Two Harbors Investment (TWO) - 2020 Q2 - Quarterly Report

PART I - FINANCIAL INFORMATION Item 1. Financial Statements (unaudited) The company reported a $2.04 billion net loss for the six months ended June 30, 2020, driven by portfolio de-risking and a $145.8 million restructuring charge, significantly impacting assets and book value Condensed Consolidated Balance Sheets Total assets significantly decreased to $21.5 billion from $35.9 billion, driven by reduced available-for-sale securities, leading to a decline in stockholders' equity from $5.0 billion to $2.8 billion Condensed Consolidated Balance Sheet Highlights (in thousands) | Account | June 30, 2020 (unaudited) | December 31, 2019 | | :--- | :--- | :--- | | Total Assets | $21,482,322 | $35,921,622 | | Available-for-sale securities, at fair value | $17,673,289 | $31,406,328 | | Mortgage servicing rights, at fair value | $1,279,195 | $1,909,444 | | Cash and cash equivalents | $1,615,639 | $558,136 | | Total Liabilities | $18,646,386 | $30,951,156 | | Repurchase agreements | $16,991,248 | $29,147,463 | | Total Stockholders' Equity | $2,835,936 | $4,970,466 | Condensed Consolidated Statements of Comprehensive Income (Loss) The company reported a $2.08 billion net loss for the six months ended June 30, 2020, primarily due to $1.03 billion loss on investment securities and $825.5 million loss on servicing assets, resulting in a $2.09 billion comprehensive loss Key Income Statement Data (in thousands, except per share data) | Metric | Three Months Ended June 30, 2020 | Six Months Ended June 30, 2020 | | :--- | :--- | :--- | | Net Interest Income | $45,213 | $133,412 | | Total Other Loss | $(42,658) | $(1,963,399) | | Restructuring Charges | $145,069 | $145,788 | | Net Loss | $(173,564) | $(2,043,220) | | Net Loss Attributable to Common Stockholders | $(192,515) | $(2,081,121) | | Diluted Loss Per Share | $(0.70) | $(7.61) | | Comprehensive Income (Loss) Attributable to Common Stockholders | $279 | $(2,086,397) | Condensed Consolidated Statements of Stockholders' Equity Stockholders' equity decreased from $5.0 billion at year-end 2019 to $2.8 billion by June 30, 2020, primarily due to a $2.04 billion net loss for the six months Change in Stockholders' Equity (in thousands) | Description | Amount | | :--- | :--- | | Balance, December 31, 2019 | $4,970,466 | | Net loss (6 months) | $(2,043,220) | | Other comprehensive loss, net of tax (6 months) | $(5,276) | | Preferred dividends declared (6 months) | $(37,901) | | Common dividends declared (6 months) | $(51,936) | | Balance, June 30, 2020 | $2,835,936 | Condensed Consolidated Statements of Cash Flows Net cash provided by investing activities was $12.8 billion, largely offset by $12.6 billion used in financing activities, resulting in a $433.5 million increase in cash and equivalents Six Months Ended June 30, 2020 Cash Flow Summary (in thousands) | Cash Flow Category | Amount | | :--- | :--- | | Net cash provided by operating activities | $152,373 | | Net cash provided by investing activities | $12,841,638 | | Net cash used in financing activities | $(12,560,554) | | Net increase in cash, cash equivalents and restricted cash | $433,457 | Notes to the Condensed Consolidated Financial Statements The notes detail significant events including the Q1 2020 portfolio de-risking due to COVID-19, adoption of the CECL standard, and the termination of the management agreement with PRCM Advisers for 'cause', transitioning to self-management - In Q1 2020, due to the COVID-19 pandemic, the company sold substantially all of its non-Agency securities and about one-third of its Agency RMBS to raise liquidity and de-risk the portfolio[28][51] - The company terminated its Management Agreement with PRCM Advisers for "cause," effective August 14, 2020, and will become self-managed. No termination fee is expected to be paid, though a legal dispute is ongoing[30][190][247] - A restructuring charge of $145.1 million was recognized in Q2 2020 related to the expected termination fee for the management agreement, prior to the 'for cause' termination notice[189][228] - On January 1, 2020, the company adopted the new credit loss standard (ASU 2016-13, Topic 326), which requires estimating lifetime expected credit losses for financial assets[38] Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Management discusses the Q1 2020 strategic shift to a rates-focused portfolio, resulting in a $2.1 billion GAAP net loss and a decline in book value per share, alongside a transition to self-management - The company's capital allocation shifted to 100% in its rates strategy (Agency RMBS and MSR) as of March 31, 2020, after selling substantially all of its credit strategy assets (non-Agency securities) in Q1 2020[253][255] - Book value per common share decreased significantly from $14.54 at year-end 2019 to $6.70 at June 30, 2020, driven by a comprehensive loss of $2.1 billion[295] - The company maintained a strong liquidity position with $1.6 billion in unrestricted cash as of June 30, 2020, and expects to deploy this excess capital into target assets through the rest of 2020[296][348] - The company terminated its management agreement with PRCM Advisers for "cause" and will become a self-managed company effective August 14, 2020. No termination fee is expected to be paid[263][327] Results of Operations For the six months ended June 30, 2020, results were dominated by a $1.03 billion loss on investment securities, an $825.5 million loss on servicing assets, and a $145.8 million restructuring charge Comparison of Results (Six Months Ended June 30) | (in millions) | 2020 | 2019 | | :--- | :--- | :--- | | Net Interest Income | $133.4 | $150.5 | | Gain (Loss) on Investment Securities | $(1,028.1) | $3.1 | | Loss on Servicing Asset | $(825.5) | $(441.4) | | Loss on Interest Rate Swaps, etc. | $(297.5) | $(172.0) | | Restructuring Charges | $145.8 | $0.0 | | Net Loss Attributable to Common Stockholders | $(2,081.1) | $(154.4) | - The decrease in net interest income was due to lower borrowing balances and a lower rate environment, following the sale of a significant portion of the investment portfolio[301][302] - Servicing expenses increased year-over-year due to a higher cost to service loans in forbearance as a result of the COVID-19 pandemic[324] Financial Condition As of June 30, 2020, the portfolio was concentrated in Agency RMBS ($17.7 billion) and MSR ($1.3 billion), with a 6.3:1.0 debt-to-equity ratio and compliance with all financial covenants Portfolio Composition (June 30, 2020) | Asset Type | Carrying Value (in billions) | % of Portfolio | | :--- | :--- | :--- | | Agency RMBS | $17.7 | 92.8% | | Mortgage Servicing Rights | $1.3 | 6.7% | | Non-Agency Securities | $0.02 | 0.1% | | Agency Derivatives | $0.07 | 0.4% | | Total | $19.0 | 100.0% | Leverage Ratios (as of June 30, 2020) | Ratio | Value | | :--- | :--- | | Debt-to-Equity Ratio | 6.3:1.0 | | Economic Debt-to-Equity Ratio (incl. TBAs) | 7.4:1.0 | - The company is subject to financial covenants, including a maximum total indebtedness to tangible net worth of 8.0:1.0 (actual 6.5:1.0) and minimum liquidity of $200.0 million (actual $1.6 billion)[360] Liquidity and Capital Resources The company maintained $1.6 billion in cash and significant unused borrowing capacity, actively managing liquidity risk from long-maturity assets financed by shorter-term borrowings and potential servicing advances - As of June 30, 2020, the company held $1.6 billion in cash and cash equivalents available to support operations[348] - The company had master repurchase agreements with 46 counterparties, with outstanding balances with 20 of them, diversifying its funding sources[286][351] - The company is managing liquidity risk related to potential servicing advances for loans in forbearance under the CARES Act, and is in advanced stages of securing specific funding facilities for this purpose[292][395] Item 3. Quantitative and Qualitative Disclosures About Market Risk The company actively manages market risks, primarily interest rate risk, using derivatives and MSR, with a 25 bps rate rise estimated to decrease annualized net interest income by $25.0 million - The company uses a variety of derivative and non-derivative instruments, including interest rate swaps, TBAs, and MSR, to hedge its exposure to interest rate risk[371] Interest Rate Sensitivity Analysis (as of June 30, 2020) | Change in Interest Rates | Change in Annualized Net Interest Income (in millions) | Change in Total Net Assets as a % of Common Equity | | :--- | :--- | :--- | | +50 bps | $(49.99) | 0.4% | | +25 bps | $(25.00) | 0.6% | | -25 bps | $24.63 | (1.3)% | | -50 bps | $48.70 | (3.1)% | - The company faces liquidity risk from financing long-maturity assets with shorter-term borrowings and potential margin calls. It also faces liquidity needs from servicing advance obligations on MSR for loans in forbearance due to the CARES Act[393][395] Item 4. Controls and Procedures Management concluded that disclosure controls and procedures were effective as of June 30, 2020, with no material changes to internal control over financial reporting during the quarter - The CEO and CFO concluded that the company's disclosure controls and procedures were effective as of the end of the period covered by the report[398] - No changes in internal control over financial reporting occurred during the quarter that materially affected, or are reasonably likely to materially affect, internal controls[399] PART II - OTHER INFORMATION Item 1. Legal Proceedings The company is involved in a legal dispute with its former manager, PRCM Advisers, following the termination of the management agreement for cause, with no contingency liability recognized - PRCM Advisers filed a federal complaint against the company alleging misappropriation of trade secrets, breach of contract, and other claims related to the termination of the management agreement[404] - The company's board believes the complaint is without merit and intends to transition to self-management in August 2020[404] - No contingency liability has been recorded as of June 30, 2020, because a loss is not deemed probable or reasonably estimable[405] Item 1A. Risk Factors New material risks include challenges in transitioning to a self-managed company, potential disruptions from litigation with PRCM Advisers, and the financial impact of the COVID-19 pandemic on asset values and servicing advances - Risks related to the transition to a self-managed company include the inability to retain senior management, potential disruptions from litigation with PRCM Advisers, and unforeseen expenses[409] - Litigation with PRCM Advisers could result in significant damages or interfere with the company's ability to hire its dedicated personnel and use certain intellectual property[410][411] - The COVID-19 pandemic poses risks of declining asset values, increased borrower delinquencies, and a material adverse impact on liquidity due to the requirement to make servicing advances on MSR assets for loans in forbearance[415][416] Item 2. Unregistered Sales of Equity Securities and Use of Proceeds The company has a share repurchase program, but no common stock shares were repurchased during the three months ended June 30, 2020 - The company did not repurchase any shares of its common stock during the three months ended June 30, 2020[418] Item 6. Exhibits This section lists the exhibits filed with the Quarterly Report on Form 10-Q, including corporate documents and CEO/CFO certifications