TWO

Business Context and Reporting Period

Company: Two Harbors Investment Corp. (TWO)
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2009
Business Overview: Two Harbors is a Maryland corporation formed to invest in, finance, and manage residential mortgage-backed securities (RMBS). The company commenced operations on October 28, 2009, following a reverse merger with Capitol Acquisition Corp. It intends to qualify as a Real Estate Investment Trust (REIT) for U.S. federal income tax purposes. The company is externally managed by PRCM Advisers LLC, a subsidiary of Pine River Capital Management L.P.

Key Financial Metrics

Note: 2008 financial data reflects Capitol Acquisition Corp. as a development stage company with no operating portfolio. 2009 results include significant one-time merger costs.

Material Changes vs. Prior Period

• Operational Status: The company transitioned from a development stage shell company (Capitol) to an operating REIT in Q4 2009. Prior to October 28, 2009, the company held no RMBS assets.
• Portfolio Deployment: As of December 31, 2009, the company deployed capital into a $494.5 million RMBS portfolio. This portfolio consists of 84.5% Agency RMBS ($417.8 million) and 15.5% Non-Agency RMBS ($76.6 million).
• Leverage: The company initiated financing through repurchase agreements, totaling $411.9 million, resulting in a debt-to-equity ratio of 3.4x. No debt existed in 2008.
• Net Income/Loss: The company reported a GAAP net loss of $8.7 million for 2009, compared to a net income of $2.3 million in 2008. The 2009 loss was primarily driven by $9.6 million in costs associated with the business combination (merger) and $1.3 million in development stage costs. Excluding these non-recurring items, the company would have reported a net income of approximately $1.7 million.
• Dividends: The company declared its first quarterly dividend of $0.26 per share on December 21, 2009, to satisfy REIT distribution requirements.

Guidance, Outlook, and Risks

Management Commentary & Outlook: Management expects to deploy moderate leverage, potentially up to 10x on Agency RMBS and up to 2x on Non-Agency RMBS. The company anticipates an annualized expense ratio ranging from 2.8% to 3.2% in 2010. The portfolio strategy focuses on a blend of Agency and Non-Agency RMBS to balance interest rate risk and prepayment risk. Management does not expect a significant increase in prepayment speeds in 2010 due to stagnant unemployment and housing inventory.

Key Risks and Contingencies:

• REIT Qualification: Failure to qualify as a REIT would subject the company to corporate income taxes and preclude it from qualifying for four subsequent years.
• Liquidity and Leverage: The company relies heavily on repurchase agreements. A decline in asset values could trigger margin calls, forcing asset sales at depressed prices. The company maintains an estimated unused borrowing capacity of $29.8 million.
• Interest Rate Risk: Rising interest rates could increase borrowing costs faster than asset yields adjust, compressing net interest margins. The company uses interest rate swaps (notional amount of $100 million) to hedge a portion of this risk.
• Credit Risk: While Agency RMBS are guaranteed, Non-Agency RMBS are exposed to credit losses. The portfolio includes subprime and Alt-A loans, which are sensitive to economic downturns and home price declines.
• 1940 Act Exemption: The company must maintain specific asset tests (55% and 80%) to avoid registration as an investment company, which could limit investment flexibility.

Investor Verification Checklist

• Merger Cost Impact: Verify the non-GAAP reconciliation to understand the core operating performance excluding the $9.6 million in one-time merger expenses.
• Portfolio Composition: Confirm the split between Agency (guaranteed) and Non-Agency (credit risk) assets and the specific vintage/credit quality of the Non-Agency holdings.
• Liquidity Position: Review the $26.1 million cash balance and $29.8 million unused borrowing capacity against potential margin call scenarios.
• REIT Compliance: Monitor the company's ability to meet the 90% distribution requirement and maintain asset tests for REIT and 1940 Act exemptions.
• Management Fee Structure: Note that the 1.5% management fee is based on stockholders' equity, which may incentivize capital raising regardless of performance.