Annual report pursuant to Section 13 and 15(d)

Derivative Instruments and Hedging Activities

v3.8.0.1
Derivative Instruments and Hedging Activities
12 Months Ended
Dec. 31, 2017
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 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 market risk and 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 (i.e., LIBOR) 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 interest rate swap and swaption agreements, TBAs, put and call options for TBAs and total return swaps (based on the Markit IOS Index). The Company has also entered into a number of non-derivative instruments to manage interest rate risk, principally MSR and Agency 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.
Balance Sheet Presentation
In accordance with ASC 815, Derivatives and Hedging, or 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 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.
The following tables present the gross fair value and notional amounts of the Company’s derivative financial instruments treated as trading instruments as of December 31, 2017 and December 31, 2016.
(in thousands)
 
December 31, 2017
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
91,827

 
$
588,246

 
$

 
$

Interest rate swap agreements
 
206,773

 
21,516,125

 
(29,867
)
 
6,966,000

Swaptions, net
 
10,405

 
2,666,000

 

 

TBAs
 
913

 
733,000

 
(1,930
)
 
1,306,000

Markit IOS total return swaps
 

 

 
(106
)
 
63,507

Total
 
$
309,918

 
$
25,503,371

 
$
(31,903
)
 
$
8,335,507


(in thousands)
 
December 31, 2016
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
127,843

 
$
740,844

 
$

 
$

Interest rate swap agreements
 
109,531

 
18,471,063

 
(495
)
 
1,900,000

Swaptions, net
 
39,881

 
825,000

 
(1,645
)
 
600,000

TBAs
 
4,294

 
536,000

 
(10,344
)
 
953,000

Put and call options for TBAs, net
 
42,633

 
1,136,000

 

 

Markit IOS total return swaps
 

 

 
(17
)
 
90,593

Total
 
$
324,182

 
$
21,708,907

 
$
(12,501
)
 
$
3,543,593



Comprehensive Income (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.
The following table summarizes the location and amount of gains and losses on derivative instruments reported in the consolidated statements of comprehensive income (loss):
Trading Instruments
 
Location of Gain (Loss) Recognized in Income on Derivatives
 
Amount of Gain (Loss) Recognized in Income on Derivatives
 
 
 
 
Year Ended
(in thousands)
 
 
 
December 31,
 
 
 
 
2017
 
2016
 
2015
Interest rate risk management
 
 
 
 
 
 
 
 
TBAs
 
(Loss) gain on other derivative instruments
 
$
(46,778
)
 
$
51,816

 
$
(39,748
)
Short U.S. Treasuries
 
(Loss) gain on other derivative instruments
 

 

 
125

Put and call options for TBAs
 
(Loss) gain on other derivative instruments
 
(22,623
)
 
64,920

 
6,846

Put and call options for U.S. Treasuries
 
(Loss) gain on other derivative instruments
 

 

 
(837
)
Constant maturity swaps
 
(Loss) gain on other derivative instruments
 

 

 
6,164

Interest rate swap agreements - Payers
 
(Loss) gain on interest rate swap and swaption agreements
 
67,124

 
(3,110
)
 
(199,609
)
Interest rate swap agreements - Receivers
 
(Loss) gain on interest rate swap and swaption agreements
 
(17,677
)
 
37,272

 
52,785

Swaptions
 
(Loss) gain on interest rate swap and swaption agreements
 
(59,200
)
 
11,209

 
(63,797
)
Markit IOS total return swaps
 
(Loss) gain on other derivative instruments
 
(870
)
 
(36,898
)
 
(13,371
)
Credit risk management
 
 
 
 
 
 
 
 
Credit default swaps - Receive protection
 
(Loss) gain on other derivative instruments
 

 
962

 
(294
)
Non-risk management
 
 
 
 
 
 
 
 
Inverse interest-only securities
 
(Loss) gain on other derivative instruments
 
112

 
18,579

 
36,066

Forward purchase commitments
 
Gain on residential mortgage loans held-for-sale
 

 
2,418

 
(1,668
)
Total
 
 
 
$
(79,912
)
 
$
147,168

 
$
(217,338
)


For the years ended December 31, 2017, 2016 and 2015, the Company recognized $8.8 million, $21.1 million, and $85.6 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 paying either a fixed interest rate or LIBOR interest and receiving either LIBOR interest or a fixed interest rate on an average $19.4 billion, $15.5 billion and $16.1 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, 2017 and 2016:
 
Year Ended December 31, 2017
(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
$
740,844

 
$

 
$
(152,598
)
 
$
588,246

 
$
662,273

 
$
(40
)
Interest rate swap agreements
20,371,063

 
36,642,245

 
(28,531,183
)
 
28,482,125

 
19,447,067

 
54,476

Swaptions, net
225,000

 
4,306,000

 
(1,865,000
)
 
2,666,000

 
1,014,578

 
8,694

TBAs, net
(1,489,000
)
 
(7,249,400
)
 
8,165,400

 
(573,000
)
 
(1,256,424
)
 
(51,810
)
Put and call options for TBAs, net
(1,136,000
)
 
4,460,000

 
(3,324,000
)
 

 
11,978

 
20,010

Markit IOS total return swaps
90,593

 

 
(27,086
)
 
63,507

 
74,183

 
(181
)
Total
$
18,802,500

 
$
38,158,845

 
$
(25,734,467
)
 
$
31,226,878

 
$
19,953,655

 
$
31,149

 
Year Ended December 31, 2016
(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
$
932,037

 
$

 
$
(191,193
)
 
$
740,844

 
$
836,707

 
$

Interest rate swap agreements
14,268,806

 
25,103,456

 
(19,001,199
)
 
20,371,063

 
15,506,763

 
16,032

Credit default swaps
125,000

 
10,000

 
(135,000
)
 

 
71,257

 
1,022

Swaptions, net
5,200,000

 
1,668,000

 
(6,643,000
)
 
225,000

 
2,449,268

 
(98,016
)
TBAs, net
297,000

 
(10,173,000
)
 
8,387,000

 
(1,489,000
)
 
(531,866
)
 
57,616

Put and call options for TBAs, net

 
11,260,000

 
(12,396,000
)
 
(1,136,000
)
 
2,569,117

 
22,288

Markit IOS total return swaps
889,418

 
99,911

 
(898,736
)
 
90,593

 
471,028

 
(13,374
)
Forward purchase commitments
286,120

 
1,548,027

 
(1,834,147
)
 

 
269,562

 
2,068

Total
$
21,998,381

 
$
29,516,394

 
$
(32,712,275
)
 
$
18,802,500

 
$
21,641,836

 
$
(12,364
)
____________________
(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 loss (gain) on interest rate swaps and swaptions, unrealized loss (gain) on other derivative instruments, and gain on residential mortgage loans held-for-sale 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 other derivative instruments, proceeds from sales (payments for termination) of other derivative instruments, net and (decrease) 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 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 on the Company’s fixed-rate Agency pool portfolio, the Company maintains a portfolio of fixed-rate interest-only securities and MSR, which increase in value when interest rates increase. As of December 31, 2017 and December 31, 2016, the Company had $117.8 million and $71.1 million, respectively, of interest-only securities, and $1.1 billion and $0.7 billion, respectively, of MSR in place to economically hedge its Agency RMBS. Interest-only securities are included in AFS securities, at fair value, in the consolidated balance sheets.
The Company monitors its borrowings under repurchase agreements, FHLB advances 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 (i.e., LIBOR) 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, 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, put and call options for TBAs, interest rate swap and swaption agreements and Markit IOS total return swaps.
TBAs. At times, the Company may use TBAs as a means of deploying capital until targeted investments are available and to take advantage of temporary displacements 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.
As of December 31, 2017, $0.7 billion of the Company’s long notional TBA positions and $1.3 billion of the Company’s short notional TBA positions were held in order to economically hedge portfolio risk. As of December 31, 2016, $1.5 billion of the Company’s long notional TBA positions and $3.0 billion of the Company’s short notional TBA positions were held in order to economically hedge portfolio risk. The Company discloses these positions 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, 2017 and December 31, 2016:
 
December 31, 2017
 
 
 
 
 
 
 
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Derivative Assets
 
Derivative Liabilities
Purchase contracts
$
733,000

 
$
769,446

 
$
770,359

 
$
913

 
$

Sale contracts
(1,306,000
)
 
(1,316,368
)
 
(1,318,297
)
 

 
(1,930
)
TBAs, net
$
(573,000
)
 
$
(546,922
)
 
$
(547,938
)
 
$
913

 
$
(1,930
)
 
December 31, 2016
 
 
 
 
 
 
 
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Derivative Assets
 
Derivative Liabilities
Purchase contracts
$
1,500,000

 
$
1,576,270

 
$
1,576,875

 
$
605

 
$

Sale contracts
(2,989,000
)
 
(3,028,470
)
 
(3,035,125
)
 
3,689

 
(10,344
)
TBAs, net
$
(1,489,000
)
 
$
(1,452,200
)
 
$
(1,458,250
)
 
$
4,294

 
$
(10,344
)
___________________
(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.

Put and Call Options for TBAs. The Company may use put and call options for TBAs independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. As of December 31, 2016, the Company had purchased put and call options for TBAs with a notional amount of $2.5 billion and short sold put and call options for TBAs with a notional amount of $3.6 billion. As of December 31, 2016, put and call options for TBAs had a fair market value of $42.6 million included in derivative assets, at fair value, on the consolidated balance sheet. The Company did not hold any put and call options for TBAs as of December 31, 2017.
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. As of December 31, 2017 and December 31, 2016, 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 three-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
December 31, 2017
Swaps Maturities
 
Notional Amount (1)
 
Weighted Average Fixed Pay Rate (2)
 
Weighted Average Receive Rate (2)
 
Weighted Average Maturity (Years) (2)
2018
 
$
4,320,000

 
1.155
%
 
1.508
%
 
0.50
2019
 
5,448,135

 
1.767
%
 
1.386
%
 
1.79
2020
 
5,490,000

 
1.945
%
 
1.509
%
 
2.87
2021
 
2,417,000

 
1.788
%
 
1.628
%
 
3.92
2022 and Thereafter
 
5,245,000

 
1.764
%
 
1.516
%
 
6.44
Total
 
$
22,920,135

 
1.694
%
 
1.493
%
 
3.01

(notional in thousands)
 
 
 
 
 
 
December 31, 2016
Swaps Maturities
 
Notional Amount (1)
 
Weighted Average Fixed Pay Rate (2)
 
Weighted Average Receive Rate (2)
 
Weighted Average Maturity (Years) (2)
2018
 
$
2,375,000

 
0.765
%
 
0.934
%
 
0.59
2019
 
5,340,000

 
1.232
%
 
0.945
%
 
1.59
2020
 
350,000

 
1.283
%
 
0.895
%
 
2.44
2021
 
1,460,000

 
1.481
%
 
0.920
%
 
3.74
2022 and Thereafter
 
5,782,063

 
1.984
%
 
0.955
%
 
6.17
Total
 
$
15,307,063

 
1.441
%
 
0.943
%
 
3.24
____________________
(1)
Notional amount includes $570.0 million and $777.1 million in forward starting interest rate swaps as of December 31, 2017 and December 31, 2016, respectively.
(2)
Weighted averages exclude forward starting interest rate swaps. As of December 31, 2017 and December 31, 2016, the weighted average fixed pay rate on forward starting interest rate swaps was 2.1% and 2.0%, respectively.

Additionally, as of December 31, 2017 and December 31, 2016, 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 three-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
December 31, 2017
Swaps Maturities
 
Notional Amounts
 
Weighted Average Pay Rate
 
Weighted Average Fixed Receive Rate
 
Weighted Average Maturity (Years)
2020
 
$
200,000

 
1.391
%
 
1.642
%
 
2.60
2021
 
500,000

 
1.357
%
 
1.327
%
 
3.05
2022 and Thereafter
 
4,861,990

 
1.475
%
 
2.325
%
 
8.34
Total
 
$
5,561,990

 
1.462
%
 
2.211
%
 
7.66
(notional in thousands)
 
 
 
 
 
 
December 31, 2016
Swaps Maturities
 
Notional Amounts
 
Weighted Average Pay Rate
 
Weighted Average Fixed Receive Rate
 
Weighted Average Maturity (Years)
2019
 
$
575,000

 
0.911
%
 
1.440
%
 
1.89
2020
 
500,000

 
0.882
%
 
1.042
%
 
2.06
2021
 
510,000

 
0.881
%
 
1.580
%
 
3.59
2022 and Thereafter
 
3,479,000

 
0.963
%
 
2.137
%
 
5.52
Total
 
$
5,064,000

 
0.941
%
 
1.894
%
 
4.57


Interest Rate Swaptions. The Company may use 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) independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. As of December 31, 2017 and December 31, 2016, the Company had the following outstanding interest rate swaptions that were utilized as macro-economic hedges:
 
 
December 31, 2017
(notional and dollars in thousands)
 
Option
 
Underlying Swap
Swaption
 
Expiration
 
Cost Basis
 
Fair Value
 
Average Months to Expiration
 
Notional Amount
 
Average Pay Rate
 
Average Receive Rate
 
Average Term (Years)
Purchase contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
< 6 Months
 
$
21,380

 
$
17,736

 
4.03

 
$
7,200,000

 
2.27
%
 
3M Libor
 
3.8
Receiver
 
< 6 Months
 
$
4,660

 
$
2,982

 
3.72

 
$
2,300,000

 
3M Libor
 
2.10
%
 
10.0
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sale contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
< 6 Months
 
$
(7,950
)
 
$
(5,619
)
 
4.66

 
$
(1,693,000
)
 
2.70
%
 
3M Libor
 
10.0
Receiver
 
< 6 Months
 
$
(16,260
)
 
$
(4,694
)
 
5.17

 
$
(5,141,000
)
 
3M Libor
 
1.89
%
 
5.6
 
 
December 31, 2016
(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)
Purchase contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
< 6 Months
 
$
29,360

 
$
42,149

 
1.22

 
$
4,500,000

 
2.16
%
 
3M Libor
 
4.8
Payer
 
≥ 6 Months
 
13,655

 
792

 
6.70

 
300,000

 
3.50
%
 
3M Libor
 
10.0
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sale contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
< 6 Months
 
$
(51,355
)
 
$
(1,414
)
 
5.81

 
$
(500,000
)
 
3.40
%
 
3M Libor
 
10.0
Payer
 
≥ 6 Months
 
(29,893
)
 
(938
)
 
6.77

 
(300,000
)
 
3.50
%
 
3M Libor
 
10.0
Receiver
 
< 6 Months
 
$

 
$
(2,353
)
 
2.30

 
$
(3,775,000
)
 
3M Libor
 
1.19
%
 
4.9


Markit IOS Total Return Swaps. The Company may use total return swaps (agreements whereby the Company receives or makes payments based on the total return of an underlying instrument or index, such as the Markit IOS Index, in exchange for fixed or floating rate interest payments) independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. The Company enters into total return swaps to help mitigate the potential impact of larger increases or decreases in interest rates on the performance of our portfolio (referred to as “convexity risk”). Total return swaps based on the Markit IOS Index are intended to synthetically replicate the performance of interest-only securities. The Company had the following total return swap agreements in place at December 31, 2017 and December 31, 2016:
(notional and dollars in thousands)
 
 
 
 
 
December 31, 2017
Maturity Date
 
Current Notional Amount
 
Fair Value
 
Cost Basis
 
Unrealized Gain (Loss)
January 12, 2043
 
$
(24,362
)
 
$
(24
)
 
$
201

 
$
(225
)
January 12, 2044
 
(39,145
)
 
(82
)
 
366

 
(448
)
Total
 
$
(63,507
)
 
$
(106
)
 
$
567

 
$
(673
)
(notional and dollars in thousands)
 
 
 
 
 
December 31, 2016
Maturity Date
 
Current Notional Amount
 
Fair Value
 
Cost Basis
 
Unrealized Gain (Loss)
January 12, 2043
 
$
(45,083
)
 
$
(5
)
 
$
320

 
$
(325
)
January 12, 2044
 
(45,510
)
 
(12
)
 
366

 
(378
)
Total
 
$
(90,593
)
 
$
(17
)
 
$
686

 
$
(703
)


Credit Risk
The Company’s exposure to credit losses on its Agency RMBS portfolio is limited due to implicit or explicit backing from the 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 residential 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 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 and residential mortgage loans.
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, 2017, the fair value of derivative financial instruments as an asset and liability position was $309.9 million and $31.9 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 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, in the case of centrally cleared interest rate swaps, 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 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 interest rate swap’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. As a result of amendments to rules governing certain central clearing activities, the exchange of variation margin is a settlement of the interest rate swap, as opposed to pledged collateral. Accordingly, beginning in the first quarter of 2018 and in subsequent periods, the Company will account for the receipt or payment of variation margin as a direct reduction to the carrying value of the interest rate swap asset or liability. As of December 31, 2017 and December 31, 2016, variation margin pledged or received 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.
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 Agency RMBS.
Inverse Interest-Only Securities. As of December 31, 2017 and December 31, 2016, inverse interest-only securities with a carrying value of $91.8 million and $127.8 million, including accrued interest receivable of $0.9 million and $1.2 million, respectively, are accounted for as derivative financial instruments in the consolidated financial statements. The following table presents the amortized cost and carrying value (which approximates fair value) of inverse interest-only securities as of December 31, 2017 and December 31, 2016:
(in thousands)
December 31,
2017
 
December 31,
2016
Face Value
$
588,246

 
$
740,844

 
 
 
 
Amortized Cost
$
86,734

 
$
109,762

Gross unrealized gains
6,843

 
18,389

Gross unrealized losses
(2,602
)
 
(1,552
)
Market Value
$
90,975

 
$
126,599