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: June 30, 2015

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.)

590 Madison Avenue, 36th Floor
New York, New York
 
10022
(Address of Principal Executive Offices)
 
(Zip Code)
(612) 629-2500
(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer 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 August 5, 2015 there were 367,539,843 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)
 
June 30,
2015
 
December 31,
2014
ASSETS
(unaudited)
 
 
Available-for-sale securities, at fair value
$
12,807,658

 
$
14,341,102

Trading securities, at fair value
—

 
1,997,656

Residential mortgage loans held-for-sale, at fair value
695,078

 
535,712

Residential mortgage loans held-for-investment in securitization trusts, at fair value
2,449,199

 
1,744,746

Commercial real estate loans held-for-investment
45,605

 
—

Mortgage servicing rights, at fair value
437,576

 
452,006

Cash and cash equivalents
933,579

 
1,005,792

Restricted cash
410,903

 
336,771

Accrued interest receivable
57,011

 
65,529

Due from counterparties
27,230

 
35,625

Derivative assets, at fair value
347,322

 
380,791

Other assets
236,560

 
188,579

Total Assets  (1)
$
18,447,721

 
$
21,084,309

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Liabilities
 
 
 
Repurchase agreements
$
9,422,803

 
$
12,932,463

Collateralized borrowings in securitization trusts, at fair value
1,714,735

 
1,209,663

Federal Home Loan Bank advances
3,000,000

 
2,500,000

Derivative liabilities, at fair value
22,475

 
90,233

Due to counterparties
160,014

 
124,206

Dividends payable
95,557

 
95,263

Other liabilities
60,568

 
64,439

Total Liabilities  (1)
14,476,152

 
17,016,267

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; 900,000,000 shares authorized and 367,527,725 and 366,395,920 shares issued and outstanding, respectively
3,675

 
3,664

Additional paid-in capital
3,816,861

 
3,811,027

Accumulated other comprehensive income
631,032

 
855,789

Cumulative earnings
1,508,839

 
1,195,536

Cumulative distributions to stockholders
(1,988,838
)
 
(1,797,974
)
Total Stockholders’ Equity
3,971,569

 
4,068,042

Total Liabilities and Stockholders’ Equity
$
18,447,721

 
$
21,084,309

____________________
(1)
The condensed consolidated balance sheets include assets of consolidated variable interest entities, or VIEs, that can only be used to settle obligations of these VIEs, and liabilities of the consolidated VIEs for which creditors do not have recourse to Two Harbors Investment Corp. At June 30, 2015 and December 31, 2014 , assets of the VIEs totaled $2,508,625 and $1,754,943 , and liabilities of the VIEs totaled $1,727,995 and $1,219,821 , respectively. See Note 3 - Variable Interest Entities for additional information.
The accompanying notes are an integral part of these condensed consolidated financial statements.

1
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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands, except share data)
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2015
 
2014
 
2015
 
2014
Interest income:
(unaudited)
 
(unaudited)
Available-for-sale securities
$
118,129

 
$
127,605

 
$
253,654

 
$
251,518

Trading securities
3,981

 
1,940

 
8,676

 
3,866

Residential mortgage loans held-for-sale
7,518

 
2,699

 
11,789

 
7,285

Residential mortgage loans held-for-investment in securitization trusts
21,830

 
7,761

 
40,067

 
15,654

Commercial real estate loans held-for-investment
850

 
—

 
894

 
—

Cash and cash equivalents
221

 
144

 
418

 
361

Total interest income
152,529

 
140,149

 
315,498

 
278,684

Interest expense:
 
 
 
 


 


Repurchase agreements
19,398

 
18,603

 
39,963

 
39,175

Collateralized borrowings in securitization trusts
13,131

 
5,592

 
23,839

 
10,945

Federal Home Loan Bank advances
2,500

 
755

 
4,730

 
908

Total interest expense
35,029

 
24,950

 
68,532

 
51,028

Net interest income
117,500

 
115,199

 
246,966

 
227,656

Other-than-temporary impairments:
 
 
 
 

 

Total other-than-temporary impairment losses
(170
)
 
—

 
(297
)
 
(212
)
Non-credit portion of loss recognized in other comprehensive (loss) income
—

 
—

 
—

 
—

Net other-than-temporary credit impairment losses
(170
)
 
—

 
(297
)

(212
)
Other income:
 
 
 
 

 

Gain (loss) on investment securities
69,932

 
37,688

 
199,389

 
(967
)
Gain (loss) on interest rate swap and swaption agreements
44,952

 
(116,019
)
 
(81,491
)
 
(221,547
)
Loss on other derivative instruments
(5,484
)
 
(24,202
)
 
(2,517
)
 
(18,401
)
(Loss) gain on residential mortgage loans held-for-sale
(6,832
)
 
11,801

 
2,260

 
8,620

Servicing income
30,516

 
33,868

 
62,603

 
64,309

Gain (loss) on servicing asset
17,635

 
(29,571
)
 
(34,768
)
 
(62,331
)
Other (loss) income
(16,609
)
 
21,003

 
(18,466
)
 
21,463

Total other income (loss)
134,110

 
(65,432
)
 
127,010

 
(208,854
)
Expenses:
 
 
 
 

 

Management fees
12,686

 
12,190

 
25,407

 
24,301

Securitization deal costs
2,484

 
—

 
5,095

 
—

Servicing expenses
5,899

 
6,857

 
12,615

 
12,082

Other operating expenses
15,827

 
14,323

 
31,882

 
28,857

Total expenses
36,896

 
33,370

 
74,999

 
65,240

Income (loss) before income taxes
214,544

 
16,397

 
298,680

 
(46,650
)
Benefit from income taxes
(6,957
)
 
(23,260
)
 
(17,614
)
 
(57,162
)
Net income
$
221,501

 
$
39,657

 
$
316,294

 
$
10,512

Basic and diluted earnings per weighted average common share
$
0.60

 
$
0.11

 
$
0.86

 
$
0.03

Dividends declared per common share
$
0.26

 
$
0.26

 
$
0.52

 
$
0.52

Basic and diluted weighted average number of shares of common stock outstanding
367,074,131

 
366,078,124

 
366,792,459

 
365,846,295

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

2
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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME, continued
(in thousands, except share data)
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2015
 
2014
 
2015
 
2014
 
(unaudited)
 
(unaudited)
Comprehensive income:
 
 
 
 
 
 
 
Net income
$
221,501

 
$
39,657

 
$
316,294

 
$
10,512

Other comprehensive (loss) income:
 
 
 
 
 
 
 
Unrealized (loss) gain on available-for-sale securities, net
(218,826
)
 
191,160

 
(224,757
)
 
372,895

Other comprehensive (loss) income
(218,826
)
 
191,160

 
(224,757
)
 
372,895

Comprehensive income
$
2,675

 
$
230,817

 
$
91,537

 
$
383,407

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


3
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TWO HARBORS INVESTMENT CORP. 
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except share data)
 
Common Stock
 
 
 
 
 
 
 
 
 
 
 
Shares
 
Amount
 
Additional Paid-in Capital
 
Accumulated Other Comprehensive Income
 
Cumulative Earnings
 
Cumulative Distributions to Stockholders
 
Total Stockholders’ Equity
 
 
 
 
 
 
 
(unaudited)
 
 
 
 
 
 
Balance, December 31, 2013
364,935,168

 
$
3,649

 
$
3,795,372

 
$
444,735

 
$
1,028,397

 
$
(1,417,158
)
 
$
3,854,995

Net income
—

 
—

 
—

 
—

 
10,512

 
—

 
10,512

Other comprehensive income before reclassifications
—

 
—

 
—

 
350,455

 
—

 
—

 
350,455

Amounts reclassified from accumulated other comprehensive income
—

 
—

 
—

 
22,440

 
—

 
—

 
22,440

Net other comprehensive income
—

 
—

 
—

 
372,895

 
—

 
—

 
372,895

Issuance of common stock, net of offering costs
23,474

 
—

 
240

 
—

 
—

 
—

 
240

Common dividends declared
—

 
—

 
—

 
—

 
—

 
(190,361
)
 
(190,361
)
Non-cash equity award compensation
1,152,277

 
12

 
10,212

 
—

 
—

 
—

 
10,224

Balance, June 30, 2014
366,110,919

 
$
3,661

 
$
3,805,824

 
$
817,630

 
$
1,038,909

 
$
(1,607,519
)
 
$
4,058,505

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2014
366,395,920

 
$
3,664

 
$
3,811,027

 
$
855,789

 
$
1,195,536

 
$
(1,797,974
)
 
$
4,068,042

Cumulative effect of adoption of new accounting principle
—

 
—

 
—

 
—

 
(2,991
)
 
—

 
(2,991
)
Adjusted balance, January 1, 2015
366,395,920

 
3,664

 
3,811,027

 
855,789

 
1,192,545

 
(1,797,974
)
 
4,065,051

Net income
—

 
—

 
—

 
—

 
316,294

 
—

 
316,294

Other comprehensive loss before reclassifications
—

 
—

 
—

 
(49,983
)
 
—

 
—

 
(49,983
)
Amounts reclassified from accumulated other comprehensive loss
—

 
—

 
—

 
(174,774
)
 
—

 
—

 
(174,774
)
Net other comprehensive loss
—

 
—

 
—

 
(224,757
)
 
—

 
—

 
(224,757
)
Issuance of common stock, net of offering costs
36,184

 
—

 
226

 
—

 
—

 
—

 
226

Common dividends declared
—

 
—

 
—

 
—

 
—

 
(190,864
)
 
(190,864
)
Non-cash equity award compensation
1,095,621

 
11

 
5,608

 
—

 
—

 
—

 
5,619

Balance, June 30, 2015
367,527,725

 
$
3,675

 
$
3,816,861

 
$
631,032

 
$
1,508,839

 
$
(1,988,838
)
 
$
3,971,569

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
(in thousands)
 
Six Months Ended
 
June 30,
 
2015
 
2014
Cash Flows From Operating Activities:
(unaudited)
Net income
$
316,294

 
$
10,512

Adjustments to reconcile net income to net cash (used in) provided by operating activities:
 
 
 
Amortization of premiums and discounts on investment securities and commercial real estate loans held-for-investment, net
22,157

 
1,840

Other-than-temporary impairment losses
297

 
212

Realized and unrealized (gains) losses on investment securities, net
(199,389
)
 
967

Gain on residential mortgage loans held-for-sale
(2,260
)
 
(8,620
)
Loss (gain) on residential mortgage loans held-for-investment and collateralized borrowings in securitization trusts
20,525

 
(21,142
)
Loss on servicing asset
34,768

 
62,331

Loss on termination and option expiration of interest rate swaps and swaptions
63,076

 
6,401

Unrealized (gain) loss on interest rate swaps and swaptions
(35,258
)
 
182,420

Unrealized gain on other derivative instruments
(1,634
)
 
(51
)
Equity based compensation
5,619

 
10,224

Depreciation of fixed assets
652

 
463

Amortization of intangible assets
—

 
533

Purchases of residential mortgage loans held-for-sale
(1,382,061
)
 
(261,983
)
Proceeds from sales of residential mortgage loans held-for-sale
75,272

 
400,739

Proceeds from repayment of residential mortgage loans held-for-sale
53,452

 
11,160

Net change in assets and liabilities:


 
 
Decrease in accrued interest receivable
8,518

 
193

Increase in deferred income taxes, net
(11,393
)
 
(60,310
)
Increase in income taxes receivable
(7,175
)
 
(290
)
Increase in prepaid and fixed assets
(228
)
 
(929
)
Decrease (increase) in other receivables
6,059

 
(11,396
)
Increase in servicing advances
(3,338
)
 
(8,532
)
Decrease in accrued interest payable
(4,788
)
 
(3,756
)
Decrease in income taxes payable
(1,336
)
 
(465
)
Increase in accrued expenses and other liabilities
2,253

 
5,673

Net cash (used in) provided by operating activities
$
(1,039,918
)
 
$
316,194

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

5
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TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Six Months Ended
 
June 30,
 
2015
 
2014
Cash Flows From Investing Activities:
(unaudited)
Purchases of available-for-sale securities
$
(1,705,012
)
 
$
(2,232,865
)
Proceeds from sales of available-for-sale securities
2,572,015

 
1,273,923

Principal payments on available-for-sale securities
611,850

 
474,696

Short sales and purchases of other derivative instruments
4,825

 
102,423

Proceeds from sales of other derivative instruments, net
(69,085
)
 
(74,476
)
Purchases of trading securities
—

 
(143,022
)
Proceeds from sales of trading securities
2,004,375

 
143,378

Proceeds from repayment of residential mortgage loans held-for-investment in securitization trusts
335,346

 
26,330

Purchases of commercial real estate loans held-for-investment
(45,556
)
 
—

Purchases of mortgage servicing rights, net of purchase price adjustments
(19,522
)
 
(48,419
)
Purchases of Federal Home Loan Bank stock
(25,240
)
 
(60,000
)
Purchases of equity investments
—

 
(3,000
)
Increase (decrease) in due to counterparties, net
44,203

 
(183,167
)
(Increase) decrease in restricted cash
(74,132
)
 
114,682

Net cash provided by (used in) investing activities
3,634,067

 
(609,517
)
Cash Flows From Financing Activities:
 
 
 
Proceeds from repurchase agreements
28,285,657

 
140,931,599

Principal payments on repurchase agreements
(31,795,316
)
 
(141,790,862
)
Proceeds from issuance of collateralized borrowings in securitization trusts
771,271

 
33,483

Principal payments on collateralized borrowings in securitization trusts
(237,630
)
 
(128,756
)
Proceeds from Federal Home Loan Bank advances
500,000

 
3,793,911

Principal payments on Federal Home Loan Bank advances
—

 
(2,293,911
)
Proceeds from issuance of common stock, net of offering costs
226

 
240

Dividends paid on common stock
(190,570
)
 
(95,172
)
Net cash (used in) provided by financing activities
(2,666,362
)
 
450,532

Net (decrease) increase in cash and cash equivalents
(72,213
)
 
157,209

Cash and cash equivalents at beginning of period
1,005,792

 
1,025,487

Cash and cash equivalents at end of period
$
933,579

 
$
1,182,696

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

6
Table of Contents



TWO HARBORS INVESTMENT CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
 
Six Months Ended
 
June 30,
 
2015
 
2014
Supplemental Disclosure of Cash Flow Information:
(unaudited)
Cash paid for interest
$
50,932

 
$
54,785

Cash paid for taxes
$
2,286

 
$
3,903

Noncash Investing and Financing Activities:
 
 
 
Transfers of residential mortgage loans held-for-sale to residential mortgage loans held-for-investment in securitization trusts
$
1,091,884

 
$
—

Transfers of residential mortgage loans held-for-sale to other receivables for foreclosed government-guaranteed loans
$
7,318

 
$
—

Additions to mortgage servicing rights due to sale of residential mortgage loans held-for-sale
$
816

 
$
—

Cumulative-effect adjustment to equity for adoption of new accounting principle
$
(2,991
)
 
$
—

Cash dividends declared but not paid at end of period
$
95,557

 
$
95,189

Reconciliation of residential mortgage loans held-for-sale:
 
 
 
Residential mortgage loans held-for-sale at beginning of period
$
535,712

 
$
544,581

Purchases of residential mortgage loans held-for-sale
1,382,061

 
261,983

Transfers to residential mortgage loans held-for-investment in securitization trusts
(1,091,884
)
 
—

Transfers to other receivables for foreclosed government-guaranteed loans
(7,318
)
 
—

Proceeds from sales of residential mortgage loans held-for-sale
(75,272
)
 
(400,739
)
Proceeds from repayment of residential mortgage loans held-for-sale
(53,452
)
 
(11,160
)
Realized and unrealized gains on residential mortgage loans held-for-sale
5,231

 
5,176

Residential mortgage loans held-for-sale at end of period
$
695,078

 
$
399,841

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

7
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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, mortgage servicing rights, or MSR, commercial real estate and other financial assets. The Company is externally managed and advised by PRCM Advisers LLC, or PRCM Advisers, which is a subsidiary of Pine River Capital Management L.P., or Pine River, a global multi-strategy asset management firm. The Company’s common stock is listed on the NYSE under the symbol “TWO”.
The Company was incorporated on May 21, 2009, and commenced operations as a publicly traded company on October 28, 2009, upon completion of a merger with Capitol Acquisition Corp., or Capitol, which became a wholly owned indirect subsidiary of the Company as a result of the merger.
The Company has elected to be treated as a real estate investment trust, or REIT, as defined under the Internal Revenue Code of 1986, as amended, or the Code, for U.S. federal income tax purposes. As long as the Company continues to comply with a number of requirements under federal tax law and maintains its qualification as a REIT, the Company generally will not be subject to U.S. federal income taxes to the extent that the Company distributes its taxable income to its stockholders on an annual basis and does not engage in prohibited transactions. However, certain activities that the Company may perform may cause it to earn income which will not be qualifying income for REIT purposes. The Company has designated certain of its subsidiaries as taxable REIT subsidiaries, or TRSs, as defined in the Code, to engage in such activities, and the Company may in the future form additional TRSs.

Note 2 . Basis of Presentation and Significant Accounting Policies
Consolidation and Basis of Presentation
The interim unaudited condensed consolidated financial statements of the Company have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission, or SEC. Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP, have been condensed or omitted according to such SEC rules and regulations. However, management believes that the disclosures included in these interim condensed consolidated financial statements are adequate to make the information presented not misleading. The 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, 2014 . In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at June 30, 2015 and results of operations for all periods presented have been made. The results of operations for the three and six months ended June 30, 2015 should not be construed as indicative of the results to be expected for future periods or the full year.
The condensed consolidated financial statements of the Company have been prepared on the accrual basis of accounting in accordance with U.S. GAAP. The preparation of financial statements in conformity with U.S. 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.
All trust entities in which the Company holds investments that are considered VIEs for financial reporting purposes were reviewed for consolidation under the applicable consolidation guidance. Because the Company has both the power to direct the activities of the trusts that most significantly impact the entities’ performance, and the obligation to absorb losses or the right to receive benefits of the entities that could be significant, the Company consolidates the trusts.

8

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

Significant Accounting Policies
Included in Note 2 to the Consolidated Financial Statements of the Company’s 2014 Annual Report on Form 10-K is a summary of the Company’s significant accounting policies. Provided below is a summary of additional accounting policies that are significant to the Company’s consolidated financial condition and results of operations for the six months ended June 30, 2015 .
Commercial Real Estate Loans Held-for-Investment
The Company is the sole certificate holder of a trust entity that holds a commercial real estate loan. The trust is considered a VIE for financial reporting purposes and, thus, is reviewed for consolidation under the applicable consolidation guidance. As the Company has both the power to direct the activities of the trust that most significantly impact the entity’s performance, and the obligation to absorb losses or the right to receive benefits of the entity that could be significant, the Company consolidates the trust. The underlying loan is classified as commercial real estate loans held-for-investment on the condensed consolidated balance sheets. The loan is legally isolated from the Company and has been structured to be beyond the reach of creditors of the Company. Interest income on commercial real estate loans held-for-investment is recorded on the condensed consolidated statements of comprehensive income.
Commercial real estate loans held-for-investment are reported at cost, net of any unamortized premiums or discounts, unless deemed impaired. The Company evaluates each loan for impairment at least quarterly. Impairment occurs when it is deemed probable that the Company will not be able to collect all amounts due according to the contractual terms of the loan. If a loan is considered to be impaired, the Company records an allowance to reduce the carrying value of the loan to the present value of expected future cash flows.
The Company’s commercial real estate loans are collateralized either by real property or by equity interests in the commercial real estate borrower. As a result, the Company regularly evaluates the extent and impact of any credit deterioration associated with the performance and/or value of the underlying collateral property, as well as the financial and operating capability of the borrower, borrowing entity or loan sponsor. The Company also evaluates the financial wherewithal of any loan guarantors as well as the borrower’s competency in managing and operating the properties. In addition, the Company considers the overall economic environment, real estate sector, and geographic sub-market in which the borrower operates.
Interest income on commercial real estate loans held-for-investment is recognized at the loan coupon rate. Any premiums or discounts are amortized or accreted into interest income using the effective interest method. Loans are considered past due when they are 30 days past their contractual due date. Interest income recognition is suspended when loans are placed on nonaccrual status. Generally, commercial real estate loans are placed on nonaccrual status when delinquent for more than 60 days or when determined not to be probable of full collection. Interest accrued, but not collected, at the date loans are placed on nonaccrual is reversed and subsequently recognized only to the extent it is received in cash or until it qualifies for return to accrual status. However, where there is doubt regarding the ultimate collectability of loan principal, all cash received is applied to reduce the carrying value of such loans. Commercial real estate loans are restored to accrual status only when contractually current or the collection of future payments is reasonably assured.
Offsetting Assets and Liabilities
Certain of the Company’s repurchase agreements are governed by underlying agreements that provide for a right of setoff in the event of default of either party to the agreement. The Company also has netting arrangements in place with all derivative counterparties pursuant to standard documentation developed by the International Swap and Derivatives Association, or ISDA, or central clearing exchange agreements, in the case of centrally cleared interest rate swaps. Additionally, the Company and the counterparty or clearing agency are required to post cash collateral based upon the net underlying market value of the Company’s open positions with the counterparty.
Under U.S. GAAP, if the Company has a valid right of setoff, it may offset the related asset and liability and report the net amount. The Company presents repurchase agreements subject to master netting arrangements or similar agreements on a gross basis, and derivative assets and liabilities subject to such arrangements on a net basis, based on derivative type and counterparty, in its condensed consolidated balance sheets. Separately, the Company presents cash collateral subject to such arrangements on a net basis, based on counterparty, in its condensed consolidated balance sheets. However, the Company does not offset financial assets and liabilities with the associated cash collateral on its condensed consolidated balance sheets.

9

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

The following tables present information about the Company’s assets and liabilities that are subject to master netting arrangements or similar agreements and can potentially be offset on the Company’s condensed consolidated balance sheets as of June 30, 2015 and December 31, 2014 :
 
June 30, 2015
 
 
 
 
 
 
 
Gross Amounts Not Offset with Financial Assets (Liabilities) in the Condensed Consolidated Balance Sheets (1)
 
 
(in thousands)
Gross Amounts of Recognized Assets (Liabilities)
 
Gross Amounts Offset in the Condensed Consolidated Balance Sheets
 
Net Amounts of Assets (Liabilities) Presented in the Condensed Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral (Received) Pledged
 
Net Amount
Assets
 
 
 
 
 
 
 
 
 
 
 
Derivative assets
$
414,958

 
$
(67,636
)
 
$
347,322

 
$
(22,475
)
 
$
—

 
$
324,847

Total Assets
$
414,958

 
$
(67,636
)
 
$
347,322

 
$
(22,475
)
 
$
—

 
$
324,847

 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(9,422,803
)
 
$
—

 
$
(9,422,803
)
 
$
9,422,803

 
$
—

 
$
—

Derivative liabilities
(90,111
)
 
67,636

 
(22,475
)
 
22,475

 
—

 
—

Total Liabilities
$
(9,512,914
)
 
$
67,636

 
$
(9,445,278
)
 
$
9,445,278

 
$
—

 
$
—

 
December 31, 2014
 
 
 
 
 
 
 
Gross Amounts Not Offset with Financial Assets (Liabilities) in the Condensed Consolidated Balance Sheets (1)
 
 
(in thousands)
Gross Amounts of Recognized Assets (Liabilities)
 
Gross Amounts Offset in the Condensed Consolidated Balance Sheets
 
Net Amounts of Assets (Liabilities) Presented in the Condensed Consolidated Balance Sheets
 
Financial Instruments
 
Cash Collateral (Received) Pledged
 
Net Amount
Assets
 
 
 
 
 
 
 
 
 
 
 
Derivative assets
$
443,490

 
$
(62,699
)
 
$
380,791

 
$
(90,233
)
 
$
—

 
$
290,558

Total Assets
$
443,490

 
$
(62,699
)
 
$
380,791

 
$
(90,233
)
 
$
—

 
$
290,558

 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Repurchase agreements
$
(12,932,463
)
 
$
—

 
$
(12,932,463
)
 
$
12,932,463

 
$
—

 
$
—

Derivative liabilities
(152,932
)
 
62,699

 
(90,233
)
 
90,233

 
—

 
—

Total Liabilities
$
(13,085,395
)
 
$
62,699

 
$
(13,022,696
)
 
$
13,022,696

 
$
—

 
$
—

____________________
(1)
Amounts presented are limited in total to the net amount of assets or liabilities presented in the condensed consolidated balance sheets by instrument. Excess cash collateral or financial assets that are pledged to counterparties may exceed the financial liabilities subject to a master netting arrangement or similar agreement, or counterparties may have pledged excess cash collateral to the Company that exceed the corresponding financial assets. These excess amounts are excluded from the table above, although separately reported within restricted cash, due from counterparties, or due to counterparties in the Company’s condensed consolidated balance sheets.


10

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

Recently Issued and/or Adopted Accounting Standards
Revenue from Contracts with Customers
In May 2014, the FASB issued ASU No. 2014-09, which is a comprehensive revenue recognition standard that supersedes virtually all existing revenue guidance under U.S. GAAP. The standard’s core principle is that an entity will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. The ASU is effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2016, with early adoption prohibited. The Company has determined this ASU will not have a material impact on the Company’s financial condition or results of operations.
Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures
In June 2014, the FASB issued ASU No. 2014-11, which requires repurchase-to-maturity transactions to be accounted for as secured borrowings, eliminates the existing guidance for repurchase financings, and requires new disclosures for certain transactions accounted for as secured borrowings and sales. This ASU is effective for the first interim or annual period beginning after December 15, 2014, except for the disclosures related to transactions accounted for as secured borrowings, which are effective for periods beginning on or after March 15, 2015. Adoption of this ASU did not have any impact on the Company’s financial condition or results of operations, but did impact financial statement disclosures.
Measuring the Financial Assets and the Financial Liabilities of a Consolidated Collateralized Financing Entity
In August 2014, the FASB issued ASU No. 2014-13, which updates the guidance on measuring the financial assets and financial liabilities of consolidated collateralized financing entities, or CFEs. The update allows an entity to measure both the financial assets and financial liabilities of a qualifying CFE it consolidates using the fair value of either the CFE’s financial assets or financial liabilities, whichever is more observable. The ASU requires certain recurring disclosures and is effective for annual periods beginning on or after December 15, 2015, with early adoption permitted as of the beginning of an annual period. Early adoption of this ASU was applied using a modified retrospective approach by recording a cumulative-effect adjustment to equity as of January 1, 2015, which did not have a material impact on the Company’s financial condition or results of operations.
Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure
In August 2014, the FASB issued ASU No. 2014-14, which requires that, upon foreclosure, a mortgage loan that is fully guaranteed under certain government programs be derecognized and a separate receivable be recognized when specific criteria are met . The ASU requires certain recurring disclosures and is effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2014, with early adoption permitted. Adoption of this ASU did not have a material impact on the Company’s financial condition or results of operations.
Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern
In August 2014, the FASB issued ASU No. 2014-15, which requires management to evaluate whether there are conditions and events that raise substantial doubt about the entity’s ability to continue as a going concern for both annual and interim reporting periods . The update requires certain disclosures if management concludes that substantial doubt exists and plans to alleviate that doubt. The ASU is effective for annual periods ending after December 15, 2016, and for both annual and interim periods thereafter, with early adoption permitted.
Amendments to the Consolidation Analysis
In February 2015, the FASB issued ASU No. 2015-02, which changes the guidance on the consolidation of certain investment funds as well as both the variable interest model and the voting model. The ASU requires certain recurring disclosures and is effective for annual periods, and interim periods within those annual periods, beginning on or after December 15, 2015, with early adoption permitted. Early adoption of this ASU did not have a material impact on the Company’s financial condition or results of operations.


11

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

Note 3 . Variable Interest Entities
The Company purchases subordinated debt and excess servicing rights from securitization trusts sponsored by either third parties or the Company’s subsidiaries. Additionally, the Company is the sole certificate holder of a trust entity that holds a commercial real estate loan. All of these trusts are considered VIEs for financial reporting purposes and, thus, were reviewed for consolidation under the applicable consolidation guidance. Because the Company has both the power to direct the activities of the trusts that most significantly impact the entities’ performance, and the obligation to absorb losses or the right to receive benefits of the entities that could be significant, the Company consolidates the trusts. As the Company is required to reassess VIE consolidation guidance each quarter, new facts and circumstances may change the Company’s determination. A change in the Company’s determination could result in a material impact to the Company’s condensed consolidated financial statements during subsequent reporting periods.
The following table presents a summary of the assets and liabilities of all consolidated trusts as reported on the condensed consolidated balance sheets:
(in thousands)
June 30,
2015
 
December 31,
2014
Residential mortgage loans held-for-investment in securitization trusts
$
2,449,199

 
$
1,744,746

Commercial real estate loans held-for-investment
45,605

 
—

Accrued interest receivable
13,821

 
10,197

Total Assets
$
2,508,625

 
$
1,754,943

Collateralized borrowings in securitization trusts
$
1,714,735

 
$
1,209,663

Accrued interest payable
5,128

 
3,678

Other liabilities
8,132

 
6,480

Total Liabilities
$
1,727,995

 
$
1,219,821


Note 4 . Available-for-Sale Securities, at Fair Value
The Company holds available-for-sale, or AFS, investment securities, which are carried at fair value. AFS securities exclude the retained interests from the Company’s on-balance sheet securitizations, as they are eliminated in consolidation in accordance with U.S. GAAP. The following table presents the Company’s AFS investment securities by collateral type as of June 30, 2015 and December 31, 2014 :
(in thousands)
June 30,
2015
 
December 31,
2014
Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
$
2,279,632

 
$
2,418,546

Federal National Mortgage Association
5,796,614

 
6,768,875

Government National Mortgage Association
2,024,567

 
2,104,896

Non-Agency
2,706,845

 
3,048,785

Total mortgage-backed securities
$
12,807,658

 
$
14,341,102


At June 30, 2015 and December 31, 2014 , the Company pledged AFS securities with a carrying value of $12.6 billion and $14.2 billion , respectively, as collateral for repurchase agreements and advances from Federal Home Loan Bank of Des Moines, or the FHLB. See Note 16  -  Repurchase Agreements and Note 18 - Federal Home Loan Bank of Des Moines Advances .
At June 30, 2015 and December 31, 2014 , 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 , or ASC 860, to be considered linked transactions and, therefore, classified as derivatives.

12

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

The following tables present the amortized cost and carrying value (which approximates fair value) of AFS securities by collateral type as of June 30, 2015 and December 31, 2014 :
 
June 30, 2015
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
12,222,579

 
$
3,667,195

 
$
15,889,774

Unamortized premium
612,534

 
—

 
612,534

Unamortized discount
 
 
 
 
 
Designated credit reserve
—

 
(657,626
)
 
(657,626
)
Net, unamortized
(2,848,032
)
 
(820,024
)
 
(3,668,056
)
Amortized Cost
9,987,081

 
2,189,545

 
12,176,626

Gross unrealized gains
189,522

 
522,291

 
711,813

Gross unrealized losses
(75,790
)
 
(4,991
)
 
(80,781
)
Carrying Value
$
10,100,813

 
$
2,706,845

 
$
12,807,658

 
December 31, 2014
(in thousands)
Agency
 
Non-Agency
 
Total
Face Value
$
13,421,555


$
4,291,872

 
$
17,713,427

Unamortized premium
676,641


—

 
676,641

Unamortized discount
 
 
 
 
 
Designated credit reserve
—


(927,605
)
 
(927,605
)
Net, unamortized
(3,009,782
)

(967,368
)
 
(3,977,150
)
Amortized Cost
11,088,414


2,396,899

 
13,485,313

Gross unrealized gains
238,291


653,529

 
891,820

Gross unrealized losses
(34,388
)

(1,643
)
 
(36,031
)
Carrying Value
$
11,292,317

 
$
3,048,785

 
$
14,341,102


The following tables present the carrying value of the Company’s AFS investment securities by rate type as of June 30, 2015 and December 31, 2014 :
 
June 30, 2015
(in thousands)
 Agency
 
 Non-Agency
 
 Total
Adjustable Rate
$
119,710

 
$
2,231,509

 
$
2,351,219

Fixed Rate
9,981,103

 
475,336

 
10,456,439

Total
$
10,100,813

 
$
2,706,845

 
$
12,807,658

 
December 31, 2014
(in thousands)
Agency
 
Non-Agency
 
Total
Adjustable Rate
$
128,285


$
2,558,832

 
$
2,687,117

Fixed Rate
11,164,032


489,953

 
11,653,985

Total
$
11,292,317


$
3,048,785

 
$
14,341,102



13

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

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 a credit reserve on the security, with unamortized net discounts or premiums amortized into income over time to the extent realizable.
The following table presents the changes for the six months ended June 30, 2015 and 2014 , of the unamortized net discount and designated credit reserves on non-Agency AFS securities.
 
Six Months Ended June 30,
 
2015
 
2014
(in thousands)
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
 
Designated Credit Reserve
 
Unamortized Net Discount
 
Total
Beginning balance at January 1
$
(927,605
)
 
$
(967,368
)
 
$
(1,894,973
)
 
$
(1,234,449
)
 
$
(1,071,559
)
 
$
(2,306,008
)
Acquisitions
(1,284
)
 
(3,283
)
 
(4,567
)
 
(62,752
)
 
(46,581
)
 
(109,333
)
Accretion of net discount
—

 
52,759

 
52,759

 
—

 
64,084

 
64,084

Realized credit losses
8,470

 
—

 
8,470

 
6,607

 
—

 
6,607

Reclassification adjustment for other-than-temporary impairments
1,619

 
—

 
1,619

 
(212
)
 
—

 
(212
)
Transfers from (to)
58,716

 
(58,716
)
 
—

 
47,495

 
(47,495
)
 
—

Sales, calls, other
202,458

 
156,584

 
359,042

 
80,854

 
45,251

 
126,105

Ending balance at June 30
$
(657,626
)
 
$
(820,024
)
 
$
(1,477,650
)
 
$
(1,162,457
)
 
$
(1,056,300
)
 
$
(2,218,757
)

The following table presents the components comprising the carrying value of AFS securities not deemed to be other than temporarily impaired by length of time that the securities had an unrealized loss position as of June 30, 2015 and December 31, 2014 . At June 30, 2015 , the Company held 1,455 AFS securities, of which 198 were in an unrealized loss position for less than twelve consecutive months and 177 were in an unrealized loss position for more than twelve consecutive months. At December 31, 2014 , the Company held 1,452 AFS securities, of which 57 were in an unrealized loss position for less than twelve months and 172 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
June 30, 2015
$
2,659,052

 
$
(40,295
)
 
$
1,204,291

 
$
(40,486
)
 
$
3,863,343

 
$
(80,781
)
December 31, 2014
$
413,102

 
$
(3,146
)
 
$
1,323,688

 
$
(32,885
)
 
$
1,736,790

 
$
(36,031
)


14

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

Evaluating AFS Securities for Other-Than-Temporary Impairments
In evaluating AFS securities for OTTI, the Company determines whether there has been a significant adverse quarterly change in the cash flow expectations for a security. The Company compares the amortized cost of each security in an unrealized loss position against the present value of expected future cash flows of the security. The Company also considers whether there has been a significant adverse change in the regulatory and/or economic environment as part of this analysis. If the amortized cost of the security is greater than the present value of expected future cash flows using the original yield as the discount rate, an other-than-temporary credit impairment has occurred. If the Company does not intend to sell and will not be more likely than not required to sell the security, the credit loss is recognized in earnings and the balance of the unrealized loss is recognized in other comprehensive (loss) 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 $0.2 million and $0.3 million in other-than-temporary credit impairments during the three and six months ended June 30, 2015 , respectively, on one non-Agency RMBS where the future expected cash flows for each security were less than its amortized cost. As of June 30, 2015 , impaired securities with a carrying value of $141.2 million had actual weighted average cumulative losses of 10.4% , weighted average three-month prepayment speed of 4.3% , weighted average 60+ day delinquency of 27.2% of the pool balance, and weighted average FICO score of 664 . At June 30, 2015 , the Company did not intend to sell the securities and determined that it was not more likely than not that the Company will be required to sell the securities; therefore, only the projected credit loss was recognized in earnings. During the six months ended June 30, 2014 , the Company recorded $0.2 million in other-than-temporary credit impairments on a total of three non-Agency RMBS where the future expected cash flows for each security were less than its amortized cost.
The following table presents the changes in OTTI included in earnings for three and six months ended June 30, 2015 and 2014 :
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Cumulative credit loss at beginning of period
$
(6,452
)
 
$
(9,215
)
 
$
(8,241
)
 
$
(9,467
)
Additions:
 
 
 
 
 
 
 
Other-than-temporary impairments not previously recognized
—

 
—

 
—

 
(91
)
Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments
(170
)
 
—

 
(297
)
 
(121
)
Reductions:
 
 
 
 
 
 
 
Decreases related to other-than-temporary impairments on securities paid down
—

 
—

 
—

 
464

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

 
1,154

 
1,916

 
1,154

Cumulative credit loss at end of period
$
(6,622
)
 
$
(8,061
)
 
$
(6,622
)
 
$
(8,061
)

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 (loss) on investment securities in the Company’s condensed consolidated statements of comprehensive income. For the three and six months ended June 30, 2015 , the Company sold AFS securities for $1.7 billion and $2.6 billion with an amortized cost of $1.6 billion and $2.4 billion for net realized gains of $75.9 million and $193.3 million , respectively. For the three and six months ended June 30, 2014 , the Company sold AFS securities for $459.4 million and $1.3 billion with an amortized cost of $423.4 million and $1.3 billion for net realized gains of $36.0 million and losses of $2.8 million , respectively.

15

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

The following table presents the gross realized gains and losses on sales of AFS securities for the three and six months ended June 30, 2015 and 2014 :
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Gross realized gains
$
76,199

 
$
35,954

 
$
193,887

 
$
43,163

Gross realized losses
(336
)
 
—

 
(556
)
 
(45,997
)
Total realized gains (losses) on sales, net
$
75,863

 
$
35,954

 
$
193,331

 
$
(2,834
)

Note 5 . Trading Securities, at Fair Value
At December 31, 2014 and during the three and six months ended June 30, 2015 , the Company held U.S. Treasuries in a TRS and classified these securities as trading instruments due to short-term investment objectives. The following table presents the carrying value of the Company’s trading securities as of June 30, 2015 and December 31, 2014 :
(in thousands)
June 30,
2015
 
December 31,
2014
Amortized cost
$
—

 
$
1,996,289

Unrealized gains (losses), net
—

 
1,367

Carrying value
$
—

 
$
1,997,656


For both the three and six months ended June 30, 2015 , the Company sold trading securities for $2.0 billion with an amortized cost of $2.0 billion , resulting in realized gains of $7.4 million on the sale of these securities. For the three and six months ended June 30, 2014 , the Company sold trading securities for $44.8 million and $143.4 million with an amortized cost of $44.8 million and $143.0 million , resulting in realized losses of $7,031 and gains of $0.4 million , respectively, on the sale of these securities.
For the three and six months ended June 30, 2015 , trading securities experienced changes in unrealized losses of $13.4 million and $1.4 million , respectively. For the three and six months ended June 30, 2014 , trading securities experienced changes in unrealized gains of $1.7 million and $1.5 million , respectively. Both realized and unrealized gains and losses are recorded as a component of gain (loss) on investment securities in the Company’s condensed consolidated statements of comprehensive income.
At December 31, 2014 , the Company pledged trading securities with a carrying value of $2.0 billion as collateral for repurchase agreements. See Note 16 - Repurchase Agreements .

Note 6 . Residential Mortgage Loans Held-for-Sale, at Fair Value
Residential mortgage loans held-for-sale consists of residential mortgage loans carried at fair value as a result of a fair value option election. The following table presents the carrying value of the Company’s residential mortgage loans held-for-sale as of June 30, 2015 and December 31, 2014 :
(in thousands)
June 30,
2015
 
December 31,
2014
Unpaid principal balance
$
703,966

 
$
534,101

Fair value adjustment
(8,888
)
 
1,611

Carrying value
$
695,078

 
$
535,712


At June 30, 2015 and December 31, 2014 , the Company pledged residential mortgage loans with a carrying value of $561.8 million and $416.8 million , respectively, as collateral for repurchase agreements and FHLB advances. See Note 16  -  Repurchase Agreements and Note 18 - Federal Home Loan Bank of Des Moines Advances .


16

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

Note 7 . Residential Mortgage Loans Held-for-Investment in Securitization Trusts, at Fair Value
The Company purchases subordinated debt and excess servicing rights from securitization trusts sponsored by either third parties or the Company’s subsidiaries. The underlying residential mortgage loans held by the trusts, which are consolidated on the Company’s condensed consolidated balance sheets, are classified as residential mortgage loans held-for-investment in securitization trusts and carried at fair value as a result of a fair value option election. See Note 3 - Variable Interest Entities for additional information regarding consolidation of the securitization trusts. The following table presents the carrying value of the Company’s residential mortgage loans held-for-investment in securitization trusts as of June 30, 2015 and December 31, 2014 :
(in thousands)
June 30,
2015
 
December 31,
2014
Unpaid principal balance
$
2,431,573

 
$
1,699,748

Fair value adjustment
17,626

 
44,998

Carrying value
$
2,449,199

 
$
1,744,746


Note 8 . Commercial Real Estate Loans Held-for-Investment
The Company is the sole certificate holder of a trust entity that holds a commercial real estate loan. The underlying loan held by the trust, which is consolidated on the Company’s condensed consolidated balance sheet, is classified as commercial real estate loans held-for-investment and carried at cost, net of any unamortized premiums or discounts, unless deemed impaired. See Note 3 - Variable Interest Entities for additional information regarding consolidation of the trust.
The following table presents the carrying value of the Company’s commercial real estate loans held-for-investment as of June 30, 2015 and December 31, 2014 :
(in thousands)
June 30,
2015
 
December 31,
2014
Unpaid principal balance
$
45,900

 
$
—

Unamortized discount
(295
)
 
—

Carrying value
$
45,605

 
$
—


As of June 30, 2015 , the Company’s commercial real estate loans held-for-investment were comprised of one newly-issued senior mezzanine commercial real estate loan with a two-year interest-only term. The Company evaluates each loan for impairment at least quarterly as described in Note 2 - Basis of Presentation and Significant Accounting Policies . As of June 30, 2015 , the properties collateralizing the Company’s one commercial real estate loan have continued to perform as originally underwritten, and as such, are considered to have very low risk. The Company has not recorded any allowances for losses as it is not deemed probable that the Company will not be able to collect all amounts due according to the contractual terms of the loan. The Company did not hold any commercial real estate loans held-for-investment as of December 31, 2014 . At June 30, 2015 , the Company pledged commercial real estate loans held-for-investment with a carrying value of $45.6 million as collateral for repurchase agreements. See Note 16 - Repurchase Agreements .


17

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

Note 9 . Servicing Activities
Mortgage Servicing Rights, at Fair Value
One of the Company’s wholly owned subsidiaries has approvals from the Federal National Mortgage Association, or Fannie Mae, the Federal Home Loan Mortgage Corporation, or Freddie Mac, and the Government National Mortgage Association, or Ginnie Mae, to hold and manage MSR, which represent the right to control the servicing of mortgage loans. The Company and its subsidiaries do not originate or directly service mortgage loans, and instead contract with fully licensed subservicers to handle substantially all servicing functions for the loans underlying the Company’s MSR. The following table summarizes activity related to MSR for the three and six months ended June 30, 2015 and 2014 .
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Balance at beginning of period
$
410,229

 
$
476,663

 
$
452,006

 
$
514,402

Additions from purchases of servicing rights
4,210

 
53,013

 
8,534

 
54,293

Additions from sales of residential mortgage loans
589

 
—

 
816

 
—

Changes in fair value due to:
 
 
 
 
 
 
 
Changes in valuation inputs or assumptions used in the valuation model
25,440

 
(15,655
)
 
(17,649
)
 
(35,905
)
Other changes in fair value (1)
(7,805
)
 
(13,916
)
 
(17,119
)
 
(26,427
)
Other changes (2)
4,913

 
385

 
10,988

 
(5,873
)
Balance at end of period
$
437,576

 
$
500,490

 
$
437,576

 
$
500,490

____________________
(1)
Other changes in fair value primarily represents changes due to the realization of expected cash flows.
(2)
Other changes includes purchase price adjustments, contractual prepayment protection, and changes due to the Company’s purchase of the underlying collateral.

As of June 30, 2015 and December 31, 2014 , the key economic assumptions and sensitivity of the fair value of MSR to immediate 10% and 20% adverse changes in these assumptions were as follows:
(in thousands)
June 30,
2015
 
December 31,
2014
Weighted average prepayment speed:
11.2
%
 
11.9
%
Impact on fair value of 10% adverse change
$
(17,941
)
 
$
(14,012
)
Impact on fair value of 20% adverse change
$
(34,131
)
 
$
(31,640
)
Weighted average delinquency:
4.6
%
 
5.6
%
Impact on fair value of 10% adverse change
$
(2,188
)
 
$
(3,616
)
Impact on fair value of 20% adverse change
$
(4,376
)
 
$
(6,780
)
Weighted average discount rate:
9.4
%
 
9.5
%
Impact on fair value of 10% adverse change
$
(15,753
)
 
$
(16,272
)
Impact on fair value of 20% adverse change
$
(30,630
)
 
$
(31,640
)

These assumptions and sensitivities are hypothetical and should be considered with caution. Changes in fair value based on 10% and 20% variations in assumptions generally cannot be extrapolated because the relationship of the change in assumptions to the change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of MSR is calculated without changing any other assumptions. In reality, changes in one factor may result in changes in another ( e.g. , increased market interest rates may result in lower prepayments and increased credit losses) that could magnify or counteract the sensitivities. Further, these sensitivities show only the change in the asset balances and do not show any expected change in the fair value of the instruments used to manage the interest rates and prepayment risks associated with these assets.

18

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

Risk Mitigation Activities
The primary risk of the Company’s MSR is interest rate risk and the resulting impact on prepayments. A significant decline in interest rates could lead to higher-than-expected prepayments that could reduce the value of the MSR. The Company economically hedges the impact of these risks with AFS securities and derivative financial instruments. Refer to Note 12 - Derivative Instruments and Hedging Activities for additional information regarding the derivative financial instruments used to economically hedge MSR.
Mortgage Servicing Income
The following table presents the components of servicing income recorded on the Company’s condensed consolidated statements of comprehensive income for the three and six months ended June 30, 2015 and 2014 :
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Servicing fee income
$
29,586

 
$
33,079

 
$
60,823

 
$
62,950

Ancillary fee income
551

 
581

 
1,115

 
1,044

Float income
379

 
208

 
665

 
315

Total
$
30,516

 
$
33,868

 
$
62,603

 
$
64,309


Mortgage Servicing Advances
In connection with the servicing of loans, the Company’s subservicers make certain payments for property taxes and insurance premiums, default and property maintenance payments, as well as advances of principal and interest payments before collecting them from individual borrowers. Servicing advances, including contractual interest, are priority cash flows in the event of a loan principal reduction or foreclosure and ultimate liquidation of the real estate-owned property, thus making their collection reasonably assured. These servicing advances, which are funded by the Company, totaled $30.8 million and $27.5 million and were included in other assets on the condensed consolidated balance sheets as of June 30, 2015 and December 31, 2014 , respectively.
Serviced Mortgage Assets
The Company’s total serviced mortgage assets consist of loans owned and classified as residential mortgage loans held-for-sale, loans held in consolidated VIEs classified as residential mortgage loans held-for-investment in securitization trusts and loans underlying MSR. The following table presents the number of loans and unpaid principal balance of the mortgage assets for which the Company manages the servicing as of June 30, 2015 and December 31, 2014 :
 
June 30, 2015
 
December 31, 2014
(dollars in thousands)
Number of Loans
 
Unpaid Principal Balance
 
Number of Loans
 
Unpaid Principal Balance
Residential mortgage loans held-for-sale
1,293

 
$
703,966

 
1,008

 
$
534,101

Residential mortgage loans held-for-investment in securitization trusts
441

 
322,335

 
487

 
358,458

Mortgage servicing rights (1)
214,745

 
42,811,294

 
224,073

 
44,949,061

Total serviced mortgage assets
216,479

 
$
43,837,595

 
225,568

 
$
45,841,620

____________________
(1)
Includes residential mortgage loans held-for-investment in securitization trusts for which the Company is the named servicing administrator.


19

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

Note 10 . Restricted Cash
The Company is required to maintain certain cash balances with counterparties for securities and derivatives trading activity and collateral for the Company’s repurchase agreements and FHLB advances in restricted accounts. The Company has also placed cash in a restricted account pursuant to a letter of credit on an office space lease.
The following table presents the Company’s restricted cash balances as of June 30, 2015 and December 31, 2014 :
(in thousands)
June 30,
2015
 
December 31,
2014
Restricted cash balances held by trading counterparties:
 
 
 
For securities and loan trading activity
$
17,250

 
$
12,000

For derivatives trading activity
210,597

 
211,989

As restricted collateral for repurchase agreements and Federal Home Loan Bank advances
182,709

 
112,435

Total restricted cash balances held by trading counterparties
410,556

 
336,424

Restricted cash balance pursuant to letter of credit on office lease
347

 
347

Total
$
410,903

 
$
336,771


Note 11 . Accrued Interest Receivable
The following table presents the Company’s accrued interest receivable by collateral type:
(in thousands)
June 30,
2015
 
December 31,
2014
Accrued Interest Receivable:
 
 
 
U.S. Treasuries
$
—

 
$
8,084

Mortgage-backed securities:
 
 
 
Agency
 
 
 
Federal Home Loan Mortgage Corporation
8,042

 
8,734

Federal National Mortgage Association
19,223

 
22,392

Government National Mortgage Association
9,901

 
10,290

Non-Agency
3,576

 
3,835

Total mortgage-backed securities
40,742

 
45,251

Residential mortgage loans held-for-sale
2,448

 
1,997

Residential mortgage loans held-for-investment in securitization trusts
13,680

 
10,197

Commercial real estate loans held-for-investment
141

 
—

Total
$
57,011

 
$
65,529


Note 12 . 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 derivative 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, credit default swaps and total return swaps. In executing on the Company’s current risk management strategy, the Company has entered into interest rate swap and swaption agreements, TBAs, short U.S. Treasuries, put and call options for TBAs and U.S. Treasuries, constant maturity swaps, credit default swaps and total return swaps (based on the Markit IOS Index). The Company has also entered into a number of non-derivative instruments to manage interest rate risk, principally U.S. Treasuries and Agency interest-only securities.

20

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

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
In accordance with ASC 815, Derivatives and Hedging , as amended and interpreted, or ASC 815, the Company records derivative financial instruments on its condensed consolidated balance sheets as assets or liabilities at fair value. Changes in fair value are accounted for depending on the use of the derivative instruments and whether they 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.
The following tables present the gross fair value and notional amounts of the Company’s derivative financial instruments treated as trading instruments as of June 30, 2015 and December 31, 2014 .
(in thousands)
 
June 30, 2015
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
178,848

 
$
1,049,743

 
$
—

 
$
—

Interest rate swap agreements
 
46,935

 
14,325,523

 
(1,402
)
 
1,900,000

Credit default swaps
 
—

 
—

 
(1,164
)
 
125,000

Swaptions, net
 
120,707

 
10,050,000

 
(11,887
)
 
640,000

TBAs
 
—

 
—

 
(5,187
)
 
1,434,000

Put and call options for TBAs, net
 
—

 
—

 
(105
)
 
—

Constant maturity swaps
 
—

 
—

 
—

 
—

Markit IOS total return swaps
 
725

 
855,872

 
(134
)
 
132,537

Forward purchase commitments
 
107

 
135,181

 
(2,596
)
 
491,479

Total
 
$
347,322

 
$
26,416,319

 
$
(22,475
)
 
$
4,723,016

(in thousands)
 
December 31, 2014
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
188,592

 
$
1,168,226

 
$
—

 
$
—

Interest rate swap agreements
 
55,471

 
9,569,000

 
(65,392
)
 
9,015,000

Credit default swaps
 
—

 
—

 
(1,672
)
 
125,000

Swaptions, net
 
121,591

 
9,550,000

 
(4,999
)
 
2,860,000

TBAs
 
10,350

 
875,000

 
(17,687
)
 
2,200,000

Put and call options for TBAs, net
 
90

 
2,000,000

 
—

 
—

Constant maturity swaps
 
2,013

 
12,000,000

 
(483
)
 
2,000,000

Markit IOS total return swaps
 
1,387

 
598,459

 
—

 
—

Forward purchase commitments
 
1,297

 
554,838

 
—

 
—

Total
 
$
380,791

 
$
36,315,523

 
$
(90,233
)
 
$
16,200,000



21

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

Comprehensive Income Statement Presentation
The Company has not applied hedge accounting to its current derivative portfolio held to mitigate the interest rate risk and credit risk associated with its 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.
The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed consolidated statements of comprehensive income on the Company’s derivative trading 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 June 30,
 
Six Months Ended June 30,
 
 
 
 
2015
 
2014
 
2015
 
2014
Interest rate risk management
 
 
 
 
 
 
 
 
 
 
TBAs  (1)
 
Loss on other derivative instruments
 
$
5,262

 
$
(29,877
)
 
$
(22,696
)
 
$
(47,780
)
Short U.S. Treasuries  (1)
 
Loss on other derivative instruments
 
125

 
(8
)
 
125

 
(8
)
Put and call options for TBAs  (1)
 
Loss on other derivative instruments
 
5,671

 
(4,614
)
 
8,206

 
(6,319
)
Put and call options for U.S. Treasuries  (1)
 
Loss on other derivative instruments
 
(837
)
 
—

 
(837
)
 
—

Constant maturity swaps  (1)
 
Loss on other derivative instruments
 
74

 
(6,103
)
 
6,164

 
5,428

Interest rate swap agreements - Receivers  (1)
 
Gain (loss) on interest rate swap and swaption agreements
 
(42,470
)
 
65,963

 
(144
)
 
106,942

Interest rate swap agreements - Payers  (1)
 
Gain (loss) on interest rate swap and swaption agreements
 
20,713

 
(46,341
)
 
(31,846
)
 
(59,761
)
Swaptions (1)
 
Gain (loss) on interest rate swap and swaption agreements
 
19,752

 
(57,250
)
 
1,246

 
(169,808
)
Markit IOS total return swaps (1)
 
Loss on other derivative instruments
 
(20,658
)
 
353

 
(17,526
)
 
(1,372
)
Interest rate swap agreements - Payers  (2)
 
Gain (loss) on interest rate swap and swaption agreements
 
46,957

 
(78,391
)
 
(50,747
)
 
(98,920
)
Credit risk management
 
 
 
 
 
 
 
 
 
 
Credit default swaps - Receive protection  (3)
 
Loss on other derivative instruments
 
(30
)
 
(5
)
 
(123
)
 
1,976

Non-risk management
 
 
 
 
 
 
 
 
 
 
TBAs
 
Loss on other derivative instruments
 
—

 
—

 
—

 
(4,701
)
Inverse interest-only securities
 
Loss on other derivative instruments
 
4,909

 
16,052

 
24,170

 
34,375

Forward purchase commitments
 
(Loss) gain on residential mortgage loans held-for-sale
 
(5,130
)
 
4,163

 
(4,160
)
 
3,746

Total
 
 
 
$
34,338

 
$
(136,058
)
 
$
(88,168
)
 
$
(236,202
)
____________________
(1)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s investment portfolio.
(2)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s repurchase agreements and FHLB advances.
(3)
Includes derivative instruments held to mitigate credit risk associated with the Company’s non-Agency RMBS and residential mortgage loans held-for-sale.


22

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

For the three and six months ended June 30, 2015 , the Company recognized $26.1 million and $53.7 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 paying either a fixed interest rate or LIBOR interest on an average $16.7 billion and $17.5 billion notional, respectively, and receiving either LIBOR interest or a fixed interest rate. For the three and six months ended June 30, 2014 , the Company recognized $18.9 million and $32.7 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 paying either a fixed interest rate or LIBOR interest on an average $23.5 billion and $21.3 billion notional, respectively, and receiving either LIBOR interest or a fixed interest rate.
The following tables present information with respect to the volume of activity in the Company’s derivative instruments during the three and six months ended June 30, 2015 and 2014 :
 
Three Months Ended June 30, 2015
(in thousands)
Beginning of Period Notional Amount
 
Additions
 
Settlement, Termination, Expiration or Exercise
 
End of Period Notional Amount
 
Average Notional Amount
 
Realized Gain (Loss), net (1)
Inverse interest-only securities
$
1,106,210

 
$
12,563

 
$
(69,030
)
 
$
1,049,743

 
$
1,086,760

 
$
64

Interest rate swap agreements
19,929,000

 
11,493,227

 
(15,196,704
)
 
16,225,523

 
16,681,983

 
(66,799
)
Credit default swaps
125,000

 
—

 
—

 
125,000

 
125,000

 
—

Swaptions, net
12,960,000

 
1,500,000

 
(5,050,000
)
 
9,410,000

 
10,292,418

 
(8,053
)
TBAs, net
(2,496,000
)
 
(3,929,000
)
 
5,401,000

 
(1,024,000
)
 
(1,362,451
)
 
(7,482
)
Short U.S. Treasuries
—

 
(50,000
)
 
50,000

 
—

 
—

 
125

Put and call options for TBAs, net
(2,500,000
)
 
—

 
2,500,000

 
—

 
(722,527
)
 
10,843

Put and call options for U.S. Treasuries, net
—

 
500,000

 
(500,000
)
 
—

 
2,747

 
(837
)
Constant maturity swaps
3,000,000

 
—

 
(3,000,000
)
 
—

 
384,615

 
1,310

Markit IOS total return swaps
877,529

 
747,910

 
(637,030
)
 
988,409

 
1,201,515

 
(13,130
)
Forward purchase commitments
707,304

 
978,297

 
(1,058,941
)
 
626,660

 
679,266

 
(1,318
)
Total
$
33,709,043

 
$
11,252,997

 
$
(17,560,705
)
 
$
27,401,335

 
$
28,369,326

 
$
(85,277
)
 
Three Months Ended June 30, 2014
(in thousands)
Beginning of Period Notional Amount
 
Additions
 
Settlement, Termination, Expiration or Exercise
 
End of Period Notional Amount
 
Average Notional Amount
 
Realized Gain (Loss), net (1)
Inverse interest-only securities
$
1,412,374

 
$
—

 
$
(88,724
)
 
$
1,323,650

 
$
1,372,535

 
$
—

Interest rate swap agreements
21,663,148

 
8,465,000

 
(6,500,000
)
 
23,628,148

 
23,467,489

 
(2,983
)
Credit default swaps
125,000

 
—

 
—

 
125,000

 
125,000

 
—

Swaptions, net
9,500,000

 
3,250,000

 
(1,300,000
)
 
11,450,000

 
10,412,088

 
(2,178
)
TBAs, net
(1,022,000
)
 
(2,032,000
)
 
2,682,000

 
(372,000
)
 
660,308

 
(26,530
)
Short U.S. Treasuries
—

 
(125,000
)
 
125,000

 
—

 
1,374

 
2

Put and call options for TBAs, net
1,500,000

 
—

 
(1,500,000
)
 
—

 
901,099

 
(5,332
)
Constant maturity swaps
10,000,000

 
4,000,000

 
(8,000,000
)
 
6,000,000

 
5,571,429

 
(1,460
)
Markit IOS total return swaps
243,987

 
339,869

 
(7,378
)
 
576,478

 
393,910

 
—

Forward purchase commitments
153,637

 
872,756

 
(378,452
)
 
647,941

 
367,940

 
332

Total
$
43,576,146

 
$
14,770,625

 
$
(14,967,554
)
 
$
43,379,217

 
$
43,273,172

 
$
(38,149
)

23

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

 
Six Months Ended June 30, 2015
(in thousands)
Beginning of Period Notional Amount
 
Additions
 
Settlement, Termination, Expiration or Exercise
 
End of Period Notional Amount
 
Average Notional Amount
 
Realized Gain (Loss), net (1)
Inverse interest-only securities
$
1,168,226

 
$
12,563

 
$
(131,046
)
 
$
1,049,743

 
$
1,112,471

 
$
64

Interest rate swap agreements
18,584,000

 
17,113,227

 
(19,471,704
)
 
16,225,523

 
17,455,887

 
(67,869
)
Credit default swaps
125,000

 
—

 
—

 
125,000

 
125,000

 
—

Swaptions, net
12,410,000

 
7,050,000

 
(10,050,000
)
 
9,410,000

 
11,564,972

 
4,793

TBAs, net
(1,325,000
)
 
(10,862,000
)
 
11,163,000

 
(1,024,000
)
 
(1,739,978
)
 
(24,846
)
Short U.S. Treasuries
—

 
(50,000
)
 
50,000

 
—

 
—

 
125

Put and call options for TBAs, net
2,000,000

 
250,000

 
(2,250,000
)
 
—

 
(359,116
)
 
7,796

Put and call options for U.S. Treasuries, net
—

 
500,000

 
(500,000
)
 
—

 
1,381

 
(837
)
Constant maturity swaps
14,000,000

 
6,000,000

 
(20,000,000
)
 
—

 
4,552,486

 
7,694

Markit IOS total return swaps
598,459

 
1,424,543

 
(1,034,593
)
 
988,409

 
1,039,332

 
(8,928
)
Forward purchase commitments
554,838

 
2,106,931

 
(2,035,109
)
 
626,660

 
663,890

 
(374
)
Total
$
48,115,523

 
$
23,545,264

 
$
(44,259,452
)
 
$
27,401,335

 
$
34,416,325

 
$
(82,382
)
 
Six Months Ended June 30, 2014
(in thousands)
Beginning of Period Notional Amount
 
Additions
 
Settlement, Termination, Expiration or Exercise
 
End of Period Notional Amount
 
Average Notional Amount
 
Realized Gain (Loss), net (1)
Inverse interest-only securities
$
1,525,845

 
$
—

 
$
(202,195
)
 
$
1,323,650

 
$
1,421,330

 
$
193

Interest rate swap agreements
19,619,000

 
11,409,148

 
(7,400,000
)
 
23,628,148

 
21,324,091

 
(3,005
)
Credit default swaps
427,073

 
—

 
(302,073
)
 
125,000

 
152,059

 
(13,705
)
Swaptions, net
5,130,000

 
7,150,000

 
(830,000
)
 
11,450,000

 
9,699,558

 
(3,396
)
TBAs, net
603,000

 
(2,924,000
)
 
1,949,000

 
(372,000
)
 
593,746

 
(14,677
)
Short U.S. Treasuries
—

 
(125,000
)
 
125,000

 
—

 
691

 
2

Put and call options for TBAs, net
—

 
1,500,000

 
(1,500,000
)
 
—

 
580,110

 
(5,332
)
Constant maturity swaps
10,000,000

 
12,000,000

 
(16,000,000
)
 
6,000,000

 
7,773,481

 
2,427

Markit IOS total return swaps
49,629

 
536,881

 
(10,032
)
 
576,478

 
274,573

 
—

Forward purchase commitments
12,063

 
1,058,706

 
(422,828
)
 
647,941

 
204,336

 
302

Total
$
37,366,610

 
$
30,605,735

 
$
(24,593,128
)
 
$
43,379,217

 
$
42,023,975

 
$
(37,191
)
____________________
(1)
Excludes net interest paid or received in full settlement of the net interest spread liability.

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 (gain) loss on interest rate swaps and swaptions, unrealized gain on other derivative instruments, and gain on residential mortgage loans held-for-sale line items within the operating activities section of the condensed consolidated statements of cash flows. Realized gains and losses on interest rate swap and swaption agreements are reflected within the loss on termination and option expiration of interest rate swaps and swaptions line item within the operating activities section of the condensed consolidated statements of cash flows. The remaining cash flow activity related to derivative instruments is reflected within the short sales and purchases of other derivative instruments, proceeds from sales of other derivative instruments, net and increase (decrease) in due to counterparties, net line items within the investing activities section of the condensed consolidated statements of cash flows.

24

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

Interest Rate Sensitive Assets/Liabilities
The Company’s RMBS investment securities and MSR 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 and an increase in the value of the Company’s MSR. To mitigate the impact of this risk, the Company maintains a portfolio of fixed-rate interest-only securities, which increase in value when interest rates increase, as well as TBA positions, short U.S. Treasuries, put and call options for TBAs and U.S. Treasuries, constant maturity swaps, interest rate swap and swaption agreements and Markit IOS total return swaps to further mitigate its exposure to higher interest rates, decreased prepayment speeds and widening mortgage spreads.
As of June 30, 2015 and December 31, 2014 , the Company had outstanding fair value of $49.3 million and $55.7 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.
The Company is exposed to interest rate risk on residential mortgage loans from the time it commits to purchase a mortgage loan until it acquires the loan from the originator and subsequently sells the loan to a third party. Changes in interest rates impact the market price for the mortgage loans. For example, as market interest rates decline, the value of residential mortgage loans held-for-sale increases, and vice versa. To mitigate the impact of this risk, the Company may enter into derivative contracts to hedge the interest rate risk related to its commitments to purchase residential mortgage loans and residential mortgage loans held-for-sale, such as interest rate swaps, swaptions, TBA positions, short U.S. Treasuries, put and call options for TBAs and U.S. Treasuries and constant maturity swaps.
TBAs. At times, the Company may use TBAs for risk management purposes or as a means of deploying capital until targeted investments are available and to take advantage of temporary displacements in the marketplace. TBAs are forward contracts for the purchase (long notional positions) or sale (short notional positions) of Agency RMBS. The issuer, coupon and stated maturity of the Agency RMBS are predetermined as well as the trade price, face amount and future settle date (published each month by the Securities Industry and Financial Markets Association). However, the specific Agency RMBS to be delivered upon settlement is not known at the time of the TBA transaction. As a result, and because physical delivery of the Agency RMBS upon settlement cannot be assured, the Company accounts for TBAs as derivative instruments.
As of June 30, 2015 , $0.2 billion of the Company’s long notional TBA positions and $1.2 billion of the Company’s short notional TBA positions were held in order to economically hedge portfolio risk. As of December 31, 2014 , $0.9 billion of the Company’s long notional TBA positions and  $2.2 billion of the Company’s short notional TBA positions were held in order to economically hedge portfolio risk. The Company discloses these positions on a gross basis according to the unrealized gain or loss position of each TBA contract regardless of long or short notional position. The following tables present the notional amount, cost basis, market value and carrying value (which approximates fair value) of the Company’s TBA positions as of June 30, 2015 and December 31, 2014 :
 
As of June 30, 2015
 
 
 
 
 
 
 
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Derivative Assets
 
Derivative Liabilities
Purchase contracts
$
205,000

 
$
219,441

 
$
219,369

 
$
—

 
$
(72
)
Sale contracts
(1,229,000
)
 
(1,284,198
)
 
(1,289,313
)
 
—

 
(5,115
)
TBAs, net
$
(1,024,000
)
 
$
(1,064,757
)
 
$
(1,069,944
)
 
$
—

 
$
(5,187
)

25

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

 
As of December 31, 2014
 
 
 
 
 
 
 
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Derivative Assets
 
Derivative Liabilities
Purchase contracts
$
875,000

 
$
862,868

 
$
873,218

 
$
10,350

 
$
—

Sale contracts
(2,200,000
)
 
(2,294,813
)
 
(2,312,500
)
 
—

 
(17,687
)
TBAs, net
$
(1,325,000
)
 
$
(1,431,945
)
 
$
(1,439,282
)
 
$
10,350

 
$
(17,687
)
___________________
(1)
Notional amount represents the face amount of the underlying Agency RMBS.
(2)
Cost basis represents the forward price to be paid (received) for the underlying Agency RMBS.
(3)
Market value represents the current market value of the TBA (or of the underlying Agency RMBS) as of period-end.
(4)
Net carrying value represents the difference between the market value of the TBA as of period-end and its cost basis, and is reported in derivative assets / (liabilities), at fair value, in the condensed consolidated balance sheets.

Put and Call Options for TBAs . As of June 30, 2015 , the Company had purchased put options for TBAs with a notional amount of $250.0 million and paid upfront premiums of approximately $0.9 million . The Company had also short sold call options for TBAs with a notional amount of $250.0 million and received upfront premiums of approximately $0.9 million as of June 30, 2015 . Each of the options will expire in August 2015 . The put and call options had a net fair market value of $0.1 million included in derivative liabilities, at fair value, in the condensed consolidated balance sheet as of June 30, 2015 . As of December 31, 2014 , the Company had purchased put options for TBAs with a notional amount of $2.0 billion and paid upfront premiums of approximately $0.6 million . The put options had a net fair market value of $0.1 million included in derivative assets, at fair value, in the condensed consolidated balance sheet as of December 31, 2014 .
Constant Maturity Swaps . The Company has also entered into constant maturity swaps between the 10-year interest rate swap curve and the yield to maturity on a 30-year Fannie Mae TBA to economically hedge mortgage spread widening risk. The Company had the following constant maturity swap agreements in place at December 31, 2014 :
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2014
Determination Date
 
Average Strike Swap Rate
 
Notional Amount
 
Fair Value
 
Upfront Premium Paid
 
Unrealized Gain (Loss)
January 2015
 
0.538
%
 
$
7,000,000

 
$
1,502

 
$
—

 
$
1,502

February 2015
 
0.572
%
 
2,000,000

 
(13
)
 
—

 
(13
)
March 2015
 
0.552
%
 
5,000,000

 
41

 
—

 
41

Total
 
0.548
%
 
$
14,000,000

 
$
1,530

 
$
—

 
$
1,530


The Company did not have any constant maturity swap agreements in place at June 30, 2015 .
Interest Rate Swap Agreements . As of June 30, 2015 and December 31, 2014 , the Company held the following interest rate swaps in order to mitigate mortgage interest rate exposure (or duration) risk associated with the Company’s investment portfolio whereby the Company receives interest at a three-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
June 30, 2015
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2018
 
$
2,040,000

 
1.563
%
 
0.282
%
 
3.44

2020 and Thereafter
 
1,210,000

 
2.164
%
 
0.281
%
 
5.58

Total
 
$
3,250,000

 
1.787
%
 
0.282
%
 
4.24


26

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

(notional in thousands)
 
 
 
 
 
 
December 31, 2014
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2017
 
$
2,000,000

 
1.070
%
 
0.229
%
 
2.54

2018
 
2,040,000

 
1.563
%
 
0.238
%
 
3.94

2019 and Thereafter
 
900,000

 
2.378
%
 
0.255
%
 
6.24

Total
 
$
4,940,000

 
1.512
%
 
0.237
%
 
3.80


Additionally, as of June 30, 2015 and December 31, 2014 , the Company held the following interest rate swaps in order to mitigate mortgage interest rate exposure (or duration) risk associated with the Company’s investment portfolio whereby the Company pays interest at a three-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
June 30, 2015
Swaps Maturities
 
Notional Amounts
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2018
 
$
575,000

 
0.281
%
 
1.440
%
 
3.39

2020 and Thereafter
 
1,889,000

 
0.283
%
 
2.588
%
 
8.10

Total
 
$
2,464,000

 
0.282
%
 
2.320
%
 
7.00

(notional in thousands)
 
 
 
 
 
 
December 31, 2014
Swaps Maturities
 
Notional Amounts
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2018
 
$
575,000

 
0.231
%
 
1.440
%
 
3.89

2019 and Thereafter
 
1,579,000

 
0.239
%
 
2.794
%
 
9.19

Total
 
$
2,154,000

 
0.237
%
 
2.433
%
 
7.77


The Company monitors its borrowings under repurchase agreements and FHLB advances, which are generally floating rate debt, in relation 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 borrowings under repurchase agreements and FHLB advances with that of its investment securities and debt portfolios. This particularly applies to borrowing agreements with maturities or interest rate resets of less than six 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 or FHLB advance from floating to fixed.

27

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

As of June 30, 2015 and December 31, 2014 , the Company had the following outstanding interest rate swaps that were utilized as economic hedges of interest rate exposure (or duration) associated with the Company’s short-term repurchase agreements and FHLB advances:
(notional in thousands)
 
 
 
 
 
 
June 30, 2015
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2016
 
$
4,200,000

 
0.583
%
 
0.282
%
 
1.10

2017
 
2,375,000

 
0.864
%
 
0.281
%
 
2.09

2018
 
800,000

 
1.165
%
 
0.280
%
 
2.65

2019
 
350,000

 
1.730
%
 
0.278
%
 
3.94

2020 and Thereafter
 
2,786,523

 
1.944
%
 
0.279
%
 
7.62

Total
 
$
10,511,523

 
1.090
%
 
0.281
%
 
3.26

(notional in thousands)
 
 
 
 
 
 
December 31, 2014
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2016
 
$
4,100,000

 
0.667
%
 
0.249
%
 
1.65

2017
 
5,285,000

 
1.063
%
 
0.248
%
 
2.55

2018
 
625,000

 
0.945
%
 
0.233
%
 
3.08

2019 and Thereafter
 
1,480,000

 
2.408
%
 
0.235
%
 
7.70

Total
 
$
11,490,000

 
1.089
%
 
0.246
%
 
2.92



28

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

Interest Rate Swaptions . As of June 30, 2015 and December 31, 2014 , the Company had the following outstanding interest rate swaptions (agreements to enter into interest rate swaps in the future for which the Company would either pay or receive a fixed rate) that were utilized as macro-economic hedges:
 
 
June 30, 2015
(notional and dollars in thousands)
 
Option
 
Underlying Swap
Swaption
 
Expiration
 
Cost
 
Fair Value
 
Average Months to Expiration
 
Notional Amount
 
Average Pay Rate
 
Average Receive Rate
 
Average Term (Years)
Purchase contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
< 6 Months
 
$
17,963

 
$
14,444

 
4.36
 
$
5,600,000

 
2.75
%
 
3M Libor
 
6.3

Payer
 
≥ 6 Months
 
259,328

 
134,633

 
50.71
 
9,210,000

 
4.01
%
 
3M Libor
 
6.9

Total Payer
 
 
 
$
277,291

 
$
149,077

 
46.40
 
$
14,810,000

 
3.53
%
 
3M Libor
 
6.7

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Receiver
 
< 6 Months
 
$
13,538

 
$
298

 
1.04
 
$
2,000,000

 
3M Libor
 
1.33
%
 
5.0

Total Receiver
 
 
 
$
13,538

 
$
298

 
1.04
 
$
2,000,000

 
3M Libor
 
1.33
%
 
5.0

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sale contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
≥ 6 Months
 
$
(81,248
)
 
$
(20,660
)
 
24.02
 
$
(800,000
)
 
3.44
%
 
3M Libor
 
10.0

Total Payer
 
 
 
$
(81,248
)
 
$
(20,660
)
 
24.02
 
$
(800,000
)
 
3.44
%
 
3M Libor
 
10.0

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Receiver
 
< 6 Months
 
$
(28,980
)
 
$
(19,895
)
 
4.29
 
$
(6,600,000
)
 
3M Libor
 
1.64
%
 
6.1

Total Receiver
 
 
 
$
(28,980
)
 
$
(19,895
)
 
4.29
 
$
(6,600,000
)
 
3M Libor
 
1.64
%
 
6.1

 
 
December 31, 2014
(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)
Purchase contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
≥ 6 Months
 
$
255,358

 
$
130,120

 
56.62
 
$
8,210,000

 
4.12
%
 
3M Libor
 
7.4

Total Payer
 
 
 
$
255,358

 
$
130,120

 
56.62
 
$
8,210,000

 
4.12
%
 
3M Libor
 
7.4

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Receiver
 
< 6 Months
 
$
10,715

 
$
6,462

 
3.38
 
$
5,000,000

 
3M Libor
 
1.35
%
 
5.0

Total Receiver
 
 
 
$
10,715

 
$
6,462

 
3.38
 
$
5,000,000

 
3M Libor
 
1.35
%
 
5.0

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sale contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
≥ 6 Months
 
$
(81,248
)
 
$
(19,990
)
 
30.02
 
$
(800,000
)
 
3.44
%
 
3M Libor
 
10.0

Total Payer
 
 
 
$
(81,248
)
 
$
(19,990
)
 
30.02
 
$
(800,000
)
 
3.44
%
 
3M Libor
 
10.0



29

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

Markit IOS Total Return Swaps . The Company also enters into total return swaps (agreements whereby the Company receives or makes payments based on the total return of an underlying instrument or index, such as the Markit IOS Index, in exchange for fixed or floating rate interest payments) to help mitigate the potential impact of larger increases or decreases in interest rates on the performance of our investment portfolio (referred to as “convexity risk”). Total return swaps based on the Markit IOS Index are intended to synthetically replicate the performance of interest-only securities. The Company had the following total return swap agreements in place at  June 30, 2015 and December 31, 2014 :
(notional and dollars in thousands)
 
 
 
 
 
June 30, 2015
Maturity Date
 
Current Notional Amount
 
Fair Value
 
Upfront Payable
 
Unrealized Gain (Loss)
January 12, 2043
 
$
(390,645
)
 
$
641

 
$
(866
)
 
$
(225
)
January 12, 2044
 
(597,764
)
 
(50
)
 
(7,799
)
 
(7,849
)
Total
 
$
(988,409
)
 
$
591

 
$
(8,665
)
 
$
(8,074
)
(notional and dollars in thousands)
 
 
 
 
 
December 31, 2014
Maturity Date
 
Current Notional Amount
 
Fair Value
 
Upfront Payable
 
Unrealized Gain (Loss)
January 12, 2043
 
$
(411,281
)
 
$
763

 
$
(1,457
)
 
$
(694
)
January 12, 2044
 
(187,178
)
 
624

 
(275
)
 
349

Total
 
$
(598,459
)
 
$
1,387

 
$
(1,732
)
 
$
(345
)

Credit Risk
The Company’s exposure to credit losses on its U.S. Treasuries and Agency portfolio of investment securities is limited due to implicit or explicit backing from the U.S. Department of the Treasury or the 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.
Credit Default Swaps . For non-Agency investment securities and residential mortgage loans, the Company may enter 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 discussion under “Non-Risk Management Activities” below). The Company also has processes and controls in place to monitor, analyze, manage and mitigate its credit risk with respect to non-Agency RMBS and residential mortgage loans.
As of June 30, 2015 and December 31, 2014 , the Company held credit default swaps whereby the Company received 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.

30

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

The following tables present credit default swaps whereby the Company is receiving protection held as of June 30, 2015 and December 31, 2014 :
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
June 30, 2015
Protection
 
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable) Receivable
 
Unrealized Gain (Loss)
Receive
 
June 20, 2016
 
105.50

 
$
(100,000
)
 
$
(901
)
 
$
(260
)
 
$
(1,161
)
 
 
December 20, 2016
 
496.00

 
(25,000
)
 
(263
)
 
(4,062
)
 
(4,325
)
 
 
Total
 
183.60

 
$
(125,000
)
 
$
(1,164
)
 
$
(4,322
)
 
$
(5,486
)
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2014
Protection
 
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable) Receivable
 
Unrealized Gain (Loss)
Receive
 
June 20, 2016
 
105.50

 
$
(100,000
)
 
$
(1,350
)
 
$
(260
)
 
$
(1,610
)
 
 
December 20, 2016
 
496.00

 
(25,000
)
 
(322
)
 
(4,062
)
 
(4,384
)
 
 
Total
 
183.60

 
$
(125,000
)
 
$
(1,672
)
 
$
(4,322
)
 
$
(5,994
)

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 such 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 June 30, 2015 , the fair value of derivative financial instruments as an asset and liability position was $347.3 million and $22.5 million , respectively.
The Company attempts to mitigate its credit risk exposure on derivative financial instruments by limiting its counterparties to banks and financial institutions that meet established credit guidelines. The Company also seeks spread its credit risk exposure across multiple 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 or clearing agency, in the case of centrally cleared interest rate swaps, upon occurrence of certain events. To further mitigate the risk of counterparty default, the Company maintains collateral agreements with certain of its counterparties and clearing agencies, which require both parties to maintain cash deposits in the event the fair values of the derivative financial instruments exceed established thresholds. As of June 30, 2015 , the Company has received cash deposits from counterparties of $75.9 million and placed cash deposits of $211.4 million in 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 Company’s condensed consolidated balance sheet.
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 forward purchase commitments, TBAs and inverse interest-only RMBS.

31

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

Commitments to Purchase Residential 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 Company’s condensed consolidated balance sheets as assets or liabilities and measured at fair value. Subsequent changes in fair value are recorded on the Company’s condensed consolidated balance sheets as adjustments to the carrying value of these assets or liabilities with a corresponding adjustment recognized in current period earnings. As of June 30, 2015 and December 31, 2014 , the Company had outstanding commitments to purchase $626.7 million and $554.8 million of mortgage loans, subject to fallout if the loans do not close, with a fair value asset of $0.1 million and a fair value liability of $2.6 million at June 30, 2015 and a fair value asset of $1.3 million at December 31, 2014 , respectively.
Inverse Interest-Only Securities . As of June 30, 2015 and December 31, 2014 , inverse interest-only securities with a carrying value of $178.8 million and $188.6 million , including accrued interest receivable of $1.9 million and $2.2 million , respectively, 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 June 30, 2015 and December 31, 2014 :
(in thousands)
June 30,
2015
 
December 31,
2014
Face Value
$
1,049,743

 
$
1,168,226

Unamortized premium
—

 
—

Unamortized discount
 
 
 
Designated credit reserve
—

 
—

Net, unamortized
(891,752
)
 
(991,715
)
Amortized Cost
157,991

 
176,511

Gross unrealized gains
21,068

 
14,162

Gross unrealized losses
(2,156
)
 
(4,269
)
Carrying Value
$
176,903

 
$
186,404


Note 13 . Other Assets
Other assets as of June 30, 2015 and December 31, 2014 are summarized in the following table:
(in thousands)
June 30,
2015
 
December 31,
2014
Property and equipment at cost
$
5,492

 
$
4,849

Accumulated depreciation (1)
(2,593
)
 
(1,941
)
Net property and equipment
2,899

 
2,908

Prepaid expenses
1,375

 
1,790

Income taxes receivable
7,175

 
—

Deferred tax assets, net
52,240

 
40,847

Servicing advances
30,828

 
27,490

Federal Home Loan Bank stock
125,250

 
100,010

Equity investments
3,000

 
3,000

Other receivables
13,793

 
12,534

Total other assets
$
236,560

 
$
188,579

____________________
(1)
Depreciation expense for the three and six months ended June 30, 2015 was $0.3 million and $0.7 million , respectively.


32

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

Note 14 . Other Liabilities
Other liabilities as of June 30, 2015 and December 31, 2014 are summarized in the following table:
(in thousands)
June 30,
2015
 
December 31,
2014
Accrued expenses
$
30,724

 
$
29,819

Accrued interest payable
18,984

 
23,772

Income taxes payable
39

 
1,375

Other
10,821

 
9,473

Total other liabilities
$
60,568

 
$
64,439


Note 15 . Fair Value
Fair Value Measurements
ASC 820, Fair Value Measurements and Disclosures , or 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.


33

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

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 sheets. 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. The third-party pricing providers and brokers use pricing models that generally incorporate such factors as coupons, primary and secondary mortgage rates, rate reset period, issuer, prepayment speeds, credit enhancements and expected life of the security. In determining the fair value of its non-Agency RMBS, management judgment may be used to arrive at fair value that considers prices obtained from third-party pricing providers, broker quotes received and other 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 did not hold any U.S. Treasuries at June 30, 2015 . The Company classified 100% of its RMBS AFS securities reported at fair value as Level 2 at June 30, 2015 . AFS securities account for 76.5% of all assets reported at fair value at June 30, 2015 .
Residential mortgage loans held-for-sale . The Company holds residential mortgage loans held-for-sale that are carried at fair value in the condensed consolidated balance sheets as a result of a fair value option election. The Company determines fair value of its residential 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 91.2% and 8.8% of its residential mortgage loans held-for-sale as Level 2 and Level 3 fair value assets, respectively, at June 30, 2015 .
Residential mortgage loans held-for-investment in securitization trusts . The Company recognizes on its condensed consolidated balance sheets residential mortgage loans held-for-investment in securitization trusts that are carried at fair value as a result of a fair value option election. An entity is allowed to measure both the financial assets and financial liabilities of a qualifying CFE it consolidates using the fair value of either the CFE’s financial assets or financial liabilities, whichever is more observable. As the Company’s securitization trusts are considered qualifying CFEs, the Company determines the fair value of these residential mortgage loans based on the fair value of its collateralized borrowings in securitization trusts and its retained interests from the Company’s on-balance sheet securitizations (eliminated in consolidation in accordance with U.S. GAAP), as the fair value of these instruments is more observable. The Company classified 100% of its residential mortgage loans held-for-investment in securitization trusts as Level 2 fair value assets at June 30, 2015 .
Mortgage servicing rights . The Company holds a portfolio of MSR that are carried at fair value on the condensed consolidated balance sheets. The Company determines fair value of its MSR based on prices obtained from third-party pricing providers. Although MSR transactions are observable in the marketplace, the valuation is based upon cash flow models that include unobservable market data inputs (including prepayment speeds, delinquency levels and discount rates). As a result, the Company classified 100% of its MSR as Level 3 fair value assets at June 30, 2015 .
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, put and call options for TBAs and U.S. Treasuries, credit default swaps, constant maturity swaps and Markit IOS total return swaps. The Company utilizes third-party pricing providers to value its financial derivative instruments. The Company classified 100% of the interest rate swaps, swaptions, put and call options for TBAs and U.S. Treasuries, credit default swaps, constant maturity swaps and total returns swaps reported at fair value as Level 2 at June 30, 2015 .
The Company also enters into certain other derivative financial instruments, such as TBAs, short U.S. Treasuries and inverse interest-only securities. These instruments are similar in form to the Company’s AFS and trading securities and the Company utilizes a pricing service to value TBAs and broker quotes to value short U.S. Treasuries and inverse interest-only securities. The Company classified 100% of its inverse interest-only securities at fair value as Level 2 at June 30, 2015 . The Company reported 100% of its TBAs as Level 1 as of June 30, 2015 . The Company did not hold any short U.S. Treasuries at June 30, 2015 .

34

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

The Company may also enter into forward purchase commitments on residential mortgage loans whereby the Company commits to purchasing the loans at a particular interest rate. The fair value of these derivatives is determined based on prices currently offered in the marketplace for new commitments. Fallout assumptions if the borrower elects not to close the loan are applied to the pricing. As of June 30, 2015 , the Company had outstanding commitments to purchase $626.7 million of mortgage loans, subject to fallout if the loans do not close, with a fair value asset of $0.1 million and a fair value liability of $2.6 million . The Company classified 100% of the forward purchase commitments reported at fair value as Level 2 at June 30, 2015 .
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 ISDA, or central clearing exchange agreements, in the case of centrally cleared interest rate swaps. Additionally, both the Company and the counterparty or clearing agency are required to post cash collateral based upon the net underlying market value of the Company’s open positions with the counterparty. 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 or clearing agency is considered materially mitigated. Based on the Company’s assessment, there is no requirement for any additional adjustment to derivative valuations specifically for credit.
Collateralized borrowings in securitization trusts . The Company recognizes on its condensed consolidated balance sheets collateralized borrowings that are carried at fair value as a result of a fair value option election. In determining the fair value of its collateralized borrowings, management judgment may be used to arrive at fair value that considers prices obtained from third-party pricing providers, broker quotes received and other 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% of its collateralized borrowings in securitization trusts as Level 2 fair value liabilities at June 30, 2015 .
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 June 30, 2015
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$
—

 
$
12,807,658

 
$
—

 
$
12,807,658

Residential mortgage loans held-for-sale
—

 
633,578

 
61,500

 
695,078

Residential mortgage loans held-for-investment in securitization trusts
—

 
2,449,199

 
—

 
2,449,199

Mortgage servicing rights
—

 
—

 
437,576

 
437,576

Derivative assets
—

 
347,322

 
—

 
347,322

Total assets
$
—

 
$
16,237,757

 
$
499,076

 
$
16,736,833

Liabilities
 
 
 
 
 
 
 
Collateralized borrowings in securitization trusts
$
—

 
$
1,714,735

 
$
—

 
$
1,714,735

Derivative liabilities
5,187

 
17,288

 
—

 
22,475

Total liabilities
$
5,187

 
$
1,732,023

 
$
—

 
$
1,737,210


35

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

 
Recurring Fair Value Measurements
 
At December 31, 2014
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$
—

 
$
14,341,102

 
$
—

 
$
14,341,102

Trading securities
1,997,656

 
—

 
—

 
1,997,656

Residential mortgage loans held-for-sale
—

 
500,159

 
35,553

 
535,712

Residential mortgage loans held-for-investment in securitization trusts
—

 
1,744,746

 
—

 
1,744,746

Mortgage servicing rights
—

 
—

 
452,006

 
452,006

Derivative assets
10,350

 
370,441

 
—

 
380,791

Total assets
$
2,008,006

 
$
16,956,448

 
$
487,559

 
$
19,452,013

Liabilities
 
 
 
 
 
 
 
Collateralized borrowings in securitization trusts
$
—

 
$
1,209,663

 
$
—

 
$
1,209,663

Derivative liabilities
17,687

 
72,546

 
—

 
90,233

Total liabilities
$
17,687

 
$
1,282,209

 
$
—

 
$
1,299,896


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 U.S. GAAP. These items would constitute nonrecurring fair value measures under ASC 820. As of June 30, 2015 , 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 condensed consolidated 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.
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, credit default swaps and Markit IOS total return swaps, are valued by the Company using observable inputs, specifically quotations received from third-party pricing providers, and are therefore classified within Level 2.

36

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

The following table presents the reconciliation for all of the Company’s Level 3 assets measured at fair value on a recurring basis:
 
Level 3 Recurring Fair Value Measurements
 
 
Three Months Ended
 
Six Months Ended
 
 
June 30, 2015
 
June 30, 2015
 
(in thousands)
Residential Mortgage Loans Held-For-Sale
 
Mortgage Servicing Rights
 
Residential Mortgage Loans Held-For-Sale
 
Mortgage Servicing Rights
 
Beginning of period level 3 fair value
$
70,149

 
$
410,229

 
$
35,553

 
$
452,006

 
Gains (losses) included in net income (loss):
 
 
 
 
 
 
 
 
Realized gains (losses)
10,491

 
(7,805
)
 
15,612

 
(17,119
)
 
Unrealized gains (losses)
30

(1)  
25,440

(3)  
777

(1)  
(17,649
)
(3)  
Total net gains (losses) included in net income (loss)
10,521

 
17,635

 
16,389

 
(34,768
)
 
Other comprehensive income  
—

 
—

 
—

 
—

 
Purchases
61,054

 
4,799

 
131,720

 
9,350

 
Sales
(51,981
)
 
—

 
(75,890
)
 
—

 
Settlements
(28,243
)
 
4,913

 
(46,272
)
 
10,988

 
Gross transfers into level 3
—

 
—

 
—

 
—

 
Gross transfers out of level 3
—

 
—

 
—

 
—

 
End of period level 3 fair value
$
61,500

 
$
437,576

 
$
61,500

 
$
437,576

 
Change in unrealized gains or losses for the period included in earnings for assets held at the end of the reporting period
$
370

(2)  
$
25,440

(4)  
$
352

(2)  
$
(17,649
)
(4)  
___________________
(1)
For the three and six months ended June 30, 2015 , the change in unrealized gains or losses on residential mortgage loans held-for-sale was recorded in (loss) gain on residential mortgage loans held-for-sale on the condensed consolidated statements of comprehensive income.
(2)
For the three and six months ended June 30, 2015 , the change in unrealized gains or losses on residential mortgage loans held-for-sale that were held at the end of the reporting period was recorded in (loss) gain on residential mortgage loans held-for-sale on the condensed consolidated statements of comprehensive income.
(3)
For the three and six months ended June 30, 2015 , the change in unrealized gains or losses on MSR was recorded in gain (loss) on servicing asset on the condensed consolidated statements of comprehensive income.
(4)
For the three and six months ended June 30, 2015 , the change in unrealized gains or losses on MSR that were held at the end of the reporting period was recorded in gain (loss) on servicing asset on the condensed consolidated statements of comprehensive income.

The Company did not incur transfers between Level 1, Level 2 or Level 3 during the six months ended June 30, 2015 . Transfers between Levels are deemed to take place on the first day of the reporting period in which the transfer has taken place.
The Company used a third-party pricing provider in the fair value measurement of its Level 3 residential mortgage loans held-for-sale. The significant unobservable inputs used by the third-party pricing provider included expected default, severity and discount rate. Significant increases (decreases) in any of the inputs in isolation may result in significantly lower (higher) fair value measurement.

37

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

The Company also used a third-party pricing provider in the fair value measurement of its Level 3 MSR. The table below presents information about the significant unobservable inputs used by the third-party pricing provider in the fair value measurement of the Company’s MSR classified as Level 3 fair value assets at June 30, 2015 :
As of June 30, 2015
Valuation Technique
 
Unobservable Input (1)
 
Range
 
Weighted Average
Discounted cash flow
 
Constant prepayment speed
 
9.5
-
12.8
%
 
11.2%
 
 
Delinquency
 
4.3
-
4.9
%
 
4.6%
 
 
Discount rate
 
8.1
-
10.7
%
 
9.4%
___________________
(1)
Significant increases (decreases) in any of the inputs in isolation may result in significantly lower (higher) fair value measurement. A change in the assumption used for discount rates may be accompanied by a directionally similar change in the assumption used for the probability of delinquency and a directionally opposite change in the assumption used for prepayment rates.

Fair Value Option for Financial Assets and Financial Liabilities
The Company elected the fair value option for the residential mortgage loans it has acquired. The fair value option was elected to mitigate earnings volatility by better matching the accounting for the assets with the related hedges. The mortgage loans are carried within residential mortgage loans held-for-sale on the condensed consolidated balance sheets. 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 (loss) gain on residential mortgage loans held-for-sale on the condensed consolidated statements of comprehensive income. The fair value option is irrevocable once the loan is acquired.
The Company also elected the fair value option for both the residential mortgage loans held-for-investment in securitization trusts and the collateralized borrowings in securitization trusts carried on the condensed consolidated balance sheets. The fair value option was elected to better reflect the economics of the Company’s retained interests. The Company’s policy is to separately record interest income on the fair value elected loans and interest expense on the fair value elected borrowings. Upfront fees and costs are not deferred or capitalized. Fair value adjustments are reported in other (loss) income on the condensed consolidated statements of comprehensive income.
The following tables summarize the fair value option elections and information regarding the line items and amounts recognized in the condensed consolidated statements of comprehensive income for each fair value option-elected item.
 
Three Months Ended June 30, 2015
(in thousands)
Interest income (expense)
 
(Loss) gain on residential mortgage loans held-for-sale
 
Other (loss) income
 
Total included in net income
 
Change in fair value due to credit risk
Assets
 
 
 
 
 
 
 
 
 
 
 
Residential mortgage loans held-for-sale
$
7,518

(1)  
 
$
(3,019
)
 
$
—

 
$
4,499

 
$
272

(2)  
Residential mortgage loans held-for-investment in securitization trusts
21,830

(1)  
 
—

 
(49,143
)
 
(27,313
)
 
—

(3)  
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Collateralized borrowings in securitization trusts
(13,131
)
 
 
—

 
31,536

 
18,405

 
—

(3)  
Total
$
16,217

 
 
$
(3,019
)
 
$
(17,607
)
 
$
(4,409
)
 
$
272

 

38

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

 
Three Months Ended June 30, 2014
(in thousands)
Interest income (expense)
 
(Loss) gain on residential mortgage loans held-for-sale
 
Other (loss) income
 
Total included in net income
 
Change in fair value due to credit risk
Assets
 
 
 
 
 
 
 
 
 
 
 
Residential mortgage loans held-for-sale
$
2,699

(1)  
 
$
7,638

 
$
—

 
$
10,337

 
$
1,036

(2)  
Residential mortgage loans held-for-investment in securitization trusts
7,761

(1)  
 
—

 
36,631

 
44,392

 
—

(3)  
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Collateralized borrowings in securitization trusts
(5,592
)
 
 
—

 
(15,802
)
 
(21,394
)
 
—

(3)  
Total
$
4,868

 
 
$
7,638

 
$
20,829

 
$
33,335

 
$
1,036

 
 
Six Months Ended June 30, 2015
(in thousands)
Interest income (expense)
 
(Loss) gain on residential mortgage loans held-for-sale
 
Other (loss) income
 
Total included in net income
 
Change in fair value due to credit risk
Assets
 
 
 
 
 
 
 
 
 
 
 
Residential mortgage loans held-for-sale
$
11,789

(1)  
 
$
6,047

 
$
—

 
$
17,836

 
$
30

(2)  
Residential mortgage loans held-for-investment in securitization trusts
40,067

(1)  
 
—

 
(49,094
)
 
(9,027
)
 
—

(3)  
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Collateralized borrowings in securitization trusts
(23,839
)
 
 
—

 
28,569

 
4,730

 
—

(3)  
Total
$
28,017

 
 
$
6,047

 
$
(20,525
)
 
$
13,539

 
$
30

 

39

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

 
Six Months Ended June 30, 2014
(in thousands)
Interest income (expense)
 
(Loss) gain on residential mortgage loans held-for-sale
 
Other (loss) income
 
Total included in net income
 
Change in fair value due to credit risk
Assets
 
 
 
 
 
 
 
 
 
 
 
Residential mortgage loans held-for-sale
$
7,285

(1)  
 
$
4,874

 
$
—

 
$
12,159

 
$
1,069

(2)  
Residential mortgage loans held-for-investment in securitization trusts
15,654

(1)  
 
—

 
38,606

 
54,260

 
—

(3)  
Liabilities
 
 
 
 
 
 
 
 
 
 
 
Collateralized borrowings in securitization trusts
(10,945
)
 
 
—

 
(17,463
)
 
(28,408
)
 
—

(3)  
Total
$
11,994

 
 
$
4,874

 
$
21,143

 
$
38,011

 
$
1,069

 
____________________
(1)
Interest income on residential mortgage loans held-for-sale and residential mortgage loans held-for-investment in securitization trusts is measured by multiplying the unpaid principal balance on the loans by the coupon rate and the number of days of interest due.
(2)
The change in fair value due to credit risk on residential mortgage loans held-for-sale was quantified by holding yield constant in the cash flow model in order to isolate credit risk component.
(3)
The change in fair value on residential mortgage loans held-for-investment in securitization trusts and collateralized borrowings in securitization trusts was due entirely to changes in market interest rates.

The table below provides the fair value and the unpaid principal balance for the Company’s fair value option-elected loans and collateralized borrowings.
 
June 30, 2015
 
December 31, 2014
(in thousands)
Unpaid Principal Balance
 
Fair
Value (1)
 
Unpaid Principal Balance
 
Fair
Value (1)
Residential mortgage loans held-for-sale
 
 
 
 
 
 
 
Total loans
$
703,966

 
$
695,078

 
$
534,101

 
$
535,712

Nonaccrual loans
$
48,379

 
$
42,212

 
$
26,405

 
$
20,574

Loans 90+ days past due
$
45,547

 
$
39,525

 
$
25,263

 
$
19,675

Residential mortgage loans held-for-investment in securitization trusts
 
 
 
 
 
 
 
Total loans
$
2,431,573

 
$
2,449,199

 
$
1,699,748

 
$
1,744,746

Nonaccrual loans
$
862

 
$
865

 
$
—

 
$
—

Loans 90+ days past due
$
—

 
$
—

 
$
—

 
$
—

Collateralized borrowings in securitization trusts
 
 
 
 
 
 
 
Total borrowings
$
1,743,289

 
$
1,714,735

 
$
1,218,589

 
$
1,209,663

____________________
(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 sheets, for which fair value can be estimated.

40

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

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, residential mortgage loans held-for-sale, residential mortgage loans held-for-investment in securitization trusts, MSR, derivative assets and liabilities, and collateralized borrowings in securitization trusts 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.
•
Commercial real estate loans held-for-investment are carried at cost, net of any unamortized premiums or discounts, unless deemed impaired. Because the Company has not yet recorded any allowances for losses and the rate and terms of the one newly-issued senior mezzanine commercial real estate loan held are similar to those observed in the market, carrying value, or amortized cost, approximates fair value. The Company categorizes the fair value measurement of these assets as Level 2.
•
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.
•
As a condition to membership in the FHLB, the Company is required to purchase and hold a certain amount of FHLB stock, which is considered a non-marketable, long-term investment, and is carried at cost. Because this stock can only be redeemed or sold at its par value, and only to the FHLB, carrying value, or cost, approximates fair value. The Company categorizes the fair value measurement of these assets as Level 3.
•
Equity investments include cost method investments for which fair value is not estimated. Carrying value, or cost, approximates fair value. The Company categorizes the fair value measurement of these assets as Level 3.
•
The carrying value of repurchase agreements and FHLB advances that mature in less than one year generally approximates fair value due to the short maturities. The Company holds $3.0 billion of FHLB advances that are considered long-term. The Company’s long-term FHLB advances have floating rates based on an index plus a spread and, for members of the FHLB, the credit spread is typically consistent with those demanded in the market. Accordingly, the interest rates on these borrowings are at market and thus carrying value approximates fair value. The Company categorizes the fair value measurement of these liabilities as Level 2.
The following table presents the carrying values and estimated fair values of assets and liabilities that are required to be recorded or disclosed at fair value at June 30, 2015 and December 31, 2014 .
 
June 30, 2015
 
December 31, 2014
(in thousands)
Carrying Value
 
Fair Value
 
Carrying Value
 
Fair Value
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$
12,807,658

 
$
12,807,658

 
$
14,341,102

 
$
14,341,102

Trading securities
$
—

 
$
—

 
$
1,997,656

 
$
1,997,656

Residential mortgage loans held-for-sale
$
695,078

 
$
695,078

 
$
535,712

 
$
535,712

Residential mortgage loans held-for-investment in securitization trusts
$
2,449,199

 
$
2,449,199

 
$
1,744,746

 
$
1,744,746

Commercial real estate loans held-for-investment
$
45,605

 
$
45,605

 
$
—

 
$
—

Mortgage servicing rights
$
437,576

 
$
437,576

 
$
452,006

 
$
452,006

Cash and cash equivalents
$
933,579

 
$
933,579

 
$
1,005,792

 
$
1,005,792

Restricted cash
$
410,903

 
$
410,903

 
$
336,771

 
$
336,771

Derivative assets
$
347,322

 
$
347,322

 
$
380,791

 
$
380,791

Federal Home Loan Bank stock
$
125,250

 
$
125,250

 
$
100,010

 
$
100,010

Equity investments
$
3,000

 
$
3,000

 
$
3,000

 
$
3,000

Liabilities
 
 
 
 
 
 
 
Repurchase agreements
$
9,422,803

 
$
9,422,803

 
$
12,932,463

 
$
12,932,463

Collateralized borrowings in securitization trusts
$
1,714,735

 
$
1,714,735

 
$
1,209,663

 
$
1,209,663

Federal Home Loan Bank advances
$
3,000,000

 
$
3,000,000

 
$
2,500,000

 
$
2,500,000

Derivative liabilities
$
22,475

 
$
22,475

 
$
90,233

 
$
90,233


41

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


Note 16 . Repurchase Agreements
As of June 30, 2015 , the Company had outstanding $9.4 billion of repurchase agreements. Excluding the effect of the Company’s interest rate swaps, the repurchase agreements had a weighted average borrowing rate of 0.75% and weighted average remaining maturities of 69 days as of June 30, 2015 . As of December 31, 2014 , the Company had outstanding $12.9 billion of repurchase agreements, including repurchase agreements funding the Company’s U.S. Treasuries of $2.0 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 0.72% and weighted average remaining maturities of 64 days as of December 31, 2014 . As of December 31, 2014 , the debt associated with the Company’s U.S. Treasuries had a weighted average borrowing rate of 0.23% . The Company did not have any repurchase agreements collateralized by U.S. Treasuries as of June 30, 2015 .
At June 30, 2015 and December 31, 2014 , the repurchase agreement balances were as follows:
(in thousands)
June 30,
2015
 
December 31,
2014
Short-term
$
9,422,803

 
$
12,839,242

Long-term
—

 
93,221

Total
$
9,422,803

 
$
12,932,463


At June 30, 2015 and December 31, 2014 , the repurchase agreements had the following characteristics and remaining maturities:
 
June 30, 2015
 
Collateral Type
 
 
(in thousands)
Agency RMBS
 
Non-Agency RMBS (1)
 
Agency Derivatives
 
Residential Mortgage Loans Held-for-Sale
 
Commercial Real Estate Loans Held-for-Investment
 
Total Amount Outstanding
Within 30 days
$
1,912,119

 
$
471,133

 
$
47,770

 
$
—

 
$
22,950

 
$
2,453,972

30 to 59 days
3,077,003

 
461,904

 
85,097

 
—

 
—

 
3,624,004

60 to 89 days
484,627

 
230,613

 
—

 
—

 
—

 
715,240

90 to 119 days
471,052

 
64,420

 
—

 
—

 
—

 
535,472

120 to 364 days
1,376,499

 
708,162

 
—

 
9,454

 
—

 
2,094,115

Total
$
7,321,300

 
$
1,936,232

 
$
132,867

 
$
9,454

 
$
22,950

 
$
9,422,803

Weighted average borrowing rate
0.45
%
 
1.85
%
 
1.03
%
 
2.63
%
 
1.84
%
 
0.75
%

42

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

 
December 31, 2014
 
Collateral Type
 
(in thousands)
U.S Treasuries
 
Agency RMBS
 
Non-Agency RMBS (1)
 
Agency Derivatives
 
Residential Mortgage Loans Held-for-Sale
 
Total Amount Outstanding
Within 30 days
$
998,750

 
$
2,305,726

 
$
630,118

 
$
44,723

 
$
—

 
$
3,979,317

30 to 59 days
—

 
3,568,049

 
945,032

 
82,344

 
—

 
4,595,425

60 to 89 days
—

 
631,992

 
260,228

 
11,066

 
—

 
903,286

90 to 119 days
—

 
317,155

 
117,395

 
—

 
—

 
434,550

120 to 364 days
—

 
1,635,650

 
278,401

 
—

 
15,113

 
1,929,164

Open maturity (2)
997,500

 
—

 
—

 
—

 
—

 
997,500

One year and over
—

 
—

 
93,221

 
—

 
—

 
93,221

Total
$
1,996,250

 
$
8,458,572

 
$
2,324,395

 
$
138,133

 
$
15,113

 
$
12,932,463

Weighted average borrowing rate
0.23
%
 
0.42
%
 
1.79
%
 
0.99
%
 
3.03
%
 
0.64
%
____________________
(1)
Includes repurchase agreements collateralized by retained interests from the Company’s on-balance sheet securitizations, which are eliminated in consolidation in accordance with U.S. GAAP.
(2)
Includes repurchase agreements collateralized by U.S. Treasuries with an open maturity period ( i.e. , rolling 1-day maturity) renewable at the discretion of either party to the agreements.

The following table summarizes assets at carrying values that are pledged or restricted as collateral for the future payment obligations of repurchase agreements:
(in thousands)
June 30,
2015
 
December 31,
2014
Available-for-sale securities, at fair value
$
10,284,534

 
$
11,874,783

Trading securities, at fair value
—

 
1,997,656

Residential mortgage loans held-for-sale, at fair value
10,545

 
19,123

Commercial real estate loans held-for-investment
45,605

 
—

Net economic interests in consolidated securitization trusts (1)
113,824

 
363,564

Cash and cash equivalents
15,000

 
14,117

Restricted cash
182,709

 
112,435

Due from counterparties
24,252

 
32,495

Derivative assets, at fair value
176,017

 
185,067

Total
$
10,852,486

 
$
14,599,240

____________________
(1)
Includes the retained interests from the Company’s on-balance sheet securitizations, which are eliminated in consolidation in accordance with U.S. GAAP.

Although the transactions under repurchase agreements represent 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.

43

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 June 30, 2015 and December 31, 2014 :
 
June 30, 2015
 
December 31, 2014
(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
Royal Bank of Canada
$
1,161,333

 
$
316,965

 
8
%
 
119.6

 
$
1,373,549

 
$
401,194

 
10
%
 
83.8

Barclays Capital Inc.
789,908

 
265,129

 
7
%
 
59.5

 
1,346,085

 
365,879

 
9
%
 
50.5

All other counterparties  (2) (3)
7,471,562

 
843,313

 
21
%
 
61.5

 
9,215,329

 
907,066

 
22
%
 
57.7

Total
$
9,422,803

 
$
1,425,407

 
 
 
 
 
$
11,934,963

 
$
1,674,139

 
 
 
 
____________________
(1)
Represents the net carrying value of the securities, residential mortgage loans held-for-sale and commercial real estate loans held-for-investment 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. Payables due to broker counterparties for unsettled securities purchases are not included in the amounts presented above. However, at both June 30, 2015 and  December 31, 2014 , the Company did not have any such payables.
(2)
Excludes $997.5 million of repurchase agreements collateralized by U.S. Treasuries with a rolling 1-day maturity as of December 31, 2014 .
(3)
Represents amounts outstanding with 21 and 23 counterparties at June 30, 2015 and December 31, 2014 , respectively.

The Company does not anticipate any defaults by its repurchase agreement counterparties. There can be no assurance, however, that any such default or defaults will not occur.

Note 17 . Collateralized Borrowings in Securitization Trusts, at Fair Value
The Company purchases subordinated debt and excess servicing rights from securitization trusts sponsored by either third parties or the Company’s subsidiaries. The debt associated with the underlying residential mortgage loans held by the trusts, which are consolidated on the Company’s condensed consolidated balance sheets, is classified as collateralized borrowings in securitization trusts and carried at fair value as a result of a fair value option election. See Note 3 - Variable Interest Entities for additional information regarding consolidation of the securitization trusts. As of June 30, 2015 and December 31, 2014 , collateralized borrowings in securitization trusts had a carrying value of $1.7 billion and $1.2 billion with a weighted average interest rate of 3.6% for both period ends. The stated maturity dates for all collateralized borrowings were more than five years from both June 30, 2015 and December 31, 2014 .

Note 18 . Federal Home Loan Bank of Des Moines Advances
The Company’s wholly owned subsidiary, TH Insurance Holdings Company LLC, or TH Insurance, is a member in the FHLB. As a member of the FHLB, TH Insurance has access to a variety of products and services offered by the FHLB, including secured advances. As of June 30, 2015 and December 31, 2014 , TH Insurance had $3.0 billion and $2.5 billion in outstanding secured advances with a weighted average borrowing rate of 0.35% and 0.34% , respectively, and had an additional  $1.0 billion  of available uncommitted capacity for borrowings as of June 30, 2015 . As of December 31, 2014 , TH Insurance had no additional uncommitted capacity to borrow. To the extent TH Insurance has uncommitted capacity, it may be adjusted at the sole discretion of the FHLB.
The ability to borrow from the FHLB is subject to the Company’s continued creditworthiness, pledging of sufficient eligible collateral to secure advances, and compliance with certain agreements with the FHLB. Each advance requires approval by the FHLB and is secured by collateral in accordance with the FHLB’s credit and collateral guidelines, as may be revised from time to time by the FHLB. Eligible collateral may include conventional 1-4 family residential mortgage loans, commercial real estate loans, Agency RMBS and certain non-Agency RMBS with a rating of A and above.

44

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

At June 30, 2015 and December 31, 2014 , FHLB advances had the following remaining maturities:
(in thousands)
June 30,
2015
 
December 31,
2014
≤ 1 year
$
—

 
$
33,738

> 1 and ≤ 3 years
651,238

 
651,238

> 3 and ≤ 5 years
815,024

 
815,024

> 5 and ≤ 10 years
—

 
—

> 10 years
1,533,738

 
1,000,000

Total
$
3,000,000

 
$
2,500,000


The following table summarizes assets at carrying values that are pledged or restricted as collateral for the future payment obligations of FHLB advances:
(in thousands)
June 30,
2015
 
December 31,
2014
Available-for-sale securities, at fair value
$
2,268,550

 
$
2,284,532

Residential mortgage loans held-for-sale, at fair value
551,257

 
397,656

Net economic interests in consolidated securitization trusts (1)
491,270

 
80,732

Total
$
3,311,077

 
$
2,762,920

____________________
(1)
Includes the retained interests from the Company’s on-balance sheet securitizations, which are eliminated in consolidation in accordance with U.S. GAAP.

The FHLB retains the right to mark the underlying collateral for FHLB advances to fair value. A reduction in the value of pledged assets would require the Company to provide additional collateral. In addition, as a condition to membership in the FHLB, the Company is required to purchase and hold a certain amount of FHLB stock, which is based, in part, upon the outstanding principal balance of advances from the FHLB. At June 30, 2015 and December 31, 2014 , the Company had stock in the FHLB totaling $125.3 million and $103.0 million , respectively, which is included in other assets on the condensed consolidated balance sheets. FHLB stock is considered a non-marketable, long-term investment, is carried at cost and is subject to recoverability testing under applicable accounting standards. This stock can only be redeemed or sold at its par value, and only to the FHLB. Accordingly, when evaluating FHLB stock for impairment, the Company considers the ultimate recoverability of the par value rather than recognizing temporary declines in value. As of June 30, 2015 and December 31, 2014 , the Company had not recognized an impairment charge related to its FHLB stock.

Note 19 . Stockholders’ Equity
Distributions to Stockholders
The following table presents cash dividends declared by the Company on its common stock during the three months ended June 30, 2015 , and the four immediately preceding quarters:
Declaration Date
 
Record Date
 
Payment Date
 
Cash Dividend Per Share
June 17, 2015
 
June 30, 2015
 
July 21, 2015
 
$
0.26

March 18, 2015
 
March 31, 2015
 
April 21, 2015
 
$
0.26

December 16, 2014
 
December 30, 2014
 
January 20, 2015
 
$
0.26

September 16, 2014
 
September 30, 2014
 
October 21, 2014
 
$
0.26

June 17, 2014
 
July 2, 2014
 
July 22, 2014
 
$
0.26



45

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

Accumulated Other Comprehensive Income
Accumulated other comprehensive income at June 30, 2015 and December 31, 2014 was as follows:
(in thousands)
June 30,
2015
 
December 31,
2014
Available-for-sale securities, at fair value
 
 
 
Unrealized gains
$
711,813

 
$
891,820

Unrealized losses
(80,781
)
 
(36,031
)
Accumulated other comprehensive income
$
631,032

 
$
855,789


Reclassifications out of Accumulated Other Comprehensive Income
The following table summarizes reclassifications out of accumulated other comprehensive income for the three and six months ended June 30, 2015 and 2014 :
(in thousands)
 
Affected Line Item in the Condensed Consolidated Statements of Comprehensive Income
 
Amount Reclassified out of Accumulated Other Comprehensive Income
 
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
 
 
2015
 
2014
 
2015
 
2014
Other-than-temporary-impairments on AFS securities
 
Total other-than-temporary impairment losses
 
$
170

 
$
—

 
$
297

 
$
212

Realized (gains) losses on sales of AFS securities
 
Gain (loss) on investment securities
 
(75,135
)
 
(20,952
)
 
(175,071
)
 
22,228

 
 
 
 
$
(74,965
)
 
$
(20,952
)
 
$
(174,774
)
 
$
22,440


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 the Company’s common stock were originally reserved for issuance under the plan. As of June 30, 2015 , 249,650 shares have been issued under the plan for total proceeds of approximately $2.6 million , of which 16,772 and 36,184 shares were issued for total proceeds of $178,436 and $378,700 during the three and six months ended June 30, 2015 , respectively. During the three and six months ended June 30, 2014 , 12,694 and 23,474 shares were issued under the plan for total proceeds for $130,652 and $240,792 , respectively.
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. On November 14, 2012, the board of directors authorized an increase in the share repurchase program of 15,000,000 , for a total of 25,000,000 shares. Shares may 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 the Exchange Act, 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 SEC rules. The share repurchase program does not require the purchase of any minimum number of shares, and purchases may be commenced or suspended at any time without prior notice. As of June 30, 2015 , 2,450,700 shares had been repurchased by the Company under the program for a total cost of $23.9 million ; however, no shares were repurchased during the three and six months ended June 30, 2015 and 2014 .

46

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

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, or the Securities Act. On May 22, 2015, the Company entered into an amendment to the equity distribution agreement providing that any subsequent offers or sales of the Company’s common stock under the equity distribution agreement shall be made pursuant to a new prospectus supplement, which was filed on the same date. As of June 30, 2015 , 7,585,869 shares of common stock have been sold under the equity distribution agreement for total accumulated net proceeds of approximately $77.6 million ; however, no shares were sold during the three and six months ended June 30, 2015 and 2014 .

Note 20 . Equity Incentive Plan
On May 14, 2015, the Company’s stockholders approved the Company’s Second Restated 2009 Equity Incentive Plan, which replaced the previous Restated 2009 Equity Incentive Plan, both of which are referred to collectively as the Plan. This stockholder approval effectuated, among other changes, an increase in the number of shares of common stock available for issuance under the Plan by 10,000,000 shares.
On May 20, 2014 and May 14, 2015, the Company granted  52,180  and 35,521 shares of common stock, respectively, to its independent directors pursuant to the Plan. The estimated fair value of these awards was $10.31 and $10.53 per share on grant date, based on the closing price of the Company’s common stock on the NYSE on such date. The grants vested immediately.
Additionally, on February 5, 2014, February 12, 2015 and May 14, 2015, the Company granted 1,103,162 , 206,275 and 909,299 shares of restricted common stock, respectively, to key employees of PRCM Advisers pursuant to the Plan. The estimated fair value of these awards was $9.79 ,  $10.30 and $10.53 per share on grant date, based on the closing market price of the Company’s common stock on the NYSE on such date. However, as the cost of these awards is measured at fair value at each reporting date based on the price of the Company’s stock as of period end in accordance with ASC 505, Equity , or ASC 505, the fair value of these awards as of June 30, 2015 was $9.74 per share based on the closing market price of the Company’s common stock on the NYSE on such date. The shares underlying the grants vest in three equal annual installments commencing on the first anniversary of the grant date, as long as such grantee complies with the terms and conditions of his or her applicable restricted stock award agreement.
The following table summarizes the activity related to restricted common stock for the six months ended June 30, 2015 and 2014 :
 
Six Months Ended June 30,
 
2015
 
2014
(in thousands)
Shares
 
Weighted Average Grant Date Fair Market Value
 
Shares
 
Weighted Average Grant Date Fair Market Value
Outstanding at Beginning of Period
2,002,406

 
$
10.32

 
1,024,459

 
$
11.22

Granted
1,151,095

 
10.49

 
1,155,342

 
9.81

Vested
(711,124
)
 
(10.45
)
 
(395,986
)
 
(11.10
)
Forfeited
(55,474
)
 
(10.19
)
 
(3,065
)
 
(9.79
)
Outstanding at End of Period
2,386,903

 
$
10.36

 
1,780,750

 
$
10.34


For the three and six months ended June 30, 2015 , the Company recognized compensation costs related to restricted common stock of $2.9 million and $5.6 million , respectively. For the three and six months ended June 30, 2014 , the Company recognized compensation costs related to restricted common stock of $3.7 million and $6.8 million , respectively.


47

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

Note 21 . Income Taxes
For the three and six months ended June 30, 2015 and 2014 , 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, and does not engage in prohibited transactions. The Company intends to distribute 100% of its REIT taxable income and comply with all requirements to continue to qualify as a REIT. The majority of states also recognize the Company’s REIT status. The Company’s TRSs file separate tax returns and are fully taxed as standalone U.S. C-corporations. 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.
During the three and six months ended June 30, 2015 , the Company’s TRSs recognized a benefit from income taxes of $7.0 million and $17.6 million , respectively, which was primarily due to losses incurred on derivative instruments held in the Company’s TRSs. During the three and six months ended June 30, 2014 , the Company’s TRSs recognized a benefit from income taxes of $23.3 million and $57.2 million , respectively, which was primarily due to losses incurred on derivative instruments held in the Company’s TRSs.
Based on the Company’s evaluation, it has been concluded that there are no significant uncertain tax positions requiring recognition in the Company’s condensed consolidated financial statements of a contingent tax liability for uncertain tax positions.

Note 22 . 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 six months ended June 30, 2015 and 2014 :
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands, except share data)
2015
 
2014
 
2015
 
2014
Numerator:
 
 
 
 
 
 
 
Net income
$
221,501

 
$
39,657

 
$
316,294

 
$
10,512

Denominator:
 
 
 
 
 
 
 
Weighted average common shares outstanding
364,919,352

 
364,078,669

 
364,775,066

 
363,996,652

Weighted average restricted stock shares
2,154,779

 
1,999,455

 
2,017,393

 
1,849,643

Basic and diluted weighted average shares outstanding
367,074,131

 
366,078,124

 
366,792,459

 
365,846,295

Basic and Diluted Earnings Per Share:
$
0.60

 
$
0.11

 
$
0.86

 
$
0.03


Note 23 . 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 $12.7 million and $25.4 million as a management fee to PRCM Advisers for the three and six months ended June 30, 2015 , respectively, and $12.2 million and $24.3 million as a management fee to PRCM Advisers for the three and six months ended June 30, 2014 , respectively, which represents approximately 1.5% of stockholders’ equity on an annualized basis as defined by the Management Agreement. For purposes of calculating the management fee, stockholders’ equity is adjusted to exclude any common stock repurchases as well as any unrealized gains, losses or other items that do not affect realized net income (loss), among other adjustments, in accordance with 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 $5.4 million and $10.1 million for the three and six months ended June 30, 2015 , respectively, and $3.9 million and $7.2 million for the three and six months ended June 30, 2014 , respectively.
The Company has 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 are paid directly by the Company.

48

The Company recognized $2.9 million and $5.6 million of compensation expense during the three and six months ended June 30, 2015 , respectively, related to restricted common stock. The Company recognized $3.7 million and $6.8 million of compensation expense during the three and six months ended June 30, 2014 , respectively, related to restricted common stock. See Note 20 - Equity Incentive Plan for additional information.

Note 24 . Subsequent Events
Events subsequent to June 30, 2015 , 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.


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 our unaudited 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, 2014 .

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

•
Agency RMBS (which includes inverse interest-only Agency securities classified as “Agency Derivatives” for purposes of U.S. generally accepted accounting principles, or U.S. GAAP), 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;
•
MSR;
•
Commercial real estate assets; and
•
Other financial assets comprising approximately 5% to 10% of the portfolio.

We generally view our target assets in three strategies that rely on our core competencies of managing prepayment and credit risk. Our rates strategy includes assets that are sensitive to changes in interest rates and prepayment speeds, specifically Agency RMBS and MSR. Our credit strategy includes assets with inherent credit risk including non-Agency RMBS, residential mortgage loans and net economic interests in securitizations on prime nonconforming residential mortgage loans. Additionally, in the fourth quarter of 2014, we announced our intended expansion into the commercial real estate market, planning an initial allocation of approximately $500 million of equity capital. Our commercial strategy will include first mortgage loans, mezzanine loans, b-notes and preferred equity. As of June 30, 2015 , we had invested $45.6 million in one senior mezzanine commercial real estate loan.
During the three months ended June 30, 2015 , we maintained our hybrid Agency and non-Agency RMBS investment model and continued to develop our operational businesses in support of other mortgage-related investments, which stem from the changing opportunities in the residential mortgage marketplace, including residential mortgage loans and MSR. Within our non-Agency RMBS portfolio, we have historically had a substantial emphasis on “legacy” bonds, which include bonds issued prior to 2009. Throughout the past year, however, we have sold a number of these bonds that we believe had reached maximum value, many of which were replaced with “new issue” non-Agency RMBS. We believe these “new issue” bonds, which include some GSE credit risk transfer bonds, have enabled us to find attractive returns and further diversify our non-Agency RMBS portfolio.
Within our mortgage loan conduit and securitization business, we acquire prime nonconforming residential mortgage loans from select mortgage loan originators and secondary market institutions with the intent to securitize the loans through the issuance of non-Agency mortgage-backed securities. Our intention is to retain the related subordinated securities, representing the credit risk piece associated with these deals. We also hold a small legacy portfolio of credit sensitive residential mortgage loans, or CSL, which are loans that are currently performing, but where the borrower has previously experienced payment delinquencies and is more likely to be underwater ( i.e. , the amount owed on a mortgage loan exceeds the current market value of the home). As a result, there is a higher probability of default on CSL than on newly originated residential mortgage loans. We do not originate loans or provide direct financing to lenders; rather, through our mortgage loan conduit we contract with originators to acquire loans they originate that meet our purchase criteria.

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Within our MSR business, we purchase the right to control the servicing of mortgage loans from high-quality originators. Additionally, as owner of MSR on loans from securitizations guaranteed by Ginnie Mae, we are obligated to purchase these loans from time to time in order to complete modifications on the mortgage loans or to convey foreclosed properties to the U.S. Department of Housing and Urban Development, or HUD. We held a small portfolio of these Ginnie Mae buyout residential mortgage loans as of June 30, 2015 , which, in the majority of instances, will undergo successful loan modifications, return to performing loans and be redelivered to future Ginnie Mae pools or be immediately conveyed to HUD. We do not directly service the mortgage loans we acquire, nor the mortgage loans underlying the MSR we acquire; rather, we contract with fully licensed third-party subservicers to handle substantially all servicing functions.
We believe our investment model allows management to allocate capital across various sectors within the mortgage market, with a focus on asset selection and the implementation of a relative value investment approach. Capital allocation decisions factor in the opportunities in the marketplace, cost of financing and cost of hedging interest rate, prepayment, credit and other portfolio risks. As a result, capital allocation reflects management’s opportunistic approach to investing in the marketplace. The following table provides our capital allocation among the target assets in each of our investment strategies as of June 30, 2015 and the four immediately preceding period ends:
 
As of
 
June 30,
2015
 
March 31,
2015
 
December 31,
2014
 
September 30,
2014
 
June 30,
2014
Rates strategy
 
 
 
 
 
 
 
 
 
Agency RMBS
44%
 
45%
 
44%
 
44%
 
45%
Mortgage servicing rights
11%
 
10%
 
12%
 
12%
 
13%
Credit strategy
 
 
 
 
 
 
 
 
 
Non-Agency RMBS
33%
 
34%
 
34%
 
36%
 
36%
Mortgage loan conduit/securitization
12%
 
11%
 
10%
 
8%
 
6%
Commercial strategy
< 1%
 
< 1%
 
—%
 
—%
 
—%

As our capital allocation shifts, our annualized yields and cost of financing shift. 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 (e.g., uncertainty of prepayment speeds, extension risk and credit events).
For the three months ended June 30, 2015 , our net yield realized on the portfolio was lower than previous periods. Yields and net interest spreads on Agency and non-Agency RMBS, residential mortgage loans held-for-sale and MSR are generally lower than what we have historically realized in our portfolio, while yields and spreads on net economic interests in securitization have remained consistent. Our cost of financing increased as a result of higher swap spread. The following table provides the average annualized yield on our target assets, including Agency and non-Agency RMBS, residential mortgage loans held-for-sale, residential mortgage loans held-for-investment, net of collateralized borrowings, in securitization trusts, commercial real estate loans held-for-investment and MSR for the three months ended June 30, 2015 , and the four immediately preceding quarters:
 
Three Months Ended
 
June 30,
2015
 
March 31,
2015
 
December 31,
2014
 
September 30,
2014
 
June 30,
2014
Average annualized portfolio yield (1)
4.16%
 
4.40%
 
4.46%
 
4.46%
 
4.64%
Cost of financing (2)
1.37%
 
1.33%
 
1.55%
 
1.47%
 
1.26%
Net portfolio yield
2.79%
 
3.07%
 
2.91%
 
2.99%
 
3.38%
____________________
(1)
Average annualized yield incorporates future prepayment, credit loss and other assumptions, all of which are estimates and subject to change.
(2)
Cost of financing includes swap interest rate spread.


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We seek to deploy moderate leverage as part of our investment strategy. We generally finance our RMBS assets through short- and long-term borrowings structured as repurchase agreements and through short- and long-term advances from the Federal Home Loan Bank of Des Moines, or the FHLB. Our Agency RMBS, given their liquidity and high credit quality, are eligible for higher levels of leverage, while non-Agency RMBS, with less liquidity and exposure to credit risk, utilize lower levels of leverage. We may also finance our U.S. Treasuries, which we hold from time to time for trading purposes, and our residential mortgage loans held-for-sale and commercial real estate loans held-for-investment. We believe the debt-to-equity ratio funding our Agency RMBS, non-Agency RMBS, residential mortgage loans held-for-sale and commercial real estate loans held-for-investment is the most meaningful leverage measure as U.S. Treasuries are viewed to be highly liquid in nature and collateralized borrowings on residential mortgage loans held-for-investment in securitization trusts represents term financing with no stated maturity. As a result, our debt-to-equity ratio is determined by our RMBS portfolio mix as well as many additional factors, including the liquidity of our portfolio, the sustainability and price of our financing, diversification of our counterparties and their available capacity to finance our RMBS assets, and anticipated regulatory developments. Over the past several quarters, we have generally maintained a debt-to-equity ratio range of 3.0 to 5.0 times to finance our RMBS portfolio, residential mortgage loans held-for-sale and commercial real estate loans held-for-investment, 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 RMBS portfolio between Agency and non-Agency RMBS depending on the relative value of the assets that are available to purchase from time to time, including at times when we are deploying proceeds from common stock offerings we conduct. The debt-to-equity ratio range has been driven by our relatively stable asset allocation between Agency and non-Agency RMBS, as disclosed above. See the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Repurchase Agreements” for further discussion.
We recognize that investing in our target assets is competitive and that we compete with other entities for attractive investment opportunities. We rely on our management team and our dedicated team of investment professionals provided by our external manager to identify investment opportunities. In addition, we have benefited and expect to continue to benefit from our external manager’s analytical and portfolio management expertise and infrastructure. We believe that our significant focus in the mortgage market, the extensive mortgage market 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. While we do not currently originate or service residential mortgage loans, certain of our subsidiaries have obtained the requisite licenses and approvals to purchase and sell residential mortgage loans and to hold and manage MSR.

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 Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, or the Exchange Act, and that are subject to the safe harbors created by such sections. 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,” “goals,” “future,” “likely,” “may” 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 our Annual Report on Form 10-K for the year ended December 31, 2014 , 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 Securities and Exchange Commission, or SEC, including our 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, except as required by law.
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;

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•
the occurrence, extent and 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 to which we are exposed;
•
legislative and regulatory actions affecting our business;
•
the availability and cost of our target assets;
•
the availability and cost of financing for our target assets, including repurchase agreement financing, lines of credit and financing through the FHLB;
•
declines in home prices;
•
increases in payment delinquencies and defaults on the mortgages comprising and underlying our target assets;
•
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 condensed consolidated statements of comprehensive income and balance sheets, including our stockholders’ equity;
•
our ability to generate cash flow from our target assets;
•
changes in our investment, financing and hedging strategies and the new risks to which those changes may expose us;
•
changes in the competitive landscape within our industry, including changes that may affect our ability to attract and retain personnel;
•
our ability to build and maintain successful relationships with loan originators;
•
our ability to acquire mortgage loans in connection with our mortgage loan conduit program;
•
our ability to securitize the mortgage loans we acquire;
•
our exposure to legal and regulatory claims, including litigation arising from our involvement in securitization transactions and investments in MSR;
•
our ability to acquire MSR and successfully operate our seller-servicer subsidiary and oversee our subservicers;
•
our ability to acquire commercial real estate debt and related assets, and to originate commercial loans, in connection with our commercial real estate initiative;
•
the state of commercial real estate markets, including the demand for commercial loans;
•
our ability to successfully diversify our business into new asset classes, and manage the new risks to which they may expose us;
•
our ability to manage various operational and regulatory risks associated with our business;
•
interruptions in or impairments to our communications and information technology systems;
•
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, including the amortization of purchase premiums and accretion of purchase discounts, and income from our residential mortgage loans and commercial real estate loans. Net interest income, as well as our servicing income, net of subservicing expenses, will fluctuate primarily as a result of changes in market interest rates, our financing costs, and prepayment speeds on our assets. Interest rates, financing costs and prepayment rates vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty. Our operating results will also be affected by default rates and credit losses with respect to the mortgage loans underlying our non-Agency RMBS and in our mortgage and real estate loan portfolios.


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Fair Value Measurement
A significant portion of our assets and liabilities are at fair value and, therefore, our condensed consolidated balance sheets and statements of comprehensive income are significantly affected by fluctuations in market prices. At June 30, 2015 , approximately 90.7% of total assets, or $16.7 billion , and approximately 12.0% of total liabilities, or $1.7 billion , consisted of financial instruments recorded at fair value. See Note 15 - 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. 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. Although markets for asset-backed securities, including RMBS, have modestly stabilized since the severe dislocations experienced as a result of the financial crisis, these markets continue to experience volatility and, as a result, our assets and liabilities will be subject to valuation adjustment as well as changes in the inputs we use to measure fair value.
Any temporary change in the fair value of our available-for-sale, or AFS, securities is recorded as a component of accumulated other comprehensive income and does not impact our earnings. Our condensed consolidated balance sheets and statements of comprehensive income are affected, however, by fluctuations in market prices on the remainder of our financial assets and liabilities recorded at fair value. For the three and six months ended June 30, 2015 , our unrealized fair value gains on interest rate swap and swaption agreements, which are accounted for as derivative trading instruments under U.S. GAAP, positively 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 six months ended June 30, 2015 . Our financial results for the three and six months ended June 30, 2015 were negatively affected by unrealized fair value losses on certain U.S. Treasuries classified as trading instruments due to their short-term investment objectives and residential mortgage loans held-for-sale, and positively affected by unrealized fair value gains on MSR for the three months ended June 30, 2015 . Our financial results for the six months ended June 30, 2015 were negatively affected by unrealized fair value losses on MSR.
For the three and six months ended June 30, 2014 , our unrealized fair value losses on interest rate swap and swaption agreements negatively affected our financial results. The change in fair value of the interest rate swaps was a result of changes to LIBOR, the swap curve and corresponding counterparty borrowing rates during the three and six months ended June 30, 2014 . Our financial results for the three and six months ended June 30, 2014 were positively affected by unrealized fair value gains on certain U.S. Treasuries classified as trading instruments and residential mortgage loans held-for-sale, and negatively affected by unrealized fair value losses on MSR.
In addition, our financial results for the three and six months ended June 30, 2015 and 2014 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, short U.S. Treasuries, put and call options for TBAs and U.S. Treasuries, constant maturity swaps, Markit IOS total return swaps, inverse interest-only securities and forward residential mortgage loan purchase commitments).
We have numerous internal controls in place to help ensure the appropriateness of fair value measurements. Significant fair value measures are subject to detailed analytics and management review and approval. Our entire investment portfolio is priced by third-party brokers and/or by independent pricing providers. We generally receive three or more broker and vendor quotes on pass-through Agency RMBS, and generally receive multiple broker or vendor quotes on all other RMBS instruments, including interest-only Agency RMBS, inverse interest-only Agency RMBS, and non-Agency RMBS. We also typically receive two vendor quotes for the residential mortgage loans and MSR in our investment portfolio. For Agency RMBS, the third-party pricing providers and brokers use pricing models that commonly incorporate such factors as coupons, primary and secondary mortgage rates, rate reset period, issuer, prepayment speeds, credit enhancements and expected life of the security. For non-Agency RMBS, the third-party pricing providers and brokers utilize both observable and unobservable inputs such as pool-specific characteristics ( i.e. , loan age, loan size, credit quality of borrowers, vintage, servicer quality), floating rate indices, prepayment and default assumptions, and recent trading of the same or similar bonds. For residential mortgage loans and MSR, vendors use pricing models that generally incorporate observable inputs such as principal balance, note rate, geographical location, LTV ratios, FICO, appraised value and other loan characteristics, along with observed market yields, securitization economics and trading levels. Additionally for MSR, pricing providers will customarily incorporate loan servicing cost, servicing fee, ancillary income, and earnings rate on escrow as observable inputs. Unobservable or model-driven inputs include forecast cumulative defaults, default curve, forecast loss severity and forecast voluntary prepayment.
We evaluate the prices we receive from both brokers and independent pricing providers by comparing those prices to actual purchase and sale transactions, our internally modeled prices calculated based on market observable rates and credit spreads, and to each other both in current and prior periods. We review and may challenge broker quotes and valuations from third-party pricing providers to ensure that such quotes and valuations are indicative of fair value as a result of this analysis. We then estimate the fair value of each security based upon the median of the final broker quotes received, and we estimate the fair value of residential mortgage loans and MSR based upon the average of prices received from independent providers, subject to internally-established hierarchy and override procedures.

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We utilize “bid side” pricing for our RMBS assets and, as a result, certain assets, especially the most recent purchases, may realize a markdown due to the “bid-offer” spread. To the extent that this occurs, any economic effect of this would be reflected in accumulated other comprehensive income.
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 key macroeconomic factors that impact our business are home prices and the employment and interest rate environments. Home price metrics remained steady through the second quarter of 2015. While home prices are expected to appreciate over the next several years, the pace of the recovery remains muted. Despite a modest easing in recent months, credit standards remain tight and have had the effect of limiting borrowers’ ability to refinance their mortgages notwithstanding low interest rates and government programs that promote refinancing. Employment market conditions remain solid as jobless claims, unemployment and payroll data are showing positive or stable trends, although underemployment levels remain stubbornly high. Other than LTV ratios and cash reserves, employment is the most powerful determinant of homeowners’ ongoing likelihood to pay their mortgages. Home price performance and employment are particularly important to our non-Agency portfolio.
The interest rate environment was volatile in the second quarter of 2015 as interest rates rose higher in May and June. Overall, interest rates remain at historically low levels despite stable employment statistics and other economic indicators. While the market generally expects a modest increase in rates later in 2015, the low interest rate environment is expected to persist in the near term, as the Federal Reserve has made dovish commentary suggesting it will take a measured approach to its interest rate decisions. Additionally, it appears the Federal Reserve will continue to reinvest its mortgage-backed security principal repayments for the foreseeable future.
The U.S. economy continues to navigate headwinds that include global economic lethargy, geopolitical unrest across various regions worldwide, the ongoing European debt crisis, quantitative easing by the European Central Bank, persistently high underemployment, tepid wage inflation and a fragile housing market.
Regulatory and legislative actions taken in the past few years in an effort to improve 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, continue to impact the market. Regulatory actions that could affect the value and availability of our target assets, either positively or negatively, include: attempts by the U.S. government to further simplify the refinancing process to allow more borrowers to refinance into lower interest rate mortgage loans; the streamlined loan modification initiative for borrowers that are 90+ days delinquent implemented by the government sponsored entities, or GSEs; the real estate owned, or REO, to-rental program supported by the GSEs; the extension of both the Home Affordable Modification Program, or HAMP, and the Home Affordable Refinance Program 2.0, or HARP 2.0, through 2016; the strict “ability-to-repay” and “qualified mortgage” regulations promulgated by the Consumer Financial Protection Bureau, or the CFPB; and the application of the risk retention requirements of Section 15G of the Exchange Act.
There are also a number of impending legislative proposals related to the eventual wind-down or phase out of the GSEs. While it remains uncertain if any proposal will ultimately become legislation, it does not appear that meaningful efforts relative to GSE reform will take place in the near future. We will continue to monitor these and other regulatory and policy activities closely.
In fall of 2014, the FHFA published a proposed rulemaking regarding membership in the Federal Home Loan Bank system. Among other effects, the rulemaking would exclude captive insurers from membership, including our subsidiary member, TH Insurance Holdings Company LLC, or TH Insurance. We have no indication of how the FHFA will proceed with the rulemaking, if at all, but we are currently a member in good standing with the FHLB and believe our mission aligns well with that of the Federal Home Loan Bank system. We continue to closely monitor matters that could impact our FHLB membership.
Also in 2014, the U.S. Department of Treasury, or the Treasury, requested comment on the development of a responsible private label securities market. We believe that private capital, through the private label securities market, is a critical component to the long-term stability of the mortgage market and, accordingly, submitted a comment letter in response to the request. The Treasury echoes our sentiment and views a diverse housing finance system with numerous capital streams as critical to promoting competition, market efficiency, and consumer choice.

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We believe our blended Agency and non-Agency RMBS portfolio and our investing expertise, as well as our operational business platforms, will allow us to better navigate the dynamic mortgage market while future regulatory and policy activities take shape. Having a diversified portfolio allows us to mitigate a variety of risks, including interest rate and RMBS spread volatility. As such, we have diversified into several target assets that capitalize on our prepayment and credit expertise, including MSR, prime nonconforming residential mortgage loans and commercial real estate loans.
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 and MSR 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 prior QE programs and continued reinvestment of its mortgage-backed security principal repayments and other policy changes may impact the returns of our Agency RMBS portfolio.
The following table provides the carrying value of our RMBS portfolio by product type:
(dollars in thousands)
June 30,
2015
 
December 31,
2014
Agency
 
 
 
 
 
 
 
Fixed Rate
$
9,981,103

 
76.9
%
 
$
11,164,032

 
76.8
%
Hybrid ARMs
119,710

 
0.9
%
 
128,285

 
0.9
%
Total Agency
10,100,813

 
77.8
%
 
11,292,317

 
77.7
%
Agency Derivatives
176,903

 
1.4
%
 
186,404

 
1.3
%
Non-Agency
 
 
 
 
 
 
 
Senior
1,904,680

 
14.6
%
 
2,370,435

 
16.3
%
Mezzanine
795,071

 
6.1
%
 
670,421

 
4.6
%
Interest-only securities
7,094

 
0.1
%
 
7,929

 
0.1
%
Total Non-Agency
2,706,845

 
20.8
%
 
3,048,785

 
21.0
%
Total
$
12,984,561

 
 
 
$
14,527,506

 
 

Prepayment speeds and volatility due to interest rates
Our Agency RMBS and MSR portfolios are 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 and MSR to deteriorate, and our fixed coupon Agency pools to increase. The inverse relationship occurs when interest rates increase and prepayments slow. As previously discussed, while the market generally expects a modest increase in rates later in 2015, the low interest rate environment is expected to persist in the near term. However, changes in home price performance, key employment metrics and government programs, among other macroeconomic factors, could cause prepayment speeds to increase on many RMBS, which could lead to less attractive reinvestment opportunities. Nonetheless, we believe our portfolio management approach, including our security selection process, positions us to ideally respond to a variety of market scenarios, including an overall faster prepayment environment.
Although we are unable to predict the movement in interest rates in 2015 and beyond, our diversified portfolio management strategy is intended to generate attractive yields with a low level of sensitivity to changes in the yield curve, prepayments and interest rate cycles.
Our portfolio includes Agency securities, which includes bonds with explicit prepayment protection, $85,000 maximum loan balance pools (securities collateralized by loans of less than $85,000 in principal), other low loan balances (securities collateralized by loans of less than $175,000, but more than $85,000 in principal), high 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), home equity conversion mortgages (securities collateralized by reverse mortgages), low FICO scores (lower credit borrowers), and seasoned bonds reflecting less prepayment risk due to previously experienced high levels of refinancing. We believe these RMBS 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 June 30, 2015
 
Agency RMBS AFS
 
Agency Derivatives
 
Total Agency RMBS
(dollars in thousands)
Fixed Rate
 
Hybrid ARMs
 
 
Other low loan balances
$
3,793,833

 
$
—

 
$
—

 
$
3,793,833

 
37
%
$85K Max Pools
1,748,879

 
—

 
—

 
1,748,879

 
17
%
Home equity conversion mortgages
1,691,235

 
—

 
—

 
1,691,235

 
16
%
2006 and subsequent vintages
945,523

 
27,120

 
—

 
972,643

 
10
%
High LTV (predominantly MHA)
458,475

 
—

 
—

 
458,475

 
4
%
Pre-pay lock-out or penalty-based
464,517

 
3,554

 
—

 
468,071

 
5
%
Seasoned (2005 and prior vintages)
205,389

 
89,036

 
125,264

 
419,689

 
4
%
2006 and subsequent vintages - discount
334,194

 
—

 
51,639

 
385,833

 
4
%
Low FICO
339,058

 
—

 
—

 
339,058

 
3
%
Total
$
9,981,103

 
$
119,710

 
$
176,903

 
$
10,277,716

 
100
%
 
As of December 31, 2014
 
Agency RMBS AFS
 
Agency Derivatives
 
Total Agency RMBS
(dollars in thousands)
Fixed Rate
 
Hybrid ARMs
 
 
Other low loan balances
$
3,815,603

 
$
—

 
$
—

 
$
3,815,603

 
33
%
$85K Max Pools
2,529,610

 
—

 
—

 
2,529,610

 
22
%
Home equity conversion mortgages
1,740,830

 
—

 
—

 
1,740,830

 
15
%
2006 and subsequent vintages
1,353,827

 
28,997

 
—

 
1,382,824

 
12
%
High LTV (predominantly MHA)
515,428

 
—

 
—

 
515,428

 
5
%
Pre-pay lock-out or penalty-based
492,333

 
3,670

 
—

 
496,003

 
4
%
Seasoned (2005 and prior vintages)
254,921

 
95,618

 
130,961

 
481,500

 
4
%
2006 and subsequent vintages - discount
347,618

 
—

 
55,443

 
403,061

 
4
%
Low FICO
113,862

 
—

 
—

 
113,862

 
1
%
Total
$
11,164,032

 
$
128,285

 
$
186,404

 
$
11,478,721

 
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 June 30, 2015
(in thousands)
Principal and Interest Securities
 
Interest-Only Securities
 
Total
 
Senior
 
Mezzanine
 
 
Face Value
$
2,511,578

 
$
897,459

 
$
258,158

 
$
3,667,195

Unamortized discount
 
 
 
 
 
 
 
Designated credit reserve
(597,875
)
 
(59,751
)
 
—

 
(657,626
)
Unamortized net discount
(424,032
)
 
(143,840
)
 
(252,152
)
 
(820,024
)
Amortized Cost
$
1,489,671

 
$
693,868

 
$
6,006

 
$
2,189,545


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As of December 31, 2014
(in thousands)
Principal and Interest Securities
 
Interest-Only Securities
 
Total
 
Senior
 
Mezzanine
 
 
Face Value
$
3,213,104

 
$
794,798

 
$
283,970

 
$
4,291,872

Unamortized discount
 
 
 
 
 
 
 
Designated credit reserve
(843,106
)
 
(84,499
)
 
—

 
(927,605
)
Unamortized net discount
(531,531
)
 
(158,465
)
 
(277,372
)
 
(967,368
)
Amortized Cost
$
1,838,467

 
$
551,834

 
$
6,598

 
$
2,396,899


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 and residential mortgage and commercial real estate loans.
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. 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. In addition, the discounted purchase prices paid for our non-Agency RMBS provide additional insulation from credit losses in the event we receive less than 100% of par on such assets. 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. We review our non-Agency RMBS on an ongoing basis using quantitative and qualitative analysis of the risk-adjusted returns on such investments and through on-going asset surveillance. Nevertheless, unanticipated credit losses could occur, adversely impacting our operating results.
We evaluate credit risk on our residential mortgage loans through a comprehensive asset selection process, which includes pre-acquisition due diligence and underwriting. We review our residential mortgage loans on an ongoing basis using quantitative and qualitative analysis and through on-going asset surveillance.
We also evaluate credit risk on our commercial real estate loans through a comprehensive asset selection process, which includes valuing the underlying collateral property as well as the financial and operating capability of the borrower, borrowing entity or loan sponsor. We also assess the financial wherewithal of any loan guarantors, the borrower’s competency in managing and operating the properties, and the overall economic environment, real estate sector, and geographic sub-market in which the borrower operates. We evaluate each loan for impairment at least quarterly and may record an allowance to reduce the carrying value of the loan to the present value of expected future cash flows, if deemed impaired.
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.
As of June 30, 2015 , we had entered into repurchase agreements with 30 counterparties, 23 of which had outstanding balances at June 30, 2015 , including one facility that provides short-term financing for our mortgage loan collateral with outstanding balances at June 30, 2015 . In addition, we held both short- and long-term secured advances from the FHLB. As of June 30, 2015 , we had a total consolidated debt-to-equity ratio of 3.6 times. As of June 30, 2015 , we had $0.9 billion in cash and cash equivalents, approximately $215.4 million of unpledged Agency securities and derivatives and $158.6 million of unpledged non-Agency securities and retained interests from the Company’s on-balance sheet securitizations, which are eliminated in consolidation in accordance with U.S. GAAP. As a result, we had an overall estimated unused borrowing capacity on our unpledged RMBS and retained interests of approximately $312.1 million . We also had approximately $71.8 million of unpledged prime nonconforming residential mortgage loans, $10.9 million of unpledged CSL, and $50.6 million of unpledged Ginnie Mae buyout residential mortgage loans, and an overall estimated unused borrowing capacity on unpledged residential mortgage loans held-for-sale of approximately $64.6 million . As of June 30, 2015 , we did not have any unpledged commercial real estate loans held-for-investment. If borrowing rates and collateral requirements change in the near term, we believe we are subject to less earnings volatility than if we carried higher leverage.

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We also monitor exposure to counterparties involved in our mortgage loan conduit and MSR businesses. In connection with securitization transactions and MSR assets, we are required to make certain representations and warranties to the investors in the RMBS we issue or the loans underlying the MSR we own. If the representations and warranties that we are required to make prove to be inaccurate, we may be obligated to repurchase certain mortgage loans, which may impact the profitability of these businesses. Although we obtain similar representations and warranties from the counterparty from which we acquired the relevant asset, if those representations and warranties do not directly mirror those we make to the investor, or if we are unable to enforce the representations and warranties against the party for a variety of reasons, including the financial condition or insolvency of the counterparty, we may not be able to seek indemnification from our counterparties for any losses attributable to the breach.

Summary of Results of Operations and Financial Condition
Our reported earnings for U.S. GAAP purposes, or GAAP net income, was $221.5 million and $316.3 million ( $0.60 and $0.86 per weighted share) for the three and six months ended June 30, 2015 , as compared to $39.7 million and $10.5 million ( $0.11 and $0.03 per weighted share) for the three and six months ended June 30, 2014 .
With our accounting treatment for AFS securities, unrealized fluctuations in the market values of securities do not impact our GAAP net income (loss) or taxable income but are recognized on our condensed consolidated balance sheets as a change in stockholders’ equity under “accumulated other comprehensive income.” As a result of this fair value accounting through stockholders’ equity, we expect our net income (loss) to have less significant fluctuations and result in less U.S. GAAP to taxable income timing differences, than if the portfolio were accounted for as trading instruments. For the three months ended June 30, 2015 and 2014 , net unrealized losses on AFS securities recognized as other comprehensive loss were $218.8 million and net unrealized gains on AFS securities recognized as other comprehensive income were $191.2 million , respectively, which resulted in comprehensive income of $2.7 million for the three months ended June 30, 2015 as compared to $230.8 million for the three months ended June 30, 2014 . For the six months ended June 30, 2015 and 2014 , net unrealized losses on AFS securities recognized as other comprehensive loss were $224.8 million and net unrealized gains on AFS securities recognized as other comprehensive income were $372.9 million , respectively, which resulted in comprehensive income of $91.5 million for the six months ended June 30, 2015 as compared to $383.4 million for the six months ended June 30, 2014 .
On June 17, 2015 , we declared a cash dividend of $0.26 per share. Our book value per common share for U.S. GAAP purposes was $10.81 at June 30, 2015 , a decrease from $11.08 book value per common share at December 31, 2014 . During this six month period , we recognized a decrease in accumulated other comprehensive income due to net unrealized losses on AFS securities of $224.8 million and declared cash dividends of $190.9 million , driving the overall decrease in book value.

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The following tables present the components of our comprehensive income for the three and six months ended June 30, 2015 and 2014 :
(in thousands, except share data)
 
Three Months Ended
 
Six Months Ended
Income Statement Data:
 
June 30,
 
June 30,
 
 
2015
 
2014
 
2015
 
2014
Interest income:
 
(unaudited)
 
(unaudited)
Available-for-sale securities
 
$
118,129

 
$
127,605

 
$
253,654

 
$
251,518

Trading securities
 
3,981

 
1,940

 
8,676

 
3,866

Residential mortgage loans held-for-sale
 
7,518

 
2,699

 
11,789

 
7,285

Residential mortgage loans held-for-investment in securitization trusts
 
21,830

 
7,761

 
40,067

 
15,654

Commercial real estate loans held-for-investment
 
850

 
—

 
894

 
—

Cash and cash equivalents
 
221

 
144

 
418

 
361

Total interest income
 
152,529

 
140,149

 
315,498

 
278,684

Interest expense:
 
 
 
 
 
 
 
 
Repurchase agreements
 
19,398

 
18,603

 
39,963

 
39,175

Collateralized borrowings in securitization trusts
 
13,131

 
5,592

 
23,839

 
10,945

Federal Home Loan Bank advances
 
2,500

 
755

 
4,730

 
908

Total interest expense
 
35,029

 
24,950

 
68,532

 
51,028

Net interest income
 
117,500

 
115,199

 
246,966

 
227,656

Other-than-temporary impairment losses
 
(170
)
 
—

 
(297
)
 
(212
)
Other income:
 
 
 
 
 
 
 
 
Gain (loss) on investment securities
 
69,932

 
37,688

 
199,389

 
(967
)
Gain (loss) on interest rate swap and swaption agreements
 
44,952

 
(116,019
)
 
(81,491
)
 
(221,547
)
Loss on other derivative instruments
 
(5,484
)
 
(24,202
)
 
(2,517
)
 
(18,401
)
(Loss) gain on residential mortgage loans held-for-sale
 
(6,832
)
 
11,801

 
2,260

 
8,620

Servicing income
 
30,516

 
33,868

 
62,603

 
64,309

Gain (loss) on servicing asset
 
17,635

 
(29,571
)
 
(34,768
)
 
(62,331
)
Other (loss) income
 
(16,609
)
 
21,003

 
(18,466
)
 
21,463

Total other income (loss)
 
134,110

 
(65,432
)
 
127,010

 
(208,854
)
Expenses:
 
 
 
 
 
 
 
 
Management fees
 
12,686

 
12,190

 
25,407

 
24,301

Securitization deal costs
 
2,484

 
—

 
5,095

 
—

Servicing expenses
 
5,899

 
6,857

 
12,615

 
12,082

Other operating expenses
 
15,827

 
14,323

 
31,882

 
28,857

Total expenses
 
36,896

 
33,370

 
74,999

 
65,240

Income (loss) before income taxes
 
214,544

 
16,397

 
298,680

 
(46,650
)
Benefit from for income taxes
 
(6,957
)
 
(23,260
)
 
(17,614
)
 
(57,162
)
Net income
 
$
221,501

 
$
39,657

 
$
316,294

 
$
10,512

Basic and diluted earnings per weighted average common share
 
$
0.60

 
$
0.11

 
$
0.86

 
$
0.03

Dividends declared per common share
 
$
0.26

 
$
0.26

 
$
0.52

 
$
0.52

Basic and diluted weighted average number of shares of common stock
 
367,074,131

 
366,078,124

 
366,792,459

 
365,846,295



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(in thousands)
 
Three Months Ended
 
Six Months Ended
Income Statement Data:
 
June 30,
 
June 30,
 
 
2015
 
2014
 
2015
 
2014
Comprehensive income:
 
(unaudited)
 
(unaudited)
Net income
 
$
221,501

 
$
39,657

 
$
316,294

 
$
10,512

Other comprehensive (loss) income:
 
 
 
 
 
 
 
 
Unrealized (loss) gain on available-for-sale securities, net
 
(218,826
)
 
191,160

 
(224,757
)
 
372,895

Other comprehensive (loss) income
 
(218,826
)
 
191,160

 
(224,757
)
 
372,895

Comprehensive income
 
$
2,675

 
$
230,817

 
$
91,537

 
$
383,407

(in thousands)
 
June 30,
2015
 
December 31,
2014
Balance Sheet Data:
 
 
 
 
(unaudited)
 
 
Available-for-sale securities
 
$
12,807,658

 
$
14,341,102

Total assets
 
$
18,447,721

 
$
21,084,309

Repurchase agreements
 
$
9,422,803

 
$
12,932,463

Federal Home Loan Bank advances
 
$
3,000,000

 
$
2,500,000

Total stockholders’ equity
 
$
3,971,569

 
$
4,068,042


Results of Operations
The following analysis focuses on the results generated during the three and six months ended June 30, 2015 and 2014 .
Interest Income and Average Portfolio Yield
The following tables present the components of interest income and average annualized net asset yield earned by investment type on our AFS securities, trading securities, residential mortgage loans held-for-sale, residential mortgage loans held-for-investment in securitization trusts, commercial real estate loans held-for-investment and Agency Derivatives for the three and six months ended June 30, 2015 and 2014 :
 
Three Months Ended June 30, 2015
 
Six Months Ended June 30, 2015
(dollars in thousands)
Average Balance (1)
 
Interest Income
 
Net Asset Yield
 
Average Balance (1)
 
Interest Income
 
Net Asset Yield
Available-for-sale securities
$
12,435,182

 
$
118,129

 
3.8
%
 
$
12,926,307

 
$
253,654

 
3.9
%
Trading securities
1,996,767

 
3,981

 
0.8
%
 
1,831,154

 
8,676

 
0.9
%
Residential mortgage loans held-for-sale
839,611

 
7,518

 
3.6
%
 
634,310

 
11,789

 
3.7
%
Residential mortgage loans held-for-investment in securitization trusts
2,254,686

 
21,830

 
3.9
%
 
2,065,134

 
40,067

 
3.9
%
Commercial real estate loans held-for-investment
45,583

 
850

 
7.5
%
 
24,427

 
894

 
7.3
%
 
17,571,829

 
152,308

 
3.5
%
 
17,481,332

 
315,080

 
3.6
%
Agency derivatives (2)
160,981

 
6,903

 
17.2
%
 
162,943

 
15,088

 
18.5
%
Total
$
17,732,810

 
$
159,211

 
3.6
%
 
$
17,644,275

 
$
330,168

 
3.7
%

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Three Months Ended June 30, 2014
 
Six Months Ended June 30, 2014
(dollars in thousands)
Average Balance (1)
 
Interest Income
 
Net Asset Yield
 
Average Balance (1)
 
Interest Income
 
Net Asset Yield
Available-for-sale securities
$
12,160,180

 
$
127,605

 
4.2
%
 
$
12,001,266

 
$
251,518

 
4.2
%
Trading securities
996,667

 
1,940

 
0.8
%
 
998,124

 
3,867

 
0.8
%
Residential mortgage loans held-for-sale
253,944

 
2,699

 
4.3
%
 
362,904

 
7,285

 
4.0
%
Residential mortgage loans held-for-investment in securitization trusts
794,771

 
7,761

 
3.9
%
 
801,418

 
15,654

 
3.9
%
Commercial real estate loans held-for-investment
—

 
—

 
—
%
 
—

 
—

 
—
%
 
14,205,562

 
140,005

 
3.9
%
 
14,163,712

 
278,324

 
3.9
%
Agency derivatives (2)
203,831

 
7,928

 
15.6
%
 
208,740

 
14,934

 
14.3
%
Total
$
14,409,393

 
$
147,933

 
4.1
%
 
$
14,372,452

 
$
293,258

 
4.1
%
____________________
(1)
Average balance represents average amortized cost on AFS, trading securities and Agency Derivatives and average unpaid principal balance, adjusted for purchase price changes, on residential mortgage loans held-for-sale, residential mortgage loans held-for-investment in securitization trusts and commercial real estate loans held-for-investment.
(2)
Interest income on Agency Derivatives is included in loss on other derivative instruments on the condensed consolidated statements of comprehensive income.

Total interest income, including interest income on Agency Derivatives, has increased from $147.9 million and $293.3 million for the three and six months ended June 30, 2014 to $159.2 million and $330.2 million for the same periods in 2015 , due primarily to purchases of residential mortgage loans held-for-sale and the completion of multiple securitization transactions in the latter half of 2014 and the first half of 2015, offset by decreases in yields on Agency and non-Agency RMBS.
The decrease in net yields on AFS securities for the three and six months ended June 30, 2015 , as compared to the same periods in 2014 , was predominantly driven by sales of non-Agency RMBS previously purchased at higher yields that we believe had reached maximum value, which were replaced with bonds at lower yields as well as faster prepayments on Agency RMBS. The yields on trading securities for the  three months ended June 30, 2015 were consistent with those for the same period in  2014 . The increase in yields on trading securities for the six months ended June 30, 2015 , as compared to the same period in  2014 , was the result of increases in Treasury rates. The decrease in yields on residential mortgage loans held-for-sale for the three and six months ended   June 30, 2015  as compared to the same period in  2014 , was the result of a decline in market interest rates as well as the sale of substantially all of our CSL portfolio during the first quarter of 2014. The yields on residential mortgage loans held-for-investment in securitization trusts for the  three and six months ended June 30, 2015 were consistent with those for the same periods in  2014 . The increase in net yields on Agency Derivatives for the three and six months ended June 30, 2015 , as compared to the same periods in 2014 , was predominantly driven by slower expectation of prepayments on these interest-only securities. The yield on commercial real estate loans held-for-investment for the three and six months ended June 30, 2015 represents interest income on one commercial real estate loan settled during the first quarter of 2015, which, as a result, is not indicative of future yields.
The following tables present the components of the net yield earned by investment type on our RMBS AFS portfolio as a percentage of our average amortized cost of securities for the three and six months ended June 30, 2015 and 2014 :
 
Three Months Ended June 30, 2015
 
Six Months Ended June 30, 2015
 
Agency (1)
 
Non-Agency
 
Total
 
Agency (1)
 
Non-Agency
 
Total
Gross yield/stated coupon
4.5
 %
 
3.3
%
 
4.3
 %
 
4.5
 %
 
3.2
%
 
4.3
 %
Net (premium amortization) discount accretion
(1.6
)%
 
4.6
%
 
(0.5
)%
 
(1.4
)%
 
4.7
%
 
(0.4
)%
Net yield (2)
2.9
 %
 
7.9
%
 
3.8
 %
 
3.1
 %
 
7.9
%
 
3.9
 %

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Three Months Ended June 30, 2014
 
Six Months Ended June 30, 2014
 
Agency (1)
 
Non-Agency
 
Total
 
Agency (1)
 
Non-Agency
 
Total
Gross yield/stated coupon
4.5
 %
 
3.1
%
 
4.3
 %
 
4.5
 %
 
3.1
%
 
4.2
 %
Net (premium amortization) discount accretion
(1.4
)%
 
5.6
%
 
(0.1
)%
 
(1.4
)%
 
5.7
%
 
—
 %
Net yield (2)
3.1
 %
 
8.7
%
 
4.2
 %
 
3.1
 %
 
8.8
%
 
4.2
 %
____________________
(1)
Excludes Agency Derivatives. For the three and six months ended June 30, 2015 , average annualized net yield on total Agency RMBS, including Agency Derivatives, was 3.1% and 3.3% , respectively, compared to 3.4% for both of the same periods in 2014 .
(2)
These yields have not been adjusted for cost of delay and cost to carry purchase premiums.

The following tables provide the components of interest income and net asset yield by investment type on our RMBS AFS portfolio:
 
Three Months Ended June 30, 2015
 
Six Months Ended June 30, 2015
(dollars in thousands)
Agency  (1)
 
Non-Agency
 
Total
 
Agency  (1)
 
Non-Agency
 
Total
Average amortized cost
$
10,242,687

 
$
2,192,495

 
$
12,435,182

 
$
10,676,950

 
$
2,249,356

 
$
12,926,306

Coupon interest
115,257

 
17,829

 
133,086

 
240,982

 
35,541

 
276,523

Net (premium amortization) discount accretion
(40,251
)
 
25,294

 
(14,957
)
 
(75,628
)
 
52,759

 
(22,869
)
Interest income
$
75,006

 
$
43,123

 
$
118,129

 
$
165,354

 
$
88,300

 
$
253,654

Net asset yield
2.9
%
 
7.9
%
 
3.8
%
 
3.1
%
 
7.9
%
 
3.9
%
 
Three Months Ended June 30, 2014
 
Six Months Ended June 30, 2014
(dollars in thousands)
Agency  (1)
 
Non-Agency
 
Total
 
Agency  (1)
 
Non-Agency
 
Total
Average amortized cost
$
9,848,383

 
$
2,311,797

 
$
12,160,180

 
$
9,763,230

 
$
2,238,036

 
$
12,001,266

Coupon interest
111,662

 
17,808

 
129,470

 
218,524

 
34,833

 
253,357

Net (premium amortization) discount accretion
(34,118
)
 
32,253

 
(1,865
)
 
(65,923
)
 
64,084

 
(1,839
)
Interest income
$
77,544

 
$
50,061

 
$
127,605

 
$
152,601

 
$
98,917

 
$
251,518

Net asset yield
3.1
%
 
8.7
%
 
4.2
%
 
3.1
%
 
8.8
%
 
4.2
%
____________________
(1)
Excludes Agency Derivatives. For the three and six months ended June 30, 2015 , average annualized net yield on total Agency RMBS, including Agency Derivatives, was 3.1% and 3.3% , respectively, compared to 3.4% for both of the same periods in 2014 .

The decrease in net yields on Agency RMBS AFS for the three months ended June 30, 2015 , as compared to the same period in  2014 , was predominantly driven by faster prepayments. The yields on Agency RMBS AFS for the  six months ended June 30, 2015 were consistent with those for the same period in  2014 . The decrease in net yields on non-Agency RMBS for the three and six months ended June 30, 2015 , as compared to the same periods in 2014 , was due to the sale of bonds previously purchased at higher yields that we believe had reached maximum value, which were replaced with bonds at lower yields.

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Interest Expense and the Cost of Funds
The following tables present the components of interest expense and average annualized cost of funds on borrowings incurred by investment type on our AFS securities, Agency Derivatives, trading securities, residential mortgage loans held-for-sale, residential mortgage loans held-for-investment in securitization trusts and commercial real estate loans held-for-investment for the three and six months ended June 30, 2015 and 2014 :
 
Three Months Ended June 30, 2015
 
Six Months Ended June 30, 2015
(dollars in thousands)
Average Balance (1)
 
Interest Expense
 
Cost of Funds (2)
 
Average Balance (1)
 
Interest Expense
 
Cost of Funds (2)
Available-for-sale securities
 
 
 
 
 
 
 
 
 
 
 
Agency (3)
$
9,819,649

 
$
10,502

 
0.4
%
 
$
10,227,512

 
$
21,345

 
0.4
%
Non-Agency
1,850,870

 
8,759

 
1.9
%
 
1,894,072

 
17,680

 
1.9
%
 
11,670,519

 
19,261

 
0.7
%
 
12,121,584

 
39,025

 
0.6
%
Agency derivatives
133,923

 
346

 
1.0
%
 
134,563

 
683

 
1.0
%
Trading securities
1,672,198

 
881

 
0.2
%
 
1,835,364

 
1,727

 
0.2
%
Residential mortgage loans held-for-sale
440,797

 
457

 
0.4
%
 
424,593

 
900

 
0.4
%
Residential mortgage loans held-for-investment in securitization trusts (4)
2,072,674

 
14,025

 
2.7
%
 
1,887,402

 
26,138

 
2.8
%
Commercial real estate loans held-for-investment
12,610

 
59

 
1.9
%
 
6,340

 
59

 
1.9
%
Total
$
16,002,721

 
$
35,029

 
0.9
%
 
$
16,409,846

 
$
68,532

 
0.8
%
 
Three Months Ended June 30, 2014
 
Six Months Ended June 30, 2014
(dollars in thousands)
Average Balance (1)
 
Interest Expense
 
Cost of Funds (2)
 
Average Balance (1)
 
Interest Expense
 
Cost of Funds (2)
Available-for-sale securities
 
 
 
 
 
 
 
 
 
 
 
Agency (3)
$
9,301,465

 
$
9,383

 
0.4
%
 
$
9,177,489

 
$
19,179

 
0.4
%
Non-Agency
1,965,593

 
8,711

 
1.8
%
 
1,910,300

 
17,707

 
1.9
%
 
11,267,058

 
18,094

 
0.6
%
 
11,087,789

 
36,886

 
0.7
%
Agency derivatives
155,961

 
403

 
1.0
%
 
159,125

 
826

 
1.0
%
Trading securities
943,626

 
228

 
0.1
%
 
972,443

 
388

 
0.1
%
Residential mortgage loans held-for-sale
104,330

 
633

 
2.4
%
 
143,762

 
1,983

 
2.8
%
Residential mortgage loans held-for-investment in securitization trusts (4)
630,917

 
5,592

 
3.5
%
 
659,296

 
10,945

 
3.3
%
Commercial real estate loans held-for-investment
—

 
—

 
—
%
 
—

 
—

 
—
%
Total
$
13,101,892

 
$
24,950

 
0.8
%
 
$
13,022,415

 
$
51,028

 
0.8
%
____________________
(1)
Average balance represents average total repurchase agreements and FHLB advances on AFS securities, Agency Derivatives, trading securities, residential mortgage loans held-for-sale and commercial real estate loans held-for-investment, and average collateralized borrowings for residential mortgage loans held-for-investment in securitization trusts.
(2)
Cost of funds by investment type is based on the underlying investment type of the asset assigned as collateral. Cost of funds does not include the accrual and settlement of interest associated with interest rate swaps. In accordance with U.S. GAAP, those costs are included in gain (loss) on interest rate swap and swaption agreements in the condensed consolidated statements of comprehensive income. For the three and six months ended June 30, 2015 , our total average cost of funds on the assets assigned as collateral for repurchase agreements, FHLB advances and collateralized borrowings shown in the table above, including interest spread expense associated with interest rate swaps, was 1.7% and 1.6% , respectively, compared to 1.4% and 1.3% for the same periods in 2014 .
(3)
Excludes Agency Derivatives. For the three and six months ended June 30, 2015 , our average cost of funds on total Agency RMBS, including Agency Derivatives, was 0.4% , compared to 0.4% for both of the same periods in 2014 .
(4)
Includes repurchase agreements and FHLB advances collateralized by retained interests from our on-balance sheet securitizations, which are eliminated in consolidation in accordance with U.S. GAAP.

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Total interest expense has increased from $24.9 million and $51.0 million for the three and six months ended June 30, 2014 to $35.0 million and $68.5 million for the same periods in 2015 , due primarily to increased interest expense on collateralized borrowings due to the completion of multiple securitization transactions in the latter half of 2014 and the first half of 2015.
The cost of funds associated with the financing of Agency RMBS AFS and Agency Derivatives for the  three and six months ended June 30, 2015 and non-Agency RMBS for the six months ended June 30, 2015 were consistent with those for the same periods in  2014 . However, the increase in cost of funds associated with the financing of non-Agency RMBS for the three months ended June 30, 2015 , as compared to the same period in  2014 , was the result of increases in the repurchase agreement borrowing rates offered by counterparties, which are generally based on a specified margin over one-month LIBOR. The increase in cost of funds associated with the financing of trading securities for the three and six months ended June 30, 2015 , as compared to the same periods in 2014 , was due to an increase in U.S. Treasury borrowing rates. The decrease in cost of funds associated with the financing of residential mortgage loans held-for-sale for the three and six months ended June 30, 2015 , as compared to the same periods in  2014 , was the result of a decrease in the outstanding balance under repurchase agreements and increase in the outstanding balance under FHLB advances, which provide lower financing rates. The decrease in cost of funds associated with the financing of residential mortgage loans held-for-investment in securitization trusts for the  three and six months ended June 30, 2015 , as compared to the same periods in  2014 , was primarily the result of an increase in the outstanding balance of FHLB advances collateralized by retained interests from our on-balance sheet securitizations. The cost of funds associated with the financing of commercial real estate loans held-for-investment for the three and six months ended June 30, 2015 represents repurchase agreement financing on one commercial real estate loan started in May 2015, which, as a result, is not indicative of future cost of funds.
Net Interest Income
The following tables present the components of net interest income and average annualized net interest rate spread earned by investment type on our AFS securities, trading securities, residential mortgage loans held-for-sale, residential mortgage loans held-for-investment in securitization trusts, commercial real estate loans held-for-investment and Agency Derivatives for the three and six months ended June 30, 2015 and 2014 :
 
Three Months Ended June 30, 2015
 
Six Months Ended June 30, 2015
(dollars in thousands)
Net Interest Income
 
Net Interest Rate Spread (1)
 
Net Interest Income
 
Net Interest Rate Spread (1)
Available-for-sale securities
 
 
 
 
 
 
 
Agency (2)
$
64,504

 
2.5
%
 
$
144,009

 
2.7
%
Non-Agency
34,364

 
6.0
%
 
70,620

 
6.0
%
 
98,868

 
3.1
%
 
214,629

 
3.3
%
Trading securities
3,100

 
0.6
%
 
6,949

 
0.7
%
Residential mortgage loans held-for-sale
7,061

 
3.2
%
 
10,889

 
3.3
%
Residential mortgage loans held-for-investment in securitization trusts (3)
7,805

 
1.2
%
 
13,929

 
1.1
%
Commercial real estate loans held-for-investment
791

 
5.6
%
 
835

 
12.8
%
 
117,625

 
2.6
%
 
247,231

 
2.8
%
Agency derivatives (4)
6,557

 
16.2
%
 
14,405

 
17.5
%
Total
$
124,182

 
2.7
%
 
$
261,636

 
2.9
%

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Three Months Ended June 30, 2014
 
Six Months Ended June 30, 2014
(dollars in thousands)
Net Interest Income
 
Net Interest Rate Spread (1)
 
Net Interest Income
 
Net Interest Rate Spread (1)
Available-for-sale securities
 
 
 
 
 
 
 
Agency (2)
$
68,161

 
2.7
%
 
$
133,422

 
2.7
%
Non-Agency
41,350

 
6.9
%
 
81,210

 
6.9
%
 
109,511

 
3.6
%
 
214,632

 
3.5
%
Trading securities
1,712

 
0.7
%
 
3,479

 
0.7
%
Residential mortgage loans held-for-sale
2,066

 
1.9
%
 
5,302

 
1.2
%
Residential mortgage loans held-for-investment in securitization trusts (3)
2,169

 
0.4
%
 
4,709

 
0.6
%
Commercial real estate loans held-for-investment
—

 
—
%
 
—

 
—
%
 
115,458

 
3.1
%
 
228,122

 
3.1
%
Agency derivatives (4)
7,525

 
14.6
%
 
14,108

 
13.3
%
Total
$
122,983

 
3.3
%
 
$
242,230

 
3.3
%
____________________
(1)
Net interest rate spread does not include the accrual and settlement of interest associated with interest rate swaps. In accordance with U.S. GAAP, those costs are included in gain (loss) on interest rate swap and swaption agreements in the condensed consolidated statements of comprehensive income. For the three and six months ended June 30, 2015 , our total average net interest rate spread on the assets shown in the table above, including interest spread expense associated with interest rate swaps, was 1.9% and 2.1% , respectively, compared to 2.7% and 2.8% for the same periods in 2014 .
(2)
Excludes Agency Derivatives. For the three and six months ended June 30, 2015 , our average annualized net interest rate spread on total Agency RMBS, including Agency Derivatives, was 2.7% and 2.9% , respectively, compared to 3.0% for both of the same periods in 2014 .
(3)
Net of interest expense on repurchase agreements and FHLB advances collateralized by retained interests from our on-balance sheet securitizations, which are eliminated in consolidation in accordance with U.S. GAAP.
(4)
Interest income on Agency Derivatives is included in loss on other derivative instruments on the condensed consolidated statements of comprehensive income, while interest expense on Agency Derivatives is included in interest expense on repurchase agreements on the condensed consolidated statements of comprehensive income.

The decrease in net interest rate spread on Agency RMBS AFS for the three months ended June 30, 2015 , as compared to the same period in  2014 , was predominantly driven by faster prepayments. The net interest rate spread on Agency RMBS AFS for the  six months ended June 30, 2015 was consistent with the spread for the same period in  2014 . The decrease in net interest rate spread on non-Agency RMBS was due to the sale of bonds previously purchased at higher yields that we believe had reached maximum value, which were replaced with bonds at lower yields.
The decrease in net interest rate spread on trading securities for the three months ended June 30, 2015 , as compared to the same period in  2014 , was due to a slight increase in borrowing rates on U.S. Treasuries. The net interest rate spread on trading securities for the  six months ended June 30, 2015 was consistent with the spread for the same period in  2014 . The increase in net interest spread on our residential mortgage loans held-for-sale for the three and six months ended June 30, 2015 , as compared to the same periods in  2014 , was generally driven by lower financing rates, as discussed above. The increase in net interest spread on our residential mortgage loans held-for-investment in securitization trusts for the three and six months ended June 30, 2015 , as compared to the same periods in  2014 , was generally the result of the securitization transactions completed in the latter half of 2014 and the first half of 2015. The increase in net interest spread on Agency Derivatives for the three and six months ended June 30, 2015 , as compared to the same periods in 2014 , was predominantly driven by slower expectation of prepayments on these interest-only securities.
The net interest rate spread on commercial real estate loans held-for-investment for the three and six months ended June 30, 2015 represents interest income on one commercial real estate loan settled during the first quarter of 2015, net of interest expense on one repurchase agreement started in May 2015, which, as a result, is not indicative of future spreads.

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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 six months ended June 30, 2015 , we recognized $0.2 million and $0.3 million of OTTI losses. For the  three months ended   June 30, 2014 , we did not recognize any OTTI losses, but for the  six months ended   June 30, 2014 , we recognized $0.2 million in OTTI losses. For further information about evaluating AFS securities for other-than-temporary impairments, refer to Note 4 - Available-for-Sale Securities, at Fair Value of the notes to the condensed consolidated financial statements.
Gain (Loss) on Investment Securities
During the three and six months ended June 30, 2015 , we sold AFS securities for $1.7 billion and $2.6 billion with an amortized cost of $1.6 billion and $2.4 billion , for net realized gains of $75.9 million and $193.3 million , respectively. We also sold U.S. Treasuries for $2.0 billion with an amortized cost of $2.0 billion , resulting in realized gains of $7.4 million for both the three and six months ended June 30, 2015 . During the three and six months ended June 30, 2014 , we sold AFS securities for $459.4 million and $1.3 billion with an amortized cost of $423.4 million and $1.3 billion , for net realized gains of $36.0 million and losses of $2.8 million , respectively. We also sold U.S. Treasuries for $44.8 million and $143.4 million with an amortized cost of $44.8 million and $143.0 million , resulting in realized losses of $7,031 and gains of $0.4 million , respectively, for the three and six months ended June 30, 2014 . 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 six months ended June 30, 2015 , trading securities experienced a change in unrealized losses of $13.4 million and $1.4 million , respectively, compared to a change in unrealized gains of $1.7 million and $1.5 million for the same periods in 2014 . The decrease in change in unrealized gains for the three and six months ended June 30, 2015 , as compared to the same periods in 2014 , was driven by the sale of our U.S. Treasuries and corresponding recognition of realized gains during the three and six months ended June 30, 2015 .
Gain (Loss) on Interest Rate Swap and Swaption Agreements
For the three and six months ended June 30, 2015 , we recognized $26.1 million and $53.7 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 paying either a fixed interest rate or LIBOR interest on an average $16.7 billion and $17.5 billion notional for the three and six months ended June 30, 2015 , respectively, to economically hedge/mitigate interest rate exposure (or duration) risk associated with our investment portfolio and our short-term repurchase agreements and FHLB advances, and receiving either LIBOR interest or a fixed interest rate. For the three and six months ended June 30, 2014 , we recognized $18.9 million and $32.7 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 paying either a fixed interest rate or LIBOR interest on an average $23.5 billion and $21.3 billion notional for the three and six months ended June 30, 2014 , respectively, to economically hedge/mitigate interest rate exposure (or duration) risk associated with our investment portfolio and our short-term repurchase agreements and FHLB advances, and receiving either LIBOR interest or a fixed interest rate.
During the three and six months ended June 30, 2015 , we terminated, had agreements mature or had options expire on 29 and 44 interest rate swap and swaption positions of $20.2 billion and $29.5 billion notional, respectively. Upon settlement of the early terminations and option expirations, we paid $23.0 million and $27.6 million in full settlement of our net interest spread liability and recognized $74.9 million and $63.1 million in realized losses on the swaps and swaptions for the three and six months ended June 30, 2015 , respectively, including early termination penalties. During the three and six months ended June 30, 2014 , we terminated, had agreements mature or had options expire on 10 and 17 interest rate swap and swaption positions of $8.8 billion and $11.8 billion notional, respectively. Upon settlement of the early terminations and option expirations, we paid $3.0 million and $3.8 million in full settlement of our net interest spread liability and recognized $5.2 million and $6.4 million in realized losses on the swaps and swaptions for the three and six months ended June 30, 2014 , respectively, including early termination penalties. We elected to terminate certain swaps and swaptions during these periods to align with our investment portfolio.
Also included in our financial results for the three and six months ended June 30, 2015 , was the recognition of a change in unrealized valuation gains of $146.0 million and $35.3 million , respectively, on our interest rate swap and swaption agreements that were accounted for as trading instruments. For the  three and six months ended   June 30, 2014 , we recognized changes in unrealized valuation losses of  $92.0 million  and  $182.4 million , respectively, on our interest rate swap and swaption agreements that were accounted for as trading instruments. The change in fair value of interest rate swaps was a result of changes to LIBOR, the swap curve and corresponding counterparty borrowing rates during the six months ended June 30, 2015 . Since these swaps and swaptions are used for purposes of hedging our interest rate exposure, their unrealized valuation gains and losses are generally offset by unrealized losses and gains in our Agency RMBS AFS portfolio, which are recorded directly to stockholders’ equity through other comprehensive (loss) income.

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The following table provides the net interest spread and gains and losses associated with our interest rate swap and swaption positions:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2015
 
2014
 
2015
 
2014
Net interest spread
$
(26,147
)
 
$
(18,891
)
 
$
(53,673
)
 
$
(32,727
)
Early termination, agreement maturation and option expiration gains (losses)
(74,851
)
 
(5,161
)
 
(63,076
)
 
(6,401
)
Change in unrealized loss on interest rate swap and swaption agreements, at fair value
145,950

 
(91,967
)
 
35,258

 
(182,419
)
Loss on interest rate swap and swaption agreements
$
44,952

 
$
(116,019
)
 
$
(81,491
)
 
$
(221,547
)

Loss on Other Derivative Instruments
Included in our financial results for the three and six months ended June 30, 2015 , was the recognition of $5.5 million and $2.5 million of losses, respectively, on other derivative instruments we hold for purposes of both hedging and non-hedging activities, principally credit default swaps, TBAs, short U.S. Treasuries, put and call options for TBAs and U.S. Treasuries, constant maturity swaps, Markit IOS total return swaps and inverse interest-only securities. Included within the results for the three and six months ended June 30, 2015 , was the recognition of $6.9 million and $15.1 million of interest income, net of accretion on inverse interest-only securities on an average amortized cost basis of $161.0 million and $162.9 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.
Included in our financial results for the three and six months ended June 30, 2014 , was the recognition of $24.2 million and $18.4 million of losses, respectively, on other derivative instruments we hold for purposes of both hedging and non-hedging activities, principally credit default swaps, TBAs, short U.S. Treasuries, put and call options for TBAs, constant maturity swaps, Markit IOS total return swaps and inverse interest-only securities. Included within the results for the three and six months ended June 30, 2014 , was the recognition of $7.9 million and $14.9 million of interest income, net of accretion on inverse interest-only securities on an average amortized cost basis of $203.8 million and $208.7 million , respectively. The remainder represented realized and unrealized net gains (losses) on other derivative instruments. Since our derivative instruments are generally used for purposes of hedging our interest rate and credit risk exposure, their unrealized valuation gains and losses are generally offset by unrealized losses and gains in our RMBS AFS and residential mortgage loan portfolios.
(Loss) Gain on Residential Mortgage Loans Held-for-Sale
For the three and six months ended June 30, 2015 , we recorded losses of $6.8 million and gains of $2.3 million , respectively, on residential mortgage loans held-for-sale. Included within these results was the recognition of losses of $1.7 million and gains of $6.4 million , respectively, on residential mortgage loans held-for-sale and losses of $5.1 million and $4.2 million on commitments to purchase residential mortgage loans held-for-sale for the three and six months ended June 30, 2015 , respectively. For the three and six months ended June 30, 2014 , we recorded gains of $11.8 million and $8.6 million , respectively, on residential mortgage loans held-for-sale. Included within these results was the recognition of gains of $7.6 million and $4.9 million , respectively, on residential mortgage loans held-for-sale and gains of $4.2 million and $3.7 million on commitments to purchase residential mortgage loans held-for-sale for the three and six months ended June 30, 2014 , respectively. The increase in losses (decrease in gains) on residential mortgage loans held-for-sale during the three and six months ended June 30, 2015 , as compared to the same periods in 2014 , were due in part to rising interest rates during the three and six months ended June 30, 2015 as compared to falling interest rates during the three and six months ended June 30, 2014 .
Servicing Income
For the three and six months ended June 30, 2015 , we recognized total servicing income of $30.5 million and $62.6 million , respectively. These amounts include servicing fee income of $29.6 million and $60.8 million , ancillary fee income of $0.6 million and $1.1 million , and float income of $0.4 million and $0.7 million , respectively. For the three and six months ended June 30, 2014 , we recognized total servicing income of $33.9 million and $64.3 million , respectively. These amounts include servicing fee income of $33.1 million and $62.9 million , ancillary fee income of $0.6 million and $1.0 million , and float income of $0.2 million and $0.3 million , respectively. The decrease in servicing income for the three and six months ended June 30, 2015 , as compared to the same periods in 2014 , was the result of a decline in the size of our MSR portfolio due to prepayments.

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Gain (Loss) on Servicing Asset
For the three and six months ended June 30, 2015 , gain on servicing asset of $17.6 million and loss on servicing asset of $34.8 million , respectively, includes a decrease in fair value of MSR due to realization of cash flows (runoff) of $7.8 million and $17.1 million , respectively, and an increase in fair value of MSR due to changes in valuation inputs or assumptions of $25.4 million and a decrease in fair value of MSR due to changes in valuation inputs or assumptions of $17.6 million , respectively. For the three and six months ended June 30, 2014 , loss on servicing asset of $29.6 million and $62.3 million , respectively, includes a decrease in fair value of MSR due to realization of cash flows (runoff) of $13.9 million and $26.4 million and a decrease in fair value of MSR due to changes in valuation inputs or assumptions of $15.7 million and $35.9 million , respectively. The increase in gain (decrease in loss) on servicing asset for the three and six months ended June 30, 2015 , as compared to the same periods in 2014 , was the result of decreased prepayment speeds and a slight decrease in the discount rate.
Other (Loss) Income
For the three and six months ended June 30, 2015 , we recorded other loss of $16.6 million and $18.5 million , which includes $49.1 million in losses on residential mortgage loans held-for-investment in securitization trusts for both respective periods and $31.5 million and $28.6 million in gain, respectively, on collateralized borrowings in securitization trusts. Also included in other (loss) income for the three and six months ended June 30, 2015 was other mortgage loan revenue of $0.1 million and $0.3 million , respectively, and dividend income on our FHLB stock of $0.9 million and $1.7 million for the three and six months ended June 30, 2015 .
For the three and six months ended June 30, 2014 , we recorded other income of $21.0 million and $21.5 million , which includes $36.6 million and $38.6 million in gains, respectively, on residential mortgage loans held-for-investment in securitization trusts and $15.8 million and $17.5 million in losses, respectively, on collateralized borrowings in securitization trusts. Also included in other (loss) income for the three and six months ended June 30, 2014 was other mortgage loan revenue of $0.1 million and $0.3 million , respectively, and dividend income on our FHLB stock of $0.1 million for both the three and six months ended June 30, 2014 . The decrease in other (loss) income for the three and six months ended June 30, 2015 , as compared to the same periods in 2014 , was due in part to rising interest rates during the three and six months ended June 30, 2015 as compared to falling interest rates during the three and six months ended June 30, 2014 .
Management Fees
We incurred management fees of $12.7 million and $25.4 million for the three and six months ended June 30, 2015 and $12.2 million and $24.3 million for the three and six months ended June 30, 2014 , respectively, which are payable to PRCM Advisers, our external manager, under our management agreement. The management fee is calculated based on our stockholders’ equity with certain adjustments outlined in the management agreement. See further discussion of the management fee calculation in Note 23 - Related Party Transactions of the notes to the condensed consolidated financial statements.
Securitization Deal Costs
For the three and six months ended June 30, 2015 , we recognized $2.5 million and $5.1 million in upfront costs related to the sponsoring of securitization trusts. Because we did not participate in any securitization deals during the six months ended June 30, 2014 , we did not incur any securitization deal costs. These costs are included when evaluating the economics of a securitization; however, the election of the fair value option for the assets and liabilities held in the securitization trusts requires the expense to be recognized upfront on the condensed consolidated statements of comprehensive income. Changes in securitization deal costs are directly related to the number and size of securitization trusts sponsored by either third parties or our subsidiaries during the respective periods.
Servicing Expenses
For the three and six months ended June 30, 2015 , we recognized $5.9 million and $12.6 million , respectively, in servicing expenses generally related to the subservicing of residential mortgage loans held-for-sale and MSR, compared to $6.9 million and $12.1 million in servicing expenses recognized during the three and six months ended June 30, 2014 , respectively. Included in servicing expenses for the three and six months ended June 30, 2015 was a decrease in the MSR representation and warranty reserve of $0.9 million and $0.8 million , compared to $0.6 million in reserve expense for both the three and six months ended June 30, 2014 . The decrease in servicing expenses during the three months ended June 30, 2015 , as compared to the same period in 2014 , was the result of a reduction in the MSR representation and warranty reserve. The slight increase in servicing expenses during the six months ended June 30, 2015 , as compared to the same period in 2014 , was due to the timing of certain servicing costs passed on to us by our subservicers.
Other Operating Expenses
For the three and six months ended June 30, 2015 , we recognized $15.8 million and $31.9 million , of other operating expenses, which represents an annualized expense ratio of 1.6% of average equity for both periods, compared to $14.3 million and $28.9 million of expenses, which represents an annualized expense ratio of 1.5% of average equity, for both of the same periods in 2014 . The increase of our operating expense ratio resulted primarily from an increase in expenses related to the personnel and infrastructure to support our residential mortgage loan, MSR and commercial real estate activities.

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Included in other operating expenses are direct and allocated costs incurred by PRCM Advisers on our behalf and reimbursed by us. For the three and six months ended June 30, 2015 , these direct and allocated costs totaled approximately $5.4 million and $10.1 million , respectively, compared to $3.9 million and $7.2 million for the same periods in 2014 . Included in these reimbursed costs was compensation paid to employees of Pine River serving as our principal financial officer and general counsel of $0.2 million and $1.3 million for the three and six months ended June 30, 2015 and $0.2 million and $1.3 million for the three and six months ended June 30, 2014 , respectively. The allocation of compensation paid to employees of Pine River serving as our principal financial officer and general counsel is based on time spent overseeing our company’s activities in accordance with the management agreement. Equity based compensation expense for the three and six months ended June 30, 2015 also includes the amortization of the restricted stock awarded to our executive officers in conjunction with the Company’s Second Restated 2009 Equity Incentive Plan, or the Plan (see discussion in Note 20 - Equity Incentive Plan ), including our chief executive officer, chief investment officer, principal financial officer and general counsel of $1.1 million and $2.6 million , compared to $1.9 million and $3.8 million for the three and six months ended June 30, 2014 , respectively.
We have 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 of our expenses with third-party vendors are paid directly by us.
Income Taxes
During the three and six months ended June 30, 2015 , our TRSs recognized a benefit from income taxes of $7.0 million and $17.6 million , compared to $23.3 million and $57.2 million during the three and six months ended June 30, 2014 , respectively, which for each period was primarily due to losses incurred on derivative instruments held in our TRSs. We currently intend to distribute 100% of our REIT taxable income and comply with all requirements to continue to qualify as a REIT.

Financial Condition
Available-for-Sale Securities, at Fair Value
Agency RMBS
Our Agency RMBS AFS 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 AFS were Fannie Mae or Freddie Mac mortgage pass-through certificates or collateralized mortgage obligations that carry an implied rating of “AAA,” 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.
The table below summarizes certain characteristics of our Agency RMBS AFS securities at June 30, 2015 :
 
June 30, 2015
(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
$
9,051,042

 
$
577,131

 
$
9,628,173

 
$
165,513

 
$
(63,794
)
 
$
9,729,892

 
4.32
%
 
$
108.01

Hybrid/ARM
111,399

 
5,009

 
116,408

 
3,638

 
(336
)
 
119,710

 
3.51
%
 
$
106.05

Total P&I Securities
9,162,441

 
582,140

 
9,744,581

 
169,151

 
(64,130
)
 
9,849,602

 
4.31
%
 
$
107.98

Interest-only securities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fixed
326,102

 
(290,672
)
 
35,430

 
7,018

 
(265
)
 
42,183

 
4.32
%
 
$
15.23

Fixed Other (1)
2,734,036

 
(2,526,966
)
 
207,070

 
13,353

 
(11,395
)
 
209,028

 
1.64
%
 
$
9.25

Total
$
12,222,579

 
$
(2,235,498
)
 
$
9,987,081

 
$
189,522

 
$
(75,790
)
 
$
10,100,813

 
 
 
 
____________________
(1)
Fixed Other represents 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 AFS owned by us as of June 30, 2015 , on an annualized basis, was 8.9% .

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The following table summarizes the number of months until the next re-set for our floating or adjustable rate Agency RMBS AFS mortgage portfolio at June 30, 2015 :
(in thousands)
June 30,
2015
0-12 months
$
118,366

13-36 months
1,344

Total
$
119,710


Non-Agency RMBS
Our non-Agency RMBS portfolio is comprised of senior and mezzanine tranches of mortgage-backed securities, and excludes the retained interests from our on-balance sheet securitizations, as they are eliminated in consolidation in accordance with U.S. GAAP. The following table provides investment information on our non-Agency RMBS as of June 30, 2015 :
 
As of June 30, 2015
(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
$
2,511,578

 
$
(424,032
)
 
$
(597,875
)
 
$
1,489,671

 
$
415,729

 
$
(720
)
 
$
1,904,680

Mezzanine
897,459

 
(143,840
)
 
(59,751
)
 
693,868

 
105,474

 
(4,271
)
 
795,071

Total P&I Securities
3,409,037

 
(567,872
)
 
(657,626
)
 
2,183,539

 
521,203

 
(4,991
)
 
2,699,751

Interest-only securities
258,158

 
(252,152
)
 
—

 
6,006

 
1,088

 
—

 
7,094

Total
$
3,667,195

 
$
(820,024
)
 
$
(657,626
)
 
$
2,189,545

 
$
522,291

 
$
(4,991
)
 
$
2,706,845


The majority of our non-Agency RMBS were rated at June 30, 2015 . 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, based on the Bloomberg Index Rating, a composite of each of the four major credit rating agencies ( i.e. , DBRS Ltd., Moody’s Investors Services, Inc., Standard & Poor’s Corporation and Fitch, Inc.), as of June 30, 2015 :
 
June 30,
2015
AAA
6.6
%
AA
—
%
A
1.0
%
BBB
0.3
%
BB
0.8
%
B
5.1
%
Below B
68.5
%
Not rated
17.7
%
Total
100.0
%


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The size of our non-Agency RMBS portfolio has decreased slightly since June 30, 2014 . Our allocation of non-Agency RMBS to prime securities has increased from 10.9% at June 30, 2014 to 11.6% at June 30, 2015 . Conversely, our allocation of non-Agency RMBS to subprime securities has decreased from 78.3% at June 30, 2014 to 65.2% at June 30, 2015 . As a result, our designated credit reserve as a percentage of total discount and total face value has also decreased (as disclosed in Note 4 - Available-for-Sale Securities, at Fair Value of the notes to the condensed consolidated financial statements). When focused on principal and interest securities, from June 30, 2014 to June 30, 2015 , our designated credit reserve as a percentage of total discount decreased from 60.6% to 53.7% and our designated credit reserve as a percentage of total face value decreased from 25.4% to 17.9% . As our allocation of non-Agency RMBS to subprime securities has decreased over the period from June 30, 2014 to June 30, 2015 , we believe these comparable portfolio metrics are reflective of our investment profile, regardless of portfolio size.
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.
Within our non-Agency RMBS portfolio, we have historically had a substantial emphasis on “legacy” bonds, which include bonds issued prior to 2009, many subprime. We believe these deeply discounted bonds can add relative value as the economy and housing markets continue to improve. There remains upside optionality to lower delinquencies, higher recoveries and faster prepays. Throughout the past year, however, we have sold a number of these bonds that we believe had reached maximum value, many of which were replaced with “new issue” non-Agency RMBS. We believe these “new issue” bonds, which include some GSE credit risk transfer bonds, have enabled us to find attractive returns and further diversify our non-Agency RMBS portfolio. Our allocation of non-Agency RMBS to “legacy” bonds has decreased from 92.4% at June 30, 2014 to 86.7% at June 30, 2015 . Conversely, our allocation of non-Agency RMBS to “new issue” bonds has increased from 7.6% at June 30, 2014 to 13.3% at June 30, 2015 .
The following tables present certain information by investment type and, if applicable, their respective underlying loan characteristics for our senior and mezzanine non-Agency RMBS, excluding our non-Agency interest-only portfolio, at June 30, 2015 :
 
At June 30, 2015
Non-Agency Principal and Interest (P&I) RMBS
Senior Bonds
 
Mezzanine Bonds
 
Total P&I Bonds
Carrying Value (in thousands)
$
1,904,680

 
$
795,071

 
$
2,699,751

% of Non-Agency Portfolio
70.6
%
 
29.4
%
 
100.0
%
Average Purchase Price (1)
$
57.24

 
$
76.78

 
$
62.99

Average Coupon
2.7
%
 
2.7
%
 
2.7
%
Average Fixed Coupon
4.2
%
 
5.5
%
 
4.3
%
Average Floating Coupon
2.1
%
 
2.6
%
 
2.3
%
Average Hybrid Coupon
5.2
%
 
—
%
 
5.2
%
Collateral Attributes
 
 
 
 
 
Avg Loan Age (months)
98

 
78

 
92

Avg Loan Size (in thousands)
$
385

 
$
294

 
$
361

Avg Original Loan-to-Value
71.1
%
 
73.0
%
 
71.6
%
Avg Original FICO (2)
647

 
692

 
659

Current Performance
 
 
 
 
 
60+ day delinquencies
26.4
%
 
14.3
%
 
23.1
%
Average Credit Enhancement (3)
8.9
%
 
14.7
%
 
10.4
%
3-Month CPR (4)
4.3
%
 
10.5
%
 
6.0
%
____________________
(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 $53.12 , $73.75 , and $58.55 , respectively, at June 30, 2015 .
(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.

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June 30, 2015
(dollars in thousands)
Senior Bonds
 
Mezzanine Bonds
 
Total Bonds
Collateral Type
Carrying Value
 
% of Senior Bonds
 
Carrying Value
 
% of Mezzanine Bonds
 
Carrying Value
 
% of Non-Agency Portfolio
Prime
$
269,026

 
14.1
%
 
$
43,428

 
5.5
%
 
$
312,454

 
11.6
%
Alt-A
64,129

 
3.4
%
 
23,251

 
2.9
%
 
87,380

 
3.2
%
POA
152,132

 
8.0
%
 
29,609

 
3.7
%
 
181,741

 
6.7
%
Subprime
1,419,393

 
74.5
%
 
339,967

 
42.8
%
 
1,759,360

 
65.2
%
Other
—

 
—
%
 
358,816

 
45.1
%
 
358,816

 
13.3
%
 
$
1,904,680

 
100.0
%
 
$
795,071

 
100.0
%
 
$
2,699,751

 
100.0
%
 
June 30, 2015
(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
$
451,719

 
23.7
%
 
$
23,617

 
3.0
%
 
$
475,336

 
17.6
%
Hybrid or Floating
1,452,961

 
76.3
%
 
771,454

 
97.0
%
 
2,224,415

 
82.4
%
 
$
1,904,680

 
100.0
%
 
$
795,071

 
100.0
%
 
$
2,699,751

 
100.0
%
 
June 30, 2015
(dollars in thousands)
Senior Bonds
 
Mezzanine Bonds
 
Total Bonds
Origination Year
Carrying Value
 
% of Senior Bonds
 
Carrying Value
 
% of Mezzanine Bonds
 
Carrying Value
 
% of Non-Agency Portfolio
2006+
$
1,631,980

 
85.7
%
 
$
448,895

 
56.4
%
 
$
2,080,875

 
77.0
%
2002-2005
268,666

 
14.1
%
 
345,649

 
43.5
%
 
614,315

 
22.8
%
Pre-2002
4,034

 
0.2
%
 
527

 
0.1
%
 
4,561

 
0.2
%
 
$
1,904,680

 
100.0
%
 
$
795,071

 
100.0
%
 
$
2,699,751

 
100.0
%

Residential Mortgage Loans Held-for-Sale, at Fair Value
We acquire prime nonconforming residential mortgage loans from select mortgage loan originators and secondary market institutions. As of June 30, 2015 , we held prime nonconforming residential mortgage loans with a carrying value of $633.6 million and had outstanding commitments to purchase $626.7 million of residential mortgage loans, subject to fallout if the loans do not close. Our intention is to securitize these loans and/or exit through a whole loan sale.
In 2013, we acquired a portfolio of CSL, which are loans that are currently performing, but where the borrower has previously experienced payment delinquencies and is more likely to be underwater ( i.e. , the amount owed on a mortgage loan exceeds the current market value of the home). As a result, there is a higher probability of default than on newly originated residential mortgage loans. We subsequently sold substantially all of our CSL portfolio during the first quarter of 2014. As of June 30, 2015 , we had CSL with a carrying value of $10.9 million remaining.
Additionally, as owner of MSR on loans from securitizations guaranteed by Ginnie Mae, we are obligated to purchase these loans from time to time in order to complete modifications on the mortgage loans or to convey foreclosed properties to HUD. As of June 30, 2015 , we held Ginnie Mae buyout residential mortgage loans with a carrying value of $50.6 million , which, in the majority of instances, will undergo successful loan modifications, return to performing loans and be redelivered to future Ginnie Mae pools or be immediately conveyed to HUD.

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The following table presents our residential mortgage loans held-for-sale portfolio by loan type as of June 30, 2015 :
 
June 30, 2015
(in thousands)
Unpaid Principal Balance
 
Fair Value - Purchase Price
 
Fair Value - Unrealized
 
Carrying Value
Prime nonconforming residential mortgage loans
$
630,435

 
$
10,660

 
$
(7,517
)
 
$
633,578

Credit sensitive residential mortgage loans
19,294

 
(5,707
)
 
(2,737
)
 
10,850

Ginnie Mae buyout residential mortgage loans
54,237

 
(3,918
)
 
331

 
50,650

Residential mortgage loans held-for-sale
$
703,966

 
$
1,035

 
$
(9,923
)
 
$
695,078


Residential Mortgage Loans Held-for-Investment in Securitization Trusts, at Fair Value
We purchase subordinated debt and excess servicing rights from securitization trusts sponsored by either third parties or our subsidiaries. The underlying residential mortgage loans held by the trusts, which are consolidated on our condensed consolidated balance sheets, are classified as residential mortgage loans held-for-investment in securitization trusts and carried at fair value as a result of a fair value option election. See Note 3 - Variable Interest Entities to the Condensed Consolidated Financial Statements for additional information regarding consolidation of the securitization trusts. As of June 30, 2015 , residential mortgage loans held-for-investment in securitization trusts had a carrying value of $2.4 billion .
Commercial Real Estate Loans Held-for-Investment
We are the sole certificate holder of a trust entity that holds a commercial real estate loan. The underlying loan held by the trust, which is consolidated on our condensed consolidated balance sheet, is classified as commercial real estate loans held-for-investment and carried at cost, net of any unamortized premiums or discounts, unless deemed impaired. See Note 3 - Variable Interest Entities for additional information regarding consolidation of the trust. As of June 30, 2015 , our commercial real estate loans held-for-investment were comprised of one newly-issued senior mezzanine loan with a two-year interest-only term and carrying value of $45.6 million .
Mortgage Servicing Rights, at Fair Value
One of our wholly owned subsidiaries has approvals from Fannie Mae, Freddie Mac and Ginnie Mae to hold and manage MSR, which represent the right to control the servicing of mortgage loans. We do not directly service mortgage loans, and instead contract with fully licensed subservicers to handle substantially all servicing functions for the loans underlying our MSR. As of June 30, 2015 our MSR had a fair market value of $437.6 million .
As of June 30, 2015 , our MSR portfolio included MSR on 214,745 loans with an unpaid principal balance of approximately $42.8 billion . The following table summarizes certain characteristics of the loans underlying our MSR at June 30, 2015 :
 
At June 30, 2015
 
Government FHA (1)
 
Government VA/USDA (1)
 
Conventional (2)
 
Total
Unpaid principal balance (in thousands)
$
8,187,381

 
$
2,789,337

 
$
31,834,576

 
$
42,811,294

Number of loans
56,429

 
14,901

 
143,415

 
214,745

Average Coupon
4.4
%
 
3.9
%
 
3.8
%
 
3.9
%
Avg Loan Age (months)
51

 
39

 
31

 
35

Avg Loan Size (in thousands)
$
145

 
$
187

 
$
222

 
$
199

Avg Original Loan-to-Value
92.3
%
 
96.1
%
 
67.6
%
 
74.2
%
Avg Original FICO
699

 
719

 
764

 
749

60+ day delinquencies
5.0
%
 
2.6
%
 
0.3
%
 
1.4
%
3-Month CPR
19.4
%
 
17.2
%
 
13.3
%
 
14.8
%
____________________
(1)
Includes loans issued by Ginnie Mae.
(2)
Includes loans issued by Fannie Mae, Freddie Mac or private investors.

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Repurchase Agreements and Federal Home Loan Bank of Des Moines Advances
Our borrowings consist primarily of repurchase agreements and FHLB advances collateralized by our pledge of AFS securities, derivative instruments, residential mortgage loans, commercial real estate loans and certain cash balances. Substantially all of our Agency RMBS AFS are currently pledged as collateral, and the majority of our non-Agency RMBS have been pledged, either through repurchase agreements or FHLB advances. As of June 30, 2015 , our total consolidated debt-to-equity ratio was 3.6 :1.0. The debt-to-equity ratio funding our RMBS AFS, residential mortgage loans held-for-sale, commercial real estate loans held-for-investment and Agency Derivatives only was 3.1 :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.
At June 30, 2015 , repurchase agreements and FHLB advances had the following characteristics:
(dollars in thousands)
 
June 30, 2015
Collateral Type
 
Amount Outstanding
 
Weighted Average Borrowing Rate
 
Weighted Average Haircut on Collateral Value
Agency RMBS
 
$
9,438,364

 
0.43
%
 
6.0
%
Non-Agency RMBS (1)
 
2,386,050

 
1.56
%
 
25.9
%
Agency Derivatives
 
132,867

 
1.03
%
 
26.5
%
Residential mortgage loans held-for-sale
 
442,572

 
0.40
%
 
21.9
%
Commercial real estate loans held-for-investment
 
22,950

 
1.84
%
 
50.0
%
Total
 
$
12,422,803

 
0.66
%
 
10.7
%
____________________
(1)
Includes repurchase agreements and FHLB advances collateralized by retained interests from the Company’s on-balance sheet securitizations which are eliminated in consolidation in accordance with U.S. GAAP.

As of June 30, 2015 , we had outstanding $9.4 billion of repurchase agreements, and the term to maturity ranged from one day to over 11 months . Repurchase agreements had a weighted average borrowing rate of 0.8% and weighted average remaining maturities of 69 days as of June 30, 2015 .
As of June 30, 2015 , we had outstanding $3.0 billion of FHLB advances. As of June 30, 2015 , the weighted average term to maturity of our FHLB advances was 137 months, ranging from approximately 18 months to over 19 years . The weighted average cost of funds for our advances was 0.35% at June 30, 2015 .
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 and FHLB advances (total borrowings) for the three months ended June 30, 2015 , and the four immediately preceding quarters:
(dollars in thousands)
Quarterly Average (1)
 
End of Period Balance (1)
 
Maximum Balance of Any Month-End (1)
 
Total Borrowings to Equity Ratio
For the Three Months Ended June 30, 2015
$
12,809,115

 
$
12,422,803

 
$
12,763,673

 
3.1
:1.0
For the Three Months Ended March 31, 2015
$
13,598,611

 
$
13,718,628

 
$
13,843,240

 
3.4
:1.0
For the Three Months Ended December 31, 2014
$
12,726,721

 
$
13,436,213

 
$
13,436,213

 
3.3
:1.0
For the Three Months Ended September 30, 2014
$
11,626,507

 
$
11,788,628

 
$
11,788,628

 
2.9
:1.0
For the Three Months Ended June 30, 2014
$
11,527,349

 
$
11,891,187

 
$
11,891,187

 
2.9
:1.0
____________________
(1)
Includes repurchase agreements and FHLB advances collateralized by RMBS AFS, residential mortgage loans held-for-sale, commercial real estate loans held-for-investment and Agency Derivatives and excludes repurchase agreements collateralized by U.S. Treasuries and collateralized borrowings in securitization trusts.


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Collateralized Borrowings in Securitization Trusts, at Fair Value
We purchase subordinated debt and excess servicing rights from securitization trusts sponsored by either third parties or our subsidiaries. The underlying debt held by the trusts, which are consolidated on our condensed consolidated balance sheets, is classified as collateralized borrowings in securitization trusts and carried at fair value as a result of a fair value option election. See Note 3 - Variable Interest Entities to the Condensed Consolidated Financial Statements for additional information regarding consolidation of the securitization trusts. As of June 30, 2015 , collateralized borrowings in securitization trusts had a carrying value of $1.7 billion with a weighted average interest rate of 3.6% . The stated maturity dates for all collateralized borrowings are more than five years from June 30, 2015 .
Equity
As of June 30, 2015 , our stockholders’ equity was $4.0 billion and our book value per share was $10.81 . As of March 31, 2015 , our stockholders’ equity was $4.1 billion and our book value per share was $11.08 .
The following table provides details of our changes in stockholders’ equity from March 31, 2015 to June 30, 2015 :
(dollars in millions, except per share amounts)
Book Value
 
Common Shares Outstanding
 
Book Value Per Share
Stockholders' equity at March 31, 2015
$
4,061.5

 
366.6

 
$
11.08

GAAP net income:
 
 
 
 
 
Core Earnings, net of tax expense of $0.4 million (1)
80.2

 
 
 
 
Realized gains and losses, net of tax benefit of $2.5 million
4.0

 
 
 
 
Unrealized mark-to-market gains and losses, net of tax benefit of $4.9 million
137.3

 
 
 
 
Total GAAP net income
221.5

 
 
 
 
Other comprehensive loss
(218.8
)
 
 
 
 
Dividend declaration
(95.5
)
 
 
 
 
Other
2.9

 
0.9

 
 
Balance before capital transactions
3,971.6

 
367.5

 


Issuance of common stock, net of offering costs
—

 
—

 
 
Stockholders' equity at June 30, 2015
$
3,971.6

 
367.5

 
$
10.81

____________________
(1)
Core Earnings is a non-U.S. GAAP measure that we define as GAAP net income, excluding impairment losses, realized and unrealized gains or losses on the aggregate portfolio, amortization of business combination intangible assets, reserve expense for representation and warranty obligations on MSR and certain upfront costs related to securitization transactions. As defined, Core Earnings includes interest income or expense and premium income or loss on derivative instruments and servicing income, net of estimated amortization on MSR. Core Earnings is provided for purposes of comparability to other peer issuers.

Equity Incentive Plan
Our Second Restated 2009 Equity Incentive Plan was approved by our stockholders on May 14, 2015. The Plan provides incentive compensation to attract and retain qualified directors, officers, advisors, consultants and other personnel, including PRCM Advisers and its affiliates. The Plan is administered by the compensation committee of our board of directors. The Plan provides for grants of common stock, restricted common stock, phantom shares, dividend equivalent rights and other equity-based awards, subject to a ceiling of 13,000,000 shares. In addition, with respect to awards intended to qualify for relief from the limitations of Section 162(m) of the Code, the maximum number of shares that may underlie awards over any three-year period to any eligible person may not exceed 1,500,000 as options and 600,000 as other grants. Section 162(m) generally disallows a federal income tax deduction for any publicly held corporation with respect to compensation exceeding $1 million (on a per employee basis) paid in any year to the corporation’s chief executive officer or to any of the corporation’s three other most highly compensated executive officers, other than its chief financial officer. Because we do not have any employees, management does not believe that Section 162(m) is applicable to us and, therefore, does not currently consider and has not previously considered the effects of Section 162(m) with respect to the granting of awards under the Plan. As such, certain individual restricted stock awards previously disclosed in our proxy statements and other filings with the SEC have exceeded 600,000 shares, as permitted under the Plan. See  Note 20  -  Equity Incentive Plan  for further details regarding the Plan.


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Liquidity and Capital Resources
Our liquidity and capital resources are managed and forecast on a daily basis. We believe this ensures that we have sufficient liquidity to absorb market events that could negatively impact collateral valuations and result in margin calls, and 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 and FHLB advances, payments of principal and interest we receive on our target assets, 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, residential mortgage loans, MSR, commercial real estate debt and related assets and other target assets and for other general corporate purposes.
As of June 30, 2015 , we held $0.9 billion in cash and cash equivalents available to support our operations, $16.7 billion of AFS securities, residential mortgage loans held-for-sale, residential mortgage loans held-for-investment in securitization trusts, commercial real estate loans held-for-investment, MSR and derivative assets held at fair value, and $14.1 billion of outstanding debt in the form of repurchase agreements, FHLB advances and collateralized borrowings in securitization trusts. During the three months ended June 30, 2015 , our total consolidated debt-to-equity ratio decreased from 4.2 :1.0 to 3.6 :1.0 (excludes payables due to broker counterparties for unsettled securities purchases; however, at June 30, 2015 , we did not have any such payables). The debt-to-equity ratio funding our RMBS AFS, residential mortgage loans held-for-sale, commercial real estate loans held-for-investment and Agency Derivatives only also decreased from 3.4 :1.0 to 3.1 :1.0 due to the repayment of repurchase agreements as a result of sales of AFS securities of $1.6 billion during the three months ended June 30, 2015 . We believe the debt-to-equity ratio funding our RMBS AFS, residential mortgage loans held-for-sale, commercial real estate loans held-for-investment and Agency Derivatives is the most meaningful debt-to-equity measure as U.S. Treasuries are viewed to be highly liquid in nature and collateralized borrowings on residential mortgage loans held-for-investment in securitization trusts represents term financing with no stated maturity.
As of June 30, 2015 , we had approximately $215.4 million of unpledged Agency RMBS AFS and Agency Derivatives and $158.6 million of unpledged non-Agency securities and retained interests from our on-balance sheet securitizations, which are eliminated in consolidation in accordance with U.S. GAAP. As a result, we had an overall estimated unused borrowing capacity on unpledged RMBS and retained interests of approximately $312.1 million . We also had approximately $71.8 million of unpledged prime nonconforming residential mortgage loans, $10.9 million of unpledged CSL, $50.6 million of unpledged Ginnie Mae buyout residential mortgage loans and an overall estimated unused borrowing capacity on unpledged residential mortgage loans held-for-sale of approximately $64.6 million . As of June 30, 2015 , we did not have any unpledged commercial real estate loans held-for-investment. 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/or collateral requirements change in the near term, we believe we are subject to less earnings volatility than a more leveraged organization.
During the six months ended June 30, 2015 , we did not experience any restrictions to our funding sources and have generally experienced an increase in available financing in the RMBS marketplace, including FHLB advances with maturities greater than one year. We expect ongoing sources of financing to be primarily repurchase agreements, FHLB advances 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.
As of June 30, 2015 , we have master repurchase agreements in place with 30 counterparties (lenders), 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 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.

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The following table summarizes our repurchase agreements and counterparty geographical concentration at June 30, 2015 and December 31, 2014 :
 
June 30, 2015
 
December 31, 2014
(dollars in thousands)
Amount Outstanding
 
Net Counterparty Exposure (1)
 
Percent of Funding
 
Amount Outstanding
 
Net Counterparty Exposure (1)
 
Percent of Funding
North America
$
5,804,879

 
$
919,409

 
64.5
%
 
$
8,331,244

 
$
974,519

 
57.9
%
Europe (2)
2,229,597

 
420,232

 
29.5
%
 
2,950,991

 
604,711

 
35.9
%
Asia (2)
1,388,327

 
85,766

 
6.0
%
 
1,650,228

 
103,571

 
6.2
%
Total
$
9,422,803

 
$
1,425,407

 
100.0
%
 
$
12,932,463

 
$
1,682,801

 
100.0
%
____________________
(1)
Represents the net carrying value of the securities, residential mortgage loans held-for-sale and commercial real estate loans held-for-investment 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. Payables due to broker counterparties for unsettled securities purchases are not included in the amounts presented above. However, at both June 30, 2015 and  December 31, 2014 , we did not have any such payables.
(2)
Exposure to European and Asian domiciled banks and their U.S. subsidiaries.

In addition to our master repurchase agreements to fund our RMBS and commercial real estate loans held-for-investment, we have two facilities that provide short-term financing for our mortgage loan collateral during our aggregation period. An overview of the facilities is presented in the table below:
(dollars in thousands)
 
 
 
 
 
 
 
 
As of June 30, 2015
Expiration Date
 
Committed
 
Amount Outstanding
 
Unused Capacity
 
Total Capacity
 
Eligible Collateral
May 10, 2016
(1)  
 
No
 
$
—

 
$
50,000

 
$
50,000

 
Prime nonconforming residential mortgage loans
May 19, 2016
(1)  
 
No
 
$
9,454

 
$
190,546

 
$
200,000

 
Prime nonconforming residential mortgage loans
 
 
 
 
 
 
 
 
 
 
Credit sensitive residential mortgage loans
____________________
(1)
The facilities are set to mature on the stated expiration date, unless extended pursuant to their terms.

Our wholly owned subsidiary, TH Insurance, is a member in the FHLB. As a member of the FHLB, TH Insurance has access to a variety of products and services offered by the FHLB, including secured advances. As of June 30, 2015 , TH Insurance had $3.0 billion in outstanding secured advances with a weighted average borrowing rate of 0.35% , and had an additional  $1.0 billion  of available uncommitted capacity for borrowings. To the extent TH Insurance has uncommitted capacity, it may be adjusted at the sole discretion of the FHLB.
The ability to borrow from the FHLB is subject to our continued creditworthiness, pledging of sufficient eligible collateral to secure advances, and compliance with certain agreements with the FHLB. Each advance requires approval by the FHLB and is secured by collateral in accordance with the FHLB’s credit and collateral guidelines, as may be revised from time to time by the FHLB. Eligible collateral may include conventional 1-4 family residential mortgage loans, commercial real estate loans, Agency RMBS and certain non-Agency RMBS with a rating of A and above.
In fall of 2014, the FHFA published a proposed rulemaking regarding membership in the Federal Home Loan Bank system. Among other effects, the rulemaking would exclude captive insurers from membership, including our subsidiary member, TH Insurance. We have no indication of what, if anything, will come of the proposal, but we are currently a member in good standing with the FHLB and believe our mission aligns well with that of the Federal Home Loan Bank system. We continue to closely monitor matters that could impact our FHLB membership.

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We are subject to a variety of financial covenants under our lending agreements. The following represent the most restrictive financial covenants across the agreements as of June 30, 2015 :
(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 June 30, 2015 , our debt to net worth, as defined, was 3.6 :1.0 while our threshold ratio, as defined, was 5.4 :1.0.
(b)
As of the last business day of each calendar quarter, liquidity must be greater than $100 million and the aggregate amount of unrestricted cash or cash equivalents must be greater than $35 million. As of June 30, 2015 , our liquidity, as defined, was $1.5 billion and our total unrestricted cash and cash equivalents, as defined, was $0.9 billion .
(c)
As of the last business day of each calendar quarter, net worth must be greater than $1.75 billion. As of June 30, 2015 , our net worth, as defined, was $4.0 billion .
We are also subject to additional financial covenants in connection with various other 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 values that are pledged or restricted as collateral for the future payment obligations of repurchase agreements and FHLB advances.
(in thousands)
June 30,
2015
 
December 31,
2014
Available-for-sale securities, at fair value
$
12,553,084

 
$
14,159,315

Trading securities, at fair value
—

 
1,997,656

Residential mortgage loans held-for-sale, at fair value
561,802

 
416,779

Commercial real estate loans held-for-investment
45,605

 
—

Net economic interests in consolidated securitization trusts (1)
605,094

 
367,468

Cash and cash equivalents
15,000

 
14,117

Restricted cash
182,709

 
112,435

Due from counterparties
24,252

 
38,200

Derivative assets, at fair value
176,017

 
185,067

Total
$
14,163,563

 
$
17,291,037

____________________
(1)
Includes the retained interests from the Company’s on-balance sheet securitizations, which are eliminated in consolidation in accordance with U.S. GAAP.

Although we generally intend to hold our target assets as long-term investments, we may sell certain of our assets in order to manage our interest rate risk and liquidity needs, to meet other operating objectives and to adapt to market conditions. Our RMBS are generally publicly traded and, thus, readily liquid. However, certain of our assets, including residential mortgage loans and MSR, are subject to longer trade timelines, and, as a result, market conditions could significantly and adversely affect the liquidity of our assets. Any illiquidity of our assets may make it difficult for us to sell such assets if the need or desire arises. Our ability to quickly sell certain assets, such as mortgage loans and MSR, may be limited by delays encountered while obtaining certain regulatory approvals required for such dispositions and may be further limited by delays due to the time period needed for negotiating transaction documents, conducting diligence, and complying with regulatory requirements regarding the transfer of such assets before settlement may occur. Consequently, even if we identify a buyer for our residential mortgage loans and MSR, there is no assurance that we would be able to quickly sell such assets if the need or desire arises.
In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we previously recorded our assets. Assets that are illiquid are more difficult to finance, and to the extent that we use leverage to finance assets that become illiquid, we may lose that leverage or have it reduced. Assets tend to become less liquid during times of financial stress, which is often the time that liquidity is most needed. As a result, our ability to sell assets or vary our portfolio in response to changes in economic and other conditions may be limited by liquidity constraints, which could adversely affect our results of operations and financial condition.
We cannot predict the timing and impact of future sales of our assets, if any. Because many of our assets are financed with repurchase agreements and FHLB advances, and may be financed with credit facilities (including term loans and revolving facilities), a significant portion of the proceeds from sales of our assets (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 and FHLB advances as of June 30, 2015 and December 31, 2014 :
(in thousands)
June 30,
2015
 
December 31,
2014
Within 30 days
$
2,453,972

 
$
4,013,055

30 to 59 days
3,624,004

 
4,595,425

60 to 89 days
715,240

 
903,286

90 to 119 days
535,472

 
434,550

120 to 364 days (1)
2,094,115

 
1,929,164

One to three years
651,238

 
744,459

Three to five years
815,024

 
815,024

Five to ten years
—

 
—

Ten years and over
1,533,738

 
1,000,000

Open maturity (2)
—

 
997,500

Total
$
12,422,803

 
$
15,432,463

____________________
(1)
As of June 30, 2015 , 120 to 364 days includes the amounts outstanding under the uncommitted mortgage loan warehouse facilities.
(2)
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.

For the three months ended June 30, 2015 , our unrestricted cash balance decreased approximately $86.8 million to $933.6 million at June 30, 2015 . The cash movements can be summarized by the following:
•
Cash flows from operating activities. For the three months ended June 30, 2015 , operating activities decreased our cash balances by approximately $541.5 million , primarily driven by purchases of residential mortgage loans held-for-sale.
•
Cash flows from investing activities . For the three months ended June 30, 2015 , investing activities increased our cash balances by approximately $3.5 billion , primarily driven by sales of AFS and trading securities.
•
Cash flows from financing activities. For the three months ended June 30, 2015 , financing activities decreased our cash balance by approximately $3.0 billion , primarily driven by repayment of repurchase agreements due to sales of AFS and trading securities.

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 U.S. 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 total return 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 asset-specific risk measurement and management processes in our daily operations. PRCM Advisers and its affiliates’ risk management tools include software and services licensed or purchased from third parties and proprietary software and analytical methods developed by Pine River. There can be no guarantee that these tools will protect us from market risks.

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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.
We may utilize U.S. Treasuries as well as derivative financial instruments, which during the six months ended June 30, 2015 were limited to interest rate swaps, swaptions, TBAs, short U.S. Treasuries, put and call options for TBAs and U.S. Treasuries, constant maturity swaps, Markit IOS total return swaps and, to a certain extent, inverse interest-only securities, to hedge the interest rate risk associated with our portfolio. In addition, because MSR are negative duration assets, they provide a natural hedge to interest rate exposure on our RMBS 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 implement part of our hedging strategy through our TRSs, which are 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 and residential mortgage loans held-for-sale will remain static. Moreover, interest rates may rise at a faster pace than the yields earned on our leveraged adjustable-rate and hybrid RMBS and adjustable-rate residential mortgage loans held-for-sale. 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 could 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.
We also acquire adjustable-rate residential mortgage loans held-for-sale. These assets are typically subject to periodic and lifetime interest rate caps and floors, which may limit the amount by which the loan’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 residential mortgage loans held-for-sale could effectively be limited by caps.
Interest Rate Mismatch Risk
We fund the majority of our adjustable-rate and hybrid Agency RMBS, adjustable-rate residential mortgage loans held-for-sale and commercial real estate loans held-for-investment 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 11 th 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.

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The following table provides the indices of our variable rate RMBS AFS, residential mortgage loans held-for-sale and commercial real estate loans held-for-investment of June 30, 2015 and December 31, 2014 , respectively, based on carrying value (dollars in thousands).
 
 
As of June 30, 2015
 
As of December 31, 2014
Index Type
 
Floating
 
Hybrid (1)
 
Total
 
Index %
 
Floating
 
Hybrid (1)
 
Total
 
Index %
CMT
 
$
1,284

 
$
107,653

 
$
108,937

 
4
%
 
$
1,121

 
$
115,619

 
$
116,740

 
4
%
LIBOR
 
2,339,410

 
37,997

 
2,377,407

 
90
%
 
2,762,807

 
42,530

 
2,805,337

 
93
%
Other (2)
 
146,424

 
18,116

 
164,540

 
6
%
 
68,244

 
19,228

 
87,472

 
3
%
Total
 
$
2,487,118

 
$
163,766

 
$
2,650,884

 
100
%
 
$
2,832,172

 
$
177,377

 
$
3,009,549

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

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.

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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 rate 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 June 30, 2015 .
All changes in value are measured as the change from the June 30, 2015 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
$
397,077

 
$
198,123

 
$
(286,344
)
 
$
(588,081
)
As a % of June 30, 2015 equity
10.0
 %
 
5.0
 %
 
(7.2
)%
 
(14.8
)%
Residential mortgage loans held-for-sale
$
32,361

 
$
17,626

 
$
(21,284
)
 
$
(43,044
)
As a % of June 30, 2015 equity
0.8
 %
 
0.4
 %
 
(0.5
)%
 
(1.1
)%
Residential mortgage loans held-for-investment in securitization trusts
$
122,908

 
$
67,481

 
$
(81,058
)
 
$
(162,528
)
As a % of June 30, 2015 equity
3.1
 %
 
1.7
 %
 
(2.0
)%
 
(4.1
)%
Commercial real estate loans held-for-investment
$
—

 
$
—

 
$
—

 
$
—

As a % of June 30, 2015 equity
—
 %
 
—
 %
 
—
 %
 
—
 %
Mortgage servicing rights
$
(90,959
)
 
$
(25,696
)
 
$
17,927

 
$
29,792

As a % of June 30, 2015 equity
(2.3
)%
 
(0.7
)%
 
0.5
 %
 
0.8
 %
Derivatives, net
$
(519,943
)
 
$
(234,219
)
 
$
275,777

 
$
595,434

As a % of June 30, 2015 equity
(13.1
)%
 
(5.9
)%
 
6.9
 %
 
15.0
 %
Repurchase Agreements
$
(4,892
)
 
$
(4,892
)
 
$
8,519

 
$
17,038

As a % of June 30, 2015 equity
(0.1
)%
 
(0.1
)%
 
0.2
 %
 
0.4
 %
Collateralized borrowings in securitization trusts
$
(97,025
)
 
$
(53,284
)
 
$
59,626

 
$
119,682

As a % of June 30, 2015 equity
(2.5
)%
 
(1.3
)%
 
1.5
 %
 
3.0
 %
Federal Home Loan Bank advances
$
(820
)
 
$
(820
)
 
$
1,442

 
$
2,883

As a % of June 30, 2015 equity
—
 %
 
—
 %
 
—
 %
 
0.1
 %
Total Net Assets
$
(161,293
)
 
$
(35,681
)
 
$
(25,395
)
 
$
(28,824
)
As a % of June 30, 2015 total assets
(0.9
)%
 
(0.2
)%
 
(0.1
)%
 
(0.2
)%
As a % of June 30, 2015 equity
(4.1
)%
 
(0.9
)%
 
(0.6
)%
 
(0.7
)%
 
-100 bps
 
-50 bps
 
+50 bps
 
+100 bps
Change in annualized net interest income:
$
(10,276
)
 
$
(9,650
)
 
$
8,889

 
$
17,777

% change in net interest income
(2.6
)%
 
(2.4
)%
 
2.2
 %
 
4.5
 %

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 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 include anticipated interest rates, collateral requirements as a percentage of borrowings and amount and term of borrowing.
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 June 30, 2015 . 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.

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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 interest rate scenarios will generate lower realized yields on Agency and non-Agency premium and interest-only securities and higher realized yields on Agency and 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 rate environment at June 30, 2015 , 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 prepayment 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 above 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 RMBS 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.
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.
MSR are also subject to prepayment risk in that, generally, an increase in prepayment rates would result in a decline in value of the MSR.
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.
Our residential mortgage loans held-for-sale and held-for-investment are reflected at their estimated fair value. The estimated fair value fluctuates primarily due to changes in interest rates, market valuation of credit risks and other factors. Generally in a rising rate environment, we would expect the fair value of these loans to decrease; conversely, in a decreasing rate environment, we would expect the fair value of these loans to increase. However, the fair value of the CSL and Ginnie Mae buyout residential mortgage loans included in residential mortgage loans held-for-sale is generally less sensitive to interest rate changes.
Our MSR are reflected at their estimated fair value. The estimated fair value fluctuates primarily due to changes in interest rates and other factors. Generally, in a rising interest rate environment, we would expect prepayments to decrease, resulting in an increase in the fair value of our MSR. Conversely, in a decreasing interest rate environment, we would expect prepayments to increase, resulting in a decline in fair value.
Real estate risk . Both residential and commercial 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; retroactive changes to building or similar codes; and natural disasters and other catastrophes. Decreases in property values reduce the value of the collateral for residential mortgage and commercial real estate 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 and residential mortgage and commercial real estate loans.

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Liquidity Risk
Our liquidity risk is principally associated with our financing of long-maturity assets with shorter-term borrowings in the form of repurchase agreements and FHLB advances. 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 the FHLB or one or more of our repurchase agreement counterparties chose not to provide ongoing 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 and FHLB advances. 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 and on our residential mortgage and commercial real estate loans. 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, which includes comprehensive underwriting, and by factoring assumed credit losses into the purchase prices we pay for non-Agency RMBS and residential mortgage and commercial real estate loans. In addition, with respect to any particular target 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. We further mitigate credit risk in our residential mortgage and commercial real estate loan portfolios through (1) selecting servicers whose specialties are well matched against the underlying attributes of the borrowers contained in the loan pools, and (2) an actively managed internal servicer oversight and surveillance program. 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 Exchange 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 Exchange Act.
There was no change in our internal control over financial reporting that occurred during the quarter ended June 30, 2015 that has materially affected, or is 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
Except as set forth below, 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, 2014 , or the Form 10-K. The materialization of any risks and uncertainties identified in our Forward-Looking Statements contained in this Quarterly Report on Form 10-Q, together with those previously disclosed in the Form 10-K 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.
Risks Related to Our Business and Operations
The commercial real estate debt and related assets in which the Company invests are subject to delinquency, foreclosure and loss, which may adversely impact the Company’s business, results of operations and financial condition.
The Company has initiated its previously announced expansion into the commercial real estate market, with target assets including first mortgage loans, mezzanine loans, B-notes and preferred equity. Such investments may be subject to risks of delinquency, foreclosure and loss that are greater than similar risks associated with loans made on the security of residential properties. The ability of a borrower to repay a loan secured by an income-producing property typically is dependent primarily upon the successful operation of the property, as opposed to the borrower’s independent income or assets. If the net operating income of the property is reduced, the borrower’s ability to repay the loan may be impaired. The net operating income of an income-producing property can be affected by numerous factors, including:
•
tenant mix;
•
success of tenant businesses;
•
property management decisions, including decisions on capital improvements;
•
property location and condition;
•
competition from similar properties;
•
changes in national, regional or local economic conditions;
•
changes in regional or local real estate values;
•
changes in regional or local rental or occupancy rates;
•
changes in interest rates and in the state of the debt and equity capital markets, including the availability of debt financing for commercial real estate;
•
changes in governmental rules, regulations and fiscal policies, including real estate taxes, environmental legislation and zoning laws;
•
environmental contamination; and
•
acts of God, terrorism, social unrest and civil disturbances, which may result in property damage, decrease the availability of or increase the cost of insurance or otherwise result in uninsured losses.
In the event any of the properties or entities underlying or collateralizing the Company’s commercial real estate loans or investments is adversely impacted by any of the foregoing events or occurrences, the value of, and return on, such investments could be reduced, which in turn would adversely affect the Company’s results of operations and financial condition.

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The lack of liquidity in certain commercial real estate investments may materially and adversely affect the Company.
The illiquidity of certain commercial real estate investments may make it difficult for the Company to sell such investments if the need or desire arises. Investments such as commercial mortgages, B-notes, mezzanine and other loans (including participations) and preferred equity, in particular, are relatively illiquid due to their short life, their potential unsuitability for securitization and the greater difficulty of recovery in the event of a borrower’s default. Moreover, certain of the Company’s investments will not be registered under the relevant securities laws, resulting in prohibitions against their transfer, sale, pledge or their disposition except in transactions that are exempt from registration requirements or are otherwise in accordance with such laws. If the Company desires or is required to liquidate all or a portion of its portfolio, it may have difficulty selling these investments in a timely manner or be forced to sell them for an amount less than it would otherwise have been able to realize, or both.
Risks Related to Our Assets
Most commercial mortgage loans are nonrecourse loans and the assets securing these loans may not be sufficient to protect the Company from a partial or complete loss if a borrower defaults on a loan, which could materially and adversely affect the Company.
Except for customary nonrecourse carve-outs for certain “bad acts” and environmental liability, most commercial mortgage loans are nonrecourse obligations of the borrower, meaning that there is no recourse against the assets of the borrower other than the underlying collateral. In the event of any default under a commercial mortgage loan, the Company will bear the risk of loss to the extent of any deficiency between the value of the collateral and the principal of and accrued interest on the mortgage loan, which could materially and adversely affect the Company. Even if a commercial mortgage loan is recourse to the borrower (or if a nonrecourse carve-out to the borrower applies), in most cases, the borrower’s assets are limited primarily to its interest in the related mortgaged property. Further, although a commercial mortgage loan may provide for limited recourse to a principal or affiliate of a borrower, there is no assurance that any recovery from such principal or affiliate will be made or that such principal’s or affiliate’s assets would be sufficient to pay any otherwise recoverable claim. In the event of the bankruptcy of a borrower, the loan to such borrower will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the extent the lien is unenforceable under state law.
The Company may be subject to additional risks associated with commercial mortgage loan participations.
Some of the Company’s commercial mortgage loans may be held in the form of participation interests or co-lender arrangements in which the Company shares the loan rights, obligations and benefits with other lenders. With respect to such participation interests, the Company may require the consent of these parties to exercise its rights under such loans, including rights with respect to amendment of loan documentation, enforcement proceedings upon a default and the institution of, and control over, foreclosure proceedings. In circumstances where the Company holds a minority interest, it may be become bound to actions of the majority to which it otherwise would object. The Company may be adversely affected by this lack of control with respect to these interests.
B-notes may be subject to additional risks related to the privately negotiated structure and terms of the transaction, which may result in losses to the Company.
The Company may originate or acquire B-notes, which are mortgage loans that are typically secured by a first mortgage on a single commercial property or group of related properties, but subordinated to an A-note secured by the same first mortgage on the same collateral. As a result, if a borrower defaults, there may not be sufficient funds remaining for B-notes holders after payment to the A-note holders. Because each transaction is privately negotiated, B-notes can vary in their structural characteristics and risks. For example, the rights of holders of B-notes to control the process following a borrower default may vary from transaction to transaction. Further, B-notes typically are secured by a single property and accordingly reflect the risks associated with significant concentration. Losses related to the Company’s B-notes would adversely affect its financial condition and results of operations.
Mezzanine loan assets involve greater risks of loss than senior loans secured by income-producing properties.
The Company may originate or acquire mezzanine loans, which are subordinated loans secured by a pledge of the ownership interests of the entity that owns the interest in the entity owning the property. These types of assets involve a higher degree of risk than long-term senior mortgage lending secured by income producing real property, because the loan may become unsecured as a result of foreclosure by the senior lender. In the event of a bankruptcy of the entity providing the pledge of its ownership interests as security, the Company may not have full recourse to the assets of such entity, or the assets of the entity may not be sufficient to satisfy the Company’s mezzanine loan. If a borrower on any debt that is senior to the Company’s mezzanine loan, or in the event of a borrower bankruptcy, the Company’s mezzanine loan will be satisfied only after the senior debt. As a result, the Company may not be able to recover all, or possibly any, of its initial expenditure. In addition, mezzanine loans have higher loan-to-value ratios than conventional mortgage loans, resulting in less equity in the property and increasing the risk of loss of principal. Losses related to the Company’s mezzanine loans would adversely affect its financial condition and results of operations.

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Investments in preferred equity involve a greater risk of loss than traditional debt financing.
The Company may invest in real estate preferred equity, which involves a higher degree of risk than first mortgage loans due to a variety of factors, including the risk that, similar to mezzanine loans, such investments are subordinate to first mortgage loans and are not collateralized by property underlying the investment. Unlike mezzanine loans, preferred equity investments generally do not have a pledge of the ownership interests of the entity that owns the interest in the entity owning the property. Although as a holder of preferred equity the Company may protect its position with covenants that limit the activities of the entity in which the Company holds an interest and protect its equity by obtaining an exclusive right to control the underlying property after an event of default, should such a default occur, the Company would only be able to proceed against the entity in which it holds an interest, and not the property owned by such entity and underlying the investment. Further, similar to mezzanine loans, preferred equity investments do not ordinarily afford the holder with the full range of traditional creditor protections. As a result, the Company may not be able to recover all of its investment.
Investments in nonconforming and non-investment grade rated commercial real estate loans or securities involve increased risk of loss.
Certain commercial real estate investments may not conform to conventional loan standards applied by traditional lenders and either will not be rated or will be rated as non-investment grade by the rating agencies. The non-investment grade ratings for these assets typically result from the overall leverage of the loans, the lack of a strong operating history for the properties underlying the loans, the borrowers' credit history, the underlying properties' cash flow or other factors. As a result, these investments should be expected to have a higher risk of default and loss than investment grade rated assets. Losses related to the Company’s non-investment grade loans or securities would adversely affect its financial condition and results of operations.
Tax Risks
The failure of a mezzanine loan to qualify as a real estate asset could adversely affect the Company’s ability to continue to qualify as a REIT.
In Revenue Procedure 2003-65, the IRS provided a safe harbor pursuant to which a mezzanine loan, if it meets each of the requirements contained in the Revenue Procedure, will be treated by the IRS as a real estate asset for purposes of the REIT asset tests, and interest derived from the mezzanine loan will be treated as qualifying mortgage interest for purposes of the REIT 75% gross income test. Although the Revenue Procedure provides a safe harbor on which taxpayers may rely, it does not prescribe rules of substantive tax law. The Company expects to treat certain mezzanine loans that may not meet all of the requirements for reliance on this safe harbor as real estate assets giving rise to qualifying mortgage interest for purposes of the REIT asset and income requirements, or otherwise not adversely affecting the Company’s qualification as a REIT. There can be no assurance that the IRS will not challenge the tax treatment of these mezzanine loans, and if such a challenge were sustained, the Company could in certain circumstances be required to pay a penalty tax or fail to qualify as a REIT.

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:
August 5, 2015
By:
/s/ Thomas E. Siering
 
 
 
Thomas E. Siering
Chief Executive Officer, President and
Director (Principal Executive Officer)
Dated:
August 5, 2015
By:
/s/ Brad Farrell
 
 
 
Brad Farrell
Chief Financial Officer and Treasurer
(Principal Accounting and Financial Officer)


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Exhibit Number
 
Exhibit Index
3.1
 
Articles of Amendment and Restatement of Two Harbors Investment Corp. (incorporated by reference to Exhibit 99.1 to Annex B filed with Pre-effective Amendment No. 4 to the Company’s Registration Statement on Form S-4 (File No. 333-160199), filed with the SEC on October 8, 2009).
3.2
 
Articles of Amendment to the Articles of Amendment and Restatement of Two Harbors Investment Corp. (incorporated by reference to Exhibit 99.1 to the Company’s Current Report on Form 8-K, filed with the SEC on December 19, 2012).
3.3
 
Amended and Restated Bylaws of Two Harbors Investment Corp. (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K, filed with the SEC on December 19, 2013).
10.1*
 
Second Restated 2009 Equity Incentive Plan (incorporated by reference to Appendix A to the Registrant’s Definitive Proxy Statement filed with the SEC on March 26, 2015).
10.2*
 
Form of Restricted Stock Agreement under the Second Restated 2009 Equity Incentive Plan. (filed herewith)
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 June 30, 2015, filed with the SEC on August 5, 2015, formatted in XBRL: (i) the Condensed Consolidated Balance Sheets, (ii) the Condensed Consolidated Statements of Comprehensive Income, (iii) the Condensed Consolidated Statements of Stockholders’ Equity, (iv) the Condensed Consolidated Statements of Cash Flows, and (v) the Notes to the Condensed Consolidated Financial Statements. (filed herewith)
____________________
*
Management or compensatory agreement

90


EXHIBIT 10.2

TWO HARBORS INVESTMENT CORP.
SECOND RESTATED 2009 EQUITY INCENTIVE PLAN

RESTRICTED STOCK AWARD AGREEMENT
RESTRICTED STOCK AWARD AGREEMENT by and between Two Harbors Investment Corp., a Maryland corporation (the “Company”), and ______________ (the “Grantee”), dated as of the _____ day of ______________, 20___ (the “Effective Date”).
WHEREAS, the Company maintains the Two Harbors Second Restated 2009 Equity Incentive Plan (the “Plan”) (capitalized terms used but not otherwise defined herein shall have the respective meanings ascribed thereto by the Plan);
WHEREAS, the Grantee is a[n] ______________ of a Participating Company; and
WHEREAS, in accordance with the Plan, the Committee has determined that it is in the best interests of the Company and its stockholders to grant Restricted Stock to the Grantee subject to the terms and conditions set forth below.
NOW, THEREFORE, IT IS HEREBY AGREED AS FOLLOWS:
1.
Grant of Restricted Stock .
The Company hereby grants the Grantee ______________ Shares of Restricted Stock of the Company, subject to the following terms and conditions and subject to the provisions of the Plan. The Plan is incorporated herein by reference as though set forth herein in its entirety. To the extent such terms or conditions conflict with any provision of the Plan, the terms and conditions set forth in the Plan shall govern.
2.
Restrictions and Conditions .
The Restricted Stock awarded pursuant to this Agreement and the Plan shall be subject to the following restrictions and conditions:
a.
Subject to clauses (c) through [(f)] [g]) below, the period of restriction with respect to Shares granted hereunder (the “ Restriction Period ”) shall begin on the Effective Date and lapse[, if and as [employment] [service] continues] on the following schedule:
Date Restriction Lapses
Number of Shares
(Whole Shares Only)
,20___
[ ]
,20___
[ ]
,20___
[ ]

For purposes of the Plan and this Agreement, Shares with respect to which the Restriction Period has lapsed shall be vested. Notwithstanding the foregoing, the Restriction Period with respect to such Shares shall only lapse as to whole Shares. Subject to the provisions of the Plan and this Agreement, during the Restriction Period, the Grantee shall not be permitted voluntarily or involuntarily to sell, transfer, pledge, anticipate, alienate, encumber or assign Shares of Restricted Stock (or have such Shares attached or garnished).
b.
Except as provided in the foregoing clause (a), below in this clause (b) or in the Plan, the Grantee shall have, in respect of the Shares of Restricted Stock, all of the rights of a stockholder of the Company, including the right to vote the Shares and the right to receive dividends. The Grantee shall be entitled

i



to receive any cash dividends on any shares of Restricted Stock (whether or not then subject to restrictions) which have not been forfeited. Certificates for Shares (not subject to restrictions) shall be delivered to the Grantee or his or her designee promptly after, and only after, the Restriction Period shall lapse without forfeiture in respect of such Shares of Restricted Stock.
c.
Subject to clause (e) below, if the Grantee has a Termination of Service by the Company and its Subsidiaries for Cause or by the Grantee for any reason other than his or her death, Retirement or Disability, during the Restriction Period, then (A) all Shares still subject to restriction shall thereupon, and with no further action, be forfeited by the Grantee, and (B) the Company shall pay to the Grantee as soon as practicable (and in no event more than 30 days) after such termination an amount equal to the lesser of (x) the amount (if any) paid by the Grantee for such forfeited Restricted Stock as contemplated by the Plan, and (y) the Fair Market Value on the date of termination of the forfeited Restricted Stock.
d.
If the Grantee has a Termination of Service on account of death, Disability or Retirement or the Grantee has a Termination of Service by the Company and its Subsidiaries for any reason other than for Cause, during the Restriction Period, then the Restriction Period will immediately lapse on all Restricted Stock.
e.
If there occurs during the Restriction Period a Change of Control in which the Resulting Entity assumes or continues the Grant of Restricted Stock and if the Grantee experiences a Termination of Service by the Resulting Entity and its Subsidiaries voluntarily for good reason, as defined by the Committee, during the twenty-four (24) months following the Change of Control, then the Restriction Period will lapse on all Restricted Stock on the date of the Termination of Service. If an event described in clause (d) above occurs during or after the twenty-four (24) months following the Change of Control, then the Restriction Period will lapse on all Restricted Stock on the date of the Termination of Service. If there occurs during the Restriction Period a Change of Control in which the Resulting Entity does not assume or continue the Grant of Restricted Stock, then the Restriction Period will lapse on all Restricted Stock as of immediately prior to the Change of Control. For purposes of this Agreement, the “Resulting Entity” in the event of a Change of Control shall mean (A) the Company, in the event of a Change of Control as defined in Section 15(j) (i), (ii), or (iii) (C) of the Plan; (B) the entity (which may or may not be the Company) that is the continuing entity in the event of a merger or consolidation, in the event of a Change of Control as defined in Section 15(j)(iii)(A) of the Plan; or (C) the acquirer of the Company’s assets, in the event of a Change of Control as defined in Section 15(j)(iii)(B) of the Plan.
f.
Grantee shall forfeit such Shares of Restricted Stock as are required to be forfeited under (a) Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the related rules of the Securities and Exchange Commission or the applicable listing exchange or (b) such clawback or recoupment policy as the Board or Compensation Committee may adopt.
g.
[ for use where the Grantee has an Employment Agreement ] [Notwithstanding any other provision hereof, if the Grantee is a party to an effective employment agreement with the Company from time to time, then the Restriction Period shall also end if and as may be otherwise required by such employment agreement; and nothing herein shall limit any rights the Grantee may otherwise have under such employment agreement.]

3.
Miscellaneous .
a.
THIS AGREEMENT SHALL BE GOVERNED BY THE LAWS OF THE STATE OF MARYLAND, WITHOUT REGARD TO ANY PRINCIPLES OF CONFLICT OF LAWS WHICH COULD CAUSE THE APPLICATION OF THE LAWS OF ANY JURISDICTION OTHER THAN THE STATE OF MARYLAND. The captions of this Agreement are not part of the provisions hereof and shall have no force or effect. This Agreement may not be amended or modified except by a written agreement executed by the parties hereto or their respective successors

ii



and legal representatives. The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement.
b.
The Committee may make such rules and regulations and establish such procedures for the administration of this Agreement as it deems appropriate. Without limiting the generality of the foregoing, the Committee may interpret the Plan and this Agreement, with such interpretations to be conclusive and binding on all persons and otherwise accorded the maximum deference permitted by law, provided that the Committee’s interpretation shall not be entitled to deference on and after a Change of Control except to the extent that such interpretations are made exclusively by members of the Committee who are individuals who served as Committee members before the Change of Control and take any other actions and make any other determinations or decisions that it deems necessary or appropriate in connection with the Plan, this Agreement or the administration or interpretation thereof. In the event of any dispute or disagreement as to interpretation of the Plan or this Agreement or of any rule, regulation or procedure, or as to any question, right or obligation arising from or related to the Plan or this Agreement, the decision of the Committee, except as provided above, shall be final and binding upon all persons.
c.
All notices hereunder shall be in writing and, if to the Company or the Committee, shall be delivered to the Board or mailed to its principal office, addressed to the attention of the Board; and if to the Grantee, shall be delivered personally, sent by facsimile transmission, or mailed to the Grantee at the address appearing in the records of the Company. Such addresses may be changed at any time by written notice to the other party given in accordance with this Paragraph 3(c). Notices may also be given electronically pursuant to such rules and procedures as the Committee may adopt for electronic notice.
d.
[for use if Grant is made to an employee of Pine River Domestic Management L.P.] [The parties to this agreement acknowledge that Grantee is not an employee of the Company and, instead, provides services to the Company pursuant to a Management Agreement between the Company and the Manager. Grantee is an Employee of Pine River Domestic Management L.P. (“PRDM”), which provides Grantee’s services to Manager pursuant to a Shared Services Agreement between PRDM and Manager so that Manager may fulfill its obligations to Company under the Management Agreement. Accordingly, the grant made hereby is made to Manager in consideration of services rendered thereby to the Company; and, in turn, is made by the Manager to PRDM in consideration of services rendered thereby to the Manager; and, finally, in turn, is made by PRDM to Grantee in consideration of the services rendered thereby to PRDM. For purposes of the provisions in Paragraphs 2(c) through 2(f) above relating to employment with the Company (and the termination thereof), and also for purposes of any references in the Plan to an employment agreement, “Company,” as the context so requires, shall include Manager, PRDM and their respective affiliates to the extent that Grantee is an Employee or a provider of services to such entities.]
e.
The failure of the Grantee or the Company to insist upon strict compliance with any provision of this Agreement, or to assert any right the Grantee or the Company, respectively, may have under this Agreement, shall not be deemed to be a waiver of such provision or right or any other provision or right of this Agreement.
f.
The Company shall be entitled to withhold from any payments or deemed payments any amount of tax withholding it determines to be required by law.
g.
Nothing in this Agreement shall confer on the Grantee any right to continue in the employ or other service of the Company or its Subsidiaries or interfere in any way with the right of the Company or its Subsidiaries and its stockholders to terminate the Grantee’s employment or other service at any time.
h.
This Agreement contains the entire agreement between the parties with respect to the subject matter hereof and supersedes all prior agreements, written or oral, with respect thereto.

iii




IN WITNESS WHEREOF, the Company and the Grantee have executed this Agreement as of the day and year first above written.
TWO HARBORS INVESTMENT CORP.


By:     
Name:
Title:
    
[GRANTEE]


Acknowledged as external manager of the Company:

PRCM ADVISERS LLC


By:     
Name:
Title:





iv



EXHIBIT 31.1

CHIEF EXECUTIVE OFFICER CERTIFICATION PURSUANT TO SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002

I, Thomas E. Siering, certify that:

1. I have reviewed this Quarterly Report on Form 10-Q of Two Harbors Investment Corp.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
 
Date:
August 5, 2015
 
/s/ Thomas E. Siering
 
 
 
 
Thomas E. Siering
 
 
 
 
Chief Executive Officer and President
 

 





EXHIBIT 31.2

CHIEF FINANCIAL OFFICER CERTIFICATION PURSUANT TO SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002

I, Brad Farrell, certify that:

1. I have reviewed this Quarterly Report on Form 10-Q of Two Harbors Investment Corp.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
 
Date:
August 5, 2015
 
/s/ Brad Farrell
 
 
 
 
Brad Farrell
 
 
 
 
Chief Financial Officer and Treasurer
 





EXHIBIT 32.1

CERTIFICATION

Pursuant to 18 U.S.C. §1350, the undersigned officer of Two Harbors Investment Corp. (the “Registrant”) hereby certifies that the Registrant’s Quarterly Report on Form 10-Q for the three months ended June 30, 2015 (the “Quarterly Report”) fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Quarterly Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant.
 
Date:
August 5, 2015
 
/s/ Thomas E. Siering
 
 
 
 
Thomas E. Siering
 
 
 
 
Chief Executive Officer and President
 

The foregoing certification is being furnished solely pursuant to 18 U.S.C. §1350 and is not being filed as part of the Quarterly Report or as a separate disclosure document.





EXHIBIT 32.2

CERTIFICATION

Pursuant to 18 U.S.C. §1350, the undersigned officer of Two Harbors Investment Corp. (the “Registrant”) hereby certifies that the Registrant’s Quarterly Report on Form 10-Q for the three months ended June 30, 2015 (the “Quarterly Report”) fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Quarterly Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant.
 
Date:
August 5, 2015
 
/s/ Brad Farrell
 
 
 
 
Brad Farrell
 
 
 
 
Chief Financial Officer and Treasurer
 

The foregoing certification is being furnished solely pursuant to 18 U.S.C. §1350 and is not being filed as part of the Quarterly Report or as a separate disclosure document.