TWO

Business Context and Reporting Period

Company: Two Harbors Investment Corp. (TWO)
Filing Type: Form 10-Q (Unaudited)
Period Ended: June 30, 2010
Business Overview: Two Harbors is a Maryland corporation and externally managed Real Estate Investment Trust (REIT) focused on investing in residential mortgage-backed securities (RMBS), including Agency and non-Agency tranches. The company is advised by PRCM Advisers LLC, a subsidiary of Pine River Capital Management L.P.

Key Financial Metrics

Material Changes vs. Prior Period

• Profitability Turnaround: The company reported a net income of $9.4 million for the six months ended June 30, 2010, compared to a net loss of $1.4 million for the same period in 2009. This improvement is largely due to the commencement of full operations following a merger in late 2009 and the deployment of capital.
• Balance Sheet Expansion: Total assets more than doubled from $538.4 million at December 31, 2009, to $1.13 billion at June 30, 2010. This growth was driven by a public offering of common stock in April 2010, which raised approximately $106.8 million in net proceeds.
• Portfolio Growth: Available-for-sale securities increased from $494.5 million to $977.9 million. The portfolio composition shifted to include $145.4 million in U.S. Treasuries and a significant increase in non-Agency RMBS (from $76.6 million to $194.7 million).
• Derivative Activity: Derivative assets surged from $0.4 million to $32.6 million, while derivative liabilities increased to $21.6 million. The company recognized a loss of $5.6 million on interest rate swap agreements for the six-month period, attributed to changes in fair value.

Guidance, Outlook, and Risks

• Management Commentary: Management expects to maintain a blended Agency and non-Agency strategy to navigate interest rate volatility. The company aims to deploy moderate leverage, with a target debt-to-equity ratio that provides unused borrowing capacity. As of June 30, 2010, the company had an estimated unused borrowing capacity of approximately $24.6 million.
• Dividends: The company declared a dividend of $0.33 per share on June 14, 2010. Total dividends declared for the six months ended June 30, 2010, were $0.69 per share.
• Market Risks:
  • Interest Rate Risk: Rising rates could increase borrowing costs faster than asset yields, compressing net interest margins. Sensitivity analysis suggests a 100 basis point increase in rates could decrease total net assets by approximately 3.9%.
  • Prepayment Risk: Changes in prepayment speeds affect the amortization of premiums and accretion of discounts, directly impacting net interest income.
  • Liquidity Risk: The company relies on repurchase agreements for funding. A decline in collateral values could trigger margin calls, requiring the posting of additional cash or securities.
• Unusual Items: The financial results include significant unrealized fair value losses on interest rate swaps ($4.4 million for the six months) which were not hedged for accounting purposes. Additionally, the company recognized a tax benefit of $1.3 million related to losses in its Taxable REIT Subsidiary (TRS).

Investor Verification Checklist

• Capital Deployment: Verify the pace of investment of the $106.8 million raised in the April 2010 offering and the resulting yield on new assets.
• Leverage Management: Monitor the debt-to-equity ratio (currently 3.8:1) and the weighted average cost of funds (0.56%) to ensure borrowing costs remain favorable relative to asset yields.
• Derivative Exposure: Review the impact of interest rate swap valuations on net income, as these mark-to-market fluctuations can significantly distort GAAP earnings.
• Non-Agency Credit Quality: Assess the credit performance of the non-Agency RMBS portfolio, specifically the 35% delinquency rate on underlying loans and the adequacy of the $96.6 million designated credit reserve.
• Liquidity Position: Confirm the sufficiency of the $71.4 million cash balance and $24.6 million unused borrowing capacity to meet potential margin calls in volatile markets.