Quarterly report pursuant to Section 13 or 15(d)

Derivative Instruments and Hedging Activities (Notes)

v2.4.0.6
Derivative Instruments and Hedging Activities (Notes)
9 Months Ended
Sep. 30, 2012
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 derivatives 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. At times, the Company may use TBAs for risk management or other purposes. 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.
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, 2012 and December 31, 2011.
(in thousands)
 
September 30, 2012
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
Notional
 
Fair Value
Notional
Inverse interest-only securities
 
$
332,569

2,031,621

 
$


Interest rate swap agreements
 


 
(132,322
)
13,095,000

Credit default swap agreements
 
54,584

610,707

 


Swaptions
 
105,064

5,150,000

 


TBAs
 
3,967

450,000

 


Forward purchase commitment
 
604

319,931

 


Total
 
$
496,788

8,562,259

 
$
(132,322
)
13,095,000


(in thousands)
 
December 31, 2011
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
Notional
 
Fair Value
Notional
Inverse interest-only securities
 
$
157,421

1,131,084

 
$


Interest rate swap agreements
 


 
(28,790
)
5,810,000

Credit default swap agreements
 
86,136

544,699

 
(14,638
)
154,812

Swaptions
 
5,635

2,900,000

 


TBAs
 
2,664

275,000

 
(5,652
)
850,000

Forward sale commitment
 

5,202

 


Total
 
$
251,856

4,855,985

 
$
(49,080
)
6,814,812



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, 2012.
(in thousands)
 
Three Months Ended September 30, 2012
 
Nine Months Ended September 30, 2012
Trading instruments
 
Derivative Assets
 
Derivative Liabilities
 
Derivative Assets
 
Derivative Liabilities
Inverse interest-only securities
 
1,953,128

 

 
1,669,944

 

Interest rate swap agreements
 

 
11,327,391

 

 
8,625,967

Credit default swaps
 
545,611

 
48,576

 
554,568

 
91,555

Swaptions
 
4,891,304

 

 
3,687,328

 

TBAs
 
304,348

 

 
278,741

 
564,416

Short treasuries
 

 
46,739

 

 
15,693

Forward purchase commitment
 
45,872

 

 
15,894

 

Forward sale commitment
 

 

 
3,199

 



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 statement 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,
 
Nine Months Ended September 30,
 
 
 
 
2012
 
2011
 
2012
 
2011
Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Interest Rate Contracts
 
 
 
 
 
 
 
 
 
 
Investment securities - RMBS
 
Gain (loss) on other derivative instruments
 
$
2,170

 
$
5,729

 
$
(22,817
)
 
$
5,091

Investment securities - U.S. Treasuries and TBA contracts
 
Loss on interest rate swap and swaption agreements
 
(5,429
)
 
6,544

 
(12,774
)
 
2,733

Mortgage loans held-for-sale
 
Gain (loss) on other derivative instruments
 
604

 

 
578

 

Repurchase agreements
 
Loss gain on interest rate swap and swaption agreements
 
(71,043
)
 
(45,855
)
 
(140,905
)
 
(90,913
)
Credit default swaps - Receive protection
 
Gain (loss) on other derivative instruments
 
(18,661
)
 
21,994

 
(44,187
)
 
22,267

Non-Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Credit default swaps - Provide protection
 
Gain (loss) on other derivative instruments
 
3,015

 
(4,414
)
 
11,987

 
(5,589
)
Inverse interest-only securities
 
Gain (loss) on other derivative instruments
 
18,094

 
(948
)
 
43,154

 
15,705

Short treasuries
 
Gain (loss) on other derivative instruments
 
(1,768
)
 

 
(1,768
)
 

Total
 
 
 
$
(73,018
)
 
$
(16,950
)
 
$
(166,732
)
 
$
(50,706
)


For the three and nine months ended September 30, 2012, the Company recognized $10.7 million and $23.1 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 $11.3 billion and $8.6 billion notional, respectively, to 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, 2012, the Company terminated or had options expire on a total of 3 and 22 interest rate swap and swaption positions of $0.8 billion notional and $3.7 billion notional, respectively. Upon settlement of the early terminations and option expirations, the Company paid $1.5 million in full settlement of its net interest spread liability and recognized $7.5 million and $26.1 million in realized losses on the swaps and swaptions, respectively, including early termination penalties.
For the three and nine months ended September 30, 2012, the Company terminated a total of 3 and 13 credit default swap positions totaling $185.0 million and $425.0 million notional, respectively. Upon settlement of the early terminations, the Company received $94,069 and $30,861, respectively, in full settlement of its net interest spread receivable and recognized $1.0 million in realized gains and $2.3 million in realized losses for the three and nine months ended September 30, 2012, respectively, on the credit default swaps, including early termination 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 loss on interest rate swaps and swaptions and unrealized loss gain on other derivative instruments line items and 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 increase (decrease) 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 to further mitigate its exposure to increased prepayment speeds. 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, 2012 and December 31, 2011, the Company had outstanding fair value of $86.2 million and $48.4 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. In addition, the Company held TBA positions with $450.0 million and $275.0 million in long notional as of September 30, 2012 and December 31, 2011, respectively, and an additional $850.0 million in short notional as of December 31, 2011. 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. These contracts held a fair market value of $4.0 million and $2.7 million, included in derivative assets, at fair value, as of September 30, 2012 and December 31, 2011, respectively, and $5.7 million, included in derivative liabilities, at fair value, in the condensed consolidated balance sheet as of December 31, 2011.
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 September 30, 2012, the Company had entered into commitments to purchase mortgage loans of $319.9 million, subject to fallout if the loans do not close, with a fair value of $0.6 million at September 30, 2012.
The Company is exposed to interest rate risk on mortgage loans from the time it commits to purchase the mortgage loan until the mortgage loan is sold. 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 December 31, 2011, one trade had been executed under the Forward Agreement with a notional of $5.2 million. No fair value was assigned to the derivative at December 31, 2011 as it was entered into at market terms at the end of the year. This trade was settled by the Company in the three months ended June 30, 2012. As of September 30, 2012, the Company had no additional 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 or TBAs.
Repurchase Agreements  - The Company monitors its repurchase agreements, which are generally floating rate debt, in relationship 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, 2012 and December 31, 2011, the Company had the following outstanding interest rate swaps that were utilized as economic hedges of interest rate risk associated with the Company's short-term repurchase agreements:
(notional in thousands)
 
 
 
 
 
 
September 30, 2012
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
25,000

 
0.868
%
 
0.502
%
 
0.23

2013
 
2,275,000

 
0.713
%
 
0.484
%
 
0.81

2014
 
1,675,000

 
0.644
%
 
0.497
%
 
1.82

2015
 
2,770,000

 
0.908
%
 
0.471
%
 
2.68

2016 and Thereafter
 
5,350,000

 
0.923
%
 
0.410
%
 
4.45

Total
 
12,095,000

 
0.841
%
 
0.450
%
 
2.99

(notional in thousands)
 
 
 
 
 
 
December 31, 2011
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
25,000

 
0.868
%
 
0.315
%
 
0.98

2013
 
2,025,000

 
0.737
%
 
0.368
%
 
1.55

2014
 
1,275,000

 
0.670
%
 
0.380
%
 
2.72

2015
 
820,000

 
1.575
%
 
0.329
%
 
3.52

2016
 
240,000

 
2.156
%
 
0.316
%
 
4.32

Total
 
4,385,000

 
0.952
%
 
0.361
%
 
2.41



The Company has also entered into interest rate swaps in combination with U.S. Treasuries to economically hedge funding cost risk. As of September 30, 2012 and December 31, 2011, the Company held $1.0 billion in fair value of U.S. Treasuries classified as trading securities and the following outstanding interest rate swaps:
(notional in thousands)
 
 
 
 
 
 
September 30, 2012
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2015
 
1,000,000

 
0.799
%
 
0.470
%
 
2.53

Total
 
1,000,000

 
 
 
 
 
 
(notional in thousands)
 
 
 
 
 
 
December 31, 2011
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2013
 
1,250,000

 
0.620
%
 
0.339
%
 
1.54

Total
 
1,250,000

 
 
 
 
 
 


As of September 30, 2012, all of the Company's interest rate swap contracts receive interest at a 1-month or 3-month LIBOR rate. As of December 31, 2011, all of the Company's interest rate swap contracts received interest at a 1-month or 3-month LIBOR rate, except the following interest rate swap entered in combination with TBA contracts to economically hedge mortgage basis widening where the Company paid interest at a 3-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
December 31, 2011
Swaps Maturities
 
Notional Amounts
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2016
 
175,000

 
0.420
%
 
1.772
%
 
4.58

Total
 
175,000

 
 
 
 
 
 


Additionally, as of September 30, 2012 and December 31, 2011, the Company had the following outstanding interest rate swaptions (agreements to enter into interest rate swaps in the future for which the Company would pay a fixed rate) that were utilized as macro-economic hedges:
September 30, 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
 
$
1,995

 
$

 
0.87
 
200,000

 
3.25
%
 
3M Libor
 
7.0

Payer
 
≥ 6 Months
 
133,908

 
105,064

 
55.43
 
4,950,000

 
3.75
%
 
3M Libor
 
9.8

Total Payer
 
 
 
$
135,903

 
$
105,064

 
55.43
 
5,150,000

 
3.73
%
 
3M Libor
 
9.7

December 31, 2011
(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
 
$
16,147

 
$
4

 
4.97
 
1,600,000

 
3.22
%
 
3M Libor
 
3.7

Payer
 
≥ 6 Months
 
13,523

 
5,631

 
12.27
 
1,300,000

 
3.19
%
 
3M Libor
 
6.5

Total Payer
 
 
 
$
29,670

 
$
5,635

 
12.26
 
2,900,000

 
3.21
%
 
3M Libor
 
4.9



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 government sponsored entities, 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, the Company enters 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.
As of September 30, 2012, the Company held credit default swaps where 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 where the Company is receiving protection held as of September 30, 2012 and December 31, 2011:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
September 30, 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
)
 
$
(269
)
 
$
(3,127
)
 
$
(3,396
)
 
12/20/2013
 
181.91

 
(105,000
)
 
(178
)
 
(3,225
)
 
(3,403
)
 
6/20/2016
 
105.50

 
(100,000
)
 
(1,538
)
 
(260
)
 
(1,798
)
 
12/20/2016
 
682.82

 
(121,000
)
 
(1,029
)
 
(13,062
)
 
(14,091
)
 
6/20/2017
 
586.18

 
(99,000
)
 
(863
)
 
(3,563
)
 
(4,426
)
 
5/25/2046
 
306.99

 
(140,707
)
 
58,461

 
(61,852
)
 
(3,391
)
 
Total
 
383.49

 
(610,707
)
 
$
54,584

 
$
(85,089
)
 
$
(30,505
)

(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2011
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
)
 
$
2,422

 
$
(3,127
)
 
$
(705
)
 
12/20/2013
 
172.50

 
(105,000
)
 
3,742

 
(3,225
)
 
517

 
6/20/2016
 
105.00

 
(150,000
)
 
2,074

 
(355
)
 
1,719

 
12/20/2016
 
684.38

 
(125,000
)
 
10,200

 
(13,062
)
 
(2,862
)
 
5/25/2046
 
377.23

 
(119,699
)
 
67,698

 
(57,322
)
 
10,376

 
Total
 
341.94

 
(544,699
)
 
$
86,136

 
$
(77,091
)
 
$
9,045



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 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, 2012, the fair value of derivative financial instruments as an asset and liability position was $496.8 million and $132.3 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, and the Company 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, 2012, the Company has received cash deposits from counterparties of $102.9 million and placed cash deposits of $183.4 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, and, on occasion, TBAs.
Inverse interest-only securities with a carrying value of $332.6 million, including accrued interest receivable of $3.9 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, 2012 and December 31, 2011:
(in thousands)
September 30,
2012
 
December 31,
2011
Face Value
$
2,031,621

 
$
1,131,084

Unamortized premium

 

Unamortized discount
 
 
 
Designated credit reserve

 

Net, unamortized
(1,721,349
)
 
(973,066
)
Amortized Cost
310,272

 
158,018

Gross unrealized gains
25,009

 
4,606

Gross unrealized losses
(6,646
)
 
(7,385
)
Carrying Value
$
328,635

 
$
155,239



As of December 31, 2011, the Company also held credit default swaps where the Company provides 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 Company did not hold any credit default swaps where the Company provides credit protection as of September 30, 2012.
The following table presents credit default swaps where the Company is providing protection held as of December 31, 2011:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2011
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Loss
Provide
7/25/2036
 
358.71

 
99,890

 
$
2,733

 
$
(11,089
)
 
$
(8,356
)
 
5/25/2046
 
146.18

 
54,922

 
(17,371
)
 
13,574

 
(3,797
)
 
 
 
289.59

 
154,812

 
$
(14,638
)
 
$
2,485

 
$
(12,153
)