Quarterly report pursuant to Section 13 or 15(d)

Derivative Instruments and Hedging Activities (Notes)

v2.4.0.8
Derivative Instruments and Hedging Activities (Notes)
 9 Months Ended
Sep. 30, 2013
Derivative Instruments and Hedging Activities Disclosure [Abstract]  
Derivative Instruments and Hedging Activities
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 Company’s 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. The Company’s derivative financial instruments are utilized principally to manage market risk and cash flow volatility associated with interest rate risk (including associated prepayment risk) related to certain assets and liabilities. As part of its risk management activities, 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 credit default swaps. In executing on the Company’s current risk management strategy, the Company has entered into interest rate swap and swaption agreements and credit default swaps. The Company has also entered into a number of non-derivative instruments to manage interest rate risk, principally U.S. Treasuries and Agency interest-only securities.
At times, the Company may use TBAs for risk management purposes, or as a means of deploying capital until targeted investments are available and to take advantage of temporary displacements in the marketplace. 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 is 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 since physical delivery of the Agency RMBS upon settlement cannot be assured, the Company accounts for TBAs as derivative instruments.
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 certain of these risks. The discussion includes both derivative and non-derivative instruments used as part of these risk management activities. While the Company uses non-derivative and 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.
Balance Sheet Presentation
The following tables present the gross fair value and notional amounts of the Company’s derivative financial instruments treated as trading instruments as of September 30, 2013 and December 31, 2012.
(in thousands)
 
September 30, 2013
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
226,744

 
$
1,648,236

 
$
—

 
$
—

Interest rate swap agreements
 
51,374

 
17,575,000

 
—

 
—

Credit default swaps
 
—

 
—

 
(29,852
)
 
1,462,165

Swaptions
 
237,871

 
4,430,000

 
—

 
—

TBAs
 
21,896

 
1,504,000

 
(34,634
)
 
4,247,000

Put and call options for TBAs
 
6,630

 
2,500,000

 
—

 
—

Constant maturity swaps
 
—

 
—

 
(9,341
)
 
8,000,000

Total
 
$
544,515

 
$
27,657,236

 
$
(73,827
)
 
$
13,709,165


(in thousands)
 
December 31, 2012
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
304,975

 
$
1,909,351

 
$
—

 
$
—

Interest rate swap agreements
 
—

 
—

 
(129,055
)
 
14,070,000

Credit default swaps
 
52,906

 
438,440

 
—

 
—

Swaptions
 
102,048

 
4,950,000

 
—

 
—

TBAs
 
1,917

 
2,414,000

 
(239
)
 
139,000

Forward purchase commitment
 
234

 
56,865

 
—

 
—

Total
 
$
462,080

 
$
9,768,656

 
$
(129,294
)
 
$
14,209,000



The following table provides the average outstanding notional amounts of the Company’s derivative financial instruments treated as trading instruments for the three and nine months ended September 30, 2013.
(in thousands)
 
Three Months Ended September 30, 2013
 
Nine Months Ended September 30, 2013
Trading instruments
 
Derivative Assets
 
Derivative Liabilities
 
Derivative Assets
 
Derivative Liabilities
Inverse interest-only securities
 
$
1,735,973

 
$
—

 
$
1,850,637

 
$
—

Interest rate swap agreements
 
19,884,272

 
—

 
17,486,421

 
—

Credit default swaps
 
—

 
1,525,716

 
—

 
913,477

Swaptions
 
6,002,717

 
—

 
5,766,300

 
—

TBAs
 
2,584,391

 
2,270,489

 
1,904,608

 
1,295,974

Put and call options for TBAs
 
413,043

 
—

 
95,560

 
—

Constant maturity swaps
 
—

 
10,032,609

 
—

 
5,225,275

Short U.S. Treasuries
 
—

 
—

 
—

 
8,901

Forward purchase commitment
 
—

 
6,672

 
—

 
75,117



Comprehensive Income Statement Presentation
The Company has not applied hedge accounting to its current derivative portfolio held to mitigate the interest rate risk associated with its debt portfolio. As a result, the Company is subject to volatility in its earnings due to movement in the unrealized gains and losses associated with its interest rate swaps and its other derivative instruments.
The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed consolidated statements of comprehensive income on its derivative instruments:
(in thousands)
 
 
 
 
 
 
Trading Instruments
 
Location of Gain/(Loss) Recognized in Income on Derivatives
 
Amount of Gain/(Loss) Recognized in Income on Derivatives
 
 
 
 
Three Months Ended September 30,
 
 
 
 
2013
 
2012
Interest rate risk management
 
 
 
 
 
 
TBAs (1)
 
Gain (loss) on other derivative instruments
 
$
71,751

 
$
2,170

Put and call options for TBAs (1)
 
Gain (loss) on other derivative instruments
 
(37,052
)
 
—

Constant maturity swaps (1)
 
Gain (loss) on other derivative instruments
 
71

 
—

Short U.S. Treasuries (1)
 
Gain (loss) on other derivative instruments
 
—

 
(1,768
)
Interest rate swap agreements - Receivers (1)
 
(Loss) gain on interest rate swap and swaption agreements
 
7,852

 
—

Interest rate swap agreements - Payers (2)
 
(Loss) gain on interest rate swap and swaption agreements
 
(8,691
)
 
(5,428
)
Interest rate swap agreements - Payers (4)
 
(Loss) gain on interest rate swap and swaption agreements
 
(58,282
)
 
(64,774
)
Swaptions (4)
 
(Loss) gain on interest rate swap and swaption agreements
 
3,711

 
(6,270
)
Credit risk management
 
 
 
 
 
 
Credit default swaps - Receive protection (5)
 
Gain (loss) on other derivative instruments
 
(30,344
)
 
(18,661
)
Non-risk management
 
 
 
 
 
 
TBAs
 
Gain (loss) on other derivative instruments
 
10,322

 
—

Inverse interest-only securities
 
Gain (loss) on other derivative instruments
 
5,686

 
18,094

Credit default swaps - Provide protection
 
Gain (loss) on other derivative instruments
 
—

 
3,015

Forward purchase commitments
 
(Loss) gain on mortgage loans held-for-sale
 
—

 
604

Total
 
 
 
$
(34,976
)
 
$
(73,018
)
(in thousands)
 
 
 
 
 
 
Trading Instruments
 
Location of Gain/(Loss) Recognized in Income on Derivatives
 
Amount of Gain/(Loss) Recognized in Income on Derivatives
 
 
 
 
Nine Months Ended September 30,
 
 
 
 
2013
 
2012
Interest rate risk management
 
 
 
 
 
 
TBAs (1)
 
Gain (loss) on other derivative instruments
 
$
138,429

 
$
(22,817
)
Put and call options for TBAs (1)
 
Gain (loss) on other derivative instruments
 
15,375

 
—

Constant maturity swaps (1)
 
Gain (loss) on other derivative instruments
 
(13,986
)
 
—

Short U.S. Treasuries (1)
 
Gain (loss) on other derivative instruments
 
(991
)
 
(1,768
)
Interest rate swap agreements - Receivers (1)
 
(Loss) gain on interest rate swap and swaption agreements
 
7,852

 
—

Interest rate swap agreements - Payers (2)
 
(Loss) gain on interest rate swap and swaption agreements
 
(8,371
)
 
(12,774
)
Forward sale commitments (3)
 
(Loss) gain on mortgage loans held-for-sale
 
—

 
(26
)
Interest rate swap agreements - Payers (4)
 
(Loss) gain on interest rate swap and swaption agreements
 
128,431

 
(110,409
)
Swaptions (4)
 
(Loss) gain on interest rate swap and swaption agreements
 
95,476

 
(30,496
)
Credit risk management
 
 
 
 
 
 
Credit default swaps - Receive protection (5)
 
Gain (loss) on other derivative instruments
 
(40,206
)
 
(44,187
)
Non-risk management
 
 
 
 
 
 
TBAs
 
Gain (loss) on other derivative instruments
 
668

 
—

Inverse interest-only securities
 
Gain (loss) on other derivative instruments
 
(33,234
)
 
43,154

Credit default swaps - Provide protection
 
Gain (loss) on other derivative instruments
 
—

 
11,987

Forward purchase commitments
 
(Loss) gain on mortgage loans held-for-sale
 
(20,015
)
 
604

Total
 
 
 
$
269,428

 
$
(166,732
)

____________________
(1)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s available-for-sale securities, mortgage loans held-for-sale and forward purchase commitments.
(2)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s U.S. Treasuries, TBAs and MSRs.
(3)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s mortgage loans held-for-sale.
(4)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s repurchase agreements.
(5)
Includes derivative instruments held to mitigate credit risk associated with the Company’s non-Agency RMBS and mortgage loans held-for-sale.

For the three and nine months ended September 30, 2013, the Company recognized $15.1 million and $48.5 million, respectively, of expenses for the accrual and/or settlement of the net interest expense associated with its interest rate swaps. The expenses result from generally paying a fixed interest rate on an average $19.9 billion and $17.5 billion notional, respectively, to economically hedge a portion of the Company’s interest rate risk on its short-term repurchase agreements, funding costs, and macro-financing risk and generally receiving LIBOR interest.
For the three and nine months ended September 30, 2013, the Company terminated, had agreements mature or had options expire on a total of 35 and 107 interest rate swap and swaption positions of $8.0 billion and $16.5 billion notional, respectively. Upon settlement of the early terminations, contractual maturities and option expirations, the Company paid $10.2 million and $27.4 million in full settlement of its net interest spread liability and recognized $40.8 million in realized gains and $21.9 million in realized losses on the swaps and swaptions for the three and nine months ended September 30, 2013, respectively, including early termination penalties.
For the three and nine months ended September 30, 2013, the Company terminated or had agreements mature on eight and 13 credit default swap positions of $870.0 million and $985.0 million notional, respectively. Upon settlement of the early terminations, the Company paid $0.5 million in full settlement of its net interest spread liability and recognized $9.9 million and $22.3 million, respectively, in realized losses on the credit default swaps, including early terminations penalties.
Cash flow activity related to derivative instruments is reflected within the operating activities and investing activities sections of the condensed consolidated statements of cash flows. Derivative fair value adjustments are reflected within the unrealized (gain) loss on interest rate swaps and swaptions, unrealized loss (gain) on other derivative instruments, and loss (gain) on mortgage loans held-for-sale line items within the operating activities section of the condensed consolidated statements of cash flows. Realized losses on interest rate swap and swaption agreements are reflected within the loss on termination of interest rate swaps and swaptions line item within the operating activities section of the condensed consolidated statements of cash flows. The remaining cash flow activity related to derivative instruments is reflected within the purchases of other derivative instruments, proceeds from sales of other derivative instruments, and (decrease)/increase in due to counterparties, net line items within the investing activities section of the condensed consolidated statements of cash flows.
Interest Rate Sensitive Assets/Liabilities
Available-for-sale Securities - The Company’s RMBS investment securities are generally subject to change in value when mortgage rates decline or increase, depending on the type of investment. Rising mortgage rates generally result in a slowing of refinancing activity, which slows prepayments and results in a decline in the value of the Company’s fixed-rate Agency pools. To mitigate the impact of this risk, the Company maintains a portfolio of financial instruments, primarily fixed-rate interest-only securities, which increase in value when interest rates increase. In addition, the Company has initiated TBA positions, put and call options for TBAs, and constant maturity swaps to further mitigate its exposure to higher interest rates, decreased prepayment speeds and widening mortgage spreads. The objective is to reduce the risk of losses to the portfolio caused by interest rate changes and changes in prepayment speeds.
As of September 30, 2013 and December 31, 2012, the Company had outstanding fair value of $89.1 million and $77.3 million, respectively, of interest-only securities in place to economically hedge its investment securities. These interest-only securities are included in AFS securities, at fair value, in the condensed consolidated balance sheets.
At September 30, 2013, $654.0 million of the Company’s long notional TBA positions and $2.4 billion of the Company’s short notional TBA positions were held as a means to mitigate exposure to higher interest rates and wider mortgage spreads, while the remaining $2.7 billion long notional TBA positions were held for non-risk management purposes (see “Non-Risk Management Activities” section). The Company discloses these 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 table presents the notional amount, cost basis, market value and carrying value (which approximates fair value) of the Company’s TBA positions as of September 30, 2013 and December 31, 2012:
 
As of September 30, 2013
 
 
 
 
 
 
 
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Derivative Assets
 
Derivative Liabilities
Purchase contracts
$
3,304,000

 
$
3,509,122

 
$
3,530,416

 
$
21,896

 
$
(601
)
Sale contracts
(2,447,000
)
 
(2,451,599
)
 
(2,485,632
)
 
—

 
(34,033
)
TBAs, net
$
857,000

 
$
1,057,523

 
$
1,044,784

 
$
21,896

 
$
(34,634
)
 
As of December 31, 2012
 
 
 
 
 
 
 
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Derivative Assets
 
Derivative Liabilities
Purchase contracts
$
1,753,000

 
$
1,867,621

 
$
1,869,112

 
$
1,729

 
$
(239
)
Sale contracts
(800,000
)
 
(857,625
)
 
(857,438
)
 
188

 
—

TBAs, net
$
953,000

 
$
1,009,996

 
$
1,011,674

 
$
1,917

 
$
(239
)
___________________
(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 condensed consolidated balance sheets.

As of September 30, 2013, the Company had purchased put and call options for TBAs with a total notional amount of $2.5 billion. The Company paid upfront premiums of approximately $17.3 million for the options purchased. Each of the options will expire by December 2013. The put and call options had a net fair market value of $6.6 million, included in derivative assets, at fair value, in the condensed consolidated balance sheet as of September 30, 2013. The Company did not hold any put or call options for TBAs as of December 31, 2012.
The Company has also entered into constant maturity swaps between the 10-year interest rate swap curve and the yield to maturity on a 30-year Fannie Mae TBA to economically hedge mortgage spread widening. The Company had the following constant maturity swaps agreements in place at September 30, 2013:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
September 30, 2013
Determination Date
 
Average Strike Swap Rate
 
Notional Amount
 
Fair Value
 
Upfront Premium Paid
 
Unrealized Gain/(Loss)
November 2013
 
0.869
%
 
3,000,000

 
(3,205
)
 
—

 
(3,205
)
December 2013
 
0.890
%
 
5,000,000

 
(6,136
)
 
—

 
(6,136
)
Total
 
0.882
%
 
$
8,000,000

 
$
(9,341
)
 
$
—

 
$
(9,341
)


The Company did not hold any constant maturity swaps as of December 31, 2012.
U.S. Treasuries, TBAs and MSRs - The Company has entered into interest rate swaps in combination with U.S. Treasuries, TBAs and MSRs to economically hedge funding cost risk, mortgage interest rate exposure (or duration), and mortgage basis widening, depending on the type of investment.
As of September 30, 2013 and December 31, 2012, the Company held $1.0 billion in fair value of U.S. Treasuries classified as trading securities and the following outstanding interest rate swaps utilized to economically hedge funding cost risk:
(notional in thousands)
 
 
 
 
 
 
September 30, 2013
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2016
 
$
1,000,000

 
0.955
%
 
0.259
%
 
2.92

Total
 
$
1,000,000

 
 
 
 
 
 
(notional in thousands)
 
 
 
 
 
 
December 31, 2012
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2015
 
$
1,000,000

 
0.799
%
 
0.350
%
 
2.28

Total
 
$
1,000,000

 
 
 
 
 
 

As of September 30, 2013 and December 31, 2012, the Company held the following interest rate swaps entered in combination with TBA contracts and/or MSRs to economically hedge mortgage basis widening and duration:
(notional in thousands)
 
 
 
 
 
 
September 30, 2013
Swaps Maturities
 
Notional Amount
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2014
 
$
—

 
—
%
 
—
%
 
—

2015
 
—

 
—
%
 
—
%
 
—

2016
 
750,000

 
0.266
%
 
0.754
%
 
2.81

2017
 
—

 
—
%
 
—
%
 
—

2018 and Thereafter
 
1,725,000

 
0.266
%
 
1.981
%
 
6.36

Total
 
$
2,475,000

 
0.266
%
 
1.609
%
 
5.28

(notional in thousands)
 
 
 
 
 
 
December 31, 2012
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2014
 
$
500,000

 
0.399
%
 
0.356
%
 
1.78

Total
 
$
500,000

 
 
 
 
 
 


As of December 31, 2012, all of the Company’s interest rate swap contracts received interest at a 3-month LIBOR rate. However, as of September 30, 2013, the Company also utilized the above interest rate swaps entered in combination with TBA contracts and/or MSRs where the Company paid interest at a 3-month LIBOR rate.
Commitments to Purchase and/or Sell Mortgage Loans Held-for-Sale - Prior to a mortgage loan purchase, the Company may enter into forward purchase commitments with counterparties whereby the Company commits to purchasing the loans at a particular interest rate, provided the borrower elects to close the loan. These commitments to purchase mortgage loans have been defined as derivatives and are, therefore, recorded on the balance sheet as assets or liabilities and measured at fair value. Subsequent changes in fair value are recorded on the balance sheet as adjustments to the carrying value of these assets or liabilities with a corresponding adjustment recognized in current period earnings. As of December 31, 2012, the Company had entered into commitments to purchase $56.9 million of mortgage loans, subject to fallout if the loans do not close, with a fair value of $0.2 million included in derivative assets on the condensed consolidated balance sheet at December 31, 2012. As of September 30, 2013, the Company had no remaining commitments to purchase mortgage loans.
The Company is exposed to interest rate risk on mortgage loans from the time it commits to purchase the mortgage loan until it acquires the loan from the originator and subsequently sells the loan to a third party. Changes in interest rates impact the market price for the mortgage loans. For example, as market interest rates decline, the value of mortgage loans held-for-sale increases, and vice versa. To mitigate the impact of this risk, the Company may from time to time enter into a forward sale commitment under the Forward AAA Securities Agreement, or the Forward Agreement, with Barclays Bank PLC, or Barclays, pursuant to which Barclays would purchase certain securities issued in connection with a potential securitization transaction involving mortgage loans subject to the Forward Agreement. As of September 30, 2013, the Company did not have any trades under the Forward Agreement. The Company may also enter into other derivative contracts to hedge the interest rate risk related to the commitments to purchase mortgage loans, such as interest rate swaps, swaptions, TBA positions, put and call options for TBAs or constant maturity swaps.
Repurchase Agreements - The Company monitors its repurchase agreements, which are generally floating rate debt, in relation to the rate profile of its investment securities. When it is cost effective to do so, the Company may enter into interest rate swap arrangements to align the interest rate composition of its investment securities and debt portfolios, specifically repurchase agreements with maturities of less than 6 months. Typically, the interest receivable terms (i.e., LIBOR) of the interest rate swaps match the terms of the underlying debt, resulting in an effective conversion of the rate of the related repurchase agreement from floating to fixed.
As of September 30, 2013 and December 31, 2012, the Company had the following outstanding interest rate swaps that were utilized as economic hedges of interest rate exposure (or duration) associated with the Company’s short-term repurchase agreements:
(notional in thousands)
 
 
 
 
 
 
September 30, 2013
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2014
 
$
900,000

 
0.318
%
 
0.269
%
 
0.29

2015
 
4,000,000

 
0.386
%
 
0.270
%
 
1.28

2016
 
2,650,000

 
0.579
%
 
0.263
%
 
2.42

2017
 
4,225,000

 
0.888
%
 
0.263
%
 
3.62

2018 and Thereafter
 
2,325,000

 
1.294
%
 
0.259
%
 
5.52

Total
 
$
14,100,000

 
0.718
%
 
0.265
%
 
2.83

(notional in thousands)
 
 
 
 
 
 
December 31, 2012
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2013
 
$
2,275,000

 
0.713
%
 
0.315
%
 
0.56

2014
 
1,675,000

 
0.644
%
 
0.311
%
 
1.57

2015
 
2,770,000

 
0.908
%
 
0.313
%
 
2.43

2016
 
1,940,000

 
0.874
%
 
0.323
%
 
3.46

2017 and Thereafter
 
3,910,000

 
0.960
%
 
0.313
%
 
4.72

Total
 
$
12,570,000

 
0.850
%
 
0.315
%
 
2.85



As of September 30, 2013 and December 31, 2012, the Company had the following outstanding interest rate swaptions (agreements to enter into interest rate swaps in the future for which the Company would either pay or receive a fixed rate) that were utilized as macro-economic hedges:
September 30, 2013
(notional and dollars in thousands)
 
Option
 
Underlying Swap
Swaption
 
Expiration
 
Cost
 
Fair Value
 
Average Months to Expiration
 
Notional Amount
 
Average Pay Rate
 
Average Receive Rate
 
Average Term (Years)
Payer
 
≥ 6 Months
 
229,944

 
313,418

 
41.79
 
6,400,000

 
4.23
%
 
3M Libor
 
9.06

Total Payer
 
 
 
$
229,944

 
$
313,418

 
41.79
 
$
6,400,000

 
4.23
%
 
3M Libor
 
9.06

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Receiver
 
< 6 Months
 
$
(7,383
)
 
$
(5
)
 
0.10
 
$
(1,170,000
)
 
3M Libor
 
3.11
%
 
10.00

Receiver
 
≥ 6 Months
 
(81,248
)
 
(75,542
)
 
45.02
 
(800,000
)
 
3M Libor
 
3.44
%
 
10.00

Total Receiver
 
 
 
$
(88,631
)
 
$
(75,547
)
 
45.02
 
$
(1,970,000
)
 
3M Libor
 
3.24
%
 
10.00

December 31, 2012
(notional and dollars in thousands)
 
Option
 
Underlying Swap
Swaption
 
Expiration
 
Cost
 
Fair Value
 
Average Months to Expiration
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Term (Years)
Payer
 
< 6 Months
 
$
3,983

 
$
30

 
5.38
 
$
300,000

 
4.00
%
 
3M Libor
 
10.00

Payer
 
≥ 6 Months
 
129,925

 
102,018

 
53.38
 
4,650,000

 
3.74
%
 
3M Libor
 
9.74

Total Payer
 
 
 
$
133,908

 
$
102,048

 
53.38
 
$
4,950,000

 
3.75
%
 
3M Libor
 
9.76



The Company has not applied hedge accounting to its current derivative portfolio held to mitigate the interest rate risk associated with its debt portfolio. As a result, the Company is subject to volatility in its earnings due to movement in the unrealized gains and losses associated with its interest rate swaps and its other derivative instruments.
Foreign Currency Risk
In compliance with the Company’s REIT requirements, the Company does not have exposure to foreign denominated assets or liabilities. As such, the Company is not subject to foreign currency risk.
Credit Risk
The Company’s exposure to credit losses on its U.S. Treasuries and Agency portfolio of investment securities is limited because these securities are issued by the U.S. Department of the Treasury or GSEs. 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.
For non-Agency investment securities and mortgage loans, the Company may enter into credit default swaps to hedge credit risk. 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 “Non-Risk Management Activities” section). The Company also has processes and controls in place to monitor, analyze, manage and mitigate its credit risk with respect to non-Agency RMBS and mortgage loans.
As of September 30, 2013, the Company held credit default swaps whereby the Company receives credit protection for a fixed premium. The maximum payouts for these credit default swaps are limited to the current notional amounts of each swap contract. Maximum payouts for credit default swaps do not represent the expected future cash requirements, as the Company’s credit default swaps are typically liquidated or expire and are not exercised by the holder of the credit default swaps.
The following tables present credit default swaps whereby the Company is receiving protection held as of September 30, 2013 and December 31, 2012:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
September 30, 2013
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Receive
12/20/2013
 
181.91

 
(105,000
)
 
(67
)
 
(3,225
)
 
(3,292
)
 
6/20/2016
 
105.50

 
(100,000
)
 
(2,043
)
 
(260
)
 
(2,303
)
 
12/20/2016
 
496.00

 
(25,000
)
 
(95
)
 
(4,062
)
 
(4,157
)
 
6/20/2018
 
432.20

 
(500,000
)
 
(30,139
)
 
14,563

 
(15,576
)
 
12/20/2018
 
80.88

 
(700,000
)
 
(6,472
)
 
6,662

 
190

 
5/25/2046
 
356.00

 
(32,165
)
 
8,964

 
(15,026
)
 
(6,062
)
 
Total
 
223.10

 
$
(1,462,165
)
 
$
(29,852
)
 
$
(1,348
)
 
$
(31,200
)

(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2012
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront Payable
 
Unrealized Gain/(Loss)
Receive
9/20/2013
 
460.00

 
$
(45,000
)
 
$
(264
)
 
$
(3,127
)
 
$
(3,391
)
 
12/20/2013
 
181.91

 
(105,000
)
 
(198
)
 
(3,225
)
 
(3,423
)
 
6/20/2016
 
105.50

 
(100,000
)
 
(1,940
)
 
(260
)
 
(2,200
)
 
12/20/2016
 
496.00

 
(25,000
)
 
527

 
(4,062
)
 
(3,535
)
 
5/25/2046
 
297.60

 
(163,440
)
 
54,781

 
(71,114
)
 
(16,333
)
 
Total
 
254.06

 
$
(438,440
)
 
$
52,906

 
$
(81,788
)
 
$
(28,882
)


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 September 30, 2013, the fair value of derivative financial instruments as an asset and liability position was $544.5 million and $73.8 million, respectively.
The Company mitigates the credit risk exposure on derivative financial instruments by limiting the counterparties to those major banks and financial institutions that meet established credit guidelines; the Company also seeks to transact with several different counterparties in order to reduce the 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 upon occurrence of certain events. To further mitigate the risk of counterparty default, the Company maintains collateral agreements with certain of its counterparties. The agreements require both parties to maintain cash deposits in the event the fair values of the derivative financial instruments exceed established thresholds. As of September 30, 2013, the Company has received cash deposits from counterparties of $231.8 million and placed cash deposits of $410.7 million in accounts maintained by counterparties, of which the amounts are netted on a counterparty basis and classified within restricted cash, due from counterparties, or due to counterparties on the condensed consolidated balance sheet.
In accordance with ASC 815, as amended and interpreted, the Company records derivative financial instruments on its condensed consolidated balance sheet 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 qualify for hedge accounting treatment. Due to the volatility of the credit markets and difficulty in effectively matching pricing or cash flows, the Company has elected to treat all current derivative contracts as trading instruments.
Non-Risk Management Activities
The Company has entered into certain financial instruments that are considered derivative contracts under ASC 815 that are not for purposes of hedging. These contracts are currently limited to inverse interest-only RMBS, credit default swaps, forward purchase commitments and TBAs. As of September 30, 2013, the Company held $2.7 billion notional TBAs as a means of deploying capital until targeted investments are available, and to take advantage of temporary displacements in the marketplace.
Inverse interest-only securities with a carrying value of $226.7 million, including accrued interest receivable of $3.1 million, are accounted for as derivative financial instruments in the condensed consolidated financial statements. The following table presents the amortized cost and carrying value (which approximates fair value) of inverse interest-only securities as of September 30, 2013 and December 31, 2012:
(in thousands)
September 30,
2013
 
December 31,
2012
Face Value
$
1,648,236

 
$
1,909,351

Unamortized premium
—

 
—

Unamortized discount
 
 
 
Designated credit reserve
—

 
—

Net, unamortized
(1,395,982
)
 
(1,620,966
)
Amortized Cost
252,254

 
288,385

Gross unrealized gains
3,807

 
21,616

Gross unrealized losses
(32,386
)
 
(8,737
)
Carrying Value
$
223,675

 
$
301,264