Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes included elsewhere in this Annual Report on Form 10-K. This section of this Form 10-K generally discusses 2022 and 2021 items and year-to-year comparisons between 2022 and 2021. Discussions of 2020 items and year-to-year comparisons between 2021 and 2020 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2021.
General
We are a Maryland corporation focused on investing in and managing Agency residential mortgage-backed securities, or Agency RMBS, mortgage servicing rights, or MSR, 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.
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 acquire and manage an investment portfolio of our target assets, which 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 a U.S. government agency, such as the Government National Mortgage Association (or Ginnie Mae), or a U.S. government sponsored enterprise, or GSE, such as the Federal National Mortgage Association (or Fannie Mae) or the Federal Home Loan Mortgage Corporation (or Freddie Mac);
•MSR; and
•Other financial assets comprising approximately 5% to 10% of the portfolio.
Our Agency RMBS portfolio is comprised primarily of fixed rate mortgage-backed securities backed by single-family and multi-family mortgage loans. All of our principal and interest Agency RMBS are Fannie Mae or Freddie Mac mortgage pass-through certificates or collateralized mortgage obligations, 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.
Within our MSR business, we acquire MSR assets, which represent the right to control the servicing of residential mortgage loans and the obligation to service the loans in accordance with relevant standards, from high-quality originators. We do not directly service the mortgage loans underlying the MSR we acquire; rather, we contract with appropriately licensed third-party subservicers to handle substantially all servicing functions in the name of the subservicer. As the servicer of record, however, we remain accountable to the GSEs for all servicing matters and, accordingly, provide substantial oversight of each of our subservicers. We believe MSR are a natural fit for our portfolio over the long term. Our MSR business leverages our core competencies in prepayment and credit risk analytics and the MSR assets provide offsetting risks to our Agency RMBS, hedging both interest rate and mortgage spread risk.
On August 2, 2022, Matrix Financial Services Corporation, or Matrix, one of our wholly owned subsidiaries, entered into a definitive stock purchase agreement to acquire RoundPoint Mortgage Servicing Corporation, or RoundPoint, from Freedom Mortgage Corporation. In connection with the acquisition, Matrix has agreed to pay a purchase price upon closing in an amount equal to the tangible net book value of RoundPoint, plus a premium amount of $10.5 million, subject to certain additional post-closing adjustments. In connection with the transaction, RoundPoint will divest its retail origination business as well as its RPX servicing exchange platform. Matrix also agreed to engage RoundPoint as a subservicer prior to the closing date and began transferring loans to RoundPoint in the fourth quarter of 2022. Upon closing, all servicing licenses and operational capabilities will remain with RoundPoint, and RoundPoint will become a wholly owned subsidiary of Matrix. The parties expect to close the transaction in 2023, subject to the satisfaction of customary closing conditions and the receipt of required regulatory and GSE approvals.
For the three months ended December 31, 2022, our net spread realized on the portfolio was lower than recent quarters due primarily to higher cost of financing due to rising interest rates, offset by higher coupon and lower amortization on Agency RMBS due to slower prepayment speeds and the higher yielding MSR making up a larger proportion of the portfolio. The following table provides the average portfolio yield and cost of financing on our assets for the three months ended December 31, 2022, and the four immediately preceding quarters:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended |
| December 31,
2022 | | September 30,
2022 | | June 30,
2022 | | March 31,
2022 | | December 31,
2021 |
Average portfolio yield (1) | 4.92% | | 4.61% | | 4.39% | | 3.90% | | 3.72% |
Average cost of financing (2) | 3.95% | | 2.84% | | 1.13% | | 1.01% | | 0.73% |
| Net spread | 0.97% | | 1.77% | | 3.26% | | 2.89% | | 2.99% |
____________________
(1)Average portfolio yield includes interest income on Agency RMBS and non-Agency securities and MSR servicing income, net of estimated amortization, and servicing expenses. Beginning with the three months ended June 30, 2022, average portfolio yield also includes the implied asset yield portion of dollar roll income on TBAs. MSR estimated amortization refers to the portion of change in fair value of MSR primarily attributed to the realization of expected cash flows (runoff) of the portfolio, which is deemed a non-GAAP measure due to the company’s decision to account for MSR at fair value. TBA dollar roll income is the non-GAAP economic equivalent to holding and financing Agency RMBS using short-term repurchase agreements.
(2)Average cost of financing includes interest expense and amortization of deferred debt issuance costs on borrowings under repurchase agreements (excluding those collateralized by U.S. Treasuries), revolving credit facilities, term notes payable and convertible senior notes and interest spread income/expense and amortization of upfront payments made or received upon entering into interest rate swap agreements. Beginning with the three months ended June 30, 2022, average cost of financing also includes the implied financing benefit/cost portion of dollar roll income on TBAs. TBA dollar roll income is the non-GAAP economic equivalent to holding and financing Agency RMBS using short-term repurchase agreements. Beginning with the three months ended September 30, 2022, average cost of financing also includes U.S. Treasury futures income, which represents the economic equivalent to holding and financing a relevant cheapest-to-deliver U.S. Treasury note or bond using short-term repurchase agreements.
We seek to deploy moderate leverage as part of our investment strategy. We generally finance our Agency RMBS through short- and long-term borrowings structured as repurchase agreements. We also finance our MSR through revolving credit facilities, repurchase agreements, term notes payable and convertible senior notes.
Our Agency RMBS, given their liquidity and high credit quality, are eligible for higher levels of leverage, while MSR, with less liquidity and/or more exposure to prepayment, utilize lower levels of leverage. As a result, our debt-to-equity ratio is determined by our portfolio mix as well as many additional factors, including the liquidity of our portfolio, the availability and price of our financing, the diversification of our counterparties and their available capacity to finance our assets, and anticipated regulatory developments. Our debt-to-equity ratio is also directly correlated to the composition of our portfolio; specifically, the higher percentage of Agency RMBS we hold, the higher our debt-to-equity ratio is. We may alter the percentage allocation of our portfolio among our target assets 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 offerings we conduct. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Financing” for further discussion.
We recognize that investing in our target assets is competitive and we compete with other entities for attractive investment opportunities. We believe that our significant focus in the residential market, the extensive mortgage market expertise of our investment team, our operational capabilities to invest in MSR, 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. 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 directly service residential mortgage loans, certain of our subsidiaries have obtained the requisite licenses and approvals to own and manage MSR.
Factors Affecting our Operating Results
Our net interest income includes income from our securities portfolio, including the amortization of purchase premiums and accretion of purchase discounts. 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.
Fair Value Measurement
A significant portion of our assets and liabilities are reported at fair value and, therefore, our consolidated balance sheets and statements of comprehensive loss are significantly affected by fluctuations in market prices. At December 31, 2022, approximately 80.1% of our total assets, or $10.8 billion, consisted of financial instruments recorded at fair value. See Note 10 - Fair Value to the consolidated financial statements, included in this Annual Report on Form 10-K, 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.
Any temporary change in the fair value of our AFS securities, excluding certain AFS securities for which we have elected the fair value option, is recorded as a component of accumulated other comprehensive (loss) income and does not impact our reported income (loss) for U.S. GAAP purposes, or GAAP net income (loss). However, changes in the provision for credit losses on AFS securities are recognized immediately in GAAP net income (loss). Our GAAP net income (loss) is also affected by fluctuations in market prices on the remainder of our financial assets and liabilities recorded at fair value, including interest rate swap, cap and swaption agreements and certain other derivative instruments (i.e., Agency to-be-announced securities, or TBAs, options on TBAs, futures, options on futures, and inverse interest-only securities), which are accounted for as derivative trading instruments under U.S. GAAP, fair value option elected AFS securities and MSR.
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 reported at fair value is priced by third-party brokers and/or by independent pricing vendors. We generally receive three or more broker and vendor quotes on pass-through Agency P&I RMBS, and generally receive multiple broker or vendor quotes on all other securities, including interest-only Agency RMBS and inverse interest-only Agency RMBS. We also receive multiple vendor quotes for the MSR in our investment portfolio. For Agency RMBS, the third-party pricing vendors and brokers use pricing models that commonly incorporate such factors as coupons, primary and secondary mortgage rates, rate reset periods, issuer, prepayment speeds, credit enhancements and expected life of the security. For MSR, vendors use pricing models that generally incorporate observable inputs such as principal balance, note rate, geographical location, loan-to-value (LTV) ratios, FICO, appraised value and other loan characteristics, along with observed market yields and trading levels. Pricing vendors 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 third-party brokers and pricing vendors 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 valuations from third-party brokers and pricing vendors 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 MSR based upon the average of prices received from third-party vendors, subject to internally-established hierarchy and override procedures.
We utilize “bid side” pricing for our Agency RMBS 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 (loss) 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. At December 31, 2022, 23.1% of our total assets were classified as Level 3 fair value assets.
Critical Accounting Estimates
The preparation of financial statements in accordance with U.S. GAAP requires us to make certain judgments and assumptions, based on information available at the time of our preparation of the financial statements, in determining accounting estimates used in preparation of the statements. Accounting estimates are considered critical if the estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made and if different estimates reasonably could have been used in the reporting period or changes in the accounting estimate are reasonably likely to occur from period to period that would have a material impact on our financial condition, results of operations or cash flows. Our significant accounting policies are described in Note 2 to the consolidated financial statements, included under Item 8 of this Annual Report on Form 10-K. Our most critical accounting policies involve our fair valuation of AFS securities, MSR and derivative instruments.
The methods used by us to estimate fair value for AFS securities, MSR and derivative instruments may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while we believe that our valuation methods are appropriate and consistent with other market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. We use prices obtained from third-party pricing vendors or broker quotes deemed indicative of market activity and current as of the measurement date, which in periods of market dislocation, may have reduced transparency. For more information on our fair value measurements, see Note 10 to the consolidated financial statements, included under Item 8 of this Annual Report on Form 10-K. Additionally, the key economic assumptions and sensitivity of the fair value of MSR to immediate adverse changes in these assumptions are presented in Note 5 to the consolidated financial statements, included under Item 8 of this Annual Report on Form 10-K.
Market Conditions and Outlook
Fixed-income volatility remained high throughout the fourth quarter of 2022, and the Federal Reserve, or Fed, continued to raise short-term rates to combat inflation, despite lower than expected inflation readings that provided some evidence that inflation was easing in response to prior rate hikes. During the quarter, the Fed raised the Federal Funds target rate by 150 basis points (75 basis points in each of November and December), in excess of the 116 basis points priced into the market at the beginning of the quarter. By December 31, 2022, the market’s expectation for where short-term rates will be once the Fed finishes hiking rose by 43 basis points, to 4.97% in June 2023. Though the Fed raised rates more than expected and the market’s expectations for forward rates continued to move higher, the deviations were smaller than in the prior quarter, indicating that market expectations were more closely aligned with the Fed. Interest rates on U.S. Treasuries rose slightly in the fourth quarter and the yield curve flattened, with the 2-year U.S. Treasury rate increasing by 15 basis points to 4.43% and the 10-year U.S. Treasury rate increasing by 5 basis points to 3.88%. The Standard and Poor’s 500 Index, or the S&P 500, gained about 7% after losing close to 25% through the first three quarters of the year.
Interest rate volatility and mortgage spreads peaked in October, then declined into quarter end. The better than expected CPI data (first reported on November 10th and then on December 13th) encouraged market participants that the Fed’s actions were working and provided greater confidence that further rate hikes, while expected, were nearing an end. Spreads for mortgages ratcheted tighter in November, displacing July as the best month on record for the excess return of the Bloomberg U.S. MBS Index, and contributing to the seventh best quarterly performance in history. Nominal and option-adjusted spreads for current coupon RMBS had tightened by 30 and 37 basis points, respectively, to 128 and 30 basis points. Thirty-year mortgage rates declined by 28 basis points to finish at 6.42%, though still 330 basis points higher for the year, driving the MBS Refinance Index to its lowest level in two decades.
Funding markets for RMBS and MSR continued to function well. Spreads on repurchase agreement financing for RMBS increased marginally to SOFR plus 11 to 17 basis points with no signs of balance sheet stress.
We continue to believe that inflation will subside and expect volatility to decline in the first quarter of 2023, given the historically aggressive rate hikes by the Fed. Though mortgage spreads tightened over the quarter, they are still near the 90th percentile of long-term averages, and on a levered basis generate attractive long-term returns. Furthermore, should volatility fall, we expect mortgage spreads to tighten, adding to our portfolio’s returns. With regard to MSR, continued slow prepayment rates on our existing portfolio should generate attractive long-term returns. Owing to a supply/demand imbalance driven by lower origination volumes and the decision of several market participants to step back from the MSR market, we intend to opportunistically allocate capital to acquire MSR at attractive prices in the first half of 2023. Taking all this into account, we are optimistic that our paired Agency RMBS and MSR portfolio strategy will deliver strong results.
The following table provides the carrying value of our investment portfolio by product type:
| | | | | | | | | | | | | | | | | | | | | | | |
| (dollars in thousands) | December 31,
2022 | | December 31,
2021 |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Agency RMBS | $ | 7,653,576 | | | 71.0 | % | | $ | 7,149,399 | | | 76.1 | % |
| Mortgage servicing rights | 2,984,937 | | | 27.7 | % | | 2,191,578 | | | 23.3 | % |
| Agency Derivatives | 15,176 | | | 0.1 | % | | 40,911 | | | 0.5 | % |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Non-Agency securities | 125,158 | | | 1.2 | % | | 12,304 | | | 0.1 | % |
| Total | $ | 10,778,847 | | | | | $ | 9,394,192 | | | |
Prepayment speeds and volatility due to interest rates
Our portfolio is subject to market risks, primarily interest rate risk and prepayment risk. We seek to offset a portion of our Agency pool market value exposure through our MSR and interest-only Agency RMBS portfolios. During periods of decreasing interest rates with rising prepayment speeds, the market value of our Agency pools generally increases and the market value of our interest-only securities and MSR generally decreases. The inverse relationship occurs when interest rates rise and prepayments fall. Although 30-year mortgage rates fell modestly during the fourth quarter of 2022, most mortgages continue to have large refinancing disincentive. Reported prepayment speeds continued to decline during the quarter reflecting the drop in activity in the housing market owing to seasonality and a slowing economy. Looking forward, prepayment speeds are expected to slow further in the first quarter of 2023 as seasonal factors plunge to their lowest annual levels. In addition to changes in interest rates, changes in home price performance, key employment metrics and government programs, among other macroeconomic factors, can affect prepayment speeds. We believe our portfolio management approach, including our asset selection process, positions us to respond to a variety of market scenarios. Although we are unable to predict future interest rate movements, our strategy of pairing Agency RMBS with MSR, with a focus on managing various associated risks, including interest rate, prepayment, credit, mortgage spread and financing risk, is intended to generate attractive yields with a low level of sensitivity to changes in the yield curve, prepayments and interest rate cycles.
The following table provides the three-month average constant prepayment rate, or CPR, experienced by our Agency RMBS and MSR during the three months ended December 31, 2022, and the four immediately preceding quarters:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended |
| | December 31,
2022 | | September 30,
2022 | | June 30,
2022 | | March 31,
2022 | | December 31,
2021 |
| Agency RMBS | | 5.9 | % | | 9.1 | % | | 14.2 | % | | 17.3 | % | | 27.7 | % |
| | | | | | | | | | |
| Mortgage servicing rights | | 4.6 | % | | 6.9 | % | | 10.0 | % | | 14.2 | % | | 22.1 | % |
Our Agency RMBS are primarily collateralized by pools of fixed-rate mortgage loans. Our Agency portfolio also includes securities with implicit prepayment protection, including lower loan balances (securities collateralized by loans of less than $200,000 in initial principal balance), higher LTVs (securities collateralized by loans with LTVs greater than or equal to 80%), certain geographic concentrations, loans secured by investor-owned properties and lower FICO scores. Our overall allocation of Agency RMBS and holdings of pools with specific characteristics are viewed in the context of our aggregate portfolio strategy, including MSR and related derivative hedging instruments. Additionally, the selection of securities with certain attributes is driven by the perceived relative value of the securities, which factors in the opportunities in the marketplace, the cost of financing and the cost of hedging interest rate, prepayment, credit and other portfolio risks. As a result, Agency RMBS capital allocation reflects management’s flexible approach to investing in the marketplace.
The following tables provide the carrying value of our Agency RMBS portfolio by underlying mortgage loan rate type:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2022 |
| (dollars in thousands) | Principal/ Current Face | | Carrying Value | | | | Weighted Average CPR (1) | | % Prepayment Protected | | Gross Weighted Average Coupon Rate | | Amortized Cost | | Allowance for Credit Losses | | Weighted Average Loan Age (months) |
| Agency RMBS AFS: | | | | | | | | | | | | | | | | | |
| 30-Year Fixed | | | | | | | | | | | | | | | | | |
| ≤ 2.5% | $ | — | | | $ | — | | | | | — | % | | — | % | | — | % | | $ | — | | | $ | — | | | — | |
| 3.0% | — | | | — | | | | | — | % | | — | % | | — | % | | — | | | — | | | — | |
| 3.5% | — | | | — | | | | | — | % | | — | % | | — | % | | — | | | — | | | — | |
| 4.0% | 1,459,733 | | | 1,382,120 | | | | | 3.9 | % | | 100.0 | % | | 4.6 | % | | 1,474,169 | | | — | | | 20 | |
| 4.5% | 3,087,310 | | | 3,006,356 | | | | | 5.9 | % | | 100.0 | % | | 5.2 | % | | 3,152,567 | | | — | | | 25 | |
| 5.0% | 2,439,709 | | | 2,430,470 | | | | | 6.5 | % | | 100.0 | % | | 5.7 | % | | 2,506,339 | | | — | | | 10 | |
| ≥ 5.5% | 411,899 | | | 419,956 | | | | | 3.9 | % | | 98.8 | % | | 6.5 | % | | 424,199 | | | — | | | 36 | |
| 7,398,651 | | | 7,238,902 | | | | | 5.6 | % | | 99.9 | % | | 5.3 | % | | 7,557,274 | | | — | | | 19 | |
| Other P&I | 382,626 | | | 378,558 | | | | | 1.3 | % | | 88.5 | % | | 5.4 | % | | 379,837 | | | — | | | 30 | |
| Interest-only | 963,865 | | | 36,116 | | | | | 8.1 | % | | — | % | | 4.9 | % | | 45,882 | | | (6,785) | | | 143 | |
| Agency Derivatives | 196,457 | | | 15,176 | | | | | 8.4 | % | | — | % | | 6.7 | % | | 20,696 | | | — | | | 216 | |
| Total Agency RMBS | $ | 8,941,599 | | | $ | 7,668,752 | | | | | | | 98.7 | % | | | | $ | 8,003,689 | | | $ | (6,785) | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2021 |
| (dollars in thousands) | Principal/ Current Face | | Carrying Value | | | | Weighted Average CPR (1) | | % Prepayment Protected | | Gross Weighted Average Coupon Rate | | Amortized Cost | | Allowance for Credit Losses | | Weighted Average Loan Age (months) |
| Agency RMBS AFS: | | | | | | | | | | | | | | | | | |
| 30-Year Fixed | | | | | | | | | | | | | | | | | |
| ≤ 2.5% | $ | 1,243,928 | | | $ | 1,271,382 | | | | | 5.9 | % | | — | % | | 3.3 | % | | $ | 1,272,323 | | | $ | — | | | 3 | |
| 3.0% | 1,316,662 | | | 1,384,176 | | | | | 9.6 | % | | 100.0 | % | | 3.7 | % | | 1,381,936 | | | — | | | 8 | |
| 3.5% | 739,922 | | | 789,499 | | | | | 27.3 | % | | 100.0 | % | | 4.2 | % | | 769,989 | | | — | | | 29 | |
| 4.0% | 1,421,793 | | | 1,543,595 | | | | | 26.5 | % | | 100.0 | % | | 4.6 | % | | 1,478,444 | | | — | | | 49 | |
| 4.5% | 1,307,504 | | | 1,435,877 | | | | | 27.7 | % | | 100.0 | % | | 5.0 | % | | 1,373,076 | | | — | | | 47 | |
| 5.0% | 231,941 | | | 255,059 | | | | | 44.9 | % | | 100.0 | % | | 5.7 | % | | 244,888 | | | — | | | 47 | |
| ≥ 5.5% | 93,544 | | | 106,687 | | | | | 15.7 | % | | 93.1 | % | | 6.4 | % | | 99,655 | | | — | | | 172 | |
| 6,355,294 | | | 6,786,275 | | | | | 20.5 | % | | 81.2 | % | | 4.3 | % | | 6,620,311 | | | — | | | 31 | |
| Other P&I | 56,069 | | | 62,228 | | | | | 53.9 | % | | — | % | | 6.5 | % | | 61,739 | | | — | | | 224 | |
| Interest-only | 3,198,447 | | | 300,896 | | | | | 20.2 | % | | — | % | | 3.6 | % | | 305,577 | | | (12,851) | | | 47 | |
| Agency Derivatives | 247,101 | | | 40,911 | | | | | 18.6 | % | | — | % | | 6.7 | % | | 33,237 | | | — | | | 206 | |
| Total Agency RMBS | $ | 9,856,911 | | | $ | 7,190,310 | | | | | | | 76.6 | % | | | | $ | 7,020,864 | | | $ | (12,851) | | | |
____________________
(1)Weighted average actual one-month CPR released at the beginning of the following month based on RMBS held as of the preceding month-end.
Our MSR business offers attractive spreads and has many risk reducing characteristics when paired with our Agency RMBS portfolio. The following table summarizes activity related to the unpaid principal balance, or UPB, of loans underlying our MSR portfolio for the three months ended December 31, 2022, and the four immediately preceding quarters:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended |
| (in thousands) | | December 31,
2022 | | September 30,
2022 | | June 30,
2022 | | March 31,
2022 | | December 31,
2021 |
| UPB at beginning of period | | $ | 206,613,560 | | | $ | 227,074,413 | | | $ | 229,415,913 | | | $ | 193,770,566 | | | $ | 194,393,942 | |
Purchases of mortgage servicing rights | | 2,677,674 | | | 4,448,870 | | | 5,720,323 | | | 45,136,996 | | | 13,562,240 | |
Sales of mortgage servicing rights | | — | | | (19,807,427) | | | — | | | — | | | 9,065 | |
| Scheduled payments | | (1,538,046) | | | (1,564,465) | | | (1,697,237) | | | (1,572,871) | | | (1,441,835) | |
| Prepaid | | (2,439,936) | | | (3,709,416) | | | (6,026,461) | | | (8,249,432) | | | (11,966,741) | |
| Other changes | | (436,559) | | | 171,585 | | | (338,125) | | | 330,654 | | | (786,105) | |
| UPB at end of period | | $ | 204,876,693 | | | $ | 206,613,560 | | | $ | 227,074,413 | | | $ | 229,415,913 | | | $ | 193,770,566 | |
Counterparty exposure and leverage ratio
We monitor counterparty exposure amongst 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 any single counterparty.
As of December 31, 2022, we had entered into repurchase agreements with 39 counterparties, 20 of which had outstanding balances. In addition, we held short- and long-term borrowings under revolving credit facilities, long-term term notes payable and long-term unsecured convertible senior notes. As of December 31, 2022, the debt-to-equity ratio funding our AFS securities, MSR and Agency Derivatives, which includes unsecured borrowings under convertible senior notes, was 4.4:1.0.
As of December 31, 2022, we held $683.5 million in cash and cash equivalents, approximately $344.6 million of unpledged AFS securities and Agency derivatives, which includes $343.0 million of unsettled Agency RMBS purchases, and $7.6 million of unpledged non-Agency securities. As a result, we had an overall estimated unused borrowing capacity on our unpledged securities of approximately $6.1 million. As of December 31, 2022, we held approximately $26.9 million of unpledged MSR and $51.2 million of unpledged servicing advances. Overall, on December 31, 2022, we had $293.8 million unused committed and $402.3 million unused uncommitted borrowing capacity on MSR financing facilities, and $176.2 million in unused committed borrowing capacity on servicing advance financing facilities. Generally, unused borrowing capacity may be the result of our election not to utilize certain financing, as well as delays in the timing in which funding is provided, insufficient collateral or the inability to meet lenders’ eligibility requirements for specific types of asset classes.
We also monitor exposure to our MSR counterparties. We may be required to make representations and warranties to investors in the loans underlying the MSR we own; however, some of our MSR were purchased on a bifurcated basis, meaning the representation and warranty obligations remain with the seller. If the representations and warranties we make prove to be inaccurate, we may be obligated to repurchase certain mortgage loans, which may impact the profitability of our portfolio. 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 counterparty 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.
LIBOR transition
The London Interbank Offered Rate, or LIBOR, has been used extensively in the U.S. and globally as a “benchmark” or “reference rate” for various commercial and financial contracts, including corporate and municipal bonds and loans, floating rate mortgages, asset-backed securities, consumer loans, and interest rate swaps and other derivatives. On March 5, 2021, Intercontinental Exchange Inc. announced that ICE Benchmark Administration Limited, the administrator of LIBOR, intends to stop publication of the majority of USD-LIBOR tenors on June 30, 2023. In the U.S., the Alternative Reference Rates Committee, or ARRC, has identified the Secured Overnight Financing Rate, or SOFR, as its preferred alternative rate for U.S. dollar-based LIBOR. SOFR is a measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and is based on directly observable U.S. Treasury-backed repurchase transactions. Numerous industry wide and company-specific transitions as it relates to derivatives and cash markets exposed to LIBOR are in process, if not complete. The majority of our material contracts that are or were indexed to USD-LIBOR have been amended to transition to an alternative benchmark, where necessary. As of December 31, 2022, only the Company’s term notes incorporate LIBOR as the referenced rate and mature after the phase-out of LIBOR. However, the related agreements have provisions in place that provide for an alternative to LIBOR upon its phase-out. The Company has no other financing arrangements or derivative instruments that incorporate LIBOR as the referenced rate as of December 31, 2022. Additionally, each series of our fixed-to-floating preferred stock that becomes redeemable at the time the stock begins to pay a LIBOR-based rate has existing LIBOR cessation fallback language.
Summary of Results of Operations and Financial Condition
All per share amounts, common shares outstanding and common equity-based awards for all periods presented have been adjusted on a retroactive basis to reflect the reverse stock split.
Our book value per common share for U.S. GAAP purposes was $17.72 at December 31, 2022, an increase from $16.42 per common share at September 30, 2022, and a decrease from $23.47 per common share at December 31, 2021. The rise in book value for the three months ended December 31, 2022 was primarily the result of mortgage spread tightening, as well as the repurchase of 2,957,950 shares of preferred stock, which contributed approximately $0.26 to book value per common share. The decline in book value for the year ended December 31, 2022 was primarily the result of significant widening in mortgage spreads during the first nine months of the year, as the market reacted unfavorably to higher than expected inflation and aggressively hawkish words and actions from the Fed as it removed accommodation, offset by the positive fourth quarter developments noted above.
Our GAAP net loss attributable to common stockholders was $262.4 million and GAAP net income attributable to common stockholders was $186.8 million ($(3.04) and $2.13 per diluted weighted average share) for the three and twelve months ended December 31, 2022, respectively, as compared to GAAP net loss attributable to common stockholders of $15.0 million and GAAP net income attributable to common stockholders of $128.8 million ($(0.18) and $1.72 per diluted weighted average share) for the three and twelve months ended December 31, 2021, respectively.
With our accounting treatment for AFS securities, unrealized fluctuations in the market values of AFS securities, excluding certain AFS securities for which we have elected the fair value option and securities with an allowance for credit losses, do not impact our GAAP net income (loss) or taxable income but are recognized on our consolidated balance sheets as a change in stockholders’ equity under “accumulated other comprehensive (loss) income.” For the three months ended December 31, 2022, net unrealized gains on AFS securities recognized as other comprehensive income were $106.7 million, which was the result of mortgage spread tightening. For the year ended December 31, 2022, net unrealized losses on AFS securities recognized as other comprehensive loss were $893.6 million, which was driven by significant underperformance of fixed income markets in general and widening mortgage spreads, particularly in the third quarter. Additionally, we reclassify unrealized gains and losses on AFS securities in accumulated other comprehensive (loss) income to net income (loss) upon the recognition of any realized gains and losses on sales as individual securities are sold. For the three and twelve months ended December 31, 2022 we reclassified $316.0 million and $428.5 million in unrealized losses, respectively, on sold AFS securities from accumulated other comprehensive (loss) income to (loss) gain on investment securities on the consolidated statements of comprehensive loss.
In total, we recognized other comprehensive income of $422.7 million for the three months ended December 31, 2022 and other comprehensive loss of $465.1 million for the year ended December 31, 2022. Combined with GAAP net loss attributable to common stockholders of $262.4 million and GAAP net income attributable to common stockholders of $186.8 million for the three and twelve months ended December 31, 2022, respectively, this resulted in comprehensive income attributable to common stockholders of $160.2 million and comprehensive loss attributable to common stockholders of $278.3 million for the three and twelve months ended December 31, 2022, respectively.
The following tables present the components of our comprehensive loss for the three and twelve months ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| (in thousands, except share data) | | Three Months Ended | | Year Ended |
| Income Statement Data: | | December 31, | | December 31, |
| | 2022 | | 2021 | | 2022 | | 2021 | | |
| | (unaudited) | | |
| Interest income: | | | | | | | | | | |
| Available-for-sale securities | | $ | 83,712 | | | $ | 32,729 | | | $ | 272,230 | | | $ | 167,310 | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| Other | | 15,591 | | | 276 | | | 23,310 | | | 1,287 | | | |
| Total interest income | | 99,303 | | | 33,005 | | | 295,540 | | | 168,597 | | | |
| Interest expense: | | | | | | | | | | |
| Repurchase agreements | | 81,975 | | | 4,562 | | | 167,455 | | | 25,774 | | | |
| | | | | | | | | | |
| Revolving credit facilities | | 21,854 | | | 5,050 | | | 51,814 | | | 22,425 | | | |
| Term notes payable | | 6,906 | | | 3,251 | | | 19,514 | | | 12,936 | | | |
| Convertible senior notes | | 4,892 | | | 7,295 | | | 19,612 | | | 28,038 | | | |
| | | | | | | | | | |
| Total interest expense | | 115,627 | | | 20,158 | | | 258,395 | | | 89,173 | | | |
Net interest (expense) income | | (16,324) | | | 12,847 | | | 37,145 | | | 79,424 | | | |
| | | | | | | | | | |
Other (loss) income: | | | | | | | | | | |
(Loss) gain on investment securities | | (347,450) | | | 1,626 | | | (603,937) | | | 121,617 | | | |
Servicing income | | 160,926 | | | 125,511 | | | 603,911 | | | 468,406 | | | |
(Loss) gain on servicing asset | | (64,085) | | | (131,828) | | | 425,376 | | | (114,941) | | | |
Gain on interest rate swap and swaption agreements | | — | | | 36,989 | | | 29,499 | | | 42,091 | | | |
Gain (loss) on other derivative instruments | | 53,301 | | | (11,565) | | | 9,310 | | | (251,283) | | | |
| Other income (loss) | | 112 | | | 1,856 | | | (5) | | | (3,845) | | | |
| Total other (loss) income | | (197,196) | | | 22,589 | | | 464,154 | | | 262,045 | | | |
| Expenses: | | | | | | | | | | |
| | | | | | | | | | |
| Servicing expenses | | 25,272 | | | 21,582 | | | 94,119 | | | 86,250 | | | |
| | | | | | | | | | |
| Compensation and benefits | | 7,411 | | | 6,396 | | | 40,723 | | | 35,041 | | | |
| Other operating expenses | | 15,540 | | | 6,648 | | | 42,005 | | | 28,759 | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| Total expenses | | 48,223 | | | 34,626 | | | 176,847 | | | 150,050 | | | |
(Loss) income before income taxes | | (261,743) | | | 810 | | | 324,452 | | | 191,419 | | | |
| Provision for income taxes | | 8,480 | | | 2,104 | | | 104,213 | | | 4,192 | | | |
| | | | | | | | | | |
| | | | | | | | | | |
Net (loss) income | | (270,223) | | | (1,294) | | | 220,239 | | | 187,227 | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| Dividends on preferred stock | | (12,365) | | | (13,747) | | | (53,607) | | | (58,458) | | | |
| Gain on repurchase and retirement of preferred stock | | 20,149 | | | — | | | 20,149 | | | — | | | |
Net (loss) income attributable to common stockholders | | $ | (262,439) | | | $ | (15,041) | | | $ | 186,781 | | | $ | 128,769 | | | |
Basic (loss) earnings per weighted average common share | | $ | (3.04) | | | $ | (0.18) | | | $ | 2.15 | | | $ | 1.72 | | | |
Diluted (loss) earnings per weighted average common share | | $ | (3.04) | | | $ | (0.18) | | | $ | 2.13 | | | $ | 1.72 | | | |
| Dividends declared per common share | | $ | 0.60 | | | $ | 0.68 | | | $ | 2.64 | | | $ | 2.72 | | | |
Weighted average number of shares of common stock: | | | | | | | | | | |
Basic | | 86,391,405 | | | 83,775,184 | | | 86,179,418 | | | 74,443,000 | | | |
Diluted | | 86,391,405 | | | 83,775,184 | | | 96,076,175 | | | 74,510,884 | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| (in thousands) | | Three Months Ended | | Year Ended |
| Income Statement Data: | | December 31, | | December 31, |
| | 2022 | | 2021 | | 2022 | | 2021 | | |
| | (unaudited) | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
Comprehensive income (loss): | | | | | | | | | | |
| Net (loss) income | | $ | (270,223) | | | $ | (1,294) | | | $ | 220,239 | | | $ | 187,227 | | | |
Other comprehensive income (loss): | | | | | | | | | | |
Unrealized gain (loss) on available-for-sale securities | | 422,672 | | | (113,553) | | | (465,057) | | | (455,255) | | | |
Other comprehensive income (loss) | | 422,672 | | | (113,553) | | | (465,057) | | | (455,255) | | | |
Comprehensive income (loss) | | 152,449 | | | (114,847) | | | (244,818) | | | (268,028) | | | |
| | | | | | | | | | |
| | | | | | | | | | |
| Dividends on preferred stock | | (12,365) | | | (13,747) | | | (53,607) | | | (58,458) | | | |
| Gain on repurchase and retirement of preferred stock | | 20,149 | | | — | | | 20,149 | | | — | | | |
Comprehensive income (loss) attributable to common stockholders | | $ | 160,233 | | | $ | (128,594) | | | $ | (278,276) | | | $ | (326,486) | | | |
| | | | | | | | | | | | | | |
| (in thousands) | | December 31,
2022 | | December 31,
2021 |
| Balance Sheet Data: | | |
| | | | |
| Available-for-sale securities | | $ | 7,778,734 | | | $ | 7,161,703 | |
| Mortgage servicing rights | | $ | 2,984,937 | | | $ | 2,191,578 | |
| Total assets | | $ | 13,466,160 | | | $ | 12,114,305 | |
| Repurchase agreements | | $ | 8,603,011 | | | $ | 7,656,445 | |
| | | | |
| Revolving credit facilities | | $ | 1,118,831 | | | $ | 420,761 | |
| Term notes payable | | $ | 398,011 | | | $ | 396,776 | |
| Convertible senior notes | | $ | 282,496 | | | $ | 424,827 | |
| Total stockholders’ equity | | $ | 2,183,525 | | | $ | 2,743,953 | |
| | | | |
Results of Operations
The following analysis focuses on financial results during the three and twelve months ended December 31, 2022 and 2021. The analysis of our financial results during the three and twelve months ended December 31, 2021 and 2020 is omitted from this Form 10-K and included in Part II Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2021, which analysis is incorporated by reference.
Interest Income
Interest income increased from $33.0 million and $168.6 million for the three and twelve months ended December 31, 2021, respectively, to $99.3 million and $295.5 million for the same periods in 2022 due to lower amortization recognized on Agency RMBS due to slower prepayments, higher interest on cash balances as a result of the higher interest rate environment and increased use of reverse repurchase agreements. Also contributing to the increase for the three months ended December 31, 2022, as compared to the same period in 2021, was an increase in average AFS securities average amortized cost held due to net purchases. However, for the year ended December 31, 2022, as compared to the same period in 2021, the increase was offset by a decrease in average AFS securities average amortized cost held due to net sales.
Interest Expense
Interest expense increased from $20.2 million and $89.2 million for the three and twelve months ended December 31, 2021, respectively, to $115.6 million and $258.4 million for the same periods in 2022 due primarily to the higher interest rate environment as well as an increase in financing on MSR and Agency RMBS.
Net Interest Income
The following tables present the components of interest income and average net asset yield earned by asset type, the components of interest expense and average cost of funds on borrowings incurred by collateral type, and net interest income and average net interest spread for the three and twelve months ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended December 31, 2022 | | Year Ended December 31, 2022 | | |
| (dollars in thousands) | Average Balance (1) | | Interest Income/Expense | | Net Yield/Cost of Funds | | Average Balance (1) | | Interest Income/Expense | | Net Yield/Cost of Funds | | | | | | |
Interest-earning assets: | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Available-for-sale securities | $ | 8,118,269 | | | $ | 83,712 | | | 4.1 | % | | $ | 7,997,618 | | | $ | 272,230 | | | 3.4 | % | | | | | | |
| Reverse repurchase agreements | 743,925 | | | 7,109 | | | 3.8 | % | | 311,844 | | | 8,469 | | | 2.7 | % | | | | | | |
Other | — | | | 8,482 | | | — | % | | — | | | 14,841 | | | — | % | | | | | | |
| | | | | | | | | | | | | | | | | |
Total interest income/net asset yield | $ | 8,862,194 | | | $ | 99,303 | | | 4.5 | % | | $ | 8,309,462 | | | $ | 295,540 | | | 3.6 | % | | | | | | |
Interest-bearing liabilities: | | | | | | | | | | | | | | | | | |
Borrowings collateralized by: | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Available-for-sale securities | $ | 7,664,204 | | | $ | 68,627 | | | 3.6 | % | | $ | 7,804,563 | | | $ | 138,138 | | | 1.8 | % | | | | | | |
Agency Derivatives (2) | 14,618 | | | 155 | | | 4.2 | % | | 24,553 | | | 438 | | | 1.8 | % | | | | | | |
Mortgage servicing rights and advances (3) | 1,917,069 | | | 36,938 | | | 7.7 | % | | 1,620,847 | | | 95,192 | | | 5.9 | % | | | | | | |
U.S. Treasuries (4) | 493,872 | | | 5,015 | | | 4.1 | % | | 123,468 | | | 5,015 | | | 4.1 | % | | | | | | |
| | | | | | | | | | | | | | | | | |
Unsecured borrowings: | | | | | | | | | | | | | | | | | |
Convertible senior notes | 282,363 | | | 4,892 | | | 6.9 | % | | 287,399 | | | 19,612 | | | 6.8 | % | | | | | | |
| | | | | | | | | | | | | | | | | |
Total interest expense/cost of funds | $ | 10,372,126 | | | $ | 115,627 | | | 4.5 | % | | $ | 9,860,830 | | | $ | 258,395 | | | 2.6 | % | | | | | | |
Net interest (expense) income/spread | | | $ | (16,324) | | | — | % | | | | $ | 37,145 | | | 1.0 | % | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended December 31, 2021 | | Year Ended December 31, 2021 |
| (dollars in thousands) | Average Balance (1) | | Interest Income/Expense | | Net Yield/Cost of Funds | | Average Balance (1) | | Interest Income/Expense | | Net Yield/Cost of Funds |
Interest-earning assets | | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| Available-for-sale securities | $ | 6,067,568 | | | $ | 32,729 | | | 2.2 | % | | $ | 8,450,440 | | | $ | 167,310 | | | 2.0 | % |
| Reverse repurchase agreements | 111,209 | | | 1 | | | — | % | | 89,011 | | | 7 | | | — | % |
Other | — | | | 275 | | | — | % | | — | | | 1,280 | | | — | % |
| | | | | | | | | | | |
Total interest income/net asset yield | $ | 6,178,777 | | | $ | 33,005 | | | 2.1 | % | | $ | 8,539,451 | | | $ | 168,597 | | | 2.0 | % |
Interest-bearing liabilities | | | | | | | | | | | |
Borrowings collateralized by: | | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| Available-for-sale securities | $ | 6,503,608 | | | $ | 2,911 | | | 0.2 | % | | $ | 9,098,301 | | | $ | 20,794 | | | 0.2 | % |
Agency Derivatives (2) | 38,045 | | | 69 | | | 0.7 | % | | 43,910 | | | 349 | | | 0.8 | % |
Mortgage servicing rights and advances (3) | 942,357 | | | 9,883 | | | 4.2 | % | | 931,565 | | | 39,992 | | | 4.3 | % |
| | | | | | | | | | | |
| | | | | | | | | | | |
Unsecured borrowings: | | | | | | | | | | | |
Convertible senior notes | 424,641 | | | 7,295 | | | 6.9 | % | | 412,107 | | | 28,038 | | | 6.8 | % |
| | | | | | | | | | | |
Total interest expense/cost of funds | $ | 7,908,651 | | | $ | 20,158 | | | 1.0 | % | | $ | 10,485,883 | | | $ | 89,173 | | | 0.9 | % |
Net interest income/spread | | | $ | 12,847 | | | 1.1 | % | | | | $ | 79,424 | | | 1.1 | % |
____________________
(1)Average asset balance represents average amortized cost on AFS securities and average unpaid principal balance on other assets.
(2)Yields on Agency Derivatives not shown as interest income is included in gain (loss) on other derivative instruments in the consolidated statements of comprehensive loss.
(3)Yields on mortgage servicing rights and advances not shown as these assets do not earn interest.
(4)U.S. Treasury securities effectively borrowed under reverse repurchase agreements.
The increase in yields on AFS securities for the three and twelve months ended December 31, 2022, as compared to the same periods in 2021 was primarily driven by lower amortization as a result of slower prepayment speeds. The increase in cost of funds associated with the financing of AFS securities for the three and twelve months ended December 31, 2022, as compared to the same periods in 2021, was due to rising interest rates.
The increase in yields on reverse repurchase agreements for the three and twelve months ended December 31, 2022, as compared to the same periods in 2021, was the result of rising interest rates. However, these yields were offset by the cost of financing the associated repurchase agreements collateralized by U.S. Treasury securities during the three and twelve months ended December 31, 2022. We did not hold any repurchase agreements collateralized by U.S. Treasury securities during the three and twelve months ended December 31, 2021.
The increase in cost of funds associated with the financing of Agency Derivatives for the three and twelve months ended December 31, 2022, as compared to the same periods in 2021, was the result of rising interest rates.
The increase in cost of funds associated with the financing of MSR assets and related servicing advance obligations for the three and twelve months ended December 31, 2022, as compared to the same periods in 2021, was due to rising interest rates and an increase in the use of revolving credit facility and repurchase agreement financing which on average carry higher floating rate spreads than term notes. We have one revolving credit facility in place to finance our servicing advance obligations, which are included in other assets on our consolidated balance sheets.
The cost of funds associated with our convertible senior notes for the three and twelve months ended December 31, 2022, as compared to the same periods in 2021, was consistent.
The following tables present the components of the yield earned on our AFS securities portfolio as a percentage of our average amortized cost of securities for the three and twelve months ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended | | Year Ended |
| December 31, | | December 31, |
| (in thousands) | 2022 | | 2021 | | 2022 | | 2021 |
| Gross yield/stated coupon | 4.6 | % | | 4.9 | % | | 4.4 | % | | 4.7 | % |
Net (premium amortization) discount accretion | (0.5) | % | | (2.7) | % | | (1.0) | % | | (2.7) | % |
| Net yield | 4.1 | % | | 2.2 | % | | 3.4 | % | | 2.0 | % |
(Loss) Gain On Investment Securities
The following table presents the components of (loss) gain on investment securities for the three and twelve months ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended | | Year Ended |
| December 31, | | December 31, |
| (in thousands) | 2022 | | 2021 | | 2022 | | 2021 | | |
| Proceeds from sales | $ | 2,770,811 | | | $ | 1,171,299 | | | $ | 7,793,705 | | | $ | 6,274,193 | | | |
| Amortized cost of securities sold | (3,113,102) | | | (1,139,241) | | | (8,359,967) | | | (6,137,824) | | | |
| Total realized (losses) gains on sales | (342,291) | | | 32,058 | | | (566,262) | | | 136,369 | | | |
| Reversal of (provision for) credit losses | 318 | | | (3,347) | | | (2,730) | | | (9,763) | | | |
| Other | (5,477) | | | (27,085) | | | (34,945) | | | (4,989) | | | |
(Loss) gain on investment securities | $ | (347,450) | | | $ | 1,626 | | | $ | (603,937) | | | $ | 121,617 | | | |
In the ordinary course of our business, we make investment decisions and allocate capital in accordance with our views on the changing risk/reward dynamics in the market and in our portfolio. We do not expect to sell assets on a frequent basis, but may sell assets to reallocate capital into new assets that we believe have higher risk-adjusted returns.
We use a discounted cash flow method to estimate and recognize an allowance for credit losses on AFS securities. Subsequent adverse or favorable changes in expected cash flows are recognized immediately in earnings as a provision for or reversal of provision for credit losses (within (loss) gain on investment securities).
The majority of the “other” component of (loss) gain on investment securities is related to changes in unrealized gains (losses) on certain AFS securities for which we have elected the fair value option. Fluctuations in this line item are primarily driven by the reclassification of unrealized gains and losses to realized gains and losses upon sale, as well as changes in fair value assumptions.
Servicing Income
The following table presents the components of servicing income for the three and twelve months ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended | | Year Ended |
| December 31, | | December 31, |
| (in thousands) | 2022 | | 2021 | | 2022 | | 2021 | | |
| Servicing fee income | $ | 137,949 | | | $ | 123,912 | | | $ | 564,923 | | | $ | 461,381 | | | |
| Ancillary and other fee income | 418 | | | 548 | | | 1,932 | | | 2,436 | | | |
| Float income | 22,559 | | | 1,051 | | | 37,056 | | | 4,589 | | | |
| Total | $ | 160,926 | | | $ | 125,511 | | | $ | 603,911 | | | $ | 468,406 | | | |
The increase in servicing income for the three and twelve months ended December 31, 2022, as compared to the same periods in 2021, was due to a higher portfolio balance, lower compensating interest as a result of lower prepayment rates and higher float income as a result of the higher interest rate environment.
(Loss) Gain On Servicing Asset
The following table presents the components of gain (loss) on servicing asset for the three and twelve months ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended | | Year Ended |
| December 31, | | December 31, |
| (in thousands) | 2022 | | 2021 | | 2022 | | 2021 |
Changes in fair value due to changes in valuation inputs or assumptions used in the valuation model | $ | (6,441) | | | $ | 21,189 | | | $ | 793,631 | | | $ | 562,843 | |
Changes in fair value due to realization of cash flows (runoff) | (60,908) | | | (152,450) | | | (371,023) | | | (666,160) | |
Gains (losses) on sales | 3,264 | | | (567) | | | 2,768 | | | (11,624) | |
(Loss) gain on servicing asset | $ | (64,085) | | | $ | (131,828) | | | $ | 425,376 | | | $ | (114,941) | |
The decrease in loss on servicing asset for the three months ended December 31, 2022, as compared to the same period in 2021, was driven by lower portfolio runoff and gains on sales of MSR, offset by unfavorable change in valuation assumptions used in the fair valuation of MSR. The increase in gain (decrease in loss) on servicing asset for the year ended December 31, 2022, as compared to the same period in 2021, was driven by higher favorable change in valuation assumptions used in the fair valuation of MSR, lower portfolio runoff and gains on sales of MSR.
Gain On Interest Rate Swap And Swaption Agreements
The following table summarizes the net interest spread and gains and losses associated with our interest rate swap and swaption positions recognized during the three and twelve months ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended | | Year Ended |
| December 31, | | December 31, |
| (in thousands) | 2022 | | 2021 | | 2022 | | 2021 |
| Net interest spread | $ | — | | | $ | 5,772 | | | $ | (4,830) | | | $ | 14,262 | |
Early termination, agreement maturation and option expiration (losses) gains | — | | | (5,143) | | | 43,197 | | | 2,369 | |
Change in unrealized gain (loss) on interest rate swap and swaption agreements, at fair value | — | | | 36,360 | | | (8,868) | | | 25,460 | |
Gain on interest rate swap and swaption agreements | $ | — | | | $ | 36,989 | | | $ | 29,499 | | | $ | 42,091 | |
Net interest spread recognized for the accrual and/or settlement of the net interest expense associated with our interest rate swaps results from receiving either a floating interest rate (OIS or SOFR) or a fixed interest rate and paying either a fixed interest rate or a floating interest rate (OIS or SOFR) on positions held to economically hedge/mitigate portfolio interest rate exposure (or duration) risk. We may elect to terminate certain swaps and swaptions to align with our investment portfolio, agreements may mature or options may expire resulting in full settlement of our net interest spread asset/liability and the recognition of realized gains and losses, including early termination penalties. The change in fair value of interest rate swaps and swaptions during the three and twelve months ended December 31, 2022 and 2021 was a result of changes to floating interest rates (OIS or SOFR), the swap curve and corresponding counterparty borrowing rates. Since swaps and swaptions are used for purposes of hedging our interest rate exposure, their unrealized valuation gains and losses (excluding the reversal of unrealized gains and losses to realized gains and losses upon termination, maturation or option expiration) are generally offset by unrealized losses and gains in our Agency RMBS AFS portfolio, which are recorded either directly to stockholders’ equity through other comprehensive loss or to (loss) gain on investment securities, in the case of certain AFS securities for which we have elected the fair value option.
Gain (Loss) On Other Derivative Instruments
The following table provides a summary of the total net gains (losses) recognized on other derivative instruments we hold for purposes of both hedging and non-hedging activities, principally TBAs, futures, options on futures, and inverse interest-only securities during the three and twelve months ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended | | Year Ended |
| (in thousands) | December 31, | | December 31, |
| 2022 | | 2021 | | 2022 | | 2021 | | |
TBAs | $ | 48,233 | | | $ | (20,225) | | | $ | (487,713) | | | $ | (193,479) | | | |
| | | | | | | | | |
Futures | 5,016 | | | 14,638 | | | 514,467 | | | (49,213) | | | |
Options on TBAs | — | | | (5,683) | | | — | | | (5,683) | | | |
| | | | | | | | | |
Options on futures | — | | | — | | | (2,224) | | | — | | | |
| | | | | | | | | |
| | | | | | | | | |
Inverse interest-only securities | 52 | | | (295) | | | (15,220) | | | (2,908) | | | |
| | | | | | | | | |
Gain (loss) on other derivative instruments | $ | 53,301 | | | $ | (11,565) | | | $ | 9,310 | | | $ | (251,283) | | | |
All derivative instruments shown above are considered trading instruments. As a result, our financial results include both realized and unrealized gains (losses) associated with these instruments. The increase in gain (decrease in loss) on other derivative instruments for the three months ended December 31, 2022, as compared to the same period in 2021, was driven by net realized and unrealized gains recognized on TBAs. The increase in gain (decrease in loss) on other derivative instruments for the year ended December 31, 2022, as compared to the same period in 2021, was driven by net realized and unrealized gains recognized on futures, offset by net realized and unrealized losses recognized on TBAs. For further details regarding our use of derivative instruments and related activity, refer to Note 7 - Derivative Instruments and Hedging Activities to the consolidated financial statements, included in this Annual Report on Form 10-K.
Expenses
The following table presents the components of expenses for the three and twelve months ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended | | Year Ended |
| December 31, | | December 31, |
| (dollars in thousands) | 2022 | | 2021 | | 2022 | | 2021 |
| | | | | | | |
Servicing expenses | $ | 25,272 | | | $ | 21,582 | | | $ | 94,119 | | | $ | 86,250 | |
| Operating expenses: | | | | | | | |
| Compensation and benefits: | | | | | | | |
Non-cash equity compensation expenses | $ | 1,653 | | | $ | 2,525 | | | $ | 11,630 | | | $ | 11,485 | |
All other compensation and benefits | 5,758 | | | 3,871 | | | 29,093 | | | 23,556 | |
Total compensation and benefits | $ | 7,411 | | | $ | 6,396 | | | $ | 40,723 | | | $ | 35,041 | |
| Other operating expenses: | | | | | | | |
| Nonrecurring expenses | $ | 10,836 | | | $ | 665 | | | $ | 18,982 | | | $ | 5,220 | |
All other operating expenses | 4,704 | | | 5,983 | | | 23,023 | | | 23,539 | |
| Total other operating expenses | $ | 15,540 | | | $ | 6,648 | | | $ | 42,005 | | | $ | 28,759 | |
Annualized operating expense ratio | 4.2 | % | | 1.9 | % | | 3.3 | % | | 2.3 | % |
Annualized operating expense ratio, excluding non-cash equity compensation and other nonrecurring expenses | 1.9 | % | | 1.4 | % | | 2.1 | % | | 1.7 | % |
We incur servicing expenses generally related to the subservicing of MSR. The increase in servicing expenses during the three and twelve months ended December 31, 2022, as compared to the same periods in 2021, was a result of an increase in portfolio size and subservicing fees.
The increase in total operating expenses during the three and twelve months ended December 31, 2022, as compared to the same period in 2021, was driven by higher compensation and benefits and nonrecurring expenses, offset by lower other operating expenses.
Income Taxes
During the three and twelve months ended December 31, 2022, our TRSs recognized a provision for income taxes of $8.5 million and $104.2 million, respectively. The provision recognized for the three months ended December 31, 2022 was primarily due to income from MSR servicing activities and net gains recognized on derivative instruments offset by net losses recognized on MSR and operating expenses. The provision recognized for the year ended December 31, 2022 was primarily due to income from MSR servicing activities and net gains recognized on MSR offset by net losses recognized on derivative instruments and operating expenses. During the three and twelve months ended December 31, 2021, our TRSs recognized a provision for income taxes of $2.1 million and $4.2 million, respectively, which was primarily due to income from MSR servicing activities and gains recognized on MSR, offset by net losses recognized on derivative instruments held and operating expenses.
Financial Condition
Available-for-Sale Securities, at Fair Value
The majority of our AFS investment securities portfolio is comprised of fixed rate Agency mortgage-backed securities backed by single-family and multi-family mortgage loans. We also hold $125.2 million in tranches of mortgage-backed and asset-backed P&I and interest-only non-Agency securities. All of our P&I Agency RMBS AFS are Fannie Mae or Freddie Mac mortgage pass-through certificates or collateralized mortgage obligations, 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 tables below summarizes certain characteristics of our Agency RMBS AFS at December 31, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2022 |
| (dollars in thousands, except purchase price) | Principal/ Current Face | | Net (Discount) Premium | | Amortized Cost | | Allowance for Credit Losses | | Unrealized Gain | | Unrealized Loss | | Carrying Value | | Weighted Average Coupon Rate | | Weighted Average Purchase Price |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| P&I securities | $ | 7,781,277 | | | $ | 155,833 | | | $ | 7,937,110 | | | $ | — | | | $ | 6,310 | | | $ | (325,960) | | | $ | 7,617,460 | | | 4.64 | % | | $ | 102.26 | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Interest-only securities | 963,866 | | | 45,882 | | | 45,882 | | | (6,785) | | | 1,890 | | | (4,871) | | | 36,116 | | | 1.98 | % | | $ | 19.55 | |
| Total | $ | 8,745,143 | | | $ | 201,715 | | | $ | 7,982,992 | | | $ | (6,785) | | | $ | 8,200 | | | $ | (330,831) | | | $ | 7,653,576 | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2021 |
| (dollars in thousands, except purchase price) | Principal/ Current Face | | Net (Discount) Premium | | Amortized Cost | | Allowance for Credit Losses | | Unrealized Gain | | Unrealized Loss | | Carrying Value | | Weighted Average Coupon Rate | | Weighted Average Purchase Price |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| P&I securities | $ | 6,411,363 | | | $ | 270,687 | | | $ | 6,682,050 | | | $ | — | | | $ | 171,308 | | | $ | (4,855) | | | $ | 6,848,503 | | | 3.65 | % | | $ | 104.66 | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Interest-only securities | 3,198,447 | | | 305,577 | | | 305,577 | | | (12,851) | | | 20,699 | | | (12,529) | | | 300,896 | | | 2.93 | % | | $ | 14.09 | |
| Total | $ | 9,609,810 | | | $ | 576,264 | | | $ | 6,987,627 | | | $ | (12,851) | | | $ | 192,007 | | | $ | (17,384) | | | $ | 7,149,399 | | | | | |
Mortgage Servicing Rights, at Fair Value
One of our wholly owned subsidiaries has approvals from Fannie Mae and Freddie Mac to own 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 appropriately licensed subservicers to handle substantially all servicing functions in the name of the subservicer for the loans underlying our MSR. As of December 31, 2022 and December 31, 2021, our MSR had a fair market value of $3.0 billion and $2.2 billion, respectively.
As of December 31, 2022 and December 31, 2021, our MSR portfolio included MSR on 809,025 and 796,205 loans with an unpaid principal balance of approximately $204.9 billion and $193.8 billion, respectively. The following tables summarize certain characteristics of the loans underlying our MSR by gross weighted average coupon rate types and ranges at December 31, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2022 |
| (dollars in thousands) | Number of Loans | | Unpaid Principal Balance | | | | | | Weighted Average Gross Coupon Rate | | Weighted Average Current Loan Size | | Weighted Average Loan Age (months) | | Weighted Average Original FICO | | Weighted Average Original LTV | | 60+ Day Delinquencies | | 3-Month CPR | | Net Servicing Fee (bps) |
| 30-Year Fixed: | | | | | | | | | | | | | | | | | | | | | | | |
| ≤ 3.25% | 299,221 | | | $ | 96,929,358 | | | | | | | 2.8 | % | | $ | 382 | | | 23 | | | 768 | | | 71.0 | % | | 0.4 | % | | 3.3 | % | | 25.8 | |
| > 3.25 - 3.75% | 140,499 | | | 36,531,127 | | | | | | | 3.4 | % | | 327 | | | 38 | | | 754 | | | 74.2 | % | | 0.8 | % | | 5.0 | % | | 26.3 | |
| > 3.75 - 4.25% | 108,214 | | | 22,603,005 | | | | | | | 3.9 | % | | 272 | | | 61 | | | 751 | | | 75.7 | % | | 1.3 | % | | 6.3 | % | | 27.3 | |
| > 4.25 - 4.75% | 60,343 | | | 10,752,661 | | | | | | | 4.4 | % | | 249 | | | 63 | | | 736 | | | 77.4 | % | | 2.4 | % | | 7.8 | % | | 26.4 | |
| > 4.75 - 5.25% | 31,694 | | | 5,735,770 | | | | | | | 4.9 | % | | 285 | | | 44 | | | 732 | | | 78.5 | % | | 2.9 | % | | 7.0 | % | | 28.2 | |
| > 5.25% | 31,046 | | | 7,270,132 | | | | | | | 5.9 | % | | 343 | | | 15 | | | 736 | | | 80.8 | % | | 1.4 | % | | 6.4 | % | | 33.5 | |
| 671,017 | | | 179,822,053 | | | | | | | 3.4 | % | | 344 | | | 34 | | | 758 | | | 73.3 | % | | 0.8 | % | | 4.5 | % | | 26.5 | |
| 15-Year Fixed: | | | | | | | | | | | | | | | | | | | | | | | |
| ≤ 2.25% | 23,157 | | | 6,521,890 | | | | | | | 2.0 | % | | 330 | | | 20 | | | 777 | | | 59.1 | % | | 0.1 | % | | 3.0 | % | | 25.2 | |
| > 2.25 - 2.75% | 38,830 | | | 8,781,681 | | | | | | | 2.4 | % | | 277 | | | 24 | | | 772 | | | 58.9 | % | | 0.2 | % | | 4.2 | % | | 25.9 | |
| > 2.75 - 3.25% | 36,300 | | | 5,297,231 | | | | | | | 2.9 | % | | 202 | | | 53 | | | 766 | | | 61.5 | % | | 0.3 | % | | 6.6 | % | | 26.2 | |
| > 3.25 - 3.75% | 21,402 | | | 2,307,332 | | | | | | | 3.4 | % | | 159 | | | 65 | | | 757 | | | 63.8 | % | | 0.6 | % | | 8.3 | % | | 26.9 | |
| > 3.75 - 4.25% | 10,044 | | | 909,909 | | | | | | | 3.9 | % | | 146 | | | 61 | | | 742 | | | 65.1 | % | | 0.8 | % | | 9.0 | % | | 28.6 | |
| > 4.25% | 5,648 | | | 575,114 | | | | | | | 4.7 | % | | 193 | | | 34 | | | 734 | | | 65.7 | % | | 1.3 | % | | 10.0 | % | | 33.5 | |
| 135,381 | | | 24,393,157 | | | | | | | 2.6 | % | | 257 | | | 35 | | | 769 | | | 60.4 | % | | 0.3 | % | | 5.1 | % | | 26.2 | |
| Total ARMs | 2,627 | | | 661,483 | | | | | | | 3.6 | % | | 330 | | | 56 | | | 761 | | | 67.7 | % | | 1.0 | % | | 13.6 | % | | 25.5 | |
| Total | 809,025 | | | $ | 204,876,693 | | | | | | | 3.3 | % | | $ | 334 | | | 34 | | | 760 | | | 71.7 | % | | 0.8 | % | | 4.6 | % | | 26.5 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2021 |
| (dollars in thousands) | Number of Loans | | Unpaid Principal Balance | | | | | | Weighted Average Gross Coupon Rate | | Weighted Average Current Loan Size | | Weighted Average Loan Age (months) | | Weighted Average Original FICO | | Weighted Average Original LTV | | 60+ Day Delinquencies | | 3-Month CPR | | Net Servicing Fee (bps) |
| 30-Year Fixed: | | | | | | | | | | | | | | | | | | | | | | | |
| ≤ 3.25% | 215,128 | | | $ | 72,197,662 | | | | | | | 2.8 | % | | $ | 395 | | | 11 | | | 767 | | | 70.7 | % | | 0.3 | % | | 10.7 | % | | 25.7 | |
| > 3.25 - 3.75% | 167,615 | | | 43,576,971 | | | | | | | 3.4 | % | | 321 | | | 28 | | | 755 | | | 74.2 | % | | 0.8 | % | | 24.0 | % | | 26.3 | |
| > 3.75 - 4.25% | 125,831 | | | 26,250,276 | | | | | | | 3.9 | % | | 263 | | | 54 | | | 753 | | | 75.7 | % | | 2.3 | % | | 34.0 | % | | 27..4 |
| > 4.25 - 4.75% | 79,107 | | | 14,291,435 | | | | | | | 4.4 | % | | 239 | | | 58 | | | 797 | | | 77.5 | % | | 4.4 | % | | 36.4 | % | | 26.3 | |
| > 4.75 - 5.25% | 38,902 | | | 6,318,470 | | | | | | | 4.9 | % | | 230 | | | 52 | | | 722 | | | 78.9 | % | | 6.4 | % | | 37.4 | % | | 27.3 | |
| > 5.25% | 15,796 | | | 2,176,065 | | | | | | | 5.5 | % | | 211 | | | 51 | | | 705 | | | 79.2 | % | | 9.2 | % | | 37.6 | % | | 30.5 | |
| 642,379 | | | 164,810,879 | | | | | | | 3.4 | % | | 332 | | | 29 | | | 756 | | | 73.4 | % | | 1.5 | % | | 22.7 | % | | 26.3 | |
| 15-Year Fixed: | | | | | | | | | | | | | | | | | | | | | | | |
| ≤ 2.25% | 16,525 | | | 5,397,141 | | | | | | | 2.0 | % | | 371 | | | 9 | | | 778 | | | 57.1 | % | | 0.1 | % | | 8.3 | % | | 25.2 | |
| > 2.25 - 2.75% | 41,168 | | | 9,901,133 | | | | | | | 2.4 | % | | 294 | | | 13 | | | 774 | | | 58.0 | % | | 0.2 | % | | 14.2 | % | | 25.6 | |
| > 2.75 - 3.25% | 46,236 | | | 7,568,257 | | | | | | | 2.9 | % | | 220 | | | 40 | | | 768 | | | 61.3 | % | | 0.4 | % | | 21.6 | % | | 26.1 | |
| > 3.25 - 3.75% | 28,010 | | | 3,485,491 | | | | | | | 3.4 | % | | 172 | | | 55 | | | 758 | | | 64.3 | % | | 1.1 | % | | 26.6 | % | | 27.4 | |
| > 3.75 - 4.25% | 12,685 | | | 1,302,862 | | | | | | | 3.9 | % | | 152 | | | 55 | | | 742 | | | 65.3 | % | | 2.1 | % | | 28.5 | % | | 28.8 | |
| > 4.25% | 5,965 | | | 513,255 | | | | | | | 4.5 | % | | 130 | | | 47 | | | 727 | | | 66.1 | % | | 2.6 | % | | 29.4 | % | | 31.2 | |
| 150,589 | | | 28,168,139 | | | | | | | 2.7 | % | | 264 | | | 27 | | | 769 | | | 60.0 | % | | 0.5 | % | | 18.1 | % | | 26.1 | |
| Total ARMs | 3,237 | | | 791,548 | | | | | | | 3.0 | % | | 315 | | | 54 | | | 762 | | | 68.0 | % | | 2.9 | % | | 29.5 | % | | 25.2 | |
| Total | 796,205 | | | $ | 193,770,566 | | | | | | | 3.3 | % | | $ | 322 | | | 28 | | | 758 | | | 71.5 | % | | 1.3 | % | | 22.1 | % | | 26.3 | |
Financing
Our borrowings consist primarily of repurchase agreements, revolving credit facilities, term notes payable and convertible senior notes. Repurchase agreements, revolving credit facilities and term notes payable are collateralized by our pledge of AFS securities, derivative instruments, MSR, servicing advances and certain cash balances. Substantially all of our Agency RMBS are currently pledged as collateral, and a portion of our non-Agency securities have been pledged as collateral for repurchase agreements. Additionally, a substantial portion of our MSR is currently pledged as collateral for repurchase agreements, revolving credit facilities and term notes payable, and a portion of our servicing advances have been pledged as collateral for revolving credit facilities. In connection with our securitization of MSR and issuance of term notes payable, a variable funding note, or VFN, was issued to one of our subsidiaries. We have one repurchase facility that is secured by the VFN, which is collateralized by our MSR. Finally, our convertible senior notes due 2026 are unsecured and pay interest semiannually at a rate of 6.25% per annum.
Some of our financing arrangements incorporate LIBOR as the referenced rate; however all arrangements either mature prior to the phase out of LIBOR or have provisions in place that provide for an alternative to LIBOR upon its phase-out. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Market Conditions and Outlook - LIBOR transition” in this Annual Report on Form 10-K for further discussion.
At December 31, 2022 and December 31, 2021, borrowings under repurchase agreements, revolving credit facilities, term notes payable and convertible senior notes had the following characteristics:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| (dollars in thousands) | | December 31, 2022 | | December 31, 2021 |
| Borrowing Type | | Amount Outstanding | | Weighted Average Borrowing Rate | | Weighted Average Years to Maturity | | Amount Outstanding | | Weighted Average Borrowing Rate | | Weighted Average Years to Maturity |
| Repurchase agreements | | $ | 8,603,011 | | | 3.95 | % | | 0.2 | | | $ | 7,656,445 | | | 0.24 | % | | 0.2 | |
| Revolving credit facilities | | 1,118,831 | | | 7.68 | % | | 1.1 | | | 420,761 | | | 3.46 | % | | 1.2 | |
| Term notes payable | | 398,011 | | | 7.19 | % | | 1.5 | | | 396,776 | | | 2.90 | % | | 2.5 | |
Convertible senior notes (1) | | 282,496 | | | 6.25 | % | | 3.0 | | | 424,827 | | | 6.25 | % | | 2.7 | |
| Total | | $ | 10,402,349 | | | 4.54 | % | | 1.7 | | | $ | 8,898,809 | | | 0.80 | % | | 0.5 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| (dollars in thousands) | | December 31, 2022 | | December 31, 2021 |
| Collateral Type | | Amount Outstanding | | Weighted Average Borrowing Rate | | Weighted Average Haircut on Collateral Value | | Amount Outstanding | | Weighted Average Borrowing Rate | | Weighted Average Haircut on Collateral Value |
| Agency RMBS | | $ | 7,321,834 | | | 3.70 | % | | 3.9 | % | | $ | 7,495,230 | | | 0.17 | % | | 4.2 | % |
| Non-Agency securities | | 70,809 | | | 5.73 | % | | 40.0 | % | | 171 | | | 1.24 | % | | 43.9 | % |
| Agency Derivatives | | 13,073 | | | 4.83 | % | | 18.9 | % | | 36,044 | | | 0.74 | % | | 17.8 | % |
| | | | | | | | | | | | |
| | | | | | | | | | | | |
Mortgage servicing rights | | 1,801,992 | | | 7.61 | % | | 30.6 | % | | 923,337 | | | 3.30 | % | | 27.9 | % |
| Mortgage servicing advances | | 23,850 | | | 7.75 | % | | 12.9 | % | | 19,200 | | | 3.23 | % | | 13.8 | % |
U.S. Treasuries (2) | | 888,295 | | | 4.49 | % | | — | % | | — | | | — | % | | — | % |
Other (1) | | 282,496 | | | 6.25 | % | | N/A | | 424,827 | | | 6.25 | % | | N/A |
| Total | | $ | 10,402,349 | | | 4.54 | % | | 8.4 | % | | $ | 8,898,809 | | | 0.80 | % | | 6.6 | % |
____________________
(1)Includes unsecured convertible senior notes due 2026 paying interest semiannually at a rate of 6.25% per annum on the aggregate principal amount of $287.5 million.
(2)U.S. Treasury securities effectively borrowed under reverse repurchase agreements.
As of December 31, 2022, the debt-to-equity ratio funding our AFS securities, MSR, servicing advances and Agency Derivatives, which includes unsecured borrowings under convertible senior notes, was 4.4:1.0. As previously discussed, our Agency RMBS, given their liquidity and high credit quality, are eligible for higher levels of leverage, while MSR, with less liquidity and/or more exposure to prepayment risk, utilize lower levels of leverage. Generally, our debt-to-equity ratio is directly correlated to the composition of our portfolio; typically, the higher the percentage of Agency RMBS we hold, the higher our debt-to-equity ratio will be. However, in addition to portfolio mix, our debt-to-equity ratio is a function of many other factors, including the liquidity of our portfolio, the availability and price of our financing, the diversification of our counterparties and their available capacity to finance our assets, and anticipated regulatory developments. We may alter the percentage allocation of our portfolio among our target assets 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 offerings we conduct. We believe the current degree of leverage within our portfolio helps ensure that we have access to unused borrowing capacity, thus supporting our liquidity and the strength of our balance sheet.
The following table provides a summary of our borrowings under repurchase agreements (excluding those collateralized by U.S. Treasuries), revolving credit facilities, term notes payable and convertible senior notes and our debt-to-equity ratios for the three months ended December 31, 2022, and the four immediately preceding quarters:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| (dollars in thousands) | | | | | | | | | | | | | | |
| For the Three Months Ended | | Quarterly Average | | End of Period Balance | | Maximum Balance of Any Month-End | | End of Period Total Borrowings to Equity Ratio | | End of Period Net Long (Short) TBA Cost Basis | | End of Period Net Payable (Receivable) for Unsettled RMBS | | End of Period Economic Debt-to-Equity Ratio (1) |
| December 31, 2022 | | $ | 9,878,254 | | | $ | 9,514,054 | | | $ | 10,672,731 | | | 4.4:1.0 | | $ | 3,923,298 | | | $ | 342,964 | | | 6.3:1.0 |
| September 30, 2022 | | $ | 10,973,416 | | | $ | 11,844,972 | | | $ | 11,844,972 | | | 5.5:1.0 | | $ | 4,153,582 | | | $ | 34,576 | | | 7.5:1.0 |
| June 30, 2022 | | $ | 8,949,630 | | | $ | 9,463,102 | | | $ | 9,463,102 | | | 3.8:1.0 | | $ | 6,409,396 | | | $ | 1,240,666 | | | 6.9:1.0 |
| March 31, 2022 | | $ | 9,139,305 | | | $ | 9,121,894 | | | $ | 9,366,946 | | | 3.5:1.0 | | $ | 4,737,226 | | | $ | (234,971) | | | 5.2:1.0 |
| December 31, 2021 | | $ | 7,908,651 | | | $ | 8,898,809 | | | $ | 8,898,809 | | | 3.2:1.0 | | $ | 4,238,881 | | | $ | — | | | 4.8:1.0 |
____________________
(1)Defined as total borrowings under repurchase agreements (excluding those collateralized by U.S. Treasuries), revolving credit facilities, term notes payable and convertible senior notes, plus implied debt on net TBA cost basis and net payable (receivable) for unsettled RMBS, divided by total equity. Effective as of December 31, 2022, net payable (receivable) on unsettled RMBS is now included in the calculation for economic debt-to-equity. Prior period data have been updated to conform to the current period calculation.
Equity
The following table provides details of our changes in stockholders’ equity from December 31, 2021 to December 31, 2022. All per share amounts, common shares outstanding and common equity-based awards for all periods presented have been adjusted on a retroactive basis to reflect the reverse stock split.
| | | | | | | | | | | | | | | | | |
| (in millions, except per share amounts) | Book Value | | Common Shares Outstanding | | Common Book Value Per Share |
Common stockholders’ equity at December 31, 2021 | $ | 2,017.7 | | | 86.0 | | | $ | 23.47 | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
| Net income | 220.2 | | | | | |
| Other comprehensive loss | (465.0) | | | | | |
| Comprehensive loss | (244.8) | | | | | |
| Dividends on preferred stock | (53.6) | | | | | |
| Gain on repurchase and retirement of preferred stock | 20.1 | | | | | |
| Comprehensive loss attributable to common stockholders | (278.3) | | | | | |
| Dividend declarations | (228.9) | | | | | |
| Other | 11.7 | | | 0.1 | | | |
| Balance before capital transactions | 1,522.2 | | | 86.1 | | | |
| Repurchase and retirement of preferred stock | 2.4 | | | | | |
| | | | | |
| Issuance of common stock, net of offering costs | 6.6 | | | 0.3 | | | |
Common stockholders’ equity at December 31, 2022 | $ | 1,531.2 | | | 86.4 | | | $ | 17.72 | |
| Total preferred stock liquidation preference | 652.3 | | | | | |
Total stockholders’ equity at December 31, 2022 | $ | 2,183.5 | | | | | |
U.S. GAAP to Estimated Taxable Income
The following tables provide reconciliations of our GAAP net income (loss) to our estimated taxable income (loss) split between our REIT and TRSs for the years ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | |
| Year Ended December 31, 2022 |
| (in millions) | TRS | | REIT | | | | Consolidated |
| GAAP net income (loss), pre-tax | $ | 445.5 | | | $ | (121.0) | | | | | $ | 324.5 | |
| State taxes | (13.4) | | | 0.1 | | | | | (13.3) | |
| Adjusted GAAP net income (loss), pre-tax | 432.1 | | | (120.9) | | | | | 311.2 | |
| Permanent differences | | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| State deferred tax expense | 14.3 | | | — | | | | | 14.3 | |
| Other permanent differences | 0.9 | | | (1.3) | | | | | (0.4) | |
| Temporary differences | | | | | | | |
| Net accretion of OID and market discount | (61.7) | | | 2.8 | | | | | (58.9) | |
Net unrealized gains and losses | (416.8) | | | (206.7) | | | | | (623.5) | |
| | | | | | | |
| Net realized gains and losses on sales of RMBS | — | | | 18.9 | | | | | 18.9 | |
| Net realized gains and losses on sales of MSR | 15.9 | | | (124.0) | | | | | (108.1) | |
| Credit loss impairment | — | | | 2.7 | | | | | 2.7 | |
| Other temporary differences | (0.5) | | | 24.9 | | | | | 24.4 | |
| Capital loss carryforward deferral | — | | | 1,029.3 | | | | | 1,029.3 | |
| Net operating loss carryforward utilization | — | | | (336.6) | | | | | (336.6) | |
| Estimated taxable (loss) income | (15.8) | | | 289.1 | | | | | 273.3 | |
| Dividend paid deduction | — | | | (289.1) | | | | | (289.1) | |
Estimated taxable loss post-dividend deduction | $ | (15.8) | | | $ | — | | | | | $ | (15.8) | |
| | | | | | | | | | | | | | | | | | | |
| Year Ended December 31, 2021 |
| (in millions) | TRS | | REIT | | | | Consolidated |
| GAAP net income (loss), pre-tax | $ | 60.1 | | | $ | 131.3 | | | | | $ | 191.4 | |
| State taxes | 10.6 | | | — | | | | | 10.6 | |
| Adjusted GAAP net income (loss), pre-tax | 70.7 | | | 131.3 | | | | | 202.0 | |
| Permanent differences | | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| State deferred tax benefit | (9.0) | | | — | | | | | (9.0) | |
| Other permanent differences | — | | | 0.1 | | | | | 0.1 | |
| Temporary differences | | | | | | | |
| Net accretion of OID and market discount | (53.7) | | | (59.4) | | | | | (113.1) | |
Net unrealized gains and losses | (137.3) | | | (31.6) | | | | | (168.9) | |
| Net realized gains and losses on sales of RMBS | — | | | (4.9) | | | | | (4.9) | |
| Credit loss impairment | — | | | 9.8 | | | | | 9.8 | |
| Other temporary differences | 5.8 | | | 2.0 | | | | | 7.8 | |
| Capital loss carryforward deferral | — | | | 16.6 | | | | | 16.6 | |
| | | | | | | |
| Estimated taxable (loss) income | (123.5) | | | 63.9 | | | | | (59.6) | |
| | | | | | | |
| Dividend paid deduction | — | | | (63.9) | | | | | (63.9) | |
Estimated taxable (loss) post-dividend deduction | $ | (123.5) | | | $ | — | | | | | $ | (123.5) | |
The permanent tax differences recorded in 2022 and 2021 included a difference related to officer’s compensation deduction limitations, compensation expense related to restricted stock dividends and vesting, and state deferred taxes. The temporary tax differences recorded in 2022 and 2021 were principally timing differences between U.S. GAAP and tax accounting related to unrealized gains and losses from derivative instruments, realized and unrealized gains and losses from MSR and RMBS, accretion and amortization from RMBS, changes in reserves related to servicing advances and allowance for credit losses on certain RMBS, and deferral of net capital losses. There was also a temporary tax difference recorded in 2022 related to the utilization of net operating losses.
Change in Accumulated Other Comprehensive (Loss) Income
With our accounting treatment for AFS securities, unrealized fluctuations in the market values of AFS securities, excluding certain AFS securities for which we have elected the fair value option, do not impact our GAAP net (loss) income or taxable income but are recognized on our consolidated balance sheets as a change in stockholders’ equity under “accumulated other comprehensive (loss) income.” As a result of this fair value accounting through stockholders’ equity, we expect our net income 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.
Dividends
For the year ended December 31, 2022, we declared cash dividends totaling $2.64 per common share. As a REIT, we are required to distribute at least 90% of our taxable income to stockholders, subject to certain distribution requirements. For the year ended December 31, 2022, our board of directors elected to distribute all of our REIT taxable income for the year. Temporary differences between GAAP net income (loss) and taxable income can generate deterioration in book value on a permanent and temporary basis as taxable income is distributed that has not been earned for U.S. GAAP purposes.
Liquidity and Capital Resources
Our liquidity and capital resources are managed and forecasted 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. We also believe that it gives us the flexibility to manage our portfolio to take advantage of market opportunities.
Our principal sources of cash consist of borrowings under repurchase agreements, revolving credit facilities, term notes payable, 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 borrowings, 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 our target assets and for other general corporate purposes. Such general corporate purposes may include the refinancing or repayment of debt, the repurchase or redemption of common and preferred equity securities, and other capital expenditures.
As of December 31, 2022, we held $683.5 million in cash and cash equivalents available to support our operations; $10.8 billion of AFS securities, MSR, and derivative assets held at fair value; and $10.4 billion of outstanding debt in the form of repurchase agreements, borrowings under revolving credit facilities, term notes payable and convertible senior notes. During the three months ended December 31, 2022, the debt-to-equity ratio funding our AFS securities, MSR and Agency Derivatives, which includes unsecured borrowings under convertible senior notes, decreased from 5.5:1.0 to 4.4:1.0 due to decreased financing on Agency RMBS and MSR. During the year ended December 31, 2022, the debt-to-equity ratio funding our AFS securities, MSR and Agency Derivatives, which includes unsecured borrowings under convertible senior notes, increased from 3.2:1.0 to 4.4:1.0 due to increased financing on Agency RMBS and MSR as well as a decrease in equity. During the three and twelve months ended December 31, 2022, our economic debt-to-equity ratio funding our AFS securities, MSR and Agency Derivatives, which includes unsecured borrowings under convertible senior notes, implied debt on net TBA cost basis and net payable (receivable) for unsettled RMBS, decreased from 7.5:1.0 to 6.3:1.0 and increased from 4.8:1.0 to 6.3:1.0, respectively.
As of December 31, 2022, we held approximately $344.6 million of unpledged AFS securities and Agency derivatives, which includes $343.0 million of unsettled Agency RMBS purchases, and $7.6 million of unpledged non-Agency securities. As a result, we had an overall estimated unused borrowing capacity on unpledged securities of approximately $6.1 million. As of December 31, 2022, we held approximately $26.9 million of unpledged MSR and $51.2 million of unpledged servicing advances. Overall, on December 31, 2022, we had $293.8 million unused committed and $402.3 million unused uncommitted borrowing capacity on MSR financing facilities, and $176.2 million in unused committed borrowing capacity on servicing advance financing facilities. Generally, unused borrowing capacity may be the result of our election not to utilize certain financing, as well as delays in the timing in which funding is provided, insufficient collateral or the inability to meet lenders’ eligibility requirements for specific types of asset classes. 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.
During the year ended December 31, 2022, we did not experience any material issues accessing our funding sources. We expect ongoing sources of financing to be primarily repurchase agreements, revolving credit facilities, term notes payable, convertible notes 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 December 31, 2022, we had master repurchase agreements in place with 39 counterparties (lenders), the majority of which are U.S. domiciled financial institutions, and we continue to evaluate additional counterparties to manage and optimize 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 assets 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.
In addition to our master repurchase agreements to fund our Agency and non-Agency securities, we have one repurchase facility and three revolving credit facilities that provide short- and long-term financing for our MSR portfolio. We also have one revolving credit facility that provides long-term financing for our servicing advances. An overview of the facilities is presented in the table below:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| (dollars in thousands) | | | | | | | | | |
| December 31, 2022 |
Expiration Date (1) | | Amount Outstanding | | Unused Committed Capacity (2) | | Unused Uncommitted Capacity | | Total Capacity | | Eligible Collateral |
| April 4, 2024 | | $ | 638,731 | | | $ | — | | | $ | 61,269 | | | $ | 700,000 | | | Mortgage servicing rights |
| December 29, 2023 | | $ | 309,000 | | | $ | — | | | $ | 191,000 | | | $ | 500,000 | | | Mortgage servicing rights (3) |
| March 20, 2024 | | $ | 256,250 | | | $ | 93,750 | | | $ | 150,000 | | | $ | 500,000 | | | Mortgage servicing rights (4) |
| June 30, 2023 | | $ | 200,000 | | | $ | 200,000 | | | $ | — | | | $ | 400,000 | | | Mortgage servicing rights |
| September 28, 2024 | | $ | 23,850 | | | $ | 176,150 | | | $ | — | | | $ | 200,000 | | | Mortgage servicing advances |
____________________
(1)The facilities are set to mature on the stated expiration date, unless extended pursuant to their terms.
(2)Represents unused capacity amounts to which commitment fees are charged.
(3)This repurchase facility is secured by a VFN issued in connection with our securitization of MSR, which is collateralized by our MSR. During the three months ended December 31, 2022, this repurchase facility was amended to prescribe a reduction in the total capacity to $300.0 million starting February 8, 2023.
(4)The revolving period of this facility ceases on March 17, 2023, at which time the facility starts a 12-month amortization period.
We are subject to a variety of financial covenants under our lending agreements. The following represent the most restrictive financial covenants across our lending agreements as of December 31, 2022:
•Total indebtedness to tangible net worth must be less than 8.0:1.0. As of December 31, 2022, our total indebtedness to tangible net worth, as defined, was 5.1:1.0.
•Cash liquidity must be greater than $200.0 million. As of December 31, 2022, our liquidity, as defined, was $683.5 million.
•Net worth must be greater than the higher of $1.5 billion or 50% of the highest net worth during the 24 calendar months prior. As of December 31, 2022, 50% of the highest net worth during the 24 calendar months prior, as defined, was $1.6 billion and our net worth, as defined, was $2.2 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 were pledged or restricted as collateral for the future payment obligations of repurchase agreements, revolving credit facilities, term notes payable and derivative instruments at December 31, 2022 and December 31, 2021:
| | | | | | | | | | | |
| (in thousands) | December 31,
2022 | | December 31,
2021 |
| Available-for-sale securities, at fair value | $ | 7,426,953 | | | $ | 7,009,449 | |
| | | |
| | | |
| | | |
| Mortgage servicing rights, at fair value | 2,958,057 | | | 2,130,807 | |
| | | |
| | | |
| Restricted cash | 324,854 | | | 747,979 | |
| Due from counterparties | 22,055 | | | 33,718 | |
| Derivative assets, at fair value | 14,738 | | | 39,608 | |
| Other assets | 67,819 | | | 33,767 | |
U.S. Treasuries (1) | 877,632 | | | — | |
| Total | $ | 11,692,108 | | | $ | 9,995,328 | |
____________________
(1)U.S. Treasury securities effectively borrowed under reverse repurchase agreements.
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 Agency RMBS are generally actively traded and thus, in most circumstances, readily liquid. However, certain of our assets, including 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 MSR, may be limited by delays encountered while obtaining certain Agency 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 Agency requirements regarding the transfer of such assets before settlement may occur. Consequently, even if we identify a buyer for our 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, revolving credit facilities and term notes payable, 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.
The following table provides the maturities of our repurchase agreements, revolving credit facilities, term notes payable and convertible senior notes as of December 31, 2022 and December 31, 2021:
| | | | | | | | | | | |
| (in thousands) | December 31,
2022 | | December 31,
2021 |
| Within 30 days | $ | 2,691,195 | | | $ | 1,771,027 | |
| 30 to 59 days | 2,160,737 | | | 1,807,544 | |
| 60 to 89 days | 2,536,636 | | | 1,981,056 | |
| 90 to 119 days | 905,443 | | | 1,249,435 | |
| 120 to 364 days | 509,000 | | | 1,265,638 | |
| One to three years | 1,316,842 | | | 543,026 | |
| Three to five years | 282,496 | | | 281,083 | |
| | | |
| | | |
| | | |
| Total | $ | 10,402,349 | | | $ | 8,898,809 | |
For the year ended December 31, 2022, our restricted and unrestricted cash balance decreased approximately $962.2 million to $1.1 billion at December 31, 2022. The cash movements can be summarized by the following:
•Cash flows from operating activities. For the year ended December 31, 2022, operating activities increased our cash balances by approximately $623.4 million, primarily driven by our financial results for the year.
•Cash flows from investing activities. For the year ended December 31, 2022, investing activities decreased our cash balances by approximately $2.8 billion, primarily driven by purchases of AFS securities and MSR and net payments under reverse repurchase agreements, offset by proceeds from sales of and principal payments on AFS securities and sales of MSR.
•Cash flows from financing activities. For the year ended December 31, 2022, financing activities increased our cash balance by approximately $1.2 billion, primarily driven by an increase in financing on RMBS and MSR, offset by the repayment of our convertible senior notes due 2022 and payment of dividends.
Recently Issued Accounting Standards
Refer to Note 2 - Basis of Presentation and Significant Accounting Policies of the notes to the consolidated financial statements included in Item 8 of this Form 10-K.
Inflation
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, although inflation rates can often have a meaningful influence over the direction of interest rates. 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.
Other Matters
We intend to conduct our business so as to maintain our exempt status under, and not to become regulated as, an investment company for purposes of the 1940 Act. If we failed to maintain our exempt status under the 1940 Act and became regulated as an investment company, our ability to, among other things, use leverage would be substantially reduced and, as a result, we would be unable to conduct our business as described in Item 1, “Business - Other Business - Regulation” of this Annual Report on Form 10-K. Accordingly, we monitor our compliance with both the 55% Test and the 80% Tests of the 1940 Act in order to maintain our exempt status. As of December 31, 2022, we determined that we maintained compliance with both the 55% Test and the 80% Test requirements.
We calculate that at least 75% of our assets were qualified REIT assets, as defined in the Code for the year ended December 31, 2022. We also calculate that our revenue qualified for the 75% source of income test and for the 95% source of income test rules for the year ended December 31, 2022. Consequently, we met the REIT income and asset tests. We also met all REIT requirements regarding the ownership of our common stock and the distribution of our net income. Therefore, for the year ended December 31, 2022, we believe that we qualified as a REIT under the Code.
Item 8. Financial Statements and Supplementary Data
TWO HARBORS INVESTMENT CORP.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
To the Stockholders and the Board of Directors
of Two Harbors Investment Corp.
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Two Harbors Investment Corp. (the Company) as of December 31, 2022 and 2021, the related consolidated statements of comprehensive loss, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2022, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2022 and 2021, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2022, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2022, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 28, 2023 expressed an unqualified opinion thereon.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
| | | | | |
| Valuation of Mortgage Servicing Rights
|
| Description of the Matter | At December 31, 2022, the Company held $3.0 billion of mortgage servicing rights (MSR) which are reported at fair value. As more fully described in Note 10 to the consolidated financial statements, the Company utilizes third-party pricing vendors in the fair value measurement of its MSR portfolio. Significant unobservable market data inputs inherent in the prices determined by the third-party pricing vendors include prepayment speeds, option-adjusted spread, and cost to service. Significant increases or decreases in these inputs in isolation may result in significantly lower or higher fair value measurements. Auditing the Company’s valuation of the MSR portfolio was especially challenging because the valuation involved significant judgment due to the unobservable inputs used in the valuation of this portfolio. These subjective assumptions consider a number of factors that are affected by market, economic, and asset-specific conditions. |
| | | | | |
| How We Addressed the Matter in Our Audit | Our audit procedures related to the fair value of the MSR portfolio included the following procedures, among others. We obtained an understanding of the MSR fair value measurements process, evaluated the design, and tested the operating effectiveness of internal controls. This included testing controls over management’s review of the third-party pricing vendors’ qualifications and methodologies applied. We also tested controls over management’s evaluation of pricing information obtained from third-party pricing vendors, including the consideration of applicable market data.
To test the fair value of the Company’s MSR fair value measurements, our audit procedures included, among others, testing the completeness and accuracy of data used in the fair value measurement process and involving our internal valuation specialists to independently develop a fair value estimate for the MSR portfolio using independently developed cash flow models and assumptions including consideration of market transactions. We compared our independently developed fair value estimate to the Company’s valuation. |
/s/ Ernst & Young LLP
We have served as the Company’s auditor since 2009.
Minneapolis, Minnesota
February 28, 2023
TWO HARBORS INVESTMENT CORP.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
| | | | | | | | | | | |
| December 31,
2022 | | December 31,
2021 |
| ASSETS | | | |
Available-for-sale securities, at fair value (amortized cost $8,114,627 and $7,005,013, respectively; allowance for credit losses $6,958 and $14,238, respectively) | $ | 7,778,734 | | | $ | 7,161,703 | |
| | | |
| Mortgage servicing rights, at fair value | 2,984,937 | | | 2,191,578 | |
| Cash and cash equivalents | 683,479 | | | 1,153,856 | |
| Restricted cash | 443,026 | | | 934,814 | |
| Accrued interest receivable | 36,018 | | | 26,266 | |
| Due from counterparties | 253,374 | | | 168,449 | |
| Derivative assets, at fair value | 26,438 | | | 80,134 | |
| Reverse repurchase agreements | 1,066,935 | | | 134,682 | |
| Other assets | 193,219 | | | 262,823 | |
Total Assets (1) | $ | 13,466,160 | | | $ | 12,114,305 | |
| LIABILITIES AND STOCKHOLDERS’ EQUITY | | | |
| Liabilities: | | | |
| Repurchase agreements | $ | 8,603,011 | | | $ | 7,656,445 | |
| | | |
| Revolving credit facilities | 1,118,831 | | | 420,761 | |
| Term notes payable | 398,011 | | | 396,776 | |
| Convertible senior notes | 282,496 | | | 424,827 | |
| Derivative liabilities, at fair value | 34,048 | | | 53,658 | |
| Due to counterparties | 541,709 | | | 196,627 | |
| Dividends payable | 64,504 | | | 72,412 | |
| Accrued interest payable | 94,034 | | | 18,382 | |
Commitments and contingencies (see Note 15) | — | | | — | |
| Other liabilities | 145,991 | | | 130,464 | |
Total Liabilities (1) | 11,282,635 | | | 9,370,352 | |
| Stockholders’ Equity: | | | |
Preferred stock, par value $0.01 per share; 100,000,000 shares authorized and 26,092,050 and 29,050,000 shares issued and outstanding, respectively ($652,301 and $726,250 liquidation preference, respectively) | 630,999 | | | 702,550 | |
Common stock, par value $0.01 per share; 175,000,000 shares authorized and 86,428,845 and 85,977,831 shares issued and outstanding, respectively | 864 | | | 860 | |
| Additional paid-in capital | 5,645,998 | | | 5,627,758 | |
| Accumulated other comprehensive (loss) income | (278,711) | | | 186,346 | |
| Cumulative earnings | 1,453,371 | | | 1,212,983 | |
| Cumulative distributions to stockholders | (5,268,996) | | | (4,986,544) | |
| Total Stockholders’ Equity | 2,183,525 | | | 2,743,953 | |
| | | |
| | | |
| Total Liabilities and Stockholders’ Equity | $ | 13,466,160 | | | $ | 12,114,305 | |
____________________
(1)The consolidated balance sheets include assets and liabilities of consolidated variable interest entities, or VIEs. At December 31, 2022 and December 31, 2021, assets of the VIEs totaled $497,921 and $454,596, and liabilities of the VIEs totaled $453,952 and $440,030, respectively. See Note 3 - Variable Interest Entities for additional information.
The accompanying notes are an integral part of these consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands, except share data)
| | | | | | | | | | | | | | | | | | | | | | |
| | | | Year Ended |
| | | | December 31, |
| | | | | | 2022 | | 2021 | | 2020 |
| Interest income: | | | | | | | |
| Available-for-sale securities | | | | | $ | 272,230 | | | $ | 167,310 | | | $ | 515,685 | |
| | | | | | | | | | |
| | | | | | | | | | |
| Other | | | | | 23,310 | | | 1,287 | | | 9,365 | |
| Total interest income | | | | | 295,540 | | | 168,597 | | | 525,050 | |
| Interest expense: | | | | | | | | | |
| Repurchase agreements | | | | | 167,455 | | | 25,774 | | | 233,069 | |
| | | | | | | | | | |
| Revolving credit facilities | | | | | 51,814 | | | 22,425 | | | 12,261 | |
| Term notes payable | | | | | 19,514 | | | 12,936 | | | 14,974 | |
| Convertible senior notes | | | | | 19,612 | | | 28,038 | | | 19,197 | |
| Federal Home Loan Bank advances | | | | | — | | | — | | | 1,747 | |
| Total interest expense | | | | | 258,395 | | | 89,173 | | | 281,248 | |
| Net interest income | | | | | 37,145 | | | 79,424 | | | 243,802 | |
| | | | | | | | | | |
| | | | | | | | | | |
| Other income (loss): | | | | | | | | | |
| (Loss) gain on investment securities | | | | | (603,937) | | | 121,617 | | | (999,859) | |
| Servicing income | | | | | 603,911 | | | 468,406 | | | 443,351 | |
| Gain (loss) on servicing asset | | | | | 425,376 | | | (114,941) | | | (935,697) | |
| Gain (loss) on interest rate swap, cap and swaption agreements | | | | | 29,499 | | | 42,091 | | | (310,806) | |
| Gain (loss) on other derivative instruments | | | | | 9,310 | | | (251,283) | | | 90,023 | |
| Other (loss) income | | | | | (5) | | | (3,845) | | | 1,422 | |
| Total other income (loss) | | | | | 464,154 | | | 262,045 | | | (1,711,566) | |
| Expenses: | | | | | | | | | |
| Management fees | | | | | — | | | — | | | 31,738 | |
| Servicing expenses | | | | | 94,119 | | | 86,250 | | | 94,266 | |
| | | | | | | | | | |
| Compensation and benefits | | | | | 40,723 | | | 35,041 | | | 37,723 | |
| Other operating expenses | | | | | 42,005 | | | 28,759 | | | 28,626 | |
| | | | | | | | | | |
| Restructuring charges | | | | | — | | | — | | | 5,706 | |
| Total expenses | | | | | 176,847 | | | 150,050 | | | 198,059 | |
| Income (loss) before income taxes | | | | | 324,452 | | | 191,419 | | | (1,665,823) | |
| Provision for (benefit from) income taxes | | | | | 104,213 | | | 4,192 | | | (35,688) | |
| | | | | | | | | | |
| | | | | | | | | | |
| Net income (loss) | | | | | 220,239 | | | 187,227 | | | (1,630,135) | |
| | | | | | | | | | |
| | | | | | | | | | |
| Dividends on preferred stock | | | | | (53,607) | | | (58,458) | | | (75,802) | |
| Gain on repurchase and retirement of preferred stock | | | | | 20,149 | | | — | | | — | |
| Net income (loss) attributable to common stockholders | | | | | $ | 186,781 | | | $ | 128,769 | | | $ | (1,705,937) | |
| Basic earnings (loss) per weighted average common share | | | | | $ | 2.15 | | | $ | 1.72 | | | $ | (24.94) | |
| Diluted earnings (loss) per weighted average common share | | | | | $ | 2.13 | | | $ | 1.72 | | | $ | (24.94) | |
| | | | | | | | | | |
| Weighted average number of shares of common stock: | | | | | | | | | |
| Basic | | | | | 86,179,418 | | | 74,443,000 | | | 68,400,237 | |
| Diluted | | | | | 96,076,175 | | | 74,510,884 | | | 68,400,237 | |
The accompanying notes are an integral part of these consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS, continued
(in thousands, except share data)
| | | | | | | | | | | | | | | | | | | | | | |
| | | | Year Ended |
| | | | December 31, |
| | | | | | 2022 | | 2021 | | 2020 |
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| Comprehensive loss: | | | | | | | | | |
| Net income (loss) | | | | | $ | 220,239 | | | $ | 187,227 | | | $ | (1,630,135) | |
| Other comprehensive loss: | | | | | | | | | |
| Unrealized loss on available-for-sale securities | | | | | (465,057) | | | (455,255) | | | (47,799) | |
| Other comprehensive loss | | | | | (465,057) | | | (455,255) | | | (47,799) | |
| Comprehensive loss | | | | | (244,818) | | | (268,028) | | | (1,677,934) | |
| | | | | | | | | | |
| | | | | | | | | | |
| Dividends on preferred stock | | | | | (53,607) | | | (58,458) | | | (75,802) | |
| Gain on repurchase and retirement of preferred stock | | | | | 20,149 | | | — | | | — | |
| Comprehensive loss attributable to common stockholders | | | | | $ | (278,276) | | | $ | (326,486) | | | $ | (1,753,736) | |
The accompanying notes are an integral part of these consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands)
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Preferred Stock | | Common Stock Par Value | | Additional Paid-in Capital | | Accumulated Other Comprehensive Income (Loss) | | Cumulative Earnings | | Cumulative Distributions to Stockholders | | Total Stockholders’ Equity | | | | |
| Balance, December 31, 2019 | $ | 977,501 | | | $ | 682 | | | $ | 5,156,811 | | | $ | 689,400 | | | $ | 2,655,891 | | | $ | (4,509,819) | | | $ | 4,970,466 | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Net loss | — | | | — | | | — | | | — | | | (1,630,135) | | | — | | | (1,630,135) | | | | | |
Other comprehensive income before reclassifications | — | | | — | | | — | | | 482,663 | | | — | | | — | | | 482,663 | | | | | |
Amounts reclassified from accumulated other comprehensive income | — | | | — | | | — | | | (530,462) | | | — | | | — | | | (530,462) | | | | | |
Other comprehensive loss | — | | | — | | | — | | | (47,799) | | | — | | | — | | | (47,799) | | | | | |
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Issuance of common stock, net of offering costs | — | | | — | | | 372 | | | — | | | — | | | — | | | 372 | | | | | |
Repurchase of common stock | — | | | — | | | (1,064) | | | — | | | — | | | — | | | (1,064) | | | | | |
Preferred dividends declared | — | | | — | | | — | | | — | | | — | | | (75,802) | | | (75,802) | | | | | |
Common dividends declared | — | | | — | | | — | | | — | | | — | | | (136,842) | | | (136,842) | | | | | |
| | | | | | | | | | | | | | | | | |
Non-cash equity award compensation | — | | | 2 | | | 9,728 | | | — | | | — | | | — | | | 9,730 | | | | | |
| Balance, December 31, 2020 | $ | 977,501 | | | $ | 684 | | | $ | 5,165,847 | | | $ | 641,601 | | | $ | 1,025,756 | | | $ | (4,722,463) | | | $ | 3,088,926 | | | | | |
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Net income | — | | | — | | | — | | | — | | | 187,227 | | | — | | | 187,227 | | | | | |
Other comprehensive loss before reclassifications | — | | | — | | | — | | | (319,694) | | | — | | | — | | | (319,694) | | | | | |
Amounts reclassified from accumulated other comprehensive income | — | | | — | | | — | | | (135,561) | | | — | | | — | | | (135,561) | | | | | |
Other comprehensive loss | — | | | — | | | — | | | (455,255) | | | — | | | — | | | (455,255) | | | | | |
| Redemption of preferred stock | (274,951) | | | — | | | — | | | — | | | — | | | — | | | (274,951) | | | | | |
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Issuance of common stock, net of offering costs | — | | | 175 | | | 450,427 | | | — | | | — | | | — | | | 450,602 | | | | | |
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Preferred dividends declared | — | | | — | | | — | | | — | | | — | | | (58,458) | | | (58,458) | | | | | |
Common dividends declared | — | | | — | | | — | | | — | | | — | | | (205,623) | | | (205,623) | | | | | |
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Non-cash equity award compensation | — | | | 1 | | | 11,484 | | | — | | | — | | | — | | | 11,485 | | | | | |
| Balance, December 31, 2021 | $ | 702,550 | | | $ | 860 | | | $ | 5,627,758 | | | $ | 186,346 | | | $ | 1,212,983 | | | $ | (4,986,544) | | | $ | 2,743,953 | | | | | |
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| Net income | — | | | — | | | — | | | — | | | 220,239 | | | — | | | 220,239 | | | | | |
Other comprehensive loss before reclassifications | — | | | — | | | — | | | (893,589) | | | — | | | — | | | (893,589) | | | | | |
Amounts reclassified from accumulated other comprehensive income | — | | | — | | | — | | | 428,532 | | | — | | | — | | | 428,532 | | | | | |
Other comprehensive loss | — | | | — | | | — | | | (465,057) | | | — | | | — | | | (465,057) | | | | | |
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| Repurchase and retirement of preferred stock | (71,551) | | | — | | | — | | | — | | | 20,149 | | | — | | | (51,402) | | | | | |
Issuance of common stock, net of offering costs | — | | | 3 | | | 6,611 | | | — | | | — | | | — | | | 6,614 | | | | | |
| | | | | | | | | | | | | | | | | |
Preferred dividends declared | — | | | — | | | — | | | — | | | — | | | (53,607) | | | (53,607) | | | | | |
Common dividends declared | — | | | — | | | — | | | — | | | — | | | (228,845) | | | (228,845) | | | | | |
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Non-cash equity award compensation | — | | | 1 | | | 11,629 | | | — | | | — | | | — | | | 11,630 | | | | | |
| Balance, December 31, 2022 | $ | 630,999 | | | $ | 864 | | | $ | 5,645,998 | | | $ | (278,711) | | | $ | 1,453,371 | | | $ | (5,268,996) | | | $ | 2,183,525 | | | | | |
The accompanying notes are an integral part of these consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
| | | | | | | | | | | | | | | | | | |
| | Year Ended |
| | December 31, |
| | 2022 | | 2021 | | 2020 |
| Cash Flows From Operating Activities: | | | | | |
| Net income (loss) | $ | 220,239 | | | $ | 187,227 | | | $ | (1,630,135) | |
| Adjustments to reconcile net income (loss) to net cash provided by operating activities: | | | | | |
| Amortization of premiums and discounts on investment securities, net | 79,794 | | | 228,344 | | | 238,840 | |
| Amortization of deferred debt issuance costs on term notes payable and convertible senior notes | 2,678 | | | 2,999 | | | 2,336 | |
| Provision for credit losses on investment securities | 2,730 | | | 9,763 | | | 58,440 | |
| Realized and unrealized losses (gains) on investment securities | 601,207 | | | (131,380) | | | 941,419 | |
| (Gain) loss on servicing asset | (425,376) | | | 114,941 | | | 935,697 | |
| | | | | | |
| Realized and unrealized (gains) losses on interest rate swaps, caps and swaptions | (34,328) | | | (27,830) | | | 244,631 | |
| Unrealized losses (gains) on other derivative instruments | 13,797 | | | (5,217) | | | (25,530) | |
| Gains on mortgage loans held-for-sale | (9) | | | (1,812) | | | (580) | |
| Equity based compensation | 11,630 | | | 11,485 | | | 9,730 | |
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| Purchases of mortgage loans held-for-sale | (264) | | | (64,008) | | | — | |
| Proceeds from sales of mortgage loans held-for-sale | — | | | 65,772 | | | 9,001 | |
| Proceeds from repayment of mortgage loans held-for-sale | 30 | | | 8 | | | 212 | |
| Net change in assets and liabilities: | | | | | |
| (Increase) decrease in accrued interest receivable | (9,752) | | | 20,908 | | | 45,460 | |
| Decrease (increase) in deferred income taxes, net | 105,241 | | | 5,960 | | | (40,267) | |
| Increase (decrease) in accrued interest payable | 75,652 | | | (3,284) | | | (127,960) | |
| Change in other operating assets and liabilities, net | (19,867) | | | 9,634 | | | (29,691) | |
| | | | | | |
| Net cash provided by operating activities | 623,402 | | | 423,510 | | | 631,603 | |
| Cash Flows From Investing Activities: | | | | | |
| Purchases of available-for-sale securities | (10,662,518) | | | (2,494,603) | | | (7,120,871) | |
| Proceeds from sales of available-for-sale securities | 7,793,705 | | | 6,274,193 | | | 18,349,338 | |
| Principal payments on available-for-sale securities | 1,102,994 | | | 3,147,647 | | | 4,239,445 | |
| Purchases of trading securities | — | | | — | | | (1,052,500) | |
| Proceeds from sales of trading securities | — | | | — | | | 1,053,477 | |
| Purchases of mortgage servicing rights, net of purchase price adjustments | (629,810) | | | (742,153) | | | (620,394) | |
| Proceeds from (payments for) sales of mortgage servicing rights | 261,827 | | | 31,787 | | | (2,012) | |
| (Purchases) short sales of derivative instruments, net | (71,291) | | | 51,438 | | | (29,286) | |
| Proceeds from sales and settlement (payments for termination and settlement) of derivative instruments, net | 125,908 | | | 40,012 | | | (93,383) | |
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| Payments for reverse repurchase agreements | (3,241,834) | | | (1,174,883) | | | (2,208,977) | |
| Proceeds from reverse repurchase agreements | 2,309,581 | | | 1,131,726 | | | 2,337,452 | |
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| Increase in due to counterparties, net | 260,157 | | | 38,773 | | | 48,921 | |
| Change in other investing assets and liabilities, net | — | | | 10,000 | | | 2,508 | |
| | | | | | |
| Net cash (used in) provided by investing activities | $ | (2,751,281) | | | $ | 6,313,937 | | | $ | 14,903,718 | |
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The accompanying notes are an integral part of these consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
(in thousands)
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| | Year Ended |
| | December 31, |
| | 2022 | | 2021 | | 2020 |
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| Cash Flows From Financing Activities: | | | | | |
| Proceeds from repurchase agreements | $ | 35,927,488 | | | $ | 29,934,379 | | | $ | 83,480,699 | |
| Principal payments on repurchase agreements | (34,980,922) | | | (37,421,832) | | | (97,484,264) | |
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| Proceeds from revolving credit facilities | 720,000 | | | 296,500 | | | 152,000 | |
| Principal payments on revolving credit facilities | (21,930) | | | (159,569) | | | (168,170) | |
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| Proceeds from issuance of convertible senior notes | — | | | 279,930 | | | — | |
| Repurchase of convertible senior notes | (143,774) | | | (143,118) | | | — | |
| | | | | | |
| Proceeds from Federal Home Loan Bank advances | — | | | — | | | 585,000 | |
| Principal payments on Federal Home Loan bank advances | — | | | — | | | (795,000) | |
| Redemption/repurchase and retirement of preferred stock | (51,402) | | | (274,951) | | | — | |
| Proceeds from issuance of common stock, net of offering costs | 6,614 | | | 450,602 | | | 372 | |
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| Repurchase of common stock | — | | | — | | | (1,064) | |
| Dividends paid on preferred stock | (54,989) | | | (63,661) | | | (75,802) | |
| Dividends paid on common stock | (235,371) | | | (193,488) | | | (199,487) | |
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| Net cash provided by (used in) financing activities | 1,165,714 | | | (7,295,208) | | | (14,505,716) | |
| Net (decrease) increase in cash, cash equivalents and restricted cash | (962,165) | | | (557,761) | | | 1,029,605 | |
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| Cash, cash equivalents and restricted cash at beginning of period | 2,088,670 | | | 2,646,431 | | | 1,616,826 | |
| Cash, cash equivalents and restricted cash at end of period | $ | 1,126,505 | | | $ | 2,088,670 | | | $ | 2,646,431 | |
| Supplemental Disclosure of Cash Flow Information: | | | |
| Cash paid for interest | $ | 153,181 | | | $ | 81,248 | | | $ | 404,261 | |
| Cash (received) paid for taxes, net | $ | (1,575) | | | $ | (23,322) | | | $ | 9,574 | |
| Noncash Activities: | | | | | |
| | | | | | |
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| Dividends declared but not paid at end of period | $ | 64,504 | | | $ | 72,412 | | | $ | 65,480 | |
The accompanying notes are an integral part of these consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Note 1. Organization and Operations
Two Harbors Investment Corp. is a Maryland corporation that, through its wholly owned subsidiaries (collectively, the Company), invests in and manages Agency residential mortgage-backed securities, or Agency RMBS, mortgage servicing rights, or MSR, and other financial assets. Agency refers to a U.S. government sponsored enterprise, or GSE, such as the Federal National Mortgage Association (or Fannie Mae) or the Federal Home Loan Mortgage Corporation (or Freddie Mac), or a U.S. government agency such as the Government National Mortgage Association (or Ginnie Mae). The investment portfolio is managed as a whole and resources are allocated and financial performance is assessed on a consolidated basis. The Company’s common stock is listed on the NYSE under the symbol “TWO”.
On August 2, 2022, Matrix Financial Services Corporation, or Matrix, a wholly owned subsidiary of the Company, entered into a definitive stock purchase agreement to acquire RoundPoint Mortgage Servicing Corporation, or RoundPoint, from Freedom Mortgage Corporation. In connection with the acquisition, Matrix has agreed to pay a purchase price upon closing in an amount equal to the tangible net book value of RoundPoint, plus a premium amount of $10.5 million, subject to certain additional post-closing adjustments. In connection with the transaction, RoundPoint will divest its retail origination business as well as its RPX servicing exchange platform. Matrix also agreed to engage RoundPoint as a subservicer prior to the closing date and began transferring loans to RoundPoint in the fourth quarter of 2022. Upon closing, all servicing licenses and operational capabilities will remain with RoundPoint, and RoundPoint will become a wholly owned subsidiary of Matrix. The parties expect to close the transaction in 2023, subject to the satisfaction of customary closing conditions and the receipt of required regulatory and GSE approvals.
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.
Note 2. Basis of Presentation and Significant Accounting Policies
Consolidation and Basis of Presentation
The accompanying consolidated financial statements include the accounts of all subsidiaries; inter-company accounts and
transactions have been eliminated. All trust entities in which the Company holds investments that are considered variable interest entities, or VIEs, for financial reporting purposes were reviewed for consolidation under the applicable consolidation guidance. Whenever the Company has both the power to direct the activities of a trust 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 trust. The accounting and reporting policies of the Company conform to U.S. generally accepted accounting principles, or U.S. GAAP. Certain prior period amounts have been reclassified to conform to the current period presentation. All per share amounts, common shares outstanding and common equity-based awards for the year ended December 31, 2022 and all prior periods reflect the Company’s one-for-four reverse stock split effected on November 1, 2022 at 5:01 p.m. Eastern Time (refer to Note 16 - Stockholders’ Equity for additional information).
Use of Estimates
The preparation of financial statements in conformity with U.S. GAAP requires management to make a number of significant estimates. These 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 as of the date of the 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 in the market, 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.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Significant Accounting Policies
Variable Interest Entities
The Company enters into transactions with subsidiary trust entities that are established for limited purposes. One of the Company’s subsidiary trust entities, MSR Issuer Trust, was formed for the purpose of financing MSR through securitization, pursuant to which, through two of the Company’s wholly owned subsidiaries, MSR is pledged to MSR Issuer Trust and in return, MSR Issuer Trust issues term notes to qualified institutional buyers and a variable funding note, or VFN, to one of the subsidiaries, in each case secured on a pari passu basis.
Another of the Company’s subsidiary trust entities, Servicing Advance Receivables Issuer Trust, was formed for the purpose of financing servicing advances through a revolving credit facility, pursuant to which Servicing Advance Receivables Issuer Trust issued a VFN backed by servicing advances pledged to the financing counterparty.
Both MSR Issuer Trust and Servicing Advance Receivables Issuer Trust are considered VIEs for financial reporting purposes and were reviewed for consolidation under the applicable consolidation guidance. As 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 is the primary beneficiary and, thus, consolidates the trusts.
Additionally, as discussed in Note 1 - Organization and Operations, the Company has entered into a definitive stock purchase agreement to acquire RoundPoint whereby the purchase price will be subject to an adjustment based on RoundPoint’s aggregate “earnings” (as defined in the agreement) from October 1, 2022 through the closing date, or the Interim Period, in addition to other post-closing adjustments. The manner in which the purchase price is calculated represents an implicit guarantee of the value of RoundPoint’s net book value, in which the Company holds the variable interests. These terms also indicate that RoundPoint meets the criteria to be considered a VIE that the Company must review for consolidation. As the Company has the obligation to absorb losses and the right to receive benefits of RoundPoint during the Interim Period that could be significant, but not the power to direct the activities of RoundPoint that most significantly impacts its performance, the Company is not the primary beneficiary and, thus, does not consolidate RoundPoint.
Available-for-Sale Securities, at Fair Value
The Company invests primarily in mortgage pass-through certificates, collateralized mortgage obligations and other residential mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans issued by a U.S. government sponsored enterprise, or GSE, such as the Federal National Mortgage Association (or Fannie Mae) or the Federal Home Loan Mortgage Corporation (or Freddie Mac), or a U.S. government agency such as the Government National Mortgage Association (or Ginnie Mae) (collectively “Agency RMBS”). The Company also holds securities that are not issued by a GSE or U.S government agency, or non-Agency securities, and, from time to time, U.S. Treasuries.
The Company classifies its Agency RMBS and non-Agency securities, excluding inverse interest-only Agency securities which are classified as derivatives for purposes of U.S. GAAP, as available-for-sale, or AFS, investments. Although the Company generally intends to hold most of its investment securities until maturity, it may, from time to time, sell any of its investment securities as part of its overall management of its portfolio. Accordingly, the Company classifies all of its securities as AFS, including its interest-only strips, which represent the Company’s right to receive a specified portion of the contractual interest flows of specific Agency or non-Agency securities. All assets classified as AFS, excluding certain AFS securities for which we have elected the fair value option, are reported at estimated fair value with unrealized gains and losses included in accumulated other comprehensive (loss) income.
On July 1, 2015, the Company elected the fair value option for Agency interest-only securities acquired on or after such date. On July 1, 2021, the Company elected the fair value option for all non-Agency securities acquired on or after such date. All Agency interest-only securities acquired on or after July 1, 2015 and all non-Agency securities acquired on or after July 1, 2021 are carried at estimated fair value with changes in fair value recorded as a component of (loss) gain on investment securities in the consolidated statements of comprehensive loss.
Fair value is determined under the guidance of Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures, or ASC 820. The Company determines the fair value of its RMBS that are issued or guaranteed as to principal and/or interest by a GSE or U.S. government agency, based upon prices obtained from third-party pricing vendors or broker quotes received using the bid price, which are both deemed indicative of market activity. In determining the fair value of its non-Agency securities, management judgment is used to arrive at fair value that considers prices obtained from third-party pricing vendors, broker quotes received and other applicable market data. If listed price data is not available or insufficient, 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. See Note 10 - Fair Value of these notes to the consolidated financial statements for details on fair value measurement.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Investment securities transactions are recorded on the trade date. The cost basis for realized gains and losses on sales of investment securities are determined on the first-in, first-out, or FIFO, method.
Interest income (i.e., gross yield/stated coupon) on securities is accrued based on the outstanding principal balance and their contractual terms. Premiums and discounts associated with Agency RMBS and non-Agency securities rated AA and higher at the time of purchase, are amortized and accreted, respectively, as an adjustment to interest income over the life of such securities using the contractual method under ASC 310-20, Nonrefundable Fees and Other Costs, which is applied at the individual security level based upon each security’s effective interest rate. The Company calculates each security’s effective interest rate at the time of purchase by solving for the discount rate that equates the present value of that security's remaining contractual cash flows, assuming no principal prepayments, to its purchase price. When applying the contractual effective interest method, as principal prepayments occur, an amount of the unamortized premium or discount is recognized in interest income such that the contractual effective interest rate on the remaining security balance is unaffected.
Discounts associated with non-Agency securities that were purchased at a discount to par value and were rated below AA at the time of purchase and Agency and non-Agency interest-only securities that can be contractually prepaid or otherwise settled in such a way that the Company would not recover substantially all of its recorded investment are accreted as an adjustment to interest income over the life of such securities using the prospective method under ASC 325-40, Investments - Other: Beneficial Interests in Securitized Financial Assets, which is applied at the individual security level based upon each security’s effective interest rate. At the time of acquisition, the security’s effective interest rate is calculated by solving for the single discount rate that equates the present value of the Company’s best estimate of the amount and timing of the cash flows expected to be collected from the security to its purchase price. On at least a quarterly basis, the Company reviews and, if appropriate, makes adjustments to its cash flow projections based on input and analysis received from external sources, internal models, and its judgment about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. Changes in cash flows from those originally projected, or from those estimated at the last evaluation, may result in a prospective change in the effective interest rate and interest income recognized on such securities.
Actual maturities of the AFS securities are affected by the contractual lives of the associated mortgage collateral, periodic payments of principal, and prepayments of principal. Therefore actual maturities of AFS securities are generally shorter than stated contractual maturities. Stated contractual maturities are generally greater than ten years.
The Company uses a discounted cash flow method to estimate and recognize an allowance for credit losses on both Agency and non-Agency AFS securities that are not accounted for under the fair value option. The initial estimated allowance for credit losses is equal to the difference between the prepayment adjusted contractual cash flows with no credit losses and the prepayment adjusted expected cash flows with credit losses, discounted at the effective interest rate on the AFS security. The contractual cash flows and expected cash flows are based on management’s best estimate and take into consideration current prepayment assumptions, lifetime expected losses based on past loss experience, current market conditions, and reasonable and supportable forecasts of future conditions. The allowance for credit losses on Agency AFS securities relates to prepayment assumption changes on interest-only Agency RMBS. The initial allowance for credit losses causes an increase in the AFS security amortized cost and recognizes an allowance for credit losses in the same amount. Subsequent adverse or favorable changes in the allowance for credit losses are recognized immediately in earnings as a provision for or reduction in credit losses (within (loss) gain on investment securities). Adverse changes are reflected as an increase to the allowance for credit losses and favorable changes are reflected as a decrease to the allowance for credit losses. The allowance for credit losses is limited to the difference between the beneficial interest’s fair value and its amortized cost, and any remaining adverse changes in these circumstances are reflected as a prospective adjustment to accretable yield. If the allowance for credit losses has been reduced to zero, the remaining favorable changes are reflected as a prospective adjustment to accretable yield. The Company does not adjust the effective interest rate in subsequent periods for prepayment assumption changes or variable-rate changes. Any changes in the allowance for credit losses due to the time-value-of-money are accounted for in the consolidated statements of comprehensive loss as provision for credit losses rather than a reduction to interest income. Any portion of the AFS securities that is deemed uncollectible results in a write-off of the uncollectible amortized cost with a corresponding reduction to the allowance for credit losses. Recoveries of amounts previously written off results in an increase to the allowance for credit losses.
Mortgage Servicing Rights, at Fair Value
The Company’s MSR represent the right to service mortgage loans. The Company and its subsidiaries do not originate or directly service mortgage loans, and instead contract with appropriately licensed subservicers to handle substantially all servicing functions in the name of the subservicer for the loans underlying the Company’s MSR. However, as an owner and manager of MSR, the Company may be obligated to fund advances of principal and interest payments due to third-party owners of the loans, but not yet received from the individual borrowers. These advances are reported as servicing advances within the other assets line item on the consolidated balance sheets.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
MSR are reported at fair value on the consolidated balance sheets. Although MSR transactions are observable in the marketplace, the valuation includes unobservable market data inputs (prepayment speeds; delinquency levels; option-adjusted spread, or OAS, which represents the incremental spread added to the risk-free rate to reflect the effects of any embedded options and other risk inherent in MSR; and cost to service). Changes in the fair value of MSR as well as servicing fee income and servicing expenses are reported on the consolidated statements of comprehensive loss.
Cash and Cash Equivalents
Cash and cash equivalents include cash held in bank accounts and cash held in money market funds on an overnight basis.
Restricted Cash
Restricted cash represents cash balances the Company is required to maintain with counterparties for securities and derivatives trading activity, servicing activities and collateral for the Company’s borrowings. Also included is the cash balance held pursuant to a letter of credit on the New York office lease. Cash balances required to be maintained with counterparties are not available to the Company for general corporate purposes, but may be applied against amounts due to security, derivative, servicing or financing counterparties or returned to the Company when collateral requirements are exceeded, or at the maturity of the derivative or financing arrangement.
Accrued Interest Receivable
Accrued interest receivable represents interest that is due and payable to the Company. Cash interest is generally received within 30 days of recording the receivable.
Due from/to Counterparties, net
Due from counterparties includes cash held by counterparties for payment of principal and interest as well as cash held by counterparties for securities and derivatives trading activity, servicing activities and collateral for the Company’s borrowings but represents excess capacity and deemed unrestricted and a receivable from the counterparty as of the balance sheet date. Due from counterparties also includes cash receivable from counterparties for sales of MSR pending final transfer and settlement. Due to counterparties includes cash payable by the Company upon settlement of trade positions as well as cash deposited to and held by the Company for securities and derivatives trading activity, servicing activities and collateral for the Company’s borrowings but represents a payable to the counterparty as of the balance sheet date. Due to counterparties also includes purchase price holdbacks on MSR acquisitions for early prepayment or default provisions, collateral exceptions and other contractual terms.
Derivative Financial Instruments, at Fair Value
In accordance with ASC 815, Derivatives and Hedging, or ASC 815, all derivative financial instruments, whether designated for hedging relationships or not, are recorded on the consolidated balance sheets as assets or liabilities and carried at fair value.
At the inception of a derivative contract, the Company determines whether the instrument will be part of a qualifying hedge accounting relationship or whether the Company will account for the contract as a trading instrument. Due to the volatility of the interest rate and credit markets and difficulty in effectively matching pricing or cash flows, the Company has elected to treat all current derivative contracts as trading instruments. Changes in fair value as well as the accrual and settlement of interest associated with derivatives accounted for as trading instruments are reported in the consolidated statements of comprehensive loss as gain (loss) on interest rate swap, cap and swaption agreements or gain (loss) on other derivative instruments depending on the type of derivative instrument.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The Company enters into interest rate derivative contracts for a variety of reasons, including minimizing fluctuations in earnings or market values on certain assets or liabilities that may be caused by changes in interest rates. The Company may, at times, enter into various forward contracts including short securities, Agency to-be-announced securities, or TBAs, options, futures, swaps, and caps. Due to the nature of these instruments, they may be in a receivable/asset position or a payable/liability position at the end of an accounting period. Amounts payable to and receivable from the same party under contracts may be offset as long as the following conditions are met: (a) each of the two parties owes the other determinable amounts; (b) the reporting party has the right to offset the amount owed with the amount owed by the other party; (c) the reporting party intends to offset; and (d) the right of offset is enforceable by law. If the aforementioned conditions are not met, amounts payable to and receivable from are presented by the Company on a gross basis in its consolidated balance sheets. The Company’s centrally cleared interest rate swaps and exchange-traded futures and options on futures require that the Company posts an “initial margin” amount determined by the clearing exchange, which is generally intended to be set at a level sufficient to protect the exchange from the derivative instrument’s maximum estimated single-day price movement. The Company also exchanges “variation margin” based upon daily changes in fair value, as measured by the exchange. The exchange of variation margin is considered a settlement of the derivative instrument, as opposed to pledged collateral. Accordingly, the Company accounts for the receipt or payment of variation margin as a direct reduction to the carrying value of the centrally cleared or exchange-traded derivative asset or liability. The receipt or payment of initial margin is accounted for separate from the derivative asset or liability and is netted on a counterparty basis and classified within restricted cash, due from counterparties, or due to counterparties on the Company’s consolidated balance sheets.
The Company has provided specific disclosure regarding the location and amounts of derivative instruments in the consolidated financial statements and how derivative instruments and related hedged items are accounted for. See Note 7 - Derivative Instruments and Hedging Activities of these notes to the consolidated financial statements.
Reverse Repurchase Agreements
The Company may enter into reverse repurchase agreements with third-party broker-dealers whereby it purchases U.S. Treasury securities under agreements to resell at an agreed-upon price and date. Generally, the Company may enter into reverse repurchase agreement transactions in order to effectively borrow U.S. Treasury securities that it can then deliver to counterparties to whom it has made short sales of the same securities, earn a yield on excess cash balances, or preserve existing repurchase agreements by substituting collateral. The Company accounts for these reverse repurchase agreements as securities borrowing transactions and records them at their contractual amounts, as specified in the respective agreements.
Repurchase Agreements
The Company may finance certain of its investment securities and MSR through the use of repurchase agreements. These repurchase agreements are generally short-term debt, which expire within one year. At times, certain of the Company’s repurchase agreements may have contractual terms of greater than one year, and, thus, would be considered long-term debt. Borrowings under repurchase agreements generally bear interest rates based on an index plus a spread and are generally uncommitted. The repurchase agreements are treated as collateralized financing transactions and are carried at their contractual amounts, as specified in the respective agreements.
Revolving Credit Facilities
To finance MSR assets and related servicing advance obligations, the Company enters into revolving credit facilities collateralized by the value of the MSR and/or servicing advances pledged. Borrowings under these revolving credit facilities that expire within one year are considered short-term debt. As of December 31, 2022, the Company’s revolving credit facilities that had contractual terms of greater than one year were considered long-term debt. The Company’s revolving credit facilities generally bear interest rates based on an index plus a spread. Borrowings under revolving credit facilities are treated as collateralized financing transactions and are carried at contractual amounts, as specified in the respective agreements.
Term Notes Payable
Term notes payable related to the Company’s consolidated securitization are recorded at outstanding principal balance, net of any unamortized deferred debt issuance costs, on the Company’s consolidated balance sheets.
Convertible Senior Notes
Convertible senior notes include unsecured convertible debt that are carried at their unpaid principal balance, net of any unamortized deferred issuance costs, on the Company’s consolidated balance sheet. Interest on the notes is payable semiannually until such time the notes mature or are converted into shares of the Company’s common stock.
Accrued Interest Payable
Accrued interest payable represents interest that is due and payable to third parties. Interest is generally paid within 30 days to three months of recording the payable, based upon the Company’s remittance requirements.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Deferred Tax Assets and Liabilities
Income recognition for U.S. GAAP and tax differ in certain respects. These differences often reflect differing accounting treatments for tax and U.S. GAAP, such as accounting for discount and premium amortization, credit losses, asset impairments, recognition of certain operating expenses and certain valuation estimates. Some of these differences are temporary in nature and create timing mismatches between when taxable income is earned and the tax is paid versus when the earnings (losses) for U.S. GAAP purposes, or GAAP net income (loss), are recognized and the tax provision is recorded. Some of these differences are permanent since certain income (or expense) may be recorded for tax purposes but not for U.S. GAAP purposes (or vice-versa). One such significant permanent difference is the Company’s ability as a REIT to deduct dividends paid to stockholders as an expense for tax purposes, but not for U.S. GAAP purposes.
As a result of these temporary differences, the Company’s TRSs may recognize taxable income in periods prior or subsequent to when it recognizes income for U.S. GAAP purposes. When this occurs, the TRSs pay or defer the tax liability and establish deferred tax assets or deferred tax liabilities, respectively, for U.S. GAAP purposes.
Deferred tax assets generally represent items that may be used as a tax deduction in a tax return in future years for which the Company has already recognized the tax benefit for U.S. GAAP purposes. The Company estimates, based on existence of sufficient evidence, the ability to realize the remainder of any deferred tax asset its TRSs recognize. Any adjustments to such estimates will be made in the period such determination is made. Deferred tax liabilities generally represent tax expense for which payment has been deferred or expense has already been taken as a deduction on the Company’s tax return but has not yet been recognized as an expense for U.S. GAAP purposes. The Company’s deferred tax assets and/or liabilities are generated solely by differences in GAAP net income (loss) and taxable income (loss) at our taxable subsidiaries. U.S. GAAP and tax differences in the REIT may create additional deferred tax assets and/or liabilities to the extent the Company does not distribute all of its taxable income.
Income Taxes
The Company has elected to be taxed as a REIT under the Code and the corresponding provisions of state law. To qualify as a REIT, the Company must distribute at least 90% of its annual REIT taxable income to stockholders (not including taxable income retained in its taxable subsidiaries) within the time frame set forth in the tax Code and the Company must also meet certain other requirements. In addition, because certain activities, if performed by the Company, may cause the Company to earn income which is not qualifying for the REIT gross income tests, the Company has formed TRSs, as defined in the Code, to engage in such activities. These TRSs’ activities are subject to income taxes as well as any REIT taxable income not distributed to stockholders.
The Company assesses its tax positions for all open tax years and determines whether the Company has any material unrecognized liabilities in accordance with ASC 740, Income Taxes. The Company records these liabilities to the extent the Company deems them more likely than not to be incurred. The Company classifies interest and penalties on material uncertain tax positions as interest expense and operating expense, respectively, in its consolidated statements of comprehensive loss.
Expenses
Expenses on the consolidated statements of comprehensive loss typically consist of management fees, servicing expenses generally related to the subservicing of MSR, compensation and benefits and other operating expenses. Prior to the termination of the Management Agreement on August 14, 2020, management fees were payable to PRCM Advisers under the agreement. The management fee was calculated based on the Company’s stockholders’ equity with certain adjustments outlined in the management agreement (see Note 21 - Related Party Transactions for further detail). Also prior to the termination of the Management Agreement, included in compensation and benefits and other operating expenses were direct and allocated costs incurred by PRCM Advisers on the Company’s behalf and reimbursed by the Company. Included in these reimbursed costs was (a) the Company’s allocable share of the compensation paid by PRCM Advisers to its personnel serving as the Company’s principal financial officer and general counsel and personnel employed by PRCM Advisers as in-house legal, tax, accounting, consulting, auditing, administrative, information technology, valuation, computer programming and development and back-office resources to the Company, (b) any amounts for personnel of PRCM Advisers’ affiliates arising under a shared facilities and services agreement, and (c) certain costs allocated to the Company by PRCM Advisers for data services and technology. Subsequent to the transition to self-management, the Company no longer pays a management fee to, or reimburses the expenses of, PRCM Advisers. Expenses for which the Company previously reimbursed PRCM Advisers are now borne directly by the Company. The Company is also now responsible for the cash compensation and employee benefits of the Company’s Chief Executive Officer, Chief Investment Officer and investment professionals, which were previously the responsibility of PRCM Advisers. Prior to the termination of the Management Agreement, the Company was only responsible for the equity compensation paid to such individuals.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Other Comprehensive Income (Loss)
Current period net unrealized gains and losses on AFS securities, excluding certain AFS securities for which we have elected the fair value option, are reported as components of accumulated other comprehensive (loss) income on the consolidated statements of stockholders’ equity and in the consolidated statements of comprehensive loss. Net unrealized gains and losses on securities held by our taxable subsidiaries that are reported in accumulated other comprehensive (loss) income are adjusted for the effects of taxation and may create deferred tax assets or liabilities.
Earnings Per Share
The Company’s common stock, par value and shares issued and outstanding, includes issued and unvested shares of restricted common stock, which have full rights to the common stock dividend declarations of the Company. Common shares underlying certain other equity-based awards granted by the Company are not included in common stock until the awards vest. If these awards have non-forfeitable dividend participation rights, they are considered participating securities in the calculations of basic and diluted earnings (loss) per share.
Basic earnings (loss) per share is computed by dividing net income (loss) attributable to common stockholders, less income allocated to participating securities pursuant to the two-class method, by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed by dividing basic net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding during the period, further adjusted for the dilutive effect, if any, of share-based payment awards and the assumed conversion of convertible notes into common shares.
Unvested equity-based awards are included in the calculation of diluted earnings (loss) per share under either the two-class method or the treasury stock method, depending upon which method produces the more dilutive result. The two-class method is an earnings allocation formula under which earnings (loss) per share is calculated for common stock and participating securities according to dividends declared and participating rights in undistributed earnings. Under this method, all earnings (distributed and undistributed) are allocated between participating securities and common shares based on their respective rights to receive dividends or dividend equivalents. Under the treasury stock method, common equivalent shares are calculated assuming that any share-based payment awards vest according to their respective agreements and unrecognized compensation cost is used to repurchase shares of the Company’s outstanding common stock at the average market price during the reported period. Under the if-converted method, the assumed conversion of each convertible note into common shares is calculated by adding back the respective periodic interest expense (net of any tax effects) associated with dilutive convertible notes to net income (loss) attributable to common stockholders and adding the shares issued in an assumed conversion to the diluted weighted average share count.
Equity Incentive Plans
The Company’s Second Restated 2009 Equity Incentive Plan, or the 2009 Plan, and the Company’s 2021 Equity Incentive Plan, or the 2021 Plan, or collectively, the Equity Incentive Plans, provide incentive compensation to attract and retain qualified directors, officers, personnel and other parties who may provide significant services to the Company. The Equity Incentive Plans are administered by the compensation committee of the Company’s board of directors. The Equity Incentive Plans permit the grants of restricted common stock, restricted stock units, or RSUs, performance-based awards (including performance share units, or PSUs), phantom shares, dividend equivalent rights and other equity-based awards. See Note 17 - Equity Incentive Plans for further details regarding the Equity Incentive Plans.
Equity-based compensation costs are initially measured at the estimated fair value of the awards on the grant date. Valuation methods used and subsequent expense recognition is dependent upon each award’s service and performance conditions. The Company has elected not to estimate forfeitures when valuing equity-based awards and adjusts compensation costs as actual forfeitures occur. Compensation costs for equity-based awards subject only to service conditions are measured at the closing stock price on the grant date and are recognized as expense on a straight-line basis over the requisite service periods for the awards, adjusted for any forfeitures. Compensation costs for equity-based awards subject to market-based performance metrics are measured at the grant date using Monte Carlo simulations which incorporate assumptions for stock return volatility, dividend yield and risk-free interest rates. These initial valuation amounts are recognized as expense over the requisite performance periods, subject to adjustments only for actual forfeitures. Amortization of equity-based awards (non-cash equity compensation expense) is included within compensation and benefits on the consolidated statements of comprehensive loss.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Recently Issued and/or Adopted Accounting Standards
Facilitation of the Effects of Reference Rate Reform on Financial Reporting
The London Interbank Offered Rate, or LIBOR, has been used extensively in the U.S. and globally as a “benchmark” or “reference rate” for various commercial and financial contracts, including corporate and municipal bonds and loans, floating rate mortgages, asset-backed securities, consumer loans, and interest rate swaps and other derivatives. On March 5, 2021, Intercontinental Exchange Inc. announced that ICE Benchmark Administration Limited, the administrator of LIBOR, intends to stop publication of the majority of USD-LIBOR tenors on June 30, 2023. In the U.S., the Alternative Reference Rates Committee, or ARRC, has identified the Secured Overnight Financing Rate, or SOFR, as its preferred alternative rate for U.S. dollar-based LIBOR. SOFR is a measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and is based on directly observable U.S. Treasury-backed repurchase transactions. Numerous industry wide and company-specific transitions as it relates to derivatives and cash markets exposed to LIBOR are in process, if not completed.
In March 2020, the FASB issued Accounting Standards Update (ASU) No. 2020-04, which provides temporary optional expedients and exceptions on accounting for contract modifications and hedging relationships in anticipation of the replacement of LIBOR with another reference rate. The guidance also provides a one-time election to sell held-to-maturity debt securities or to transfer such securities to the available-for-sale or trading category. The majority of the Company’s material contracts that are or were indexed to USD-LIBOR have been amended to transition to an alternative benchmark, where necessary. As of December 31, 2022, only the Company’s term notes incorporate LIBOR as the referenced rate and mature after the phase-out of LIBOR. However, the related agreements have provisions in place that provide for an alternative to LIBOR upon its phase-out. The Company had no other financing arrangements or derivative instruments that incorporate LIBOR as the referenced rate as of December 31, 2022. Additionally, each series of the Company’s fixed-to-floating preferred stock that becomes redeemable at the time the stock begins to pay a LIBOR-based rate has existing LIBOR cessation fallback language. The ASU was effective immediately for all entities and expired after December 31, 2022. The Company’s adoption of this ASU did not have an impact on the Company’s financial condition, results of operations or financial statement disclosures.
Note 3. Variable Interest Entities
The trusts that were formed for the purpose of financing MSR through securitization and servicing advances through revolving credit facilities (see discussion in Note 2 - Basis of Presentation and Significant Accounting Policies) are considered VIEs for financial reporting purposes and were reviewed for consolidation under the applicable consolidation guidance. As 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 is the primary beneficiary and, thus, consolidates the trusts. Additionally, in accordance with arrangements entered into in connection with the securitization transaction and the servicing advance revolving credit facility, the Company has direct financial obligations payable to both MSR Issuer Trust and Servicing Advance Receivables Issuer Trust, which, in turn, support MSR Issuer Trust’s obligations to noteholders under the securitization transaction and Servicing Advance Receivables Issuer Trust’s obligations to the financing counterparty.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The following table presents a summary of the assets and liabilities of all consolidated trusts as reported on the consolidated balance sheets as of December 31, 2022 and December 31, 2021:
| | | | | | | | | | | |
| (in thousands) | December 31,
2022 | | December 31,
2021 |
Note receivable (1) | $ | 398,011 | | | $ | 396,776 | |
| | | |
| Restricted cash | 31,691 | | | 23,892 | |
Accrued interest receivable (1) | 400 | | | 161 | |
| Other assets | 67,819 | | | 33,767 | |
| Total Assets | $ | 497,921 | | | $ | 454,596 | |
| Term notes payable | $ | 398,011 | | | $ | 396,776 | |
| Revolving credit facilities | 23,850 | | | 19,200 | |
| Accrued interest payable | 560 | | | 216 | |
| Other liabilities | 31,531 | | | 23,838 | |
| Total Liabilities | $ | 453,952 | | | $ | 440,030 | |
____________________
(1)Receivables due from a wholly owned subsidiary of the Company to the trusts are eliminated in consolidation in accordance with U.S. GAAP.
As discussed in Note 2 - Basis of Presentation and Significant Accounting Policies, RoundPoint is also considered a VIE for financial reporting purposes and was reviewed for consolidation under the applicable consolidation guidance. As the Company has the obligation to absorb losses and the right to receive benefits of RoundPoint during the Interim Period that could be significant, but not the power to direct the activities of RoundPoint that most significantly impacts its performance, the Company is not the primary beneficiary and, thus, does not consolidate RoundPoint.
Note 4. Available-for-Sale Securities, at Fair Value
The Company holds both Agency and non-Agency available-for sale, or AFS, investment securities which are carried at fair value on the consolidated balance sheets. The following table presents the Company’s AFS investment securities by collateral type as of December 31, 2022 and December 31, 2021:
| | | | | | | | | | | |
| (in thousands) | December 31,
2022 | | December 31,
2021 |
| Agency: | | | |
| Federal National Mortgage Association | $ | 4,112,556 | | | $ | 5,040,988 | |
| Federal Home Loan Mortgage Corporation | 3,332,314 | | | 1,922,809 | |
| Government National Mortgage Association | 208,706 | | | 185,602 | |
| Non-Agency | 125,158 | | | 12,304 | |
| Total available-for-sale securities | $ | 7,778,734 | | | $ | 7,161,703 | |
At December 31, 2022 and December 31, 2021, the Company pledged AFS securities with a carrying value of $7.4 billion and $7.0 billion, respectively, as collateral for repurchase agreements. See Note 11 - Repurchase Agreements.
At December 31, 2022 and December 31, 2021, the Company did not have any securities purchased from and financed with the same counterparty that did not meet the conditions of ASC 860, Transfers and Servicing, to be considered linked transactions and, therefore, classified as derivatives.
The Company is not required to consolidate VIEs for which it has concluded it does not have both the power to direct the activities of the VIEs 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’s investments in these unconsolidated VIEs include all non-Agency securities, which are classified within available-for-sale securities, at fair value on the consolidated balance sheets. As of December 31, 2022 and December 31, 2021, the carrying value, which also represents the maximum exposure to loss, of all non-Agency securities in unconsolidated VIEs was $125.2 million and $12.3 million, respectively.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The following tables present the amortized cost and carrying value of AFS securities by collateral type as of December 31, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2022 |
| (in thousands) | Principal/ Current Face | | Un-amortized Premium | | Accretable Purchase Discount | | | | Amortized Cost | | Allowance for Credit Losses | | Unrealized Gain | | Unrealized Loss | | Carrying Value |
Agency: | | | | | | | | | | | | | | | | | |
Principal and interest | $ | 7,781,277 | | | $ | 189,246 | | | $ | (33,413) | | | | | $ | 7,937,110 | | | $ | — | | | $ | 6,310 | | | $ | (325,960) | | | $ | 7,617,460 | |
| Interest-only | 963,866 | | | 45,882 | | | — | | | | | 45,882 | | | (6,785) | | | 1,890 | | | (4,871) | | | 36,116 | |
| Total Agency | 8,745,143 | | | 235,128 | | | (33,413) | | | | | 7,982,992 | | | (6,785) | | | 8,200 | | | (330,831) | | | 7,653,576 | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
Non-Agency | 1,263,789 | | | 8,511 | | | (225) | | | | | 131,635 | | | (173) | | | 545 | | | (6,849) | | | 125,158 | |
| Total | $ | 10,008,932 | | | $ | 243,639 | | | $ | (33,638) | | | | | $ | 8,114,627 | | | $ | (6,958) | | | $ | 8,745 | | | $ | (337,680) | | | $ | 7,778,734 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2021 |
| (in thousands) | Principal/ Current Face | | Un-amortized Premium | | Accretable Purchase Discount | | | | Amortized Cost | | Allowance for Credit Losses | | Unrealized Gain | | Unrealized Loss | | Carrying Value |
Agency: | | | | | | | | | | | | | | | | | |
Principal and interest | $ | 6,411,363 | | | $ | 270,699 | | | $ | (12) | | | | | $ | 6,682,050 | | | $ | — | | | $ | 171,308 | | | $ | (4,855) | | | $ | 6,848,503 | |
| Interest-only | 3,198,447 | | | 305,577 | | | — | | | | | 305,577 | | | (12,851) | | | 20,699 | | | (12,529) | | | 300,896 | |
| Total Agency | 9,609,810 | | | 576,276 | | | (12) | | | | | 6,987,627 | | | (12,851) | | | 192,007 | | | (17,384) | | | 7,149,399 | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
Non-Agency | 1,940,815 | | | 16,533 | | | (27) | | | | | 17,386 | | | (1,387) | | | 33 | | | (3,728) | | | 12,304 | |
| Total | $ | 11,550,625 | | | $ | 592,809 | | | $ | (39) | | | | | $ | 7,005,013 | | | $ | (14,238) | | | $ | 192,040 | | | $ | (21,112) | | | $ | 7,161,703 | |
The following table presents the Company’s AFS securities according to their estimated weighted average life classifications as of December 31, 2022:
| | | | | | | | | | | | | | | | | |
| December 31, 2022 |
| (in thousands) | Agency | | Non-Agency | | Total |
| < 1 year | $ | 2,001 | | | $ | — | | | $ | 2,001 | |
| ≥ 1 and < 3 years | 28,953 | | | — | | | 28,953 | |
| ≥ 3 and < 5 years | 149,872 | | | 117,203 | | | 267,075 | |
| ≥ 5 and < 10 years | 7,471,903 | | | 7,955 | | | 7,479,858 | |
| ≥ 10 years | 847 | | | — | | | 847 | |
| Total | $ | 7,653,576 | | | $ | 125,158 | | | $ | 7,778,734 | |
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Measurement of Allowances for Credit Losses on AFS Securities
The Company uses a discounted cash flow method to estimate and recognize an allowance for credit losses on both Agency and non-Agency AFS securities that are not accounted for under the fair value option. The following tables present the changes for the years ended December 31, 2022, 2021 and 2020 in the allowance for credit losses on Agency and non-Agency AFS securities:
| | | | | | | | | | | | | | | | | |
| Year Ended |
| December 31, 2022 |
| |
| (in thousands) | Agency | | Non-Agency | | Total |
Allowance for credit losses at beginning of period | $ | (12,851) | | | $ | (1,387) | | | $ | (14,238) | |
| | | | | |
Additions on securities for which credit losses were not previously recorded | (482) | | | (501) | | | (983) | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
| (Increase) decrease on securities with previously recorded credit losses | (3,462) | | | 1,715 | | | (1,747) | |
Write-offs | 10,010 | | | — | | | 10,010 | |
| | | | | |
Allowance for credit losses at end of period | $ | (6,785) | | | $ | (173) | | | $ | (6,958) | |
| | | | | | | | | | | | | | | | | |
| Year Ended |
| December 31, 2021 |
| (in thousands) | Agency | | Non-Agency | | Total |
Allowance for credit losses at beginning of period | $ | (17,889) | | | $ | (4,639) | | | $ | (22,528) | |
| | | | | |
Additions on securities for which credit losses were not previously recorded | (190) | | | (4,365) | | | (4,555) | |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
| Increase on securities with previously recorded credit losses | (4,542) | | | (666) | | | (5,208) | |
Write-offs | 9,770 | | | 8,283 | | | 18,053 | |
| | | | | |
Allowance for credit losses at end of period | $ | (12,851) | | | $ | (1,387) | | | $ | (14,238) | |
| | | | | | | | | | | | | | | | | |
| Year Ended |
| December 31, 2020 |
| (in thousands) | Agency | | Non-Agency | | Total |
Allowance for credit losses at beginning of period | $ | — | | | $ | (244,876) | | | $ | (244,876) | |
| | | | | |
Additions on securities for which credit losses were not previously recorded | (32,931) | | | (11,428) | | | (44,359) | |
| | | | | |
| | | | | |
Reductions for securities sold | — | | | 246,792 | | | 246,792 | |
| | | | | |
| Decrease (increase) on securities with previously recorded credit losses | 385 | | | (14,466) | | | (14,081) | |
Write-offs | 14,657 | | | 21,874 | | | 36,531 | |
Recoveries of amounts previously written off | — | | | (2,535) | | | (2,535) | |
Allowance for credit losses at end of period | $ | (17,889) | | | $ | (4,639) | | | $ | (22,528) | |
Prior to the adoption of ASU No. 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments on January 1, 2020, the Company periodically evaluated AFS securities for other-than-temporary impairments, or OTTI, and recognized the related credit losses in earnings. As of December 31, 2019, the Company’s cumulative credit losses related to OTTI totaled $17.0 million. During the three months ended March 31, 2020, the Company sold all securities for which OTTI had been recognized prior to January 1, 2020, reducing the Company’s cumulative credit losses related to OTTI to zero.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The following tables present the components comprising the carrying value of AFS securities for which an allowance for credit losses has not been recorded by length of time that the securities had an unrealized loss position as of December 31, 2022 and December 31, 2021. At December 31, 2022 and December 31, 2021, the Company held 704 and 756 AFS securities, respectively; of the securities for which an allowance for credit losses has not been recorded, 553 and 45 were in an unrealized loss position for less than twelve consecutive months. At both December 31, 2022 and December 31, 2021, none of the Company’s AFS securities were in an unrealized loss position for more than twelve months without an allowance for credit losses recorded.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2022 |
| 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 |
| Agency | $ | 7,168,694 | | | $ | (328,258) | | | $ | — | | | $ | — | | | $ | 7,168,694 | | | $ | (328,258) | |
| Non-Agency | 117,816 | | | (5,933) | | | — | | | — | | | 117,816 | | | (5,933) | |
| Total | $ | 7,286,510 | | | $ | (334,191) | | | $ | — | | | $ | — | | | $ | 7,286,510 | | | $ | (334,191) | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2021 |
| 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 |
| Agency | $ | 2,371,216 | | | $ | (12,031) | | | $ | — | | | $ | — | | | $ | 2,371,216 | | | $ | (12,031) | |
| Non-Agency | 9,613 | | | (1,230) | | | — | | | — | | | 9,613 | | | (1,230) | |
| Total | $ | 2,380,829 | | | $ | (13,261) | | | $ | — | | | $ | — | | | $ | 2,380,829 | | | $ | (13,261) | |
Realized Gains and Losses
Gains and losses from the sale of AFS securities are recorded as realized gains (losses) within (loss) gain on investment securities in the Company’s consolidated statements of comprehensive loss. The following table presents details around sales of AFS securities during the years ended December 31, 2022, 2021 and 2020:
| | | | | | | | | | | | | | | | | | | | | |
| | | Year Ended |
| | | December 31, |
| (in thousands) | | | | | 2022 | | 2021 | | 2020 |
| Proceeds from sales of available-for-sale securities | | | | | $ | 7,793,705 | | | $ | 6,274,193 | | | $ | 18,349,338 | |
| Amortized cost of available-for-sale securities sold | | | | | (8,359,967) | | | (6,137,824) | | | (19,273,667) | |
| Total realized (losses) gains on sales, net | | | | | $ | (566,262) | | | $ | 136,369 | | | $ | (924,329) | |
| | | | | | | | | |
| Gross realized gains | | | | | $ | 40,574 | | | $ | 167,269 | | | $ | 337,360 | |
| Gross realized losses | | | | | (606,836) | | | (30,900) | | | (1,261,689) | |
| Total realized (losses) gains on sales, net | | | | | $ | (566,262) | | | $ | 136,369 | | | $ | (924,329) | |
Note 5. Servicing Activities
Mortgage Servicing Rights, at Fair Value
A wholly owned subsidiary of the Company has approvals from Fannie Mae and Freddie Mac to own and manage MSR, which represent the right to control the servicing of residential mortgage loans. The Company and its subsidiaries do not originate or directly service mortgage loans, and instead contract with appropriately licensed subservicers to handle substantially all servicing functions in the name of the subservicer for the loans underlying the Company’s MSR.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The following table summarizes activity related to MSR for the years ended December 31, 2022, 2021 and 2020.
| | | | | | | | | | | | | | | | | | | | | |
| | | Year Ended |
| | | December 31, |
| (in thousands) | | | | | 2022 | | 2021 | | 2020 |
| Balance at beginning of period | | | | | $ | 2,191,578 | | | $ | 1,596,153 | | | $ | 1,909,444 | |
Purchases of mortgage servicing rights | | | | | 640,051 | | | 777,305 | | | 623,284 | |
| | | | | | | | | |
Sales of mortgage servicing rights | | | | | (259,059) | | | (43,411) | | | 1,976 | |
| Changes in fair value due to: | | | | | | | | | |
Changes in valuation inputs or assumptions used in the valuation model (1) | | | | | 793,631 | | | 562,843 | | | (396,900) | |
Other changes in fair value (2) | | | | | (371,023) | | | (666,160) | | | (538,761) | |
Other changes (3) | | | | | (10,241) | | | (35,152) | | | (2,890) | |
Balance at end of period (4) | | | | | $ | 2,984,937 | | | $ | 2,191,578 | | | $ | 1,596,153 | |
____________________
(1)Includes the impact of acquiring MSR at a cost different from fair value.
(2)Primarily represents changes due to the realization of cash flows.
(3)Includes purchase price adjustments, contractual prepayment protection, and changes due to the Company’s purchase of the underlying collateral.
(4)Based on the principal balance of the loans underlying the MSR reported by servicers on a month lag, adjusted for current month purchases.
At December 31, 2022 and December 31, 2021, the Company pledged MSR with a carrying value of $3.0 billion and $2.1 billion, respectively, as collateral for repurchase agreements, revolving credit facilities and term notes payable. See Note 11 - Repurchase Agreements, Note 12 - Revolving Credit Facilities and Note 13 - Term Notes Payable.
As of December 31, 2022 and December 31, 2021, 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:
| | | | | | | | | | | |
| (dollars in thousands, except per loan data) | December 31,
2022 | | December 31,
2021 |
| Weighted average prepayment speed: | 6.9 | % | | 12.9 | % |
| Impact on fair value of 10% adverse change | $ | (50,192) | | | $ | (110,222) | |
| Impact on fair value of 20% adverse change | $ | (100,995) | | | $ | (210,406) | |
| Weighted average delinquency: | 0.9 | % | | 1.3 | % |
| Impact on fair value of 10% adverse change | $ | (3,880) | | | $ | (3,470) | |
| Impact on fair value of 20% adverse change | $ | (7,777) | | | $ | (6,947) | |
| Weighted average option-adjusted spread: | 5.3 | % | | 4.7 | % |
| Impact on fair value of 10% adverse change | $ | (44,431) | | | $ | (42,188) | |
| Impact on fair value of 20% adverse change | $ | (87,354) | | | $ | (82,126) | |
| Weighted average per loan annual cost to service: | $ | 67.92 | | | $ | 66.76 | |
| Impact on fair value of 10% adverse change | $ | (20,148) | | | $ | (25,919) | |
| Impact on fair value of 20% adverse change | $ | (39,401) | | | $ | (51,911) | |
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.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Risk Mitigation Activities
The primary risks associated with the Company’s MSR are changes in interest rates, mortgage spreads and prepayments. The Company economically hedges interest rate and mortgage spread risk primarily with its Agency RMBS portfolio. Prepayment risk is carefully monitored and partially mitigated through the Company’s ability to retain the MSR, in certain circumstances, through recapture agreements with its subservicers if the underlying loan is refinanced.
Mortgage Servicing Income
The following table presents the components of servicing income recorded on the Company’s consolidated statements of comprehensive loss for the years ended December 31, 2022, 2021 and 2020:
| | | | | | | | | | | | | | | | | | | | | |
| | | Year Ended |
| | | December 31, |
| (in thousands) | | | | | 2022 | | 2021 | | 2020 |
| Servicing fee income | | | | | $ | 564,923 | | | $ | 461,381 | | | $ | 416,936 | |
| Ancillary and other fee income | | | | | 1,932 | | | 2,436 | | | 1,945 | |
| Float income | | | | | 37,056 | | | 4,589 | | | 24,470 | |
| Total | | | | | $ | 603,911 | | | $ | 468,406 | | | $ | 443,351 | |
Mortgage Servicing Advances
As the servicer of record for the MSR assets, the Company may be required to advance principal and interest payments to security holders, and intermittent tax and insurance payments to local authorities and insurance companies on mortgage loans that are in forbearance, delinquency or default. The Company is responsible for funding these advances, potentially for an extended period of time, before receiving reimbursement from Fannie Mae and Freddie Mac. Servicing advances 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 totaled $119.0 million and $130.6 million and were included in other assets on the consolidated balance sheets as of December 31, 2022 and December 31, 2021, respectively. At December 31, 2022 and December 31, 2021, mortgage loans in 60+ day delinquent status (whether or not subject to forbearance) accounted for approximately 0.8% and 1.3%, respectively, of the aggregate principal balance of loans for which the Company had servicing advance funding obligations.
The Company has one revolving credit facility to finance its servicing advance obligations. At December 31, 2022 and December 31, 2021, the Company had pledged servicing advances with a carrying value of $67.8 million and $33.8 million, respectively, as collateral for this revolving credit facility. See Note 12 - Revolving Credit Facilities.
Serviced Mortgage Assets
The Company’s total serviced mortgage assets consist of residential mortgage loans underlying its MSR assets, off-balance sheet residential mortgage loans owned by other entities for which the Company acts as servicing administrator and other assets. 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 December 31, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2022 | | December 31, 2021 |
| (dollars in thousands) | Number of Loans | | Unpaid Principal Balance | | Number of Loans | | Unpaid Principal Balance |
| Mortgage servicing rights | 809,025 | | | $ | 204,876,693 | | | 796,205 | | | $ | 193,770,566 | |
Residential mortgage loans | 636 | | | 374,005 | | | 868 | | | 519,270 | |
| Other assets | 4 | | | 269 | | | 2 | | | 40 | |
| Total serviced mortgage assets | 809,665 | | | $ | 205,250,967 | | | 797,075 | | | $ | 194,289,876 | |
Note 6. Cash, Cash Equivalents and Restricted Cash
Cash and cash equivalents include cash held in bank accounts and cash held in money market funds on an overnight basis.
The Company is required to maintain certain cash balances with counterparties for securities and derivatives trading activity, servicing activities and collateral for the Company’s borrowings in restricted accounts. The Company has also placed cash in a restricted account pursuant to a letter of credit on an office space lease.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The following table presents the Company’s restricted cash balances as of December 31, 2022 and December 31, 2021:
| | | | | | | | | | | |
| (in thousands) | December 31,
2022 | | December 31,
2021 |
| Restricted cash balances held by trading counterparties: | | | |
| For securities trading activity | $ | 2,202 | | | $ | 23,800 | |
| For derivatives trading activity | 79,220 | | | 136,271 | |
| For servicing activities | 36,690 | | | 26,704 | |
As restricted collateral for borrowings | 324,854 | | | 747,979 | |
| Total restricted cash balances held by trading counterparties | 442,966 | | | 934,754 | |
| Restricted cash balance pursuant to letter of credit on office lease | 60 | | | 60 | |
| Total | $ | 443,026 | | | $ | 934,814 | |
The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported on the Company’s consolidated balance sheets as of December 31, 2022 and December 31, 2021 that sum to the total of the same such amounts shown in the statements of cash flows:
| | | | | | | | | | | |
| (in thousands) | December 31,
2022 | | December 31,
2021 |
| Cash and cash equivalents | $ | 683,479 | | | $ | 1,153,856 | |
| Restricted cash | 443,026 | | | 934,814 | |
| Total cash, cash equivalents and restricted cash | $ | 1,126,505 | | | $ | 2,088,670 | |
Note 7. 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 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, principally cash flow volatility associated with interest rate risk (including associated prepayment risk). Specifically, the Company enters into derivative and non-derivative instruments to economically hedge interest rate risk or “duration mismatch (or gap)” by adjusting the duration of its floating-rate borrowings into fixed-rate borrowings to more closely match the duration of its assets. This particularly applies to floating-rate borrowing agreements with maturities or interest rate resets of less than six months. Typically, the interest receivable terms (e.g., LIBOR, Overnight Index Swap Rate, or OIS, or SOFR) of certain derivatives match the terms of the underlying debt, resulting in an effective conversion of the rate of the related borrowing agreement from floating to fixed. The objective is to manage the cash flows associated with current and anticipated interest payments on borrowings, as well as the ability to roll or refinance borrowings at the desired amount by adjusting the duration.
To help manage the adverse impact of interest rate changes on the value of the Company’s portfolio as well as its cash flows, the Company may, at times, enter into various forward contracts, including short securities, Agency to-be-announced securities, or TBAs, options, futures, swaps, caps and total return swaps. In executing on the Company’s current risk management strategy, the Company has entered into TBAs, interest rate swap and swaption agreements, futures and options on futures. The Company has also entered into a number of non-derivative instruments to manage interest rate risk, principally MSR and interest-only securities (see discussion below).
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 these risks. The discussion includes both derivative and non-derivative instruments used as part of these risk management activities. Any of the Company’s derivative and non-derivative instruments may be entered into in conjunction with one another in order to mitigate risks. As a result, the following discussions of each type of instrument should be read as a collective representation of the Company’s risk mitigation efforts and should not be considered independent of one another. While the Company uses derivative and non-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.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Balance Sheet Presentation
In accordance with ASC 815, the Company records derivative financial instruments on its 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 are designated or qualifying as hedge instruments. Due to the volatility of the interest rate and credit markets and difficulty in effectively matching pricing or cash flows, the Company has not designated any current derivatives as hedging instruments.
The following tables present the gross fair value and notional amounts of the Company’s derivative financial instruments treated as trading derivatives as of December 31, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | December 31, 2022 |
| | Derivative Assets | | Derivative Liabilities |
| (in thousands) | | Fair Value | | Notional | | Fair Value | | Notional |
Inverse interest-only securities | | $ | 15,293 | | | $ | 196,456 | | | $ | — | | | $ | — | |
Interest rate swap agreements | | — | | | — | | | — | | | — | |
| | | | | | | | |
| | | | | | | | |
| Swaptions, net | | — | | | — | | | — | | | — | |
| TBAs | | 11,145 | | | (650,000) | | | (34,048) | | | 4,476,000 | |
| | | | | | | | |
| | | | | | | | |
| Futures, net | | — | | | (18,285,452) | | | — | | | — | |
| | | | | | | | |
| | | | | | | | |
| Total | | $ | 26,438 | | | $ | (18,738,996) | | | $ | (34,048) | | | $ | 4,476,000 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | December 31, 2021 |
| | Derivative Assets | | Derivative Liabilities |
| (in thousands) | | Fair Value | | Notional | | Fair Value | | Notional |
Inverse interest-only securities | | $ | 41,367 | | | $ | 247,101 | | | $ | — | | | $ | — | |
Interest rate swap agreements | | — | | | 20,387,300 | | | — | | | — | |
| | | | | | | | |
| | | | | | | | |
| Swaptions, net | | — | | | — | | | (51,743) | | | (1,761,000) | |
| TBAs | | 3,405 | | | 3,523,000 | | | (1,915) | | | 593,000 | |
| | | | | | | | |
| | | | | | | | |
| Futures, net | | 35,362 | | | (5,829,600) | | | — | | | — | |
| | | | | | | | |
| | | | | | | | |
| Total | | $ | 80,134 | | | $ | 18,327,801 | | | $ | (53,658) | | | $ | (1,168,000) | |
Comprehensive Loss Statement Presentation
The Company has not applied hedge accounting to its current derivative portfolio held to mitigate interest rate risk and credit risk. As a result, the Company is subject to volatility in its earnings due to movement in the unrealized gains and losses associated with its derivative instruments.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The following table summarizes the location and amount of gains and losses on derivative instruments reported in the consolidated statements of comprehensive loss:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Derivative Instruments | | Location of Gain (Loss) Recognized in Income | | | | Amount of Gain (Loss) Recognized in Income |
| | | | | | Year Ended |
| (in thousands) | | | | | | December 31, |
| | | | | | | | 2022 | | 2021 | | 2020 |
Interest rate risk management: | | | | | | | | | | |
TBAs | | Gain (loss) on other derivative instruments | | | | | | $ | (487,713) | | | $ | (193,479) | | | $ | 60,798 | |
| | | | | | | | | | | | |
Futures | | Gain (loss) on other derivative instruments | | | | | | 514,467 | | | (49,213) | | | 18,143 | |
Options on TBAs | | Gain (loss) on other derivative instruments | | | | | | — | | | (5,683) | | | — | |
| | | | | | | | | | | | |
Options on futures | | Gain (loss) on other derivative instruments | | | | | | (2,224) | | | — | | | — | |
Interest rate swaps - Payers | | Gain (loss) on interest rate swap, cap and swaption agreements | | | | | | 772,829 | | | 92,317 | | | (1,128,788) | |
Interest rate swaps - Receivers | | Gain (loss) on interest rate swap, cap and swaption agreements | | | | | | (756,744) | | | (66,828) | | | 879,289 | |
Swaptions | | Gain (loss) on interest rate swap, cap and swaption agreements | | | | | | 13,414 | | | 16,602 | | | (61,307) | |
| | | | | | | | | | | | |
Markit IOS total return swaps | | Gain (loss) on other derivative instruments | | | | | | — | | | — | | | (2,430) | |
| | | | | | | | | | | | |
| | | | | | | | | | | | |
Non-risk management: | | | | | | | | | | |
| | | | | | | | | | | | |
Inverse interest-only securities | | Gain (loss) on other derivative instruments | | | | | | (15,220) | | | (2,908) | | | 13,512 | |
| | | | | | | | | | | | |
| Total | | | | | | | | $ | 38,809 | | | $ | (209,192) | | | $ | (220,783) | |
For the years ended December 31, 2022, 2021 and 2020, the Company recognized $4.8 million of expense, $14.3 million of income, and $66.2 million of expense, respectively, for the accrual and/or settlement of the net interest expense associated with its interest rate swaps and caps. The income resulted from paying either a fixed interest rate or a floating interest rate (e.g., LIBOR, OIS or SOFR) and receiving either a floating interest rate (e.g., LIBOR, OIS or SOFR) or a fixed interest rate on an average $12.4 billion, $15.9 billion and $27.1 billion notional, respectively.
The following tables present information with respect to the volume of activity in the Company’s derivative instruments during the years ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Year Ended December 31, 2022 |
| (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 | $ | 247,101 | | | $ | — | | | $ | (50,645) | | | $ | 196,456 | | | $ | 219,813 | | | $ | — | |
| Interest rate swap agreements | 20,387,300 | | | 22,398,148 | | | (42,785,448) | | | — | | | 12,424,320 | | | 29,543 | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| Swaptions, net | (1,761,000) | | | (1,000,000) | | | 2,761,000 | | | — | | | (1,274,101) | | | 13,654 | |
| TBAs, net | 4,116,000 | | | 69,828,000 | | | (70,118,000) | | | 3,826,000 | | | 4,743,504 | | | (463,320) | |
| | | | | | | | | | | |
| | | | | | | | | | | |
Futures, net | (5,829,600) | | | (68,777,002) | | | 56,321,150 | | | (18,285,452) | | | (13,921,620) | | | 487,267 | |
| | | | | | | | | | | |
| | | | | | | | | | | |
Options on futures, net | — | | | 2,000 | | | (2,000) | | | — | | | 416 | | | (2,224) | |
| Total | $ | 17,159,801 | | | $ | 22,451,146 | | | $ | (53,873,943) | | | $ | (14,262,996) | | | $ | 2,192,332 | | | $ | 64,920 | |
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Year Ended December 31, 2021 |
| (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 | $ | 318,162 | | | $ | — | | | $ | (71,061) | | | $ | 247,101 | | | $ | 282,380 | | | $ | (398) | |
| Interest rate swap agreements | 12,646,341 | | | 10,107,476 | | | (2,366,517) | | | 20,387,300 | | | 15,870,590 | | | (5,778) | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| Swaptions, net | 3,750,000 | | | (2,871,000) | | | (2,640,000) | | | (1,761,000) | | | (428,586) | | | 8,147 | |
| TBAs, net | 5,197,000 | | | 90,927,000 | | | (92,008,000) | | | 4,116,000 | | | 6,538,666 | | | (175,368) | |
| | | | | | | | | | | |
| Options on TBAs, net | — | | | 1,500,000 | | | (1,500,000) | | | — | | | 267,123 | | | (5,683) | |
Futures, net | 2,021,100 | | | 7,447,600 | | | (15,298,300) | | | (5,829,600) | | | (2,197,734) | | | (80,867) | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| Total | $ | 23,932,603 | | | $ | 107,111,076 | | | $ | (113,883,878) | | | $ | 17,159,801 | | | $ | 20,332,439 | | | $ | (259,947) | |
____________________
(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 consolidated statements of cash flows. Realized gains and losses and derivative fair value adjustments are reflected within the realized and unrealized (gains) losses on interest rate swaps, caps and swaptions and unrealized losses (gains) on other derivative instruments line items within the operating activities section of the consolidated statements of cash flows. The remaining cash flow activity related to derivative instruments is reflected within the (purchases) short sales of derivative instruments, net; proceeds from sales and settlement (payments for termination and settlement) of derivative instruments, net; and increase in due to counterparties, net line items within the investing activities section of the consolidated statements of cash flows.
Interest Rate Sensitive Assets/Liabilities
The Company’s Agency RMBS portfolio is generally subject to change in value when interest rates or prepayment speeds decrease or increase, depending on the type of investment. Periods of rising interest rates with corresponding decreasing prepayment speeds generally result in a decline in the value of the Company’s fixed-rate Agency principal and interest (P&I) RMBS. The impact of this effect on the Company’s fixed-rate Agency P&I RMBS portfolio is partially mitigated by the presence of fixed-rate interest-only Agency RMBS, which generally increase in value when prepayment speeds decrease and MSR, which generally increase in value when prepayment speeds decrease and interest rates increase. As of December 31, 2022 and December 31, 2021, the Company had $23.8 million and $274.1 million, respectively, of interest-only securities, and $3.0 billion and $2.2 billion, respectively, of MSR. Interest-only securities are included in AFS securities, at fair value, in the consolidated balance sheets.
The Company monitors its borrowings under repurchase agreements and revolving credit facilities, which are generally floating-rate debt, in relation to the rate profile of its portfolio. In connection with its risk management activities, the Company enters into a variety of derivative and non-derivative instruments to economically hedge interest rate risk or duration mismatch (or gap) by adjusting the duration of its floating-rate borrowings into fixed-rate borrowings to more closely match the duration of its assets. This particularly applies to borrowing agreements with maturities or interest rate resets of less than six months. Typically, the interest receivable terms (e.g., LIBOR, OIS or SOFR) of certain derivatives match the terms of the underlying debt, resulting in an effective conversion of the rate of the related borrowing agreement from floating to fixed. The objective is to manage the cash flows associated with current and anticipated interest payments on borrowings, as well as the ability to roll or refinance borrowings at the desired amount by adjusting the duration. To help manage the adverse impact of interest rate changes on the value of the Company’s portfolio as well as its cash flows, the Company may, at times, enter into various forward contracts, including short securities, TBAs, options, futures, swaps, caps, credit default swaps and total return swaps. In executing on the Company’s current interest rate risk management strategy, the Company has entered into TBAs, interest rate swap and swaption agreements, futures and options on futures.
The Company did not hold any derivative instruments that incorporate LIBOR as the referenced rate as of December 31, 2022. See Note 2 - Basis of Presentation and Significant Accounting Policies for further discussion of the transition away from LIBOR.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
TBAs. The Company may use TBAs as a means of deploying capital until targeted investments are available or to take advantage of temporary displacements, funding advantages or valuation differentials in the marketplace. Additionally, the Company may use TBAs independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. 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.
The Company may hold both long and short notional TBA positions, which are disclosed 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 December 31, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2022 |
| | | | | | | Net Carrying Value (4) |
| (in thousands) | Notional Amount (1) | | Cost Basis (2) | | Market Value (3) | | Derivative Assets | | Derivative Liabilities |
| Purchase contracts | $ | 4,826,000 | | | $ | 4,802,009 | | | $ | 4,767,989 | | | $ | 28 | | | $ | (34,048) | |
| Sale contracts | (1,000,000) | | | (878,711) | | | (867,594) | | | 11,117 | | | — | |
| TBAs, net | $ | 3,826,000 | | | $ | 3,923,298 | | | $ | 3,900,395 | | | $ | 11,145 | | | $ | (34,048) | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2021 |
| | | | | | | Net Carrying Value (4) |
| (in thousands) | Notional Amount (1) | | Cost Basis (2) | | Market Value (3) | | Derivative Assets | | Derivative Liabilities |
| Purchase contracts | $ | 4,116,000 | | | $ | 4,238,881 | | | $ | 4,240,371 | | | $ | 3,405 | | | $ | (1,915) | |
| Sale contracts | — | | | — | | | — | | | — | | | — | |
| TBAs, net | $ | 4,116,000 | | | $ | 4,238,881 | | | $ | 4,240,371 | | | $ | 3,405 | | | $ | (1,915) | |
___________________
(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 consolidated balance sheets.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Futures. The Company may use a variety of types of futures independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. The following table summarizes certain characteristics of the Company’s futures as of December 31, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| (dollars in thousands) | | December 31, 2022 | | December 31, 2021 |
| Type & Maturity | | Notional Amount | | Carrying Value | | Weighted Average Days to Expiration | | Notional Amount | | Carrying Value | | Weighted Average Days to Expiration |
| U.S. Treasury futures - 2 year | | $ | (562,200) | | | $ | — | | | 95 | | $ | — | | | $ | — | | | 0 |
| U.S. Treasury futures - 5 year | | (3,855,500) | | | — | | | 95 | | — | | | — | | | 0 |
| U.S. Treasury futures - 10 year | | (2,397,200) | | | — | | | 90 | | 687,900 | | | 1,809 | | | 90 |
| U.S. Treasury futures - 20 year | | 101,000 | | | — | | | 90 | | — | | | — | | | 0 |
| Federal Funds futures - 30 day | | (7,948,552) | | | — | | | 92 | | — | | | — | | | 0 |
| Eurodollar futures - 3 month: | | | | | | | | | | | | |
| ≤ 1 year | | (2,957,000) | | | — | | | 184 | | (3,582,000) | | | 15,121 | | | 213 |
| > 1 and ≤ 2 years | | (666,000) | | | — | | | 489 | | (2,269,500) | | | 14,952 | | | 560 |
| > 2 and ≤ 3 years | | — | | | — | | | 0 | | (666,000) | | | 3,480 | | | 854 |
| Total futures | | $ | (18,285,452) | | | $ | — | | | 122 | | $ | (5,829,600) | | | $ | 35,362 | | | 370 |
Interest Rate Swap Agreements. The Company may use interest rate swaps independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. The Company did not hold any interest rate swaps as of December 31, 2022. As of December 31, 2021, the Company held the following interest rate swaps that were utilized as economic hedges of interest rate exposure (or duration) whereby the Company receives interest at a floating interest rate (OIS or SOFR):
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| (notional in thousands) | | | | | | |
| December 31, 2021 |
| Swaps Maturities | | Notional Amount | | Weighted Average Fixed Pay Rate | | Weighted Average Receive Rate | | Weighted Average Maturity (Years) |
| 2022 | | $ | 7,415,818 | | | 0.420 | % | | 0.070 | % | | 0.66 |
| 2023 | | 2,582,084 | | | 0.113 | % | | 0.068 | % | | 1.51 |
| 2024 | | — | | | — | % | | — | % | | 0.00 |
| 2025 | | 377,610 | | | 1.030 | % | | 0.050 | % | | 3.96 |
| 2026 and Thereafter | | 2,782,057 | | | 0.652 | % | | 0.063 | % | | 6.56 |
| Total | | $ | 13,157,569 | | | 0.213 | % | | 0.067 | % | | 2.17 |
Additionally, as of December 31, 2021, the Company held the following interest rate swaps in order to mitigate mortgage interest rate exposure (or duration) risk whereby the Company pays interest at a floating interest rate (OIS or SOFR):
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| (notional in thousands) | | | | | | |
| December 31, 2021 |
| Swaps Maturities | | Notional Amount | | Weighted Average Pay Rate | | Weighted Average Fixed Receive Rate | | Weighted Average Maturity (Years) |
| 2022 | | $ | 2,221,658 | | | 0.070 | % | | 0.118 | % | | 1.19 |
| 2023 | | — | | | — | % | | — | % | | 0.00 |
| 2024 | | — | | | — | % | | — | % | | 0.00 |
| 2025 | | — | | | — | % | | — | % | | 0.00 |
| 2026 and Thereafter | | 5,008,073 | | | 0.058 | % | | 1.049 | % | | 10.00 |
| Total | | $ | 7,229,731 | | | 0.062 | % | | 0.763 | % | | 7.29 |
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Interest Rate Swaptions. The Company may use interest rate swaptions (which provide the option to enter into interest rate swap agreements for a predetermined notional amount, stated term and pay and receive interest rates in the future) independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. The Company did not hold any interest rate swaptions as of December 31, 2022. As of December 31, 2021, the Company had the following outstanding interest rate swaptions:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | December 31, 2021 |
| (notional and dollars in thousands) | | Option | | Underlying Swap |
| Swaption | | Expiration | | Cost | | Fair Value | | Average Months to Expiration | | Notional Amount | | Average Fixed Rate (1) | | | | Average Term (Years) |
| Purchase contracts: | | | | | | | | | | | | | | | | |
| Payer | | < 6 Months | | $ | 11,314 | | | $ | 3,539 | | | 5.33 | | | $ | 886,000 | | | 2.26 | % | | | | 10.0 |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| Sale contracts: | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| Payer | | ≥ 6 Months | | $ | (26,329) | | | $ | (23,958) | | | 17.79 | | | $ | (780,000) | | | 1.72 | % | | | | 10.0 |
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| Receiver | | < 6 Months | | $ | (10,640) | | | $ | (6,856) | | | 5.11 | | | $ | (1,087,000) | | | 1.26 | % | | | | 10.0 |
| Receiver | | ≥ 6 Months | | $ | (26,329) | | | $ | (24,468) | | | 18.91 | | | $ | (780,000) | | | 1.72 | % | | | | 10.0 |
| | | | | | | | | | | | | | | | |
____________________
(1)As of December 31, 2021, 100.0% of the underlying swap floating rates were tied to 3-Month LIBOR.
Credit Risk
The Company’s exposure to credit losses on its Agency RMBS portfolio is limited due to implicit or explicit backing from either a GSE or a U.S. government agency. 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.
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 securities.
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 December 31, 2022, the fair value of derivative financial instruments as an asset and liability position was $26.4 million and $34.0 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 internal credit guidelines. The Company also seeks to spread its credit risk exposure across multiple counterparties in order to reduce its 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 upon the 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. The Company’s centrally cleared interest rate swaps and exchange-traded futures and options on futures require the Company to post an “initial margin” amount determined by the clearing exchange, which is generally intended to be set at a level sufficient to protect the exchange from the derivative instrument’s maximum estimated single-day price movement. The Company also exchanges “variation margin” based upon daily changes in fair value, as measured by the exchange. The exchange of variation margin is considered a settlement of the derivative instrument, as opposed to pledged collateral. Accordingly, the Company accounts for the receipt or payment of variation margin as a direct reduction to the carrying value of the centrally cleared or exchange-traded derivative asset or liability.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Note 8. Reverse Repurchase Agreements
As of December 31, 2022 and December 31, 2021, the Company had $189.5 million and $129.2 million in amounts due to counterparties as collateral for reverse repurchase agreements that could be pledged, delivered or otherwise used, with a fair value of $189.3 million and $134.7 million, respectively. Additionally, as of December 31, 2022, the Company had entered into $877.6 million in reverse repurchase agreements in order to effectively borrow U.S. Treasury securities and pledge them as collateral for $888.3 million of repurchase agreements (see Note 11 - Repurchase Agreements for further detail).
Note 9. 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 by 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. 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. Additionally, the Company’s centrally cleared interest rate swaps and exchange-traded futures and options on futures require the Company to post an initial margin amount determined by the clearing exchange, which is generally intended to be set at a level sufficient to protect the exchange from the derivative instrument’s maximum estimated single-day price movement. The Company also exchanges variation margin based upon daily changes in fair value, as measured by the exchange.
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. Based on rules governing certain central clearing and exchange-trading activities, the exchange of variation margin is considered a settlement of the derivative instrument, as opposed to pledged collateral. Accordingly, the Company accounts for the receipt or payment of variation margin on Chicago Mercantile Exchange, or CME, and London Clearing House, or LCH, cleared positions as a direct reduction to the carrying value of the centrally cleared or exchange-traded derivative asset or liability. The receipt or payment of initial margin is accounted for separate from the derivative asset or liability.
Reverse repurchase agreements and repurchase agreements with the same counterparty and the same maturity are presented net in the Company’s consolidated balance sheets when the terms of the agreements meet the criteria to permit netting. The Company reports cash flows on repurchase agreements as financing activities and cash flows on reverse repurchase agreements as investing activities in the consolidated statements of cash flows. The Company presents derivative assets and liabilities (other than centrally cleared or exchange-traded derivative instruments) subject to master netting arrangements or similar agreements on a net basis, based on derivative type and counterparty, in its consolidated balance sheets. Separately, the Company presents cash collateral subject to such arrangements (other than variation margin on centrally cleared or exchange-traded derivative instruments) on a net basis, based on counterparty, in its consolidated balance sheets. However, the Company does not offset repurchase agreements, reverse repurchase agreements or derivative assets and liabilities (other than centrally cleared or exchange-traded derivative instruments) with the associated cash collateral on its consolidated balance sheets.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
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 consolidated balance sheets as of December 31, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2022 |
| | | | | | | Gross Amounts Not Offset with Financial Assets (Liabilities) in the Balance Sheets (1) | | |
| (in thousands) | Gross Amounts of Recognized Assets (Liabilities) | | Gross Amounts Offset in the Balance Sheets | | Net Amounts of Assets (Liabilities) Presented in the Balance Sheets | | Financial Instruments | | Cash Collateral (Received) Pledged | | Net Amount |
| Assets | | | | | | | | | | | |
| Derivative assets | $ | 98,609 | | | $ | (72,171) | | | $ | 26,438 | | | $ | (26,438) | | | $ | — | | | $ | — | |
Reverse repurchase agreements | 1,066,935 | | | — | | | 1,066,935 | | | (888,295) | | | (178,640) | | | — | |
| Total Assets | $ | 1,165,544 | | | $ | (72,171) | | | $ | 1,093,373 | | | $ | (914,733) | | | $ | (178,640) | | | $ | — | |
| Liabilities | | | | | | | | | | | |
| Repurchase agreements | $ | (8,603,011) | | | $ | — | | | $ | (8,603,011) | | | $ | 8,603,011 | | | $ | — | | | $ | — | |
| Derivative liabilities | (106,219) | | | 72,171 | | | (34,048) | | | 26,438 | | | — | | | (7,610) | |
| Total Liabilities | $ | (8,709,230) | | | $ | 72,171 | | | $ | (8,637,059) | | | $ | 8,629,449 | | | $ | — | | | $ | (7,610) | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2021 |
| | | | | | | Gross Amounts Not Offset with Financial Assets (Liabilities) in the Balance Sheets (1) | | |
| (in thousands) | Gross Amounts of Recognized Assets (Liabilities) | | Gross Amounts Offset in the Balance Sheets | | Net Amounts of Assets (Liabilities) Presented in the Balance Sheets | | Financial Instruments | | Cash Collateral (Received) Pledged | | Net Amount |
| Assets | | | | | | | | | | | |
| Derivative assets | $ | 215,084 | | | $ | (134,950) | | | $ | 80,134 | | | $ | (53,658) | | | $ | — | | | $ | 26,476 | |
Reverse repurchase agreements | 134,682 | | | — | | | 134,682 | | | — | | | (129,227) | | | 5,455 | |
| Total Assets | $ | 349,766 | | | $ | (134,950) | | | $ | 214,816 | | | $ | (53,658) | | | $ | (129,227) | | | $ | 31,931 | |
| Liabilities | | | | | | | | | | | |
| Repurchase agreements | $ | (7,656,445) | | | $ | — | | | $ | (7,656,445) | | | $ | 7,656,445 | | | $ | — | | | $ | — | |
| Derivative liabilities | (188,608) | | | 134,950 | | | (53,658) | | | 53,658 | | | — | | | — | |
| Total Liabilities | $ | (7,845,053) | | | $ | 134,950 | | | $ | (7,710,103) | | | $ | 7,710,103 | | | $ | — | | | $ | — | |
____________________
(1)Amounts presented are limited in total to the net amount of assets or liabilities presented in the 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 consolidated balance sheets.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Note 10. Fair Value
Fair Value Measurements
ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices available in active markets (i.e., observable inputs) and the lowest priority to data lacking transparency (i.e., unobservable inputs). Additionally, ASC 820 requires an entity to consider all aspects of nonperformance risk, including the entity’s own credit standing, when measuring fair value of a liability.
ASC 820 establishes a three-level hierarchy to be used when measuring and disclosing fair value. An instrument’s categorization within the fair value hierarchy is based on the lowest level of significant input to its valuation. The following is a description of the three levels:
Level 1Inputs 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 2Inputs 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 3Unobservable 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.
The 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.
Available-for-sale securities. The Company holds a portfolio of AFS securities that are carried at fair value in the consolidated balance sheets and primarily comprised of Agency RMBS and non-Agency securities. The Company determines the fair value of its Agency RMBS based upon prices obtained from third-party brokers and pricing vendors received using bid price, which are deemed indicative of market activity. The third-party pricing vendors 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 securities, management judgment may be used to arrive at fair value that considers prices obtained from third-party pricing vendors 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 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 98.4% and 1.6% of its AFS securities as Level 2 and Level 3 fair value assets, respectively, at December 31, 2022.
Mortgage servicing rights. The Company holds a portfolio of MSR that are carried at fair value on the consolidated balance sheets. The Company determines fair value of its MSR based on prices obtained from third-party pricing vendors. Although MSR transactions may be observable in the marketplace, the details of those transactions are not necessarily reflective of the value of the Company’s MSR portfolio. Third-party vendors use both observable market data and unobservable market data (including forecasted prepayment speeds, delinquency levels, OAS, and cost to service) as inputs into models, which help to inform their best estimates of fair value market price. As a result, the Company classified 100% of its MSR as Level 3 fair value assets at December 31, 2022.
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 and swaptions. The Company utilizes third-party brokers to value its financial derivative instruments. The Company did not hold any interest rate swaps or swaptions at December 31, 2022.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The Company may also enter into certain other derivative financial instruments, such as inverse interest-only securities, TBAs, futures and options on futures. The Company utilizes third-party pricing vendors to value inverse interest-only securities, as these instruments are similar in form to the Company’s AFS securities. The Company classified 100% of its inverse interest-only securities at fair value as Level 2 at December 31, 2022. TBAs, futures and options on futures are considered to be active markets such that participants transact with sufficient frequency and volume to provide transparent pricing information for identical instruments. The Company utilizes third-party pricing vendors to value TBAs, futures and options on futures. The Company reported 100% of its TBAs and futures as Level 1 as of December 31, 2022. The Company did not hold any options on futures at December 31, 2022.
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. Additionally, both the Company and the counterparty or clearing agency are required to post cash margin based upon the net underlying market value of the Company’s open positions with the counterparty. Posting of cash margin typically occurs daily, subject to certain dollar thresholds. Due to the existence of netting arrangements, as well as frequent cash margin 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.
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 |
| December 31, 2022 |
| (in thousands) | Level 1 | | Level 2 | | Level 3 | | Total |
| Assets: | | | | | | | |
| Available-for-sale securities | $ | — | | | $ | 7,653,576 | | | $ | 125,158 | | | $ | 7,778,734 | |
| | | | | | | |
| Mortgage servicing rights | — | | | — | | | 2,984,937 | | | 2,984,937 | |
| | | | | | | |
| Derivative assets | 11,145 | | | 15,293 | | | — | | | 26,438 | |
| | | | | | | |
| Total assets | $ | 11,145 | | | $ | 7,668,869 | | | $ | 3,110,095 | | | $ | 10,790,109 | |
| Liabilities: | | | | | | | |
| | | | | | | |
| Derivative liabilities | $ | 34,048 | | | $ | — | | | $ | — | | | $ | 34,048 | |
| Total liabilities | $ | 34,048 | | | $ | — | | | $ | — | | | $ | 34,048 | |
| | | | | | | | | | | | | | | | | | | | | | | |
| Recurring Fair Value Measurements |
| December 31, 2021 |
| (in thousands) | Level 1 | | Level 2 | | Level 3 | | Total |
| Assets: | | | | | | | |
| Available-for-sale securities | $ | — | | | $ | 7,149,399 | | | $ | 12,304 | | | $ | 7,161,703 | |
| | | | | | | |
| Mortgage servicing rights | — | | | — | | | 2,191,578 | | | 2,191,578 | |
| | | | | | | |
| Derivative assets | 38,767 | | | 41,367 | | | — | | | 80,134 | |
| | | | | | | |
| Total assets | $ | 38,767 | | | $ | 7,190,766 | | | $ | 2,203,882 | | | $ | 9,433,415 | |
| Liabilities: | | | | | | | |
| | | | | | | |
| Derivative liabilities | $ | 1,915 | | | $ | 51,743 | | | $ | — | | | $ | 53,658 | |
| Total liabilities | $ | 1,915 | | | $ | 51,743 | | | $ | — | | | $ | 53,658 | |
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
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 December 31, 2022, 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 vendors and/or management. The third-party pricing vendors 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 vendors in the absence of market information. Assumptions used by the third-party pricing vendors due to lack of observable inputs may significantly impact the resulting fair value and therefore the Company’s consolidated financial statements.
The Company’s valuation committee reviews all valuations that are based on pricing information received from third-party pricing vendors. 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 pricing vendors.
In determining fair value, third-party pricing vendors 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 vendor 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 that are priced using third-party broker quotations 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 swap and swaption agreements, are valued by the Company using observable inputs, specifically quotations received from third-party brokers. Exchange-traded derivative instruments, including futures and options on futures, are valued based on quoted prices for identical instruments in active markets.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The following table presents the reconciliation for the Company’s Level 3 assets measured at fair value on a recurring basis:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Year Ended | |
| | | December 31, | |
| | | 2022 | | 2021 | |
| (in thousands) | | | | | Available-For-Sale Securities | | Mortgage Servicing Rights | | Available-For-Sale Securities | | Mortgage Servicing Rights | |
Beginning of period level 3 fair value | | | | | $ | 12,304 | | | $ | 2,191,578 | | | $ | 13,031 | | | $ | 1,596,153 | | |
| Gains (losses) included in net income (loss): | | | | | | | | | | | | |
| Realized | | | | | (1,405) | | | (368,255) | | | (10,905) | | | (677,784) | | |
| Unrealized | | | | | (3,632) | | (1) | 793,631 | | (2) | (1,185) | | (1) | 562,843 | | (2) |
| Reversal of provision for credit losses | | | | | 1,213 | | | — | | | 11,188 | | | — | | |
| Net gains (losses) included in net income (loss) | | | | | (3,824) | | | 425,376 | | | (902) | | | (114,941) | | |
| Other comprehensive income | | | | | 1,023 | | | — | | | (9,449) | | | — | | |
| Purchases | | | | | 122,030 | | | 640,051 | | | 11,201 | | | 777,305 | | |
| Sales | | | | | (6,375) | | | (261,827) | | | (1,577) | | | (31,787) | | |
| Settlements | | | | | — | | | (10,241) | | | — | | | (35,152) | | |
| Gross transfers into level 3 | | | | | — | | | — | | | — | | | — | | |
| Gross transfers out of level 3 | | | | | — | | | — | | | — | | | — | | |
| End of period level 3 fair value | | | | | $ | 125,158 | | | $ | 2,984,937 | | | $ | 12,304 | | | $ | 2,191,578 | | |
Change in unrealized gains or losses for the period included in earnings for assets held at the end of the reporting period | | | | | $ | (4,535) | | (3) | $ | 696,807 | | (4) | $ | (1,185) | | (3) | $ | 461,258 | | (4) |
Change in unrealized gains or losses for the period included in other comprehensive (loss) income for assets held at the end of the reporting period | | | | | $ | (3,512) | | | $ | — | | | $ | (10,635) | | | $ | — | | |
____________________
(1)The change in unrealized gains or losses on available-for-sale securities accounted for under the fair value option was recorded in (loss) gain on investment securities on the consolidated statements of comprehensive loss.
(2)The change in unrealized gains or losses on MSR was recorded in gain (loss) on servicing asset on the consolidated statements of comprehensive loss.
(3)The change in unrealized gains or losses on available-for-sale securities accounted for under the fair value option that were held at the end of the reporting period was recorded in (loss) gain on investment securities on the consolidated statements of comprehensive loss.
(4)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 consolidated statements of comprehensive loss.
No transfers between Level 1, Level 2 or Level 3 were made during the years ended December 31, 2022 and 2021. 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 multiple third-party pricing vendors in the fair value measurement of its Level 3 AFS securities. The significant unobservable inputs used by the third-party pricing vendors 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.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The Company also used multiple third-party pricing vendors in the fair value measurement of its Level 3 MSR. The tables below present information about the significant unobservable market data used by the third-party pricing vendors as inputs into models utilized to inform their best estimates of the fair value measurement of the Company’s MSR classified as Level 3 fair value assets at December 31, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2022 | |
| Valuation Technique | | Unobservable Input | | Range | | Weighted Average (1) | |
| Discounted cash flow | | Constant prepayment speed | | 6.2% | - | 7.6% | | | 6.9% | |
| | Delinquency | | 0.8% | - | 0.9% | | | 0.9% | |
| | Option-adjusted spread | | 5.1% | - | 8.5% | | | 5.3% | |
| | Per loan annual cost to service | | $67.41 | - | $80.96 | | | $67.92 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2021 | |
| Valuation Technique | | Unobservable Input | | Range | | Weighted Average (1) | |
| Discounted cash flow | | Constant prepayment speed | | 10.0% | - | 17.9% | | | 12.9% | |
| | Delinquency | | 0.9% | - | 1.8% | | | 1.3% | |
| | Option-adjusted spread | | 4.6% | - | 9.2% | | | 4.7% | |
| | Per loan annual cost to service | | $66.04 | - | $83.91 | | | $66.76 | |
___________________
(1)Calculated by averaging the weighted average significant unobservable inputs used by the multiple third-party pricing vendors in the fair value measurement of MSR.
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 consolidated balance sheets, for which fair value can be estimated.
The following describes the Company’s methods for estimating the fair value for financial instruments.
•AFS securities, MSR, and derivative assets and liabilities are recurring fair value measurements; carrying value equals fair value. See discussion of valuation methods and assumptions within the Fair Value Measurements section of this Note 10.
•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.
•Reverse repurchase agreements have a carrying value which approximates fair value due to their short-term nature. The Company categorizes the fair value measurement of these assets as Level 2.
•The carrying value of repurchase agreements and revolving credit facilities that mature in less than one year generally approximates fair value due to the short maturities. As of December 31, 2022, the Company had outstanding borrowings of $918.8 million under revolving credit facilities that are considered long-term. The Company’s long-term revolving credit facilities have floating rates based on an index plus a spread and the credit spread is typically consistent with those demanded in the market. Accordingly, the interest rates on these borrowings are at market and thus carrying value approximates fair value. The Company categorizes the fair value measurement of these liabilities as Level 2.
•Term notes payable are recorded at outstanding principal balance, net of any unamortized deferred debt issuance costs. In determining the fair value of term notes payable, management judgment may be used to arrive at fair value that considers prices obtained from third-party pricing vendors, broker quotes received 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 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 categorizes the fair value measurement of these liabilities as Level 2.
•Convertible senior notes are carried at their unpaid principal balance, net of any unamortized deferred issuance costs. The Company estimates the fair value of its convertible senior notes using the market transaction price nearest to December 31, 2022. The Company categorizes the fair value measurement of these assets as Level 2.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
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 December 31, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2022 | | December 31, 2021 |
| (in thousands) | Carrying Value | | Fair Value | | Carrying Value | | Fair Value |
| Assets: | | | | | | | |
| Available-for-sale securities | $ | 7,778,734 | | | $ | 7,778,734 | | | $ | 7,161,703 | | | $ | 7,161,703 | |
| | | | | | | |
| | | | | | | |
| Mortgage servicing rights | $ | 2,984,937 | | | $ | 2,984,937 | | | $ | 2,191,578 | | | $ | 2,191,578 | |
| | | | | | | |
| Cash and cash equivalents | $ | 683,479 | | | $ | 683,479 | | | $ | 1,153,856 | | | $ | 1,153,856 | |
| Restricted cash | $ | 443,026 | | | $ | 443,026 | | | $ | 934,814 | | | $ | 934,814 | |
| Derivative assets | $ | 26,438 | | | $ | 26,438 | | | $ | 80,134 | | | $ | 80,134 | |
| Reverse repurchase agreements | $ | 1,066,935 | | | $ | 1,066,935 | | | $ | 134,682 | | | $ | 134,682 | |
| Other assets | $ | 3,493 | | | $ | 3,493 | | | $ | 3,332 | | | $ | 3,332 | |
| Liabilities: | | | | | | | |
| Repurchase agreements | $ | 8,603,011 | | | $ | 8,603,011 | | | $ | 7,656,445 | | | $ | 7,656,445 | |
| | | | | | | |
| | | | | | | |
| Revolving credit facilities | $ | 1,118,831 | | | $ | 1,118,831 | | | $ | 420,761 | | | $ | 420,761 | |
| Term notes payable | $ | 398,011 | | | $ | 361,905 | | | $ | 396,776 | | | $ | 395,030 | |
| Convertible senior notes | $ | 282,496 | | | $ | 246,727 | | | $ | 424,827 | | | $ | 435,774 | |
| Derivative liabilities | $ | 34,048 | | | $ | 34,048 | | | $ | 53,658 | | | $ | 53,658 | |
Note 11. Repurchase Agreements
As of December 31, 2022 and December 31, 2021, the Company had outstanding $8.6 billion and $7.7 billion, respectively, of repurchase agreements. Excluding the effect of the Company’s interest rate swaps, the repurchase agreements had a weighted average borrowing rate of 3.95% and 0.24% and weighted average remaining maturities of 59 and 67 days as of December 31, 2022 and December 31, 2021, respectively. As of December 31, 2022, none of the Company’s repurchase agreements incorporated LIBOR as the referenced rate. See Note 2 - Basis of Presentation and Significant Accounting Policies for further discussion of the transition away from LIBOR.
At December 31, 2022 and December 31, 2021, the Company’s repurchase agreements had the following characteristics and remaining maturities:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2022 |
| Collateral Type | | |
| (in thousands) | Agency RMBS | | Non-Agency Securities | | Agency Derivatives | | | | Mortgage Servicing Rights | | U.S Treasuries (1) | | Total Amount Outstanding |
| Within 30 days | $ | 2,570,254 | | | $ | 59,648 | | | $ | 4,177 | | | | | $ | — | | | $ | 57,116 | | | $ | 2,691,195 | |
| 30 to 59 days | 1,774,622 | | | 10,984 | | | — | | | | | — | | | 375,131 | | | 2,160,737 | |
| 60 to 89 days | 2,280,675 | | | 177 | | | 503 | | | | | — | | | 255,282 | | | 2,536,637 | |
| 90 to 119 days | 696,283 | | | — | | | 8,393 | | | | | — | | | 200,766 | | | 905,442 | |
| 120 to 364 days | — | | | — | | | — | | | | | 309,000 | | | — | | | 309,000 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | |
| Total | $ | 7,321,834 | | | $ | 70,809 | | | $ | 13,073 | | | | | $ | 309,000 | | | $ | 888,295 | | | $ | 8,603,011 | |
Weighted average borrowing rate | 3.70 | % | | 5.73 | % | | 4.83 | % | | | | 7.91 | % | | 4.49 | % | | 3.95 | % |
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2021 |
| Collateral Type | | |
| (in thousands) | Agency RMBS | | Non-Agency Securities | | Agency Derivatives | | | | Mortgage Servicing Rights | | U.S Treasuries (1) | | Total Amount Outstanding |
| Within 30 days | $ | 1,617,186 | | | $ | — | | | $ | 10,097 | | | | | $ | — | | | $ | — | | | $ | 1,627,283 | |
| 30 to 59 days | 1,807,544 | | | — | | | — | | | | | — | | | — | | | 1,807,544 | |
| 60 to 89 days | 1,979,717 | | | 171 | | | 1,168 | | | | | — | | | — | | | 1,981,056 | |
| 90 to 119 days | 1,240,915 | | | — | | | 8,520 | | | | | — | | | — | | | 1,249,435 | |
| 120 to 364 days | 849,868 | | | — | | | 16,259 | | | | | 125,000 | | | — | | | 991,127 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | |
| Total | $ | 7,495,230 | | | $ | 171 | | | $ | 36,044 | | | | | $ | 125,000 | | | $ | — | | | $ | 7,656,445 | |
Weighted average borrowing rate | 0.17 | % | | 1.24 | % | | 0.74 | % | | | | 4.00 | % | | — | % | | 0.24 | % |
____________________
(1)U.S. Treasury securities effectively borrowed under reverse repurchase agreements.
The following table summarizes assets at carrying values that are pledged or restricted as collateral for the future payment obligations of the Company’s repurchase agreements:
| | | | | | | | | | | |
| (in thousands) | December 31,
2022 | | December 31,
2021 |
| Available-for-sale securities, at fair value | $ | 7,426,953 | | | $ | 7,009,449 | |
| | | |
| | | |
Mortgage servicing rights, at fair value (1) | 667,238 | | | 725,985 | |
| | | |
| Restricted cash | 324,654 | | | 747,779 | |
| Due from counterparties | 22,055 | | | 30,764 | |
| Derivative assets, at fair value | 14,738 | | | 39,609 | |
U.S. Treasuries (2) | 877,632 | | | — | |
| Total | $ | 9,333,270 | | | $ | 8,553,586 | |
____________________
(1)MSR repurchase agreements are secured by a VFN issued in connection with the Company’s securitization of MSR, which is collateralized by the Company’s MSR.
(2)U.S. Treasury securities effectively borrowed under reverse repurchase agreements..
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.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The following table summarizes certain characteristics of the Company’s repurchase agreements and counterparty concentration at December 31, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2022 | | December 31, 2021 |
| (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 |
| | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | |
Credit Suisse | $ | 309,000 | | | $ | 158,252 | | | 7 | % | | 363 | | $ | 125,000 | | | $ | 353,975 | | | 13 | % | | 181 |
All other counterparties (2) | 8,294,011 | | | 316,564 | | | 14 | % | | 48 | | 7,531,445 | | | 314,258 | | | 11 | % | | 65 |
| Total | $ | 8,603,011 | | | $ | 474,816 | | | | | | | $ | 7,656,445 | | | $ | 668,233 | | | | | |
____________________
(1)Represents the net carrying value of the assets 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.
(2)Represents amounts outstanding with 19 and 19 counterparties at December 31, 2022 and December 31, 2021, 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 12. Revolving Credit Facilities
To finance MSR assets and related servicing advance obligations, the Company has entered into revolving credit facilities collateralized by the value of the MSR and/or servicing advances pledged. As of December 31, 2022 and December 31, 2021, the Company had outstanding short- and long-term borrowings under revolving credit facilities of $1.1 billion and $420.8 million with a weighted average borrowing rate of 7.68% and 3.46% and weighted average remaining maturities of 1.1 and 1.2 years, respectively. As of December 31, 2022, none of the Company’s revolving credit facilities incorporated LIBOR as the referenced rate. See Note 2 - Basis of Presentation and Significant Accounting Policies for further discussion of the transition away from LIBOR.
At December 31, 2022 and December 31, 2021, borrowings under revolving credit facilities had the following remaining maturities:
| | | | | | | | | | | |
| (in thousands) | December 31,
2022 | | December 31,
2021 |
| Within 30 days | $ | — | | | $ | — | |
| 30 to 59 days | — | | | — | |
| 60 to 89 days | — | | | — | |
| 90 to 119 days | — | | | — | |
| 120 to 364 days | 200,000 | | | 274,511 | |
| One year and over | 918,831 | | | 146,250 | |
| Total | $ | 1,118,831 | | | $ | 420,761 | |
Although the transactions under revolving credit facilities represent committed borrowings from the time of funding until maturity, the respective lender retains the right to mark the underlying collateral to fair value. A reduction in the value of pledged assets below a designated threshold would require the Company to provide additional collateral or pay down the facility. As of December 31, 2022 and December 31, 2021, MSR with a carrying value of $1.8 billion and $904.8 million, respectively, was pledged as collateral for the Company’s future payment obligations under its MSR revolving credit facilities. As of December 31, 2022 and December 31, 2021, servicing advances with a carrying value of $67.8 million and $33.8 million, respectively, were pledged as collateral for the Company’s future payment obligations under its servicing advance revolving credit facility. The Company does not anticipate any defaults by its revolving credit facility counterparties, although there can be no assurance that any such default or defaults will not occur.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Note 13. Term Notes Payable
The debt issued in connection with the Company’s on-balance sheet securitization is classified as term notes payable and carried at outstanding principal balance, which was $400.0 million as of both December 31, 2022 and December 31, 2021, net of any unamortized deferred debt issuance costs, on the Company’s consolidated balance sheets. As of December 31, 2022 and December 31, 2021, the outstanding amount due on term notes payable was $398.0 million and $396.8 million, net of deferred debt issuance costs, with a weighted average interest rate of 7.19% and 2.90% and weighted average remaining maturities of 1.5 years and 2.5 years. The Company’s term notes incorporate LIBOR as the referenced rate and mature after the phase-out of LIBOR. However, the related agreements have provisions in place that provide for an alternative to LIBOR upon its phase-out. See Note 2 - Basis of Presentation and Significant Accounting Policies for further discussion of the transition away from LIBOR.
At December 31, 2022 and December 31, 2021, the Company pledged MSR with a carrying value of $500.0 million and $500.0 million and weighted average underlying loan coupon of 3.33% and 3.36%, respectively, as collateral for term notes payable. Additionally, as of December 31, 2022 and December 31, 2021, $0.2 million and $0.2 million of cash was held in restricted accounts as collateral for the future payment obligations of outstanding term notes payable, respectively.
Note 14. Convertible Senior Notes
In January 2017, the Company closed an underwritten public offering of $287.5 million aggregate principal amount of convertible senior notes due 2022, or the 2022 notes. The net proceeds from the offering were approximately $282.2 million after deducting underwriting discounts and estimated offering expenses payable by the Company. The Company used a portion of the net proceeds from the offering of the 2026 notes (defined below) to fund the repurchase via privately negotiated transactions of $143.7 million principal amount of its 2022 notes. As of December 31, 2021, $143.8 million principal amount of the 2022 notes remained outstanding, and these remaining 2022 notes matured pursuant to their terms in January 2022. The 2022 notes were unsecured, paid interest semiannually at a rate of 6.25% per annum and were convertible at the option of the holder into shares of the Company’s common stock.
In February 2021, the Company closed an underwritten public offering of $287.5 million aggregate principal amount of convertible senior notes due 2026, or the 2026 notes. The net proceeds from the offering were approximately $279.9 million after deducting underwriting discounts and estimated offering expenses payable by the Company. The 2026 notes are unsecured, pay interest semiannually at a rate of 6.25% per annum and are convertible at the option of the holder into shares of the Company’s common stock. As of December 31, 2022 and December 31, 2021, the 2026 notes had a conversion rate of 33.8752 and 33.8753 shares of common stock per $1,000 principal amount of the notes, respectively (based on the retroactive adjustment due to the Company’s one-for-four reverse stock split described in Note 16 - Stockholders’ Equity). The 2026 notes will mature in January 2026, unless earlier converted or repurchased in accordance with their terms. The Company does not have the right to redeem the 2026 notes prior to maturity, but may repurchase the 2026 notes in open market or privately negotiated transactions at the same or differing price without giving prior notice to or obtaining any consent of the holders. The Company may also be required to repurchase the notes from holders under certain circumstances.
The aggregate outstanding amount due on the 2026 notes as of December 31, 2022 and the 2022 notes and 2026 notes as of December 31, 2021 was $282.5 million and $424.8 million, respectively, net of deferred issuance costs.
Note 15. Commitments and Contingencies
The following represent the material commitments and contingencies of the Company as of December 31, 2022:
Legal and regulatory. From time to time, the Company may be subject to liability under laws and government regulations and various claims and legal actions arising in the ordinary course of business. Under ASC 450, Contingencies, or ASC 450, liabilities are established for legal claims when payments associated with the claims become probable and the costs can be reasonably estimated. The actual costs of resolving legal claims may be substantially higher or lower than the amounts established or the range of reasonably possible loss disclosed for those claims.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
As previously disclosed, on July 15, 2020, the Company provided PRCM Advisers with a notice of termination of the Management Agreement for “cause” in accordance with Section 15(a) of the Management Agreement. The Company terminated the Management Agreement for “cause” on the basis of certain material breaches and certain events of gross negligence on the part of PRCM Advisers in the performance of its duties under the Management Agreement. On July 21, 2020, PRCM Advisers filed a complaint against the Company in the United States District Court for the Southern District of New York, or the Court. Subsequently, Pine River Domestic Management L.P. and Pine River Capital Management L.P. were added as plaintiffs to the matter. As amended, the complaint, or the Federal Complaint, alleges, among other things, the misappropriation of trade secrets in violation of both the Defend Trade Secrets Act and New York common law, breach of contract, breach of the implied covenant of good faith and fair dealing, unfair competition and business practices, unjust enrichment, conversion, and tortious interference with contract. The Federal Complaint seeks, among other things, an order enjoining the Company from making any use of or disclosing PRCM Advisers’ trade secret, proprietary, or confidential information; damages in an amount to be determined at a hearing and/or trial; disgorgement of the Company’s wrongfully obtained profits; and fees and costs incurred by the plaintiffs in pursuing the action. The Company has filed its answer to the Federal Complaint and made counterclaims against PRCM Advisers and Pine River Capital Management L.P. On May 5, 2022, the plaintiffs filed a motion for judgment on the pleadings, seeking judgment in their favor on all but one of the Company’s counterclaims and on one of the Company’s affirmative defenses. The Company has opposed the motion for judgment on the pleadings, which is pending with the Court. Discovery has commenced and is ongoing. The Company’s board of directors believes the Federal Complaint is without merit and that the Company has fully complied with the terms of the Management Agreement.
As of December 31, 2022, the Company’s consolidated financial statements do not recognize a contingency liability or disclose a range of reasonably possible loss under ASC 450 because management does not believe that a loss or expense related to the Federal Complaint is probable or reasonably estimable. The specific factors that limit the Company’s ability to reasonably estimate a loss or expense related to the Federal Complaint include that the matter is in early stages and no amount of damages has been specified. If and when management believes losses associated with the Federal Complaint are a probable future event that may result in a loss or expense to the Company and the loss or expense is reasonably estimable, the Company will recognize a contingency liability and resulting loss in such period.
Based on information currently available, management is not aware of any other legal or regulatory claims that would have a material effect on the Company’s consolidated financial statements and therefore no accrual is required as of December 31, 2022.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Note 16. Stockholders’ Equity
Redeemable Preferred Stock
The following is a summary of the Company’s series of cumulative redeemable preferred stock issued and outstanding as of December 31, 2022. In the event of a voluntary or involuntary liquidation, dissolution or winding up of the Company, each series of preferred stock will rank on parity with one another and rank senior to the Company’s common stock with respect to the payment of the dividends and the distribution of assets.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | |
| (dollars in thousands) | | | | | | | | | | | | |
| Class of Stock | | Issuance Date | | Shares Issued and Outstanding | | Carrying Value | | Contractual Rate | | Redemption Eligible Date (1) | | Fixed to Floating Rate Conversion Date (2) | | Floating Annual Rate (3) |
| | | | | | | | | | | | |
| Series A | | March 14, 2017 | | 5,321,451 | | | $ | 128,522 | | | 8.125 | % | | April 27, 2027 | | April 27, 2027 | | 3M LIBOR + 5.660% |
| Series B | | July 19, 2017 | | 10,713,154 | | | 259,066 | | | 7.625 | % | | July 27, 2027 | | July 27, 2027 | | 3M LIBOR + 5.352% |
| Series C | | November 27, 2017 | | 10,057,445 | | | 243,411 | | | 7.250 | % | | January 27, 2025 | | January 27, 2025 | | 3M LIBOR + 5.011% |
| | | | | | | | | | | | | | |
| | | | | | | | | | | | | | |
| | | | | | | | | | | | | | |
| Total | | | | 26,092,050 | | | $ | 630,999 | | | | | | | | | |
____________________
(1)Subject to the Company’s right under limited circumstances to redeem the preferred stock earlier than the redemption eligible date disclosed in order to preserve its qualification as a REIT or following a change in control of the Company.
(2)The dividend rate on the fixed-to-floating rate redeemable preferred stock will remain at an annual fixed rate of the $25.00 per share liquidation preference from the issuance date up to but not including the transition date disclosed within. Effective as of the fixed-to-floating rate conversion date and onward, dividends will accumulate on a floating rate basis according to the terms disclosed in footnote (3) below.
(3)On and after the fixed-to-floating rate conversion date, the dividend will accumulate and be payable quarterly at a percentage of the $25.00 per share liquidation preference equal to an annual floating rate of three-month LIBOR plus the spread indicated within each preferred class. Each series that becomes callable at the time the stock begins to pay a LIBOR-based rate has existing LIBOR cessation fallback language.
For each series of preferred stock, the Company may redeem the stock on or after the redemption date in whole or in part, at any time or from time to time. The Company may also purchase shares of preferred stock from time to time in the open market by tender or in privately negotiated transactions. Each series of preferred stock has a par value of $0.01 per share and a liquidation and redemption price of $25.00, plus any accumulated and unpaid dividends thereon up to, but excluding, the redemption date. Through December 31, 2022, the Company had declared and paid all required quarterly dividends on the Company’s preferred stock.
On February 4, 2021, the Company announced the redemption of all outstanding shares of the Company’s 7.75% Series D Cumulative Redeemable Preferred Stock and 7.5% Series E Cumulative Redeemable Preferred Stock. The redemption date for each series was March 15, 2021 and holders of record as of such date received the redemption payment of $25.00, plus any accumulated and unpaid dividends thereon up to, but excluding, the redemption date.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Preferred Share Repurchase Program
On June 22, 2022, the Company’s Board of Directors authorized the repurchase of up to an aggregate of 5,000,000 shares of the Company’s preferred stock, which includes each series shown in the table above under the heading Redeemable Preferred Stock. Preferred shares may be repurchased from time to time through privately negotiated transactions or open market transactions, pursuant to trading plans in accordance with Rule 10b5-1 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 preferred share repurchases are subject to a variety of factors, including market conditions and applicable SEC rules. The preferred share repurchase program does not require the purchase of any minimum number of shares, and, subject to SEC rules, purchases may be commenced or suspended at any time without prior notice. The preferred share repurchase program does not have an expiration date. As of December 31, 2022, a total of 428,549 shares of the Company’s 8.125% Series A Cumulative Redeemable Preferred Stock, 786,846 shares of the Company’s 7.625% Series B Cumulative Redeemable Preferred Stock and 1,742,555 shares of the Company’s 7.25% Series C Cumulative Redeemable Preferred Stock had been repurchased by the Company under the program for an aggregate cost of $7.8 million, $13.8 million and $29.8 million, respectively, all during the year ended December 31, 2022. The difference between the consideration transferred and the carrying value of the preferred stock resulted in a gain attributable to common stockholders of $20.1 million during the year ended December 31, 2022.
Common Stock
Reverse Stock Split
On September 21, 2022, the Company’s board of directors approved a one-for-four reverse stock split of its outstanding shares of common stock. The reverse stock split was effected on November 1, 2022 at 5:01 p.m. Eastern Time. At the effective time, every four issued and outstanding shares of the Company’s common stock were converted into one share of common stock. No fractional shares were issued in connection with the reverse stock split; instead, each stockholder holding fractional shares was entitled to receive, in lieu of such fractional shares, cash in an amount determined on the basis of the volume weighted average price of the Company’s common stock on the NYSE on November 1, 2022. In connection with the reverse stock split, the number of authorized shares of the Company’s common stock was also reduced on a one-for-four basis, from 700,000,000 to 175,000,000. The par value of each share of common stock remained unchanged. All per share amounts, common shares outstanding and common equity-based awards for all periods presented have been adjusted on a retroactive basis to reflect the reverse stock split.
Public Offerings
On July 14, 2021, the Company completed a public offering of 10,000,000 shares of its common stock. The underwriters purchased the shares from the Company at a price of $25.68 per share, for net proceeds to the Company of approximately $256.5 million after deducting offering expenses. The underwriters did not exercise any portion of their 30-day overallotment option to purchase up to 1,500,000 additional shares.
On October 28, 2021, the Company completed a public offering of 7,500,000 shares of its common stock. The underwriters purchased the shares from the Company at a price of $25.872 per share, for net proceeds to the Company of approximately $193.7 million after deducting offering expenses. The underwriters did not exercise any portion of their 30-day overallotment option to purchase up to 1,125,000 additional shares.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
As of December 31, 2022, the Company had 86,428,845 shares of common stock outstanding. The following table presents a reconciliation of the common shares outstanding for the years ended December 31, 2022, 2021 and 2020:
| | | | | |
| Number of common shares |
| Common shares outstanding, December 31, 2019 | 68,233,933 | |
| Issuance of common stock | 15,306 | |
| Repurchase of common stock | (26,325) | |
Non-cash equity award compensation (1) | 203,057 | |
| |
| |
| Common shares outstanding, December 31, 2020 | 68,425,971 | |
| Issuance of common stock | 17,516,255 | |
| |
Non-cash equity award compensation (1) | 35,606 | |
| |
| |
| Common shares outstanding, December 31, 2021 | 85,977,831 | |
| Issuance of common stock | 324,896 | |
| |
Non-cash equity award compensation (1) | 126,118 | |
| Common shares outstanding, December 31, 2022 | 86,428,845 | |
____________________
(1)See Note 17 - Equity Incentive Plans for further details regarding the Company’s Equity Incentive Plans.
Distributions to Stockholders
The following table presents cash dividends declared by the Company on its preferred and common stock during the years ended December 31, 2022, 2021 and 2020:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | Year Ended |
| | | | December 31, |
| (dollars in thousands) | | | | | | 2022 | | 2021 | | 2020 |
| Class of Stock | | | | | | | | | | Amount | | Per Share | | Amount | | Per Share | | Amount | | Per Share |
| Series A Preferred Stock | | | | | | | | | | $ | 11,462 | | | $ | 2.03 | | | $ | 11,680 | | | $ | 2.03 | | | $ | 11,680 | | | $ | 2.03 | |
| Series B Preferred Stock | | | | | | | | | | $ | 21,547 | | | $ | 1.91 | | | $ | 21,921 | | | $ | 1.91 | | | $ | 21,922 | | | $ | 1.91 | |
| Series C Preferred Stock | | | | | | | | | | $ | 20,598 | | | $ | 1.81 | | | $ | 21,388 | | | $ | 1.81 | | | $ | 21,388 | | | $ | 1.81 | |
Series D Preferred Stock (1) | | | | | | | | | | $ | — | | | $ | — | | | $ | 969 | | | $ | 0.32 | | | $ | 5,812 | | | $ | 1.94 | |
Series E Preferred Stock (1) | | | | | | | | | | $ | — | | | $ | — | | | $ | 2,500 | | | $ | 0.31 | | | $ | 15,000 | | | $ | 1.88 | |
Common Stock | | | | | | | | | | $ | 228,845 | | | $ | 2.64 | | | $ | 205,623 | | | $ | 2.72 | | | $ | 136,842 | | | $ | 2.00 | |
____________________
(1)On March 15, 2021, the Company redeemed all outstanding shares of the Company’s Series D Preferred Stock and Series E Preferred Stock. Holders of record as of such date received the redemption payment of $25.00, plus any accumulated and unpaid dividends thereon up to, but excluding, the redemption date.
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 limitations detailed in the plan prospectus. The plan allows for the issuance of up to an aggregate of 937,500 shares of the Company’s common stock. As of December 31, 2022, 113,665 shares have been issued under the plan for total proceeds of approximately $6.0 million, of which 17,653, 13,206 and 15,307 shares were issued for total proceeds of $0.3 million, $0.4 million and $0.4 million during the years ended December 31, 2022, 2021 and 2020, respectively.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Common Share Repurchase Program
The Company’s common share repurchase program allows for the repurchase of up to an aggregate of 9,375,000 shares of the Company’s common stock. Common 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 Exchange Act, or by any combination of such methods. The manner, price, number and timing of common share repurchases are subject to a variety of factors, including market conditions and applicable SEC rules. The common share repurchase program does not require the purchase of any minimum number of shares, and, subject to SEC rules, purchases may be commenced or suspended at any time without prior notice. The common share repurchase program does not have an expiration date. As of December 31, 2022, a total of 3,043,575 shares had been repurchased by the Company under the program for an aggregate cost of $201.5 million; of these, 26,325 shares were repurchased for a total cost of $1.1 million during the year ended December 31, 2020. No shares were repurchased during the years ended December 31, 2022 and 2021.
At-the-Market Offerings
The Company is party to an equity distribution agreement under which the Company is authorized to sell up to an aggregate of 11,000,000 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. As of December 31, 2022, 2,183,178 shares of common stock had been sold under the current or prior equity distribution agreements for total accumulated net proceeds of approximately $134.8 million, of which 307,569 and 3,050 shares were sold for net proceeds of $6.1 million and $0.1 million during the years ended December 31, 2022 and 2021, respectively. No shares were sold during the year ended December 31, 2020.
Accumulated Other Comprehensive (Loss) Income
Accumulated other comprehensive (loss) income at December 31, 2022 and December 31, 2021 was as follows:
| | | | | | | | | | | |
| (in thousands) | December 31,
2022 | | December 31,
2021 |
| Available-for-sale securities: | | | |
| Unrealized gains | $ | 47,656 | | | $ | 208,619 | |
| Unrealized losses | (326,367) | | | (22,273) | |
Accumulated other comprehensive (loss) income | $ | (278,711) | | | $ | 186,346 | |
Reclassifications out of Accumulated Other Comprehensive (Loss) Income
The Company reclassifies unrealized gains and losses on AFS securities in accumulated other comprehensive (loss) income to net income (loss) upon the recognition of any realized gains and losses on sales as individual securities are sold. For the years ended December 31, 2022, December 31, 2021 and 2020, the Company reclassified $428.5 million in unrealized losses, $135.6 million in unrealized gains and $530.5 million in unrealized gains, respectively, on sold AFS securities from accumulated other comprehensive (loss) income to (loss) gain on investment securities on the consolidated statements of comprehensive loss.
Note 17. Equity Incentive Plans
All per share amounts, common shares outstanding and common equity-based awards for all periods presented have been adjusted on a retroactive basis to reflect the reverse stock split.
On May 19, 2021, the Company’s stockholders approved the 2021 Equity Incentive Plan, or the 2021 Plan, which replaced the Second Restated 2009 Equity Incentive Plan, or the 2009 Plan. The 2021 Plan provides for the issuance of up to 4,250,000 shares of the Company’s common stock pursuant to awards granted thereunder. Awards previously granted under the 2009 Plan remain outstanding and valid in accordance with their terms, but no new awards will be granted under the 2009 Plan.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The Company’s 2009 Plan and 2021 Plan, or collectively, the Equity Incentive Plans, provide incentive compensation to attract and retain qualified directors, officers, personnel and other parties who may provide significant services to the Company. The Equity Incentive Plans are administered by the compensation committee of the Company’s board of directors. The compensation committee has the full authority to administer and interpret the Equity Incentive Plans, to authorize the granting of awards, to determine the eligibility of potential recipients to receive an award, to determine the number of shares of common stock to be covered by each award (subject to the individual participant limitations provided in the Equity Incentive Plans), to determine the terms, provisions and conditions of each award (which may not be inconsistent with the terms of the Equity Incentive Plans), to prescribe the form of instruments evidencing awards and to take any other actions and make all other determinations that it deems necessary or appropriate in connection with the Equity Incentive Plans or the administration or interpretation thereof. In connection with this authority, the compensation committee may, among other things, establish performance goals that must be met in order for awards to be granted or to vest, or for the restrictions on any such awards to lapse.
The Equity Incentive Plans provide for grants of restricted common stock, restricted stock units, or RSUs, performance-based awards (including performance share units, or PSUs), phantom shares, dividend equivalent rights and other equity-based awards. The 2021 Plan is subject to a ceiling of 4,250,000 shares and the 2009 Plan is subject to a ceiling of 1,625,000 shares of the Company’s common stock; however, following stockholder approval of the 2021 Plan, no new awards will be granted under the 2009 Plan. The Equity Incentive Plans allow for the Company’s board of directors to expand the types of awards available under the Equity Incentive Plans to include long-term incentive plan units in the future. If an award granted under the Equity Incentive Plans expires or terminates, the shares subject to any portion of the award that expires or terminates without having been exercised or paid, as the case may be, will again become available for the issuance of additional awards. Unless earlier terminated by the Company’s board of directors, no new award may be granted under the Equity Incentive Plans after the tenth anniversary of the date that the Equity Incentive Plans were approved by the Company’s board of directors. No award may be granted under the Equity Incentive Plans to any person who, assuming payment of all awards held by such person, would own or be deemed to own more than 9.8% of the outstanding shares of the Company’s common stock.
Restricted Stock Units
The following table summarizes the activity related to RSUs for the years ended December 31, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| Year Ended December 31, |
| 2022 | | 2021 |
| Units | | Weighted Average Grant Date Fair Market Value | | Units | | Weighted Average Grant Date Fair Market Value |
| Outstanding at Beginning of Period | 293,426 | | | $ | 28.39 | | | — | | | $ | — | |
| Granted | 320,783 | | | 20.94 | | | 334,180 | | | 28.42 | |
| Vested | (127,283) | | | (28.17) | | | (39,336) | | | (28.60) | |
Forfeited | (18,294) | | | (23.73) | | | (1,418) | | | (28.20) | |
| Outstanding at End of Period | 468,632 | | | $ | 23.54 | | | 293,426 | | | $ | 28.39 | |
The estimated fair value of RSUs on grant date is based on the closing market price of the Company’s common stock on the NYSE on such date. The shares underlying RSUs granted to independent directors are subject to a one-year vesting period. RSUs granted to certain eligible employees 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 the applicable RSU agreement. All RSUs entitle the grantee to receive dividend equivalent rights, or DERs, during the vesting period. A DER represents the right to receive a payment equal to the amount of cash dividends declared and payable on the grantee’s unvested and outstanding equity incentive awards. In the case of RSUs, DERs are paid in cash within 60 days of the quarterly dividend payment date based on the number of unvested and outstanding RSUs held by the grantee on the applicable dividend record date. In the event that an RSU is forfeited, the related DERs which have not yet been paid shall be forfeited.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Performance Share Units
The following table summarizes the activity related to PSUs for the years ended December 31, 2022 and 2021:
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| Year Ended December 31, |
| 2022 | | 2021 |
| Target Units | | Weighted Average Grant Date Fair Market Value | | Target Units | | Weighted Average Grant Date Fair Market Value |
| Outstanding at Beginning of Period | 109,356 | | | $ | 34.68 | | | — | | | $ | — | |
| Granted | 165,820 | | | 21.83 | | | 127,868 | | | 34.68 | |
| Vested | — | | | — | | | — | | | — | |
Forfeited | (9,915) | | | (27.21) | | | (18,512) | | | (34.68) | |
| Outstanding at End of Period | 265,261 | | | $ | 26.93 | | | 109,356 | | | $ | 34.68 | |
The estimated fair value of PSUs on grant date is determined using a Monte Carlo simulation. PSUs vest promptly following the completion of a three year performance period, as long as such grantee complies with the terms and conditions of the applicable PSU award agreement. The number of underlying shares of common stock that vest and that the grantee becomes entitled to receive at the time of vesting will be determined based on the level of achievement of certain Company performance goals during the performance period and will generally range from 0% to 200% of the target number of PSUs granted. All PSUs entitle the grantee to DERs during the vesting period, which accrue in the form of additional PSUs reflecting the value of any dividends declared on the Company’s common stock during the vesting period. In the event that a PSU is forfeited, the related accrued DERs shall be forfeited.
Restricted Common Stock
The following table summarizes the activity related to restricted common stock for the years ended December 31, 2022 and 2021:
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| Year Ended December 31, |
| 2022 | | 2021 |
| Shares | | Weighted Average Grant Date Fair Market Value | | Shares | | Weighted Average Grant Date Fair Market Value |
| Outstanding at Beginning of Period | 113,239 | | | $ | 60.18 | | | 305,499 | | | $ | 54.43 | |
| Granted | — | | | — | | | 5,245 | | | 28.60 | |
| Vested | (69,191) | | | (59.71) | | | (188,530) | | | (51.76) | |
Forfeited | (1,164) | | | (60.92) | | | (8,975) | | | (22.88) | |
| Outstanding at End of Period | 42,884 | | | $ | 60.91 | | | 113,239 | | | $ | 60.18 | |
The estimated fair value of restricted common stock on grant date is based on the closing market price of the Company’s common stock on the NYSE on such date. The shares underlying restricted common stock grants to independent directors in 2021 vested immediately. The shares underlying restricted common stock grants to independent directors prior to 2021 and shown as vested or forfeited in the table above were subject to a one-year vesting period. The shares underlying restricted common stock grants to the Company’s executive officers and other eligible individuals 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 the applicable restricted stock award agreement.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Non-Cash Equity Compensation Expense
For the years ended December 31, 2022, 2021 and 2020 the Company recognized compensation related to RSUs, PSUs and restricted common stock granted pursuant to the Equity Incentive Plans of $11.6 million, $11.5 million and $9.7 million, respectively. As of December 31, 2022, the Company had $4.4 million of total unrecognized compensation cost related to unvested share-based compensation arrangements. This cost is expected to be recognized over a weighted average period of 1.34 years.
Note 18. Restructuring Charges
On April 13, 2020, the Company announced that it had elected to not renew the Management Agreement with PRCM Advisers on the basis of unfair compensation payable to the manager pursuant to Section 13(a)(ii) of the Management Agreement. As a result, the Company had expected the Management Agreement to terminate on September 19, 2020, at which time the Company would have been required to pay a termination fee equal to three times the sum of the average annual base management fee earned by PRCM Advisers during the 24-month period immediately preceding the date of termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination, pursuant to the terms of the Management Agreement. The termination fee was calculated to be $139.8 million based on results as of June 30, 2020 and recorded during the three months ended June 30, 2020.
On July 15, 2020, the Company provided PRCM Advisers with a notice of termination of the Management Agreement for “cause” on the basis of certain material breaches of the Management Agreement by PRCM Advisers, its agents and/or its assignees that are incapable of being cured within the time period set forth therein and certain events of gross negligence on the part of PRCM Advisers in the performance of its duties under the Management Agreement. The Management Agreement subsequently terminated on August 14, 2020. No termination fee was payable to PRCM Advisers in connection with such termination pursuant to Section 15(a) of the Management Agreement.
In connection with the termination of the Management Agreement for cause, the Company reversed the $139.8 million accrued fee attributable to the non-renewal during the three months ended September 30, 2020. For the year ended December 31, 2020, the Company incurred a total of $5.7 million in contract termination costs, which includes all estimated costs incurred for legal and advisory services provided to facilitate the termination of the Management Agreement. In accordance with ASC 420, Exit or Disposal Cost Obligations, all expenses incurred for contract terminations are included within restructuring charges on the Company’s consolidated statements of comprehensive loss.
Note 19. Income Taxes
For the years ended December 31, 2022, 2021 and 2020, 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.
Certain activities the Company performs may produce income that will not be qualifying income for REIT purposes. These activities include the designated portion of MSR treated as normal mortgage servicing, residential mortgage loans, certain derivative financial instruments and other risk-management instruments. The Company has designated its TRSs to engage in these activities.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
On August 16, 2022, President Biden signed into law the Inflation Reduction Act of 2022, or the IRA, sweeping legislation addressing healthcare, climate change and renewable energy incentives, and inflation, among other priorities. The bill includes numerous tax provisions that impact corporations, including the implementation of a corporate alternative minimum tax as well as a 1% excise tax on certain stock repurchases and economically similar transactions. However, REITs are excluded from the definition of an “applicable corporation” and therefore are not subject to the corporate alternative minimum tax. Additionally, stock repurchases by REITs are specifically excepted from the 1% excise tax. The Company’s TRSs operate as standalone corporations and therefore could be adversely affected by the tax law changes. The Company’s preliminary analysis of the accounting implications of the IRA result in no impact being recorded to its 2022 financial statements. As the Company completes its analysis of the IRA, collects and prepares necessary data, and interprets any additional guidance, it may make adjustments to the provisional amounts. Technical corrections or other amendments to the IRA or administrative guidance interpreting the IRA may be forthcoming at any time. While the Company does not anticipate a material effect on its operations, it will continue to analyze and monitor the application of the IRA to its business.
The following table summarizes the tax provision (benefit) recorded at the taxable subsidiary level for the years ended December 31, 2022, 2021 and 2020:
| | | | | | | | | | | | | | | | | |
| Year Ended |
| December 31, |
| (in thousands) | 2022 | | 2021 | | 2020 |
| Current tax (benefit) provision: | | | | | |
| Federal | $ | — | | | $ | — | | | $ | 3,275 | |
| State | (1,028) | | | (1,768) | | | 1,304 | |
| Total current tax (benefit) provision | (1,028) | | | (1,768) | | | 4,579 | |
| Deferred tax provision (benefit): | | | | | |
| Federal | 90,916 | | | 14,851 | | | (40,267) | |
| State | 14,325 | | | (8,891) | | | — | |
| Total deferred tax provision (benefit) | 105,241 | | | 5,960 | | | (40,267) | |
Total provision for (benefit from) income taxes | $ | 104,213 | | | $ | 4,192 | | | $ | (35,688) | |
During the year ended December 31, 2022, the Company’s TRSs recognized a provision for income taxes of $104.2 million, which was primarily due to income from MSR servicing activity and net gains recognized on MSR, offset by net losses recognized on derivative instruments and operating expenses. During the year ended December 31, 2021, the Company’s TRSs recognized a provision for income taxes of $4.2 million, which was primarily due to income from MSR servicing activity and gains recognized on MSR, offset by net losses recognized on derivative instruments and operating expenses. During the year ended December 31, 2020, the Company’s TRSs recognized a benefit from income taxes of $35.7 million, which was primarily due to losses recognized on MSR, offset by net gains recognized on derivative instruments held in the Company’s TRSs.
The Company’s taxable income before dividend distributions differs from its pre-tax net income for U.S. GAAP purposes primarily due to unrealized gains and losses, the deferral of capital losses for tax, the recognition of credit losses for U.S. GAAP purposes but not tax purposes, differences in timing of income recognition due to market discount and original issue discount and the calculations surrounding each. These book to tax differences in the REIT are not reflected in the consolidated financial statements as the Company intends to retain its REIT status.
As of December 31, 2022, the Company had $304.6 million of net operating loss carryforwards for federal income tax purposes at the REIT, which may be utilized to offset future taxable income after consideration for the dividends paid deduction. These federal net operating loss carryforwards do not have an expiration date and can be carried forward indefinitely. As of December 31, 2022, the Company had $2.2 billion of capital net operating loss carryforwards for federal income tax purposes at the REIT, which may be utilized to offset future net gains from the sale of capital assets. These federal capital net operating loss carryforwards have an expiration date of five years of which the majority of these losses will expire between 2025 and 2027. The utilization of the capital net operating loss carryforwards will depend on the REIT’s ability to generate sufficient net capital gains prior to the expiration of the carryforward period.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
The following is a reconciliation of the statutory federal and state rates to the effective rates, for the years ended December 31, 2022, 2021 and 2020:
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| Year Ended |
| December 31, |
| 2022 | | 2021 | | 2020 |
| (dollars in thousands) | Amount | | Percent | | Amount | | Percent | | Amount | | Percent |
Provision for (benefit from) income taxes at statutory federal tax rate | $ | 68,135 | | | 21 | % | | $ | 40,198 | | | 21 | % | | $ | (349,823) | | | 21 | % |
State taxes, net of federal benefit, if applicable | 10,478 | | | 3 | % | | (8,420) | | | (4) | % | | 1,030 | | | — | % |
Permanent differences in taxable income from net income for U.S. GAAP purposes | (93) | | | — | % | | 15 | | | — | % | | (3,525) | | | — | % |
REIT income not subject to corporate income tax | 25,693 | | | 8 | % | | (27,601) | | | (14) | % | | 316,630 | | | (19) | % |
Provision for (benefit from) income taxes/ effective tax rate(1) | $ | 104,213 | | | 32 | % | | $ | 4,192 | | | 3 | % | | $ | (35,688) | | | 2 | % |
____________________
(1)The provision for (benefit from) income taxes is recorded at the taxable subsidiary level.
The Company’s permanent differences in taxable income from net income (loss) for U.S. GAAP purposes in the years ended December 31, 2022 and 2021 were primarily due to state taxes, net of federal benefit in the Company’s TRSs. The Company’s permanent differences in taxable income from net income (loss) for U.S. GAAP purposes in the year ended December 31, 2020 were primarily due to the intercompany sale of securities between the Company’s TRSs and the REIT. Additionally, the Company’s recurring permanent differences in taxable income from net income (loss) for U.S. GAAP purposes in the years ended December 31, 2022, 2021 and 2020 were due to a difference in the dividends paid deduction for tax and compensation expense related to restricted stock dividends and vesting.
The Company’s consolidated balance sheets, as of December 31, 2022 and December 31, 2021 contain the following current and deferred tax liabilities and assets, which are included in other assets, and are recorded at the taxable subsidiary level:
| | | | | | | | | | | |
| (in thousands) | December 31,
2022 | | December 31,
2021 |
| Income taxes receivable: | | | |
| Federal income taxes receivable | $ | — | | | $ | — | |
| State and local income taxes receivable | 404 | | | 951 | |
| Income taxes receivable, net | 404 | | | 951 | |
| Deferred tax assets (liabilities): | | | |
| Deferred tax asset | 33,426 | | | 58,264 | |
| Deferred tax liability | (80,603) | | | (200) | |
| Total net deferred tax assets (liabilities) | (47,177) | | | 58,064 | |
| Total tax assets (liabilities), net | $ | (46,773) | | | $ | 59,015 | |
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Deferred Tax Assets and Liabilities
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amount of assets and liabilities for financial reporting and tax purposes at the TRS level. Components of the Company’s deferred tax liabilities and assets as of December 31, 2022 and December 31, 2021 were as follows:
| | | | | | | | | | | |
| (in thousands) | December 31,
2022 | | December 31,
2021 |
| | | |
| | | |
| Mortgage servicing rights | $ | (80,492) | | | $ | 26,382 | |
| | | |
| | | |
| | | |
| | | |
| | | |
| Net operating loss carryforward | 32,301 | | | 30,569 | |
| | | |
| Other | 1,014 | | | 1,113 | |
| Total deferred tax assets (liabilities) | (47,177) | | | 58,064 | |
| Valuation allowance | — | | | — | |
| Total net deferred tax assets (liabilities) | $ | (47,177) | | | $ | 58,064 | |
As of December 31, 2022 and December 31, 2021, the Company had not recorded a valuation allowance for any portion of its deferred tax assets as it did not believe, at a more likely than not level, that any portion of its deferred tax assets would not be realized.
Based on the Company’s evaluation, it has been concluded that there are no significant uncertain tax positions requiring recognition in the Company’s consolidated financial statements of a contingent tax liability for uncertain tax positions. Additionally, there were no amounts accrued for penalties or interest as of or during the periods presented in these consolidated financial statements.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Note 20. Earnings Per Share
The following table presents a reconciliation of the earnings (loss) and shares used in calculating basic and diluted earnings (loss) per share for the years ended December 31, 2022, 2021 and 2020. All per share amounts, common shares outstanding and common equity-based awards for all periods presented have been adjusted on a retroactive basis to reflect the reverse stock split.
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| | | | Year Ended |
| | | | December 31, |
| (in thousands, except share data) | | | | | | 2022 | | 2021 | | 2020 |
Basic Earnings (Loss) Per Share: | | | | | | | | | | |
| | | | | | | | | | |
| | | | | | | | | | |
Net income (loss) | | | | | | $ | 220,239 | | | $ | 187,227 | | | $ | (1,630,135) | |
| | | | | | | | | | |
| | | | | | | | | | |
Dividends on preferred stock | | | | | | (53,607) | | | (58,458) | | | (75,802) | |
| Gain on repurchase and retirement of preferred stock | | | | | | 20,149 | | | — | | | — | |
Dividends and undistributed earnings allocated to participating restricted stock units | | | | | | (1,203) | | | (731) | | | — | |
Net income (loss) attributable to common stockholders, basic | | | | | | $ | 185,578 | | | $ | 128,038 | | | $ | (1,705,937) | |
Basic weighted average common shares | | | | | | 86,179,418 | | | 74,443,000 | | | 68,400,237 | |
Basic earnings (loss) per weighted average common share | | | | | | $ | 2.15 | | | $ | 1.72 | | | $ | (24.94) | |
Diluted Earnings (Loss) Per Share: | | | | | | | | | | |
Net income (loss) attributable to common stockholders, basic | | | | | | $ | 185,578 | | | $ | 128,038 | | | $ | (1,705,937) | |
Reallocation impact of undistributed earnings to participating restricted stock units | | | | | | — | | | — | | | — | |
| | | | | | | | | | |
Interest expense attributable to convertible notes (1) | | | | | | 19,382 | | | — | | | — | |
Net income (loss) attributable to common stockholders, diluted | | | | | | $ | 204,960 | | | $ | 128,038 | | | $ | (1,705,937) | |
Basic weighted average shares | | | | | | 86,179,418 | | | 74,443,000 | | | 68,400,237 | |
Effect of dilutive shares issued in an assumed vesting of performance share units | | | | | | 157,591 | | | 67,884 | | | — | |
| Effect of dilutive shares issued in an assumed conversion | | | | | | 9,739,166 | | | — | | | — | |
| Diluted weighted average shares | | | | | | 96,076,175 | | | 74,510,884 | | | 68,400,237 | |
Diluted earnings (loss) per weighted average common share | | | | | | $ | 2.13 | | | $ | 1.72 | | | $ | (24.94) | |
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___________________
(1)If applicable, includes a nondiscretionary adjustment for the assumed change in the management fee calculation.
For the years ended December 31, 2022 and 2021, participating RSUs were included in the calculations of basic and diluted earnings per share under the two-class method since it was more dilutive than the alternative treasury stock method. For the years ended December 31, 2022 and 2021, the assumed vesting of outstanding PSUs was included in the calculation of diluted earnings per share under the two-class method since it was more dilutive than the alternative treasury stock method. The Company did not have any RSUs or PSUs during the year ended December 31, 2020.
For the years ended December 31, 2022, 2021 and 2020, excluded from the calculation of diluted earnings per share was the effect of adding back $0.2 million, $28.0 million and $19.2 million of interest expense and 87,137, 12,555,567 and 4,542,788 weighted average common share equivalents, respectively, related to the assumed conversion of the Company’s convertible senior notes, as their inclusion would have been antidilutive. For the year ended December 31, 2022, only the 2022 notes were excluded from the calculation of diluted earnings per share, and the assumed conversion of the Company’s 2026 notes was included in the calculation of diluted earnings per share under the if-converted method.
Note 21. Related Party Transactions
The following summary provides disclosure of the material transactions with affiliates of the Company.
TWO HARBORS INVESTMENT CORP.
Notes to the Consolidated Financial Statements
Through August 14, 2020, the Company was externally managed and advised by PRCM Advisers under the terms of a Management Agreement between the Company and PRCM Advisers. The Company terminated the Management Agreement effective August 14, 2020 for “cause” in accordance with Section 15(a) thereof. On August 15, 2020, the Company completed its transition to self-management and directly hired the senior management team and other personnel who had historically provided services to the Company. Prior to the termination of the Management Agreement, all of our named executive officers were employees of an affiliate of PRCM Advisers and provided services to us under the Management Agreement.
Prior to the termination of the Management Agreement, PRCM Advisers was responsible for administering the Company’s business activities and day-to-day operations, at all times subject to the supervision and oversight of the Company’s board of directors. Under the Management Agreement, PRCM Advisers was required to provide the Company with its personnel, including its executive officers, investment professionals and other support personnel. The Company did not have its own employees. Each of the Company’s executive officers was an employee or partner of an affiliate of PRCM Advisers. The Company paid PRCM Advisers a management fee equal to 1.5% per annum, calculated and payable quarterly in arrears, of the Company’s stockholders’ equity, and reimbursed it for certain expenses, as described below.
For purposes of calculating the management fee, the Company’s stockholders’ equity represented the sum of the net proceeds from all issuances of the Company’s equity securities since inception (allocated on a pro rata daily basis for such issuances during the fiscal quarter of any such issuance), plus the Company’s retained earnings at the end of the most recently completed calendar quarter (without taking into account any non-cash equity compensation expense incurred in current or prior periods), less any amount that the Company has paid for repurchases of its common stock since inception, and excluding any unrealized gains, losses or other items that do not affect realized net income (regardless of whether such items are included in other comprehensive income or loss, or in net income), among other certain adjustments outlined in the Management Agreement. The base management fee was subject to other adjustments from time to time, as described in the Management Agreement.
In accordance with the Management Agreement, the Company incurred $31.7 million as a management fee to PRCM Advisers for the year ended December 31, 2020.
Additionally, prior to the termination of the Management Agreement, the Company reimbursed PRCM Advisers for (a) the Company’s allocable share of the compensation paid by PRCM Advisers to its personnel serving as the Company’s principal financial officer and general counsel and personnel employed by PRCM Advisers as in-house legal, tax, accounting, consulting, auditing, administrative, information technology, valuation, computer programming and development and back-office resources to the Company, (b) any amounts for personnel of PRCM Advisers’ affiliates arising under a shared facilities and services agreement, and (c) certain costs allocated to the Company by PRCM Advisers for data services and technology. In accordance with the Management Agreement, expense reimbursements to PRCM Advisers were required to be made in cash on a quarterly basis following the end of each quarter. The Company reimbursed PRCM Advisers for direct and allocated costs incurred by PRCM Advisers on behalf of the Company of approximately $19.3 million for the year ended December 31, 2020.
Following the termination of the Management Agreement, the Company no longer pays a management fee to, or reimburses the expenses of, PRCM Advisers. Expenses for which the Company previously reimbursed PRCM Advisers are now paid directly by the Company. The Company is also now responsible for the cash compensation and employee benefits of the Company’s Chief Executive Officer, Chief Investment Officer and investment professionals, which were previously the responsibility of PRCM Advisers. Prior to the termination of the Management Agreement, the Company was only responsible for the equity compensation paid to such individuals.
Note 22. Subsequent Events
On February 6, 2023, the Company completed a public offering of 10,000,000 shares of its common stock. The underwriters purchased the shares from the Company at a price of $17.59 per share, for net proceeds to the Company of approximately $175.6 million after deducting offering expenses. In connection with the offering, the Company also granted the underwriters an option for 30 days to purchase up to an additional 1,500,000 shares of common stock.
Events subsequent to December 31, 2022 were evaluated through the date these consolidated financial statements were issued and no other additional events were identified requiring further disclosure in these consolidated financial statements.