932,037

 
$
—

 
$
—

Interest rate swap agreements
 
91,757

 
14,268,806

 
—

 
—

Credit default swaps
 
—

 
—

 
(703
)
 
125,000

Swaptions, net
 
17,374

 
4,700,000

 
(4,831
)
 
500,000

TBAs
 
1,074

 
847,000

 
(1,324
)
 
550,000

Markit IOS total return swaps
 
1,645

 
889,418

 
—

 
—

Forward purchase commitments
 
77

 
98,736

 
(427
)
 
187,384

Total
 
$
271,509

 
$
21,735,997

 
$
(7,285
)
 
$
1,362,384


Comprehensive (Loss) Income Statement Presentation
The Company has not applied hedge accounting to its current derivative portfolio held to mitigate the interest rate risk and credit risk associated with its portfolio. As a result, the Company is subject to volatility in its earnings due to movement in the unrealized gains and losses associated with its interest rate swaps and its other derivative instruments.

22
Table of Contents

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

The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed consolidated statements of comprehensive (loss) income on the Company’s derivative trading instruments:
Trading Instruments
 
Location of Gain (Loss) Recognized in Income on Derivatives
 
Amount of Gain (Loss) Recognized in Income on Derivatives
(in thousands)
 
 
 
Three Months Ended
March 31,
 
 
 
 
2016
 
2015
Interest rate risk management