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)

Maryland
 
27-0312904
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
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):
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.
 
 
 
 
 


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 (unaudited)
(in thousands, except share data)
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

Restricted cash
712,791

 
635,836

Accrued interest receivable
67,370

 
68,309

Due from counterparties
85,319

 
842,303

Derivative assets, at fair value
274,048

 
309,918

Other assets
159,359

 
175,838

Total Assets
$
24,077,165

 
$
24,789,313

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Liabilities
 
 
 
Repurchase agreements
$
19,148,679

 
$
19,451,207

Federal Home Loan Bank advances
865,024

 
1,215,024

Revolving credit facilities
20,000

 
20,000

Convertible senior notes
283,054

 
282,827

Derivative liabilities, at fair value
46,074

 
31,903

Due to counterparties
39,809

 
88,898

Dividends payable
96,201

 
12,552

Accrued interest payable
85,405

 
87,698

Other liabilities
25,234

 
27,780

Total Liabilities
20,609,480

 
21,217,889

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

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

Additional paid-in capital
3,674,411

 
3,672,003

Accumulated other comprehensive (loss) income
(46
)
 
334,813

Cumulative earnings
2,711,495

 
2,386,604

Cumulative distributions to stockholders
(3,622,479
)
 
(3,526,278
)
Total Stockholders’ Equity
3,467,685

 
3,571,424

Total Liabilities and Stockholders’ Equity
$
24,077,165

 
$
24,789,313

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

1

Table of Contents



TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME (unaudited)
(in thousands, except share data)
 
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

Residential mortgage loans held-for-sale
307

 
398

Other
2,996

 
1,801

Total interest income
194,019

 
169,154

Interest expense:
 
 
 
Repurchase agreements
86,580

 
32,256

Collateralized borrowings in securitization trusts

 
25,386

Federal Home Loan Bank advances
4,458

 
8,793

Revolving credit facilities
804

 
429

Convertible senior notes
4,718

 
3,821

Total interest expense
96,560

 
70,685

Net interest income
97,459

 
98,469

Other-than-temporary impairments:

 

Total other-than-temporary impairment losses
(94
)
 

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

Gain (loss) on other derivative instruments
8,053

 
(27,864
)
Other income
1,058

 
9,496

Total other income (loss)
281,982

 
(35,585
)
Expenses:
 
 
 
Management fees
11,708

 
9,808

Servicing expenses
14,554

 
5,298

Other operating expenses
14,492

 
13,764

Total expenses
40,754

 
28,870

Income from continuing operations before income taxes
338,593

 
34,014

Provision for (benefit from) income taxes
3,784

 
(24,517
)
Net income from continuing operations
334,809

 
58,531

Income from discontinued operations, net of tax

 
13,454

Net income
334,809

 
71,985

Dividends on preferred stock
13,747

 

Net income attributable to common stockholders
$
321,062

 
$
71,985

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 (unaudited), continued
(in thousands, except share data)
 
Three Months Ended
 
March 31,
 
2018
 
2017
Basic earnings per weighted average common share:
 
 
 
Continuing operations
$
1.83

 
$
0.33

Discontinued operations

 
0.08

Net income
$
1.83

 
$
0.41

Diluted earnings per weighted average common share:
 
 
 
Continuing operations
$
1.69

 
$
0.33

Discontinued operations

 
0.08

Net income
$
1.69

 
$
0.41

Dividends declared per common share
$
0.47

 
$
0.50

Weighted average number of shares of common stock:
 
 
 
Basic
175,145,964

 
174,281,965

Diluted
192,818,531

 
174,281,965

Comprehensive (loss) income:
 
 
 
Net income
$
334,809

 
$
71,985

Other comprehensive (loss) income, net of tax:
 
 
 
Unrealized (loss) gain on available-for-sale securities
(344,777
)
 
73,762

Other comprehensive (loss) income
(344,777
)
 
73,762

Comprehensive (loss) income
(9,968
)
 
145,747

Dividends on preferred stock
13,747

 

Comprehensive (loss) income attributable to common stockholders
$
(23,715
)
 
$
145,747

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 (unaudited)
(in thousands, except share data)
 
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

Net income

 

 

 

 

 

 
71,985

 

 
71,985

Other comprehensive income before reclassifications, net of tax expense of $20,591

 

 

 

 

 
64,449

 

 

 
64,449

Amounts reclassified from accumulated other comprehensive income, net of tax expense of $6,386

 

 

 

 

 
9,313

 

 

 
9,313

Other comprehensive income, net of tax expense of $26,977

 

 

 

 

 
73,762

 

 

 
73,762

Issuance of preferred stock, net of offering costs
138,872

 

 

 

 

 

 

 

 
138,872

Issuance of common stock, net of offering costs

 

 

 

 
102

 

 

 

 
102

Common dividends declared

 

 

 

 

 

 

 
(87,228
)
 
(87,228
)
Non-cash equity award compensation

 

 

 
6

 
3,951

 

 

 

 
3,957

Balance, March 31, 2017
$
138,872

 
$

 
$

 
$
1,744

 
$
3,665,765

 
$
272,989

 
$
2,110,018

 
$
(2,586,827
)
 
$
3,602,561

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


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

Cumulative effect of adoption of new accounting principle

 

 

 

 

 
9,918

 
(9,918
)
 

 

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

Net income

 

 

 

 

 

 
334,809

 

 
334,809

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

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.

4

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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
(in thousands)
 
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

Proceeds from repayment of residential mortgage loans held-for-sale
1,120

 
3,995

Net change in assets and liabilities:


 
 
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

Decrease in prepaid and fixed assets
393

 
306

(Increase) decrease in other receivables
(5,032
)
 
11,343

Decrease in servicing advances
2,871

 
1,466

(Decrease) increase in accrued interest payable
(2,293
)
 
11,159

Increase in income taxes payable

 
30

Decrease in accrued expenses and other liabilities
(2,546
)
 
(13,501
)
Net cash provided by operating activities of discontinued operations

 
9,294

Net cash provided by operating activities
$
203,143

 
$
162,264

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 (unaudited), continued
(in thousands)
 
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.

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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.

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Table of Contents



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.

8

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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.

9

Table of Contents

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.


10

Table of Contents

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.


11

Table of Contents

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


12

Table of Contents

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.

13

Table of Contents

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


14

Table of Contents

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
)


15

Table of Contents

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.

16

Table of Contents

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.

17

Table of Contents

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.

18

Table of Contents

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



19

Table of Contents

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



20

Table of Contents

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


21

Table of Contents

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