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TWO > SEC Filings for TWO > Form 10-K on 27-Feb-2014All Recent SEC Filings

Show all filings for TWO HARBORS INVESTMENT CORP.

Form 10-K for TWO HARBORS INVESTMENT CORP.


27-Feb-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes included elsewhere in this Annual Report on Form 10-K.

General
We are a Maryland corporation focused on investing in, financing and managing RMBS, residential mortgage loans, MSR and other financial assets, which we collectively refer to as our target assets. We operate as a REIT, as defined under the Code.
We are externally managed by PRCM Advisers, which is a wholly owned subsidiary of Pine River, a global multi-strategy asset management firm providing comprehensive portfolio management, transparency and liquidity to institutional and high net worth investors.
Our objective is to provide attractive risk-adjusted total return to our stockholders over the long term, primarily through dividends and secondarily through capital appreciation. We selectively acquire and manage an investment portfolio of our target assets, which is constructed to generate attractive returns through market cycles. We focus on asset selection and implement a relative value investment approach across various sectors within the residential mortgage market. Our target assets include the following:

Agency RMBS (which includes inverse interest-only Agency securities classified as Agency Derivatives for purposes of U.S. GAAP), meaning RMBS whose principal and interest payments are guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac;

Non-Agency RMBS, meaning RMBS that are not issued or guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac;

MSR;

Prime nonconforming residential mortgage loans and CSL; and

Other financial assets comprising approximately 5% to 10% of the portfolio.

We generally view our target assets in two strategies that rely on our core competencies of managing prepayment and credit risk. Our rates strategy includes assets that are sensitive to changes in interest rates and prepayment speeds, specifically Agency RMBS and MSR. Our credit strategy includes assets with inherent credit risk including non-Agency RMBS, net economic interests in securitizations and CSL.
We believe our hybrid Agency and non-Agency RMBS investment model allows management to allocate capital across various sectors within the residential mortgage market, with a focus on security selection and implementation of a relative value investment approach. Capital allocation factors in the opportunities in the marketplace, cost of financing and cost of hedging interest rate, prepayment, credit and other portfolio risks. As a result, RMBS asset allocation reflects management's opportunistic approach to investing in the marketplace.
During the year ended December 31, 2013, we did not significantly modify our RMBS asset allocation between Agency and non-Agency RMBS. The following table provides the RMBS asset allocation between Agency and non-Agency RMBS as of December 31, 2013 and the four immediately preceding period ends:

                                                  As of
                 December 31,     September 30,    June 30,    March 31,     December 31,
                     2013             2013           2013         2013           2012
Agency RMBS           77.9 %            77.1 %        80.5 %       80.2 %         81.0 %
Non-Agency RMBS       22.1 %            22.9 %        19.5 %       19.8 %         19.0 %

As our RMBS asset allocation shifts, our annualized yields and cost of financing shifts. As previously discussed, our investment decisions are not driven solely by annualized yields, but rather a multitude of macroeconomic drivers, including market environments and their respective impacts; for example, uncertainty of faster prepayments, extension risk and credit events.


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For the three months ended December 31, 2013, our net interest spread realized on Agency and non-Agency RMBS was higher than prior periods. The increase in yields and net interest spreads across comparative periods was predominantly driven by slower prepayments in the Agency market due to the rise in interest rates toward the end of 2013. The following table provides the average annualized yield on our Agency and non-Agency RMBS for the three months ended December 31, 2013, and the four immediately preceding quarters:

                                               Three Months Ended
                     December 31,   September 30,    June 30,      March 31,    December 31,
                         2013           2013           2013          2013           2012
Average annualized
yields (1)
Agency RMBS              3.1%           2.8%           2.7%          2.9%           2.9%
Non-Agency RMBS          8.9%           9.0%           9.1%          9.2%           9.5%
Aggregate RMBS           4.2%           4.0%           3.7%          4.0%           4.0%
Cost of financing
(2)                      1.1%           1.2%           1.2%          1.1%           1.1%
Net interest spread      3.1%           2.8%           2.5%          2.9%           2.9%


____________________


(1) Average annualized yield incorporates future prepayment, credit loss and other assumptions, all of which are estimates and subject to change.

(2) Cost of financing includes swap interest rate spread.

The following table provides the average annualized yield expected on our Agency and non-Agency RMBS as of December 31, 2013, and the four immediately preceding period ends:

                                                      As of
                     December 31,   September 30,    June 30,      March 31,    December 31,
                         2013           2013           2013          2013           2012
Average annualized
yields (1)
Agency RMBS              3.0%           2.9%           2.8%          2.9%           2.9%
Non-Agency RMBS          9.0%           9.0%           9.1%          9.2%           9.4%
Aggregate RMBS           4.1%           4.1%           3.8%          3.8%           4.0%
Cost of financing
(2)                      1.1%           1.2%           1.2%          1.1%           1.2%
Net interest spread      3.0%           2.9%           2.6%          2.7%           2.8%


____________________


(1) Average annualized yield incorporates future prepayment, credit loss and other assumptions, all of which are estimates and subject to change.

(2) Cost of financing includes swap interest rate spread.

During the year ended December 31, 2013, we have continued to make progress on strategic initiatives, which stem from the changing opportunities in the residential mortgage marketplace, including a mortgage loan conduit and securitization platform and an MSR platform. We acquire prime nonconforming residential mortgage loans from select mortgage loan originators and secondary market institutions and primarily securitize the loans through the issuance of non-Agency mortgage-backed securities. Late in the fourth quarter, we completed a bulk acquisition of MSR and entered into a two-year flow agreement to acquire new-origination MSR production. We believe leveraging the strength of our combined investment and operating platform will allow us to provide capital solutions to originators, servicers and RMBS investor partners. During the year ended December 31, 2013 we also acquired CSL with the intention of securitizing the loans and/or exiting through a whole loan sale.
We seek to deploy moderate leverage as part of our investment strategy. We generally finance our RMBS assets through short-term borrowings structured as repurchase agreements. Our Agency RMBS, given their liquidity and high credit quality, are eligible for higher levels of leverage, while non-Agency RMBS, with less liquidity and exposure to credit risk, utilize lower levels of leverage. We also finance our U.S. Treasuries, which we hold for trading purposes, and our mortgage loans. We believe the debt-to-equity ratio funding our Agency RMBS, non-Agency and mortgage loans held-for-sale is the most meaningful leverage measure as U.S. Treasuries are viewed to be highly liquid in nature and collateralized borrowings on mortgage loans held-for-investment in securitization trusts represent term financing with no stated maturity. As a result, our debt-to-equity ratio is determined by our RMBS portfolio mix as well as many additional factors, including the liquidity of our portfolio, the sustainability and price of our financing, diversification of our counterparties and their available capacity to


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finance our RMBS assets, and anticipated regulatory developments. Over the past several quarterly periods, we have generally maintained a debt-to-equity ratio range of 3.0 to 5.0 times to finance our RMBS portfolio and mortgage loans held-for-sale, on a fully deployed capital basis. Our debt-to-equity ratio is directly correlated to the make-up of our RMBS portfolio; specifically, the higher percentage of Agency RMBS we hold, the higher our debt-to-equity ratio is, and vice versa. We may alter the percentage allocation of our portfolio between Agency and non-Agency RMBS depending on the quality of the assets that are available to purchase from time to time, including at times when we are deploying proceeds from common stock offerings we conduct. The debt-to-equity ratio range has been driven by our relatively stable asset allocation between Agency and non-Agency RMBS, as disclosed above. See the section titled "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Financial Condition -- Repurchase Agreements" for further discussion.
We recognize that investing in our target assets is competitive and that we compete with other investment vehicles for attractive investment opportunities. We rely on our management team and our dedicated team of investment professionals provided by our external manager to identify investment opportunities. In addition, we have benefited and expect to continue to benefit from our external manager's analytical and portfolio management expertise and infrastructure. We believe that our significant focus on the RMBS area, the extensive RMBS expertise of our investment team, our strong analytics and our disciplined relative value investment approach give us a competitive advantage versus our peers.
We have elected to be treated as a REIT for U.S. federal income tax purposes. To qualify as a REIT we are required to meet certain investment and operating tests and annual distribution requirements. We generally will not be subject to U.S. federal income taxes on our taxable income to the extent that we annually distribute all of our net taxable income to stockholders, do not participate in prohibited transactions and maintain our intended qualification as a REIT. However, certain activities that we may perform may cause us to earn income which will not be qualifying income for REIT purposes. We have designated certain of our subsidiaries as TRSs, as defined in the Code, to engage in such activities, and we may form additional TRSs in the future. We also operate our business in a manner that will permit us to maintain our exemption from registration under the 1940 Act. While we do not currently originate or service loans, certain of our subsidiaries have obtained the requisite licenses and approvals to purchase and sell mortgage loans and to hold and manage MSR. On December 19, 2012, we completed the contribution of our portfolio of single-family rental properties to Silver Bay, a newly organized Maryland corporation intended to qualify as a REIT and focused on the acquisition, renovation, leasing and management of single-family residential properties for rental income and long-term capital appreciation. We contributed our equity interests in the wholly owned subsidiary, Two Harbors Property Investment LLC to Silver Bay, and in exchange for the contribution, received shares of common stock of Silver Bay. Silver Bay completed its IPO of its common stock on December 19, 2012. We distributed shares of Silver Bay common stock we received in the transaction to our stockholders on or about April 24, 2013. Because we will not have any significant continuing involvement in Two Harbors Property Investment LLC, all of the associated operating results were removed from continuing operations and are presented separately as discontinued operations for the years ended December 31, 2013, 2012 and 2011.

Overview
Our 2013 efforts focused on three strategic objectives that we believe will position us for long-term success.
Managing a portfolio of RMBS to generate attractive returns with balanced risks. We operate a hybrid REIT model, diversifying our portfolio across Agency and non-Agency RMBS in combination with derivative hedging instruments. We manage to an overall low level of interest rate exposure and leverage. We believe carrying a balance of risks within our portfolio is critical to providing an attractive return to our stockholders and our ability to adjust our allocations and deploy capital across sectors allow us to optimize portfolio results over time.

Executing business diversification opportunities across residential mortgage loans, MSR and other real estate assets. We pursued a variety of opportunities that leverage our core competencies of credit and prepayment risk management. In late 2011, we began acquiring prime nonconforming residential mortgage loans from select mortgage loan originators and secondary market institutions in order to establish a nonconforming loan securitization program. As of December 31, 2013, we have participated in two securitizations, one sponsored by a third party and one sponsored by a subsidiary of Two Harbors. In early 2013, we began acquiring CSL and have purchased $424.7 million in CSL as of December 31, 2013. In addition, on April 30, 2013, one of our wholly owned subsidiaries acquired a company that has approvals from Fannie Mae, Freddie Mac and Ginnie Mae to hold and manage MSR. As of December 31, 2013, we held $514.4 million in MSR acquired in conjunction with the acquisition of this entity as well as MSR subsequently purchased. We are taking a measured approach as we diversify, keeping true to our strategic long-term plans and our core strengths.

Maintaining "best in class" investment, corporate governance, investor relations and disclosure practices. We attribute our growth to our portfolio alpha generation, innovation and best practice in corporate governance and disclosure.


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Factors Affecting our Operating Results
Our net interest income includes income from our RMBS portfolio, including the amortization of purchase premiums and accretion of purchase discounts, and income from our residential mortgage loans. Net interest income will fluctuate primarily as a result of changes in market interest rates, our financing costs, and prepayment speeds on our assets. Interest rates, financing costs and prepayment rates vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty. Our operating results will also be affected by default rates and credit losses with respect to the mortgage loans underlying our non-Agency RMBS and in our mortgage loan portfolio.

Fair Value Measurement
ASC 820 defines fair value as the price that would be received to sell an asset
or paid to transfer a liability in an orderly transaction between willing market
participants at the measurement date. It also establishes three levels of input
to be used when measuring fair value:

Level 1        Inputs are quoted prices in active markets for identical assets or
               liabilities as of the measurement date under current market
               conditions. Additionally, the entity must have the ability to
               access the active market and the quoted prices cannot be adjusted
               by the entity.


Level 2        Inputs include quoted prices in active markets for similar assets
               or liabilities; quoted prices in inactive markets for identical or
               similar assets or liabilities; or inputs that are observable or
               can be corroborated by observable market data by correlation or
               other means for substantially the full-term of the assets or
               liabilities.


Level 3        Unobservable inputs are supported by little or no market activity.
               The unobservable inputs represent the assumptions that market
               participants would use to price the assets and liabilities,
               including risk. Generally, Level 3 assets and liabilities are
               valued using pricing models, discounted cash flow methodologies,
               or similar techniques that require significant judgment or
               estimation.

We follow the fair value hierarchy set forth above in order to prioritize the data utilized to measure fair value. We strive to obtain quoted market prices in active markets (Level 1 inputs). If Level 1 inputs are not available, we will attempt to obtain Level 2 inputs, observable market prices in inactive markets or derive the fair value measurement using observable market prices for similar assets or liabilities. When neither Level 1 nor Level 2 inputs are available, we use Level 3 inputs and independent pricing service models to estimate fair value measurements. At December 31, 2013, approximately 91.2% of total assets, or $15.7 billion, and approximately 5.0% of total liabilities, or $661.9 million, consisted of financial instruments recorded at fair value. As of December 31, 2013, we had $939.1 million, or approximately 5.5% of total assets reported at fair value using Level 3 inputs. See Note 16 - Fair Value to the Consolidated Financial Statements, included in this Annual Report on Form 10-K, for descriptions of valuation methodologies used to measure material assets and liabilities at fair value and details of the valuation models, key inputs to those models and significant assumptions utilized.
A significant portion of our assets and liabilities are at fair value and, therefore, our consolidated balance sheets and statements of comprehensive income are significantly affected by fluctuations in market prices. Although we execute various hedging strategies to mitigate our exposure to changes in fair value, we cannot fully eliminate our exposure to volatility caused by fluctuations in market prices. Starting in 2007, markets for asset-backed securities, including RMBS, have experienced severe dislocations. While these market disruptions continue, our assets and liabilities will be subject to valuation adjustment as well as changes in the inputs we use to measure fair value.
For the year ended December 31, 2013, our unrealized fair value gains on interest rate swap and swaption agreements, which are accounted for as derivative trading instruments under GAAP, positively affected our financial results. The change in fair value of the interest rate swaps was a result of the realization of losses on interest rates swaps unwound and subsequent resetting of interest rate swaps at more favorable rates, combined with changes to LIBOR, the swap curve, and corresponding counterparty borrowing rates during the year ended December 31, 2013. Our financial results for the year ended December 31, 2013 were positively affected by unrealized fair value gains on certain U.S. Treasuries classified as trading instruments due to their short-term investment objectives, and negatively affected by unrealized fair value losses on mortgage loans held-for-sale. Additionally, our financial results for the year ended December 31, 2013 were positively affected by an increase in fair value of MSR. For the year ended December 31, 2012, our unrealized fair value losses on interest rate swap and swaption agreements negatively affected our financial results. The change in fair value of the interest rate swaps was a result of changes to LIBOR, the swap curve, and corresponding counterparty borrowing rates during the year ended December 31, 2012. Our financial results for the year ended December 31, 2012 were positively affected by unrealized fair value gains on certain U.S. Treasuries classified as trading instruments, equity securities, which consisted solely of shares of Silver Bay common stock, and mortgage loans held-for-sale. In addition, our financial results for the year ended December 31, 2013 and 2012 were affected by the unrealized gains and losses of certain other derivative instruments that were accounted for as trading derivative instruments,


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i.e., credit default swaps, TBAs, put and call options for TBAs, constant maturity swaps, short U.S. Treasuries and inverse interest-only securities. Any temporary change in the fair value of our available-for-sale securities is recorded as a component of accumulated other comprehensive income and does not impact our earnings. We have numerous internal controls in place to help ensure the appropriateness of fair value measurements. Significant fair value measures are subject to detailed analytics and management review and approval. Our entire investment portfolio is priced by third-party brokers and/or by independent pricing providers. We strive to obtain multiple market data points for each valuation. We utilize "bid side" pricing for our RMBS assets and, as a result, certain assets, especially the most recent purchases, may realize a markdown due to the "bid-offer" spread. To the extent that this occurs, any economic effect of this would be reflected in accumulated other comprehensive income. We back test the fair value measurements provided by the pricing providers against actual performance. We also monitor the market for recent trades, market surveys, or other market information that may be used to benchmark pricing provider inputs. Considerable judgment is used in forming conclusions and estimating inputs to our Level 3 fair value measurements. Level 3 inputs such as interest rate movements, prepayments speeds, credit losses and discount rates are inherently difficult to estimate. Changes to these inputs can have a significant effect on fair value measurements. Accordingly, there is no assurance that our estimates of fair value are indicative of the amounts that would be realized on the ultimate sale or exchange of these assets.

Critical Accounting Estimates
The preparation of financial statements in accordance with GAAP requires us to make certain judgments and assumptions, based on information available at the time of our preparation of the financial statements, in determining accounting estimates used in preparation of the statements. Our significant accounting policies are described in Note 2 to the consolidated financial statements, included under Item 8 of this Annual Report on Form 10-K.
Accounting estimates are considered critical if the estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made and if different estimates reasonably could have been used in the reporting period or changes in the accounting estimate are reasonably likely to occur from period to period that would have a material impact on our financial condition, results of operations or cash flows.
Classification and Valuation of Available-for-Sale and Trading Securities Our RMBS investments consist primarily of Agency RMBS and non-Agency RMBS that we classify as available-for-sale, or AFS. Our RMBS classified as available-for-sale are carried at their fair value, with changes in fair value recorded through accumulated other comprehensive income (loss), a component of stockholders' equity, rather than through earnings. We also hold U.S. Treasuries for trading purposes. Our trading securities are carried at estimated fair value with changes in fair value recorded as a component of gain on investment securities, net in earnings. If our RMBS AFS were also classified as trading securities, there could be substantially greater volatility in our earnings. When the estimated fair value of an available-for-sale security is less than amortized cost, we consider whether there is an other-than-temporary impairment in the value of the security that is required to be recognized in the statement of operations. The determination of whether a security is other-than-temporarily impaired involves judgments and assumptions based on subjective and objective factors. Consideration is given to whether we (1) have the intent to sell the investment securities, (2) are more likely than not to be required to sell the investment securities before recovery, or (3) do not expect to recover the entire amortized cost basis of the investment securities. Investments with unrealized losses are not considered other-than-temporarily impaired if we have the ability and intent to hold the investments for a period of time, to maturity if necessary, sufficient for a forecasted market price recovery up to or beyond the amortized cost basis of the investments. If an impairment is determined to be solely driven by the inability to fully recover the entire amortized cost basis over the remaining life of the security, the security is further analyzed for credit loss (the difference between the present value of cash flows expected to be collected and the amortized cost basis). The credit loss, if any, is then recognized in the statement of operations, while the balance of impairment related to other factors is recognized in other comprehensive income. Classification and Valuation of Equity Securities The equity securities held as of December 31, 2012, which consisted solely of shares of Silver Bay common stock, were carried at fair value with changes in fair value recorded in earnings as a result of a fair value option election. Fair value was determined based on the closing market price at period end. As the shares were distributed to Two Harbors stockholders in 2013, equity securities are no longer recognized on the consolidated balance sheet as of December 31, 2013.
Classification and Valuation of Mortgage Loans Held-for-Sale Our mortgage loans held-for-sale are carried at fair value as a result of a fair value option election, with changes in fair value recorded in earnings. Fair value is generally determined based on current secondary market pricing or cash flow models using market-based yield requirements.


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Classification and Valuation of Mortgage Loans Held-for-Investment in Securitization Trusts
Our mortgage loans held-for-investment in securitization trusts are carried at fair value as a result of a fair value option election, with changes in fair value recorded in earnings. Fair value is generally determined based on current secondary market pricing or cash flow models using market-based yield requirements.
Classification and Valuation of Mortgage Servicing Rights We account for our MSR at fair value, with changes in fair value recorded in earnings, rather than at amortized cost. Although MSR transactions are observable in the marketplace, the valuation includes unobservable market data inputs (prepayment speeds, delinquency levels and discount rates). Classification and Valuation of Collateralized Borrowings in Securitization Trusts
Our collateralized borrowings in securitization trusts are carried at fair value as a result of a fair value option election, with changes in fair value recorded in earnings. Fair value is generally determined based on prices obtained from third-party pricing providers, broker quotes received and other applicable market data.
The methods used by us to estimate fair value for available-for-sale securities, . . .

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