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, 2018
Commission File Number 001-34506
______________________________
TWO HARBORS INVESTMENT CORP.
(Exact Name of Registrant as Specified in Its Charter)
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| | |
Maryland | | 27-0312904 |
(State or Other Jurisdiction of Incorporation or Organization) | | (I.R.S. Employer Identification No.) |
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575 Lexington Avenue, Suite 2930 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, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
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| | | |
Large accelerated filer x | | | Accelerated filer o |
Non-accelerated filer o | (Do not check if a smaller reporting company) | | Smaller reporting company o |
| | | Emerging growth company o |
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
As of May 8, 2018 there were 175,433,334 shares of outstanding common stock, par value $.01 per share, issued and outstanding.
TWO HARBORS INVESTMENT CORP.
INDEX
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| PART I - FINANCIAL INFORMATION | |
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| PART II - OTHER INFORMATION | |
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited)
(in thousands, except share data)
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| | | | | | | |
ASSETS | March 31, 2018 | | December 31, 2017 |
Available-for-sale securities, at fair value | $ | 21,059,377 |
| | $ | 21,220,819 |
|
Mortgage servicing rights, at fair value | 1,301,023 |
| | 1,086,717 |
|
Residential mortgage loans held-for-sale, at fair value | 29,428 |
| | 30,414 |
|
Cash and cash equivalents | 388,450 |
| | 419,159 |
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Restricted cash | 712,791 |
| | 635,836 |
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Accrued interest receivable | 67,370 |
| | 68,309 |
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Due from counterparties | 85,319 |
| | 842,303 |
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Derivative assets, at fair value | 274,048 |
| | 309,918 |
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Other assets | 159,359 |
| | 175,838 |
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Total Assets | $ | 24,077,165 |
| | $ | 24,789,313 |
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LIABILITIES AND STOCKHOLDERS’ EQUITY | | | |
Liabilities | | | |
Repurchase agreements | $ | 19,148,679 |
| | $ | 19,451,207 |
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Federal Home Loan Bank advances | 865,024 |
| | 1,215,024 |
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Revolving credit facilities | 20,000 |
| | 20,000 |
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Convertible senior notes | 283,054 |
| | 282,827 |
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Derivative liabilities, at fair value | 46,074 |
| | 31,903 |
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Due to counterparties | 39,809 |
| | 88,898 |
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Dividends payable | 96,201 |
| | 12,552 |
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Accrued interest payable | 85,405 |
| | 87,698 |
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Other liabilities | 25,234 |
| | 27,780 |
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Total Liabilities | 20,609,480 |
| | 21,217,889 |
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Stockholders’ Equity | | | |
Preferred stock, par value $0.01 per share; 50,000,000 shares authorized: | | | |
8.125% Series A cumulative redeemable: 5,750,000 and 5,750,000 shares issued and outstanding, respectively ($143,750 liquidation preference) | 138,872 |
| | 138,872 |
|
7.625% Series B cumulative redeemable: 11,500,000 and 11,500,000 shares issued and outstanding, respectively ($287,500 liquidation preference) | 278,094 |
| | 278,094 |
|
7.25% Series C cumulative redeemable: 11,800,000 and 11,800,000 shares issued and outstanding, respectively ($295,000 liquidation preference) | 285,584 |
| | 285,571 |
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Common stock, par value $0.01 per share; 450,000,000 shares authorized and 175,434,778 and 174,496,587 shares issued and outstanding, respectively | 1,754 |
| | 1,745 |
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Additional paid-in capital | 3,674,411 |
| | 3,672,003 |
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Accumulated other comprehensive (loss) income | (46 | ) | | 334,813 |
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Cumulative earnings | 2,711,495 |
| | 2,386,604 |
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Cumulative distributions to stockholders | (3,622,479 | ) | | (3,526,278 | ) |
Total Stockholders’ Equity | 3,467,685 |
| | 3,571,424 |
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Total Liabilities and Stockholders’ Equity | $ | 24,077,165 |
| | $ | 24,789,313 |
|
The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME (unaudited)
(in thousands, except share data)
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| | | | | | | |
| Three Months Ended |
| March 31, |
| 2018 | | 2017 |
Interest income: | | | |
Available-for-sale securities | $ | 190,716 |
| | $ | 135,327 |
|
Residential mortgage loans held-for-investment in securitization trusts | — |
| | 31,628 |
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Residential mortgage loans held-for-sale | 307 |
| | 398 |
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Other | 2,996 |
| | 1,801 |
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Total interest income | 194,019 |
| | 169,154 |
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Interest expense: | | | |
Repurchase agreements | 86,580 |
| | 32,256 |
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Collateralized borrowings in securitization trusts | — |
| | 25,386 |
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Federal Home Loan Bank advances | 4,458 |
| | 8,793 |
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Revolving credit facilities | 804 |
| | 429 |
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Convertible senior notes | 4,718 |
| | 3,821 |
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Total interest expense | 96,560 |
| | 70,685 |
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Net interest income | 97,459 |
| | 98,469 |
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Other-than-temporary impairments: |
| |
|
Total other-than-temporary impairment losses | (94 | ) | | — |
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Other income (loss): | | | |
Loss on investment securities | (20,671 | ) | | (52,352 | ) |
Servicing income | 71,190 |
| | 39,773 |
|
Gain (loss) on servicing asset | 71,807 |
| | (14,565 | ) |
Gain on interest rate swap and swaption agreements | 150,545 |
| | 9,927 |
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Gain (loss) on other derivative instruments | 8,053 |
| | (27,864 | ) |
Other income | 1,058 |
| | 9,496 |
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Total other income (loss) | 281,982 |
| | (35,585 | ) |
Expenses: | | | |
Management fees | 11,708 |
| | 9,808 |
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Servicing expenses | 14,554 |
| | 5,298 |
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Other operating expenses | 14,492 |
| | 13,764 |
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Total expenses | 40,754 |
| | 28,870 |
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Income from continuing operations before income taxes | 338,593 |
| | 34,014 |
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Provision for (benefit from) income taxes | 3,784 |
| | (24,517 | ) |
Net income from continuing operations | 334,809 |
| | 58,531 |
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Income from discontinued operations, net of tax | — |
| | 13,454 |
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Net income | 334,809 |
| | 71,985 |
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Dividends on preferred stock | 13,747 |
| | — |
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Net income attributable to common stockholders | $ | 321,062 |
| | $ | 71,985 |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME (unaudited), continued
(in thousands, except share data)
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| | | | | | | |
| Three Months Ended |
| March 31, |
| 2018 | | 2017 |
Basic earnings per weighted average common share: | | | |
Continuing operations | $ | 1.83 |
| | $ | 0.33 |
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Discontinued operations | — |
| | 0.08 |
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Net income | $ | 1.83 |
| | $ | 0.41 |
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Diluted earnings per weighted average common share: | | | |
Continuing operations | $ | 1.69 |
| | $ | 0.33 |
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Discontinued operations | — |
| | 0.08 |
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Net income | $ | 1.69 |
| | $ | 0.41 |
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Dividends declared per common share | $ | 0.47 |
| | $ | 0.50 |
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Weighted average number of shares of common stock: | | | |
Basic | 175,145,964 |
| | 174,281,965 |
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Diluted | 192,818,531 |
| | 174,281,965 |
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Comprehensive (loss) income: | | | |
Net income | $ | 334,809 |
| | $ | 71,985 |
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Other comprehensive (loss) income, net of tax: | | | |
Unrealized (loss) gain on available-for-sale securities | (344,777 | ) | | 73,762 |
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Other comprehensive (loss) income | (344,777 | ) | | 73,762 |
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Comprehensive (loss) income | (9,968 | ) | | 145,747 |
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Dividends on preferred stock | 13,747 |
| | — |
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Comprehensive (loss) income attributable to common stockholders | $ | (23,715 | ) | | $ | 145,747 |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (unaudited)
(in thousands, except share data)
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| Series A Preferred Stock | | Series B Preferred Stock | | Series C Preferred Stock | | Common Stock Par Value | | Additional Paid-in Capital | | Accumulated Other Comprehensive Income (Loss) | | Cumulative Earnings | | Cumulative Distributions to Stockholders | | Total Stockholders’ Equity |
Balance, December 31, 2016 | $ | — |
| | $ | — |
| | $ | — |
| | $ | 1,739 |
| | $ | 3,661,711 |
| | $ | 199,227 |
| | $ | 2,038,033 |
| | $ | (2,499,599 | ) | | $ | 3,401,111 |
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Net income | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | 71,985 |
| | — |
| | 71,985 |
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Other comprehensive income before reclassifications, net of tax expense of $20,591 | — |
| | — |
| | — |
| | — |
| | — |
| | 64,449 |
| | — |
| | — |
| | 64,449 |
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Amounts reclassified from accumulated other comprehensive income, net of tax expense of $6,386 | — |
| | — |
| | — |
| | — |
| | — |
| | 9,313 |
| | — |
| | — |
| | 9,313 |
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Other comprehensive income, net of tax expense of $26,977 | — |
| | — |
| | — |
| | — |
| | — |
| | 73,762 |
| | — |
| | — |
| | 73,762 |
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Issuance of preferred stock, net of offering costs | 138,872 |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | 138,872 |
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Issuance of common stock, net of offering costs | — |
| | — |
| | — |
| | — |
| | 102 |
| | — |
| | — |
| | — |
| | 102 |
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Common dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | (87,228 | ) | | (87,228 | ) |
Non-cash equity award compensation | — |
| | — |
| | — |
| | 6 |
| | 3,951 |
| | — |
| | — |
| | — |
| | 3,957 |
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Balance, March 31, 2017 | $ | 138,872 |
| | $ | — |
| | $ | — |
| | $ | 1,744 |
| | $ | 3,665,765 |
| | $ | 272,989 |
| | $ | 2,110,018 |
| | $ | (2,586,827 | ) | | $ | 3,602,561 |
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| | | | | | | | | | | | | | | | |
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Balance, December 31, 2017 | $ | 138,872 |
| | $ | 278,094 |
| | $ | 285,571 |
| | $ | 1,745 |
| | $ | 3,672,003 |
| | $ | 334,813 |
| | $ | 2,386,604 |
| | $ | (3,526,278 | ) | | $ | 3,571,424 |
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Cumulative effect of adoption of new accounting principle | — |
| | — |
| | — |
| | — |
| | — |
| | 9,918 |
| | (9,918 | ) | | — |
| | — |
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Adjusted balance, January 1, 2018 | 138,872 |
| | 278,094 |
| | 285,571 |
| | 1,745 |
| | 3,672,003 |
| | 344,731 |
| | 2,376,686 |
| | (3,526,278 | ) | | 3,571,424 |
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Net income | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | 334,809 |
| | — |
| | 334,809 |
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Other comprehensive loss before reclassifications, net of tax benefit of $510 | — |
| | — |
| | — |
| | — |
| | — |
| | (343,542 | ) | | — |
| | — |
| | (343,542 | ) |
Amounts reclassified from accumulated other comprehensive income, net of tax benefit of $0 | — |
| | — |
| | — |
| | — |
| | — |
| | (1,235 | ) | | — |
| | — |
| | (1,235 | ) |
Other comprehensive loss, net of tax benefit of $510 | — |
| | — |
| | — |
| | — |
| | — |
| | (344,777 | ) | | — |
| | — |
| | (344,777 | ) |
Issuance of preferred stock, net of offering costs | — |
| | — |
| | 13 |
| | — |
| | — |
| | — |
| | — |
| | — |
| | 13 |
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Issuance of common stock, net of offering costs | — |
| | — |
| | — |
| | — |
| | 76 |
| | — |
| | — |
| | — |
| | 76 |
|
Preferred dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | (13,747 | ) | | (13,747 | ) |
Common dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | (82,454 | ) | | (82,454 | ) |
Non-cash equity award compensation | — |
| | — |
| | — |
| | 9 |
| | 2,332 |
| | — |
| | — |
| | — |
| | 2,341 |
|
Balance, March 31, 2018 | $ | 138,872 |
| | $ | 278,094 |
| | $ | 285,584 |
| | $ | 1,754 |
| | $ | 3,674,411 |
| | $ | (46 | ) | | $ | 2,711,495 |
| | $ | (3,622,479 | ) | | $ | 3,467,685 |
|
The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
(in thousands)
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| | | | | | | |
| Three Months Ended |
| March 31, |
| 2018 | | 2017 |
Cash Flows From Operating Activities: | | | |
Net income from continuing operations | $ | 334,809 |
| | $ | 58,531 |
|
Adjustments to reconcile net income from continuing operations to net cash provided by operating activities: | | | |
Amortization of premiums and discounts on investment securities, net | 22,086 |
| | 8,502 |
|
Amortization of deferred debt issuance costs on convertible senior notes | 227 |
| | 78 |
|
Other-than-temporary impairment losses | 94 |
| | — |
|
Realized and unrealized losses on investment securities | 21,301 |
| | 52,352 |
|
(Gain) loss on servicing asset | (71,807 | ) | | 14,565 |
|
Gain on residential mortgage loans held-for-sale | (316 | ) | | (1,461 | ) |
Gain on residential mortgage loans held-for-investment and collateralized borrowings in securitization trusts | — |
| | (6,683 | ) |
Realized and unrealized gain on interest rate swaps and swaptions | (146,736 | ) | | (17,831 | ) |
Unrealized loss on other derivative instruments | 41,724 |
| | 59,841 |
|
Equity based compensation | 2,341 |
| | 3,957 |
|
Depreciation of fixed assets | 184 |
| | 285 |
|
Purchases of residential mortgage loans held-for-sale | — |
| | (437 | ) |
Proceeds from sales of residential mortgage loans held-for-sale | — |
| | 3,708 |
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Proceeds from repayment of residential mortgage loans held-for-sale | 1,120 |
| | 3,995 |
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Net change in assets and liabilities: |
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| | |
Decrease (increase) in accrued interest receivable | 939 |
| | (12,611 | ) |
Decrease (increase) in deferred income taxes, net | 4,508 |
| | (24,710 | ) |
(Increase) decrease in income taxes receivable | (724 | ) | | 86 |
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Decrease in prepaid and fixed assets | 393 |
| | 306 |
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(Increase) decrease in other receivables | (5,032 | ) | | 11,343 |
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Decrease in servicing advances | 2,871 |
| | 1,466 |
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(Decrease) increase in accrued interest payable | (2,293 | ) | | 11,159 |
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Increase in income taxes payable | — |
| | 30 |
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Decrease in accrued expenses and other liabilities | (2,546 | ) | | (13,501 | ) |
Net cash provided by operating activities of discontinued operations | — |
| | 9,294 |
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Net cash provided by operating activities | $ | 203,143 |
| | $ | 162,264 |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited), continued
(in thousands)
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| | | | | | | |
| Three Months Ended |
| March 31, |
| 2018 | | 2017 |
Cash Flows From Investing Activities: | | | |
Purchases of available-for-sale securities | $ | (2,720,032 | ) | | $ | (6,837,176 | ) |
Proceeds from sales of available-for-sale securities | 2,047,032 |
| | 2,414,267 |
|
Principal payments on available-for-sale securities | 447,664 |
| | 272,954 |
|
Purchases of mortgage servicing rights, net of purchase price adjustments | (142,799 | ) | | (68,551 | ) |
Proceeds from sales of mortgage servicing rights | 300 |
| | 250 |
|
(Purchases) short sales of derivative instruments, net | (50,500 | ) | | (42,293 | ) |
Proceeds from sales and settlement (payments for termination and settlement) of derivative instruments, net | 205,553 |
| | 78,763 |
|
Proceeds from repayment of residential mortgage loans held-for-investment in securitization trusts | — |
| | 102,545 |
|
Redemptions of Federal Home Loan Bank stock | 12,981 |
| | 19,760 |
|
Increase (decrease) in due to counterparties, net | 707,895 |
| | (74,936 | ) |
Net cash used in investing activities of discontinued operations | — |
| | (133,843 | ) |
Net cash provided by (used in) investing activities | 508,094 |
| | (4,268,260 | ) |
Cash Flows From Financing Activities: | | | |
Proceeds from repurchase agreements | 35,053,094 |
| | 36,483,681 |
|
Principal payments on repurchase agreements | (35,355,622 | ) | | (32,244,366 | ) |
Principal payments on collateralized borrowings in securitization trusts | — |
| | (101,562 | ) |
Principal payments on Federal Home Loan Bank advances | (350,000 | ) | | (428,238 | ) |
Principal payments on revolving credit facilities | — |
| | (55,000 | ) |
Proceeds from convertible senior notes | — |
| | 282,469 |
|
Proceeds from issuance of preferred stock, net of offering costs | 13 |
| | 138,872 |
|
Proceeds from issuance of common stock, net of offering costs | 76 |
| | 102 |
|
Dividends paid on preferred stock | (11,949 | ) | | — |
|
Dividends paid on common stock | (603 | ) | | (83,437 | ) |
Net cash provided by financing activities of discontinued operations | — |
| | 85,054 |
|
Net cash (used in) provided by financing activities | (664,991 | ) | | 4,077,575 |
|
Net increase (decrease) in cash, cash equivalents and restricted cash | 46,246 |
| | (28,421 | ) |
Cash, cash equivalents and restricted cash of continuing operations at beginning of period | 1,054,995 |
| | 758,916 |
|
Cash, cash equivalents and restricted cash of discontinued operations at beginning of period | — |
| | 56,279 |
|
Cash, cash equivalents and restricted cash at beginning of period | 1,054,995 |
| | 815,195 |
|
Cash, cash equivalents and restricted cash at end of period | $ | 1,101,241 |
| | $ | 786,774 |
|
The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited), continued
(in thousands)
|
| | | | | | | |
| Three Months Ended |
| March 31, |
| 2018 | | 2017 |
Supplemental Disclosure of Cash Flow Information: | |
Cash paid for interest | $ | 98,854 |
| | $ | 38,237 |
|
Cash paid for taxes | $ | — |
| | $ | 81 |
|
Noncash Activities: | | | |
Transfers of residential mortgage loans held-for-sale to other receivables for foreclosed government-guaranteed loans | $ | 182 |
| | $ | 1,626 |
|
Transfer of fair value of mortgage servicing rights to fair value of Ginnie Mae residential mortgage loans held-for-sale upon buyout | $ | — |
| | $ | 9 |
|
Additions to mortgage servicing rights due to sale of residential mortgage loans held-for-sale | $ | — |
| | $ | 20 |
|
Cumulative-effect adjustment for adoption of new accounting principle | $ | 9,918 |
| | $ | — |
|
Dividends declared but not paid at end of period | $ | 96,201 |
| | $ | 87,228 |
|
Reconciliation of residential mortgage loans held-for-sale: | | | |
Residential mortgage loans held-for-sale at beginning of period | $ | 30,414 |
| | $ | 40,146 |
|
Purchases of residential mortgage loans held-for-sale | — |
| | 437 |
|
Transfers to other receivables for foreclosed government-guaranteed loans | (182 | ) | | (1,626 | ) |
Transfer of fair value of mortgage servicing rights to fair value of Ginnie Mae residential mortgage loans held-for-sale upon buyout | — |
| | (9 | ) |
Proceeds from sales of residential mortgage loans held-for-sale | — |
| | (3,708 | ) |
Proceeds from repayment of residential mortgage loans held-for-sale | (1,120 | ) | | (3,995 | ) |
Realized and unrealized gains on residential mortgage loans held-for-sale | 316 |
| | 1,441 |
|
Residential mortgage loans held-for-sale at end of period | $ | 29,428 |
| | $ | 32,686 |
|
The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
Note 1. Organization and Operations
Two Harbors Investment Corp., or the Company, is a Maryland corporation investing in, financing and managing Agency residential mortgage-backed securities, or Agency RMBS, non-Agency securities, mortgage servicing rights, or MSR, and other financial assets. 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. 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. 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.
On June 28, 2017, the Company completed the contribution of its portfolio of commercial real estate assets to Granite Point Mortgage Trust Inc., or Granite Point, a newly formed Maryland corporation intended to qualify as a REIT, externally managed and advised by Pine River, and focused on directly originating, investing in and managing senior commercial mortgage loans and other debt and debt-like commercial real estate investments. The Company contributed its equity interests in its wholly owned subsidiary, TH Commercial Holdings LLC, to Granite Point and, in exchange for its contribution, received approximately 33.1 million shares of common stock of Granite Point, which represented approximately 76.5% of the outstanding stock of Granite Point upon completion of the initial public offering, or IPO, of its common stock on June 28, 2017. On November 1, 2017, the Company distributed, on a pro rata basis, the 33.1 million shares of Granite Point common stock that it acquired in connection with the contribution to stockholders holding shares of Two Harbors common stock outstanding as of the close of business on October 20, 2017.
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 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 per share amounts, common shares outstanding and restricted shares for all prior periods presented have been adjusted on a retroactive basis to reflect the Company’s one-for-two reverse stock split effected on November 1, 2017 (refer to Note 17 - Stockholders’ Equity for additional information). 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, 2017. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at March 31, 2018 and results of operations for all periods presented have been made. The results of operations for the three months ended March 31, 2018 should not be construed as indicative of the results to be expected for future periods or the full year.
Due to its controlling ownership interest in Granite Point through November 1, 2017, the Company consolidated Granite Point on its financial statements. Effective November 1, 2017 (the date the 33.1 million shares of Granite Point common stock were distributed to the Company’s common stockholders), the Company no longer has a controlling interest in Granite Point and, therefore, has deconsolidated Granite Point and its subsidiaries from its financial statements and reclassified all of Granite Point’s current and prior period assets, liabilities and results of operations to discontinued operations.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
The Company retains debt securities and excess servicing rights purchased from securitization trusts sponsored by either third parties or the Company’s subsidiaries. The securitization trusts are considered variable interest entities, or VIEs, for financial reporting purposes and, thus, are 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 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 trust. During the majority of 2017, the Company retained the most subordinate security in each of the securitization trusts, which gave the Company the power to direct the activities of the trusts that most significantly impact the trusts’ performance and the obligation to absorb losses or the right to receive benefits of the securitization trusts that could be significant. As a result, the Company consolidated all of the securitization trusts on its condensed consolidated balance sheet. During the fourth quarter of 2017, the Company sold all of the retained subordinated securities thereby removing the Company’s power to direct the activities of the trusts and the obligation to absorb losses or the right to receive benefits of the securitization trusts. As a result, the securitization trusts are no longer consolidated on the Company’s condensed consolidated balance sheet and the remaining retained securities are included withing non-Agency available-for-sale, or AFS, securities.
Use of Estimates
The preparation of financial statements in conformity with U.S. GAAP requires management to make a number of significant estimates. These 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 as of the date of the 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.
Significant Accounting Policies
Included in Note 2 to the Consolidated Financial Statements of the Company’s 2017 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, 2018.
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 by 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. 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. Additionally, the Company’s centrally cleared interest rate swaps require that the Company posts an “initial margin” amount determined by the clearing exchange, which is generally intended to be set at a level sufficient to protect the exchange from the interest rate swap’s maximum estimated single-day price movement. The Company also exchanges “variation margin” based upon daily changes in fair value, as measured by the exchange.
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. As a result of amendments to rules governing certain central clearing activities, the exchange of variation margin is considered a settlement of the interest rate swap, as opposed to pledged collateral. Accordingly, beginning in the first quarter of 2018 and in subsequent periods, the Company accounts for the receipt or payment of variation margin as a direct reduction to the carrying value of the interest rate swap asset or liability. The receipt or payment of initial margin will continue to be accounted for separate from the interest rate swap asset or liability. As of December 31, 2017, variation margin pledged or received was netted on a counterparty basis and classified within restricted cash, due from counterparties, or due to counterparties on the Company’s condensed consolidated balance sheets.
The Company presents repurchase agreements subject to master netting arrangements or similar agreements on a gross basis and derivative assets and liabilities (other than centrally cleared interest rate swaps) 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 (other than variation margin on centrally cleared interest rate swaps) on a net basis, based on counterparty, in its condensed consolidated balance sheets. However, the Company does not offset repurchase agreements or derivative assets and liabilities (other than centrally cleared interest rate swaps) with the associated cash collateral on its condensed consolidated balance sheets.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
The following tables present information about the Company’s assets and liabilities that are subject to master netting arrangements or similar agreements and can potentially be offset on the Company’s condensed consolidated balance sheets as of March 31, 2018 and December 31, 2017:
|
| | | | | | | | | | | | | | | | | | | | | | | |
| March 31, 2018 |
| | | | | | | Gross Amounts Not Offset with Financial Assets (Liabilities) in the Consolidated Balance Sheets (1) | | |
(in thousands) | Gross Amounts of Recognized Assets (Liabilities) | | Gross Amounts Offset in the Consolidated Balance Sheets | | Net Amounts of Assets (Liabilities) Presented in the Consolidated Balance Sheets | | Financial Instruments | | Cash Collateral (Received) Pledged | | Net Amount |
Assets | | | | | | | | | | | |
Derivative assets | $ | 446,109 |
| | $ | (172,061 | ) | | $ | 274,048 |
| | $ | (46,074 | ) | | $ | — |
| | $ | 227,974 |
|
Total Assets | $ | 446,109 |
| | $ | (172,061 | ) | | $ | 274,048 |
| | $ | (46,074 | ) | | $ | — |
| | $ | 227,974 |
|
Liabilities | | | | | | | | | | | |
Repurchase agreements | $ | (19,148,679 | ) | | $ | — |
| | $ | (19,148,679 | ) | | $ | 19,148,679 |
| | $ | — |
| | $ | — |
|
Derivative liabilities | (218,135 | ) | | 172,061 |
| | (46,074 | ) | | 46,074 |
| | — |
| | — |
|
Total Liabilities | $ | (19,366,814 | ) | | $ | 172,061 |
| | $ | (19,194,753 | ) | | $ | 19,194,753 |
| | $ | — |
| | $ | — |
|
|
| | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2017 |
| | | | | | | Gross Amounts Not Offset with Financial Assets (Liabilities) in the Consolidated Balance Sheets (1) | | |
(in thousands) | Gross Amounts of Recognized Assets (Liabilities) | | Gross Amounts Offset in the Consolidated Balance Sheets | | Net Amounts of Assets (Liabilities) Presented in the Consolidated Balance Sheets | | Financial Instruments | | Cash Collateral (Received) Pledged | | Net Amount |
Assets | | | | | | | | | | | |
Derivative assets | $ | 340,576 |
| | $ | (30,658 | ) | | $ | 309,918 |
| | $ | (31,903 | ) | | $ | — |
| | $ | 278,015 |
|
Total Assets | $ | 340,576 |
| | $ | (30,658 | ) | | $ | 309,918 |
| | $ | (31,903 | ) | | $ | — |
| | $ | 278,015 |
|
Liabilities | | | | | | | | | | | |
Repurchase agreements | $ | (19,451,207 | ) | | $ | — |
| | $ | (19,451,207 | ) | | $ | 19,451,207 |
| | $ | — |
| | $ | — |
|
Derivative liabilities | (62,561 | ) | | 30,658 |
| | (31,903 | ) | | 31,903 |
| | — |
| | — |
|
Total Liabilities | $ | (19,513,768 | ) | | $ | 30,658 |
| | $ | (19,483,110 | ) | | $ | 19,483,110 |
| | $ | — |
| | $ | — |
|
____________________
| |
(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. |
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
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 evaluated the new guidance and determined that interest income, gains and losses on financial instruments and income from servicing residential mortgage loans are outside the scope of ASC 606, Revenues from Contracts with Customers, or ASC 606. For income from servicing residential mortgage loans, the Company considered that the FASB Transition Resource Group members generally agreed that an entity should look to ASC 860, Transfers and Servicing, to determine the appropriate accounting for these fees and ASC 606 contains a scope exception for contracts that fall under ASC 860. As a result, the adoption of this ASU did not have a material impact on the Company’s financial condition, results of operations or financial statement disclosures.
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, results of operations or financial statement disclosures.
Measurement of Credit Losses on Financial Instruments
In June 2016, the FASB issued ASU No. 2016-13, which changes the impairment model for most financial assets and certain other instruments. Allowances for credit losses on AFS debt securities will be recognized, rather than direct reductions in the amortized cost of the investments. The new model also requires the estimation of lifetime expected credit losses and corresponding recognition of allowance for losses on trade and other receivables, held-to-maturity debt securities, loans, and other instruments held at amortized cost. 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, 2019, with early adoption permitted for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2018. The Company is evaluating the adoption of this ASU to determine the impact it may have on its condensed consolidated financial statements, which at the date of adoption, is expected to increase the allowance for credit losses with a resulting negative adjustment to retained earnings, with offsetting impacts to accumulated other comprehensive income.
Clarifying the Definition of a Business
In January 2017, the FASB issued ASU No. 2017-01, which changes the definition of a business to assist entities with evaluating when a set of transferred assets and activities is a business. The ASU requires an entity to evaluate if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets; if so, the set of transferred assets and activities is not a business. The guidance also requires a business to include at least one substantive process and narrows the definition of outputs by more closely aligning it with how outputs are described in ASC 606. The ASU 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’s adoption of this ASU did not have a material impact on the Company’s financial condition, results of operations or financial statement disclosures, but will impact how the Company accounts for any future transfers of sets of assets and activities.
Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income
In February 2018, the FASB issued ASU No. 2018-02, which permits entities to reclassify tax effects stranded in accumulated other comprehensive income as a result of the Tax Cuts and Jobs Act, or TCJA, to retained earnings and requires entities to disclose whether or not they elected to reclassify the tax effects related to the TCJA as well as their policy for releasing income tax effects from accumulated other comprehensive income. 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. Early adoption of this ASU was elected and applied by recording a cumulative-effect adjustment of $9.9 million to retained earnings, with the offsetting impact to accumulated other comprehensive income as of January 1, 2018.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
Note 3. Discontinued Operations
On June 28, 2017, the Company contributed its equity interests in its wholly owned subsidiary, TH Commercial Holdings LLC, to Granite Point and, in exchange for its contribution, received approximately 33.1 million shares of common stock of Granite Point, representing approximately 76.5% of the outstanding stock of Granite Point upon completion of the IPO of its common stock on June 28, 2017. On November 1, 2017, the Company distributed, on a pro rata basis, the 33.1 million shares of Granite Point common stock that it acquired in connection with the contribution to stockholders holding shares of Two Harbors common stock outstanding as of the close of business on October 20, 2017. Due to the Company’s controlling ownership interest in Granite Point through November 1, 2017, its results of operations and financial condition through such date reflect Granite Point’s commercial strategy, which includes as target assets first mortgages, mezzanine loans, B-notes and preferred equity. As of November 1, 2017, the Company no longer has a controlling interest in Granite Point and, therefore, has deconsolidated Granite Point and its subsidiaries from its financial statements and reclassified all of Granite Point’s current and prior period assets, liabilities and results of operations to discontinued operations. In accordance with ASC 845, Nonmonetary Transactions, the pro rata distribution of a consolidated subsidiary is recognized at carrying amount within stockholders’ equity. As a result, no gain or loss was recognized on the distribution.
Summarized financial information for the discontinued operations are presented below.
|
| | | |
(in thousands) | November 1, 2017 |
Assets: | |
Commercial real estate assets | $ | 2,233,080 |
|
Available-for-sale securities, at fair value | 12,814 |
|
Cash and cash equivalents | 84,183 |
|
Restricted cash | 2,838 |
|
Accrued interest receivable | 6,588 |
|
Other assets | 22,774 |
|
Total Assets | $ | 2,362,277 |
|
Liabilities: | |
Repurchase agreements | $ | 1,516,294 |
|
Dividends payable | 48 |
|
Other liabilities | 10,337 |
|
Total Liabilities | $ | 1,526,679 |
|
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
|
| | | | | | | |
| Three Months Ended |
| March 31, |
(in thousands) | 2018 | | 2017 |
Interest income: | | | |
Commercial real estate assets | $ | — |
| | $ | 23,570 |
|
Available-for-sale securities | — |
| | 246 |
|
Other | — |
| | 2 |
|
Total interest income | — |
| | 23,818 |
|
Interest expense | — |
| | 6,106 |
|
Net interest income | — |
| | 17,712 |
|
Expenses: | | | |
Management fees | — |
| | 1,662 |
|
Servicing expenses | — |
| | 322 |
|
Other operating expenses | — |
| | 2,273 |
|
Total expenses | — |
| | 4,257 |
|
Income from discontinued operations before income taxes | — |
| | 13,455 |
|
Provision for income taxes | — |
| | 1 |
|
Income from discontinued operations attributable to common stockholders | $ | — |
| | $ | 13,454 |
|
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. The following table presents the Company’s AFS investment securities by collateral type as of March 31, 2018 and December 31, 2017:
|
| | | | | | | |
(in thousands) | March 31, 2018 | | December 31, 2017 |
Agency | | | |
Federal National Mortgage Association | $ | 14,074,434 |
| | $ | 13,920,721 |
|
Federal Home Loan Mortgage Corporation | 3,287,343 |
| | 3,616,967 |
|
Government National Mortgage Association | 680,387 |
| | 701,037 |
|
Non-Agency | 3,017,213 |
| | 2,982,094 |
|
Total available-for-sale securities | $ | 21,059,377 |
| | $ | 21,220,819 |
|
At March 31, 2018 and December 31, 2017, the Company pledged AFS securities with a carrying value of $20.9 billion and $21.0 billion, respectively, as collateral for repurchase agreements and advances from the Federal Home Loan Bank of Des Moines, or the FHLB. See Note 13 - Repurchase Agreements and Note 14 - Federal Home Loan Bank of Des Moines Advances.
At March 31, 2018 and December 31, 2017, the Company did not have any securities purchased from and financed with the same counterparty that did not meet the conditions of ASC 860, to be considered linked transactions and, therefore, classified as derivatives.
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 all non-Agency securities, which are classified within available-for-sale securities, at fair value on the condensed consolidated balance sheets. As of March 31, 2018 and December 31, 2017, the carrying value, which also represents the maximum exposure to loss, of all non-Agency securities in unconsolidated VIEs was $3.0 billion and $3.0 billion, respectively.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
The following tables present the amortized cost and carrying value (which approximates fair value) of AFS securities by collateral type as of March 31, 2018 and December 31, 2017:
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| March 31, 2018 |
(in thousands) | Principal/ Current Face | | Un-amortized Premium | | Accretable Purchase Discount | | Credit Reserve Purchase Discount | | Amortized Cost | | Unrealized Gain | | Unrealized Loss | | Carrying Value |
Agency | | | | | | | | | | | | | | | |
Principal and interest | $ | 17,266,330 |
| | $ | 1,059,269 |
| | $ | (24,501 | ) | | $ | — |
| | $ | 18,301,098 |
| | $ | 14,803 |
| | $ | (468,055 | ) | | $ | 17,847,846 |
|
Interest-only | 3,115,095 |
| | 224,298 |
| | — |
| | — |
| | 224,298 |
| | 14,374 |
| | (44,354 | ) | | 194,318 |
|
Total Agency | 20,381,425 |
| | 1,283,567 |
| | (24,501 | ) | | — |
| | 18,525,396 |
| | 29,177 |
| | (512,409 | ) | | 18,042,164 |
|
Non-Agency | | | | | | | | | | | | | | | |
Principal and interest | 3,807,719 |
| | 2,781 |
| | (657,248 | ) | | (712,017 | ) | | 2,441,235 |
| | 505,434 |
| | (3,757 | ) | | 2,942,912 |
|
Interest-only | 5,495,775 |
| | 73,619 |
| | — |
| | — |
| | 73,619 |
| | 3,938 |
| | (3,256 | ) | | 74,301 |
|
Total Non-Agency | 9,303,494 |
| | 76,400 |
| | (657,248 | ) | | (712,017 | ) | | 2,514,854 |
| | 509,372 |
| | (7,013 | ) | | 3,017,213 |
|
Total | $ | 29,684,919 |
| | $ | 1,359,967 |
| | $ | (681,749 | ) | | $ | (712,017 | ) | | $ | 21,040,250 |
| | $ | 538,549 |
| | $ | (519,422 | ) | | $ | 21,059,377 |
|
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2017 |
(in thousands) | Principal/ Current Face | | Un-amortized Premium | | Accretable Purchase Discount | | Credit Reserve Purchase Discount | | Amortized Cost | | Unrealized Gain | | Unrealized Loss | | Carrying Value |
Agency | | | | | | | | | | | | | | | |
Principal and interest | $ | 17,081,849 |
| | $ | 1,079,246 |
| | $ | (24,638 | ) | | $ | — |
| | $ | 18,136,457 |
| | $ | 42,149 |
| | $ | (134,969 | ) | | $ | 18,043,637 |
|
Interest-only | 2,941,772 |
| | 223,289 |
| | — |
| | — |
| | 223,289 |
| | 10,955 |
| | (39,156 | ) | | 195,088 |
|
Total Agency | 20,023,621 |
| | 1,302,535 |
| | (24,638 | ) | | — |
| | 18,359,746 |
| | 53,104 |
| | (174,125 | ) | | 18,238,725 |
|
Non-Agency | | | | | | | | | | | | | | | |
Principal and interest | 3,758,134 |
| | 2,757 |
| | (676,033 | ) | | (653,613 | ) | | 2,431,245 |
| | 488,931 |
| | (3,166 | ) | | 2,917,010 |
|
Interest-only | 5,614,925 |
| | 65,667 |
| | — |
| | — |
| | 65,667 |
| | 2,163 |
| | (2,746 | ) | | 65,084 |
|
Total Non-Agency | 9,373,059 |
| | 68,424 |
| | (676,033 | ) | | (653,613 | ) | | 2,496,912 |
| | 491,094 |
| | (5,912 | ) | | 2,982,094 |
|
Total | $ | 29,396,680 |
| | $ | 1,370,959 |
| | $ | (700,671 | ) | | $ | (653,613 | ) | | $ | 20,856,658 |
| | $ | 544,198 |
| | $ | (180,037 | ) | | $ | 21,220,819 |
|
The following tables present the carrying value of the Company’s AFS securities by rate type as of March 31, 2018 and December 31, 2017:
|
| | | | | | | | | | | |
| March 31, 2018 |
(in thousands) | Agency | | Non-Agency | | Total |
Adjustable Rate | $ | 21,523 |
| | $ | 2,695,195 |
| | $ | 2,716,718 |
|
Fixed Rate | 18,020,641 |
| | 322,018 |
| | 18,342,659 |
|
Total | $ | 18,042,164 |
| | $ | 3,017,213 |
| | $ | 21,059,377 |
|
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
|
| | | | | | | | | | | |
| December 31, 2017 |
(in thousands) | Agency | | Non-Agency | | Total |
Adjustable Rate | $ | 23,220 |
| | $ | 2,622,710 |
| | $ | 2,645,930 |
|
Fixed Rate | 18,215,505 |
| | 359,384 |
| | 18,574,889 |
|
Total | $ | 18,238,725 |
| | $ | 2,982,094 |
| | $ | 21,220,819 |
|
The following table presents the Company’s AFS securities according to their estimated weighted average life classifications as of March 31, 2018:
|
| | | | | | | | | | | |
| March 31, 2018 |
(in thousands) | Agency | | Non-Agency | | Total |
≤ 1 year | $ | 9,912 |
| | $ | 58,342 |
| | $ | 68,254 |
|
> 1 and ≤ 3 years | 35,720 |
| | 107,516 |
| | 143,236 |
|
> 3 and ≤ 5 years | 289,226 |
| | 445,016 |
| | 734,242 |
|
> 5 and ≤ 10 years | 14,137,540 |
| | 1,819,124 |
| | 15,956,664 |
|
> 10 years | 3,569,766 |
| | 587,215 |
| | 4,156,981 |
|
Total | $ | 18,042,164 |
| | $ | 3,017,213 |
| | $ | 21,059,377 |
|
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 three months ended March 31, 2018 and 2017 of the net unamortized discount/premium and designated credit reserves on non-Agency AFS securities.
|
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended March 31, |
| 2018 | | 2017 |
(in thousands) | Designated Credit Reserve | | Net Unamortized Discount/Premium | | Total | | Designated Credit Reserve | | Net Unamortized Discount/Premium | | Total |
Beginning balance at January 1 | $ | (653,613 | ) | | $ | (607,609 | ) | | $ | (1,261,222 | ) | | $ | (367,437 | ) | | $ | (623,440 | ) | | $ | (990,877 | ) |
Acquisitions | (73,882 | ) | | (3,733 | ) | | (77,615 | ) | | (88,719 | ) | | (71,471 | ) | | (160,190 | ) |
Accretion of net discount | — |
| | 22,154 |
| | 22,154 |
| | — |
| | 22,183 |
| | 22,183 |
|
Realized credit losses | 5,482 |
| | — |
| | 5,482 |
| | 4,546 |
| | — |
| | 4,546 |
|
Reclassification adjustment for other-than-temporary impairments | (94 | ) | | — |
| | (94 | ) | | — |
| | — |
| | — |
|
Transfers from (to) | 10,090 |
| | (10,090 | ) | | — |
| | 8,754 |
| | (8,754 | ) | | — |
|
Sales, calls, other | — |
| | 18,430 |
| | 18,430 |
| | — |
| | 21,089 |
| | 21,089 |
|
Ending balance at March 31 | $ | (712,017 | ) | | $ | (580,848 | ) | | $ | (1,292,865 | ) | | $ | (442,856 | ) | | $ | (660,393 | ) | | $ | (1,103,249 | ) |
TWO HARBORS INVESTMENT CORP.
Notes to the 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 March 31, 2018 and December 31, 2017. At March 31, 2018, the Company held 1,443 AFS securities, of which 503 were in an unrealized loss position for less than twelve consecutive months and 227 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2017, the Company held 1,435 AFS securities, of which 253 were in an unrealized loss position for less than twelve consecutive months and 234 were in an unrealized loss position for more than twelve consecutive months. Of the $15.1 billion and $12.2 billion of AFS securities in an unrealized loss position for less than twelve consecutive months as of March 31, 2018 and December 31, 2017, $14.9 billion, or 98.5%, and $12.0 billion, or 98.5%, respectively, were Agency AFS securities, whose principal and interest are guaranteed by the GSEs.
|
| | | | | | | | | | | | | | | | | | | | | | | |
| Unrealized Loss Position for |
| Less than 12 Months | | 12 Months or More | | Total |
(in thousands) | Estimated Fair Value | | Gross Unrealized Losses | | Estimated Fair Value | | Gross Unrealized Losses | | Estimated Fair Value | | Gross Unrealized Losses |
March 31, 2018 | $ | 15,120,927 |
| | $ | (347,280 | ) | | $ | 2,355,005 |
| | $ | (172,142 | ) | | $ | 17,475,932 |
| | $ | (519,422 | ) |
December 31, 2017 | $ | 12,198,870 |
| | $ | (65,313 | ) | | $ | 2,464,544 |
| | $ | (114,724 | ) | | $ | 14,663,414 |
| | $ | (180,037 | ) |
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 loss 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.
During the three months ended March 31, 2018, the Company recorded $0.1 million in other-than-temporary credit impairments on one non-Agency security where its future expected cash flows were less than its amortized cost. The Company did not record any other-than-temporary credit impairments during the three months ended March 31, 2017. As of March 31, 2018, impaired securities with a carrying value of $116.8 million had actual weighted average cumulative losses of 5.7%, weighted average three-month prepayment speed of 5.4%, weighted average 60+ day delinquency of 22.0% of the pool balance, and weighted average FICO score of 658. At March 31, 2018, 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.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
The following table presents the changes in OTTI included in earnings for the three months ended March 31, 2018 and 2017:
|
| | | | | | | |
| Three Months Ended |
| March 31, |
(in thousands) | 2018 | | 2017 |
Cumulative credit loss at beginning of period | $ | (6,395 | ) | | $ | (5,606 | ) |
Additions: | | | |
Other-than-temporary impairments not previously recognized | — |
| | — |
|
Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments | (94 | ) | | — |
|
Reductions: | | | |
Decreases related to other-than-temporary impairments on securities paid down | — |
| | — |
|
Decreases related to other-than-temporary impairments on securities sold | — |
| | — |
|
Cumulative credit loss at end of period | $ | (6,489 | ) | | $ | (5,606 | ) |
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 loss on investment securities in the Company’s condensed consolidated statements of comprehensive (loss) income. For the three months ended March 31, 2018 and 2017, the Company sold AFS securities for $2.0 billion and $2.4 billion with an amortized cost of $2.1 billion and $2.5 billion for net realized losses of $19.6 million and $50.4 million, respectively.
The following table presents the gross realized gains and losses on sales of AFS securities for the three months ended March 31, 2018 and 2017:
|
| | | | | | | |
| Three Months Ended |
| March 31, |
(in thousands) | 2018 | | 2017 |
Gross realized gains | $ | 8,195 |
| | $ | 8,731 |
|
Gross realized losses | (27,758 | ) | | (59,134 | ) |
Total realized losses on sales, net | $ | (19,563 | ) | | $ | (50,403 | ) |
Note 5. Servicing Activities
Mortgage Servicing Rights, at Fair Value
One of the Company’s wholly owned subsidiaries has approvals from Fannie Mae and Freddie Mac 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 appropriately licensed subservicers to handle substantially all servicing functions in the name of the subservicer for the loans underlying the Company’s MSR.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
The following table summarizes activity related to MSR for the three months ended March 31, 2018 and 2017.
|
| | | | | | | |
| Three Months Ended |
| March 31, |
(in thousands) | 2018 | | 2017 |
Balance at beginning of period | $ | 1,086,717 |
| | $ | 693,815 |
|
Additions from purchases of mortgage servicing rights | 146,899 |
| | 76,956 |
|
Additions from sales of residential mortgage loans | — |
| | 20 |
|
Changes in fair value due to: | | | |
Changes in valuation inputs or assumptions used in the valuation model | 100,709 |
| | 3,182 |
|
Other changes in fair value (1) | (29,202 | ) | | (17,997 | ) |
Other changes (2) | (4,100 | ) | | (8,396 | ) |
Balance at end of period | $ | 1,301,023 |
| | $ | 747,580 |
|
____________________
| |
(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. |
At March 31, 2018 and December 31, 2017, the Company pledged MSR with a carrying value of $826.5 million and $584.2 million, respectively, as collateral for repurchase agreements and revolving credit facilities. See Note 13 - Repurchase Agreements and Note 15 - Revolving Credit Facilities.
As of March 31, 2018 and December 31, 2017, 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:
|
| | | | | | | |
(dollars in thousands) | March 31, 2018 | | December 31, 2017 |
Weighted average prepayment speed: | 8.1 | % | | 9.8 | % |
Impact on fair value of 10% adverse change | $ | (38,597 | ) | | $ | (40,100 | ) |
Impact on fair value of 20% adverse change | $ | (75,373 | ) | | $ | (77,483 | ) |
Weighted average delinquency: | 1.8 | % | | 1.7 | % |
Impact on fair value of 10% adverse change | $ | (5,161 | ) | | $ | (4,274 | ) |
Impact on fair value of 20% adverse change | $ | (10,712 | ) | | $ | (8,875 | ) |
Weighted average discount rate: | 10.4 | % | | 9.9 | % |
Impact on fair value of 10% adverse change | $ | (44,278 | ) | | $ | (35,137 | ) |
Impact on fair value of 20% adverse change | $ | (85,824 | ) | | $ | (68,246 | ) |
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.
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 its Agency RMBS portfolio.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
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, 2018 and 2017:
|
| | | | | | | |
| Three Months Ended |
| March 31, |
(in thousands) | 2018 | | 2017 |
Servicing fee income | $ | 66,449 |
| | $ | 38,500 |
|
Ancillary and other fee income | 322 |
| | 140 |
|
Float income | 4,419 |
| | 1,133 |
|
Total | $ | 71,190 |
| | $ | 39,773 |
|
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 $28.2 million and $31.1 million and were included in other assets on the condensed consolidated balance sheets as of March 31, 2018 and December 31, 2017, respectively.
Serviced Mortgage Assets
The Company’s total serviced mortgage assets consist of loans underlying MSR, residential mortgage loans held in previous on-balance sheet securitization trusts for which the Company is the named servicing administrator and loans owned and classified as residential mortgage loans held-for-sale. 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, 2018 and December 31, 2017:
|
| | | | | | | | | | | | | |
| March 31, 2018 | | December 31, 2017 |
(dollars in thousands) | Number of Loans | | Unpaid Principal Balance | | Number of Loans | | Unpaid Principal Balance |
Mortgage servicing rights | 500,338 |
| | $ | 111,703,234 |
| | 454,028 |
| | $ | 101,344,054 |
|
Residential mortgage loans in securitization trusts | 3,791 |
| | 2,562,653 |
| | 3,845 |
| | 2,618,016 |
|
Residential mortgage loans held-for-sale | 225 |
| | 36,016 |
| | 236 |
| | 37,632 |
|
Other assets | 22 |
| | 2,238 |
| | 24 |
| | 2,590 |
|
Total serviced mortgage assets | 504,376 |
| | $ | 114,304,141 |
| | 458,133 |
| | $ | 104,002,292 |
|
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 March 31, 2018 and December 31, 2017:
|
| | | | | | | |
(in thousands) | March 31, 2018 | | December 31, 2017 |
Unpaid principal balance | $ | 36,016 |
| | $ | 37,632 |
|
Fair value adjustment | (6,588 | ) | | (7,218 | ) |
Carrying value | $ | 29,428 |
| | $ | 30,414 |
|
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
Note 7. Cash, Cash Equivalents and Restricted Cash
Cash and cash equivalents include cash held in bank accounts and cash held in money market funds on an overnight basis.
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, 2018 and December 31, 2017:
|
| | | | | | | |
(in thousands) | March 31, 2018 | | December 31, 2017 |
Restricted cash balances held by trading counterparties: | | | |
For securities and loan trading activity | $ | 27,050 |
| | $ | 27,050 |
|
For derivatives trading activity | 228,941 |
| | 191,421 |
|
As restricted collateral for repurchase agreements and Federal Home Loan Bank advances | 456,453 |
| | 417,018 |
|
Total restricted cash balances held by trading counterparties | 712,444 |
| | 635,489 |
|
Restricted cash balance pursuant to letter of credit on office lease | 347 |
| | 347 |
|
Total | $ | 712,791 |
| | $ | 635,836 |
|
The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported on the Company’s condensed consolidated balance sheets as of March 31, 2018 and December 31, 2017 that sum to the total of the same such amounts shown in the statements of cash flows:
|
| | | | | | | |
(in thousands) | March 31, 2018 | | December 31, 2017 |
Cash and cash equivalents | $ | 388,450 |
| | $ | 419,159 |
|
Restricted cash | 712,791 |
| | 635,836 |
|
Total cash, cash equivalents and restricted cash | $ | 1,101,241 |
| | $ | 1,054,995 |
|
Note 8. Accrued Interest Receivable
The following table presents the Company’s accrued interest receivable by collateral type as of March 31, 2018 and December 31, 2017:
|
| | | | | | | |
(in thousands) | March 31, 2018 | | December 31, 2017 |
Available-for-sale securities: | | | |
Agency | | | |
Federal National Mortgage Association | $ | 46,490 |
| | $ | 46,517 |
|
Federal Home Loan Mortgage Corporation | 11,401 |
| | 12,255 |
|
Government National Mortgage Association | 4,687 |
| | 4,635 |
|
Non-Agency | 4,641 |
| | 4,740 |
|
Total available-for-sale securities | 67,219 |
| | 68,147 |
|
Residential mortgage loans held-for-sale | 151 |
| | 162 |
|
Total | $ | 67,370 |
| | $ | 68,309 |
|
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
Note 9. Derivative Instruments and Hedging Activities
The Company enters into a variety of derivative and non-derivative instruments in connection with its risk management activities. The 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, principally market risk and cash flow volatility associated with interest rate risk (including associated prepayment risk). Specifically, the Company enters into derivative and non-derivative instruments to economically hedge interest rate risk or “duration mismatch (or gap)” by adjusting the duration of its floating-rate borrowings into fixed-rate borrowings to more closely match the duration of its assets. This particularly applies to floating-rate borrowing agreements with maturities or interest rate resets of less than six months. Typically, the interest receivable terms (i.e., LIBOR) of certain derivatives match the terms of the underlying debt, resulting in an effective conversion of the rate of the related borrowing agreement from floating to fixed. The objective is to manage the cash flows associated with current and anticipated interest payments on borrowings, as well as the ability to roll or refinance borrowings at the desired amount by adjusting the duration.
To help manage the adverse impact of interest rate changes on the value of the Company’s portfolio as well as its cash flows, the Company may, at times, enter into various forward contracts, including short securities, Agency to-be-announced securities, or TBAs, options, futures, swaps, caps and total return swaps. In executing on the Company’s current risk management strategy, the Company has entered into interest rate swap and swaption agreements, TBAs, put and call options for TBAs 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 MSR and Agency interest-only securities (see discussion below).
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 these risks. The discussion includes both derivative and non-derivative instruments used as part of these risk management activities. Any of the Company’s derivative and non-derivative instruments may be entered into in conjunction with one another in order to mitigate risks. As a result, the following discussions of each type of instrument should be read as a collective representation of the Company’s risk mitigation efforts and should not be considered independent of one another. 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 are designated or qualifying as hedge instruments. Due to the volatility of the credit markets and difficulty in effectively matching pricing or cash flows, the Company has not designated any current derivatives as hedging instruments.
The following tables present the gross fair value and notional amounts of the Company’s derivative financial instruments treated as trading derivatives as of March 31, 2018 and December 31, 2017.
|
| | | | | | | | | | | | | | | | |
| | March 31, 2018 |
| | Derivative Assets | | Derivative Liabilities |
(in thousands) | | Fair Value | | Notional | | Fair Value | | Notional |
Inverse interest-only securities | | $ | 82,388 |
| | $ | 558,942 |
| | $ | — |
| | $ | — |
|
Interest rate swap agreements | | 175,525 |
| | 18,932,825 |
| | — |
| | 4,666,000 |
|
Swaptions, net | | 7,146 |
| | 2,115,000 |
| | (18,977 | ) | | 4,060,000 |
|
TBAs | | 8,117 |
| | 3,565,000 |
| | (19,964 | ) | | 3,120,000 |
|
Put and call options for TBAs, net | | 872 |
| | 785,000 |
| | (6,957 | ) | | 845,000 |
|
Markit IOS total return swaps | | — |
| | — |
| | (176 | ) | | 61,521 |
|
Total | | $ | 274,048 |
| | $ | 25,956,767 |
| | $ | (46,074 | ) | | $ | 12,752,521 |
|
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements (unaudited)
|
| | | | | | | | | | | | | | | | |
| | December 31, 2017 |
| | Derivative Assets | | Derivative Liabilities |
(in thousands) | | Fair Value | | Notional | | Fair Value | | Notional |
Inverse interest-only securities | | $ | 91,827 |
| | $ | 588,246 |
| | $ | — |
| | $ | — |
|
Interest rate swap agreements | | 206,773 |
| | 21,516,125 |
| | (29,867 | ) | | 6,966,000 |
|
Swaptions, net | | 10,405 |
| | 2,666,000 |
| | — |
| | — |
|
TBAs | | 913 |
| | 733,000 |
| | |