TWO

Business Context and Reporting Period

Company: Two Harbors Investment Corp. (TWO)
Filing Type: Form 10-Q (Unaudited)
Reporting Period: Quarter and nine months ended September 30, 2010
Business Overview: A Maryland corporation operating as a Real Estate Investment Trust (REIT) focused on investing in residential mortgage-backed securities (RMBS), including Agency and non-Agency tranches. The company is externally managed 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 $9.88 million for the quarter ended September 30, 2010, compared to a net loss of $0.94 million for the same period in 2009. For the nine-month period, net income was $19.30 million versus a loss of $2.42 million in 2009. The 2009 results reflect the company's status as a development-stage entity with no operations prior to late October 2009.
• Portfolio Expansion: Total assets increased from $538.4 million at December 31, 2009, to $1.21 billion at September 30, 2010. AFS securities grew from $494.5 million to $1.08 billion, driven by the deployment of capital raised in a public offering in April 2010.
• Leverage Increase: Repurchase agreements (debt) increased from $411.9 million to $943.0 million to fund the expanded portfolio. The debt-to-equity ratio rose to 3.9:1.0.
• Derivative Activity: The company initiated significant hedging activities, including interest rate swaps and To-Be-Announced (TBA) positions. This resulted in a reported loss on interest rate swap agreements of $4.44 million for the quarter and $10.04 million for the nine months, offset partially by gains on other derivative instruments.

Guidance, Outlook, and Risks

• Management Commentary: Management attributes the improved results to the deployment of capital into Agency and non-Agency RMBS. The company utilizes a blended strategy to manage interest rate and prepayment risks. Adjusted GAAP earnings (excluding unrealized losses on interest rate swaps) were $10.2 million for the quarter and $23.1 million for the nine months.
• Outlook: The company expects to maintain a moderate leverage ratio and continues to seek attractive risk-adjusted returns. It anticipates that its diversified portfolio will help navigate regulatory developments and market volatility.
• Key Risks:
  • Interest Rate Risk: Rising rates could increase borrowing costs faster than asset yields, compressing net interest margins. Falling rates could accelerate prepayments, reducing yields on premium Agency bonds.
  • Liquidity Risk: Reliance on short-term repurchase agreements creates refinancing risk. A decline in collateral values could trigger margin calls.
  • Credit Risk: Exposure to non-Agency RMBS involves potential credit losses, though the portfolio includes senior tranches with credit enhancement.
  • Regulatory Risk: The Dodd-Frank Act and potential changes in mortgage servicing practices (e.g., foreclosure delays) could adversely impact asset values.

Investor Verification Checklist

• Derivative Valuation Impact: Verify the magnitude of unrealized losses on interest rate swaps ($10.0 million for nine months) and their exclusion from Adjusted GAAP earnings to understand core operating performance.
• Liquidity Position: Confirm the $19.0 million estimated unused borrowing capacity and the sufficiency of cash ($66.2 million) to meet potential margin calls given the 3.9:1 leverage ratio.
• Non-Agency Credit Quality: Review the specific vintage and credit enhancement levels of the $274 million non-Agency portfolio, noting the high percentage of 2006+ vintages (54.7%) and Alt-A/Subprime exposure.
• Dividend Sustainability: Assess whether the $0.39 per share dividend declared in Q3 is fully covered by taxable income, considering the company's REIT distribution requirements.
• Counterparty Concentration: Note that Barclays Capital Inc. represents 19% of equity exposure and Wells Fargo Bank represents 10% of equity exposure in repurchase agreements.