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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, 2020
OR
|
| |
☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
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)
Securities Registered Pursuant to Section 12(b) of the Act:
|
| | | | |
Title of Each Class: | | Trading Symbol(s) | | Name of Exchange on Which Registered: |
Common Stock, par value $0.01 per share | | TWO | | New York Stock Exchange |
8.125% Series A Cumulative Redeemable Preferred Stock | | TWO PRA | | New York Stock Exchange |
7.625% Series B Cumulative Redeemable Preferred Stock | | TWO PRB | | New York Stock Exchange |
7.25% Series C Cumulative Redeemable Preferred Stock | | TWO PRC | | New York Stock Exchange |
7.75% Series D Cumulative Redeemable Preferred Stock | | TWO PRD | | New York Stock Exchange |
7.50% Series E Cumulative Redeemable Preferred Stock | | TWO PRE | | New York Stock Exchange |
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 ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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.
|
| | | |
Large accelerated filer | ☒ | Accelerated filer | ☐ |
Non-accelerated filer | ☐ | Smaller reporting company | ☐ |
| | Emerging growth company | ☐ |
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. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒
As of May 5, 2020, there were 273,531,853 shares of outstanding common stock, par value $.01 per share, issued and outstanding.
TWO HARBORS INVESTMENT CORP.
INDEX
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| | Page |
| PART I - FINANCIAL INFORMATION | |
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| | |
| | |
| | |
| | |
| | |
| | |
| PART II - OTHER INFORMATION | |
| | |
| | |
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| | |
| | |
| | |
| | |
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| |
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
|
| | | | | | | |
| March 31, 2020 | | December 31, 2019 |
ASSETS | (unaudited) | | |
Available-for-sale securities, at fair value (amortized cost $17,279,572; allowance for credit losses $41,390) | $ | 17,733,059 |
| | $ | 31,406,328 |
|
Mortgage servicing rights, at fair value | 1,505,163 |
| | 1,909,444 |
|
Cash and cash equivalents | 1,206,889 |
| | 558,136 |
|
Restricted cash | 680,395 |
| | 1,058,690 |
|
Accrued interest receivable | 57,854 |
| | 92,634 |
|
Due from counterparties | 581,355 |
| | 318,963 |
|
Derivative assets, at fair value | 117,368 |
| | 188,051 |
|
Reverse repurchase agreements | 147,651 |
| | 220,000 |
|
Other assets | 172,914 |
| | 169,376 |
|
Total Assets (1) | $ | 22,202,648 |
| | $ | 35,921,622 |
|
LIABILITIES AND STOCKHOLDERS’ EQUITY | | | |
Liabilities | | | |
Repurchase agreements | $ | 17,795,516 |
| | $ | 29,147,463 |
|
Federal Home Loan Bank advances | 50,000 |
| | 210,000 |
|
Revolving credit facilities | 252,143 |
| | 300,000 |
|
Term notes payable | 394,772 |
| | 394,502 |
|
Convertible senior notes | 285,238 |
| | 284,954 |
|
Derivative liabilities, at fair value | 176,156 |
| | 6,740 |
|
Due to counterparties | 200,729 |
| | 259,447 |
|
Dividends payable | — |
| | 128,125 |
|
Accrued interest payable | 79,543 |
| | 149,626 |
|
Other liabilities | 64,418 |
| | 70,299 |
|
Total Liabilities (1) | 19,298,515 |
| | 30,951,156 |
|
Stockholders’ Equity | | | |
Preferred stock, par value $0.01 per share; 50,000,000 shares authorized and 40,050,000 and 40,050,000 shares issued and outstanding, respectively ($1,001,250 and $1,001,250 liquidation preference, respectively) | 977,501 |
| | 977,501 |
|
Common stock, par value $0.01 per share; 450,000,000 shares authorized and 273,528,243 and 272,935,731 shares issued and outstanding, respectively | 2,735 |
| | 2,729 |
|
Additional paid-in capital | 5,156,151 |
| | 5,154,764 |
|
Accumulated other comprehensive income | 491,330 |
| | 689,400 |
|
Cumulative earnings | 786,235 |
| | 2,655,891 |
|
Cumulative distributions to stockholders | (4,509,819 | ) | | (4,509,819 | ) |
Total Stockholders’ Equity | 2,904,133 |
| | 4,970,466 |
|
Total Liabilities and Stockholders’ Equity | $ | 22,202,648 |
| | $ | 35,921,622 |
|
____________________
| |
(1) | The condensed consolidated balance sheets include assets and liabilities of consolidated variable interest entities, or VIEs. At March 31, 2020 and December 31, 2019, assets of the VIEs totaled $395,316 and $395,008, and liabilities of the VIEs totaled $395,316 and $395,008, respectively. See Note 3 - Variable Interest Entities for additional information. |
The accompanying notes are an integral part of these condensed consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME (unaudited)
(in thousands, except share data)
|
| | | | | | | |
| Three Months Ended |
| March 31, |
| 2020 | | 2019 |
Interest income: | |
Available-for-sale securities | $ | 248,684 |
| | $ | 235,886 |
|
Other | 6,823 |
| | 9,597 |
|
Total interest income | 255,507 |
| | 245,483 |
|
Interest expense: | | | |
Repurchase agreements | 152,605 |
| | 147,560 |
|
Federal Home Loan Bank advances | 1,592 |
| | 6,074 |
|
Revolving credit facilities | 3,531 |
| | 5,156 |
|
Term notes payable | 4,804 |
| | — |
|
Convertible senior notes | 4,776 |
| | 4,735 |
|
Total interest expense | 167,308 |
| | 163,525 |
|
Net interest income | 88,199 |
| | 81,958 |
|
Other-than-temporary impairments: | | | |
Total other-than-temporary impairment losses | — |
| | (206 | ) |
Other income (loss): | | | |
Loss on investment securities | (1,081,607 | ) | | (19,292 | ) |
Servicing income | 130,797 |
| | 116,948 |
|
Loss on servicing asset | (586,665 | ) | | (188,974 | ) |
Loss on interest rate swap, cap and swaption agreements | (250,596 | ) | | (83,259 | ) |
(Loss) gain on other derivative instruments | (133,468 | ) | | 104,278 |
|
Other income | 798 |
| | 123 |
|
Total other loss | (1,920,741 | ) | | (70,176 | ) |
Expenses: | | | |
Management fees | 14,550 |
| | 12,082 |
|
Servicing expenses | 19,905 |
| | 19,912 |
|
Other operating expenses | 15,797 |
| | 15,556 |
|
Total expenses | 50,252 |
| | 47,550 |
|
Loss before income taxes | (1,882,794 | ) | | (35,974 | ) |
Benefit from income taxes | (13,138 | ) | | (10,039 | ) |
Net loss | (1,869,656 | ) | | (25,935 | ) |
Dividends on preferred stock | 18,950 |
| | 18,950 |
|
Net loss attributable to common stockholders | $ | (1,888,606 | ) | | $ | (44,885 | ) |
Basic loss per weighted average common share | $ | (6.91 | ) | | $ | (0.18 | ) |
Diluted loss per weighted average common share | $ | (6.91 | ) | | $ | (0.18 | ) |
Dividends declared per common share | $ | — |
| | $ | 0.47 |
|
Weighted average number of shares of common stock: | | | |
Basic | 273,392,615 |
| | 252,357,878 |
|
Diluted | 273,392,615 |
| | 252,357,878 |
|
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)
|
| | | | | | | |
| Three Months Ended |
| March 31, |
| 2020 | | 2019 |
Comprehensive (loss) income: | | | |
Net loss | $ | (1,869,656 | ) | | $ | (25,935 | ) |
Other comprehensive (loss) income, net of tax: | | | |
Unrealized (loss) gain on available-for-sale securities | (198,070 | ) | | 356,152 |
|
Other comprehensive (loss) income | (198,070 | ) | | 356,152 |
|
Comprehensive (loss) income | (2,067,726 | ) | | 330,217 |
|
Dividends on preferred stock | 18,950 |
| | 18,950 |
|
Comprehensive (loss) income attributable to common stockholders | $ | (2,086,676 | ) | | $ | 311,267 |
|
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)
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
| 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, 2018 | $ | 977,501 |
| | $ | 2,481 |
| | $ | 4,809,616 |
| | $ | 110,817 |
| | $ | 2,332,371 |
| | $ | (3,978,297 | ) | | $ | 4,254,489 |
|
Cumulative effect of adoption of new accounting principle | — |
| | — |
| | — |
| | — |
| | (442 | ) | | — |
| | (442 | ) |
Adjusted balance, January 1, 2019 | 977,501 |
| | 2,481 |
| | 4,809,616 |
| | 110,817 |
| | 2,331,929 |
| | (3,978,297 | ) | | 4,254,047 |
|
Net loss | — |
| | — |
| | — |
| | — |
| | (25,935 | ) | | — |
| | (25,935 | ) |
Other comprehensive income before reclassifications, net of tax | — |
| | — |
| | — |
| | 327,840 |
| | — |
| | — |
| | 327,840 |
|
Amounts reclassified from accumulated other comprehensive income, net of tax | — |
| | — |
| | — |
| | 28,312 |
| | — |
| | — |
| | 28,312 |
|
Other comprehensive income, net of tax | — |
| | — |
| | — |
| | 356,152 |
| | — |
| | — |
| | 356,152 |
|
Issuance of common stock, net of offering costs | — |
| | 243 |
| | 335,035 |
| | — |
| | — |
| | — |
| | 335,278 |
|
Preferred dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | (18,950 | ) | | (18,950 | ) |
Common dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | (128,229 | ) | | (128,229 | ) |
Non-cash equity award compensation | — |
| | 4 |
| | 1,857 |
| | — |
| | — |
| | — |
| | 1,861 |
|
Balance, March 31, 2019 | 977,501 |
| | 2,728 |
| | 5,146,508 |
| | 466,969 |
| | 2,305,994 |
| | (4,125,476 | ) | | 4,774,224 |
|
| | | | | | | | | | | | | |
Balance, December 31, 2019 | $ | 977,501 |
| | $ | 2,729 |
| | $ | 5,154,764 |
| | $ | 689,400 |
| | $ | 2,655,891 |
| | $ | (4,509,819 | ) | | $ | 4,970,466 |
|
Net loss | — |
| | — |
| | — |
| | — |
| | (1,869,656 | ) | | — |
| | (1,869,656 | ) |
Other comprehensive income before reclassifications, net of tax | — |
| | — |
| | — |
| | 193,536 |
| | — |
| | — |
| | 193,536 |
|
Amounts reclassified from accumulated other comprehensive income, net of tax | — |
| | — |
| | — |
| | (391,606 | ) | | — |
| | — |
| | (391,606 | ) |
Other comprehensive loss, net of tax | — |
| | — |
| | — |
| | (198,070 | ) | | — |
| | — |
| | (198,070 | ) |
Issuance of common stock, net of offering costs | — |
| | — |
| | 142 |
| | — |
| | — |
| | — |
| | 142 |
|
Repurchase of common stock | — |
| | (1 | ) | | (1,063 | ) | | — |
| | — |
| | — |
| | (1,064 | ) |
Preferred dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
|
Common dividends declared | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
|
Non-cash equity award compensation | — |
| | 7 |
| | 2,308 |
| | — |
| | — |
| | — |
| | 2,315 |
|
Balance, March 31, 2020 | $ | 977,501 |
| | $ | 2,735 |
| | $ | 5,156,151 |
| | $ | 491,330 |
| | $ | 786,235 |
| | $ | (4,509,819 | ) | | $ | 2,904,133 |
|
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)
|
| | | | | | | |
| Three Months Ended |
| March 31, |
| 2020 | | 2019 |
Cash Flows From Operating Activities: | | | |
Net loss | $ | (1,869,656 | ) | | $ | (25,935 | ) |
Adjustments to reconcile net loss to net cash provided by operating activities: | | | |
Amortization of premiums and discounts on investment securities, net | 41,387 |
| | 22,052 |
|
Amortization of deferred debt issuance costs on term notes payable and convertible senior notes | 554 |
| | 243 |
|
Other-than-temporary impairment losses | — |
| | 206 |
|
Provision for credit losses on investment securities | 45,638 |
| | — |
|
Realized and unrealized losses on investment securities | 1,035,969 |
| | 19,292 |
|
Loss on servicing asset | 586,665 |
| | 188,974 |
|
Realized and unrealized loss on interest rate swaps, caps and swaptions | 237,980 |
| | 106,967 |
|
Unrealized loss (gain) on other derivative instruments | 64,589 |
| | (90,184 | ) |
Equity based compensation | 2,315 |
| | 1,861 |
|
Net change in assets and liabilities: |
|
| | |
Decrease in accrued interest receivable | 34,780 |
| | 8,655 |
|
Increase in deferred income taxes, net | (44,090 | ) | | (10,037 | ) |
Decrease in accrued interest payable | (70,083 | ) | | (50,692 | ) |
Change in other operating assets and liabilities, net | 34,158 |
| | (5,588 | ) |
Net cash provided by operating activities | 100,206 |
| | 165,814 |
|
Cash Flows From Investing Activities: | | | |
Purchases of available-for-sale securities | (4,354,636 | ) | | (4,551,312 | ) |
Proceeds from sales of available-for-sale securities | 15,586,752 |
| | 4,853,189 |
|
Principal payments on available-for-sale securities | 1,119,117 |
| | 487,649 |
|
Purchases of trading securities | (1,052,500 | ) | | — |
|
Proceeds from sales of trading securities | 1,053,477 |
| | — |
|
Purchases of mortgage servicing rights, net of purchase price adjustments | (180,951 | ) | | (210,193 | ) |
(Payments for) proceeds from sales of mortgage servicing rights | (1,433 | ) | | 289 |
|
(Purchases) short sales of derivative instruments, net | (3,630 | ) | | (17,344 | ) |
(Payments for termination and settlement) proceeds from sales and settlement of derivative instruments, net | (58,840 | ) | | (835,929 | ) |
Payments for reverse repurchase agreements | (1,591,621 | ) | | (901,375 | ) |
Proceeds from reverse repurchase agreements | 614,756 |
| | 1,663,190 |
|
(Decrease) increase in due to counterparties, net | (321,110 | ) | | 2,163,821 |
|
Change in other investing assets and liabilities, net | 508 |
| | 2,136 |
|
Net cash provided by investing activities | $ | 10,809,889 |
| | $ | 2,654,121 |
|
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, |
| 2020 | | 2019 |
Cash Flows From Financing Activities: | | | |
Proceeds from repurchase agreements | $ | 35,793,417 |
| | $ | 58,853,279 |
|
Principal payments on repurchase agreements | (46,096,150 | ) | | (62,257,064 | ) |
Proceeds from Federal Home Loan Bank advances | 585,000 |
| | — |
|
Principal payments on Federal Home Loan Bank advances | (745,000 | ) | | — |
|
Proceeds from revolving credit facilities | 25,000 |
| | 75,000 |
|
Principal payments on revolving credit facilities | (72,857 | ) | | (9,706 | ) |
Proceeds from issuance of common stock, net of offering costs | 142 |
| | 335,278 |
|
Repurchase of common stock | (1,064 | ) | | — |
|
Dividends paid on preferred stock | (18,950 | ) | | (18,950 | ) |
Dividends paid on common stock | (109,175 | ) | | (116,601 | ) |
Net cash used in financing activities | (10,639,637 | ) | | (3,138,764 | ) |
Net increase (decrease) in cash, cash equivalents and restricted cash | 270,458 |
| | (318,829 | ) |
Cash, cash equivalents and restricted cash at beginning of period | 1,616,826 |
| | 1,097,764 |
|
Cash, cash equivalents and restricted cash at end of period | $ | 1,887,284 |
| | $ | 778,935 |
|
Supplemental Disclosure of Cash Flow Information: | |
Cash paid for interest | $ | 236,043 |
| | $ | 214,217 |
|
Cash paid for taxes, net | $ | 119 |
| | $ | 15 |
|
Noncash Activities: | | | |
Cumulative-effect adjustment to equity for adoption of new accounting principle | $ | — |
| | $ | 442 |
|
Dividends declared but not paid at end of period | $ | — |
| | $ | 147,179 |
|
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 and managing Agency residential mortgage-backed securities, or Agency RMBS, non-Agency securities, mortgage servicing rights, or MSR, and other financial assets. The investment portfolio as a whole is managed by the Company’s Co-Chief Investment Officers 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.
As a result of the global COVID-19 pandemic, the Company experienced unprecedented market conditions during quarter ended March 31, 2020, including unusually significant spread widening in both Agency RMBS and non-Agency securities. In response, the Company focused its efforts on raising excess liquidity and de-risking its portfolio. On March 25, 2020, the Company sold substantially all of its non-Agency securities in order to eliminate the risks posed by continued outsized margin calls and ongoing funding concerns associated with the significant spread widening on these assets. The Company also sold approximately one-third of its Agency RMBS in order to reduce risk and raise cash to establish a strong defensive liquidity position to weather potential ongoing economic and market instability.
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. All trust entities in which the Company holds investments that are considered variable interest entities, or VIEs, for financial reporting purposes were reviewed for consolidation under the applicable consolidation guidance. Whenever the Company has both the power to direct the activities of a trust that most significantly impact the 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. Certain prior period amounts have been reclassified to conform to the current period presentation. 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, 2019. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at March 31, 2020 and results of operations for all periods presented have been made. The results of operations for the three months ended March 31, 2020 should not be construed as indicative of the results to be expected for future periods or the full year.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
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 in the market, 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 2019 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, 2020.
Recently Issued and/or Adopted Accounting Standards
Measurement of Credit Losses on Financial Instruments
On January 1, 2020, the Company adopted Accounting Standards Update (ASU) No. 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which changed the impairment model for most financial assets and certain other instruments. Allowances for credit losses on available-for-sale, or AFS, debt securities are recognized, rather than direct reductions in the amortized cost of the investments, regardless of whether the impairment is considered to be other-than-temporary. 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.
The Company uses a discounted cash flow method to estimate and recognize an allowance for credit losses on AFS securities. The estimated allowance for credit losses is equal to the difference between the prepayment adjusted contractual cash flows with no credit losses and the prepayment adjusted expected cash flows with credit losses, discounted at the effective interest rate on the AFS security that was in effect upon adoption of the standard. The contractual cash flows and expected cash flows are based on management’s best estimate and take into consideration current prepayment assumptions, lifetime expected losses based on past loss experience, current market conditions, and reasonable and supportable forecasts of future conditions. The allowance for credit losses causes an increase in the AFS security amortized cost and recognizes an allowance for credit losses in the same amount. The allowance for credit losses recognized in connection with adopting the guidance in Topic 326 on January 1, 2020 was equal to the present value of the credit reserve in place on December 31, 2019. As a result, no cumulative effect adjustment to opening cumulative earnings was required.
The adoption of this ASU impacts the Company’s accounting for the purchase of certain beneficial interests with purchased credit deterioration or when there is a “significant” difference between contractual cash flows and expected cash flows. For these securities, the Company records an allowance for credit losses with an increase in amortized cost above the purchase price of the same amount. Subsequent adverse or favorable changes in expected cash flows are recognized immediately in earnings as a provision for or reduction in credit losses, respectively. Adverse changes are reflected as an increase to the allowance for credit losses and favorable changes are reflected as a decrease to the allowance for credit losses. The allowance for credit losses is limited to the difference between the beneficial interest’s fair value and its amortized cost, and any remaining adverse changes in these circumstances are reflected as a prospective adjustment to accretable yield. If the allowance for credit losses has been reduced to zero, the remaining favorable changes are reflected as a prospective adjustment to accretable yield. The Company does not adjust the effective interest rate in subsequent periods for prepayment assumption changes or variable-rate changes. Any changes in the allowance for credit losses due to the time-value-of-money are accounted for in the condensed consolidated statements of comprehensive (loss) income as provision for credit losses rather than a reduction to interest income.
The standard applies to Agency and non-Agency securities that are accounted for as beneficial interests under Accounting Standards Codification (ASC) 325-40, Investments-Other: Beneficial Interests in Securitized Financial Assets, or ASC 325-40, and ASC 310-30, Receivables: Loans and Debt Securities Acquired with Deteriorated Credit Quality, or ASC 310-30. Only beneficial interests that were previously accounted for as purchased credit impaired under ASC 310-30 were accounted for as purchased credit deteriorated under Topic 326 on the transition date.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
Upon adoption of this ASU, the Company established an allowance for credit losses on AFS securities accounted for as purchased credit-impaired assets under ASC 310-30 in an unrealized loss position and with no other-than-temporary impairments, or OTTI, recognized in periods prior to transition. The effective interest rates on these debt securities remained unchanged. On January 1, 2020, the $30.7 billion net amortized cost basis of AFS securities was inclusive of a $244.9 million allowance for credit loss.
The Company used a prospective transition approach for debt securities for which OTTI had been recognized prior to January 1, 2020. As a result, the amortized cost basis remained the same before and after the effective date. The effective interest rate on these debt securities also remained unchanged. Amounts previously recognized in accumulated other comprehensive income as of January 1, 2020 relating to improvements in cash flows expected to be collected are accreted into income over the remaining life of the asset. Recoveries of amounts previously written off relating to improvements in cash flows after January 1, 2020 are recorded in earnings when received.
Note 3. Variable Interest Entities
During the second quarter of 2019, the Company formed a new trust entity, or the Issuer Trust, for the purpose of financing MSR through securitization. On June 27, 2019, the Company, through the Issuer Trust, completed an MSR securitization transaction pursuant to which, through two of the Company’s wholly owned subsidiaries, MSR is pledged to the Issuer Trust and in return, the Issuer Trust issued (a) an aggregate principal amount of $400.0 million in term notes to qualified institutional buyers and (b) a variable funding note, or VFN, with a maximum principal balance of $1.0 billion to one of the subsidiaries, in each case secured on a pari passu basis. The term notes bear interest at a rate equal to one-month LIBOR plus 2.80% per annum. The term notes will mature on June 25, 2024 or, if extended pursuant to the terms of the related indenture supplement, June 25, 2026 (unless earlier redeemed in accordance with their terms).
The Issuer Trust is considered a VIE for financial reporting purposes and, thus, was reviewed for consolidation under the applicable consolidation guidance. As the Company has both the power to direct the activities of the Issuer Trust that most significantly impact the entity’s performance, and the obligation to absorb losses or the right to receive benefits of the entity that could be significant, the Company consolidates the trust. Additionally, in accordance with arrangements entered into in connection with the securitization transaction, the Company has direct financial obligations payable to the Issuer Trust, which, in turn, support the Issuer Trust’s obligations to noteholders under the securitization transaction.
The following table presents a summary of the assets and liabilities of all consolidated trusts as reported on the condensed consolidated balance sheets as of March 31, 2020 and December 31, 2019:
|
| | | | | | | |
(in thousands) | March 31, 2020 | | December 31, 2019 |
Note receivable (1) | $ | 394,772 |
| | $ | 394,502 |
|
Cash and cash equivalents | 200 |
| | 200 |
|
Accrued interest receivable (1) | 344 |
| | 306 |
|
Total Assets | $ | 395,316 |
| | $ | 395,008 |
|
Term notes payable | $ | 394,772 |
| | $ | 394,502 |
|
Accrued interest payable | 344 |
| | 306 |
|
Other liabilities | 200 |
| | 200 |
|
Total Liabilities | $ | 395,316 |
| | $ | 395,008 |
|
____________________
| |
(1) | Receivables due from a wholly owned subsidiary of the Company to the Issuer Trust are eliminated in consolidation in accordance with U.S. GAAP. |
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
Note 4. Available-for-Sale Securities, at Fair Value
The Company holds both Agency and non-Agency AFS investment securities which are carried at fair value on the condensed consolidated balance sheets. As a result of the global COVID-19 pandemic, the Company experienced unprecedented market conditions during the quarter ended March 31, 2020, including unusually significant spread widening in both Agency RMBS and non-Agency securities. In response, the Company focused its efforts on raising excess liquidity and de-risking its portfolio. On March 25, 2020, the Company sold substantially all of its non-Agency securities in order to eliminate the risks posed by continued outsized margin calls and ongoing funding concerns associated with the significant spread widening on these assets. The Company also sold approximately one-third of its Agency RMBS in order to reduce risk and raise cash to establish a strong defensive liquidity position to weather potential ongoing economic and market instability.
The following table presents the Company’s AFS investment securities by collateral type as of March 31, 2020 and December 31, 2019:
|
| | | | | | | |
(in thousands) | March 31, 2020 | | December 31, 2019 |
Agency | | | |
Federal National Mortgage Association | $ | 14,362,782 |
| | $ | 21,252,575 |
|
Federal Home Loan Mortgage Corporation | 2,907,220 |
| | 6,070,500 |
|
Government National Mortgage Association | 436,657 |
| | 454,980 |
|
Non-Agency | 26,400 |
| | 3,628,273 |
|
Total available-for-sale securities | $ | 17,733,059 |
| | $ | 31,406,328 |
|
At March 31, 2020 and December 31, 2019, the Company pledged AFS securities with a carrying value of $17.7 billion and $29.8 billion, respectively, as collateral for repurchase agreements and advances from the Federal Home Loan Bank of Des Moines, or the FHLB. See Note 11 - Repurchase Agreements and Note 12 - Federal Home Loan Bank of Des Moines Advances.
At March 31, 2020 and December 31, 2019, 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 variable interest entities, or 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, 2020 and December 31, 2019, the carrying value, which also represents the maximum exposure to loss, of all non-Agency securities in unconsolidated VIEs was $26.4 million and $3.6 billion, respectively.
TWO HARBORS INVESTMENT CORP.
Notes to the Condensed Consolidated Financial Statements (unaudited)
The following tables present the amortized cost and carrying value of AFS securities by collateral type as of March 31, 2020 and December 31, 2019:
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| March 31, 2020 |
(in thousands) | Principal/ Current Face | | Un-amortized Premium | | Accretable Purchase Discount | | Amortized Cost | | Allowance for Credit Losses | | Unrealized Gain | | Unrealized Loss | | Carrying Value |
Agency | | | | | | | | | | | | | | | |
Principal and interest | $ | 16,316,075 |
| | $ | 764,966 |
| | $ | (17 | ) | | $ | 17,081,024 |
| | $ | — |
| | $ | 505,055 |
| | $ | (1,091 | ) | | $ | 17,584,988 |
|
Interest-only | 2,461,579 |
| | 158,209 |
| | — |
| | 158,209 |
| | (32,786 | ) | | 14,194 |
| | (17,946 | ) | | 121,671 |
|
Total Agency | 18,777,654 |
| | 923,175 |
| | (17 | ) | | 17,239,233 |
| | (32,786 | ) | | 519,249 |
| | (19,037 | ) | | 17,706,659 |
|
Non-Agency | | | | | | | | | | | | | | | |
Principal and interest | 2,591 |
| | 8 |
| | (41 | ) | | 2,558 |
| | — |
| | 44 |
| | (9 | ) | | 2,593 |
|
Interest-only | 3,770,437 |
| | 37,781 |
| | — |
| | 37,781 |
| | (8,604 | ) | | 279 |
| | (5,649 | ) | | 23,807 |
|
Total Non-Agency | 3,773,028 |
| | 37,789 |
| | (41 | ) | | 40,339 |
| | (8,604 | ) | | 323 |
| | (5,658 | ) | | 26,400 |
|
Total | $ | 22,550,682 |
| | $ | 960,964 |
| | $ | (58 | ) | | $ | 17,279,572 |
| | $ | (41,390 | ) | | $ | 519,572 |
| | $ | (24,695 | ) | | $ | 17,733,059 |
|
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2019 |
(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 | $ | 26,239,544 |
| | $ | 986,343 |
| | $ | (19 | ) | | $ | — |
| | $ | 27,225,868 |
| | $ | 424,818 |
| | $ | (8,815 | ) | | $ | 27,641,871 |
|
Interest-only | 2,601,693 |
| | 169,811 |
| | — |
| | — |
| | 169,811 |
| | 13,724 |
| | (47,351 | ) | | 136,184 |
|
Total Agency | 28,841,237 |
| | 1,156,154 |
| | (19 | ) | | — |
| | 27,395,679 |
| | 438,542 |
| | (56,166 | ) | | 27,778,055 |
|
Non-Agency | | | | | | | | | | | | | | | |
Principal and interest | 5,498,654 |
| | 8,980 |
| | (560,140 | ) | | (1,711,951 | ) | | 3,235,543 |
| | 341,583 |
| | (23,263 | ) | | 3,553,863 |
|
Interest-only | 4,356,603 |
| | 79,935 |
| | — |
| | — |
| | 79,935 |
| |