TWO 9/30/2012 10Q document
 
 
 
 
 
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: September 30, 2012

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.)

601 Carlson Parkway, Suite 150
Minnetonka, Minnesota
 
55305
(Address of Principal Executive Offices)
 
(Zip Code)
(612) 629-2500
(Registrant's Telephone Number, Including Area Code)


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x
 
Accelerated filer o
 
Non-accelerated filer o
 
Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
As of November 7, 2012 there were 295,365,085 shares of outstanding common stock, par value $.01 per share, issued and outstanding.
 
 
 
 
 


Table of Contents



TWO HARBORS INVESTMENT CORP.
INDEX

 
 
Page
 
PART I - FINANCIAL INFORMATION
 
 
 
 
 
 
 
PART II - OTHER INFORMATION
 


i

Table of Contents



PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

TWO HARBORS INVESTMENT CORP.  
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)

 
September 30,
2012
 
December 31,
2011
 
(unaudited)
 
 
ASSETS
  

 
  

Available-for-sale securities, at fair value
$
14,969,859

 
$
6,249,252

Trading securities, at fair value
1,002,461

 
1,003,301

Mortgage loans held-for-sale, at fair value
14,553

 
5,782

Investment in real estate, net
190,907

 

Cash and cash equivalents
833,608

 
360,016

Restricted cash
206,190

 
166,587

Accrued interest receivable
46,919

 
23,437

Due from counterparties
28,965

 
32,587

Derivative assets, at fair value
496,788

 
251,856

Other assets
74,445

 
7,566

Total Assets
$
17,864,695

 
$
8,100,384

LIABILITIES AND STOCKHOLDERS’ EQUITY
   

 
   

Liabilities
   

 
   

Repurchase agreements
$
14,034,327

 
$
6,660,148

Derivative liabilities, at fair value
132,322

 
49,080

Accrued interest payable
13,147

 
6,456

Due to counterparties
170,090

 
45,565

Accrued expenses
17,008

 
8,912

Dividends payable
106,325

 
56,239

Income taxes payable

 
3,898

Total liabilities
14,473,219

 
6,830,298

Stockholders’ Equity
   

 
  

Preferred stock, par value $0.01 per share; 50,000,000 shares authorized; no shares issued and outstanding

 

Common stock, par value $0.01 per share; 450,000,000 shares authorized and 295,350,370 and 140,596,708 shares issued and outstanding, respectively
2,954

 
1,406

Additional paid-in capital
2,910,293

 
1,373,099

Accumulated other comprehensive income (loss)
700,396

 
(58,716
)
Cumulative earnings
260,058

 
157,452

Cumulative distributions to stockholders
(482,225
)
 
(203,155
)
Total stockholders’ equity
3,391,476

 
1,270,086

Total Liabilities and Stockholders’ Equity
$
17,864,695

 
$
8,100,384


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 INCOME (LOSS)
(in thousands, except share data)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
 
(unaudited)
 
(unaudited)
Interest income:
 
 
 
 
  

 
   

Available-for-sale securities
$
124,621

 
$
65,919

 
$
313,154

 
$
125,413

Trading securities
1,278

 
1,706

 
3,578

 
2,783

Mortgage loans held-for-sale
167

 

 
362

 

Cash and cash equivalents
243

 
114

 
620

 
241

Total interest income
126,309

 
67,739

 
317,714

 
128,437

Interest expense
20,743

 
7,218

 
47,737

 
13,580

Net interest income
105,566

 
60,521

 
269,977

 
114,857

Other-than-temporary impairments:
 
 
 
 
 
 
 
Total other-than temporary impairment losses
(559
)
 
(3,371
)
 
(9,310
)
 
(3,665
)
Non-credit portion of loss recognized in other comprehensive income (loss)

 

 

 

Net other-than-temporary credit impairment losses
(559
)
 
(3,371
)
 
(9,310
)
 
(3,665
)
Other income:
 
 
 
 
 
 
 
Gain on investment securities, net
2,527

 
31,432

 
14,247

 
36,159

Loss on interest rate swap and swaption agreements
(76,472
)
 
(39,311
)
 
(153,679
)
 
(88,180
)
Gain (loss) on other derivative instruments
3,454

 
22,361

 
(13,053
)
 
37,474

Other income
731

 

 
822

 

Total other (loss) income
(69,760
)
 
14,482

 
(151,663
)
 
(14,547
)
Expenses:
 
 
 
 
 
 
 
Management fees
9,733

 
4,785

 
24,086

 
9,063

Other operating expenses
6,546

 
2,850

 
14,328

 
6,516

Total expenses
16,279

 
7,635

 
38,414

 
15,579

Income before income taxes
18,968

 
63,997

 
70,590

 
81,066

(Benefit from) provision for income taxes
(7,834
)
 
9,388

 
(32,016
)
 
5,064

Net income attributable to common stockholders
$
26,802

 
$
54,609

 
$
102,606

 
$
76,002

Basic earnings per weighted average common share
$
0.10

 
$
0.42

 
$
0.46

 
$
0.90

Diluted earnings per weighted average common share
$
0.10

 
$
0.42

 
$
0.46

 
$
0.90

Dividends declared per common share
$
0.36

 
$
0.40

 
$
1.16

 
$
1.20

Weighted average number of shares of common stock:
 
 
 
 
 
 
 
Basic
270,005,212

 
130,607,566

 
224,058,762

 
84,751,854

Diluted
270,937,960

 
130,607,566

 
224,369,678

 
84,751,854

Comprehensive income (loss):
 
 
 
 
 
 
 
Net income
$
26,802

 
$
54,609

 
$
102,606

 
$
76,002

Other comprehensive income (loss):
 
 
 
 
 
 
 
Unrealized gain (loss) on available-for-sale securities, net
497,598

 
(72,573
)
 
759,112

 
(48,944
)
Other comprehensive income (loss)
497,598

 
(72,573
)
 
759,112

 
(48,944
)
Comprehensive income (loss)
$
524,400

 
$
(17,964
)
 
$
861,718

 
$
27,058


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

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TWO HARBORS INVESTMENT CORP. 
CONDENDSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
AND COMPREHENSIVE INCOME (LOSS)
(in thousands, except share data)

 
Common Stock
 
 
 
 
 
 
 
 
 
 
 
Shares
 
Amount
 
Additional Paid-in Capital
 
Accumulated Other Comprehensive Income (Loss)
 
Cumulative Earnings
 
Cumulative Distributions to Stockholders
 
Total Stockholders' Equity
 
 
 
 
 
 
 
(unaudited)
 
 
 
 
 
 
Balance, January 1, 2011
40,501,212

 
$
405

 
$
366,974

 
$
22,619

 
$
30,020

 
$
(37,570
)
 
$
382,448

Net income

 

 

 

 
76,002

 

 
76,002

Other comprehensive loss

 

 

 
(48,944
)
 

 

 
(48,944
)
Net proceeds from issuance of common stock, net of offering costs
100,077,925

 
1,001

 
1,005,754

 

 

 

 
1,006,755

Common dividends declared

 

 

 

 

 
(109,346
)
 
(109,346
)
Non-cash equity award compensation
7,599

 

 
216

 

 

 

 
216

Balance, September 30, 2011
140,586,736

 
$
1,406

 
$
1,372,944

 
$
(26,325
)
 
$
106,022

 
$
(146,916
)
 
$
1,307,131

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, January 1, 2012
140,596,708

 
$
1,406

 
$
1,373,099

 
$
(58,716
)
 
$
157,452

 
$
(203,155
)
 
$
1,270,086

Net income

 

 

 

 
102,606

 

 
102,606

Other comprehensive income

 

 

 
759,112

 

 

 
759,112

Net proceeds from issuance of common stock, net of offering costs
138,731,623

 
1,388

 
1,361,167

 

 

 

 
1,362,555

Proceeds from issuance of common stock in connection with exercise of warrants
15,990,018

 
160

 
175,565

 

 

 

 
175,725

Common dividends declared

 

 

 

 

 
(279,070
)
 
(279,070
)
Non-cash equity award compensation
32,021

 

 
462

 

 

 

 
462

Balance, September 30, 2012
295,350,370

 
$
2,954

 
$
2,910,293

 
$
700,396

 
$
260,058

 
$
(482,225
)
 
$
3,391,476


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
(in thousands)
 
Nine Months Ended
 
September 30,
 
2012
 
2011
 
(unaudited)
Cash Flows From Operating Activities:
   

 
   

Net income
$
102,606

 
$
76,002

Adjustments to reconcile net income to net cash provided by operating activities:
   

 
   

Amortization of premiums and discounts on RMBS, net
(5,566
)
 
(57
)
Other-than-temporary impairment losses
9,310

 
3,665

Gain on investment securities, net
(14,247
)
 
(36,159
)
Loss on mortgage loans held-for-sale
45

 

Loss on termination and option expiration of interest rate swaps and swaptions
26,084

 
18,074

Unrealized loss on interest rate swaps and swaptions
104,506

 
51,474

Unrealized gain on other derivative instruments
(6,493
)
 
(20,144
)
Unrealized gain on mortgage loans held-for-sale
(59
)
 

Equity based compensation expense
462

 
216

Depreciation of real estate
458

 

Purchases of mortgage loans held-for-sale
(10,797
)
 

Proceeds from repayment of mortgage loans held-for-sale
2,040

 

Net change in assets and liabilities:
   

 
 
Increase in accrued interest receivable
(23,482
)
 
(20,127
)
(Increase)/decrease in deferred income taxes, net
(27,288
)
 
4,136

Increase in current income tax receivable
(4,469
)
 

(Increase)/decrease in prepaid and fixed assets
(906
)
 
155

Increase in other receivables
(99
)
 

Increase in accrued interest payable, net
6,691

 
4,657

(Decrease)/increase in income taxes payable
(3,898
)
 
928

Increase in accrued expenses
8,096

 
5,684

Net cash provided by operating activities
162,994

 
88,504

Cash Flows From Investing Activities:
   

 
   

Purchases of available-for-sale securities
(8,705,850
)
 
(6,295,100
)
Proceeds from sales of available-for-sale securities
207,083

 
1,004,248

Principal payments on available-for-sale securities
542,727

 
208,965

Purchases of other derivative instruments
(372,483
)
 
(233,764
)
Proceeds from sales of other derivative instruments
86,696

 
23,179

Purchases of trading securities
(996,016
)
 
(2,019,959
)
Proceeds from sales of trading securities
1,001,904

 
700,156

Purchases of investments in real estate
(191,365
)
 

Increase in escrow deposits
(34,117
)
 

Increase (decrease) in due to counterparties, net
128,147

 
(162,458
)
Increase in restricted cash
(39,603
)
 
(141,728
)
Net cash used in investing activities
(8,372,877
)
 
(6,916,461
)

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, continued
(in thousands)
 
Nine Months Ended
 
September 30,
 
2012
 
2011
 
(unaudited)
Cash Flows From Financing Activities:
   

 
   

Proceeds from repurchase agreements
$
45,160,427

 
$
19,621,767

Principal payments on repurchase agreements
(37,786,248
)
 
(13,490,957
)
Proceeds from issuance of common stock, net of offering costs
1,362,555

 
1,006,755

Proceeds from exercise of warrants
175,725

 

Dividends paid on common stock
(228,984
)
 
(63,561
)
Net cash provided by financing activities
8,683,475

 
7,074,004

Net increase in cash and cash equivalents
473,592

 
246,047

Cash and cash equivalents at beginning of period
360,016

 
163,900

Cash and cash equivalents at end of period
$
833,608

 
$
409,947

Supplemental Disclosure of Cash Flow Information:
   

 
 
Cash paid for interest
$
14,038

 
$
8,923

Cash paid for taxes
$
3,637

 
$
1

Non-Cash Financing Activities:
   

 
   

Cashless exercise of warrants
$
178

 
$

Dividends declared but not paid at end of period
$
106,325

 
$
56,235

Reconciliation of mortgage loans held-for-sale:
 
 
 
Mortgage loans held-for-sale at beginning of period
$
5,782

 
$

Purchases of mortgage loans held-for-sale
10,797

 

Proceeds from repayment of mortgage loans held-for-sale
(2,040
)
 

Gain on mortgage loans held-for-sale
14

 

Loans held-for-sale at end of period
$
14,553

 
$


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

5

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

Note 1. Organization and Operations
Two Harbors Investment Corp., or the Company, is a Maryland corporation focused on investing in, financing and managing residential mortgage-backed securities, or RMBS, residential mortgage loans, residential real properties, and other financial assets. The Company is externally managed and advised by PRCM Advisers LLC, a subsidiary of Pine River Capital Management L.P., or Pine River, a global multi-strategy asset management firm. The Company's common stock is listed on the NYSE and its warrants are listed on the NYSE MKT under the symbols “TWO” and “TWO.WS,” respectively.
The Company has elected to be treated as a real estate investment trust, or REIT, for U.S. federal income tax purposes commencing with its initial taxable period ended December 31, 2009. As long as the Company continues to comply with a number of requirements under federal tax law and maintains its qualification as a REIT, the Company generally will not be subject to U.S. federal income taxes to the extent that the Company distributes its taxable income to its stockholders on an annual basis and does not engage in prohibited transactions. However, certain activities that the Company may perform may cause it to earn income which will not be qualifying income for REIT purposes. The Company has designated certain of its subsidiaries as taxable REIT subsidiaries, or TRSs, as defined in the Code, to engage in such activities, and the Company may in the future form additional TRSs.
On September 11, 2012, the Company announced the proposed contribution of its portfolio of single-family rental properties to a newly formed entity intended to qualify as a REIT.  Specifically, the Company would contribute its equity interests in its wholly owned subsidiary, Two Harbors Property Investment LLC to Silver Bay Realty Trust Corp., a newly organized Maryland corporation focused on the acquisition, renovation, leasing and management of single-family residential properties for rental income and long-term capital appreciation.  In exchange for its contribution, the Company would receive shares of common stock of Silver Bay.  Silver Bay Realty Trust Corp. has filed a registration statement with the U.S. Securities and Exchange Commission with respect to the proposed initial public offering, or IPO, of its common stock.  The consummation of the proposed contribution transaction, which remains subject to approval of the Company's board of directors, is dependent upon the value of the contribution and amount of capital raised in the proposed IPO as well as market and other conditions.

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 GAAP, have been condensed or omitted according to such SEC rules and regulations. Management believes, however, that the disclosures included in these interim condensed consolidated financial statements are adequate to make the information presented not misleading. The accompanying condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2011. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at September 30, 2012 and results of operations for all periods presented have been made. The results of operations for the three and nine months ended September 30, 2012 should not be construed as indicative of the results to be expected for the full year.
The condensed consolidated financial statements of the Company have been prepared on the accrual basis of accounting in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires us to make a number of significant estimates and assumptions. These estimates include estimates of fair value of certain assets and liabilities, amount and timing of credit losses, prepayment rates, the period of time during which the Company anticipates an increase in the fair values of real estate securities sufficient to recover unrealized losses in those securities, and other estimates that affect the reported amounts of certain assets and liabilities and disclosure of contingent assets and liabilities as of the date of the condensed consolidated financial statements and the reported amounts of certain revenues and expenses during the reported period. It is likely that changes in these estimates (e.g., valuation changes due to supply and demand, credit performance, prepayments, interest rates, or other reasons) will occur in the near term. The Company's estimates are inherently subjective in nature and actual results could differ from its estimates and the differences may be material.
The condensed consolidated financial statements of the Company include the accounts of all subsidiaries; inter-company accounts and transactions have been eliminated. Certain prior period amounts have been reclassified to conform to the current period presentation.

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

Significant Accounting Policies
Investment in Real Estate, Net
Beginning in early 2012, the Company began investing in single family residential properties with the intention of renting the properties. Property acquired not subject to an existing lease is recorded at purchase price, including acquisition costs, allocated between land and building based upon their fair values at the date of acquisition. Property acquired with an existing lease is recorded at fair value (approximated by the purchase price), allocated to land, building and the existing lease based upon their fair values at the date of acquisition, with acquisition costs expensed as incurred. Fair value is determined under the guidance of ASC 820, Fair Value Measurements and Disclosures, primarily based on unobservable market data inputs, which are categorized as Level 3 valuations. In making estimates of fair values for purposes of allocating purchase price, the Company utilizes its own market knowledge and published market data. The Company is currently utilizing information obtained from county tax assessment records to develop regional averages to assist in the determination of the fair value of land and building. The estimated fair value of acquired in-place leases are the costs the Company would have incurred to lease the property at the date of acquisition, based upon current leasing activity. Building depreciation is computed on the straight-line basis over the estimated useful lives of the assets. The Company generally uses a 27.5-year estimated life with no salvage value. The Company considers the value of acquired in-place leases in the allocation of purchase price and the amortization period reflects the average remaining term of each respective in-place acquired lease. The lease periods are generally short term in nature (one year or less) and reflect market rental rates. Any difference between fair value and cost is recorded in the income statement.
The Company incurs costs to prepare its acquired properties to be rented. These costs are capitalized and allocated to building costs. Costs incurred by the Company to lease the properties are capitalized and amortized over the life of the lease (included in other assets).
The Company evaluates its long-lived assets for impairment periodically or whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. If an impairment indicator exists, the Company compares the expected future undiscounted cash flows against the carrying amount of an asset. If the sum of the estimated undiscounted cash flows is less than the carrying amount of the asset, the Company would record an impairment loss for the difference between the estimated fair value and the carrying amount of the asset.
Rental income attributable to residential leases is recorded on a straight-line basis, which is not materially different than if it were recorded when due from residents and recognized monthly as it was earned. Leases entered into between residents and the Company for the rental of property units are generally year-to-year, renewable upon consent of both parties on an annual or monthly basis. Expenditures for ordinary maintenance and repairs are expensed to operations as incurred and expenditures for significant renovations that improve the asset and extend the useful life of the asset are capitalized and depreciated over their estimated useful life. Gross rental income and expenses applicable to rental activities are reported in the statement of comprehensive income in other income and other operating expenses, respectively.
Refer to Note 2 to the Consolidated Financial Statements in the Company's 2011 Annual Report on Form 10-K regarding additional significant accounting policies.
Recently Issued and/or Adopted Accounting Standards
Comprehensive Income
In June 2011, the Financial Accounting Standards Board, or FASB, issued ASU No. 2011-05, which amends ASC 820, Comprehensive Income. The amendments are intended to make the presentation of items within Other Comprehensive Income (OCI) more prominent. ASU 2011-05 eliminates the option to present components of OCI in the statement of changes in stockholders' equity and requires companies to present all non-owner changes in stockholders' equity either as a single continuous statement of comprehensive income or as two separate but consecutive statements. In addition, reclassification adjustments between OCI and net income must be presented separately on the face of the financial statements. The new guidance does not change the components of OCI or the calculation of earnings per share. ASU 2011-05 is effective for the first interim or annual period beginning on or after December 15, 2011. Adopting this ASU did not have a material impact on the Company's condensed consolidated financial condition or results of operations. On December 23, 2011, the FASB issued ASU 2011-12, which defers those changes in ASU 2011-05 that relate to the presentation of reclassification adjustments. This was done to allow the FASB time to re-deliberate whether to present on the face of the financial statements the effects of reclassification out of accumulated OCI on the components of net income and comprehensive income for all periods presented. No other requirements under ASU 2011-05 are affected by this update.
Fair Value
In May 2011, the FASB issued ASU No. 2011-04, which amends ASC 820, Fair Value Measurements. The amendments in this ASU clarify the requirements for measuring fair value and disclosing information about fair value. It is intended to

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

improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with GAAP and International Financial Reporting Standards, or IFRS. The ASU is effective for the first interim or annual period beginning on or after December 15, 2011. Adopting this ASU did not have a material impact on the Company's condensed consolidated financial condition or results of operations.
Offsetting Assets and Liabilities
In December 2011, the FASB issued ASU No. 2011-11, which amends ASC 210, Balance Sheet. The amendments in this ASU enhance disclosures required by U.S. GAAP by requiring improved information about financial instruments and derivative instruments that are either (1) offset in accordance with ASC 210, Balance Sheet or ASC 815, Other Presentation Matters or (2) subject to an enforceable master netting arrangement or similar agreement. ASU 2011-11 is effective for the first interim or annual period beginning on or after January 1, 2013. We anticipate that adopting this ASU will not have a material impact on the Company's condensed consolidated financial condition or results of operations.

Note 3. Available-for-Sale Securities, at Fair Value
The following table presents the Company's available-for-sale, or AFS, investment securities by collateral type, which were carried at their fair value as of September 30, 2012 and December 31, 2011:
(in thousands)
September 30,
2012
 
December 31,
2011
Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
3,699,453

 
$
1,609,003

Federal National Mortgage Association
6,704,798

 
2,414,637

Government National Mortgage Association
2,064,812

 
1,029,517

Non-Agency
2,500,796

 
1,196,095

Total mortgage-backed securities
$
14,969,859

 
$
6,249,252


At September 30, 2012 and December 31, 2011, the Company pledged investment securities with a carrying value of $14.5 billion and $6.2 billion, respectively, as collateral for repurchase agreements. See Note 12 - Repurchase Agreements.
At September 30, 2012 and December 31, 2011, the Company did not have any securities purchased from and financed with the same counterparty that did not meet the conditions of ASC 860, Transfers and Servicing, to be considered linked transactions and therefore classified as derivatives.
The following tables present the amortized cost and carrying value (which approximates fair value) of AFS securities by collateral type as of September 30, 2012 and December 31, 2011:
 
September 30, 2012
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
13,101,209

 
$
4,471,572

 
$
17,572,781

Unamortized premium
850,721

 

 
850,721

Unamortized discount
 
 
 
 
 
Designated credit reserve

 
(1,339,737
)
 
(1,339,737
)
Net, unamortized
(1,853,894
)
 
(960,408
)
 
(2,814,302
)
Amortized Cost
12,098,036

 
2,171,427

 
14,269,463

Gross unrealized gains
384,523

 
345,980

 
730,503

Gross unrealized losses
(13,496
)
 
(16,611
)
 
(30,107
)
Carrying Value
$
12,469,063

 
$
2,500,796

 
$
14,969,859


8

Table of Contents

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

 
December 31, 2011
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
5,692,754

 
$
2,667,929

 
$
8,360,683

Unamortized premium
279,640

 

 
279,640

Unamortized discount
  

 
  

 
  

Designated credit reserve

 
(782,606
)
 
(782,606
)
Net, unamortized
(1,008,780
)
 
(540,969
)
 
(1,549,749
)
Amortized Cost
4,963,614

 
1,344,354

 
6,307,968

Gross unrealized gains
108,864

 
11,881

 
120,745

Gross unrealized losses
(19,321
)
 
(160,140
)
 
(179,461
)
Carrying Value
$
5,053,157

 
$
1,196,095

 
$
6,249,252


The following tables present the carrying value of the Company's AFS investment securities by rate type as of September 30, 2012 and December 31, 2011:
 
September 30, 2012
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
200,556

 
$
2,207,347

 
$
2,407,903

Fixed Rate
12,268,507

 
293,449

 
12,561,956

Total
$
12,469,063

 
$
2,500,796

 
$
14,969,859

 
December 31, 2011
(in thousands)
Agency
 
Non-Agency
 
Total
Adjustable Rate
$
231,678

 
$
995,014

 
$
1,226,692

Fixed Rate
4,821,479

 
201,081

 
5,022,560

Total
$
5,053,157

 
$
1,196,095

 
$
6,249,252


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 it does not expect to collect it 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 an off balance sheet credit reserve on the security, with unamortized net discounts or premiums amortized into income over time to the extent realizable.

9

Table of Contents

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

The following table presents the changes for the nine months ended September 30, 2012 and 2011 of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
 
Nine Months Ended September 30,
 
2012
 
2011
(in thousands)
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
 
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
Beginning balance at January 1
$
(782,606
)
 
$
(540,969
)
 
$
(1,323,575
)
 
$
(145,855
)
 
$
(129,992
)
 
$
(275,847
)
Acquisitions
(590,090
)
 
(534,000
)
 
(1,124,090
)
 
(640,451
)
 
(483,479
)
 
(1,123,930
)
Accretion of net discount
493

 
98,685

 
99,178

 

 
32,305

 
32,305

Realized credit losses
33,622

 

 
33,622

 
3,011

 

 
3,011

Reclassification adjustment for other-than-temporary impairments
(9,310
)
 

 
(9,310
)
 
(3,665
)
 

 
(3,665
)
Transfers from (to)

 

 

 
579

 
(579
)
 

Sales, calls, other
8,154

 
15,876

 
24,030

 
13,443

 
26,416

 
39,859

Ending balance at September 30
$
(1,339,737
)
 
$
(960,408
)
 
$
(2,300,145
)
 
$
(772,938
)
 
$
(555,329
)
 
$
(1,328,267
)

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 the securities had an unrealized loss position as of September 30, 2012 and December 31, 2011. At September 30, 2012, the Company held 1,490 AFS securities, of which 76 were in an unrealized loss position for less than twelve consecutive months and 70 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2011, the Company held 854 AFS securities, of which 264 were in an unrealized loss position for less than twelve months and 20 were in an unrealized loss position for more than twelve consecutive months.
 
Unrealized Loss Position for
 
Less than 12 Months
 
12 Months or More
 
Total
(in thousands)
Estimated Fair Value
 
Gross Unrealized Losses
 
Estimated Fair Value
 
Gross Unrealized Losses
 
Estimated Fair Value
 
Gross Unrealized Losses
September 30, 2012
$
301,709

 
$
(11,682
)
 
$
181,019

 
$
(18,425
)
 
$
482,728

 
$
(30,107
)
December 31, 2011
$
1,277,120

 
$
(175,348
)
 
$
15,608

 
$
(4,113
)
 
$
1,292,728

 
$
(179,461
)

Evaluating AFS Securities for Other-Than-Temporary Impairments
In order to evaluate 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 is not 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 other comprehensive income. 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.
The Company recorded a $0.6 million and a $9.3 million other-than-temporary credit impairment during the three and nine months ended September 30, 2012, respectively, on a total of 37 non-Agency RMBS where the future expected cash flows for each security was less than its amortized cost. As of September 30, 2012, the impaired securities had weighted average cumulative losses of 1.7%, weighted average three-month prepayment speed of 3.04, weighted average 60+ day delinquency of 36.6% of the pool balance, and weighted average FICO score of 650. At September 30, 2012, 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,

10

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

therefore, only the projected credit loss was recognized in earnings. During the three and nine months ended September 30, 2011, the Company recorded a $3.4 million and a $3.7 million other-than-temporary credit impairment, respectively, on eight non-Agency RMBS where the future expected cash flows for each security was less than its amortized cost.
The following table presents the changes in OTTI included in earnings for nine months ended September 30, 2012 and 2011:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2012
 
2011
 
2012
 
2011
Cumulative credit loss at beginning of period
$
(13,603
)
 
$
(294
)
 
$
(5,102
)
 
$

Additions:
 
 
 
 
 
 
 
Other-than-temporary impairments not previously recognized
(315
)
 
(3,371
)
 
(6,443
)
 
(3,665
)
Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments
(244
)
 

 
(2,867
)
 

Reductions:
 
 
 
 
 
 
 
Decreases related to other-than-temporary impairments on securities paid down

 

 
250

 

Decreases related to other-than-temporary impairments on securities sold
243

 

 
243

 

Cumulative credit loss at end of period
$
(13,919
)
 
$
(3,665
)
 
$
(13,919
)
 
$
(3,665
)

Cumulative credit losses related to OTTI may be reduced for securities sold as well as for securities that mature, pay down, or are prepaid such that the outstanding principal balance is reduced to zero. Additionally, increases in cash flows expected to be collected over the remaining life of the security cause a reduction in the cumulative credit loss.
Gross Realized Gains and Losses
Gains and losses from the sale of AFS securities are recorded as realized gains (losses) within gain on investment securities, net in the Company's condensed consolidated statements of comprehensive income. For the three and nine months ended September 30, 2012, the Company sold AFS securities for $9.4 million and $207.1 million with an amortized cost of $9.6 million and $197.3 million, for a net realized loss of $0.2 million and a net realized gain of $9.8 million, respectively.
The following table presents the gross realized gains and losses on sales of AFS securities for the three and nine months ended September 30, 2012 and 2011:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2012
 
2011
 
2012
 
2011
Gross realized gains
$

 
$
27,472

 
$
11,663

 
$
29,422

Gross realized losses
(221
)
 

 
(1,850
)
 
(265
)
Total realized gains on sales, net
$
(221
)
 
$
27,472

 
$
9,813

 
$
29,157


Note 4. Trading Securities, at Fair Value
The Company holds U.S. Treasuries in a taxable REIT subsidiary and classifies these securities as trading instruments due to short-term investment objectives. As of September 30, 2012 and December 31, 2011, the Company held U.S. Treasuries with an amortized cost of $1.0 billion and $1.0 billion and a fair value of $1.0 billion and $1.0 billion, respectively, classified as trading securities. The unrealized gains included within trading securities were $5.8 million and $3.1 million as of September 30, 2012 and December 31, 2011, respectively.
For the nine months ended September 30, 2012, the Company sold trading securities for $1.0 billion with an amortized cost of $1.0 billion, resulting in realized gains of $1.7 million on the sale of these securities. The Company did not sell any trading securities during the three months ended September 30, 2012. For the three and nine months ended September 30, 2012, trading securities experienced unrealized gains of $2.7 million. Both realized and unrealized gains and losses are recorded as a

11

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

component of gains on investment securities, net in the Company's condensed consolidated statements of comprehensive income.
At September 30, 2012, the Company pledged trading securities with a carrying value of $1.0 billion as collateral for repurchase agreements. See Note 12 - Repurchase Agreements.

Note 5. Mortgage Loans Held-for-Sale, at Fair Value
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 mortgage loans held-for-sale as of September 30, 2012 and December 31, 2011:
(in thousands)
September 30,
2012
 
December 31, 2011
Unpaid principal balance
$
14,156

 
$
5,655

Fair value adjustment
397

 
127

Carrying value
$
14,553

 
$
5,782


At September 30, 2012, the Company pledged mortgage loans with a carrying value of $14.6 million as collateral for repurchase agreements. See Note 12 - Repurchase Agreements.

Note 6. Investment in Real Estate, Net
Investments in real estate consists of single family residential properties purchased by the Company with the intention to hold and rent the properties. The following table presents the carrying value of the Company's investment in real estate as of September 30, 2012 and December 31, 2011:
(in thousands)
September 30,
2012
 
December 31,
2011
Land
$
39,377

 
$

Building
151,988

 

 
191,365

 

Accumulated depreciation (1)
(458
)
 

Investment in real estate, net
$
190,907

 
$

____________________
(1)
Depreciation expense for the three and nine months ended September 30, 2012 was $426,532 and $458,158, respectively.

Note 7. Restricted Cash
The Company is required to maintain certain cash balances with counterparties for broker activity and collateral for the Company's repurchase agreements in non-interest bearing 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 September 30, 2012 and December 31, 2011:
(in thousands)
September 30,
2012
 
December 31,
2011
Restricted cash balances held by trading counterparties:
 
 
 
For securities trading activity
$
9,000

 
$
9,000

For derivatives trading activity
182,826

 
62,784

As restricted collateral for repurchase agreements
14,018

 
94,803

 
205,844

 
166,587

Restricted cash balance pursuant to letter of credit on office lease
346

 

Total
$
206,190

 
$
166,587


12

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


Note 8. Accrued Interest Receivable
The following table presents the Company's accrued interest receivable by collateral type:
(in thousands)
September 30,
2012
 
December 31,
2011
Accrued Interest Receivable:
 
 
 
U.S. Treasuries
$
166

 
$
1,003

Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
12,571

 
5,844

Federal National Mortgage Association
22,592

 
9,770

Government National Mortgage Association
8,613

 
4,454

Non-Agency
2,881

 
2,328

Total mortgage-backed securities
46,657

 
22,396

Mortgage loans held-for-sale
96

 
38

Total
$
46,919

 
$
23,437


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 Company's primary objective for executing these derivatives and non-derivative instruments is to mitigate the Company's economic exposure to future events that are outside its control. The Company's derivative financial instruments are utilized principally to manage market risk and cash flow volatility associated with interest rate risk (including associated prepayment risk) related to certain assets and liabilities. As part of its risk management activities, the Company may, at times, enter into various forward contracts including short securities, Agency to-be-announced securities, or TBAs, options, futures, swaps, caps, and credit default swaps. In executing on the Company's current risk management strategy, the Company has entered into interest rate swap and swaption agreements, and credit default swaps. At times, the Company may use TBAs for risk management or other purposes. The Company has also entered into a number of non-derivative instruments to manage interest rate risk, principally U.S. Treasuries and Agency interest-only securities.
The following summarizes the Company's significant asset and liability classes, the risk exposure for these classes, and the Company's risk management activities used to mitigate certain of these risks. The discussion includes both derivative and non-derivative instruments used as part of these risk management activities. While the Company uses non-derivative and 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
The following tables present the gross fair value and notional amounts of the Company's derivative financial instruments treated as trading instruments as of September 30, 2012 and December 31, 2011.
(in thousands)
 
September 30, 2012
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
Notional
 
Fair Value
Notional
Inverse interest-only securities
 
$
332,569

2,031,621

 
$


Interest rate swap agreements
 


 
(132,322
)
13,095,000

Credit default swap agreements
 
54,584

610,707

 


Swaptions
 
105,064

5,150,000

 


TBAs
 
3,967

450,000

 


Forward purchase commitment
 
604

319,931

 


Total
 
$
496,788

8,562,259

 
$
(132,322
)
13,095,000


13

Table of Contents

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

(in thousands)
 
December 31, 2011
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
Notional
 
Fair Value
Notional
Inverse interest-only securities
 
$
157,421

1,131,084

 
$


Interest rate swap agreements
 


 
(28,790
)
5,810,000

Credit default swap agreements
 
86,136

544,699

 
(14,638
)
154,812

Swaptions
 
5,635

2,900,000

 


TBAs
 
2,664

275,000

 
(5,652
)
850,000

Forward sale commitment
 

5,202

 


Total
 
$
251,856

4,855,985

 
$
(49,080
)
6,814,812


The following table provides the average outstanding notional amounts of the Company's derivative financial instruments treated as trading instruments for the three and nine months ended September 30, 2012.
(in thousands)
 
Three Months Ended September 30, 2012
 
Nine Months Ended September 30, 2012
Trading instruments
 
Derivative Assets
 
Derivative Liabilities
 
Derivative Assets
 
Derivative Liabilities
Inverse interest-only securities
 
1,953,128

 

 
1,669,944

 

Interest rate swap agreements
 

 
11,327,391

 

 
8,625,967

Credit default swaps
 
545,611

 
48,576

 
554,568

 
91,555

Swaptions
 
4,891,304

 

 
3,687,328

 

TBAs
 
304,348

 

 
278,741

 
564,416

Short treasuries
 

 
46,739

 

 
15,693

Forward purchase commitment
 
45,872

 

 
15,894

 

Forward sale commitment
 

 

 
3,199

 


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

14

Table of Contents

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

The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed consolidated statement of comprehensive income on its derivative instruments:
(in thousands)
 
 
 
 
 
 
 
 
 
 
Trading Instruments
 
Location of Gain/(Loss) Recognized in Income on Derivatives
 
Amount of Gain/(Loss) Recognized in Income on Derivatives
 
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
 
 
2012
 
2011
 
2012
 
2011
Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Interest Rate Contracts
 
 
 
 
 
 
 
 
 
 
Investment securities - RMBS
 
Gain (loss) on other derivative instruments
 
$
2,170

 
$
5,729

 
$
(22,817
)
 
$
5,091

Investment securities - U.S. Treasuries and TBA contracts
 
Loss on interest rate swap and swaption agreements
 
(5,429
)
 
6,544

 
(12,774
)
 
2,733

Mortgage loans held-for-sale
 
Gain (loss) on other derivative instruments
 
604

 

 
578

 

Repurchase agreements
 
Loss gain on interest rate swap and swaption agreements
 
(71,043
)
 
(45,855
)
 
(140,905
)
 
(90,913
)
Credit default swaps - Receive protection
 
Gain (loss) on other derivative instruments
 
(18,661
)
 
21,994

 
(44,187
)
 
22,267

Non-Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Credit default swaps - Provide protection
 
Gain (loss) on other derivative instruments
 
3,015

 
(4,414
)
 
11,987

 
(5,589
)
Inverse interest-only securities
 
Gain (loss) on other derivative instruments
 
18,094

 
(948
)
 
43,154

 
15,705

Short treasuries
 
Gain (loss) on other derivative instruments
 
(1,768
)
 

 
(1,768
)
 

Total
 
 
 
$
(73,018
)
 
$
(16,950
)
 
$
(166,732
)
 
$
(50,706
)

For the three and nine months ended September 30, 2012, the Company recognized $10.7 million and $23.1 million, respectively, of expenses for the accrual and/or settlement of the net interest expense associated with its interest rate swaps. The expenses result from generally paying a fixed interest rate on an average $11.3 billion and $8.6 billion notional, respectively, to hedge a portion of the Company's interest rate risk on its short-term repurchase agreements, funding costs, and macro-financing risk and generally receiving LIBOR interest.
For the three and nine months ended September 30, 2012, the Company terminated or had options expire on a total of 3 and 22 interest rate swap and swaption positions of $0.8 billion notional and $3.7 billion notional, respectively. Upon settlement of the early terminations and option expirations, the Company paid $1.5 million in full settlement of its net interest spread liability and recognized $7.5 million and $26.1 million in realized losses on the swaps and swaptions, respectively, including early termination penalties.
For the three and nine months ended September 30, 2012, the Company terminated a total of 3 and 13 credit default swap positions totaling $185.0 million and $425.0 million notional, respectively. Upon settlement of the early terminations, the Company received $94,069 and $30,861, respectively, in full settlement of its net interest spread receivable and recognized $1.0 million in realized gains and $2.3 million in realized losses for the three and nine months ended September 30, 2012, respectively, on the credit default swaps, including early termination penalties.
Cash flow activity related to derivative instruments is reflected within the operating activities and investing activities sections of the condensed consolidated statements of cash flows. Derivative fair value adjustments are reflected within the unrealized loss on interest rate swaps and swaptions and unrealized loss gain on other derivative instruments line items and realized losses on interest rate swap and swaption agreements are reflected within the loss on termination of interest rate swaps and swaptions line item within the operating activities section of the condensed consolidated statements of cash flows. The

15

Table of Contents

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

remaining cash flow activity related to derivative instruments is reflected within the purchases of other derivative instruments, proceeds from sales of other derivative instruments and increase (decrease) in due to counterparties, net line items within the investing activities section of the condensed consolidated statements of cash flows.
Interest Rate Sensitive Assets/Liabilities
Available-for-sale Securities  - The Company's RMBS investment securities are generally subject to change in value when mortgage rates decline or increase, depending on the type of investment. Rising mortgage rates generally result in a slowing of refinancing activity, which slows prepayments and results in a decline in the value of the Company's fixed-rate Agency pools. To mitigate the impact of this risk, the Company maintains a portfolio of financial instruments, primarily fixed-rate interest-only securities, which increase in value when interest rates increase. In addition, the Company has initiated TBA positions to further mitigate its exposure to increased prepayment speeds. The objective is to reduce the risk of losses to the portfolio caused by interest rate changes and changes in prepayment speeds.
As of September 30, 2012 and December 31, 2011, the Company had outstanding fair value of $86.2 million and $48.4 million, respectively, of interest-only securities in place to economically hedge its investment securities. These interest-only securities are included in AFS securities, at fair value, in the condensed consolidated balance sheets. In addition, the Company held TBA positions with $450.0 million and $275.0 million in long notional as of September 30, 2012 and December 31, 2011, respectively, and an additional $850.0 million in short notional as of December 31, 2011. The Company discloses these on a gross basis according to the unrealized gain or loss position of each TBA contract regardless of long or short notional position. These contracts held a fair market value of $4.0 million and $2.7 million, included in derivative assets, at fair value, as of September 30, 2012 and December 31, 2011, respectively, and $5.7 million, included in derivative liabilities, at fair value, in the condensed consolidated balance sheet as of December 31, 2011.
Commitments to Purchase and/or Sell Mortgage Loans Held-for-Sale  - Prior to a mortgage loan purchase, the Company may enter into forward purchase commitments with counterparties whereby the Company commits to purchasing the loans at a particular interest rate, provided the borrower elects to close the loan. These commitments to purchase mortgage loans have been defined as derivatives and are therefore recorded on the balance sheet as assets or liabilities and measured at fair value. Subsequent changes in fair value are recorded on the balance sheet as adjustments to the carrying value of these assets or liabilities with a corresponding adjustment recognized in current period earnings. As of September 30, 2012, the Company had entered into commitments to purchase mortgage loans of $319.9 million, subject to fallout if the loans do not close, with a fair value of $0.6 million at September 30, 2012.
The Company is exposed to interest rate risk on mortgage loans from the time it commits to purchase the mortgage loan until the mortgage loan is sold. Changes in interest rates impact the market price for the mortgage loans. For example, as market interest rates decline, the value of mortgage loans held-for-sale increases, and vice versa. To mitigate the impact of this risk, the Company may from time to time enter into a forward sale commitment under the Forward AAA Securities Agreement, or the Forward Agreement, with Barclays Bank PLC, or Barclays, pursuant to which Barclays would purchase certain securities issued in connection with a potential securitization transaction involving mortgage loans subject to the Forward Agreement. As of December 31, 2011, one trade had been executed under the Forward Agreement with a notional of $5.2 million. No fair value was assigned to the derivative at December 31, 2011 as it was entered into at market terms at the end of the year. This trade was settled by the Company in the three months ended June 30, 2012. As of September 30, 2012, the Company had no additional trades under the Forward Agreement. The Company may also enter into other derivative contracts to hedge the interest rate risk related to the commitments to purchase mortgage loans, such as interest rate swaps, swaptions or TBAs.
Repurchase Agreements  - The Company monitors its repurchase agreements, which are generally floating rate debt, in relationship to the rate profile of its investment securities. When it is cost effective to do so, the Company may enter into interest rate swap arrangements to align the interest rate composition of its investment securities and debt portfolios, specifically repurchase agreements with maturities of less than 6 months. Typically, the interest receivable terms (i.e., LIBOR) of the interest rate swaps match the terms of the underlying debt, resulting in an effective conversion of the rate of the related repurchase agreement from floating to fixed.

16

Table of Contents

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

As of September 30, 2012 and December 31, 2011, the Company had the following outstanding interest rate swaps that were utilized as economic hedges of interest rate risk associated with the Company's short-term repurchase agreements:
(notional in thousands)
 
 
 
 
 
 
September 30, 2012
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
25,000

 
0.868
%
 
0.502
%
 
0.23

2013
 
2,275,000

 
0.713
%
 
0.484
%
 
0.81

2014
 
1,675,000

 
0.644
%
 
0.497
%
 
1.82

2015
 
2,770,000

 
0.908
%
 
0.471
%
 
2.68

2016 and Thereafter
 
5,350,000

 
0.923
%
 
0.410
%
 
4.45

Total
 
12,095,000

 
0.841
%
 
0.450
%
 
2.99

(notional in thousands)
 
 
 
 
 
 
December 31, 2011
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
25,000

 
0.868
%
 
0.315
%
 
0.98

2013
 
2,025,000

 
0.737
%
 
0.368
%
 
1.55

2014
 
1,275,000

 
0.670
%
 
0.380
%
 
2.72

2015
 
820,000

 
1.575
%
 
0.329
%
 
3.52

2016
 
240,000

 
2.156
%
 
0.316
%
 
4.32

Total
 
4,385,000

 
0.952
%
 
0.361
%
 
2.41


The Company has also entered into interest rate swaps in combination with U.S. Treasuries to economically hedge funding cost risk. As of September 30, 2012 and December 31, 2011, the Company held $1.0 billion in fair value of U.S. Treasuries classified as trading securities and the following outstanding interest rate swaps:
(notional in thousands)
 
 
 
 
 
 
September 30, 2012
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2015
 
1,000,000

 
0.799
%
 
0.470
%
 
2.53

Total
 
1,000,000

 
 
 
 
 
 
(notional in thousands)
 
 
 
 
 
 
December 31, 2011
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2013
 
1,250,000

 
0.620
%
 
0.339
%
 
1.54

Total
 
1,250,000

 
 
 
 
 
 


17

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

As of September 30, 2012, all of the Company's interest rate swap contracts receive interest at a 1-month or 3-month LIBOR rate. As of December 31, 2011, all of the Company's interest rate swap contracts received interest at a 1-month or 3-month LIBOR rate, except the following interest rate swap entered in combination with TBA contracts to economically hedge mortgage basis widening where the Company paid interest at a 3-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
December 31, 2011
Swaps Maturities
 
Notional Amounts
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2016
 
175,000

 
0.420
%
 
1.772
%
 
4.58

Total
 
175,000

 
 
 
 
 
 

Additionally, as of September 30, 2012 and December 31, 2011, the Company had the following outstanding interest rate swaptions (agreements to enter into interest rate swaps in the future for which the Company would pay a fixed rate) that were utilized as macro-economic hedges:
September 30, 2012
(notional and dollars in thousands)
 
Option
 
Underlying Swap
Swaption
 
Expiration
 
Cost
 
Fair Value
 
Average Months to Expiration
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Term (Years)
Payer
 
< 6 Months
 
$
1,995

 
$

 
0.87
 
200,000

 
3.25
%
 
3M Libor
 
7.0

Payer
 
≥ 6 Months
 
133,908

 
105,064

 
55.43
 
4,950,000

 
3.75
%
 
3M Libor
 
9.8

Total Payer
 
 
 
$
135,903

 
$
105,064

 
55.43
 
5,150,000

 
3.73
%
 
3M Libor
 
9.7

December 31, 2011
(notional and dollars in thousands)
 
Option
 
Underlying Swap
Swaption
 
Expiration
 
Cost
 
Fair Value
 
Average Months to Expiration
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Term (Years)
Payer
 
< 6 Months
 
$
16,147

 
$
4

 
4.97
 
1,600,000

 
3.22
%
 
3M Libor
 
3.7

Payer
 
≥ 6 Months
 
13,523

 
5,631

 
12.27
 
1,300,000

 
3.19
%
 
3M Libor
 
6.5

Total Payer
 
 
 
$
29,670

 
$
5,635

 
12.26
 
2,900,000

 
3.21
%
 
3M Libor
 
4.9


The Company has not applied hedge accounting to its current derivative portfolio held to mitigate the interest rate risk associated with its debt portfolio. As a result, the Company is subject to volatility in its earnings due to movement in the unrealized gains and losses associated with its interest rate swaps and its other derivative instruments.
Foreign Currency Risk
In compliance with the Company's REIT requirements, the Company does not have exposure to foreign denominated assets or liabilities. As such, the Company is not subject to foreign currency risk.
Credit Risk
The Company's exposure to credit losses on its U.S. Treasuries and Agency portfolio of investment securities is limited because these securities are issued by the U.S. Department of the Treasury or government sponsored entities, or GSEs. The payment of principal and interest on the Freddie Mac and Fannie Mae mortgage-backed securities are guaranteed by those respective agencies, and the payment of principal and interest on the Ginnie Mae mortgage-backed securities are backed by the full faith and credit of the U.S. Government.
For non-Agency investment securities, the Company enters into credit default swaps to hedge credit risk. In future periods, the Company could enhance its credit risk protection, enter into further paired derivative positions, including both long and short credit default swaps and/or seek opportunistic trades in the event of a market disruption (see "Non-Risk Management

18

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

Activities" section). The Company also has processes and controls in place to monitor, analyze, manage and mitigate its credit risk with respect to non-Agency RMBS.
As of September 30, 2012, the Company held credit default swaps where the Company receives credit protection for a fixed premium. The maximum payouts for these credit default swaps are limited to the current notional amounts of each swap contract. Maximum payouts for credit default swaps do not represent the expected future cash requirements, as the Company's credit default swaps are typically liquidated or expire and are not exercised by the holder of the credit default swaps.
The following tables present credit default swaps where the Company is receiving protection held as of September 30, 2012 and December 31, 2011:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
September 30, 2012
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront Payable
 
Unrealized Gain/(Loss)
Receive
9/20/2013
 
460.00

 
(45,000
)
 
$
(269
)
 
$
(3,127
)
 
$
(3,396
)
 
12/20/2013
 
181.91

 
(105,000
)
 
(178
)
 
(3,225
)
 
(3,403
)
 
6/20/2016
 
105.50

 
(100,000
)
 
(1,538
)
 
(260
)
 
(1,798
)
 
12/20/2016
 
682.82

 
(121,000
)
 
(1,029
)
 
(13,062
)
 
(14,091
)
 
6/20/2017
 
586.18

 
(99,000
)
 
(863
)
 
(3,563
)
 
(4,426
)
 
5/25/2046
 
306.99

 
(140,707
)
 
58,461

 
(61,852
)
 
(3,391
)
 
Total
 
383.49

 
(610,707
)
 
$
54,584

 
$
(85,089
)
 
$
(30,505
)
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2011
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront Payable
 
Unrealized Gain/(Loss)
Receive
9/20/2013
 
460.00

 
(45,000
)
 
$
2,422

 
$
(3,127
)
 
$
(705
)
 
12/20/2013
 
172.50

 
(105,000
)
 
3,742

 
(3,225
)
 
517

 
6/20/2016
 
105.00

 
(150,000
)
 
2,074

 
(355
)
 
1,719

 
12/20/2016
 
684.38

 
(125,000
)
 
10,200

 
(13,062
)
 
(2,862
)
 
5/25/2046
 
377.23

 
(119,699
)
 
67,698

 
(57,322
)
 
10,376

 
Total
 
341.94

 
(544,699
)
 
$
86,136

 
$
(77,091
)
 
$
9,045


Derivative financial instruments contain an element of credit risk if counterparties are unable to meet the terms of the agreements. Credit risk associated with derivative financial instruments is measured as the net replacement cost should the counterparties that owe the Company under contracts completely fail to perform under the terms of these contracts, assuming there are no recoveries of underlying collateral, as measured by the market value of the derivative financial instruments. As of September 30, 2012, the fair value of derivative financial instruments as an asset and liability position was $496.8 million and $132.3 million, respectively.
The Company mitigates the credit risk exposure on derivative financial instruments by limiting the counterparties to those major banks and financial institutions that meet established credit guidelines, and the Company seeks to transact with several different counterparties in order to reduce the exposure to any single counterparty. Additionally, the Company reduces credit risk on the majority of its derivative instruments by entering into agreements that permit the closeout and netting of transactions with the same counterparty upon occurrence of certain events. To further mitigate the risk of counterparty default, the Company maintains collateral agreements with certain of its counterparties. The agreements require both parties to maintain cash deposits in the event the fair values of the derivative financial instruments exceed established thresholds. As of September 30, 2012, the Company has received cash deposits from counterparties of $102.9 million and placed cash deposits of $183.4 million in

19

Table of Contents

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

accounts maintained by counterparties, of which the amounts are netted on a counterparty basis and classified within restricted cash, due from counterparties, or due to counterparties on the condensed consolidated balance sheet.
In accordance with ASC 815, as amended and interpreted, the Company records derivative financial instruments on its condensed consolidated balance sheet as assets or liabilities at fair value. Changes in fair value are accounted for depending on the use of the derivative instruments and whether they qualify for hedge accounting treatment. Due to the volatility of the credit markets and difficulty in effectively matching pricing or cash flows, the Company has elected to treat all current derivative contracts as trading instruments.
Non-Risk Management Activities
The Company has entered into certain financial instruments that are considered derivative contracts under ASC 815 that are not for purposes of hedging. These contracts are currently limited to inverse interest-only RMBS, credit default swaps, and, on occasion, TBAs.
Inverse interest-only securities with a carrying value of $332.6 million, including accrued interest receivable of $3.9 million, are accounted for as derivative financial instruments in the condensed consolidated financial statements. The following table presents the amortized cost and carrying value (which approximates fair value) of inverse interest-only securities as of September 30, 2012 and December 31, 2011:
(in thousands)
September 30,
2012
 
December 31,
2011
Face Value
$
2,031,621

 
$
1,131,084

Unamortized premium

 

Unamortized discount
 
 
 
Designated credit reserve

 

Net, unamortized
(1,721,349
)
 
(973,066
)
Amortized Cost
310,272

 
158,018

Gross unrealized gains
25,009

 
4,606

Gross unrealized losses
(6,646
)
 
(7,385
)
Carrying Value
$
328,635

 
$
155,239


As of December 31, 2011, the Company also held credit default swaps where the Company provides credit protection for a fixed premium. The maximum payouts for these credit default swaps are limited to the current notional amounts of each swap contract. Maximum payouts for credit default swaps do not represent the expected future cash requirements, as the Company's credit default swaps are typically liquidated or expire and are not exercised by the holder of the credit default swaps. The Company did not hold any credit default swaps where the Company provides credit protection as of September 30, 2012.
The following table presents credit default swaps where the Company is providing protection held as of December 31, 2011:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2011
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Loss
Provide
7/25/2036
 
358.71

 
99,890

 
$
2,733

 
$
(11,089
)
 
$
(8,356
)
 
5/25/2046
 
146.18

 
54,922

 
(17,371
)
 
13,574

 
(3,797
)
 
 
 
289.59

 
154,812

 
$
(14,638
)
 
$
2,485

 
$
(12,153
)


20

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

Note 10. Other Assets
Other assets as of September 30, 2012 and December 31, 2011 are summarized in the following table:
(in thousands)
September 30,
2012
 
December 31,
2011
Property and equipment at cost
$
739

 
$
322

Accumulated depreciation (1)
(170
)
 
(39
)
Net property and equipment
569

 
283

Prepaid expenses
1,342

 
722

Current income tax receivable
4,626

 
157

Deferred tax assets
33,679

 
6,391

Escrow deposits
34,117

 

Other receivables
112

 
13

Total other assets
$
74,445

 
$
7,566

____________________
(1)
Depreciation expense for the three and nine months ended September 30, 2012 was $53,604 and $131,372, respectively.

Note 11. Fair Value
Fair Value Measurements
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 market participants at the measurement date. ASC 820 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices available in active markets (i.e., observable inputs) and the lowest priority to data lacking transparency (i.e., unobservable inputs). Additionally, ASC 820 requires an entity to consider all aspects of nonperformance risk, including the entity's own credit standing, when measuring fair value of a liability.
ASC 820 establishes a three level hierarchy to be used when measuring and disclosing fair value. An instrument's categorization within the fair value hierarchy is based on the lowest level of significant input to its valuation. Following is a description of the three levels:

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.

Following are descriptions of the 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.
Investment securities  - The Company holds a portfolio of AFS and trading securities that are carried at fair value in the condensed consolidated balance sheet. AFS securities are primarily comprised of Agency and non-Agency RMBS while the Company's U.S. Treasuries are classified as trading securities. The Company determines the fair value of its U.S. Treasuries and Agency RMBS based upon prices obtained from third-party pricing providers or broker quotes received using bid price, which are deemed indicative of market activity. In determining the fair value of its non-Agency RMBS, management judgment is used to arrive at fair value that considers prices obtained from third-party pricing providers, broker quotes received and other

21

Table of Contents

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

applicable market data. If observable market prices are not available or insufficient to determine fair value due to principally illiquidity in the marketplace, then fair value is based upon internally developed models that are primarily based on observable market-based inputs but also include unobservable market data inputs (including prepayment speeds, delinquency levels, and credit losses). The Company classified 100.0% of its U.S. Treasuries as Level 1 fair value assets at September 30, 2012. The Company classified 100.0% of its RMBS AFS securities reported at fair value as Level 2 at September 30, 2012. AFS and trading securities account for 90.8% and 6.1% of all assets reported at fair value at September 30, 2012, respectively.
Mortgage loans held-for-sale  - The Company holds a portfolio of mortgage loans held-for-sale that are carried at fair value in the condensed consolidated balance sheet as a result of a fair value option election. The Company determines fair value of its mortgage loans based on prices obtained from third-party pricing providers and other applicable market data. If observable market prices are not available or insufficient to determine fair value due principally to illiquidity in the marketplace, then fair value is based upon cash flow models that are primarily based on observable market-based inputs but also include unobservable market data inputs (including prepayment speeds, delinquency levels and credit losses). The Company classified 100% of its mortgage loans held-for-sale as Level 2 fair value assets at September 30, 2012.
Derivative instruments  - The Company may enter into a variety of derivative financial instruments as part of its hedging strategies. The Company principally executes over-the-counter, or OTC, derivative contracts, such as interest rate swaps, swaptions, and credit default swaps. The Company utilizes third-party pricing providers to value its financial derivative instruments. The Company classified 100% of the interest rate swaps, swaptions and credit default swaps reported at fair value as Level 2 at September 30, 2012.
The Company also enters into certain other derivative financial instruments, such as TBAs and inverse interest-only securities. These instruments are similar in form to the Company's AFS securities and the Company utilizes broker quotes to value these instruments. The Company classified 100% of its inverse interest-only securities at fair value as Level 2 at September 30, 2012. The Company reported 100% of its TBAs as Level 1 as of September 30, 2012.
The Company may also enter into forward purchase commitments on mortgage loans whereby the Company commits to purchasing the loans at a particular interest rate. The fair value of these derivatives are determined by a valuation model. The model inputs include interest rates in effect at the end of the period and fallout assumptions if the borrower elects not to close the loan. The model input for interest rates and fallout assumptions are generally observable and do not involve significant management judgment. The Company classified 100% of its forward purchase commitments at fair value as Level 2 at September 30, 2012.
The Company's risk management committee governs trading activity relating to derivative instruments. The Company's policy is to minimize credit exposure related to financial derivatives used for hedging by limiting the hedge counterparties to major banks, financial institutions, exchanges, and private investors who meet established capital and credit guidelines as well as by limiting the amount of exposure to any individual counterparty.
The Company has netting arrangements in place with all derivative counterparties pursuant to standard documentation developed by the International Swap and Derivatives Association, or ISDA. Additionally, both the Company and the counterparty are required to post cash collateral based upon the net underlying market value of the Company's open positions with the counterparty. Posting of cash collateral typically occurs daily, subject to certain dollar thresholds. Due to the existence of netting arrangements, as well as frequent cash collateral posting at low posting thresholds, credit exposure to the Company and/or to the counterparty is considered materially mitigated. Based on the Company's assessment, there is no requirement for any additional adjustment to derivative valuations specifically for credit.

22

Table of Contents

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

The following tables display the Company's assets and liabilities measured at fair value on a recurring basis. The Company often economically hedges the fair value change of its assets or liabilities with derivatives and other financial instruments. The tables below display the hedges separately from the hedged items, and therefore do not directly display the impact of the Company's risk management activities.
 
Recurring Fair Value Measurements
 
At September 30, 2012
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$

 
$
14,969,859

 
$

 
$
14,969,859

Trading securities
1,002,461

 

 

 
1,002,461

Mortgage loans held-for-sale

 
14,553

 

 
14,553

Derivative assets
3,967

 
492,821

 

 
496,788

Total assets
$
1,006,428

 
$
15,477,233

 
$

 
$
16,483,661

Liabilities
 
 
 
 
 
 
 
Derivative liabilities
$

 
$
132,322

 
$

 
$
132,322

Total liabilities
$

 
$
132,322

 
$

 
$
132,322

 
Recurring Fair Value Measurements
 
At December 31, 2011
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$

 
$
6,238,136

 
$
11,116

 
$
6,249,252

Trading securities
1,003,301

 

 

 
1,003,301

Mortgage loans held-for-sale

 

 
5,782

 
5,782

Derivative assets
2,664

 
249,192

 

 
251,856

Total assets
$
1,005,965

 
$
6,487,328

 
$
16,898

 
$
7,510,191

Liabilities
 
 
 
 
 
 
 
Derivative liabilities
$
5,652

 
$
43,428

 
$

 
$
49,080

Total liabilities
$
5,652

 
$
43,428

 
$

 
$
49,080


The Company may be required to measure certain assets or liabilities at fair value from time to time. These periodic fair value measures typically result from application of certain impairment measures under GAAP. These items would constitute nonrecurring fair value measures under ASC 820. As of September 30, 2012, the Company did not have any assets or liabilities measured at fair value on a nonrecurring basis in the periods presented. 
The valuation of Level 3 instruments requires significant judgment by the third-party pricing providers and/or management. The third party pricing providers and/or management rely on inputs such as market price quotations from market makers (either market or indicative levels), original transaction price, recent transactions in the same or similar instruments, and changes in financial ratios or cash flows to determine fair value. Level 3 instruments may also be discounted to reflect illiquidity and/or non-transferability, with the amount of such discount estimated by the third party pricing provider in the absence of market information. Assumptions used by the third party pricing provider due to lack of observable inputs may significantly impact the resulting fair value and therefore the Company's financial statements. The Company's valuation committee reviews all valuations that are based on pricing information received from a third-party pricing provider. As part of this review, prices are compared against other pricing or input data points in the marketplace, along with internal valuation expertise, to ensure the pricing is reasonable. In addition, the Company performs back-testing of pricing information to validate price information and identify any pricing trends of a third party price provider.
In determining fair value, third party pricing providers use various valuation approaches, including market and income approaches. Inputs that are used in determining fair value of an instrument may include pricing information, credit data, volatility statistics, and other factors. In addition, inputs can be either observable or unobservable.

23

Table of Contents

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

The availability of observable inputs can vary by instrument and is affected by a wide variety of factors, including the type of instrument, whether the instrument is new and not yet established in the marketplace and other characteristics particular to the instrument. The third party pricing provider uses prices and inputs that are current as of the measurement date, including during periods of market dislocations. In periods of market dislocation, the availability of prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified to or from various levels within the fair value hierarchy.
Securities for which market quotations are readily available are valued at the bid price (in the case of long positions) or the ask price (in the case of short positions) at the close of trading on the date as of which value is determined. Exchange-traded securities for which no bid or ask price is available are valued at the last traded price. OTC derivative contracts, including interest rate swaps, swaptions, and credit default swaps, are valued by the Company using observable inputs, specifically quotations received from third-party pricing providers, and are therefore classified within Level 2.
The table below presents the reconciliation for all of the Company's Level 3 assets and liabilities measured at fair value on a recurring basis. The Level 3 items presented below may be hedged by derivatives and other financial instruments that are classified as Level 1 or Level 2. Thus, the tables below do not fully reflect the impact of the Company's risk management activities.
 
Level 3 Recurring Fair Value Measurements
 
 
Three Months Ended September 30, 2012
 
Nine Months Ended September 30, 2012
 
 
Assets
 
Assets
 
(in thousands)
Available-For-Sale Securities
 
Mortgage Loans Held-For-Sale
 
Available-For-Sale Securities
 
Mortgage Loans Held-For-Sale
 
Beginning of period level 3 fair value
$

 
$

 
$
11,116

 
$
5,782

 
Gains/(losses) included in net income:
 
 
 
 
 
 
 
 
Realized gains (losses)

 

 

 

 
Unrealized gains (losses)

 

 

 
(45
)
(1) 
Total net gains/(losses) included in net income

 

 

 
(45
)
 
Other comprehensive income 

 

 

 

 
Purchases

 

 

 

 
Sales

 

 

 

 
Settlements

 

 

 
(26
)
 
Gross transfers into level 3

 

 

 

 
Gross transfers out of level 3

 

 
(11,116
)
 
(5,711
)
 
End of period level 3 fair value
$

 
$

 
$

 
$

 
Change in unrealized gains or losses for the period included in earnings for assets held at the end of the reporting period
$

 
$

 
$

 
$

 
___________________
(1)
For the nine months ended September 30, 2012 , the change in unrealized losses on mortgage loans held-for-sale was recorded in other income on the condensed consolidated statements of comprehensive income.

The Company transferred three Level 3 assets in the amount of $16.8 million into Level 2 during the nine months ended September 30, 2012. The assets were deemed to be Level 2 based on the availability of third-party pricing and corroborating market data. The Company did not incur transfers between Level 1 and Level 2 for the three and nine months ended September 30, 2012. Transfers between Levels are deemed to take place on the first day of the reporting period in which the transfer has taken place.
Fair Value Option for Financial Assets and Financial Liabilities
The Company elected the fair value option for the residential mortgage loans it acquires. The fair value option was elected to mitigate earnings volatility by better matching the accounting for the assets with the related hedges. The residential

24

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

mortgage loans are carried within mortgage loans held-for-sale on the condensed consolidated balance sheet. The Company's policy is to separately record interest income on these fair value elected loans. Upfront fees and costs related to the fair value elected loans are not deferred or capitalized. Fair value adjustments are reported in other income on the condensed consolidated statements of comprehensive income. The fair value option is irrevocable once the loan is acquired.
The following table summarizes the fair value option elections and information regarding the amounts recognized in earnings for each fair value option-elected item.
 
Changes included in the Condensed Consolidated Statements of Comprehensive Income
 
Three Months Ended September 30, 2012
 
Nine Months Ended September 30, 2012
(in thousands)
 
 
 
Interest income (1)
$
167

 
$
362

Realized loss on mortgage loans (2)
(23
)
 
(45
)
Unrealized gain on mortgage loans (2)
34

 
59

Total included in net income
$
178

 
$
376

Change in fair value due to credit risk
$

 
$

____________________
(1)
Interest income on mortgage loans held-for-sale is measured by multiplying the unpaid principal balance on the loans by the coupon rate and the number of days of interest due.
(2)
Realized loss and unrealized gain on mortgage loans is recorded in other income on the condensed consolidated statements of comprehensive income.

The table below provides the fair value and the unpaid principal balance for the Company's fair value option-elected loans.
 
September 30, 2012
 
December 31, 2011
(in thousands)
Unpaid Principal Balance
 
Fair Value (1)
 
Unpaid Principal Balance
 
Fair Value (1)
Mortgage loans held-for-sale
 
 
 
 
 
 
 
Total loans
$
14,156

 
$
14,553

 
$
5,655

 
$
5,782

Nonaccrual loans
$

 
$

 
$

 
$

Loans 90+ days past due
$

 
$

 
$

 
$

____________________
(1)
Excludes accrued interest receivable.

Fair Value of Financial Instruments
In accordance with ASC 820, the Company is required to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the condensed consolidated balance sheet, for which fair value can be estimated.
The following describes the Company's methods for estimating the fair value for financial instruments. Descriptions are not provided for those items that have zero balances as of the current balance sheet date.
AFS securities, trading securities, mortgage loans held-for-sale, derivative assets and liabilities are recurring fair value measurements; carrying value equals fair value. See discussion of valuation methods and assumptions within the Fair Value Measurements section of this footnote.
Cash and cash equivalents and restricted cash have a carrying value which approximates fair value because of the short maturities of these instruments. The Company categorizes the fair value measurement of these assets as Level 1.
The carrying value of repurchase agreements that mature in less than one year generally approximates fair value due to the short maturities. The Company holds $280.0 million of repurchase agreements that are considered long-term. The Company's long-term repurchase agreements have floating rates based on an index plus a spread and the credit spread is typically consistent with those demanded in the market. Accordingly, the interest rates on these borrowings are at

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

market and thus carrying value approximates fair value. The Company categorizes the fair value measurement of these liabilities as Level 1.

Note 12. Repurchase Agreements
The Company had outstanding $14.0 billion of repurchase agreements, including repurchase agreements funding the Company's U.S. Treasuries of $1.0 billion. Excluding the debt associated with the Company's U.S. Treasuries and the effect of the Company's interest rate swaps, the repurchase agreements had a weighted average borrowing rate of 0.71% and weighted average remaining maturities of 123 days as of September 30, 2012. The Company had outstanding $6.7 billion of repurchase agreements with a weighted average borrowing rate of 0.78%, excluding the debt associated with the Company's U.S. Treasuries and the effect of the Company's interest rate swaps, and weighted average remaining maturities of 73 days as of December 31, 2011. As of September 30, 2012 and December 31, 2011, the debt associated with the Company's U.S. Treasuries had a weighted average borrowing rate of 0.35% and 0.12%, respectively.
At September 30, 2012 and December 31, 2011, the repurchase agreement balances were as follows:
(in thousands)
September 30,
2012
 
December 31,
2011
Short-term
$
13,754,327

 
$
6,610,148

Long-term
280,000

 
50,000

Total
$
14,034,327

 
$
6,660,148


At September 30, 2012 and December 31, 2011, the repurchase agreements had the following characteristics:
(dollars in thousands)
 
September 30, 2012
 
December 31, 2011
Collateral Type
 
Amount Outstanding
 
Weighted Average Borrowing Rate
 
Amount Outstanding
 
Weighted Average Borrowing Rate
U.S. Treasuries
 
$
997,500

 
0.35
%
 
$
1,001,250

 
0.12
%
Agency RMBS
 
11,671,026

 
0.52
%
 
4,804,533

 
0.50
%
Non-Agency RMBS
 
1,111,954

 
2.56
%
 
731,014

 
2.61
%
Agency derivatives
 
241,035

 
1.16
%
 
118,032

 
0.97
%
Mortgage loans held-for-sale
 
12,812

 
2.46
%
 
5,319

 
3.20
%
Total
 
$
14,034,327

 
0.68
%
 
$
6,660,148

 
0.68
%

As of September 30, 2012, the amounts outstanding under repurchase agreements includes $82.7 million of borrowings under the 364-day repurchase facility with Wells Fargo Bank National Association, or Wells Fargo. As of September 30, 2012, the facility provided an aggregate maximum borrowing capacity of $150.0 million and is set to mature on July 23, 2013. The facility is collateralized by non-Agency RMBS and its weighted average borrowing rate as of September 30, 2012 was 2.37%. As of December 31, 2011, the amounts outstanding under repurchase agreements included $130.0 million of borrowings under the 364-day repurchase facility with Wells Fargo. As of December 31, 2011, the facility provided an aggregate maximum borrowing capacity of $150.0 million. The facility was collateralized by non-Agency RMBS and its weighted average borrowing rate as of December 31, 2011 was 2.07%. The facility requires the Company to maintain certain financial covenants under the guaranty agreement with Wells Fargo. As of September 30, 2012 and December 31, 2011, the Company was in compliance with these covenants.
As of September 30, 2012, the Company's amounts outstanding under repurchase agreements included $12.8 million of borrowings under the 364-day repurchase facility with Barclays. The facility provides an aggregate maximum borrowing capacity of $50.0 million and is set to mature on May 14, 2013, unless extended pursuant to its terms. The facility is collateralized by eligible residential mortgage loans and its weighted average borrowing rate as of September 30, 2012 was 2.46%. As of December 31, 2011, the Company's amounts outstanding under repurchase agreements included $5.3 million of borrowings under the 364-day repurchase facility with Barclays. As of December 31, 2011, the facility provided an aggregate maximum borrowing capacity of $100.0 million. The facility was collateralized by eligible residential mortgage loans and its weighted average borrowing rate as of December 31, 2011 was 3.20%. The facility requires the Company to maintain certain

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

financial covenants under the guaranty agreement with Barclays. As of September 30, 2012 and December 31, 2011, the Company was in compliance with these covenants.
At September 30, 2012 and December 31, 2011, the repurchase agreements had the following remaining maturities:
(in thousands)
September 30,
2012
 
December 31,
2011
Within 30 days
$
1,986,019

 
$
1,967,009

30 to 59 days
3,189,709

 
1,263,060

60 to 89 days
70,259

 
1,096,410

90 to 119 days
1,868,315

 
359,171

120 to 364 days (1) (2)
5,642,525

 
923,248

Open maturity (3)
997,500

 
1,001,250

One year and over (4)
280,000

 
50,000

Total
$
14,034,327

 
$
6,660,148

____________________
(1)
120 to 364 days includes the amounts outstanding under the Wells Fargo 364-day borrowing facility.
(2)
120 to 364 days includes the amounts outstanding under the Barclays 364-day borrowing facility.
(3)
Repurchase agreements collateralized by U.S. Treasuries include an open maturity period (i.e., rolling 1-day maturity) renewable at the discretion of either party to the agreements.
(4)
One year and over includes repurchase agreements with maturity dates ranging from December 23, 2013 to July 27, 2016.

The following table summarizes assets at carrying value that are pledged or restricted as collateral for the future payment obligations of repurchase agreements:
(in thousands)
September 30,
2012
 
December 31,
2011
Available-for-sale securities, at fair value
$
14,453,848

 
$
6,160,229

Trading securities, at fair value
1,002,461

 
1,003,301

Mortgage loans held-for-sale
14,553

 
5,782

Cash and cash equivalents
10,000

 
15,000

Restricted cash
14,018

 
94,803

Due from counterparties
28,965

 
32,201

Derivative assets, at fair value
318,575

 
145,779

Total
$
15,842,420

 
$
7,457,095


Although the repurchase agreements are committed borrowings until maturity, the respective lender retains the right to mark the underlying collateral to fair value. A reduction in the value of pledged assets would require the Company to provide additional collateral or fund margin calls.

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

The following table summarizes certain characteristics of the Company's repurchase agreements and counterparty concentration at September 30, 2012 and December 31, 2011:
 
September 30, 2012
 
December 31, 2011
(dollars in thousands)
Amount Outstanding
 
Net Counterparty Exposure (1)
 
Percent of Equity
 
Weighted Average Days to Maturity
 
Amount Outstanding
 
Net Counterparty Exposure (1)
 
Percent of Equity
 
Weighted Average Days to Maturity
JP Morgan Chase (2)
$
1,834,277

 
$
321,627

 
9
%
 
145.5

 
$
1,250,629

 
$
184,046

 
14
%
 
70.0

All other counterparties (3)
11,202,550

 
1,470,542

 
43
%
 
119.5

 
4,408,269

 
613,446

 
48
%
 
73.8

Total
$
13,036,827

 
$
1,792,169

 
 
 
 
 
$
5,658,898

 
$
797,492

 
 
 
 
____________________
(1)
Represents the net carrying value of the securities sold under agreements to repurchase, including accrued interest plus any cash or assets on deposit to secure the repurchase obligation, less the amount of the repurchase liability, including accrued interest. At September 30, 2012 and December 31, 2011, the Company had $15.7 million and $45.6 million, respectively, in payables due to broker counterparties for unsettled securities purchases. The payables are not included in the amounts presented above.
(2)
Excludes repurchase agreements collateralized by U.S. Treasuries with a rolling 1-day maturity.
(3)
Represents amounts outstanding to 21 and 17 counterparties at September 30, 2012 and December 31, 2011, respectively.

The Company does not anticipate any defaults by its repurchase agreement counterparties.

Note 13. Stockholders' Equity
Distributions to stockholders
The following table presents cash dividends declared by the Company on its common stock from October 28, 2009 through September 30, 2012:
Declaration Date
 
Record Date
 
Payment Date
 
Cash Dividend Per Share
September 12, 2012
 
September 24, 2012
 
October 22, 2012
 
$
0.36

June 12, 2012
 
June 22, 2012
 
July 20, 2012
 
$
0.40

March 14, 2012
 
March 26, 2012
 
April 20, 2012
 
$
0.40

December 14, 2011
 
December 27, 2011
 
January 20, 2012
 
$
0.40

September 14, 2011
 
September 26, 2011
 
October 20, 2011
 
$
0.40

June 14, 2011
 
June 24, 2011
 
July 20, 2011
 
$
0.40

March 2, 2011
 
March 14, 2011
 
April 14, 2011
 
$
0.40

December 8, 2010
 
December 17, 2010
 
January 20, 2011
 
$
0.40

September 13, 2010
 
September 30, 2010
 
October 21, 2010
 
$
0.39

June 14, 2010
 
June 30, 2010
 
July 22, 2010
 
$
0.33

March 12, 2010
 
March 31, 2010
 
April 23, 2010
 
$
0.36

December 21, 2009
 
December 31, 2009
 
January 26, 2010
 
$
0.26


Accumulated Other Comprehensive Income (Loss)
Accumulated other comprehensive income (loss) at September 30, 2012 and December 31, 2011 was as follows:
(in thousands)
September 30,
2012
 
December 31,
2011
Available-for-sale securities, at fair value
 
 
 
Unrealized gains
$
730,503

 
$
120,745

Unrealized losses
(30,107
)
 
(179,461
)
Accumulated other comprehensive income (loss)
$
700,396

 
$
(58,716
)

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


Public offerings
On January 17, 2012, the Company completed a public offering of 34,000,000 shares of its common stock and issued an additional 5,100,000 shares of common stock pursuant to the underwriters' over-allotments at a price of $9.17 per share, for gross proceeds of approximately $358.5 million. On February 24, 2012, the Company completed a public offering of 30,000,000 shares of its common stock and issued an additional 4,500,000 shares of common stock pursuant to the underwriter's over-allotments at a price of $9.90 per share, for gross proceeds of approximately $341.6 million. On July 18, 2012, the Company completed a public offering of 50,000,000 shares of its common stock and issued an additional 7,500,000 shares of common stock pursuant to the underwriters' over-allotments at a price of $10.44 per share, for gross proceeds of approximately $600.3 million. Net proceeds to the Company from the three offerings were approximately $1.3 billion, net of issuance costs of approximately $16.1 million.
Dividend Reinvestment and Direct Stock Purchase Plan
The Company sponsors a dividend reinvestment and direct stock purchase plan through which stockholders may purchase additional shares of the Company's common stock by reinvesting some or all of the cash dividends received on shares of the Company's common stock. Stockholders may also make optional cash purchases of shares of the Company's common stock subject to certain limitation detailed in the plan prospectus. An aggregate of 7.5 million shares of our common stock were originally reserved for issuance under the plan. As of September 30, 2012, 71,500 shares have been issued under the plan for total proceeds of $0.7 million.
Share Repurchase Program
On October 5, 2011, the Company's Board of Directors authorized a Share Repurchase Program, which allows the Company to repurchase up to 10,000,000 shares of its common stock. The shares are expected to be repurchased from time to time through privately negotiated transactions or open market transactions, pursuant to a trading plan in accordance with Rules 10b5-1 and 10b-18 under the Securities Exchange Act of 1934, as amended, or by any combination of such methods. The manner, price, number and timing of share repurchases will be subject to a variety of factors, including market conditions and applicable U.S. Securities and Exchange Commission rules. The Company did not repurchase any of its common stock during the fiscal year ended December 31, 2011 or the three and nine months ended September 30, 2012.
At-the-Market Offering
On May 25, 2012, the Company entered into an Equity Distribution Agreement under which the Company may sell up to an aggregate of 20,000,000 shares of its common stock from time to time in any method permitted by law deemed to be an “at the market” offering as defined in Rule 415 under the Securities Act of 1933, as amended. During the nine months ended September 30, 2012, the company sold 7,585,869 shares of common stock for total accumulated net proceeds of approximately $77.6 million.
Warrants
During the three and nine months ended September 30, 2012, warrant holders exercised 15,975,017 warrants to purchase 15,975,017 shares of the Company's common stock, at an exercise price of $11.00 per share, resulting in proceeds to the Company totaling approximately $175.7 million. Additionally, certain Capitol founders holding warrants containing cashless exercise provisions exercised 200,000 warrants, on a cashless basis, resulting in the surrender of 184,999 shares of common stock and the issuance of 15,001 shares of common stock. No proceeds were received by the Company as a result of the cashless exercises. As of September 30, 2012, 17,073,983 warrants to purchase up to 17,073,983 shares of common stock remain outstanding.


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

Note 14. Other Operating Expenses
Components of the Company's other operating expenses for the three and nine months ended September 30, 2012 and 2011 are presented in the following table:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
Other operating expenses:
 
 
 
 
 
 
 
General and administrative
$
3,489

 
$
2,155

 
$
9,875

 
$
4,787

Directors and officers' insurance
204

 
141

 
493

 
422

Professional fees
1,067

 
554

 
1,976

 
1,307

Real estate expenses
1,786

 

 
1,984

 

Total other operating expenses
$
6,546

 
$
2,850

 
$
14,328

 
$
6,516


Note 15. Income Taxes
For the three and nine months ended September 30, 2012 and 2011, the Company qualified to be taxed as a REIT under the Code for U.S. federal income tax purposes. As long as the Company qualifies as a REIT, the Company generally will not be subject to U.S. federal income taxes on its taxable income to the extent it annually distributes its net taxable income to stockholders, does not engage in prohibited transactions, and maintains its intended qualification as a REIT. The majority of states also recognize the Company's REIT status. The Company has two TRSs, Capitol Acquisition Corp., or Capitol, and TH TRS Corp., each of which file separate tax returns and are fully taxed as standalone U.S. C-Corporations. The tables below reflect the net taxes accrued at the TRS level and the tax attributes included in the condensed consolidated financial statements. It is assumed that the Company will retain its REIT status and will incur no REIT level taxation as it intends to comply with the REIT regulations and annual distribution requirements.
Certain activities the Company performs may produce income that will not be qualifying income for REIT purposes. These activities include holding swaptions, credit default swaps, TBAs and other risk-management instruments and has designated Capitol to engage in these activities. The Company purchases and intends to sell mortgage loans through the secondary whole loan market and/or securitization market and has designated TH TRS Corp. to engage in these activities.
The following table summarizes the tax (benefit) provision recorded at the taxable subsidiary level for the three and nine months ended September 30, 2012 and 2011:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(in thousands)
2012
 
2011
 
2012
 
2011
Current tax (benefit) provision:
 
 
 
 
 
 
 
Federal
$
(266
)
 
$
923

 
$
(4,888
)
 
$
928

State
1

 

 
3

 

Total current tax (benefit) provision
(265
)
 
923

 
(4,885
)
 
928

Deferred tax (benefit) provision
(7,569
)
 
8,465

 
(27,131
)
 
4,136

Total (benefit from) provision for income taxes
$
(7,834
)
 
$
9,388

 
$
(32,016
)
 
$
5,064


The Company's taxable income before dividend distributions differs from its GAAP pre-tax net income primarily due to unrealized gains and losses, the recognition of credit losses for GAAP but not tax, differences in timing of income recognition due to market discount, and original issue discount and the calculations surrounding each. These book to tax differences in the REIT are not reflected in the financial statements as the Company believes it will retain its REIT status.

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

The following is a reconciliation of the statutory federal and state rates to the effective rates, for the three and nine months ended September 30, 2012 and 2011:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
(dollars in thousands)
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
Computed income tax (benefit) expense at federal rate
$
6,448

 
34
 %
 
$
21,759

 
34
 %
 
$
24,000

 
34
 %
 
$
27,563

 
34
 %
State taxes, net of federal benefit, if applicable

 
 %
 

 
 %
 
2

 
 %
 

 
 %
Permanent differences in taxable income from GAAP income
104

 
1
 %
 
2

 
 %
 
110

 
 %
 
6

 
 %
Dividends paid deduction
(14,386
)
 
(76
)%
 
(12,373
)
 
(19
)%
 
(56,128
)
 
(79
)%
 
(22,505
)
 
(28
)%
Provision for (benefit from) income taxes/Effective Tax Rate(1)
$
(7,834
)
 
(41
)%
 
$
9,388

 
15
 %
 
$
(32,016
)
 
(45
)%
 
$
5,064

 
6
 %
____________________
(1)
The benefit from income taxes is recorded at the taxable subsidiary level.

The Company's condensed consolidated balance sheet, as of September 30, 2012 and December 31, 2011, contains the following current and deferred tax assets and liabilities, recorded at the taxable subsidiary level:
(in thousands)
September 30,
2012
 
December 31,
2011
Current tax
 
 
 
Federal income tax payable
$

 
$
(3,898
)
Current income taxes receivable
4,626

 
157

State and local income tax payable

 

Current tax receivable (payable), net
4,626

 
(3,741
)
Deferred tax assets (liabilities)
 
 
 
Deferred tax asset
37,222

 
9,710

Deferred tax liability
(3,543
)
 
(3,319
)
Deferred tax asset, net
33,679

 
6,391

Total tax assets and liabilities, net
$
38,305

 
$
2,650



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

Deferred Tax Assets and Liabilities
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amount of assets and liabilities for financial reporting and tax purposes at the TRS level. Components of the Company's deferred tax assets and liabilities as of September 30, 2012 and December 31, 2011 are as follows:
(in thousands)
September 30,
2012
 
December 31,
2011
Unrealized loss on derivative assets
$
12,547

 
$
7,429

Unrealized gain on trading securities and mortgage loans held-for-sale
(1,989
)
 
(1,038
)
Capitalized start-up and organizational costs
29

 

Net operating loss carryforward
11,683

 

Capital loss carryforward
11,409

 

Total net deferred tax assets
$
33,679

 
$
6,391


At September 30, 2012 and December 31, 2011, the Company has not recorded a valuation allowance for any portion of its deferred tax assets as it does not believe, at a more likely than not level, that any portion of its deferred tax assets will not be realized. The net operating loss carryforward of $11.7 million is scheduled to expire December 31, 2032. The capital loss carryforward of $11.4 million is scheduled to expire December 31, 2017. The Company estimates, based on existence of sufficient evidence, the ability to realize the remainder of its deferred tax assets. Any adjustments to such estimates will be made in the period such determination is made.
Based on the Company's evaluation, it has been concluded that there are no significant uncertain tax positions requiring recognition in the Company's financial statements of a contingent tax liability for uncertain tax positions. Additionally, there were no amounts accrued for penalties or interest as of or during the periods presented in these condensed consolidated financial statements.

Note 16. Earnings Per Share
The following table presents a reconciliation of the earnings and shares used in calculating basic and diluted earnings per share, or EPS, for the three and nine months ended September 30, 2012 and 2011:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands, except share data)
2012
 
2011
 
2012
 
2011
Numerator:
 
 
 
 
 
 
 
Net income attributable to common stockholders for basic and diluted earnings per share
$
26,802

 
$
54,609

 
$
102,606

 
$
76,002

Denominator:
 
 
 
 
 
 
 
Weighted average common shares outstanding
269,972,503

 
130,548,732

 
224,015,418

 
84,695,559

Weighted average restricted stock shares
32,709

 
58,834

 
43,344

 
56,295

Basic weighted average shares outstanding
270,005,212

 
130,607,566

 
224,058,762

 
84,751,854

Dilutive weighted average warrants
932,748

 

 
310,916

 

Diluted weighted average shares outstanding
270,937,960

 
130,607,566

 
224,369,678

 
84,751,854

Basic Earnings Per Share:
$
0.10

 
$
0.42

 
$
0.46

 
$
0.90

Diluted Earnings Per Share:
$
0.10

 
$
0.42

 
$
0.46

 
$
0.90


During the three and nine months ended September 30, 2012, the weighted average market value per share of the Company's common stock was above the strike price of the warrants making the warrants dilutive. For the three and nine months ended September 30, 2011, the Company assumed that no warrants would be exercised as the weighted average market value per share of the Company's common stock was below the strike price of the warrants and the warrants would be anti-dilutive.

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


Note 17. Related Party Transactions
The following summary provides disclosure of the material transactions with affiliates of the Company.
In accordance with the Management Agreement with PRCM Advisers, the Company incurred $9.7 million and $24.1 million as a management fee to PRCM Advisers for the three and nine months ended September 30, 2012, respectively, which represents approximately 1.5% of stockholders' equity on an annualized basis as defined by the Management Agreement. In addition, the Company reimbursed PRCM Advisers for direct and allocated costs incurred by PRCM Advisers on behalf of the Company. These direct and allocated costs totaled approximately $1.8 million and $7.8 million for the three and nine months ended September 30, 2012, respectively.
During the nine months ended September 30, 2012, the Company established an accounts payable function and direct relationships with the majority of its third party vendors. The Company will continue to have certain costs allocated to it by PRCM Advisers for compensation, data services and proprietary technology, but most direct expenses with third party vendors will be paid directly by the Company.
The Company recognized $29,340 and $462,686 of compensation expense during the three and nine months ended September 30, 2012, respectively, associated with the amortization of shares of restricted stock issued to the Company's independent directors as part of their annual compensation.
As of September 30, 2012, there were 17,073,983 warrants to purchase up to 17,073,983 shares of common stock issued and outstanding. Of the 17,073,983 warrants, 3,900,000 were held in registered form by the founders of Capitol, and 2,906,918 were beneficially owned by Pine River Master Fund Ltd. and Nisswa Acquisition Master Fund Ltd., which are investment funds managed by Pine River. The Company is required to maintain a resale registration statement for the warrants and common stock issuable upon exercise thereof that are held by Pine River Master Fund Ltd., Nisswa Acquisition Master Fund Ltd., and the founders of Capitol.
On February 3, 2012, a subsidiary of the Company entered into an acquisition services agreement, a property management agreement and a side letter agreement regarding certain fees with Silver Bay Property Management LLC, or Silver Bay, which is a joint venture between Provident Real Estate Advisors LLC and an affiliate of PRCM Advisers and Pine River. Under the acquisition services agreement, Silver Bay assists the Company's subsidiaries in identifying and acquiring a portfolio of residential real properties in various geographic areas throughout the U.S. Under the property management agreement, Silver Bay operates, maintains, repairs, manages and leases the residential properties and collects rental income for the benefit of the Company and its subsidiaries. Pursuant to the side letter, the Company's subsidiary is obligated to pay Silver Bay for various services provided under the acquisition services and property management agreements. For the three and nine months ended September 30, 2012, the Company incurred $1.5 million and $2.6 million, respectively, in acquisition fees payable to Silver Bay, which were capitalized as part of the property acquisition cost. In addition, for the three and nine months ended September 30, 2012, the Company incurred $138,363 and $181,477 in property management fees payable to Silver Bay, of which $72,573 and $78,687, respectively, were expensed in the condensed consolidated statement of operations. The remaining $102,790 were deferred on the condensed consolidated balance sheet as of September 30, 2012 and will be amortized over the lease period.

Note 18. Subsequent Events
Events subsequent to September 30, 2012 were evaluated through the date these financial statements were issued and no additional events were identified requiring further disclosure in these Condensed Consolidated Financial Statements.

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and accompanying notes included elsewhere in this Quarterly Report on Form 10-Q as well as our Annual Report on Form 10-K for the year ended December 31, 2011.

General
We are a Maryland corporation focused on investing in, financing and managing residential mortgage-backed securities, or RMBS, residential mortgage loans, residential real properties and other financial assets. We operate as a real estate investment trust, or REIT, as defined under the Internal Revenue Code of 1986, as amended, or the Code.
We are externally managed by PRCM Advisers LLC. PRCM Advisers is a wholly-owned subsidiary of Pine River Capital Management L.P., or Pine River, a global asset management firm providing solutions to qualified clients across three actively managed platforms: hedge funds, managed accounts and listed investment vehicles.
Our objective is to provide attractive risk-adjusted returns 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 we believe is constructed to generate attractive returns through market cycles. Our target assets include the following:

Agency RMBS, meaning RMBS whose principal and interest payments are guaranteed by the Government National Mortgage Association (or Ginnie Mae), the Federal National Mortgage Association (or Fannie Mae), or the Federal Home Loan Mortgage Corporation (or Freddie Mac);
Non-Agency RMBS, meaning RMBS that are not issued or guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac;
Residential mortgage loans;
Residential real properties; and
Other financial assets comprising approximately 5% to 10% of the portfolio.

We believe our hybrid Agency and non-Agency RMBS investment model allows management to focus on security selection and implement a relative value investment approach across various sectors within the residential mortgage market, which factors in the displaced pricing 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.
For the three months ended September 30, 2012, 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 September 30, 2012 and the four immediately preceding period ends:
 
As of
 
September 30,
2012
 
June 30,
2012
 
March 31,
2012
 
December 31,
2011
 
September 30,
2011
Agency RMBS (1)
83.7
%
 
81.7
%
 
79.4
%
 
81.3
%
 
80.9
%
Non-Agency RMBS
16.3
%
 
18.3
%
 
20.6
%
 
18.7
%
 
19.1
%
____________________
(1)
Agency RMBS includes inverse interest-only securities which are classified as derivatives for purposes of U.S. GAAP.

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 September 30, 2012, our net interest spread realized on Agency and non-Agency RMBS was lower than prior periods. Based on recent experience, yields and net interest spreads on Agency and non-Agency RMBS securities are generally lower than what we have historically realized in our portfolio. The following table provides the average annualized yield on our Agency and non-Agency RMBS for the three months ended September 30, 2012, and the four immediately preceding quarters:
 
Three Months Ended
 
September 30,
2012
 
June 30,
2012
 
March 31,
2012
 
December 31,
2011
 
September 30,
2011
Average annualized yields (1)
 
 
 
 
 
 
 
 
 
Agency RMBS (2)
3.1
%
 
3.3
%
 
3.5
%
 
3.5
%
 
4.3
%
Non-Agency RMBS
9.6
%
 
9.6
%
 
9.7
%
 
9.7
%
 
9.8
%
Aggregate RMBS
4.2
%
 
4.6
%
 
4.9
%
 
4.8
%
 
5.5
%
Cost of financing (3)
1.1
%
 
1.0
%
 
1.0
%
 
1.0
%
 
1.3
%
Net interest spread
3.1
%
 
3.6
%
 
3.9
%
 
3.8
%
 
4.2
%
____________________
(1)
Average annualized yield incorporates future prepayment, credit loss and other assumptions, all of which are estimates and subject to change.
(2)
Agency RMBS includes inverse interest-only securities which are classified as derivatives under U.S. GAAP.
(3)
Cost of financing includes swap interest rate spread.

The following table provides the average annualized yield on our Agency and non-Agency RMBS as of September 30, 2012, and the four immediately preceding period ends:
 
As of
 
September 30,
2012
 
June 30,
2012
 
March 31,
2012
 
December 31,
2011
 
September 30,
2011
Average annualized yields (1)
 
 
 
 
 
 
 
 
 
Agency RMBS (2)
2.8
%
 
3.3
%
 
3.5
%
 
3.3
%
 
3.4
%
Non-Agency RMBS
9.6
%
 
9.6
%
 
9.7
%
 
9.7
%
 
9.6
%
Aggregate RMBS
3.8
%
 
4.5
%
 
4.7
%
 
4.7
%
 
4.7
%
Cost of financing (3)
1.1
%
 
1.0
%
 
1.0
%
 
1.0
%
 
1.3
%
Net interest spread
2.7
%
 
3.5
%
 
3.7
%
 
3.7
%
 
3.4
%
____________________
(1)
Average annualized yield incorporates future prepayment, credit loss and other assumptions, all of which are estimates and subject to change.
(2)
Agency RMBS includes inverse interest-only securities which are classified as derivatives for purposes of U.S. GAAP.
(3)
Cost of financing includes swap interest rate spread.

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 and Agency derivatives, 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 RMBS, Agency derivatives and residential mortgage loans is the most meaningful leverage measure as U.S. Treasuries are viewed to be highly liquid in nature. 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 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, Agency derivatives and mortgage loans, 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-

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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 compete with other investment vehicles for attractive investment opportunities. We rely on our management team and Pine River, who have developed strong relationships with a diverse group of financial intermediaries, to identify investment opportunities. In addition, we have benefited and expect to continue to benefit from Pine River'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 taxable REIT subsidiaries, or 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 Investment Company Act of 1940, as amended, or the 1940 Act.
On September 11, 2012, we announced the proposed contribution of our portfolio of single-family rental properties to a newly formed entity intended to qualify as a REIT. Specifically, we would contribute our equity interests in our wholly owned subsidiary, Two Harbors Property Investment LLC to Silver Bay Realty Trust Corp., a newly organized Maryland corporation focused on the acquisition, renovation, leasing and management of single-family residential properties for rental income and long-term capital appreciation. In exchange for our contribution, we would receive shares of common stock of Silver Bay. Silver Bay Realty Trust Corp. has filed a registration statement with the U.S. Securities and Exchange Commission with respect to the proposed initial public offering, or IPO, of its common stock. The consummation of the proposed contribution transaction, which remains subject to approval of our board of directors, is dependent upon the value of the contribution and amount of capital raised in the proposed IPO as well as market and other conditions.

Forward-Looking Statements
This Quarterly Report on Form 10-Q contains, or incorporates by reference, not only historical information, but also forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, as amended. Forward-looking statements involve numerous risks and uncertainties. Our actual results may differ from our beliefs, expectations, estimates, and projections and, consequently, you should not rely on these forward-looking statements as predictions of future events. Forward-looking statements are not historical in nature and can be identified by words such as “anticipate,” “estimate,” “will,” “should,” “expect,” “target,” “believe,” “intend,” “seek,” “plan” and similar expressions or their negative forms, or by references to strategy, plans, or intentions. These forward-looking statements are subject to risks and uncertainties, including, among other things, those described in this Annual Report on Form 10-K under the caption “Risk Factors.” Other risks, uncertainties, and factors that could cause actual results to differ materially from those projected are described below and may be described from time to time in reports we file with the SEC, including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K. Forward-looking statements speak only as of the date they are made, and we undertake no obligation to update or revise any such forward-looking statements, whether as a result of new information, future events, or otherwise.
Important factors, among others, that may affect our actual results include:
changes in interest rates and the market value of our target assets;
changes in prepayment rates of mortgages underlying our target assets;
the timing of credit losses within our portfolio;
our exposure to adjustable-rate and negative amortization mortgage loans underlying our target assets;
the state of the credit markets and other general economic conditions, particularly as they affect the price of earning assets and the credit status of borrowers;
the concentration of the credit risks we are exposed to;
legislative and regulatory actions affecting the mortgage and derivative industries or our business;
the availability of target assets for purchase at attractive prices;
the availability of financing for our portfolio, including the availability of repurchase agreement financing;
declines in home prices;
increases in payment delinquencies and defaults on the mortgages underlying our Non-Agency securities;

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changes in liquidity in the market for real estate securities, the re-pricing of credit risk in the capital markets, inaccurate ratings of securities by rating agencies, rating agency downgrades of securities, and increases in the supply of real estate securities available-for-sale;
changes in the values of securities we own and the impact of adjustments reflecting those changes on our income statement and balance sheet, including our stockholders' equity;
our ability to generate the amount of cash flow we expect from our investment portfolio;
changes in our investment, financing, and hedging strategies and the new risks that those changes may expose us to;
changes in the competitive landscape within our industry, including changes that may affect our ability to retain or attract personnel;
our ability to build successful relationships with loan originators;
our ability to acquire mortgage loans in connection with our securitization plans;
our ability to securitize the mortgage loans that we acquire;
our ability to acquire residential real properties at attractive prices and lease such properties on a profitable basis or to resell such properties at a gain;
our ability to manage various operational risks associated with our business;
our ability to maintain appropriate internal controls over financial reporting;
our ability to establish, adjust and maintain appropriate hedges for the risks in our portfolio;
our ability to maintain our REIT qualification for U.S. federal income tax purposes; and
limitations imposed on our business due to our REIT status and our status as exempt from registration under the 1940 Act.
This Quarterly Report on Form 10-Q may contain statistics and other data that in some cases have been obtained or compiled from information made available by mortgage loan servicers and other third-party service providers.

Factors Affecting our Operating Results
Our net interest income includes income from our RMBS portfolio and will reflect the amortization of purchase premiums and accretion of purchase discounts. 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.

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 September 30, 2012, approximately 92.3% of total

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assets, or $16.5 billion, and approximately 0.9% of total liabilities, or $132.3 million, consisted of financial instruments recorded at fair value. As of September 30, 2012, we had no assets or liabilities reported at fair value using Level 3 inputs. See Note 10 - Fair Value to the Condensed Consolidated Financial Statements, included in this Quarterly Report on Form 10-Q, 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 condensed consolidated balance sheet and income statement 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 three and nine months ended September 30, 2012, our unrealized fair value losses on interest rate swap and swaption agreements, which are accounted for as derivative trading instruments under GAAP, 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 three and nine months ended September 30, 2012. Our financial results for the three and nine months ended September 30, 2012 were positively affected by unrealized fair value gains on certain U.S. Treasuries classified as trading instruments due to their short-term investment objectives. For the three and nine months ended September 30, 2011, our unrealized fair value losses on interest rate swap and swaption agreements, which are accounted for as derivative trading instruments under GAAP, negatively affected our financial results. The change in fair value of the interest rate swaps was a result of decreases in the swap curve during the three and nine months ended September 30, 2011. Our financial results for the three and nine months ended September 30, 2011 were positively affected by unrealized fair value gains on certain U.S. Treasuries classified as trading instruments. In addition, our financial results for the three and nine months ended September 30, 2012 and 2011 were affected by the unrealized gains and losses of certain other derivative instruments that were accounted for as trading derivative instruments, i.e., credit default swaps, TBAs 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 at the “bid side” of the market, and/or by independent pricing providers. We strive to obtain multiple market data points for each valuation. By utilizing “bid side” pricing, 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.

Market Conditions and Outlook
The first nine months of 2012 continued to produce a number of regulatory actions in an effort to stabilize economic conditions and increase liquidity in the financial markets as well as other actions related to the fall-out from the financial and foreclosure crises. Regulatory actions that could impact the value of our RMBS, either positively or negatively include attempts by the U.S. government to streamline further the refinancing process to allow more borrowers to refinance into lower interest rate mortgage loans (see President Obama's address in early January); the announcement by the Federal Reserve of its intention to keep the Federal Funds Target Rate near zero into 2015; the possibility of an REO-to-Rental program supported by the GSEs; an expansion of the HAMP refinancing program to include borrowers whose loans are not in GSE pools; the Federal Reserve's announcement of an open-ended program to purchase $40 billion of RMBS per month; and the Federal Reserve's Operation Twist. Additionally, the U.S. economy continues to be burdened by the European debt crisis, elevated unemployment numbers and a struggling housing market, which, despite signs of an approaching recovery, remains weighted with backlogs of homes in the foreclosure process. Meanwhile, mortgage servicers continue to evaluate the impacts of the proposed settlement with State Attorneys General over improper foreclosure practices and the adoption by several states of various legislation aimed at curtailing or modifying foreclosure processes. Events such as these will continue to affect our portfolio.
We believe our blended Agency and non-Agency strategies and our investing expertise will allow us to better navigate the dynamic characteristics of the RMBS environment while GSE reform and any other future regulatory efforts take shape.

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Having a diversified portfolio allows us to mitigate risks, including the volatility and impacts generated by uncertainty in interest rates and changes in prepayments, home prices and homeowner default rates.
We expect that the majority of our assets will remain in whole-pool Agency RMBS in light of the long-term attractiveness of the asset class and in order to continue to satisfy the requirements of our exemption from registration under the 1940 Act. Interest-only Agency securities also provide a complementary investment and risk-management strategy to our principal and interest Agency RMBS investments. Risk-adjusted returns in our Agency RMBS portfolio may decline if we are required to pay higher purchase premiums due to lower interest rates or additional liquidity in the market. Additionally, the Federal Reserve's open-ended program to purchase RMBS may impact the returns of our Agency RMBS portfolio.
The following table provides the carrying value of our RMBS portfolio classified as available-for-sale securities by product type:
(dollars in thousands)
September 30,
2012
 
December 31,
2011
Agency
 
 
 
 
 
 
 
Fixed Rate
$
12,268,507

 
82.0
%
 
$
4,821,479

 
77.2
%
Hybrid ARMs
200,556

 
1.3
%
 
231,678

 
3.7
%
Total Agency
12,469,063

 
83.3
%
 
5,053,157

 
80.9
%
Non-Agency
 
 
 
 
 
 
 
Senior
1,989,885

 
13.3
%
 
932,867

 
14.9
%
Mezzanine
506,620

 
3.4
%
 
262,633

 
4.2
%
Interest-only securities
4,291

 
%
 
595

 
%
Total Non-Agency
2,500,796

 
16.7
%
 
1,196,095

 
19.1
%
Total
$
14,969,859

 
 
 
$
6,249,252

 
 

Prepayment speeds and volatility due to interest rates
Our Agency RMBS portfolio is subject to inherent prepayment risk: generally, a decline in interest rates that leads to rising prepayment speeds will cause the market value of our interest-only securities to deteriorate, but will cause the market value of our fixed coupon Agency pools to increase. The inverse relationship occurs when interest rates increase and prepayments slow. We do not expect housing prices to fully stabilize in 2012 and this, combined with elevated unemployment rates and housing inventory increases, leads us to expect that there will not be a significant increase in prepayment speeds in 2012. However, given the low level of interest rates, the implementation of Operation Twist, and the announcement of HARP 2.0, and the revamped Home Affordable Refinance Program, prepayment speeds, particularly due to refinancings, have increased on many RMBS. These government actions, combined with other potential government programs, could also lead to a further increase in prepayment speeds in RMBS, which could lead to less attractive reinvestment opportunities. Nonetheless, we believe our portfolio approach, including our security selection process, is well positioned to respond to a variety of market scenarios, including an overall faster prepayment environment.
Although we are unable to predict the movement in interest rates for the remainder of 2012 and beyond, our blended Agency and non-Agency portfolio strategy is intended to generate attractive yields with a low level of sensitivity to yield curve, prepayments and interest rate cycles.
Our portfolio includes Agency securities, which includes bonds with explicit prepayment protection, lower loan balances (securities collateralized by loans of less than $175,000 in principal), high loan-to-value (or LTV) ratios (securities collateralized by loans with greater or equal to 80% LTV predominantly comprised of Making Homeownership Affordable (or MHA) pools that consist of borrowers who have refinanced through HARP), low FICO scores (lower credit borrowers), home equity conversion mortgages (securities collateralized by reverse mortgages), and seasoned bonds reflecting less prepayment risk due to previously experienced high levels of refinancing. We believe these bond characteristics reduce the prepayment risk to the portfolio.

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The following tables provide the carrying value of our Agency RMBS portfolio by vintage and prepayment protection:
 
As of September 30, 2012
(dollars in thousands)
Fixed Rate
 
Hybrid ARMs
 
Total Agency RMBS
Lower loan balances
$
4,321,343

 
$

 
$
4,321,343

 
35
%
High LTV (predominantly MHA)
3,892,501

 

 
3,892,501

 
31
%
Home equity conversion mortgages
1,891,247

 

 
1,891,247

 
15
%
Seasoned (2005 and prior vintages)
451,344

 
134,660

 
586,004

 
5
%
Pre-pay lock-out or penalty-based
543,584

 
19,649

 
563,233

 
4
%
Low FICO
814,076

 

 
814,076

 
7
%
2006 and subsequent vintages
207,861

 
46,247

 
254,108

 
2
%
2006 and subsequent vintages - discount
146,551

 

 
146,551

 
1
%
Total
$
12,268,507

 
$
200,556

 
$
12,469,063

 
100
%
 
As of December 31, 2011
(dollars in thousands)
Fixed Rate
 
Hybrid ARMs
 
Total Agency RMBS
Lower loan balances
$
2,759,091

 
$

 
$
2,759,091

 
55
%
High LTV (predominantly MHA)
211,312

 

 
211,312

 
4
%
Home equity conversion mortgages
939,738

 

 
939,738

 
19
%
Seasoned (2005 and prior vintages)
346,624

 
146,826

 
493,450

 
10
%
Pre-pay lock-out or penalty-based
266,456

 
34,826

 
301,282

 
6
%
2006 and subsequent vintages
123,323

 
50,026

 
173,349

 
3
%
2006 and subsequent vintages - discount
174,935

 

 
174,935

 
3
%
Total
$
4,821,479

 
$
231,678

 
$
5,053,157

 
100
%

We offset a portion of the Agency exposure to prepayment speeds through our non-Agency portfolio. Our non-Agency RMBS yields are expected to increase if prepayment rates on such assets exceed our prepayment assumptions. To the extent that prepayment speeds increase due to macroeconomic factors, we expect to benefit from the ability to recognize the income from the heavily discounted RMBS prices that principally arose from credit or payment default expectations.
The following tables provide discount information on our non-Agency RMBS portfolio:
 
As of September 30, 2012
(in thousands)
Principal and Interest Securities
 
Interest-Only Securities
 
Total
 
Senior
 
Mezzanine
 
 
Face Value
$
3,613,562

 
$
790,302

 
$
67,708

 
$
4,471,572

Unamortized discount
 
 
 
 
 
 
 
Designated credit reserve
(1,218,956
)
 
(120,781
)
 

 
(1,339,737
)
Unamortized net discount
(666,088
)
 
(230,309
)
 
(64,011
)
 
(960,408
)
Amortized Cost
$
1,728,518

 
$
439,212

 
$
3,697

 
$
2,171,427

 
As of December 31, 2011
(in thousands)
Principal and Interest Securities
 
Interest-Only Securities
 
Total
 
Senior
 
Mezzanine
 
 
Face Value
$
2,104,161

 
$
551,867

 
$
11,901

 
$
2,667,929

Unamortized discount
 
 
 
 
 
 
 
Designated credit reserve
(663,890
)
 
(118,716
)
 

 
(782,606
)
Unamortized net discount
(387,759
)
 
(141,715
)
 
(11,495
)
 
(540,969
)
Amortized Cost
$
1,052,512

 
$
291,436

 
$
406

 
$
1,344,354



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Credit losses
Although our Agency portfolio is supported by U.S. Government agency and federally chartered corporation guarantees of payment of principal and interest, we are exposed to credit risk in our non-Agency RMBS portfolio. However, the credit support built into non-Agency RMBS deal structures is designed to provide a level of protection from potential credit losses for more senior tranches. In addition, the discounted purchase prices paid on our non-Agency RMBS assets provide additional insulation from credit losses in the event we receive less than 100% of par on such assets. We evaluate credit risk on our non-Agency investments through a comprehensive asset selection process, which is predominantly focused on quantifying and pricing credit risk. We review our non-Agency RMBS based on a quantitative and qualitative analysis of the risk-adjusted returns on such investments. We evaluate credit risk on our non-Agency investments through a comprehensive asset selection process, which is predominantly focused on quantifying and pricing credit risk, including extensive initial modeling and scenario analysis. We review on an on-going basis our non-Agency RMBS based on a quantitative and qualitative analysis of the risk-adjusted returns on such investments and through on-going asset surveillance. At purchase, we estimate the portion of the discount we do not expect to recover and factor that into our expected yield and accretion methodology. We may also record an other-than-temporary impairment, or OTTI, for a portion of our investment in a security to the extent we believe that the amortized cost exceeds the present value of expected future cash flows. Nevertheless, unanticipated credit losses could occur, adversely impacting our operating results.
Counterparty exposure and leverage ratio
We monitor counterparty exposure in our broker, banking and lending counterparties on a daily basis. We believe our broker and banking counterparties are well capitalized organizations and we attempt to manage our cash balances across these organizations to reduce our exposure to a single counterparty.
We had entered into repurchase agreements with 23 counterparties as of September 30, 2012. As of September 30, 2012, we had a total consolidated debt to equity ratio of 4.1 times. As of September 30, 2012, we had $833.6 million in cash and cash equivalents, approximately $41.9 million of unpledged Agency securities and derivatives and $468.5 million of unpledged non-Agency securities and an overall estimated unused borrowing capacity on our unpledged RMBS of approximately $295.3 million. If borrowing rates and collateral requirements change in the near term, we believe we are subject to less earnings volatility than a more levered organization.

Summary of Results of Operations and Financial Condition
Our reported GAAP net income attributable to common stockholders was $26.8 million ($0.10 per diluted weighted share) for the three months ended September 30, 2012 as compared to $54.6 million ($0.42 per diluted weighted share) for the three months ended September 30, 2011. Our reported GAAP net income attributable to common stockholders was $102.6 million ($0.46 per diluted weighted share) for the nine months ended September 30, 2012 as compared to $76.0 million ($0.90 per diluted weighted share) for the nine months ended September 30, 2011.
On September 12, 2012, we declared a dividend of $0.36 per diluted share. Our GAAP book value per diluted common share was $11.44 at September 30, 2012, an increase from $9.03 book value per diluted common share at December 31, 2011.

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The following table presents the components of our net income for the three and nine months ended September 30, 2012 and 2011:
 
 
Three Months Ended
 
Nine Months Ended
(in thousands, except share data)
 
September 30,
 
September 30,
Income Statement Data:
 
2012
 
2011
 
2012
 
2011
 
 
(unaudited)
 
(unaudited)
Interest income:
 
  

 
   

 
  

 
   

Available-for-sale securities
 
$
124,621

 
$
65,919

 
$
313,154

 
$
125,413

Trading securities
 
1,278

 
1,706

 
3,578

 
2,783

Mortgage loans held-for-sale
 
167

 

 
362

 

Cash and cash equivalents
 
243

 
114

 
620

 
241

Total interest income
 
126,309

 
67,739

 
317,714

 
128,437

Interest expense
 
20,743

 
7,218

 
47,737

 
13,580

Net interest income
 
105,566

 
60,521

 
269,977

 
114,857

Other-than-temporary impairments:
 
 
 
 
 
 
 
 
Total other-than temporary impairment losses
 
(559
)
 
(3,371
)
 
(9,310
)
 
(3,665
)
Non-credit portion of loss recognized in other comprehensive income
 

 

 

 

Net other-than-temporary credit impairment losses
 
(559
)
 
(3,371
)
 
(9,310
)
 
(3,665
)
Other income:
 
 
 
 
 
 
 
 
Gain on investment securities, net
 
2,527

 
31,432

 
14,247

 
36,159

Loss on interest rate swap and swaption agreements
 
(76,472
)
 
(39,311
)
 
(153,679
)
 
(88,180
)
Gain (loss) on other derivative instruments
 
3,454

 
22,361

 
(13,053
)
 
37,474

Other income
 
731

 

 
822

 

Total other (loss) income
 
(69,760
)
 
14,482

 
(151,663
)
 
(14,547
)
Expenses:
 
 
 
 
 
 
 
 
Management fees
 
9,733

 
4,785

 
24,086

 
9,063

Other operating expenses
 
6,546

 
2,850

 
14,328

 
6,516

Total expenses
 
16,279

 
7,635

 
38,414

 
15,579

Income before income taxes
 
18,968

 
63,997

 
70,590

 
81,066

(Benefit from) provision for income taxes
 
(7,834
)
 
9,388

 
(32,016
)
 
5,064

Net income attributable to common stockholders
 
$
26,802

 
$
54,609

 
$
102,606

 
$
76,002

Basic earnings per weighted average common share
 
$
0.10

 
$
0.42

 
$
0.46

 
$
0.90

Diluted earnings per weighted average common share
 
$
0.10

 
$
0.42

 
$
0.46

 
$
0.90

Dividends declared per common share
 
$
0.36

 
$
0.40

 
$
1.16

 
$
1.20

Weighted average number of shares of common stock:
 
 
 
 
 
 
 
 
Basic
 
270,005,212

 
130,607,566

 
224,058,762

 
84,751,854

Diluted
 
270,937,960

 
130,607,566

 
224,369,678

 
84,751,854

Balance Sheet Data:
 
September 30,
2012
 
December 31,
2011
 
 
(unaudited)
 
 
Available-for-sale securities
 
$
14,969,859

 
$
6,249,252

Total assets
 
$
17,864,695

 
$
8,100,384

Repurchase agreements
 
$
14,034,327

 
$
6,660,148

Total stockholders' equity
 
$
3,391,476

 
$
1,270,086



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Results of Operations
The following analysis focuses on the results generated during the three and nine months ended September 30, 2012 and 2011.
Interest Income and Average Portfolio Yield
For the three and nine months ended September 30, 2012, we recognized $124.6 million and $313.2 million, respectively, of interest income from our Agency and non-Agency RMBS portfolio. Our RMBS portfolio's average amortized cost of securities was approximately $12.4 billion and $9.7 billion for the three and nine months ended September 30, 2012, resulting in an annualized net yield of approximately 4.0% and 4.3%, respectively. For the three and nine months ended September 30, 2011, we recognized $65.9 million and $125.4 million, respectively, of interest income from our Agency and non-Agency RMBS portfolio. Our RMBS portfolio's average amortized cost of securities was approximately $5.2 billion and $3.4 billion for the three and nine months ended September 30, 2011, resulting in an annualized net yield of approximately 5.1% and 4.9%, respectively.
For the three and nine months ended September 30, 2012, we recognized $39.7 million and $93.6 million, respectively, of net premium amortization on our Agency RMBS, including our interest-only securities. This resulted in an overall net asset yield of approximately 2.9% and 3.0%, excluding inverse interest-only securities which are accounted for as derivatives. For the three and nine months ended September 30, 2012, we recognized $36.2 million and $99.2 million of accretion income from the discounts on our non-Agency portfolio resulting in an overall net yield of approximately 9.6% for both periods. For the three and nine months ended September 30, 2011, we recognized $15.1 million and $32.2 million, respectively, of net premium amortization on our Agency RMBS, including our interest-only securities. This resulted in an overall net asset yield of approximately 3.7%, excluding inverse interest-only securities which are accounted for as derivatives, for both periods. For the three and nine months ended September 30, 2011, we recognized $19.9 million and $32.3 million of accretion income from the discounts on our non-Agency portfolio resulting in an overall net yield of approximately 9.8% and 9.5%, respectively.
The following tables present the components of the net yield earned by investment type on our RMBS portfolio as a percentage of our average amortized cost of securities (ratios for the periods have been annualized):
 
Three Months Ended September 30, 2012
 
Nine Months Ended September 30, 2012
 
Agency
 
Non-Agency
 
Consolidated
 
Agency
 
Non-Agency
 
Consolidated
Gross Yield/Stated Coupon
4.4
 %
 
2.7
%
 
4.1
 %
 
4.6
 %
 
2.8
%
 
4.2
%
Net (Premium Amortization)/Discount Accretion
(1.5
)%
 
6.9
%
 
(0.1
)%
 
(1.6
)%
 
6.8
%
 
0.1
%
Net Yield (1)
2.9
 %
 
9.6
%
 
4.0
 %
 
3.0
 %
 
9.6
%
 
4.3
%
 
Three Months Ended September 30, 2011
 
Nine Months Ended September 30, 2011
 
Agency
 
Non-Agency
 
Consolidated
 
Agency
 
Non-Agency
 
Consolidated
Gross Yield/Stated Coupon
5.2
 %
 
3.0
%
 
4.7
%
 
5.3
 %

3.4
%

4.9
%
Net (Premium Amortization)/Discount Accretion
(1.5
)%
 
6.8
%
 
0.4
%
 
(1.6
)%

6.1
%

%
Net Yield (1)
3.7
 %
 
9.8
%
 
5.1
%
 
3.7
 %

9.5
%

4.9
%
____________________
(1)
These yields have not been adjusted for cost of delay and cost to carry purchase premiums.


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The following tables provide the components of interest income and net asset yield by investment type on our RMBS portfolio:
 
Three Months Ended September 30, 2012
 
Nine Months Ended September 30, 2012
(dollars in thousands)
Agency
 
Non-Agency
 
Total
 
Agency
 
Non-Agency
 
Total
Average amortized cost
$
10,328,961

 
$
2,103,260

 
$
12,432,221

 
$
7,800,249

 
$
1,925,141

 
$
9,725,390

Coupon interest
113,935

 
14,178

 
128,113

 
267,730

 
39,858

 
307,588

Net (premium amortization)/discount accretion
(39,652
)
 
36,160

 
(3,492
)
 
(93,612
)
 
99,178

 
5,566

Interest income
$
74,283

 
$
50,338

 
$
124,621

 
$
174,118

 
$
139,036

 
$
313,154

Net asset yield
2.9
%
 
9.6
%
 
4.0
%
 
3.0
%
 
9.6
%
 
4.3
%

 
Three Months Ended September 30, 2011
 
Nine Months Ended September 30, 2011
(dollars in thousands)
Agency
 
Non-Agency
 
Total
 
Agency
 
Non-Agency
 
Total
Average amortized cost
$
4,041,828

 
$
1,175,766

 
$
5,217,594

 
$
2,709,742


$
702,871


$
3,412,613

Coupon interest
52,354

 
8,815

 
61,169

 
107,397


17,959


125,356

Net (premium amortization)/discount accretion
(15,145
)
 
19,895

 
4,750

 
(32,248
)

32,305


57

Interest income
$
37,209

 
$
28,710

 
$
65,919

 
$
75,149

 
$
50,264

 
$
125,413

Net asset yield
3.7
%
 
9.8
%
 
5.1
%
 
3.7
%
 
9.5
%
 
4.9
%

For the three and nine months ended September 30, 2012, we recognized $1.3 million and $3.6 million of interest income, respectively, associated with our trading U.S. Treasuries, or approximately 0.5% annualized net yield on average amortized cost for each period. For the three and nine months ended September 30, 2011, we recognized $1.7 million and $2.8 million of interest income, respectively, associated with our trading U.S. Treasuries, or approximately 0.5% annualized net yield on average amortized cost for each period.
Interest Expense and the Cost of Funds
For the three and nine months ended September 30, 2012, we recognized $19.4 million and $44.5 million, respectively, in interest expense on our borrowed funds collateralized by RMBS. For the same three and nine month periods, our average outstanding balance under repurchase agreements to fund RMBS was approximately $11.0 billion and $8.5 billion, respectively, an increase from third quarter 2011 due to our increased capital base. The average cost of funds, excluding interest spread expense associated with interest rate swaps, for the three and nine months ended September 30, 2012 was 0.7% for both periods. For the three and nine months ended September 30, 2011, we recognized $6.7 million and $12.7 million, respectively, in interest expense on our borrowed funds collateralized by RMBS. For the same three and nine month periods, our average outstanding balance under repurchase agreements to fund RMBS was approximately $4.5 billion and $3.0 billion, respectively, resulting in an average cost of funds on our RMBS, excluding interest spread expense associated with interest rate swaps, of 0.6% for both periods.
For the three and nine months ended September 30, 2012, we recognized $1.3 million and $3.2 million, respectively, of interest expense associated with the financing of our U.S. Treasuries and Agency inverse interest-only derivatives, or an average cost of funds of approximately 0.4% for both periods. The additional funds borrowed during the nine months ended September 30, 2012 resulted in a total consolidated debt-to-equity ratio of 4.1:1.0. For the three and nine months ended September 30, 2011, we recognized $0.5 million and $0.9 million, respectively, of interest expense associated with the financing of our U.S. Treasuries and Agency inverse interest-only derivatives, or an average cost of funds of approximately 0.1% and 0.2%, respectively. The additional funds borrowed during the nine months ended September 30, 2011 resulted in a total consolidated debt-to-equity ratio of 5.6:1.0.
Net Interest Income
For the three and nine months ended September 30, 2012, net interest income on our RMBS AFS portfolio was $105.2 million and $268.7 million, respectively, resulting in a net interest spread of approximately 3.3% and 3.6%, respectively. For the three and nine months ended September 30, 2011, net interest income on our RMBS AFS portfolio was $59.2 million and $112.7 million, respectively, resulting in a net interest spread of approximately 4.5% and 4.3%, respectively.

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The following tables provide the interest income and expense incurred in the three and nine months ended September 30, 2012 and 2011:
 
Three Months Ended September 30, 2012
 
Nine Months Ended September 30, 2012
(dollars in thousands)
Agency(1)
 
Non-Agency
 
Total
 
Agency(1)
 
Non-Agency
 
Total
Average available-for-sale securities held (2)
$
10,328,961

 
$
2,103,260

 
$
12,432,221

 
$
7,800,249

 
$
1,925,141

 
$
9,725,390

Total interest income
$
74,283

 
$
50,338

 
$
124,621

 
$
174,118

 
$
139,036

 
$
313,154

Yield on average investment securities
2.9
%
 
9.6
%
 
4.0
%
 
3.0
%
 
9.6
%
 
4.3
%
Average balance of repurchase agreements
$
9,991,220

 
$
1,042,212

 
$
11,033,432

 
$
7,536,666

 
$
999,723

 
$
8,536,389

Total interest expense (3) (4)
$
12,708

 
$
6,691

 
$
19,399

 
$
26,467

 
$
17,985

 
$
44,452

Average cost of funds (4)
0.5
%
 
2.6
%
 
0.7
%
 
0.5
%
 
2.4
%
 
0.7
%
Net interest income
$
61,575

 
$
43,647

 
$
105,222

 
$
147,651

 
$
121,051

 
$
268,702

Net interest rate spread
2.4
%
 
7.0
%
 
3.3
%
 
2.5
%
 
7.2
%
 
3.6
%
 
Three Months Ended September 30, 2011
 
Nine Months Ended September 30, 2011
(dollars in thousands)
Agency(1)
 
Non-Agency
 
Total
 
Agency(1)
 
Non-Agency
 
Total
Average available-for-sale securities held (2)
$
4,041,828

 
$
1,175,766

 
$
5,217,594

 
$
2,709,742

 
$
702,871

 
$
3,412,613

Total interest income
$
37,209

 
$
28,710

 
$
65,919

 
$
75,149

 
$
50,264

 
$
125,413

Yield on average investment securities
3.7
%
 
9.8
%
 
5.1
%
 
3.7
%
 
9.5
%
 
4.9
%
Average balance of repurchase agreements
$
3,840,036

 
$
684,224

 
$
4,524,260

 
$
2,574,701

 
$
417,415

 
$
2,992,116

Total interest expense (3) (4)
$
3,113

 
$
3,601

 
$
6,714

 
$
6,289

 
$
6,396

 
$
12,685

Average cost of funds (4)
0.3
%
 
2.1
%
 
0.6
%
 
0.3
%
 
2.0
%
 
0.6
%
Net interest income
$
34,096

 
$
25,109

 
$
59,205

 
$
68,860

 
$
43,868

 
$
112,728

Net interest rate spread
3.4
%
 
7.7
%
 
4.5
%
 
3.4
%
 
7.5
%
 
4.3
%
____________________
(1)
Excludes inverse interest-only securities which are classified as derivatives under U.S. GAAP. For the three and nine months ended September 30, 2012, our average annualized yield on our Agency RMBS, including inverse interest-only securities, was 3.1% and 3.3%, respectively, compared to 4.3% and 4.4% for the same periods in 2011.
(2)
Excludes change in realized and unrealized gains/(losses).
(3)
Cost of funds by investment type is based on the underlying investment type of the RMBS AFS assigned as collateral.
(4)
Cost of funds does not include the accrual and settlement of interest associated with interest rate swaps. In accordance with GAAP, those costs are included in loss on interest rate swap and swaption agreements in the condensed consolidated statements of comprehensive income. For the three and nine months ended September 30, 2012, our average cost of funds, including interest spread expense associated with interest rate swaps and including inverse interest-only securities (see footnote 1 above), was 1.1% for both periods, compared to 1.3% and 1.4% for the same periods in 2011.

Other-Than-Temporary Impairments
We review each of our securities on a quarterly basis to determine if an OTTI charge is necessary. For the three and nine months ended September 30, 2012, we recognized $0.6 million and $9.3 million of OTTI losses, respectively, compared to $3.4 million and $3.7 million for the three and nine months ended September 30, 2011. The increase in OTTI during the three and nine months ended September 30, 2012 compared to the same periods in 2011 was generally driven by the $1.2 billion increase in non-Agency holdings from September 30, 2011 to September 30, 2012. For further information about evaluating AFS securities for other-than-temporary impairments, refer to Note 3 - Available-for-Sale Securities, at Fair Value of the notes to the condensed consolidated financial statements.
Gain on Investment Securities, Net
During the three and nine months ended September 30, 2012, we sold AFS and trading securities for $9.4 million and $1.2 billion with an amortized cost of $9.6 million and $1.2 billion, for a net realized loss of $0.2 million and a net realized gain of

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$11.5 million, respectively, which included sales of U.S. Treasuries with an amortized cost of $1.0 billion for the nine months ended September 30, 2012. During the three and nine months ended September 30, 2011, we sold AFS and trading securities for $1.1 billion and $1.7 billion with an amortized cost of $1.1 billion and $1.7 billion, for a net realized gain of $27.8 million and $30.2 million, respectively, which included sales of U.S. Treasuries with an amortized cost of $199.7 million and $699.1 million for the three and nine months ended September 30, 2011. We do not expect to sell assets on a frequent basis, but may sell assets to reallocate capital into new assets that our management believes have higher risk-adjusted returns.
For the three and nine months ended September 30, 2012, trading securities experienced unrealized gains of $2.7 million. For the three and nine months ended September 30, 2011, trading securities experienced unrealized gains of $3.7 million and $6.0 million, respectively..
Loss on Interest Rate Swap and Swaption Agreements
For the three and nine months ended September 30, 2012, we recognized $10.7 million and $23.1 million, respectively, of expenses for the accrual and/or settlement of the net interest expense associated with our interest rate swaps. The expenses result from generally paying a fixed interest rate on an average $11.3 billion and $8.6 billion notional, respectively, to hedge a portion of our interest rate risk on our short-term repurchase agreements, funding costs, and macro-financing risk and generally receiving LIBOR interest. For the three and nine months ended September 30, 2011, we recognized $8.3 million and $18.6 million, respectively, of expenses for the accrual and/or settlement of the net interest expense associated with our interest rate swaps. The expenses result from generally paying a fixed interest rate on an average $4.3 billion and $2.8 billion notional, respectively, to hedge a portion of our interest rate risk on our short-term repurchase agreements, funding costs, and macro-financing risk and generally receiving LIBOR interest.
During the three and nine months ended September 30, 2012, we terminated or had options expire on 3 and 22 interest rate swap and swaption positions of $0.8 billion notional and $3.7 billion notional, respectively. Upon settlement of the early terminations and option expirations, we paid $1.5 million in full settlement of our net interest spread liability and recognized $7.5 million and $26.1 million in realized losses on the swaps and swaptions, respectively, including early termination penalties. During the three and nine months ended September 30, 2011, we terminated or had options expire on twenty-four and twenty-nine interest rate swap and swaption positions of $1.9 billion notional and $2.5 billion notional, respectively. Upon settlement of the early terminations and option expirations, we paid $4.2 million and $5.1 million in full settlement of our net interest spread liability and recognized $17.8 million and $18.1 million in realized losses on the swaps and swaptions, respectively, including early termination penalties.We elected to terminate the swaps to reduce our cost of financing and align with our investment portfolio.
Also included in our financial results for the three and nine months ended September 30, 2012 was the recognition of a change in unrealized valuation losses of $58.2 million and $104.5 million, respectively, on our interest rate swap and swaption agreements that were accounted as trading instruments. For the three and nine months ended September 30, 2011, we recognized changes in unrealized valuation losses of $13.1 million and $51.5 million, respectively, on our interest rate swap and swaption agreements that were accounted as trading instruments. The overall decline in the swap rate curve during the three and nine months ended September 30, 2012 resulted in unfavorable market value movement over the three and nine month periods. Since these swaps and swaptions are used for purposes of hedging our interest rate exposure, their unrealized valuation losses are generally offset by unrealized gains in our Agency RMBS portfolio, which are recorded directly to stockholders' equity through other comprehensive income.
The following table provides the net interest spread and gains and losses associated with our interest rate swap and swaption positions:
(in thousands)
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
Net interest spread
$
(10,718
)
 
$
(8,341
)
 
$
(23,089
)
 
$
(18,632
)
Early termination and option expiration losses
(7,544
)
 
(17,847
)
 
(26,084
)
 
(18,074
)
Change in unrealized loss on interest rate swap and swaption agreements, at fair value
(58,210
)
 
(13,123
)
 
(104,506
)
 
(51,474
)
Loss on interest rate swap and swaption agreements
$
(76,472
)
 
$
(39,311
)
 
$
(153,679
)
 
$
(88,180
)

Gain (Loss) on Other Derivative Instruments
Included in our financial results for the three and nine months ended September 30, 2012 was the recognition of $3.5 million of gains and $13.1 million of losses, respectively, on other derivative instruments we hold for purposes of both hedging and non-hedging activities, principally credit default swaps, TBAs and inverse interest-only securities. Included within these three and nine months ended September 30, 2012 results, we recognized $7.7 million and $22.0 million of interest income, net

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of accretion on inverse interest-only securities on an average amortized cost basis of $293.1 million and $245.0 million, respectively. The remainder represented realized and unrealized net gains (losses) on other derivative instruments. As these derivative instruments are considered trading instruments, our financial results include both realized and unrealized gains (losses) associated with these instruments.
For the three and nine months ended September 30, 2011, we recognized $22.4 million and $37.5 million of gains, respectively, on other derivative instruments we hold for purposes of both hedging and non-hedging activities, principally credit default swaps, TBAs and inverse interest-only securities. Included within these three and nine months ended September 30, 2011 results, we recognized $8.2 million and $17.3 million of interest income, net of accretion on inverse interest-only securities on an average amortized cost basis of $157.6 million and $106.9 million, respectively. The remainder represented realized and unrealized net gains (losses) on other derivative instruments.
Other Income
For the three and nine months ended September 30, 2012, we recorded other income of $0.7 million and $0.8 million, respectively. Included within these three and nine months ended September 30, 2012 results, we recognized $11,014 and $14,750 of gains on mortgage loans held-for-sale and $0.7 million and $0.8 million of real estate related revenues on investments in real estate. We did not hold mortgage loans and investments in real estate for the three and nine months ended September 30, 2011.
On our investment in real estate portfolio, we earn revenue primarily from rents collected from tenants under lease agreements. The most important drivers of revenue (aside from portfolio growth) are rental and occupancy rates. Before an acquired property becomes an income-producing asset, we must possess, renovate, market and lease the property. We refer to this as property stabilization. We anticipate that on average, the stabilization period for each property will range from three to six months depending on factors such as the acquisition channel, the age and condition of the property, local rental demand, our marketing techniques, and the size of our available inventory. Consequently, we expect that most properties should be stabilized within six months of purchase and that properties held more than six months provide the best indication of how we expect our overall portfolio to perform.
The following table shows the average rental rates and occupancy rates of properties that have been owned for longer than six months as of September 30, 2012:
Market
 
Properties Owned for Six Months or Longer
 
Properties Leased
 
Properties Vacant
 
Occupancy Rate
 
Average Monthly Rent for Leased Properties
Atlanta
 
28

 
24

 
4

 
85.7
%
 
$
1,182

Las Vegas
 
11

 
5

 
6

 
45.5
%
 
1,157

Phoenix
 
18

 
18

 

 
100.0
%
 
1,059

Tucson
 
13

 
12

 
1

 
92.3
%
 
810

Grand Total
 
70

 
59

 
11

 
84.3
%
 
$
1,067


Expenses
Management Fees
We incurred management fees of $9.7 million and $24.1 million, respectively, for the three and nine months ended September 30, 2012, and $4.8 million and $9.1 million, respectively, for the three and nine months ended September 30, 2011, which are payable to PRCM Advisers, our external manager, under our management agreement. The management fee is calculated based on our stockholders' equity.
Other Operating Expenses
For the three and nine months ended September 30, 2012, we recognized $6.5 million and $14.3 million, respectively, of other operating expenses, which represents an annualized expense ratio of 0.9% and 0.8% of average equity, compared to $2.8 million and $6.5 million of expenses, which represents an annualized expense ratio of 0.9% and 1.0% of average equity, for the same periods in 2011. The favorable decrease of our operating expense ratio resulted primarily from the additional capital raised upon completion of our public common stock offerings, offset by real estate related expenses supporting the investments in real estate properties. See Note 13 - Stockholders' Equity of the notes to the condensed consolidated financial statements.
Included in these other operating expenses are direct and allocated costs incurred by PRCM Advisers on our behalf and reimbursed by us. For the three and nine months ended September 30, 2012, these direct and allocated costs totaled approximately $1.8 million and $7.8 million compared to $2.2 million and $5.1 million of costs for the same periods in 2011. Included in these reimbursed costs was compensation paid to our executive officers, including our principal financial officer

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and general counsel of $0.1 million and $0.3 million for the three and nine months ended September 30, 2012 and $41,715 and $130,635 for the three and nine months ended September 30, 2011. The allocation of compensation paid to our principal financial officer and general counsel is based on time spent overseeing our company's activities in accordance with the management agreement.
Also included in other operating expenses for the three and nine months ended September 30, 2012 are real estate expenses related to our residential real property investments of $2.0 million. Excluding real estate expenses, our annualized expense ratio would have been 0.6% and 0.7% for the three and nine months ended September 30, 2012. Real estate expenses include operating costs during renovation and marketing period such as utilities, as well as ongoing expenses such as home owner's association fees, property insurance, real estate taxes, depreciation and amortization, and property management fees. As our portfolio becomes seasoned, we expect our real estate expenses to decline in proportion to the increase in our rental revenue.
During the nine months ended September 30, 2012, we established an accounts payable function and direct relationships with the majority of our third party vendors. We will continue to have certain costs allocated to us by PRCM Advisers for compensation, data services and proprietary technology, but most direct expenses with third party vendors will be paid directly by us.
Income Taxes
For the three and nine months ended September 30, 2012, we recognized $7.8 million and $32.0 million, in income tax benefit related to both current and deferred income tax provisions in our TRSs. Our effective tax rate for the three and nine months ended September 30, 2012 was a negative 41.3% and 45.4%, respectively. For the three and nine months ended September 30, 2012, we recognized $0.4 million of deferred tax expense and $5.2 million of deferred tax benefit related to unrealized gains and losses on derivative instruments, and $1.2 million and $1.2 million of deferred tax expense related to unrealized gains on U.S. Treasuries. We also recognized $9.2 million and $23.1 million of deferred tax benefit for both the three and nine months ended September 30, 2012 related to net operating loss and capital loss carryforwards. For the three and nine months ended September 30, 2012, we recognized current federal tax benefit of $0.3 million and $4.9 million, respectively, due to a change in the projected taxable loss for the 2012 tax year and the projected tax refund from capital loss carrybacks to prior tax years.
For the three and nine months ended September 30, 2011, we recognized $9.4 million and $5.1 million in income tax expense related to both current and deferred income tax provisions in our TRSs. Our effective tax rate for the three and nine months ended September 30, 2011 was 14.7% and 6.2%, respectively. For the three and nine months ended September 30, 2011, we recognized $7.2 million and $2.1 million of deferred tax expense related to unrealized gains on derivative instruments, and $1.2 million and $2.0 million of deferred tax expense related to unrealized gains on U.S. Treasuries. For the three and nine months ended September 30, 2011, we recognized current federal tax expense of $0.9 million due to realized net gains on derivative instruments and U.S. Treasuries.
We currently intend to distribute 100% of our REIT taxable income and comply with all requirements to continue to qualify as a REIT, and therefore we have not recognized any further federal or state tax provisions.

Financial Condition
Available-for-Sale Securities, at Fair Value
Agency RMBS
Our Agency RMBS portfolio is comprised of adjustable rate and fixed rate mortgage-backed securities backed by single-family and multi-family mortgage loans. All of our principal and interest Agency RMBS were Fannie Mae or Freddie Mac mortgage pass-through certificates or collateralized mortgage obligations that carry an implied “AAA” rating, or Ginnie Mae mortgage pass-through certificates, which are backed by the guarantee of the U.S. Government. The majority of these securities consist of whole pools in which we own all of the investment interests in the securities.

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The table below summarizes certain characteristics of our Agency AFS securities at September 30, 2012:
 
September 30, 2012
(dollars in thousands, except purchase price)
Principal/Current Face
 
Net (Discount)/ Premium
 
Amortized Cost
 
Unrealized Gain
 
Unrealized Loss
 
Carrying Value
 
Weighted Average Coupon Rate
 
Weighted Average Purchase Price
Principal and interest securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fixed
$
10,892,782

 
$
836,414

 
$
11,729,196

 
$
373,372

 
$
(4,190
)
 
$
12,098,378

 
4.29
%
 
$
108.18

Hybrid/ARM
185,724

 
9,963

 
195,687

 
4,971

 
(102
)
 
200,556

 
4.09
%
 
$
106.56

Total P&I Securities
11,078,506

 
846,377

 
11,924,883

 
378,343

 
(4,292
)
 
12,298,934

 
4.29
%
 
$
108.15

Interest-only securities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fixed
838,964

 
(750,436
)
 
88,528

 
1,396

 
(7,994
)
 
81,930

 
4.32
%
 
$
13.84

Fixed Other (1)
1,183,739

 
(1,099,114
)
 
84,625

 
4,784

 
(1,210
)
 
88,199

 
1.58
%
 
$
7.86

Total
$
13,101,209

 
$
(1,003,173
)
 
$
12,098,036

 
$
384,523

 
$
(13,496
)
 
$
12,469,063

 
 
 
 
____________________
(1) Fixed Other represent weighted-average coupon interest-only securities that are not generally used for our interest-rate risk management purposes. These securities pay variable coupon interest based on the weighted average of the fixed rates of the underlying loans of the security, less the weighted average rates of the applicable issued principal and interest securities.
Our three-month average constant prepayment rate, or CPR, experienced by Agency RMBS owned by us as of September 30, 2012, on an annualized basis, was 5.7%.
The following table summarizes the number of months until the next re-set for our floating or adjustable rate Agency RMBS mortgage portfolio at September 30, 2012:
(in thousands)
 Carrying Value
0-12 months
$
184,163

13-36 months
11,013

37-60 months
5,380

Total
$
200,556


Non-Agency RMBS
Our non-Agency RMBS portfolio is comprised of senior and mezzanine tranches of mortgage-backed securities. The following table provides investment information on our non-Agency RMBS as of September 30, 2012:
 
As of September 30, 2012
(in thousands)
Principal/current face
 
Accretable purchase discount
 
Credit reserve purchase discount
 
Amortized cost
 
Unrealized gain
 
Unrealized loss
 
Carrying value
Principal and interest securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior
$
3,613,562

 
$
(666,088
)
 
$
(1,218,956
)
 
$
1,728,518

 
$
273,330

 
$
(11,963
)
 
$
1,989,885

Mezzanine
790,302

 
(230,309
)
 
(120,781
)
 
439,212

 
72,056

 
(4,648
)
 
506,620

Total P&I Securities
4,403,864

 
(896,397
)
 
(1,339,737
)
 
2,167,730

 
345,386

 
(16,611
)
 
2,496,505

Interest-only securities
67,708

 
(64,011
)
 

 
3,697

 
594

 

 
4,291

Total
$
4,471,572

 
$
(960,408
)
 
$
(1,339,737
)
 
$
2,171,427

 
$
345,980

 
$
(16,611
)
 
$
2,500,796



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The majority of our non-Agency RMBS were rated at September 30, 2012. Note that credit ratings are based on the par value of the non-Agency RMBS, whereas the distressed non-Agency RMBS assets in our portfolio were acquired at a heavily discounted price. The following table summarizes the credit ratings of our non-Agency RMBS portfolio as of September 30, 2012:
 
September 30, 2012
AAA
%
AA
0.2
%
A
0.3
%
BBB
1.9
%
BB
6.9
%
B
10.5
%
Below B
79.3
%
Not rated
0.9
%
Total
100.0
%

Our non-Agency RMBS portfolio has approximately doubled since September 30, 2011. As disclosed in Note 3 - Available-for-Sale Securities, at Fair Value of the notes to the condensed consolidated financial statements, our designated credit reserve as a percentage of total discount increased from 58.2% to 59.9%, when focused on principal and interest securities, from September 30, 2011 to September 30, 2012 and our designated credit reserve as a percentage of total face value increased from 29.0% to 30.0% for the same period. We believe these increases are relatively moderate in context of the portfolio growth. During this same period, we increased our subprime allocation from 74.8% to 85.4% while decreasing our allocation to Prime and Alt-A exposure. This allocation shift resulted in our average purchase price decreasing from 55.79% of par to 52.38% of par as subprime bonds are generally sold at higher discounts to par given their current delinquency performance or expectations of future credit performance. As we increased our allocation to subprime securities, our 60+ day delinquencies decreased from 39.5% to 38.1%, while our average original FICO score decreased from 647 to 638, and our average credit enhancements decreased from 24.3% to 19.8%. The net results of these bond characteristic shifts drive a higher percentage of expected losses in our portfolio and higher designated credit reserves.
A subprime bond may generally be considered higher risk; however, if purchased at a discount that reflects a high expectation of credit losses, it could be viewed less risky than a prime bond, which is subject to unanticipated credit loss performance. Accordingly, we believe our risk profile in owning a heavily discounted subprime bond with known delinquencies affords us the ability to assume a higher percentage of expected credit loss with comparable risk-adjusted returns to a less discounted prime bond with a lower percentage of expected credit loss.

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The following tables present certain information detailed by investment type and their respective underlying loan characteristics for our senior and mezzanine non-Agency RMBS, excluding our non-Agency interest-only portfolio, at September 30, 2012:
 
At September 30, 2012
Non-Agency Principal and Interest (P&I) RMBS Characteristics
Senior Bonds
 
Mezzanine Bonds
 
Total P&I Bonds
Carrying Value (in thousands)
$
1,989,885

 
$
506,620

 
$
2,496,505

% of Non-Agency Portfolio
79.7
%
 
20.3
%
 
100.0
%
Average Purchase Price (1)
$
51.01

 
$
57.80

 
$
52.38

Average Coupon
1.8
%
 
1.1
%
 
1.7
%
Average Fixed Coupon
5.5
%
 
5.7
%
 
5.6
%
Average Floating Coupon
1.2
%
 
0.9
%
 
1.1
%
Average Hybrid Coupon
4.5
%
 
2.6
%
 
4.5
%
Collateral Attributes
 
 
 
 
 
Avg Loan Age (months)
73

 
92

 
77

Avg Loan Size (in thousands)
$
250

 
$
173

 
$
235

Avg Original Loan-to-Value
78.3
%
 
77.1
%
 
78.0
%
Avg Original FICO (2)
639

 
633

 
638

Current Performance
 
 
 
 
 
60+ day delinquencies
39.3
%
 
33.5
%
 
38.1
%
Average Credit Enhancement (3)
16.4
%
 
33.2
%
 
19.8
%
3-Month CPR (4)
2.9
%
 
3.2
%
 
3.0
%
____________________
(1)
Average purchase price utilized carrying value for weighting purposes. If current face were utilized for weighting purposes, the average purchase price for senior, mezzanine, and total non-Agency RMBS, excluding our non-Agency interest-only portfolio, would be $46.19, $54.66, and $47.71, respectively, at September 30, 2012.
(2)
FICO represents a mortgage industry accepted credit score of a borrower, which was developed by Fair Isaac Corporation.
(3)
Average credit enhancement remaining on our non-Agency RMBS portfolio, which is the average amount of protection available to absorb future credit losses due to defaults on the underlying collateral.
(4)
Three-month CPR is reflective of the prepayment speed on the underlying securitization; however, it does not necessarily indicate the proceeds received on our investment tranche. Proceeds received for each security are dependent on the position of the individual security within the structure of each deal.

Non-Agency RMBS Characteristics
September 30, 2012
(dollars in thousands)
Senior Bonds
 
Mezzanine Bonds
 
Total Bonds
Loan Type
Carrying Value
 
% of Senior Bonds
 
Carrying Value
 
% of Mezzanine Bonds
 
Carrying Value
 
% of Non-Agency Portfolio
Prime
$
25,363

 
1.3
%
 
$
550

 
0.1
%
 
$
25,913

 
1.1
%
Alt-A
97,607

 
4.9
%
 
10,272

 
2.0
%
 
107,879

 
4.3
%
POA
219,000

 
11.0
%
 
11,862

 
2.4
%
 
230,862

 
9.2
%
Subprime
1,647,915

 
82.8
%
 
483,936

 
95.5
%
 
2,131,851

 
85.4
%
 
$
1,989,885

 
100.0
%
 
$
506,620

 
100.0
%
 
$
2,496,505

 
100.0
%

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Non-Agency RMBS Characteristics
September 30, 2012
(dollars in thousands)
Senior Bonds
 
Mezzanine Bonds
 
Total Bonds
Coupon Type
Carrying Value
 
% of Senior Bonds
 
Carrying Value
 
% of Mezzanine Bonds
 
Carrying Value
 
% of Non-Agency Portfolio
Fixed Rate
$
274,564

 
13.8
%
 
$
18,885

 
3.7
%
 
$
293,449

 
11.8
%
Hybrid or Floating
1,715,321

 
86.2
%
 
487,735

 
96.3
%
 
2,203,056

 
88.2
%
 
$
1,989,885

 
100.0
%
 
$
506,620

 
100.0
%
 
$
2,496,505

 
100.0
%
Non-Agency RMBS Characteristics
September 30, 2012
(dollars in thousands)
Senior Bonds
 
Mezzanine Bonds
 
Total Bonds
Loan Origination Year
Carrying Value
 
% of Senior Bonds
 
Carrying Value
 
% of Mezzanine Bonds
 
Carrying Value
 
% of Non-Agency Portfolio
2006+
$
1,538,132

 
77.3
%
 
$
46,830

 
9.3
%
 
$
1,584,962

 
63.5
%
2002-2005
448,503

 
22.5
%
 
454,556

 
89.7
%
 
903,059

 
36.2
%
Pre-2002
3,250

 
0.2
%
 
5,234

 
1.0
%
 
8,484

 
0.3
%
 
$
1,989,885

 
100.0
%
 
$
506,620

 
100.0
%
 
$
2,496,505

 
100.0
%

Mortgage Loans Held-for-Sale
In late 2011, we began acquiring prime nonconforming residential mortgage loans from select mortgage loan originators and secondary market institutions with whom we have chosen to build strategic relationships, including those with a nationwide presence. As of September 30, 2012 we had acquired mortgage loans held-for-sale with a carrying value of $14.6 million and have outstanding purchase commitments to acquire an additional $319.9 million. Our intention in the future is to securitize these loans and/or exit through a whole loan sale.
Investment in Real Estate, net
In the first quarter of 2012, we began acquiring a portfolio of single-family properties to rent for income and hold for investment. As of March 31, 2012, we had acquired 70 properties at a cost of $6.1 million. As of June 30, 2012 and September 30, 2012, we held 702 and 1,667 properties at a carrying value of $71.7 million and $190.9 million, respectively.

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The following chart shows the pace of monthly acquisitions beginning in the first quarter of 2012 through September 30, 2012:

Property Acquisition Pace
For purposes of this chart:
"MLS" refers to a purchase of a single property directly from the owner, often as part of a short sale, regardless of whether listed as part of a multiple listing service.
"Auction" refers to properties purchased at trustee or judicial auctions.
"Bulk" refers to purchases of more than one property in a single sale directly from the owner, often an investor group, bank, financial institution or governmental agency, and may include future acquisitions of entire legal entities holding single-family properties.

Repurchase Agreements
Our borrowings consist entirely of repurchase agreements collateralized by our pledge of AFS and trading securities, derivative instruments, mortgage loans and certain cash balances. Substantially all of our Agency RMBS are currently pledged as collateral, and the majority of our non-Agency RMBS have been pledged. As of September 30, 2012, our debt-to-equity ratio was 4.1:1.0, including the debt collateralized by our U.S. Treasuries, residential mortgage loans and Agency derivatives. Our debt-to-equity ratio for RMBS, residential mortgage loans and Agency derivatives only was 3.8:1.0. We believe our debt-to-equity ratio provides unused borrowing capacity and, thus, improves our liquidity and the strength of our balance sheet.
As of September 30, 2012, the term to maturity of our borrowings ranged from three days to over forty-five months. The weighted average original term to maturity of our borrowings collateralized by RMBS and mortgage loans was 123 days at September 30, 2012. At September 30, 2012, the weighted average cost of funds for all our repurchase agreements was 0.68%.
(dollars in thousands)
 
September 30, 2012
 
December 31, 2011
Collateral Type
 
Amount Outstanding
 
Weighted Average Borrowing Rate
 
Weighted Average Haircut on Collateral Value
 
Amount Outstanding
 
Weighted Average Borrowing Rate
 
Weighted Average Haircut on Collateral Value
U.S. Treasuries
 
$
997,500

 
0.35
%
 
0.5
%
 
$
1,001,250

 
0.12
%
 
0.3
%
Agency RMBS
 
11,671,026

 
0.52
%
 
5.5
%
 
4,804,533

 
0.50
%
 
5.3
%
Non-Agency RMBS
 
1,111,954

 
2.56
%
 
34.9
%
 
731,014

 
2.61
%
 
35.3
%
Agency derivatives
 
241,035

 
1.16
%
 
26.4
%
 
118,032

 
0.97
%
 
27.5
%
Mortgage loans held-for-sale
 
12,812

 
2.46
%
 
12.0
%
 
5,319

 
3.20
%
 
8.0
%
Total
 
$
14,034,327

 
0.68
%
 
7.8
%
 
$
6,660,148

 
0.68
%
 
8.2
%


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The following table provides the quarterly average balances, the quarter-end balances, and the maximum balances at any month-end within that quarterly period, of repurchase agreements for the three months ended September 30, 2012, and the four immediately preceding quarters:
(dollars in thousands)
Quarterly Average Repurchase Balances (1)
 
End of Period Balance Repurchase Agreements (1)
 
Maximum Balance of Any Month-End for Repurchase Agreements (1)
 
Repurchase Agreements to Equity Ratio
 
For the Three Months Ended September 30, 2012
$
11,271,401

 
$
13,036,827

 
$
13,036,827

 
3.8
:1.0
(2)
For the Three Months Ended June 30, 2012
$
8,526,166

 
$
9,440,941

 
$
9,440,941

 
4.3
:1.0
 
For the Three Months Ended March 31, 2012
$
6,390,647

 
$
7,692,506

 
$
7,692,506

 
3.7
:1.0
(3)
For the Three Months Ended December 31, 2011
$
5,694,818

 
$
5,658,898

 
$
5,766,848

 
4.5
:1.0
 
For the Three Months Ended September 30, 2011
$
4,640,801

 
$
5,771,063

 
$
5,771,063

 
4.4
:1.0
(4)
____________________
(1)
Includes repurchase agreements collateralized by RMBS, residential mortgage loans and Agency derivatives and excludes repurchase agreements collateralized by U.S. Treasuries.
(2)
In September 2012, warrant holders exercised 16.2 million shares generating proceeds of $175.7 million, which were invested on a leveraged basis. With a higher targeted allocation to Agency RMBS and residential properties for additional capital, we targeted a fully deployed debt-to-equity ratio of 4.0:1.0 to 4.5:1.0.
(3)
On January 17, 2012 and February 24, 2012, we completed capital raises of approximately $354.5 million and $337.4 million, respectively in net proceeds, which were invested on a leveraged basis. With a higher targeted allocation to non-Agency RMBS for additional capital, we targeted a fully deployed debt-to-equity ratio of 4.0:1.0 to 4.5:1.0.
(4)
On July 15, 2011, we completed a capital raise of approximately $483.6 million in net proceeds, which were invested on a leveraged basis. With a higher targeted allocation to non-Agency RMBS for additional capital, we targeted a fully deployed debt-to-equity ratio of 4.0:1.0 to 4.5:1.0.


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Equity
As of September 30, 2012, our stockholders' equity was $3.4 billion and our diluted book value per share was $11.44. As of June 30, 2012, our stockholders' equity was $2.2 billion and our diluted book value per share was $9.94.
The following table provides details of our changes in stockholders' equity from June 30, 2012 to September 30, 2012:
(dollars in millions, except per share amounts)
Book Value
 
Common Shares Outstanding (Diluted Basis)
 
Book Value Per Common Share (Diluted Basis)
Stockholders' equity at June 30, 2012
$
2,182.7

 
219.7

 
$
9.94

GAAP net income:
 
 
 
 
 
Core Earnings, net of tax benefit of $0.8 million (1)
84.4

 
 
 
 
Realized gains and losses, net of tax benefit of $3.3 million
(7.0
)
 
 
 
 
Unrealized mark-to-market losses, net of tax benefit of $3.7 million
(50.6
)
 
 
 
 
Other comprehensive income
497.6

 
 
 
 
Dividend declaration
(106.3
)
 
 
 
 
Other

 
 
 
 
Balance before capital transactions
$
2,600.8

 
219.7

 
$
11.84

Net proceeds from issuance of common stock
615.0

 
59.7

 
10.30

Proceeds from issuance of common stock through warrant exercise
175.7

 
16.0

 
11.00

Stockholders' equity at September 30, 2012 - basic
$
3,391.5

 
295.4

 
$
11.48

Warrants outstanding (2)

 
1.0

 
(0.04
)
Stockholders' equity at September 30, 2012 - diluted
$
3,391.5

 
296.4

 
$
11.44

____________________
(1)
Core Earnings is a non-GAAP measure that we define as net income, excluding impairment losses, gains or losses on sales of securities and termination of interest rate swaps, unrealized gains or losses on trading securities, interest rate swaps and swaptions and certain gains or losses on other derivative instruments. As defined, Core Earnings includes interest income associated with our inverse interest-only securities, or Agency derivatives, and premium income or loss on credit default swaps. Core Earnings is provided for purposes of comparability to other peer issuers.
(2)
Using the treasury stock method, $1.0 million shares would be considered outstanding and dilutive to book value per share at September 30, 2012.

Liquidity and Capital Resources
Our liquidity and capital resources are managed and forecast on a daily basis to ensure that we have sufficient liquidity to absorb market events that could negatively impact collateral valuations and result in margin calls and to ensure that we have the flexibility to manage our portfolio to take advantage of market opportunities.
Our principal sources of cash consist of borrowings under repurchase agreements, payments of principal and interest we receive on our RMBS portfolio, cash generated from our operating results, and proceeds from capital market transactions. We typically use cash to repay principal and interest on our repurchase agreements, to purchase our target assets, to make dividend payments on our capital stock, and to fund our operations.
To the extent that we raise additional equity capital through capital market transactions, we anticipate using cash proceeds from such transactions to purchase additional RMBS, mortgage loans, residential properties and other target assets and for other general corporate purposes. There can be no assurance, however, that we will be able to raise additional equity capital at any particular time or on any particular terms.
As of September 30, 2012, we held $833.6 million in cash and cash equivalents available to support our operations, $16.5 billion of AFS, trading securities, mortgage loans held-for-sale, and derivative assets held at fair value, and $14.0 billion of outstanding debt in the form of repurchase agreements (excludes $170.1 million in payables to broker counterparties for unsettled security purchases). During the three months ended September 30, 2012, our debt-to-equity ratio decreased from 4.8:1.0 to 4.1:1.0, including monies borrowed to finance our investment in U.S. Treasuries. The debt-to-equity ratio funding our RMBS, residential mortgage loans, and Agency derivatives decreased from 4.3:1.0 to 3.8:1.0 as we continued to deploy proceeds from stock offerings. We believe the debt-to-equity ratio funding our RMBS, residential mortgage loans and Agency derivatives is the most meaningful debt-to-equity measure as U.S. Treasuries are viewed to be highly liquid in nature.

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As of September 30, 2012, we had approximately $41.9 million of unpledged Agency securities and derivatives and $468.5 million of unpledged non-Agency securities and an overall estimated unused borrowing capacity on unpledged RMBS of approximately $295.3 million. On a daily basis, we monitor and forecast our available, or excess, liquidity. Additionally, we frequently perform shock analyses against various market events to monitor the adequacy of our excess liquidity. If borrowing rates and collateral requirements change in the near term, we believe we are subject to less earnings volatility than a more leveraged organization.
We have not experienced any restrictions to our funding sources in 2012 and have generally experienced an increase in available financing in the RMBS marketplace, including repurchase agreements with maturities greater than one year. We expect ongoing sources of financing to be primarily repurchase agreements and similar financing arrangements. We plan to finance our assets with a moderate amount of leverage, the level of which may vary based upon the particular characteristics of our portfolio and market conditions. We may deploy, on a debt-to-equity basis, up to ten times leverage on our Agency RMBS assets. We also deploy some leverage on our non-Agency RMBS assets utilizing repurchase agreements as the source of financing.
As of September 30, 2012, we have master repurchase agreements in place with 23 counterparties, the majority of which are U.S. domiciled financial institutions, and we continue to evaluate further counterparties to manage and reduce counterparty risk. Under our repurchase agreements, we are required to pledge additional assets as collateral to our counterparties (lenders) when the estimated fair value of the existing pledged collateral under such agreements declines and such lenders, through a margin call, demand additional collateral. Lenders generally make margin calls because of a perceived decline in the value of our assets collateralizing the repurchase agreements. This may occur following the monthly principal reduction of assets due to scheduled amortization and prepayments on the underlying mortgages, or may be caused by changes in market interest rates, a perceived decline in the market value of the investments and other market factors. To cover a margin call, we may pledge additional securities or cash. At maturity, any cash on deposit as collateral is generally applied against the repurchase agreement balance, thereby reducing the amount borrowed. Should the value of our assets suddenly decrease, significant margin calls on our repurchase agreements could result, causing an adverse change in our liquidity position.
As of September 30, 2012, a number of our counterparties have been downgraded by ratings agencies, specifically Moody's. As these downgrades were expected, we believe the markets had been well prepared for these decisions. We have not experienced any significant changes to repurchase agreement terms or related financing costs, or made any significant changes to our counterparty exposures as a result of the downgrades.
The following table summarizes our repurchase agreements and counterparty geographical concentration at September 30, 2012 and December 31, 2011:
 
September 30, 2012
 
December 31, 2011
(dollars in thousands)
Amount Outstanding
 
Net Counterparty Exposure(1)
 
Percent of Funding
 
Amount Outstanding
 
Net Counterparty Exposure(1)
 
Percent of Funding
North America
$
8,744,965

 
$
1,115,682

 
62.0
%
 
$
4,972,632

 
$
570,534

 
71.3
%
Europe (2)
3,000,969

 
533,270

 
29.7
%
 
884,888

 
183,955

 
23.0
%
Asia (2)
2,288,393

 
149,095

 
8.3
%
 
802,628

 
45,954

 
5.7
%
Total
$
14,034,327

 
$
1,798,047

 
100.0
%
 
$
6,660,148

 
$
800,443

 
100.0
%
____________________
(1)
Represents the net carrying value of the securities or mortgage loans sold under agreements to repurchase, including accrued interest plus any cash or assets on deposit to secure the repurchase obligation, less the amount of the repurchase liability, including accrued interest. At September 30, 2012 and December 31, 2011, we had $15.7 million and $45.6 million, respectively, in payables due to broker counterparties for unsettled security purchases. The payables are not included in the amounts presented above.
(2)
Exposure to European and Asian domiciled banks and their U.S. subsidiaries.

For the three and nine months ended September 30, 2012, we continued to maintain our repurchase agreement with Wells Fargo Bank. The repurchase agreement serves as a repurchase facility used from time to time to finance certain of our non-Agency securities held in our RMBS portfolio with Wells Fargo. As of September 30, 2012, borrowings under the Wells Fargo repurchase agreement were $82.7 million and unused, uncommitted capacity was $67.3 million, for an aggregate maximum borrowing capacity of $150.0 million. The facility is set to mature on July 23, 2013.
Once an RMBS is financed by Wells Fargo in accordance with the repurchase agreement, the financing is committed for the duration of the facility subject to similar pledged collateral and margin requirements as a standard repurchase agreement discussed above. As part of the repurchase agreement, we are subject to certain financial covenants, which we monitor and comply with on a daily basis. The extended duration of the facility and its terms provide an additional source to manage our liquidity and interest rate risk.

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We also maintained our repurchase agreement with Barclays, which serves as a mortgage loan warehouse facility. This uncommitted facility provides an aggregate maximum borrowing capacity of $50.0 million and is set to mature on May 14, 2013, unless extended pursuant to its terms. As of September 30, 2012, borrowings under the uncommitted facility were $12.8 million and unused capacity was $37.2 million. The facility is collateralized by eligible residential mortgage loans, which are subject to margin call provisions that provide Barclays with certain rights when there has been a decline in the market value of the purchased mortgage loans.
We are subject to the following financial covenants under the Wells Fargo and Barclays repurchase agreements, as further detailed by the guaranty agreements we entered into in connection with the repurchase agreements. The following represents the most restrictive covenant calculations as of September 30, 2012 across both agreements:
(a)
As of the last business day of each calendar quarter, Total Indebtedness to Net Worth must be less than the specified Threshold Ratio in the Repurchase Agreement. As of September 30, 2012, our debt to net worth, as defined, was 3.9:1.0 while our threshold ratio, as defined, was 6.8:1.0.
(b)
As of the last business day of each calendar quarter, Liquidity must be greater than $55 million and the aggregate amount of Unrestricted Cash or Cash Equivalents must be greater than $35 million. As of September 30, 2012, our liquidity, as defined, was $833.6 million and our total unrestricted cash and cash equivalents, as defined, was $457.8 million.
(c)
As of the last business day of each calendar quarter, Net Worth must be greater than $1 billion. As of September 30, 2012, our net worth, as defined, was $3.4 billion.
We are also subject to financial covenants in connection with various other repurchase agreements we enter into in the normal course of our business. We intend to continue to operate in a manner which complies with all of our financial covenants.
The following table summarizes assets at carrying value that are pledged or restricted as collateral for the future payment obligations of repurchase agreements.
(in thousands)
September 30,
2012
 
December 31,
2011
Available-for-sale securities, at fair value
$
14,453,848

 
$
6,160,229

Trading securities, at fair value
1,002,461

 
1,003,301

Mortgage loans held-for-sale
14,553

 
5,782

Cash and cash equivalents
10,000

 
15,000

Restricted cash
14,018

 
94,803

Due from counterparties
28,965

 
32,201

Derivative assets, at fair value
318,575

 
145,779

Total
$
15,842,420

 
$
7,457,095


Although we generally intend to hold our target assets as long-term investments, we may sell certain of our investment securities in order to manage our interest rate risk and liquidity needs, to meet other operating objectives and to adapt to market conditions. We cannot predict the timing and impact of future sales of investment securities, if any. Because many of our investment securities are financed with repurchase agreements and may be financed with credit facilities (including term loans and revolving facilities), a significant portion of the proceeds from sales of our investment securities (if any), prepayments and scheduled amortization are used to repay balances under these financing sources.

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The following table provides the maturities of our repurchase agreements as of September 30, 2012 and December 31, 2011:
(in thousands)
September 30,
2012
 
December 31,
2011
Within 30 days
$
1,986,019

 
$
1,967,009

30 to 59 days
3,189,709

 
1,263,060

60 to 89 days
70,259

 
1,096,410

90 to 119 days
1,868,315

 
359,171

120 to 364 days (1) (2)
5,642,525

 
923,248

Open maturity (3)
997,500

 
1,001,250

One year and over (4)
280,000

 
50,000

Total
$
14,034,327

 
$
6,660,148

____________________
(1)
120 to 364 days includes the amounts outstanding under the Wells Fargo 364-day borrowing facility.
(2)
120 to 364 days includes the amounts outstanding under the Barclays 364-day borrowing facility.
(3)
Repurchase agreements collateralized by U.S. Treasuries include an open maturity period (i.e., rolling 1-day maturity) renewable at the discretion of either party to the agreements.
(4)
One year and over includes repurchase agreements with maturity dates ranging from December 23, 2013 to July 27, 2016.

For the three months ended September 30, 2012, our unrestricted cash balance increased to $833.6 million from $496.7 million at June 30, 2012. The cash movements can be summarized by the following:
Cash flows from operating activities.   For the three months ended September 30, 2012, operating activities increased our cash balances by approximately $77.8 million, primarily driven by our financial results for the quarter.
Cash flows from investing activities.  For the three months ended September 30, 2012, investing activities reduced our cash balances by approximately $4.0 billion. The reduction was driven by the increase in our RMBS portfolio as we deployed capital from our common stock offerings.
Cash flows from financing activities.   For the three months ended September 30, 2012, financing activities increased our cash balance by approximately $4.3 billion, resulting from the net borrowings under repurchase agreements to fund our AFS portfolio as well as net proceeds of $790.7 million received from our common stock offering and exercise of outstanding warrants.

Inflation
Substantially all of our assets and liabilities are financial in nature. As a result, changes in interest rates and other factors impact our performance far more than does inflation. Our financial statements are prepared in accordance with GAAP and dividends are based upon net ordinary income and capital gains as calculated for tax purposes; in each case, our results of operations and reported assets, liabilities and equity are measured with reference to historical cost or fair value without considering inflation.

Item 3. Quantitative and Qualitative Disclosures about Market Risk
We seek to manage our risks related to the credit quality of our assets, interest rates, liquidity, prepayment speeds and market value while providing an opportunity to stockholders to realize attractive risk-adjusted returns through ownership of our capital stock. Although we do not seek to avoid risk completely, we believe that risk can be quantified from historical experience and we seek to manage our risk levels in order to earn sufficient compensation to justify the risks we undertake and to maintain capital levels consistent with taking such risks.
To reduce the risks to our portfolio, we employ portfolio-wide and security-specific risk measurement and management processes in our daily operations. PRCM Advisers' risk management tools include software and services licensed or purchased from third parties, in addition to proprietary software and analytical methods developed by Pine River. There can be no guarantee that these tools will protect us from market risks.
Interest Rate Risk
Interest rates are highly sensitive to many factors, including fiscal and monetary policies and domestic and international economic and political considerations, as well as other factors beyond our control. We are subject to interest rate risk in connection with our assets and related financing obligations. Subject to maintaining our qualification as a REIT, we engage in a variety of interest rate management techniques that seek to mitigate the influence of interest rate changes on the values of our assets.

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We utilize U.S. Treasuries as well as derivative financial instruments, currently limited to interest rate swaps, swaptions, TBAs, and, to a certain extent, inverse interest-only securities, as of September 30, 2012 to hedge the interest rate risk associated with our portfolio. We seek to hedge interest rate risk with respect to both the fixed income nature of our assets and the financing of our portfolio. In hedging interest rates with respect to our fixed income assets, we seek to reduce the risk of losses on the value of our investments that may result from changes in interest rates in the broader markets. In utilizing interest rate hedges with respect to our financing, we seek to improve risk-adjusted returns and, where possible, to obtain a favorable spread between the yield on our assets and the cost of our financing. We rely on PRCM Advisers' expertise to manage these risks on our behalf. We implement part of our hedging strategy through Capitol, our TRS, which is subject to U.S. federal, state and, if applicable, local income tax.
Interest Rate Effect on Net Interest Income
Our operating results depend in large part on differences between the income earned on our assets and our cost of borrowing and hedging activities. The costs associated with our borrowings are generally based on prevailing market interest rates. During a period of rising interest rates, our borrowing costs generally will increase while the yields earned on our existing portfolio of leveraged fixed-rate RMBS will remain static. Moreover, interest rates may rise at a faster pace than the yields earned on our leveraged adjustable-rate and hybrid RMBS. Both of these factors could result in a decline in our net interest spread and net interest margin. The severity of any such decline would depend on our asset/liability composition at the time, as well as the magnitude and duration of the interest rate increase. Further, an increase in short-term interest rates could also have a negative impact on the market value of our target assets. If any of these events happen, we could experience a decrease in net income or incur a net loss during these periods, which could adversely affect our liquidity and results of operations.
Our hedging techniques are partly based on assumed levels of prepayments of our target assets. If prepayments are slower or faster than assumed, the life of the investment will be longer or shorter, which would reduce the effectiveness of any hedging strategies we may use and may cause losses on such transactions. Hedging strategies involving the use of derivative securities are highly complex and may produce volatile returns.
We acquire adjustable-rate and hybrid RMBS. These are assets in which some of the underlying mortgages are typically subject to periodic and lifetime interest rate caps and floors, which may limit the amount by which the security's interest yield may change during any given period. However, our borrowing costs pursuant to our financing agreements are not subject to similar restrictions. Therefore, in a period of increasing interest rates, interest rate costs on our borrowings could increase without limitation, while the interest-rate yields on our adjustable-rate and hybrid RMBS could effectively be limited by caps. This issue will be magnified to the extent we acquire adjustable-rate and hybrid RMBS that are not based on mortgages that are fully indexed. In addition, adjustable-rate and hybrid RMBS may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. If this happens, we could receive less cash income on such assets than we would need to pay for interest costs on our related borrowings. These factors could lower our net interest income or cause a net loss during periods of rising interest rates, which would harm our financial condition, cash flows and results of operations.
Interest Rate Mismatch Risk
We fund the majority of our adjustable-rate and hybrid Agency RMBS assets with borrowings that are based on LIBOR, while the interest rates on these assets may be indexed to other index rates, such as the one-year Constant Maturity Treasury index, or CMT, the Monthly Treasury Average index, or MTA, or the 11th District Cost of Funds Index, or COFI. Accordingly, any increase in LIBOR relative to these indices may result in an increase in our borrowing costs that is not matched by a corresponding increase in the interest earnings on these assets. Any such interest rate index mismatch could adversely affect our profitability, which may negatively impact distributions to our stockholders. To mitigate interest rate mismatches, we utilize the hedging strategies discussed above.
The following table provides the indices of our variable rate assets as of September 30, 2012 and December 31, 2011, respectively, based on total notional amount of bonds (dollars in thousands).
 
 
As of September 30, 2012
 
As of December 31, 2011
Index Type
 
Floating
 
Hybrid (1)
 
Total
 
Index %
 
Floating
 
Hybrid (1)
 
Total
 
Index %
CMT
 
$

 
$
160,331

 
$
160,331

 
7
%
 
$

 
$
174,791

 
$
174,791

 
14
%
LIBOR
 
2,187,109

 
28,316

 
2,215,425

 
92
%
 
975,327

 
43,866

 
1,019,193

 
83
%
Other (2)
 
17,878

 
14,269

 
32,147

 
1
%
 
16,371

 
16,337

 
32,708

 
3
%
Total
 
$
2,204,987

 
$
202,916

 
$
2,407,903

 
100
%
 
$
991,698

 
$
234,994

 
$
1,226,692

 
100
%
____________________
(1)
"Hybrid" amounts reflect those assets with greater than 12 months to reset.
(2)
"Other" includes COFI, MTA and other indices.


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Our analysis of risks is based on PRCM Advisers' and its affiliates' experience, estimates, models and assumptions. These analyses rely on models which utilize estimates of fair value and interest rate sensitivity. Actual economic conditions or implementation of decisions by PRCM Advisers may produce results that differ significantly from the estimates and assumptions used in our models.
We use a variety of recognized industry models, as well as proprietary models, to perform sensitivity analyses which are derived from primary assumptions for prepayment rates, discount rates and credit losses. The primary assumption used in this model is implied market volatility of interest rates. The information presented in the following interest sensitivity table projects the potential impact of sudden parallel changes in interest rates on our financial results and financial condition over the next 12 months, based on our interest sensitive financial instruments at September 30, 2012.
All changes in value are measured as the change from the September 30, 2012 financial position. All projected changes in annualized net interest income are measured as the change from the projected annualized net interest income based off current performance returns.
 
Changes in Interest Rates
(dollars in thousands)
-100 bps
 
-50 bps
 
+50 bps
 
+100 bps
Change in value of financial position:
 
 
 
 
 
 
 
Available-for-sale securities, at fair value
$
237,344

 
$
121,939

 
$
(253,597
)
 
$
(498,347
)
As a % of September 30, 2012 equity
7.0
 %
 
3.6
 %
 
(7.5
)%
 
(14.7
)%
Trading securities, at fair value
$
6,482

 
$
6,482

 
$
(12,061
)
 
$
(24,122
)
As a % of September 30, 2012 equity
0.2
 %
 
0.2
 %
 
(0.4
)%
 
(0.7
)%
Mortgage loans held-for-sale, at fair value
$
71

 
$
27

 
$
(319
)
 
$
(708
)
As a % of September 30, 2012 equity
 %
 
 %
 
 %
 
 %
Derivatives, at fair value, net
$
(292,962
)
 
$
(210,786
)
 
$
212,586

 
$
448,677

As a % of September 30, 2012 equity
(8.6
)%
 
(6.2
)%
 
6.3
 %
 
13.2
 %
Repurchase Agreements
$
(21,282
)
 
$
(17,209
)
 
$
18,633

 
$
37,266

As a % of September 30, 2012 equity
(0.6
)%
 
(0.5
)%
 
0.5
 %
 
1.1
 %
Total Net Assets
$
(70,347
)
 
$
(99,547
)
 
$
(34,758
)
 
$
(37,234
)
As a % of September 30, 2012 total assets
(0.4
)%
 
(0.6
)%
 
(0.2
)%
 
(0.2
)%
As a % of September 30, 2012 equity
(2.0
)%
 
(2.9
)%
 
(1.1
)%
 
(1.1
)%
 
-100 bps
 
-50 bps
 
+50 bps
 
+100 bps
Change in annualized net interest income:
$
(9,811
)
 
$
(10,419
)
 
$
16,581

 
$
33,163

% change in net interest income
(1.9
)%
 
(2.0
)%
 
3.3
 %
 
6.5
 %

The interest rate sensitivity table quantifies the potential changes in net interest income and portfolio value, which includes the value of swaps and our other derivatives, should interest rates immediately change. The interest rate sensitivity table presents the estimated impact of interest rates instantaneously rising 50 and 100 basis points, and falling 50 and 100 basis points. The cash flows associated with the portfolio of RMBS for each rate change are calculated based on assumptions, including prepayment speeds, yield on future acquisitions, slope of the yield curve, and size of the portfolio. Assumptions made on the interest rate sensitive liabilities, which are assumed to relate to repurchase agreements, including anticipated interest rates, collateral requirements as a percent of the repurchase agreement, amount and term of borrowing.
The AFS securities, at fair value, included in the foregoing interest rate sensitivity table under “change in value of financial position” were limited to Agency RMBS. Due to the significantly discounted prices and underlying credit risks of our non-Agency RMBS, we believe our non-Agency RMBS's valuation is inherently de-sensitized to changes in interest rates. As such, we cannot project the impact to these financial instruments and have excluded these RMBS from the interest rate sensitivity analysis. However, these non-Agency RMBS have been included in the “change in annualized net interest income” analysis.
Certain assumptions have been made in connection with the calculation of the information set forth in the foregoing interest rate sensitivity table and, as such, there can be no assurance that assumed events will occur or that other events will not occur that would affect the outcomes. The base interest rate scenario assumes interest rates at September 30, 2012. The analysis utilizes assumptions and estimates based on management's judgment and experience. Furthermore, while we generally expect to retain such assets and the associated interest rate risk to maturity, future purchases and sales of assets could materially change our interest rate risk profile.
The change in annualized net interest income does not include any benefit or detriment from faster or slower prepayment rates on our Agency premium RMBS, non-Agency discount RMBS, and instruments that represent the interest payments (but not the principal) on a pool of mortgages, or interest-only securities. We anticipate that faster prepayment speeds in lower

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interest rate scenarios will generate lower realized yields on Agency premium and interest-only securities and higher realized yields on non-Agency discount RMBS. Similarly, we anticipate that slower prepayment speeds in higher interest rate scenarios will generate higher realized yields on Agency premium and interest-only bonds and lower realized yields on non-Agency discount RMBS. Although we have sought to construct the portfolio to limit the effect of changes in prepayment speeds, there can be no assurance this will actually occur, and the realized yield of the portfolio may be significantly different than we anticipate in changing interest rate scenarios.
Given the low interest rates at September 30, 2012, we applied a floor of 0% for all anticipated interest rates included in our assumptions. Because of this floor, we anticipate that any hypothetical interest rate shock decrease would have a limited positive impact on our funding costs; however, because prepayments speeds are unaffected by this floor, we expect that any increase in our prepayment speeds (occurring as a result of any interest rate decrease or otherwise) could result in an acceleration of our premium amortization on Agency and interest-only securities purchased at a premium, and accretion of discount on our non-Agency RMBS purchased at a discount. As a result, because this floor limits the positive impact of any interest rate decrease on our funding costs, hypothetical interest rate decreases could cause the fair value of our financial instruments and our net interest income to decline.
The information set forth in the interest rate sensitivity table and all related disclosures constitutes forward-looking statements within the meaning of Section 27A of the Securities Act, and Section 21E of the Exchange Act. Actual results could differ significantly from those estimated in the foregoing interest rate sensitivity table.
Prepayment Risk
Prepayment risk is the risk that principal will be repaid at a different rate than anticipated. As we receive prepayments of principal on our assets, premiums paid on such assets will be amortized against interest income. In general, an increase in prepayment rates will accelerate the amortization of purchase premiums, thereby reducing the interest income earned on the assets. Conversely, discounts on such assets are accreted into interest income. In general, an increase in prepayment rates will accelerate the accretion of purchase discounts, thereby increasing the interest income earned on the assets.
Normally, we believe that we will be able to reinvest proceeds from scheduled principal payments and prepayments at acceptable yields; however, no assurances can be given that, should significant prepayments occur, market conditions would be such that acceptable investments could be identified and the proceeds timely reinvested.
Market Risk
Market Value Risk.   Our AFS securities are reflected at their estimated fair value, with the difference between amortized cost and estimated fair value reflected in accumulated other comprehensive income. The estimated fair value of these securities fluctuates primarily due to changes in interest rates, market valuation of credit risks, and other factors. Generally, in a rising interest rate environment, we would expect the fair value of these securities to decrease; conversely, in a decreasing interest rate environment, we would expect the fair value of these securities to increase. As market volatility increases or liquidity decreases, the fair value of our assets may be adversely impacted.
Real estate risk.  RMBS and residential property values are subject to volatility and may be affected adversely by a number of factors, including national, regional and local economic conditions; local real estate conditions (such as an oversupply of housing); changes or continued weakness in specific industry segments; construction quality, age and design; demographic factors; and retroactive changes to building or similar codes. Decreases in property values reduce the value of the collateral for mortgage loans and the potential proceeds available to borrowers to repay the loans, which could cause us to suffer losses on our non-Agency RMBS investments.
Liquidity Risk
Our liquidity risk is principally associated with our financing of long-maturity assets with short-term borrowings in the form of repurchase agreements. Although the interest rate adjustments of these assets and liabilities fall within the guidelines established by our operating policies, maturities are not required to be, nor are they, matched.
Should the value of our assets pledged as collateral suddenly decrease, margin calls relating to our repurchase agreements could increase, causing an adverse change in our liquidity position. Additionally, if one or more of our repurchase agreement counterparties chose not to provide on-going funding, our ability to finance would decline or exist at possibly less advantageous terms. As such, we cannot assure that we will always be able to roll over our repurchase agreements. See Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" in this Quarterly Report on Form 10-Q for further information about our liquidity and capital resource management.
Credit Risk
We believe that our investment strategy will generally keep our risk of credit losses low to moderate. However, we retain the risk of potential credit losses on all of the loans underlying our non-Agency RMBS. With respect to our non-Agency RMBS that are senior in the credit structure, credit support contained in RMBS deal structures provide a level of protection from losses. We seek to manage the remaining credit risk through our pre-acquisition due diligence process, and by factoring assumed credit losses into the purchase prices we pay for non-Agency RMBS. In addition, with respect to any particular target

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asset, we evaluate relative valuation, supply and demand trends, shape of yield curves, prepayment rates, delinquency and default rates, recovery of various sectors and vintage of collateral. At times, we enter into credit default swaps or other derivative instruments in an attempt to manage our credit risk. Nevertheless, unanticipated credit losses could adversely affect our operating results.

Item 4. Controls and Procedures
A review and evaluation was performed by our management, including our Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, of the effectiveness of our disclosure controls and procedures (as such term is defined in Rule 13a-15(e) and 15d-15(e) under the 1934 Act) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that review and evaluation, the CEO and CFO have concluded that our current disclosure controls and procedures, as designed and implemented, were effective. Although our CEO and CFO have determined our disclosure controls and procedures were effective at the end of the period covered by this Quarterly Report on Form 10-Q, a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that it will detect or uncover failures within the Company to disclose material information otherwise required to be set forth in the reports we submit under the Securities Exchange Act of 1934.
There have been no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings
From time to time we may be involved in various legal claims and/or administrative proceedings that arise in the ordinary course of our business. As of the date of this filing, we are not party to any litigation or legal proceedings or, to the best of our knowledge, any threatened litigation or legal proceedings, which, in our opinion, individually or in the aggregate, would have a material adverse effect on our results of operations or financial condition.

Item 1A. Risk Factors
Other than those set forth in our Quarterly Report on Form 10-Q for the period ended June 30, 2012, or the Q2 Form 10-Q, there have been no material changes to the risk factors set forth under the heading "Item 1A. Risk Factors" of our Annual Report on Form 10-K for the year ended December 31, 2011, or the Form 10-K. The materialization of any risks and uncertainties identified in our Forward Looking Statements contained in this report together with those previously disclosed in the Form 10-K and Q2 Form 10-Q or those that are presently unforeseen could result in significant adverse effects on our financial condition, results of operations, and cash flows. See Item 2, “Management's Discussion and Analysis of Financial Condition and Results of Operations - Forward Looking Statements” in this Quarterly Report on Form 10-Q.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.

Item 3. Defaults Upon Senior Securities
None.

Item 4. Mine Safety Disclosures
None.

Item 5. Other Information
None.

Item 6. Exhibits
(a) Exhibits
Exhibits - The exhibits listed on the accompanying Index of Exhibits are filed or incorporated by reference as a part of this report. Such Index is incorporated herein by reference.


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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
TWO HARBORS INVESTMENT CORP.
Dated:
November 7, 2012
By:
/s/ Thomas Siering
 
 
 
Thomas Siering
Chief Executive Officer, President and
Director (principal executive officer)
Dated:
November 7, 2012
By:
/s/ Brad Farrell
 
 
 
Brad Farrell
Chief Financial Officer and Treasurer
(principal accounting and financial officer)


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Exhibit Number
 
Exhibit Index
2.1
 
Agreement and Plan of Merger, dated as of June 11, 2009, by and among Capitol Acquisition Corp., Two Harbors Investment Corp., Two Harbors Merger Corp. and Pine River Capital Management L.P. (incorporated by reference to Annex A filed with Pre Effective Amendment No. 4 to the Registrant's Registration Statement on Form S-4 (File No. 333-160199) filed with the Securities and Exchange Commission ("SEC") on October 8, 2009 ("Amendment No. 4")).
2.2
 
Amendment No. 1 to Agreement and Plan of Merger, dated as of August 17, 2009, by and among Capitol Acquisition Corp., Two Harbors Investment Corp., Two Harbors Merger Corp. and Pine River Capital Management L.P. (incorporated by reference to Annex A-2 filed with Amendment No. 4).
2.3
 
Amendment No. 2 to Agreement and Plan of Merger, dated as of September 20, 2009, by and among Capitol Acquisition Corp., Two Harbors Investment Corp., Two Harbors Merger Corp. and Pine River Capital Management L.P. (incorporated by reference to Annex A-3 filed with Amendment No. 4).
3.1
 
Articles of Amendment and Restatement of Two Harbors Investment Corp. (incorporated by reference to Annex B filed with Amendment No. 4).
3.2
 
Bylaws of Two Harbors Investment Corp. (incorporated by reference to Annex C filed with Amendment No. 4).
4.1
 
Warrant Agreement between Continental Stock Transfer & Trust Company and Capitol Acquisition Corp. (incorporated by reference to Exhibit 4.1 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 2009, filed with the SEC on March 4, 2010 ("2009 Form 10-K")).
4.2
 
Specimen Common Stock Certificate of Two Harbors Investment Corp. (incorporated by reference to Exhibit 4.2 to Amendment No. 4).
4.3
 
Specimen Warrant Certificate of Two Harbors Investment Corp. (incorporated by reference to Exhibit 4.3 filed with Pre-Effective Amendment No. 1 to the Registrant's Registration Statement on Form S-4 (File No. 333-160199) filed with the SEC on August 5, 2009).
4.4
 
Supplement and Amendment to Warrant Agreement between Continental Stock Transfer & Trust Company, Capitol Acquisition Corp. and Two Harbors Investment Corp. (incorporated by reference to Exhibit 4.4 to the Registrant's 2009 Form 10-K).
4.5
 
Second Amendment to Warrant Agreement between Two Harbors Investment Corp. and Mellon Investors Services LLC (incorporated by reference to Exhibit 99.1 to the Registrant's Current Report on Form 8-K filed with the SEC on December 13, 2010).
31.1
 
Certification of the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (filed herewith)
31.2
 
Certification of the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (filed herewith)
32.1
 
Certification of the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (filed herewith)
32.2
 
Certification of the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (filed herewith)
101
 
Financial statements from the Quarterly Report on Form 10-Q of Two Harbors Investment Corp. for the quarter ended September 30, 2012, filed on November 7, 2012, formatted in XBRL: (i) the Condensed Consolidated Balance Sheets, (ii) the Condensed Consolidated Statements of Comprehensive Income (Loss), (iii) the Condensed Consolidated Statements of Stockholders' Equity and Comprehensive Income (Loss), (iv) the Condensed Consolidated Statement of Cash Flows, and (v) the Notes to the Condensed Consolidated Financial Statements.




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